Around the world in 20 days

The three international issues facing investors right now are: Will China have a hard landing? How will the situation in the Middle East play out? Will the EU hold together for at least another year and begin the process of structural change?

I spent most of September on a three-week trip to China, the Middle East and Europe trying to get a better understanding how the these issues would develop.

Several days in China aren’t enough time to thoroughly understand what’s happening there. I had an opportunity to explore key issues with knowledgeable local observers. Real estate is no longer the primary problem given steps by the government to address the issues. The focus now is declining manufacturing activity. Exports are slowing, inventory is accumulating, plants are closing and workers are being laid off.

I believed China would experience a “soft landing” and grow at a 7 per cent real rate, but after my visit I think the underlying growth rate, may be softer. While relatively fast, growth there might still be disappointing to Chinese policy makers because it may increase the possibility of social unrest due to unemployment. Cyclical industries are hardest hit. Volumes are down, costs are increasing and margins are being squeezed, causing profit disappointments. The Chinese stock market mirrors this, as it hovers near new lows. A Chinese slowdown in raw material imports has had an impact throughout the immediate region and in Brazil and Australia. The cyclical industries are capital-intensive; therefore, cutbacks in the workforce have been limited so far, but these industries, largely state-owned enterprises, haven’t been hiring either.

To address the rate of growth below 7 per cent, policy makers will engage in a vigorous programme of fiscal and monetary stimulus to pick up the pace of economic activity, and they have the resources to do it. The important point is that China is a larger economy now and rapid growth is harder to achieve. This is likely to be a continuing problem, particularly with Europe in recession and the US growing slowly. The positive aspect is that inflation is subdued. It was a problem when China was growing at more than 10 per cent, but inflation is currently running at about a 3 per cent rate.

China has a high savings rate because of its minimal social programmes. The government attempted measures to stimulate consumer spending, but these have not been particularly effective. Retailers around the world haven’t given up on the Chinese consumer, however.

Two factors make the impending leadership change in China especially important. The economic slowdown puts a heavy burden on the new regime to improve growth, and the Bo Xilai corruption incident increases emphasis on reform. There had been concern that the new leaders were going to be more conservative than the previous team, but the current expectation is that they will be more progressive because that is what the population is demanding. The leadership seems to be waiting for the new team to take over next year before decisive action is taken.

China’s activism in pursuing interests in the South China Sea made me wonder whether the country wanted to have a greater geopolitical role. The sentiment was that China would continue to focus on its internal problems even though it is now the second largest economy in the world. Economic problems have increased nationalism and decreased the desire for greater international influence.

I went from China to the Middle East. Money continues to flow into the region from China, India and Europe. Dubai’s building boom has subsided and some of the office space and condominiums have become occupied. The Middle East shares the worries of the developed world, but in that region some of them seem more immediate. If Iran develops nuclear weapons capability, people expect an arms race throughout the region. If Israel were to strike Iran to slow its nuclear program, the price of oil would soar and the whole area would be destabilised by anti-Western attitudes and Iran’s retaliation.

The recent protests from North Africa to Pakistan caused by an anti-Islamic film are indicative of the latent resentment toward the West that exists in those areas. The riots may also be indicative of concern about Western imperialism. In the meantime, the price of oil remains high and investors from troubled areas throughout Asia and elsewhere seek refuge and opportunity in the area, but caution prevails.

The other concern in the region is Syria. Months ago, most observers believed the Assad regime would fall, but now they are less sure. Support from Iran, China and Russia has enabled Assad to endure, but everyone is saddened to see the violence there. The conflict has resulted in hundreds of thousands of Syrian refugees settling mostly in Jordan and Turkey.

Plenty of opportunity

However, most are going about their business without preoccupation with geopolitical concerns. Saudi Arabia and Abu Dhabi are thriving, and the high price of oil means plenty of opportunity. The indigenous population is used to uncertainty, and if adverse conditions develop, they will deal with it as they have in the past. A possible reversal in the price of oil as a result of diminishing demand, new supply and conservation is not given serious consideration. Most think increasing demand as a result of the rising standard of living in the developing world will offset the effects of increasing supply in North America. Economists on the ground in the region expect the real growth rate to continue of about 10 per cent.

I then left for Europe, where I had talked not only with large investors, but also to take part in a roundtable as the keynote speaker. There were two participant views that surprised me. The first was the almost universal agreement that Obama would be reelected in November, and the second was that the ECB, Germany and various other dedicated institutions would be successful in holding the EU together and keeping the euro as the continent’s basic currency. They were optimistic that there could be some movement toward structural change, including a banking union and fiscal convergence. Deposit insurance might be harder to achieve and it continued to present a potential problem.

One source of optimism was the many policy options at the ECB’s disposal. So far it has only provided funds for the continent’s banks by buying holdings of bonds issued by the weaker sovereign countries. They have not provided funds to the governments themselves, but are willing to do so if countries meet fiscal discipline objectives.

The budget problems are not confined to Greece. Spain has asked for $130 billion in aid from the European Union and Germany, and the Netherlands and Finland have expressed doubt that the country’s troubled banks can remain viable without a bailout. Over in Italy Monti has stated that he would seek another term if next April’s elections didn’t produce a clear winner.

I was convinced that Germany and the stronger countries in the EU would do whatever is necessary to hold the Union together, but Merkel, who had to play a critical role, faced significant political risks in taking a leadership position. Since then, Merkel has become bolder in efforts to keep the Union, including Greece, intact and I believe her political position has improved. If Greece were to leave the Union and default on its debts to Germany, that would be a serious political blow to Merkel and a big hit to Germany’s finances. What’s more, the “domino theory” would come into play, and if the other weak countries defaulted the cost would run into hundreds of billions.

Europe is suffering a mild recession this year, but if the EU endures, its chances for modest growth next year and beyond are good. Any break-up of the Union is likely to result in greater chaos.

— Byron Wein, Vice Chairman, Blackstone Advisory Partners LP.