The Wednesday Letter #236 - 9/4/2024
The Wednesday Letter #236 - 9/4/2024
THIS WEEK: September Starts Badly; The Idea of Mass Immigration Into China; The Era of the Submarine; Taxes on Unrealized Capital Gains.
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SEPTEMBER STARTS BADLY
Here we go again. You may recall that a month ago the equity market sold off after the ISM reported the Manufacturing PMI (purchasing managers’ index) for July. The worry at the time was about employment, combined with fresh concerns about a Japanese yen carry trade unwind. Later data on July unemployment was sufficiently reassuring to lift the indices back to their earlier levels.
Yesterday’s decline was similarly caused by the ISM Manufacturing PMI but this time, the main concern was about the New Orders component which fell from 47.4 to 44.6 (table). There was better news in the headline PMI which rose from 46.8 in July to 47.2 in August. However, it was short of expectations and remained below 50, which means that manufacturing activity is still shrinking. Other negatives were the Production component which was down, and the Inventories indicator which surged higher.
With the possible exception of Inventories, there was no real surprise in this report. Yet it reinforces an idea that I have promoted for a while, which is that the Fed is behind the curve and should have started to cut rates in July. Here is the spread between the fed funds rate (red in the chart) and the 2-year Treasury rate (blue). Going back to the 1970s, it is difficult to spot another time when the 2-year rate was this far below the fed funds rate.
And here is the same data, zoomed in to the last ten years. The Fed was late in raising rates in late 2021 and early 2022. But now, we have the opposite situation.
There is widespread concern that the stock market usually turns down when the Fed starts to cut from the peak of the interest rate cycle. If this has been true in the last two or three cycles, it was because the Fed was behind the curve in those instances. A more proactive Fed would stave off a recession and neutralize this correlation. We will soon find out whether the Fed is acting early enough this time.
In addition to the ISM report, other factors drove the stock market down yesterday: 1) the start of September which is historically the worst month for stocks, 2) downgrades of commodities price targets by Morgan Stanley (oil) and Goldman Sachs (copper) to reflect concerns about the Chinese economy, 3) concerns about upcoming employment reports today and Friday with Citi expecting a weak non-farm payrolls number, 4) a sharp fall in Nvidia’s price (down 9.5% Tuesday) ahead of an antitrust-related subpoena from the Department of Justice which was revealed after the market closed.
Economists at Citi expect that the Fed will cut by 50 bps at its September 18 meeting and that it will implement other cuts in November/December. The CME FedWatch tool (below) now places the odds of a 50 bps cut in September at 43%. Not everyone sees the need for multiple cuts. Strategist Ed Yardeni remains bullish and expects a “one and done” 25 bps cut this month and no other for the rest of the year.
THE IDEA OF MASS IMMIGRATION INTO CHINA
It is a well-known fact that China’s demographics are deteriorating rapidly. Less known is the fact that China’s rising economy in the 1990s and 2000s was powered by a halving in its dependency ratio (DR, the ratio of dependents to workers) between 1970 and 2010. That is one of the main points that I made in How China Realized a Demographic Dividend. China’s dependency ratio bottomed ten years ago and its stagnation since then has created challenges for the Chinese economy (chart). The DR is expected to rise for the next sixty years, essentially turning the economic tailwinds of 1970-2010 into headwinds.
Everyone agrees that there is a problem, but not everyone agrees on the solution. In an article in The Conversation, Professor Dudley L. Poston Jr. of Texas A&M University has proposed that China could bring in a large number of immigrants to mitigate the twin effects of a shrinking and aging population. Poston argues that raising the retirement age will not be sufficient on its own to resolve the demographic crisis. China’s current retirement age is 60, but the government has plans to raise it to 65.
If we look at the green line in the chart above, which represents the dependency ratio with retirement age of 65, we see that Poston is correct that raising the age to 65 will not be a remedy on its own.
However, Poston’s idea that China can solve its demographic problem by importing massive numbers of immigrants strikes me as wrong for many reasons:
1- China has a total population of 1.4 billion. In order to curb the demographic decline, there would need to be at least 0.5% to 0.8% of newcomers annually, or 7 to 11 million. These are not easy numbers to accommodate for an economy like China’s, especially considering cultural and language barriers.
For comparison, the US massive inflow of undocumented workers in the past two years was about 1% of the population. If China also saw 1% immigration per year, that influx would equate to 14 million new people per year. It would be difficult or impossible to successfully integrate this number of new immigrants.
2- The benefits of immigration are not about head count. Short term, they are about the demand for workers, skilled or unskilled. Long term, they are about achieving a level of integration that is conducive to social stability and economic progress.
Regarding the short term, China does not need more skilled or unskilled workers. A large percentage of its population still live in the country and off the land. If China needs more workers in its other industries, it could just incentivize more of its people to move from the country to urban areas or to regions where other industries are located. Regarding skilled workers, China is already producing more college graduates than its economy is able to absorb. The Economist says that “graduates of universities and vocational and technical colleges accounted for 70% of the unemployed young in 2022, up from 9% two decades ago.”
Regarding the long term, there is no available evidence that China would successfully integrate a large number of newcomers. China is less well conditioned than the US to deal with a large immigrant pool. The percentage of foreign born in the US is about 15%, whereas it is only 0.1% in China. Many Chinese have never seen a foreigner in person.
In my view, the solution to China’s demographic decline lies mainly outside of demographics. In the rising age of AI and automation, head count matters less than it did fifty years ago. In China After the Dividend, I argued that the solutions lie with the other main pillars of wealth creation: innovation, productivity, society and governance.