Forget the US - choose China

Could China overtake the US as the world's largest economy in the next ten years? Recent economic data suggests it's a distinct possibility. The Onassis team explain why China (and India) are the future.

In recent issues we have discussed the various aspects of the global liquidity story and the carry trade. These are financial circumstances that prevail on a massive scale at a time of an unprecedented expansion of the global economy as China and India move from developing nation status to eventual developed nation status. China should eventually overtake the US as the world's largest economy - how fascinating it will be to see the world as soon as just ten years hence.

Woody Brock, of Strategic Economic Decisions, Inc., ( headlined one of his recent essays "THE YEAR 2006 A GLOBAL TIPPING POINT' - Annus Horribilus for the US". The US, he says, is in the early stages of suffering declining political, military and economic power. To quote:

"The US remains the most significant on earth. Its market flexibility and its associated high level productivity of capital and labor make it the envy of any other nation. It will thus remain a powerful economy. But things are relative, and just as the US enjoyed a disproportionate amount of success in the 1980 to 2000 period, it now confronts the reality that its competitive economic advantage is under attack on many fronts."

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It was reported in the Financial Times that in 2006 China's exports increased by 27% and in spite of the increased value of the renminbi and increased Chinese wages, corporate profitability still increased considerably. The FT reported that China's manufacturing miracle has now entered its next phase. Exports of aircraft parts, ships, microchips and cars all increased last year by 70%, about four times the amount of the increase in exports of clothing and shoes. The key is their productivity story. Extraordinary productivity gains have been helped as old government owned plants have been replaced with new, often foreign owned, plants. It has been independently estimated that productivity gains in manufacturing are as high as 15% to 20% annually.

Conversely, and in some measure supporting Woody's essay, America's Labor Department has recently said that US productivity last year grew at its slowest pace since 1997. At the same time they said that unit labour costs rose 3.2%, the highest for six years. Economically, it would seem, China has America beaten!

From an investment point of view there are some lessons to be learned. In the last quarter 2006, US corporate profits look set to exceed 10% for a record fourteenth consecutive quarter. However, the consensus for the coming year is for earnings growth of only 6.6%. If unit labour costs continue to be high and productivity fails to improve, earnings growth must subside, in which case current US stock market valuations are unquestionably very stretched. On slower earnings growth, P/E ratios must surely contract. The largest contribution to S&P 500 earnings comes from the financial sector which, as the share price of Merrill Lynch and other investment banks testify, is likely to come under pressure. The outlook for the US stock market is potentially explosive as goes America, so goes the world.

Longer term the evidence mounts that China and India are the future and once this period of market volatility has ended, and that may take a while, a new opportunity will arise to buy investments in those regions.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

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