Gentlemen Please...Please...Start Your Engines

The world has gotten off to a pretty nervous start here in 2016. As of this writing the Shanghai Stock Exchange is down 16% year to date and the S&P 500 has hit “correction” territory, down 10% from its highs.

So what gives in the Middle Kingdom? China, as the chart below shows, has slowed down from its previously consistent 10%+ growth rate. The country is now trying to make the transition from an economy focused on manufacturing and export to one focused on consumption and services. This is the same transition every developed economy has gone through.

The consumer in the United States accounts for about 70% of economic activity. In China it is more like 40%. The transition to services and consumption is never easy. The Chinese government likes control and the service sector is not easily controlled. You can’t turn consumption off and on the way you can big infrastructure projects or housing developments.

China’s biggest nightmare is civil unrest. The best way to protect against this is to create a lot of jobs. Manufacturing and exporting do well here consistently creating jobs for new graduates. The government is reluctant to give up this golden goose and the eggs it lays but the country is running out of cheap available labor. They need to institute reforms to improve the efficiency of the economy but this risks job losses and bankruptcies. And can the service sector create jobs quickly enough to replace what is lost in heavy industry?

Barron’s laid this all out in a recent issue. Their pessimistic conclusion is that we may be looking at even more of a slowdown in China as the government dithers and debt continues to mount from previously constructed infrastructure projects. China could open up finance, insurance, retail and other service sectors to more private competition but again, this requires giving up some control and does not seem to be in the cards today. Many Chinese consumers are hesitant to go on a buying spree what with all the mixed economic signals and some are hedging their bets and buying property in the U.S. (see chart below).

Paul Krugman writing in the International New York Times (January 9–10) acknowledges all these problems but is more sanguine. China has an enormous foreign reserve stash($3.4 trillion) which gives it a cushion, and even though China is the second largest economy in the world, its slowdown will not cause major illness here. For instance U.S. exports to China amount to only about 1% of our total GDP.

But Krugman admits there is one factor that is out of anyone’s control - it is human psychology. We have just seen how nervousness in China can spread like a wildfire to our stock market and Europe too.  Psychological contagion is definitely the thing to worry about today. Fundamentally we are still optimistic about growth in the U.S. in 2016 even in the face of a slowing China.  But everyone’s antennae need to be firmly fixed on that pesky problem – human psychology.