SMA 22nd Annual Economic Forecast 2007

Economic Insight Behind the Global Knowledge Market

The Strategic Management Association, the Harvard Business School and the CDMA sponsored the 2007 Economic Forecast featuring David Hale, Chairman of Prince Street Capital Management and Lyric Hughes-Hale, Founder China Online. David has international renown as an international economist, and he presented his encyclopedic knowledge and perspective on global economic trends in Chicago on 9 January 2007. Afterward, Lyric shared her insights on China in Part II of the evening. The Global Human Capital Journal also covered the 2006 Economic Forecast.

David’s forecast was global in scope but adapted to his U.S. audience. It reflected many of the numbers behind the global shift to the Knowledge Economy, and how this is driving global prosperity:

In 2006, we saw all-encompassing prosperity with no major globally significant financial shock since the 2001 Argentina crisis. Prosperity has been broadly based, which has partially been due to the end of the Cold War, and high commodity prices have extended prosperity to developing countries in Latin America, Africa and Central Asia. Stock market capitalization reflects the prosperity. For example, in 2000, Microsoft’s market capitalization was triple that of all commodities of the world: $600 billion versus $200 billion. In 2006, Microsoft market capitalization $250 billion, that of global commodities $800 billion.

Here are his specific remarks, from my notes. All references to “dollars” are U.S. Dollars unless noted:

• U.S. economy: in 2007, the U.S. economic growth will slow to about 2.5%, where it has been 3.5-4.5% during the past 3-4 years. Highlights:
  • Housing market: during the past 4 years, the U.S. has seen the greatest housing boom in history in which the average home value increased by 65%. The spillover effects have been broad, driving consumer spending. At the same time, the household savings rate has diminished 1.5%. There was no housing growth in 2006, when housing prices dropped 4-5% in the Chicago area and 7% in Las Vegas. We haven’t seen such price drops since 1933. This decreased consumer borrowing against housing.
  • Corporate profits: U.S. corporations have seen 17 consecutive quarters of increases in profits, and there is more liquidity than we have seen since the mid sixties. This has been partially due to restrained pay increases and cautious capital investment. Since 2002, this has sharply contrasted with the situation during the IT spending boom from 1995-2001, when corporations borrowed heavily to invest in IT and remediate perceived Y2K issues. During 2007, corporate profits will lead to increasing investment that will serve to partially compensate for the slowdown in consumer spending.
  • The Federal Reserve is cautious: there will be little/no change in rates for six months or more. Inflation is 2.7%. Rents had inflated, but significant increases in supply will moderate. Oil and copper price drops will help to keep inflation low.
  • The dollar: the dollar would fall significantly, even 30-40%, but for foreign intervention. The China and Japan have huge dollar reserves and trade with the U.S., and they stabilize the dollar. No one wants his currency to appreciate against the dollar.
• U.S. politics:
  November elections gave us the first Democratic Congress since 1994, which will change the picture, but gradually:
  • Tax impasse: in 2010 the Bush tax cuts expire, and there will be a series of negotiations and compromises until then; even if we have a Democrat in the White House, it’s unlikely that Congress will allow the massive tax increase that would otherwise be invoked. Speculating, in the near term, we could see the top marginal income tax go back to 40% and capital gains back to 35%. Trade policy is already problematic but will only be more so with the new Congress. Labor laws are already bogging down negotiations. Of nine treaties on the table, the U.S. has signed two. Current Democrat initiatives are in the areas of drug/pharma pricing and oil taxes. They are aiming to roll back oil credits, and the minimum wage hike has already passed, although its impact will be limited, as many states have already increased state minimum wages. Obviously, the 2008 election will be key.
• China:
  had another banner year in 2006 and is set for another in 2007, although growth should slow from 10-11% to 9-9.5%:
  • China continues to attract multifaceted foreign investment, to the tune of $700 billion in 2006. Sixty percent of China’s exports are manufactured by foreign-owned companies. Meanwhile, capital spending was 48% of GDP last year, unprecedented in Chinese history.
  • Wage growth was 15-16% in 2006, driving consumption. Thirty years ago, major purchases were sewing machines and television sets; in the 1990s, mobile phones were the most desired consumer product; today it’s the motorcar. In fact, Goldman Sachems projects that there will be 500 million motorcars in China by 2050.
  • China’s progress in reforming its banking system is extraordinary. Its banks are cleaning up their books by disposing of bad debts, and several are going private. The market capitalization of China’s four largest banks stands at $635 billion. The ICBC (Industrial and Commercial Bank of China) has a market capitalization of $260 billion, closely behind Citibank, which is at $275 billion.
  • Trade continues to grow, and trading partners continue to put pressure on China to ease its trade surplus, which was $160 billion in 2006. The government has slowly been letting the exchange rate appreciate gradually since July 2005, as it went from 8.27 to 7.8 CNY to the U.S. Dollar. It is averaging 5% appreciation per year, and this will continue: one strong motivator is protecting Chinese farmers, who increasingly compete with foreign competitors. The slowing U.S. economy will diminish exports to the U.S. Thirty percent of China’s exports currently go to the U.S., 10% of China’s GDP.
  • The government is concerned about the speculative nature of capital spending, and it is increasing reserves.
  • There will be a “surprise” rapprochement with Taiwan in 2008. They countries will eventually unify.
• The global economy: we will have a relatively benign period for the next 12-18 months, although there are several exogenous factors that could disturb the trend (more below).
  • European Union: growth for 2007 should be in the 2.6-2.7% range, driven by exports, investment and moderate consumption. Germany, Europe’s biggest economy, is cutting wages and easing restrictions on the working week, so workers can increase productivity. This is gradually improving, after five years of stagnant wages and weak consumer spending. Spain, France and Italy have seen relatively good growth due to real estate appreciation and related wealth and consumption. This said, 2007 will see several sizable tax increases in Europe: Italy increases its income tax, Germany’s value-added tax (VAT) goes to 19% from 16%. The European Central Bank has been increasing interest rates, now at 3.5%, and they will be at 4% by summer 2007. Germany should see about 2.2% growth for 2007.
  • Japan: is a bright spot, after a seemingly terminal slowdown. Its banks are now in largely good shape, having disposed of most of their problem loans, which now stand at 2-3% of their portfolios, where they were 8-9% before. Corporate profits are increasing, and corporations are beginning to hire permanent workers again. Exports are gaining, however, consumer spending is still relatively weak. Japan should see 2-2.5% growth for 2007.
  • India: should see 7-8% growth in 2007. FDI (foreign direct investment) is high, and the software and services sector remains a bright spot. However, India continues to be plagued by high bureaucracy and 14 political parties. Many oppose liberalization, infrastructure investments and deregulation, which muddies India’s popularity for foreign investors. This situation should be relatively unchanged for the next 2-3 years.
  • Africa: should average 6% growth in 2007, helped considerably by continued high commodity prices. For example, the Zambia Kwacha has appreciated 30% against the U.S. Dollar due to high copper prices.
  • Latin America: should grow by an average of 5-6% in 2007, and Peru by 6-7%. However, politics burdens the region by adding uncertainty. Venezuela’s Chavez was reelected by a strong margin and is proceeding with increasing the state’s role in the economy. In Bolivia, Ecuador and Nicaragua, populists were elected in 2006, and Chavez backs his offers to help them adopt his economic ideas with aid. Brazil is a bright spot Da Silva is a good president for foreign investors, and Brazil has no deficits. Mexico had a photo finish presidential election this summer in which Felipe Calderón eventually triumphed, which bodes well for foreign investors. Is is pro-business, and FDI should be strong in 2007. The vision is that Mexico should compete with China as a supplier of manufacturing expertise. This should produce strong synergies with the U.S.
• Oil-producing countries: will post solid gains in 2007, but these will be moderated by the slowdown
  in U.S. growth, which will also dampen inflation possibilities.
  • Russia: has a budget surplus of $100 billion.
  • The (Persian) Gulf Region: should grow at 5-6% in 2007, with a trade surplus of $250 billion, all of which will drive stock market growth. Politics is the real story here: obviously, Iraq is a mess with no end in sight, and Iran’s influence in the region is growing significantly. Depending on whom one believes, Iran is one (Israel), two (U.S.) or three (E.U.) years away from having nuclear weapons. Given this, the pressure will mount on the U.S. to strike in the absence of diplomatic breakthrough. There is a significant chance that Bush will react before the end of his presidency. Given that Iran is the Shiite (muslim) powerhouse, and its increasing power is threatening Sunni muslim regimes elsewhere in the Gulf. If Iran succeeds in developing nuclear weapons, the region will see heated proliferation. If Bush strikes Iran, the price of oil will likely double, shipping will be disturbed, negatively impacting trade. That said, moderates did well in Iranian elections two months ago, and its current government may be losing popular support. Meanwhile, Iraq now has a full-blown civil war in everything but name. If the U.S. were to pull out as some advocate, that would produce a regional catastrophe and oil market crisis.
• Financial market threat: a significant emerging threat is surplus liquidity, which is leading to increasing levels of speculation and the risk of a significant financial crisis.
  • The Middle East and China continue to finance the U.S.’s persistent deficits by buying treasuries.
  • Worldwide, mergers and acquisitions amounted to $3.8 trillion in 2006. Private equity holdings are in the hundreds of billions (U.S. dollars). Hedge funds have $2 trillion under management, and they are very aggressive.
  • Odds are high that there will be a major financial trading accident during the next 2-3 years, which will have significant spillover throughout the global financial system. It’s impossible to say when it will happen with any precision.
• Auto industry: Detroit has been making the wrong products for the market—emphasizing trucks and SUVs in an era of high petrol prices—and Japanese companies have been making consistent gains in the U.S. market. This summer will see a major contract renegotiation with the United Auto Workers union, which will focus on health care costs. Both GM and Ford now have more retired workers than working workers. Health care cost accounts for an average of $2,000 per vehicle. Japan and Canada have nationalized health care, so their industries have a significant cost advantage. However, the days of the internal combustion engine are numbered, given the number of motorcars projected for emerging markets, and continued rises in developed economies.
• 2007 Predictions:
  • U.S. stock market growth: 5-10%, profits 6-7%.
  • Oil price/barrel: $55-65, if there is war with Iran, $120.
  • Interest rates: 4.25-4.75%.
• Concluding points: the world will continue to enjoy a broadly based prosperity in 2007. However, this benign economic climate is endangered by political struggles, with the Middle East being the most obvious.

Analysis and Conclusions

• The widespread wealth we are seeing reflects the shift from the Industrial Economy to the Knowledge Economy. In the latter, many agricultural and industrial goods—although vital—are non-production inputs (like office supplies to a manufacturing company), but demand increases in step with economic activity. India’s growth has largely been in knowledge-based activity, but the increased wealth drives demand for manufactured goods and inputs. This increases their value and spreads wealth to commodity-based economies.
• Stated another way, the Knowledge Economy creates “pull-through” for industrial and agricultural products, which should continue to drive global prosperity.
• Even thirty short years ago, the manufactured goods represented the highest value-add an economy could create, and creating economic value from industry was daunting: bits-products by nature impose all kinds of constraints in their manufacture and transport, and a region’s location and possession of natural resources locked it into its position in the world. This is much less true today.
• In the Knowledge Economy, a country with enlightened leadership can build a knowledge infrastructure (education, technical infrastructure) and move to compete in the global market for knowledge and service.
• Sustained increasing wealth across the spectrum will represent mankind’s most crucial challenge to date: it is precisely the zero sum natural resources that will produce the most friction. Limited supply in the face of increased demand will eventually confront leaders to choose between collaboration or aggression.
• Most poignantly, fossil fuels are an untenable power source as we use them today. Their cost will continue to increase, and evidence is mounting to the point of irrefutability that their use drives global warming, threatening our planet. Leaders need to think beyond next quarter’s numbers (whether stocks or elections ,^) to solve the problem. There is no time to lose.