China's weight in the world economy has been rising and was made excruciatingly apparent by the turmoil in U.S. equities markets over the past few weeks. Much of current stock market anxiety was at least "assembled" in China. With U.S. equity valuations stretched, this left the market highly susceptible to bad news and prone to a correction.
Market participants should feel reassured by recent data on housing, consumer confidence, auto sales and capital goods orders all pointing to underlying strength in the U.S. economy. Even the second quarter was stronger than previously thought with GDP growth being revised up to an annual rate of 3.7 percent, an upward revision from the first estimate of 2.3 percent.
Based upon minutes from the July Fed meeting, most voting members were leaning towards raising interest rates in September if the incoming data continued to show gathering economic strength. At 5.3 percent in July, the unemployment rate has fallen to a level that is very close to the Fed's estimate of the NAIRU (non-accelerating inflation rate of unemployment) and many other labor market indicators on Janet Yellen's dashboard are strengthening. The only missing ingredient is that core inflation hasn't hit 2.0 percent.
Yellen and her colleagues at the Fed face a difficult choice. If they go ahead and tighten, they risk being blamed for any further volatility in equity markets. However, if they postpone a rate increase into 2016, emerging markets may face another bout of turmoil in anticipation of a Fed lift-off. Unless the equity markets dive again over the next few weeks, the Fed should move rates up by 25 basis points at its September meeting and evaluate its effect on economic activity.
Chinese authorities had made concerted efforts to boost the value of equities and implemented a number of policies such as allowing greater use of margin lending in equity purchases. The plunge in Chinese stock markets was precipitated by monetary authorities' decision to allow the Yuan trading band to widen, effectively allowing a 3-4 percent depreciation.
What has really spooked financial markets is what does a Chinese economy that may be just growing around 5.5 percent mean for the global economy and the implications for diminished U.S. growth? China's economy was growing at a 14 percent rate as recently as 2007 and the rate of expansion has been cut at least by half in 2015. Nevertheless, due to the compounding effect of rapid Chinese expansion in the interim, today's seemingly mediocre growth contributes the same absolute global demand gains as in 2007.
Global Ripple Effects
As China's economy rebalances away from growth that was heavily commodity-dependent, nations previously relying on such exports are being harmed. Two of the former infamous BRICs, Russia and Brazil, are mired in recession as commodity demand and prices plunged, exposing structural weaknesses. Only India appears to be growing at a BRIC-like pace. Southeastern Asia nations such as Malaysia and Indonesia have been harmed due to their commodity exposure.
Sub-Saharan Africa commodity-dependent nations are seeing a slowdown. Oil-dependent Middle East nations are feeling the fallout as well. Within North America, Canada and Mexico are experiencing the effects of exposure to weakness in global oil markets. Other data from the euro-zone and Japan, on balance, have been generally good. Nevertheless, we are talking about 1.5 to 2.0 percent growth, at best.
U.S. Consumption and Housing Activity
Consumption and housing are underpinning growth in the U.S economy. Consumer spending is witnessing renewed vigor growing at an annual rate of 3.1 percent in the second quarter, and early data on the third quarter suggest an advance of roughly 3.0 percent. Jobs gains came in at a solid 215,000 in July and gains over the latest three months averaged 235,000.
One of the biggest risks from the plunge in U.S. equity markets is likely to be a substantial hit to measures of consumer confidence. The decline in U.S. equities in August suggests a 10 point fall in consumer confidence next month. Offsetting some of the negative equity market impact on consumer confidence is falling gasoline prices.
Housing market activity has experienced the most pronounced improvement thus far in 2015. Stronger job and wage gains, continued low mortgage rates and slower home price appreciation are aiding affordability. Housing starts in July hit the highest level, 1.206 million at an annual rate, since October, 2007 just prior to the financial crisis.
Business Investment and International Trade
Capital spending has been a source of weakness in 2015. The rise in the value of the dollar has harmed U.S. exports competitiveness and reduced the need to expand investment in plant and equipment. Members of the S&P 500 receive nearly 50 percent of their earnings from abroad. Much of this soft patch is attributable to deleterious impacts of low oil prices on petroleum exploration activity.
The good news is that the drilling rig count has been inching up in recent weeks.
Cautious optimism can be found in July's core capital goods orders jumping 2.2 percent and upward revisions to June's. Business confidence could be harmed by the recent stock market fallout and negatively affect investment plans, but underlying conditions are improving which should limit the downside risks.
Dollar strength is sapping export growth and allowing imports to capture a larger share of final demand. The dollar has climbed back to levels last witnessed in 2003. Softer demand growth in China and throughout most of emerging Asia, combined with Yuan devaluation against the dollar, will dampen export growth to China and boost imports from China.
So, where does this leave us? On balance, the U.S. economy is expanding at a 2.5 to 3.0 percent rate, but downside risks to the outlook have risen due to the correction in U.S. equity markets and financial sector stress. While there are still many downside risks to the outlook, my cautious optimism is warranted.