Can we really call a Valuation Ceiling?

The Passover holiday starts this evening, and children in Jewish households around the world will be preparing for a traditional rite of passage in reciting the Four Questions to their elders. Investors watching the two month long rally in equity markets may well have a question of their own: Why is this rally different from all other breakout rallies since the S&P 500 reached an all-time high of 2,130 nearly one year ago, in May 2015? To put it a different way, is there anything plausible to suggest a sustained move above a fiercely resistant valuation ceiling? After the three year-plus multiple expansion rally topped out last year, there have been five upside breakout attempts that have fallen short, including the current one thus far. The chart below illustrates this topping-out effect.

Tiptoeing Over the Low Bar

Much of the current focus is, rightfully, on first-quarter earnings. There are two ways to interpret the results that have come in so far (about 27 percent of all S&P 500 companies have reported Q1 earnings as of today). The first is the expectations game: a number of firms thus far have managed to clear an exceedingly low expectations bar. Back in December, the consensus among analysts was that earnings per share growth would be more or less flat for the first quarter. Today, the same analysts expect Q1 EPS to decline by nine percent from their levels one year ago, when all is said and done. So all that a company has to do in order to give the market an “upside surprise” is to report earnings slightly higher than these sharply reduced expectations.

We have seen this reduced expectations narrative play out among early reports in the financial and metals & mining sectors, two of the more beaten-down industry groups of late. For example, the market takeaway from JPMorgan Chase (NYSE:JPM), which led off earnings for the major banks last week, could be summed up thus: “bad, but could have been worse.” Bank stocks rallied sharply following the JPMorgan release, and were no less giddy a week later when Goldman Sachs (NYSE:GS) reported a decline of 56 percent in net income from the period one year ago. If bad news is not awful news, it must be good news, the convoluted logic seems to go.

Math Is Still Math

The second way to interpret Q1 earnings results is to ignore the Kabuki-like theatrics of the expectations game and point out that, however you want to frame the context, low earnings are still low earnings. Stocks are therefore still expensive. At the beginning of 2012, the ratio of the S&P 500 price index to average earnings per share for the last twelve months (LTM P/E) was 12.4 times. Investors would pay $12.40 for each dollar of average per share earnings. Over the subsequent three and a half years, the LTM P/E ratio jumped from 12.4 times to 18.1 times – a “multiple expansion” rally where prices grow faster than earnings.

Today, despite two market corrections of more than 10 percent and the repeated failure to regain last year’s high water mark, the S&P 500 is as expensive as it was a year ago. It is more expensive than it ever was at the peak of the previous bull market of 2003-07. It is even dearer on a price-to-sales (P/S) basis; the current LTM P/S ratio of 1.8 times is the highest this ratio has been since the immediate aftermath of the late-1990s tech bubble.

Animal Spirits, to a Point

The fact that the market remains expensive does not necessarily preclude a breakout to the upside into new record high territory. Stranger things have happened; asset markets are the stomping grounds of John Maynard Keynes’ “animal spirits” far more than they are the purview of the fictitious rational actors of economics textbooks. The vague but often telling indicator of investor sentiment seems tilted to the upside. The question, though, is how sustainable a strong upside breakout would be in the absence of improvement in corporate earnings prospects.

We are unlikely to see the earnings math for Q1 make much of a compelling growth case. It remains to be seen whether some of the headwinds that have clipped sales and earnings prospects of late will abate further into the year – perhaps driven by a softer US dollar and a demand pickup in key consumer markets. Until then, we tend to believe that this rally is not much different from the four post-high rallies which preceded it, and that it would be a good idea to keep one’s animal spirits in check. Not in a defensive crouch, but in check.

Why the Oil Rally is Over for now

Edward Tj GeretylOil prices (NYSEARCA:OIL) have increased substantially from the February lows in the 20s, but I believe further substantial oil price increases are unlikely for the foreseeable future, due to a number of reasons.

The first point that will prevent oil prices from rising much is the current supply and demand situation: Supply outstripped demand for the past quarters, which was the reason for the huge oil price decline in the first place. Despite a lot of analysts claiming that the supply-demand imbalance would dissolve in a short time, there is still a substantial surplus in oil production (versus oil consumption).

Edward Tj Gerety

Data from the EIA (from March 2016) shows that global consumption is still lacking behind global production by a rather wide margin: Q1’s daily global production is seen at 95.6 million barrels a day, whereas consumption is seen at 93.7 million barrels a day, which means the supply-demand gap still sits at 1.9 million barrels a day despite oil prices being down for well above a year now.

Even in Q4 of 2017, global oil supply is seen slightly above global oil demand, although the gap is forecasted to have narrowed down to 0.1 million barrels a day. Nevertheless, this means that the EIA believes that oil supply will remain “too high” for the next two years, which will prevent prices from increasing much above the current level.

Edward Tj Gerety

US oil production has declined slightly over the past months, after topping at 9.6 million barrels a day last summer. Yet, the 0.6 million production decline we have seen since is not nearly big enough to balance global oil supply and demand, especially since a lot of other producers are not cutting production at all.

Edward Tj Gerety III

As we see in this table, OPEC has increased production drastically over the last year, upping its daily production level from 30.8 million barrels of oil to 32.3 million barrels of oil (or 1.5 million barrels a day, more than twice the reduction in the US from peak levels). This does not even include the future ramp up of Iranian oil production yet, which is likely to affect OPEC’s 2016 and 2017 production levels substantially.

Russia has increased its oil production as well; Russian oil production has hit a record high in January (production in the country stood at 10.9 million barrels a day).

The Russia-OPEC freeze thus does not matter a lot since the countries involved basically agreed to freeze production at record highs, which will mean production (from these countries) will not increase further, but will likely not decline either, which means the supply surplus will remain unchanged.

Major oil companies also keep increasing production at a rather high pace, mainly due to large investments in the past years, which results in major projects coming online now:

Company Production in Q4 2015 versus prior year
Exxon Mobil (NYSE:XOM) 4.25 million barrels a day up 4.8%
Chevron (NYSE:CVX) 2.67 million barrels a day up 3.5%
Shell (NYSE:RDS.A) (NYSE:RDS.B) 3.04 million barrels a day down 5.0%
BP (NYSE:BP) 3.40 million barrels a day up 5.9%
Total (NYSE:TOT) 2.35 million barrels a day up 5.5%
Combined 15.71 million barrels a day up 3.0%

In this table, we see that Exxon Mobil, Chevron, Shell, BP and Total increased their production by a combined three percent, or about 0.5 million barrels a day over the last year. In other words, the production increases of these five companies alone are big enough to offset the effect of lower US oil production almost entirely (US production declined 0.6 million barrels from the peak).

We can thus conclude that the supply-demand gap, which is the major reason for the oil price downturn we have seen over the last two years, is not closed at all, and will not be closed for the foreseeable future.

Takeaway

US production has declined slightly from its peak last summer, but this was more than offset by production increases from OPEC countries as well as Russia. Major oil companies also increased their production by half a million barrels a day over the last year.

With the Iran production ramp up not showing up in these numbers and OPEC and Russia not agreeing on any production cuts (just on a freeze at the current record high levels), I believe global supply will continue to outstrip global oil demand, which will mean oil prices will not rise much from the current level until this imbalance narrows down substantially, which could mean a couple of more quarters (or possibly years) of oil prices trading around the current levels.

Disclosure: I have positions in ExxonMobile and BP

Reasoning why not to trust those GDP numbers

Edward Tj Gerety

An in-depth analysis of the government’s reports on gross domestic product suggests large and persistent errors that should give investors, business executives and policymakers pause in relying on the data for key decisions.

Looking at each quarterly report going back to 1990 and found an average error rate of 1.3 percentage points. So an initial report of 2 percent growth on average later would be revised to 3.3 percent or 0.7 percent.

The research does not show any systematic overstatement or understatement of growth, just persistently large revisions.

Also found:

  • The error rates in the second and third estimates of GDP are the same as the first. So despite more time and data, the error rates will be just as large three months after the end of the quarter as they are one month afterward.
  • About 30 percent of the time, the government gets the direction of growth wrong. That is, GDP initially shown to be higher than the previous quarter could in fact be lower, and vice versa.
  • The error rates haven’t improved over the decades despite vast improvements in computing power and communications speeds. The size of the revisions from 2008 to 2013 is the same as those from 1990 to 1995.

The errors have potentially important policy implications. On April 30, 2008, with the Great Recession just gathering steam, the Federal Reserve cut interest rates by one-quarter point to 2 percent. That same day, the Bureau of Economic Analysis, the agency that produces the GDP report, announced that the economy was growing an anemic 0.6 percent but still growing.

But in subsequent years, that GDP growth would be revised to show a contraction of 2.7 percent, the biggest decline in 17 years. While the Fed was acting aggressively in bringing down rates, the question is whether it might have done more had it known the severity of the decline earlier. (By the end of the year, an initial report of a contraction of 3.4 percent would be revised to show a massive decline of 8.2 percent.)

It can go the other way and have political ramifications.

In the second quarter of 1992, as President George H.W. Bush was running for re-election, growth was reported at a pedestrian 1.4 percent. It would be revised up in subsequent years, after the election of Bill Clinton, to a strong 4.5 percent.

The findings raise warning signs for investors, policymakers and business executives about reacting too strongly to the initial government reports on economic growth.

Those warnings are especially important now that the trend growth rate has slowed to just around two percent. They raise questions about whether signals from the stock and bond markets provide better clues to the direction of the economy and whether the government could improve its reporting by incorporating the growing mass of private sector data.

They also make some wonder if government data agencies should be better funded.

The majority of economists contacted did not know the error rate and most guessed an amount half of that calculated. Some were off by two-thirds.

The government publishes three initial versions of GDP: the “advanced” report, about a month after the end of the quarter, the second estimate, published two months after the end of the quarter, and the third estimate, published about three months after a quarter’s end. The research shows the error rate of all three releases is about the same 1.3 percentage points.

“That is something I’ve been concerned about, too,” said Brent Moulton, associate director for national economic accounts at the Bureau of Economic Analysis.

“We’re working to try to get more accurate data in time to improve the advance GDP estimate,” including faster data on wages from the Bureau of Labor Statistics, he said.” Revisions are not errors they represent improvements to the GDP estimate as more information becomes available.”

Moulton’s agency publishes an average error rate for only the advanced report, compared with where the number will be revised to years later. That error rate, which appears as an end note to each “advanced” report, is virtually the same one as the one calculated.

The agency, however, does not routinely publish an error rate for the second and third releases relative to the revisions in later years. It did publish a report on the overall accuracy of the GDP and all its versions in 2014.

Mark Zandi, chief economist at Moody’s Analytics who was among the economists, was surprised that the error rate did not improve from the advance to the third release. He figured, as did others, the third estimate would be better than the first.

Moulton said the large revisions result from new information that his agency receives over time. For example, it takes a year before the agency gets more complete wage data and another year before it receives data from the Internal Revenue Service; after five years, the bureau has data from the broad economic census, which it uses to go back and revise GDP.

The bureau changes its methodology from time to time, for example, altering how it adjusts different parts of the data for seasonality.

Moulton says the bureau has been working to speed up the data it receives. Trade data that once took 45 days is now received in 30 days. It’s also working on a way to speed up collecting inventory data, which is often a big swing factor in revisions.

Moulton noted that revisions are often largest around turning points in the economy, like when it’s entering or exiting recession, as it was in 1992 and in 2008. And some variables are outside its control.

For example, individuals and companies are always going to file tax data late, receive extensions and amend returns. Corporate returns are often complicated.

Outside economists do not envy the bureau’s task of measuring production in the $18 trillion U.S. economy. Over time, as the economy has become more service-oriented, it’s become harder to measure actual output, especially when the measures include complex ideas like intellectual property.

“It’s a more complex and esoteric economy,” Zandi said.

For example, the economy used to be far more reliant on manufacturing, and measuring the value of automobiles produced is far easier than measuring the value of the fast-growing health care and education service sectors of the economy.

But with trend growth only two percent, an error rate of 1.3 percentage points presents a danger for policy errors.

Officials said they tend to rely more heavily on the jobs data than the GDP data, especially when they contradict each other, as is now the case. Fed officials tend to use running quarterly averages rather than a single quarter to gauge the direction of the economy.

Indeed the work shows that a more accurate picture emerges when four quarters are averaged together.

A study by the Organization for Economic Cooperation and Development found the U.S. about middle of the pack compared with other advanced countries on its error rates. The 2014 study by the Bureau of Economic Analysis itself suggests that over long periods of time, like five to ten years, the BEA fairly accurately portrays growth.

Interestingly, it has a pretty good handle on the biggest part of the economy, the consumer. The revisions to consumptions over time are relatively small, including revisions to services. The biggest error rates are in business investment including equipment and intellectual property.

One irony is that the government data collectors have to go back and continuously revise the impact of government spending on GDP, which is to say, the government is not fully accurate in counting the government.

Chinese Regulators Completely Missed the Entire Concept of Regulating

Edward Tj GeretyOn July 8 of last year, the Chinese Securities Regulatory Commission (CSRC) put in place a six-month ban on larger shareholders (those with over 5 percent of the stock) from selling. The impact is that well over 75 percent of shareholders were banned from selling. As the Chinese economy continued a slow decline, these shareholders were increasingly nervous. Many wanted to sell, but due to CSRC’s regulatory fiat, were unable to do so.

This week, many thought, would end the troublesome circumstance. However, other shareholders, fearing that enormous selling pressure was about to commence (perhaps as much as 150 billion yuan, which is about U.S. $23 billion) began bolting. They sold and sold and sold. On Monday, new circuit breakers (price collars or limit ups or downs on how much the market could rise or fall) were hit and paused trading on the Shanghai Composite Index. On Thursday, the seven percent threshold was reached, halting all trading, less than half an hour in the entire trading day.

What all this says is more about getting the right balance between free markets and appropriate regulation than anything else. Regulators should not be in the business of trying to impact prices or trading. They should be stock or commodity blind and price neutral. The CSRC, perhaps well-intentioned, massively missed that mark by mandating a majority of stocks would not trade for months. That pressure has brought about, along with the declining Chinese economy, a record-breaking negative beginning to the year in Chinese stocks, which has also impacted other markets around the world.

To make matters worse, the CSRC has now determined that the circuit breakers are not in force. This could result in extreme volatility (time will tell). They have gone from being too prescriptive with poorly calibrated circuit breakers, to having no circuit breakers whatsoever! Meanwhile, they haven’t indicated when or if shareholders will be able to sell…creating even more uncertainty. (By the way, if you didn’t have Chinese stock, who would want to trade in such a market?)

In the U.S., as a result of Black Tuesday in 1987, circuit breakers were put in place. Those have continually been recalibrated. In 2012, following the Flash Crash of 2010, I worked with my financial regulatory colleagues to put in place harmonized circuit breakers in future and equity markets. They have, knock on wood, worked fairly well. That said, we learned after being burned. The same is taking place now in China.

Balancing a free market and prescriptive regulatory approach is a delicate task. The CSRC clearly hasn’t found that balance. That might be acceptable if it only impacted China, the world’s second largest economy, but it also impacts the rest of the world. Let’s hope they get it together soon.

All of this makes a stronger case than ever for having global market regulatory structures which are more harmonized. Today, we have international markets which operate 24-7-365. While no induvial national regulator has a requirement to harmonize with other national regulators, which is clearly what is needed. Such is true not only with regard to circuit breakers, but with regard to all other financial regulation.

The Markets are Crumbling but You can save by Refinancing

Edward Tj GeretyYou may be losing your shirt in the stock market this week, but you could get a leg up on your home loan. As investors flee stocks, they are heading to bonds, and as a result, mortgage interest rates are falling. Mortgage rates ended 2015 at their highest level in nearly six months, but have since dropped precipitously.

Bond markets continue defying the odds so far in 2016, because it is considered a safer investment. Higher demand means lower yields. Lenders price according to the yields on mortgage-backed bonds, which generally follow the 10-year Treasury.

Mortgage rates do not follow the Federal Reserve funds rate, but most expected that as the Fed raised rates, mortgage rates would rise as well. This has more to do with an improving economy, which would be behind both.

Given the Fed rate hike and strong ADP data yesterday — among other reasonably decent economic anecdotes — we would be more justified in expecting bonds to be under pressure at the start of the year, but rather the drop in rates is a pleasant surprise.

The average rate on the popular 30-year fixed mortgage is now just below 4 percent for the most credit-worthy borrowers. Applications to refinance a loan had dropped dramatically in the last two weeks of 2015 amid higher interest rates, but this move lower could create a new opportunity for thousands of borrowers who have yet to refinance at a lower rate.

There are not many regular borrowers who would benefit from the current rates, given the refinance boom of the last three years, when rates were hovering around record lows. There are, however, nearly 430,000 borrowers who could still benefit from the government’s HARP refinance program, according to the Federal Housing Finance Agency. This is for borrowers who still owe more on their mortgages than their homes are worth, commonly known as “underwater.” Their loans must be government-backed. Why so many still?

“They may be in a good financial position, able to make their monthly payments and don’t want to mess with it,” said Andrew Wilson, Fannie Mae’s chief spokesman. “There are always some number of people that just never do, and the question is why not?”

These borrowers are leaving money on the table. They could also refinance into shorter term loans, paying off principal more quickly. Even if rates don’t move much lower, refinancers could benefit from a slow easing in the credit markets.

“That would open refinancing up to homeowners shut out of the mortgage market over the past few years because of their credit scores, debt-to-income ratios, income, assets or lack of equity,” said Guy Cecala, CEO and publisher of Inside Mortgage Finance. An improving economy and rising home prices could open up re-fi’s to borrowers with higher rate mortgages who have been forced to the sidelines for several years.”

Let the Sell-Off Continue

Edward Tj GeretyFollowing a strong close yesterday, U.S. index futures were nicely in the green for most of the overnight session, but began taking on water a couple of hours ago, and are now down about 0.6% across the board.

Asia closed with modest losses as Beijing’s move to prop markets sent Shanghai higher by about 3% in that market’s final hour (it still closed down 0.25%). Europe’s given up early gains and is now modestly lower.

The 10-year Treasury yield is down three basis points to 2.23%, gold is up $4 per ounce to $1,079, and oil is down $0.12 per barrel to $36.63.

The Rise of Plastic

bottleThe past, present and future of plastic production.

1. Plastic was first invented in the 1860s and developed for industry in the 1920s.

2. Plastic production exploded in the 1940s, when it became one of the fastest-growing global industries.

3. About 299 million tons of plastics were produced in 2013, a 3.9% increase over 2012. Global production of plastic has continued to rise for more than 50 years.

4. From 1950 to 2012, plastics growth averaged 8.7% per year, rising from 1.7 million tons to the nearly 300 million tons of today.

5. Worldwide production grew as plastics gradually replaced materials like glass and metal in many consumer goods.

6. Plastics are synthetic materials manufactured from polymers, or long chains of repeating molecules.

7. They are derived from oil, natural gas, and recently from plants like corn and sugarcane.

8. Plastics made from plants still represent only a small portion of overall production.

9. About 4% of the petroleum consumed worldwide each year is used to make plastic, and another 4% is used to power plastic manufacturing processes.

Are radical Islamists heirs to Russian Nihilists?

Edward Tj GeretyOne of the first modern terrorist organizations emerged in the Russian Empire in the second half of the 19th century.

Underground bomb throwers in the Nihilist and People’s Will cells numbered in the thousands and for the first time in history, they developed a comprehensive political program, spelling out what their terror campaign planned to achieve and by what means.

They were not seeking revenge against the more odious government or police officials. Nor were terror attacks a way to improve the lives of the people by making the government treat them better.

It was in fact the exact opposite. As Lenin would later put it, “The worse, the better.” The radicals actually wanted the poor to suffer even more and the State to tighten the screws more severely.

Eventually, once conditions became untenable, the terrorists expected people to rise up, overthrow the government and build that wonderful society in which everyone would be equal, happy and there would be no violence.

People’s Will terrorists mounted a hunt for Czar Alexander II – not because he was a reactionary, but because he was too liberal. He had abolished serfdom and was about to institute the first elected body in Russia.

Predictably, a period of reaction followed his assassination in March 1881 and his reforms were rolled back. A quarter of a century later, in 1905, Russia exploded in its first revolution.

Terrorist acts in Russia succeeded with depressing regularity, with an astonishing number of top government officials assassinated in the years before World War I.

Terrorism polarized society and unleashed waves of repression. It made reforms and modernization very difficult and created an environment in which moderates and liberals were squeezed out.

There was no room for national reconciliation, only for further radicalization. Lenin’s older brother Alexander Ulyanov was involved in a plot to assassinate Alexander III and was hanged in 1887 – an event that scarred his 17 year-old brother’s psyche.

Corrosive effect on society

The brutality of Russia’s Civil War in which both sides committed unspeakable atrocities and some 1.5 million military personnel and 8 million civilians lost their lives, was certainly exacerbated by this radicalization.

The Bolsheviks, while never shy of employing terrorist means and, especially, state terror, understood terrorism’s corrosive effect on society.

After the 1917 revolution they found themselves in a tricky situation. They had to acknowledge their debt to early leftist terrorist movements. A central thoroughfare in St. Petersburg was named after Stepan Khalturin, a terrorist who blew up the Winter Palace in 1880 in an attempt to kill the Czar but got 11 soldiers instead.

At the same time, Soviet leaders were obsessed with their own protection and never tired of telling people that terrorism was extremely ineffective as a means of political struggle. However, terrorism is, in fact, deadly effective and it can change the course of history.

Just one example: the modern world emerged from the ashes of World War I and the war itself was a direct result of the assassination of Archduke Franz Ferdinand, the heir to the Austrian throne, by a Serbian terrorist. In our own time, many people in the United States refer to the “post-9/11 world.”

Russian terrorism has had a formative influence on the goals of modern terrorist organizations.

Terrorists everywhere deliberately strive to worsen the condition of the very groups whose cause they claim to champion. They sow hatred and fear and they want to destroy any chance for compromise. They want a war to the death.

Unfortunately, all too often, they provoke the kind of reaction they want — more hatred and more repression. It can even be said that terrorists are among the few effective “politicians” of the modern era.

Conflict of civilizations

Palestinian terrorists started up by blowing civilian airliners and killing Israeli civilians, including children and Olympic athletes. Their goal was never to bring about a peaceful solution to the Israeli-Palestinian conflict, but to make the Israelis hate Palestinians indiscriminately.

They wanted the conflict to drag on and both sides to engage in a tit-for-tat retribution so that the only way in the end would be a complete destruction of one of the nations. It has to be admitted that they are succeeding. The two sides are much further apart today than they were half a century ago.

The Red terror of the 1970s and 1980s in Italy and Germany pursued a similar goal.

Terrorist cells targeted police and government officials with the express purpose of bringing about a fascist dictatorship, which they believe capitalism would resort to in the end. Only then, they argued, would the working class be radicalized enough to stage a socialist revolution.

Al-Qaeda and ISIS similarly want the West to take revenge not only upon them, but also on all Muslims indiscriminately.

They want us to harass Muslims in our midst and to look at every dark-haired bearded man with fear and suspicion. They want Muslim kids to be unemployed and undirected. They want a conflict of civilizations.

True, there are huge differences between today’s ISIS terrorists and their Russian precursors of 150 years ago. The Nihilists, irrespective of their means, believed in the bright future of universal equality, freedom and happiness.

They believed in science, education and progress and rejected religion because it kept the masses ignorant and superstitious. They promoted equality between the sexes.

Muslim radicals are exactly the opposite. They are looking back to the Middle Ages and to traditional customs sanctified by the Quran. They reject modern science and education. Their views on the place of women in society are retrograde.

Differences and similarities

One big difference is that Russian terrorists never targeted the civilian population — something radical Muslims do time and again. But this is a false distinction. Theorists and practitioners of leftist terrorism never allowed an innocent life to stand in the way of the “bright future.

On the other hand, there are plenty of similarities, ranging from intolerance for moderation and compromise, to disdain for the cultural heritage of human civilization.

Russian leftists a century ago regarded “bourgeois culture” as decadent and depraved and promised to create their own cultural and artistic monuments — while destroying the old ones in the meantime.

ISIS thinks the same about the modern West and even the classical Greco-Roman world. It is keen to blow up priceless historical monuments in Palmyra and elsewhere.

All terrorists think of themselves as a sacrificial vanguard, ascetics and martyrs dedicating their lives to their cause – the image that was promoted by the early Russian theorist of terrorism Sergei Nechayev.

But most importantly, all terrorists share the ability to deceive themselves and indulge in magical thinking. They believe that violence, by breeding even more violence, can somehow bring happiness.

 

Eurasia is a large part of the world. In a few decades, it will be the principal driver of the global economy

Edward Tj GeretyThis summer, for the first time, financial turmoil in China created turbulence around the world and even hit New York. This is a historic event and is a portent of things to come.

Yes, China fumbled. It could have avoided certain obvious mistakes which many saw coming, but the Chinese will learn from it. What the episode shows is how the relative weights are shifting in the world way beyond just trade.

China still accounts for less than 15% of global GDP, but its contribution to global growth last year was in the range of 40%. So when that growth slackens, pretty much everyone around the world feels it.

Not surprisingly, people all over the world are concerned about China’s prospects. Is this the beginning of a decline? Are the internal contradictions sharpening, portending further, more serious problems?

In my view, China’s prospects are good. The closer you are to China, the more you feel that.

The more you visit China, the more you realize that, despite all the problems, the country is organically still in the phase of growth.

In terms of aggregate demand, it will take many more years before the Chinese economy has a big enough domestic consumption sector to replace investment as the principal driver – and that consumption must increasingly shift to services.

Coastal China has become very expensive, more expensive than all of Southeast Asia, except Singapore, so the factories that were in China for quite some time have moved down to Southeast Asia. The Chinese government wants to move some of them inland to develop inner China. These are long-term trends.

For the time being, the Chinese will still need investments to maintain sufficient growth. There are still many things to be done, many areas to be opened up, but the pace of future growth will no longer be as dramatic.

This is why President Xi Jinping’s initiative “One Belt, One Road” is of huge importance – not as an immediate plan, but as a long-term approach toward China’s development.

To begin with, China has all this excess capacity in steel, cement, factories producing rolling stock and so on – which can be applied to great use linking China to its neighbors.

This growing connectivity of China to its neighbors deep into Eurasia is a story of epic proportions, which is why we should follow it closely.

Building Global-Asia Connectivity

Consider that earlier this year China established a rail link to the Persian Gulf via Kazakhstan, Turkmenistan and Iran. With the opening of Iran, the dynamics across a large part of Asia will change.

Remember that, throughout history, Imperial China and Imperial Persia always had good relations – two high civilizations maintaining peace in the region. You will see this relationship revivified, not least in view of pent-up demand in Iran.

But China, ever a comprehensive, long-term planner, is proposing or already executing enormous railroad expansion – to the Gulf of Thailand, to the Andaman Sea, to the Arabian Gulf (through the Khunjerab Pass to Gwadar), to the Black Sea, to the Baltic Sea and all the way to the North Sea.

Early this year, China and Russia agreed in principle to build a fast train connecting Moscow and Beijing probably through Kazakhstan.

The distance between these two cities is 7,000 km, and the journey is supposed to take less than two days!

How can one justify such an investment? Of course, one cannot – if one just looks at the proposition on the basis of earnings from freight rates and passenger fares. But all these calculations about the economic feasibility change profoundly if, along the way, one builds a belt of cities.

This is why the words “One Belt, One Road”, announced by President Xi first in Astana in October 2013, and then in Jakarta in November 2013, are far more than a slogan. They represent a strategic reorientation.

“One Belt, One Road” goes way beyond being a plan on paper. It is intended to create a huge flow, a 21st century revival of the old overland and maritime silk roads, at the end of which we are going to find all of Eurasia crisscrossed by connections.

Using a biological metaphor, the growth of these connections is like angiogenesis in the human body.

First the vessels grow, then logistics companies provide the blood circulation — and development of organs follows.

Importance of AIIB

Eurasia is a large part of the world, and it will, in a few decades from now, be the principal driver of the global economy.

This is why the AIIB is so important. Many analysts saw its establishment as a power move against the United States, contesting the Bretton Woods institutions.

That may be a collateral effect but it is not the main purpose of the AIIB, which is an absolute economic and financial necessity.

Even so, this new institution can only supply a small part of what is required to finance all the infrastructure needed, which will be in the trillions of dollars.

Although it is not yet said, one day we may find the Chinese rail system and Indian rail system linking up through the Nathu La Pass. It is a gap of a few hundred kilometers and shorter than the one between the Chinese and Pakistani rail systems that are being connected.

Politically, the time is not right to talk about it, but watching the developing relations between China and India, it is no longer something to be dismissed.

The development of China-India relations is of great historical importance because of their large populations. Together they comprise some 40% of the world’s population.

When Indian Finance Minister Arun Jaitley was asked recently in Singapore how India could benefit from the crash in the Shanghai stock market, he replied that India did not see relations in zero-sum terms. He added that China’s growth was good for India and vice versa.

Developments in China

China knows that to improve the productivity of its real economy, it must deepen and liberalize its capital markets.

Inefficiencies there have led to inefficient SOEs, causing all kinds of problems in the country.

Despite the recent financial turmoil, this strategic intent to deepen capital markets will not be deflected.

The Chinese will learn from their mistakes and they will have to experiment along the way, because they are doing things which no other country has done.

The internationalization of the Renminbi is a case in point. This is not an easy maneuver to execute.

The Chinese are now attempting to create two separate oceans of renminbi – one within China, which is the much larger one, and another outside China (of which London is determined to be a major financial center).

The two are connected through portals like Hong Kong and, to a lesser extent, Singapore. Between the two oceans are tidal barrages like the ones protecting Venice.

If there is financial turbulence outside, the barrages can come up to protect the inland ocean until the storm subsides. The engineering is obviously complex and may not be foolproof.

Why can’t China allow the internationalization of other currencies like other major countries? To understand this we have to go back to the long history of China and the difficulty of governing a large part of the world’s population.

Whoever governs China must always be able to exercise some control over its own internal destiny.

In the second half of the 19th century, after the second opium war, western customs officers inspected any ship landing on the China coast. By the late Qing dynasty, China had lost control of its monetary system and therefore an important part of its sovereignty.

China will not allow this again. But managing the renminbi properly will not be easy because, if the two oceans are at different levels, there is a permanent arbitrage opportunity. Mistakes will be made, but the Chinese are learning. It is a deep imperative.

Recession not likely

What about fears that China will go into recession? This is not likely. Its growth will slow down, maybe to 6%, or even 5.5%, but is now on a very high base of a GDP of about $10 trillion.

That the slowdown in China is causing alarm around the world is because of the lack of aggregate demand powering the global economy. Despite easy money in the last seven years, the global economy has still not performed well.

Central bankers fear that if they withdraw the liquidity, asset markets will implode, bubbles will burst, and the real economy will spiral downwards.

Europe is still floundering. Earlier this year, freight rates per container from China to Europe went down to $200. This has never been seen before and it may take a bit of time before Europe recovers.

The United States is looking better but the Fed’s nervousness cannot be without reason. Better policy coordination with China will help but it is no guarantee that the global economy may not plunge into another crisis.

It will take many more years before the Chinese economy, together with other developing economies, become big enough to make up for insufficient demand in the mature economies.

China is probably the only major country in the world today which is able to exercise a national will on a range of subjects.

This is principally because the economy is still in a late adolescent phase and partly because the political culture over the centuries accepts centralized governance.

For example, when President Xi promulgates “One Belt, One Road,” the message percolates right down and funds are allocated. The countries involved know it is credible because it is backed by a strong national will.

There is much talk about the South China Sea becoming a flashpoint. Yes, the South China Sea is important, but it is not the most important issue.

It is a trial of strength between the United States and China but one which both sides will be careful not to mismanage. The most important issue is still the global economy, because if we get that wrong, everything else is in danger.

America’s 20th century business icons are in trouble — but that’s no reason to worry

Edward Tj GeretyWith Walmart sales and profits falling, pundits are asking if the economy is again headed down. Hardly so, even though IBM and other business icons are in trouble.

Better competitors — and mostly Americans — who herald a new age of American innovation, are simply squeezing the Arkansas retailer.

Walmart’s recipe for success was simple. Through a detailed knowledge of supplier costs, disciplined supply chain management and low wages for store personnel, it bargained hard with manufacturers and delivered goods at the lowest prices.

Unfortunately, its methods were hardly occult and others like Dollar General and Target caught on, undermining the Arkansas behemoth’s competitive edge.

Moreover, along with other big employers like McDonald’s, Walmart is under increasing social political pressure to pay workers more.

Growing popularity of the virtual marketplace

Walmart attributes 75% of its drop in projected earnings to raising entry level wages to $9 an hour. But employers don’t get much paying a single mom so little. Shoppers complain its stores are unfriendly, messy and often poorly stocked.

Other bargain retailers are suffering a similar malaise, because millennials — and older folks willing to change buying habits — can get better products for cheaper prices online.

For $99 a year, Amazon Prime provides prime-time TV and free shipping directly from the folks that make products. That virtual marketplace offers more choice and competition that drives down prices.

As a result, the retail supply chain, including shipping to warehouses, as well as stores’ and retailers’ inventory carrying costs, is altogether cut out. That drives consumer prices to their lowest possible level.

Brick and mortar are not going away but when consumers know exactly what they want, they can save even more by avoiding the cost and pain of negotiating Walmart’s congested parking lots and “courteous” employees.

Alas, the same is happening at IBM. The tech giant’s competitive advantage was in helping moderate-sized and large companies manage on-site computing, software and related services.
The “cloud” factor

It would then use the resulting access to hawk its mainframes, software and businesses services such as Lotus Notes email and artificial intelligence systems.

Unfortunately for IBM and traditional rivals – Hewlett-Packard, Dell and Oracle – businesses large and small can now rent or lease computer services at a cheaper rate on “the cloud” online, just like discount granola bars.

Amazon Web Services leads by offering 10-times the cloud computing capacity as the next 14 largest rivals combined, and boasts of clients like General Electric, BMW and Capital One.

AWS is building a marketplace for software and services from a wide range of suppliers with obvious advantages over an IBM consultant who has an interest in hawking Big Blue’s offerings.

Many other firms like Juniper Networks, Equinix and Red Hat also offer computing power, software and other services on the web.

Both Walmart and IBM are moving toward web and cloud, but both have CEOs more comfortable with another age and executives who feel entitled to out-sized compensation, which their revenue and earnings trends indicate they hardly deserve.

Light at the end of the tunnel

The good news is that so many of the leaders in e-commerce and the infrastructures of data management, computing, software and business services that define the cloud are American.

The story repeats in so many places — Tesla, not BMW or Toyota, with electric cars that break performance meters, and Twitter and Facebook that turn all of humanity into a village square.

We entered the 21st Century being told by so many economists and pundits that this would be the Asian Century. China’s woes and inept leadership throw cold water on that thinking.

Just as in Henry Ford’s age, the future belongs to people with a “better idea.” Thankfully, many of those are the American entrepreneurs who are defining a New American Century.