The prevailing view is that the US economy is slowing--taking its cue from the housing sector--and that the probability of a 2007 recession has risen significantly. Some say the likelihood is up to 40 percent.

My view is a little more sanguine, although signs of slackening growth are clearly visible. The case for a recession is based on the fact that the yield curve remains inverted--admittedly an alarming development--but other economic indicators show nothing more than a slowdown. Hence, nothing more than some strategic hedging to offset potential disappointments is required right now.

If the US falls into a recession next year (although this isn’t my forecast, it’s a strong possibility), economies around the world will be negatively affected. The dominant view among knowledgeable observers is that Asia will suffer the most.

But it won’t hurt as much as is commonly believed. I offer no vote of confidence--yet--to those who state that Asian economies have decoupled from the US. But Asian nations are better prepared than ever before to deal successfully with a US economic slowdown.

For starters, the US is gradually becoming less important to Asia’s well-being. Total Asia-ex China exports (including indirect exports to the US through China) have decreased from a high of 26 percent of total exports to a low of 18 percent currently, the same as the European Union (EU).

It’s well known that consumption represents 71 percent of US GDP. Of that, 22 percent represents expenditures on goods (ex cars, food and energy) where Asia’s exposure is greatest. Keep in mind that American businesses account for 75 percent of US tech spending, where the majority of Asian exports are concentrated. If capital spending doesn’t collapse, Asia will do just fine. And the US’ share of global imports has also steadily declined to 17 percent from a high of 21 percent in 2001.

If the US housing slowdown brings with it a total collapse of the US economy and a deep recession, all bets are off, no matter where you’ve invested (expect maybe gold bullion). But, I reiterate: This isn’t the base-case scenario I envisage.

What about China? Most observers--and I agree with this part of the thesis--expect its economy to slow. But they lose me when they argue that China’s slowdown will be severe enough to damage long-term growth prospects, and that, coupled with a crippling US recession, it will devastate the global economy.

My view is that China will weather the storm, proving more resilient than those observers anticipate. One of the main reasons is that it has policy flexibility--currency reserves, surpluses, renminbi appreciation, etc. For the month of August, China’s trade surplus reached a record USD18.8 billion. Given how the rest of the year has gone, the surplus could surpass USD150 billion by the end of 2006. And China’s foreign exchange reserves should surpass the USD1 trillion mark by the end of the year.

Most of China’s exports to the US are to the lower end of the market and should therefore hold up better and maintain momentum, as they did in Japan during the prolonged recession in that country.

That said, as the US and the global economy slow, China will follow. There are already signs of it happening: Industrial output slowed down during the summer months and should continue to do so. This doesn’t mean economic activity in China will collapse, but the market will feel the change.

Chinese leaders will eventually have to pass measures intended to boost domestic demand, which will lead to a stronger renminbi and lower surpluses. Until then, China will have to find ways to absorb investment growth that will often be directed to ill-advised projects.

We’re early in the 21st century, and it’s already clear that the US-China relationship will be the most important factor in global development. Its status will affect the world for years to come. US-China cooperation remains at the center of the global economy; mutual understanding could solve each other’s and the world’s problems.

The US will play a vital role in this transition because the two countries have reached such a level of economic integration that cooperation is the only viable alternative. As US Treasury Secretary Henry Paulson recently said, “The relationship between the US and China is the most important bilateral economic relationship in the world today.”

And as I recently noted in Silk Road Investor:

China has demonstrated that it won’t respond to outright pressure, something Paulson well knows; he’s been doing business with the Chinese for a long time. He’s currently visiting China again, and I expect an understanding to be reached during his time there. China’s leadership (especially its central bank officials) knows what needs to be done, but it also knows it needs more time than the G-7 would allow.

Given China’s importance to the world economy, don’t underestimate the efforts by Secretary Paulson and President Bush to work with China as a strategic partner rather than an adversary. And although short-term domestic political tricks (prevalent now, given the upcoming elections) create some disturbing noise, serious, long-term investors will understand it for what it is: just noise. The US and China will be the dominant players in the foreseeable future; the sooner you realize the implications of this world order, the sooner you can make the appropriate investment decisions.

Finally, as I’ve repeatedly noted, investors in Asia should continue to concentrate their portfolios in domestically oriented companies. Banks are prime candidates; the Silk Road Investor Portfolio includes several from the sector based in Asia, as well as other domestic-related investment suggestions.

© 2006 Yiannis G. Mostrous
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