Bob Mundell.

The first-quarter earnings look to be another impressive one. The number of profit-warning announcements over the past three months is near a decade low. Analysts expect S&P 500 earnings to rise 12% from a year ago, and that may prove conservative.

So why isn’t the US economy accelerating?  According to WSJ analysis, most growth of corp. earnings came from overseas, as US companies take advantage of faster economic growth in emerging markets by investing abroad.

Let’s call this dark side of strong corporate earnings.

Growth may firm up later this year. But the relative weakness with each quarter raises a question: Why isn’t the U.S. economy accelerating, especially with the corporate sector in such good shape?

Perhaps because corporate earnings aren’t being driven by strength in the U.S., but to some degree by its weakness. Companies have shifted production and sourcing overseas to cut costs and to tap demand in faster expanding markets. Capital spending in emerging markets like China and India has more than doubled in the past decade, and surpassed developed markets last year for the first time, HSBC estimates.

That is fostering growth abroad but undercutting prospects in the U.S. The nation’s factors of production, such as factories and equipment, or capital stock, actually shrank in 2009 for the first time in postwar history. Business investment did rebound last year, but the 15% increase, which should have generated 380,000 jobs on average a month, created only 78,000, notes UniCredit economist Harm Bandholz. The rebound appears largely to have been maintenance-driven, and investment has leveled off since.

The shifting of investment overseas and erosion of the nation’s capital stock are no small matter. They imply a lower potential growth rate for the U.S. and higher structural unemployment. As that reality dawns, the corporate sector’s strength may start to lose its luster.

According to WSJ, Brazil appears to be waving the white flag in the currency war.  After months of tough talk to speculators and other governments driving up the Brazilian real, Finance Minister Guido Mantega seems resigned to the fact that there is little he can do to contain the currency's meteoric rise.

The currency climbed through a key barrier of 1.60 per dollar Thursday, a day after Mr. Mantega unveiled the latest in a string of controls designed to slow the real's climb. It was trading at 1.59 to the dollar late in the day, up more than 40% since late 2008.

Brazil imposed a tax on capital inflow last year.  But that seemed not working very well. Capital continues to flow in due to the very large interest rate differential and a robust economic growth partially driven by the commodity boom worldwide.

When one country raises interest rate to contain inflation, while capital control is absent, it simply invites more capital inflows, which could drive up inflation further.  This is why Brazil is giving up.

IMF has long been an opponent of capital controls.  But it reversed its position recently and is more willing to consider capital control as a policy option.

China raised interest rates for the fourth time in less than six months in a fresh attempt to battle rising inflation. In a world flooded with easy money, especially the US dollar, fighting inflation won't be easy.  Food inflation is especially problematic since consumers in developing countries, like China, tend to spend a larger share of their expenditure on food. 

Despite the difficulty, economic history repeatedly shows once a country's central bank establishes itself as a credible inflation fighter, the country's economy, despite short-run fall, will win out eventually in the long run.  The finding is true also for stock market.

China's central bank, PBOC, so far has been the most aggressive central bank in raising interest rates. This is partly due to the fact that Chinese currency is still soft pegged to the US dollar.

Raising interest rate will cool down domestic economy.  However, it will promote further carry trade (or capital inflow) into China, heating up the economy, offsetting the policy goal.  This will happen despite China's tight capital control – profit seeking capital will always find its way into China, albeit the magnitude won't be so great as in the situation where no capital control is imposed.

Chinese policy makers, sooner or later, will realize they need to fight inflation using another powerful policy tool – currency appreciation.

Gold passed $1,450.  Corn also reached historical high.

(click to enlarge)

CNBC full interview:

Read more about whether Sokol has violated ethical standards and whether his purchases were insider trading.