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February 2, 2013

The Global Economic Restructuring: Mom, Dad, are we there yet?

Executive Summary of RCS Investments 2014 Global Macro Outlook: Written on December 28, 2013.
Its been 5 years and roughly 3 months since the financial crisis, yet the three main engines of the global economy: the U.S., China, and the Eurozone, remain stuck in low gear. Like weary kids on a long road trip, investors have been itching to arrive to their final destination of sustainable and steady global growth. China is working towards reconstructing its economy towards one based more on domestic consumption, instead of exports and fixed asset investment, fueled by dizzying credit growth. Meanwhile, the U.S. is focused on improving its current account by way of increasing exports, while working through its credit-induced hangover. In Europe, complementing efforts to improve the current accounts of the periphery are massive fiscal adjustments. Taken together, government officials are aiming to reverse the global imbalances built up over the past decade. Market participants are again asking, this time confidently, if the lengthy trip is almost over; that China will undergo a soft landing, eventually providing the rest of the world with aggregate demand; that Europe, having finally stabilized, can begin its long awaited recovery after years of austerity and reform; and that the U.S. has healed enough to hold its own and expand its business abroad. 2014 will likely answer this question: Yes children, weve arrived. No kids, weve taken a wrong turn. May 22nd will be an important day for Europe. The parliamentary elections will pit the seemingly unstoppable force of increasing anti-euro sentiment, due to years of austerity and dreadful economic and social conditions, against the immoveable object of institutional liberalism, represented by the complex web of organizations that comprise the European Union and its currency zone. The result of the elections will significantly depend on whether the recent bout of stabilization can shift into first year, reenergizing a fatigued citizenry and political class with optimism that Europe has reached the end of its historically difficult voyage. Given Germanys notable dependence on exports and the dreary repair of current accounts of many periphery nations, the global recovery must gain momentum in order for it to serve as the elixir of political will for continued economic and eventual political integration. The Asian region contains a number of potential negative surprises. First, military tensions continue to increase between China and Japan, South Korea, the Philippines, and a host of other countries. Chinas increasing economic and military potential is changing the status quo and gradually shifting the balance of power in the region. Establishment of an Air Defense Identification Zone (ADIZ) over the East China Sea overlaps with Japans own and is a sign that Xi Jinping is striving to establish regional hegemony. Rumors of a second ADIZ in the South China Sea would dangerously raise the stakes. This territory is home to almost one third of global crude oil trade flows and over half of liquid natural gas, according to the Energy Information Administration. Inherent distrust of U.S. and Japanese intentions means that China will continue to increase military expenditure, as Japan has, to counteract Nippons ally and its Asian Pivot. Realism is alive and well. John Mearsheimers article The Rise of China Will Not Be Peaceful at All, written in 2005, is evermore prescient. Second, Abenomics, the term used for Shinzo Abes 3-pronged policy of monetary easing, a hefty dose of fiscal stimulus, and structural reform depends highly on increasing wages in time for Aprils sales-tax hike. If the strategy fails to pull Japan out of its deflationary slump, the countrys world-class debt pile, aging population and resulting reduction in national savings, increasingly structural current account deficit (due to rising energy imports), and worrying politicalization of monetary policy may attract investor angst, especially if external conditions do not improve and provide a crutch for the island nations economy. Last but certainly not

| Rodrigo C. Serrano, CFA | SIPA | Columbia University Master of International Affairs 14 Candidate | New York City, NY | 01-305-510-0181 | rcs2164@columbia.edu !

This abridgment compliments my in-depth 2014 global macro outlook. The page numbers below locate the topic on the expanded version. Highlights:
The global economy remains on weak foundations, susceptible to positive and negative factors. Negative surprises include a budding political crisis in Europe ! p.4 " , a hard landing in China ! p.13 " , a wave of uncertainty from the Federal Reserve ! p.16 " , and Japan#s debt problems finally coming home to roost ! p.9 " . Positive surprises lay in a strengthening global recovery, coupled with the development of nascent, long-term trends in reshoring ! p.22 " and the fracking industry ! p.19 " . The expanded outlook can be found here: http://rcsinvestments.word investments-2014-globalmacro-outlook/ press.com/2013/12/28/rcs-

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least, Chinas ongoing economic remodeling from exports and fixed-asset investment, all the while taming a suspected credit and property bubble, calls for a resumption of global growth as well. The communist countrys 3rd Plenum of the 18th Central Committee has generated optimism that leaders have finally gotten serious about tackling the states unsustainable business model. However, reforms may lead to unintended consequences, the most pressing being increasing stress on the nations progressively fragile financial system. Meanwhile, the U.S. sports a couple of budding secular bullish tailwinds in re-shoring and hydraulic fracturing or fracking. George Mitchell, considered by most to be the father of fracking and horizontal drilling, laid the foundation for a revitalized energy industry in America. The technology has been instrumental in producing economic conditions in North Dakota, which flaunts an unemployment rate of 2.6%, envied by the rest of the nation. The evolution of the industry will close to double the segments workforce according to energy consultants. Moreover, industries ranging from trucking, to rail construction, to restaurants and hotels will benefit, providing jobs for the foreseeable future. America will likely become the worlds largest natural gas producer and will compete for the zenith in oil production, currently owned by Russia. From a macroeconomic perspective, increasing energy independence will likely help in shrinking Americas chronic current account deficit and in boosting FDI, itself a symptom of a second principal bullish trend to keep an eye on this year: Re-shoring. Lower energy costs are making the United States an increasingly attractive option for foreign businesses in Europe to set up shop. Meanwhile, the renminbi has appreciated by roughly 25% in just 6 years. Even better for re-shoring, Chinese labor costs have more than quadrupled since 2001. This sino-trend will continue due to a shrinking workforce throughout this decade. After a lackluster 1st half of the year, U.S. economic growth has accelerated; surging 4.1% on an annualized basis in Q3. Furthermore, the unemployment rate hit a 5-year low of 7.0%. The aforementioned bullish tailwinds are playing a role in Americas resurgent economic growth, in addition to rising home prices and improved consumer psyche. However, not all the news is rosy. These dynamics will bring about a wave of uncertainty over financial markets with regards to Federal Reserve policy. Janet Yellen is scheduled to take over as chairwoman of the Fed come February 1st. She wont be the only new face. Potentially 75% of the FOMC voting committee may change. The addition of Charles Plosser and Richard Fisher as voting members, replacing Charles Evans and Eric Rosengren, means a stronger hawkish contingent for Dr. Yellen to tame. Furthermore, in exchange for a slight closure of the monetary spigot (tapering), the Fed provided investors with another gadget, Forward Guidance. This concept serves as an indication to investors, business, and consumers of how the Fed intends to conduct monetary policy in the future. By stating that rates would remain low well past the time that the unemployment rate, now 7%, declines below 6.5%, long-term rates would be expected to decrease and lower borrowing costs to help the recovery. However, the risk of reputational damage increases using this strategy. What if the FOMC suddenly had to backtrack on a stated promise due to unexpected inflation? The tapering of QE and introduction of forward guidance is likely to ferment uncertainty over the coming months. Since the 2008 financial crisis feeble global growth has brought about an increasingly vocal cohort forewarning of secular stagnation, a prolonged period of insufficient worldwide aggregate demand whereby improved economic conditions come at the expense of financial stability (ie overextended asset prices). Returning to our analogy, its been a very long and exhausting journey for the kids. On the bright side, like all situations, this too shall come to pass. Long-term reforms in China will eventually strengthen the foundations for a protracted period of global expansion. Re-shoring and the rise of fracking worldwide will provide for long-term growth as well. The question that 2014 will likely answer is whether officials took a wrong turn at some point throughout the trip. Most of the time investors figure this out much later, as was the case with the repeal of portions of Glass-Steagall during the Clinton years (1999) and years of suboptimal interest rate policy by Alan Greenspan. As I stated in my prior outlook roughly 1.5 years ago: If world leaders can successfully navigate the treacherous waters of global restructuring over the coming years, eventually todays seemingly endless period of weak economic performance will lay the foundation for a powerful secular bull market that may last for decades. Until then, investing today will require flexibility, risk management, and a willingness to embrace the fact that buy-and-hold investing has taken a back seat for the time being. Always fasten your seatbelt!

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