China's growth slows and takes world equity markets with it

Slower long-term growth in China is probably an economic reality.

Robert Johnson, CFA 15 March, 2014 | 9:47PM
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Last week's cheery reaction to an above-expectations jobs report didn't last long. Equity markets suffered through a bad week with slowing growth in China and a continued tense situation in Ukraine. The S&P 500 fell 2% for the week. The iShares Emerging Market ETF EEM fell a more notable 2.8%. Bonds reacted to news of economic slowing as one might expect, with yields on the 10-year U.S. Treasury bond falling from 2.79% to 2.65%, reversing last week's shellacking. Production and retail news confirmed ongoing softening in China after last week's export data fell off a cliff and ongoing weakening in the purchasing manager surveys.

Other than a wide variety of weaker stats from China, the U.S. data flow was close to nonexistent. The normally important monthly retail sales report appeared to shake off some of the weather-related blues in February. I use the word "appeared" because a closer analysis of the data shows a sustained weakness in consumer spending on retail goods on a year-over-year basis. Worse, revisions to previous months of the same report suggest that the third revision to fourth-quarter GDP is more likely to be down than up.

News from some of the less important indicators was mixed. Small-business sentiment was down, and producer prices were lower, suggesting a soft economy. On the employment front, job openings showed a small increase, and initial unemployment claims fell, suggesting that last week's favoUrable jobs report was not a fluke.

Weekly shopping centre growth was slightly better at 2.1% year over year. I am still hoping for at least one week of 4% growth in shopping centre expenditures when consumers finally burst out of their winter bunkers and go wild at the mall. Alas, I am still waiting.

Company news reports out this week suggest that retailers serving the lower-income bracket and teen markets are suffering more than high-end retailers, continuing a trend we have seen for most of the year. Tight teen labour markets, reduced food stamp payments, and the end to extended unemployment benefits are all contributing to this phenomenon. Maybe slightly earlier and larger tax refunds will help break the jinx on retailers. And spring can't come soon enough for both retailers and all of us living in the Midwest and Northeast.

Retail sales results not nearly as strong as the headline numbers
Economists were generally pleased with the government's official retail sales report that showed 0.3% growth in the month of February compared with January. The report was well received because it beat the consensus forecast of 0.2% growth and followed two dismal months of declines.

However, the 0.2% increase was a lot less impressive considering that both December and January results were revised down by 0.2% each. Combining the three months, retail sales were actually worse than expected. The potential positive spin on the numbers is that there was a month-to-month improvement despite horrid weather conditions for the third month in a row. With somewhat better weather in March, some may argue that retail sales could really catch fire in March and April. But I am not buying all of that. Higher utility bills, continued pressure from the trimming of the food stamp program, and more-limited unemployment benefit payments will all keep a lid on the expected rebound. Those effects are especially visible when looking at the lower part of the income curve. Just this week,   Dollar General  DG announced lower-than-expected results. Meanwhile,   Williams-Sonoma  WSM, a higher-end retailer, reported better than expected results.

Weekly data looks better, but not by much
The weekly shopping centre for March so far has been better but nothing to write home about. The five-week average is still below 2% year-over-year growth, having been as high as 2.5% in April and over 3% last January. That, despite the fact that the weather was sharply better in recent weeks.

Year-over-year retail sales growth continues to erode
Returning to the official monthly data, the year-over-year data is sobering.

Excluding autos and gasoline, the year-over-year growth rate, averaged over three months, has been declining since August. The noninflation-adjusted metric has fallen from 4.3% in August to 2.4% currently. The fall-off in the inflation-adjusted data has been equally as bad. To me, the data indicates that some of the slowing or at least plateauing in growth occurred before the disastrous weather did. Nevertheless, some modest improvement in the weekly data and poor results last March probably mean that the March data, viewed on an averaged, year-over-year basis, is likely to look better than the dismal February results.

Sector data showed the truly awful categories for January rebounded nicely in February, while January gainers were generally big losers in February. When the swapping is this pronounced, it generally indicates measurement issues instead of genuine changes. For example, I still can't figure how sporting goods, hobbies, and books managed to decline an astounding 4.8% in January when that category should have been a key beneficiary of bad weather (play winter sports, read books, work on neglected hobbies) and then rebounded sharply in February. These huge category swings and the continuous and larger-than-normal revisions to past data seem to suggest some data-collection issues.

There were a few bright spots in the sector data. Nonstore retailers (for example,   Amazon  AMZN) rebounded nicely in February, basically wiping out January's surprise decline. I was particularly worried about data from electronic retailers a month ago as it suggested something besides weather was at work. The swift rebound seems to suggest that now there is less reason for worry. I was also pleased to see restaurant sales rebound from a minus 0.9% in January to a positive 0.3% in February, as consumers' propensity to dine out is a decent indicator of very short-term consumer confidence.

Service sector growth will need to offset poor sales of retail goods in the first quarter
As the data stands now, it appears that consumer purchases of goods will be a subtraction from the first-quarter GDP growth. In simpler terms, retail sales are likely to be down for the first quarter, if not in raw dollars, then at least in inflation-adjusted data. That would mark the first time inflation-adjusted goods sales have been down since 2010.

Services--a larger and less volatile sector component of GDP--could more than offset the goods weakness. Services are currently experiencing significant growth from the estimated positive effects of the Affordable Care Act and massive spending increases in utility sales. Outside of those two areas, services aren't showing much growth. Total consumer spending, including both goods and services, seems unlikely to match the 2.6% growth rate of the fourth quarter (although that will likely be revised downward as well as fourth-quarter GDP). In fact, consumption will be hard-pressed to exceed 2% in the fourth quarter.

China results weigh on markets
Chinese data can always be a bit goofy this time of year because of the shifting timing of the Lunar New Year holiday. This week-long holiday definitely has an impact on economic activity. Last year the holiday was in January, and this year it was in February. So initially, people weren't worried about soft data in January, figuring they would make up for it in February. Instead, the February data was equally as weak.

Additional Chinese data released Thursday confirmed everyone's worst fears, with industrial production, retail sales, and fixed-asset investments all falling short of the mark. It didn't help that China's Premier, Li Keqiang, seemed to indicate that there was some downside flexibility in China's 7.5% growth target for 2014 (down from 7.7% in 2013, which was already the lowest growth rate since 1999). The premier seemed to indicate that as long as labor markets met their targets, the government could tolerate lower top-line growth.

Those expecting a sharp rebound in Chinese economic activity to be a big plus for worldwide growth in 2014 now look likely to be disappointed. For those hoping for exports will be everyone's economic savior in 2014, they can only hope that strength in the U.S. economy saves the day. Unfortunately, weather-related issues mean that help won't be forthcoming until at least the second quarter.

Although it may seem like we aren't debating about much (maybe 7.2% versus 7.5% growth for 2014), the broader issue is that the Chinese economy is highly unlikely to return to the 10%-12% growth rates of recent times. Slowing growth of the working-age population, huge pollution issues, and massively higher levels of debt all mean that the headiest days of Chinese growth are now behind us. Some prognosticators believe that Chinese growth could slow to 4% by 2020. I am not sure I would go that far, but slower long-term growth in China is probably an economic reality.

Budget deficit outlook still bright
This week, the Treasury Department announced that the U.S. budget deficit shrank again in February and for the first five months of the fiscal year. For the first five months of the year, the deficit shrank by $148 billion, almost 90% of the reduction expected for the full year. That's even before we get to the heavy tax collection season in April, which will be the do-or-die month for the deficit.

At this moment, the fiscal year 2014 budgeted forecast of $514 billion (versus $680 billion in 2013 and $1.086 trillion in 2012) looks like a chip shot from here. At the forecast level of deficit and GDP, the deficit will have shrunk to 3.0% of GDP, down from close to 10% in 2009, as shown below.

Looking at just February, historically the slowest revenue collection month of the year, the deficit managed to shrink by $8 billion. Receipts were up an impressive 17%, while spending was up a much more modest 4%. So far, the October budget agreement doesn't seem to have produced the flood of additional short-term spending that some had expected. Actually, spending for the entire five-month fiscal year-to-date data is still down 4%, adjusted for timing changes. Military spending fell by $20 billion (sequestration and war winding down), unemployment payments by $9 billion (extended unemployment expired in December), and the food stamps and crop insurance programs by $10 billion (reversion to old food stamp rules, new farm bill). The downside of the lower spending is that it will keep a lid on economic growth in the short run, along with a weather-addled consumer and soft real estate data.

Housing data out in force next week along with industrial production and the consumer price index
Industrial production fell 0.3% in January, but hope springs eternal and analysts are expecting a better 0.2% growth rate for February. Given a relatively low employment growth rate in manufacturing employees and shrinking hours worked in February, as indicated in last week's employment report, I doubt we will do that well. However, utility growth could surprise me on the upside. Recall that a huge jump in utility usage kept January's report from being a complete disaster.

In housing news, builder sentiment is expected to improve from 46 to 50 after making one of its largest single-month plunges in January due to poor weather conditions. Because permits data has now moved ahead of starts, I suspect that the consensus estimate of an improvement in housing starts from 880,000 to 913,000 units looks on the mark, but it is still below last year's average of 927,000 homes. While pending home sales data suggests the end is near, it may not be in February. The consensus is forecasting existing home sales will fall yet again from 4.62 million units to 4.58 million units. Hopefully, this will be the low point.

Consumer prices are expected to remain under tight control, especially in light of this week's Producer Price Index, which showed an outright decline. Expectations are for a measly 0.1% increase in the CPI following a similar increase the previous month. That is good news for consumers whose dollars will now go further.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.

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