International Trade Archives - the patient investor

January 24, 2024January 25, 2024

The shell game

An interesting discussion with Prof. Percy Allan from University of Technology, Sydney regarding what caused declining economic growth in recent decades. The chart below shows how real GDP growth in the US declined over the past sixty years — from a 10-year average above 4.0% to a low of 2.2% over the most recent decade.

Real GDP Growth

The primary cause is the decline in capital investment, with 10-year average capital formation declining from between 3.5% and 3.6% in the 1970s and early 1980s to between 2.2% and 2.3% in the past decade. You need new investment in capital equipment in order to improve the efficiency of labor (productivity) — increasing output (GDP) at a faster rate than labor input.

Capital Formation

One possible argument for the decline is that productivity (blue) has grown at a faster rate than average hourly earnings (red) since the mid-1980s. This means that workers receive a smaller share of output (GDP) and are likely to consume less. Lower consumption will in turn lead to lower investment as there is no domestic market for the additional output¹.

GDP/Payroll & Average Hourly Earnings

But that argument does not hold true for the US, where personal consumption has grown as a percentage of GDP since the mid-1960s.

Personal Consumption

The increase in consumption was funded by an increase in debt. The ratio of non-financial debt to GDP doubled from 1.32 in 1960 to 2.64 in Q3 of last year.

NonFinancial Debt/GDP

The increase in debt occurred in three steps: 1980-1990; 2000-2009; and 2019 -2020. These steps coincide with three massive surges in the current account deficit below, when Japan, Germany and China (the largest three exporters to the US since the 1980s) exported surplus output to the US by manipulating their capital account.

Current Account/GDP

If China, for example, exports goods to the US and does not import a corresponding amount of goods and services, it will have a current account surplus. The flow of Dollars to China in payment will drive up the Yuan exchange rate, making Chinese goods more expensive and restoring the trade balance. But exporters like Japan, China and Germany manipulate their exchange rate by investing in US Dollar securities and assets. The outflow on their capital account then offsets the inflow on current account² and prevents their exchange rate from rising to restore the balance in trade.

Conclusion

US workers share of GDP has fallen since the mid-1980s, causing rising inequality and political tensions. But the impact on their standard of living was cushioned by the shell game run by US political leaders and foreign trading partners. Personal consumption climbed despite workers’ smaller share of output, enabled through increased availability of cheap debt — funded by foreign trade partners through a growing current account deficit.

The result was a strong Dollar as foreign capital flowed into the US. Wall Street were big cheerleaders of the policy because it gave them access to huge volumes of cheap debt.

The combination of cheap debt and inflation also exacerbated rising inequality between workers and owners of capital. The wealthy were able to to profit from inflation, using their balance sheets to borrow at cheap rates and buy real assets as a hedge against inflation. Workers — with weak balance sheets and no access to leverage — bore the brunt of rising prices.

The downside to the strong Dollar policy is that it made US manufacturers uncompetitive, both in export markets and against imports in domestic markets. The result was an erosion of US manufacturing jobs (below) and increased reliance on foreign imports which both the Trump and Biden administrations have tried to reverse.

Manufacturing Jobs

Efforts to weaken the US Dollar and reduce the current account deficit are laudable. They may well spur an increase in capital investment over time which could revive economic growth. But the days of cheap debt, funded by US trading partners, are likely over.

Long-term interest rates are expected to rise in 2025. So are wage rates. Workers — emboldened by a tight labor market and facing higher interest rates — are expected to demand a larger share of productivity gains than in the past. Inflation is likely to prove persistent.

Acknowledgements

Prof. Percy Allan, The Conversation: There are 4 economic scenarios for the rest of the decade – I’ve reluctantly picked one

Notes

1. The growth model used by Japan, Germany and China is an exception to this, where additional output is exported via a surplus on current account.
2. The sum of flows on capital account and current account is always equal to zero, with inflows on one account offset by outflows on the other.

June 4, 2022

The globalization trap

On March 8, 2000, President Bill Clinton made a persuasive pitch to Washington’s foreign policy elite, Congress and the international community, on the merits of China’s accession to the World Trade Organization:

“Membership in the WTO, of course, will not create a free society in China overnight or guarantee that China will play by global rules. But over time, I believe it will move China faster and further in the right direction……..We have a far greater chance of having a positive influence on China’s actions if we welcome China into the world community instead of shutting it out.”

That was little more than a decade after the Beijing government massacred thousands of students participating in pro-democracy demonstrations in Tiananmen Square, June 1989. Twenty years have passed since China’s 2002 accession to the World Trade Organization. Let’s review how that is working out.

Zero progress toward a free society

Xi Jinping reversed any progress, towards a more open society, made under Hu Jintao. Xi revoked the term limit on his leadership as General Secretary of the Chinese Communist Party; increased censorship and mass surveillance; imprisoned minorities; suppressed news of the COVID outbreak in early 2020, causing a global pandemic; he shredded the one-country-two-systems agreement with the UK and cracked down on the pro-democracy movement in Hong Kong; while threatening democratic Taiwan with invasion.

Malign influence on democratic institutions

Rather than opening up China to Western influence, an open Western society proved highly susceptible to Chinese influence operations. Efforts to suppress free speech include infiltration of universities through establishment of Confucius Institutes and research grants; the Belt-and-Road initiative to increase control over fledgling democracies in the Asia-Pacific and Africa; and growing control over appointments in UN bodies. North Korea, for example, has been appointed as the current Chair of the UN Conference on Nuclear Disarmament.

Growing geopolitical challenge

Trade with the West has empowered China’s development of a powerful nuclear ICBM force, including hypersonic weapons; seizure and militarization of disputed shoals in the South China Sea, flouting international conventions; and development of a blue-water navy to expand its influence far beyond its shores.

Negative economic impact on the US.

Ignore the flowery speeches about democracy and freedom from the former President, the primary purpose of China’s admission was to enrich US corporations. When President Clinton described China’s admission as a “win-win”, you can be sure that US multinationals understood this to mean increased profit margins and new markets. China was also meant to benefit economically, to the extent that workers’ standard of living would need to rise so that they could consume more mass-produced Western goods.

It didn’t work out as planned.

Corporate profit margins rose to new highs, post-2002, as employee compensation fell.

Corporate Profits as Percentage of Value Added

The price was destruction of millions of manufacturing jobs as US companies shifted factories to Asia, where labor costs were a fraction of those in the US. Initially the erosion started with low-skill, menial jobs but soon expanded to high technology sectors as China’s industrial base grew.

Manufacturing Jobs

Industrial production in the US stalled after the 2008 crash, losing an entire decade of growth.

Industrial Production

Current account deficits ballooned as Chinese exports flowed into the US, supported by massive capital outflows from China to maintain their currency peg against the US Dollar. Capital outflows prevented the Yuan from appreciating against the Dollar — which would have eroded China’s pricing advantage in international markets.

Current Account

The US slipped from being a net creditor in the 1980s to the world’s biggest debtor, with a negative net international investment position (NIIP) of more than $18 trillion.

Net International Investment Position

Federal debt climbed to a precarious 128% of GDP in 2021 as the government ran ever-larger deficits to support the economy and offset the massive current account hemorrhage.

Federal Debt/GDP

The traditional relationship between government deficits and unemployment started to break down in the late 1980s. Unemployment (RHS) is on an inverted scale below, so high unemployment is near the bottom and low figures are near the top of the chart. Before the late 1980s, deficits were relatively small , increasing to between 4% and 6% of GDP when unemployment spiked during a recession. But deficits were kept close to 3% of GDP in the Reagan-Bush (HW) era, even when employment had recovered (blue circle). The hoped-for boost to GDP failed to materialize but the experiment was nevertheless repeated, even more aggressively, by Trump in 2016-2020, cutting corporate taxes in the hope that this would boost growth. But GDP growth again remained low.

Fiscal Deficit/GDP & Unemployment (inverted scale)

The Fed started expanding its balance sheet after the 2008 global financial crisis, in order to support a massive fiscal deficit of 10% of GDP, and an even larger 15% deficit in 2020. The effect was self-reinforcing as QE discouraged foreign investors from purchasing Treasuries — out of fear that the Dollar was being debased — forcing the Fed to inject ever-larger amounts of QE to make up for the absence of foreign funding. Money supply (M2) spiked upwards as a percentage of GDP, adding to debasement fears.

M2/GDP

There was one win, however, from globalization that the Fed was quick to claim. Low inflation is mistakenly attributed to Fed skill in managing the economy rather than the real reason: erosion of the US industrial base which undermined wages growth, particularly in the manufacturing sector.

CPI & Average Hourly Earnings - Manufacturing

Conclusion

Admission of China to the World Trade Organization in 2002 was an unmitigated disaster, unleashing a massive deflationary shock that destabilized the global financial system. Despite being a developing economy, China become a major exporter of capital, as well as goods, upsetting the level playing field of international exchange rates. This helped to suppress the Yuan, giving Chinese manufacturers an advantage over Western competitors, and caused the loss of millions of manufacturing jobs in the West. The Western response was to run larger deficits, causing public debt to balloon to precarious levels, while central banks efforts to support growing fiscal debt destabilized the global financial system.

Central Bank Total Assets

The recent surge in inflation exposed central banks inability to protect their currencies, without causing a global recession, undermined by precarious public debt levels and bloated central bank balance sheets.

Sir James Goldsmith — interviewed here in 1994 by Charlie Rose — was on the money when he referred to breach of the social contract between capital and labor, that ensured political stability in the West, and the betrayal of trust between political leaders and their electorate.

The present course is unsustainable in the long run and we anticipate an era of de-globalization as nations on-shore critical supply chains. There is no other currency that can compete with the Dollar’s status as global reserve currency but the system is likely to evolve towards a multi-polar world, with several separate trading/currency systems backed by commodities such as Gold, Silver and Base Metals. Oil would be ideal, as energy is central to the global economy, but storage is cumbersome; so a fixed exchange rate between oil and gold/base metals is more likely.

May 14, 2022May 14, 2022

Current turmoil and its impact on Gold

Michael Every from Rabobank is bearish on Gold in his recent video:

“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”

Several readers have written, asking if this changes our view on Gold.

The short answer is NO, for three reasons:

1. The Fed can only hike rates until something breaks

Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.

The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.

Bank credit still grows at a healthy rate.

Bank Credit & Fed Funds Rate

The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.

Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.

Copper-Gold Ratio & 10-Year Treasury Yield

Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).

Unemployment & Consumer Sentiment (inverted scale)

Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.

Investment Grade & High Yield Corporate Bond Issuance

A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.

2. A strong Dollar is destroying US industry

The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.

Foreign Debt & Current Account

This has allowed the Financial sector to grow to a point where it dominates the US economy.

Market Capitalization: Financial/Non-Financial Sector

Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.

In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.

Trade Deficit

The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.

The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.

Manufacturing Jobs & Current Account

The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.

GDP/Non-financial Debt

Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.

The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.

Foreign Held Federal Debt & Current Account Balance

3. US debt above 120% of GDP would destroy the bond market

Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.

Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.

That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.

Federal Debt/GDP

The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.

Federal Debt & GDP growth

Current turmoil

The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.

China & the Dollar

After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.

China: Foreign Reserves

China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.

Trade Weighted Dollar

The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.

China: Yuan

In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.

The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.

The Belt-and-Road initiative

In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).

China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.

China: Foreign Reserves

The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.

Funding the federal deficit

China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.

Externally Held US Treasuries - Major Holders

But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.

The US is faced with a difficult choice:

Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.

It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.

China

Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.

Chinese Ports

Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.

Chinese LNG Demand

Team USA

This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:

Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.

Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.

There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.

Conclusion

Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.

It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.

The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.

The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.

Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.

Acknowledgements

Tom Mclellan for the Unemployment/Consumer Sentiment comparison
Frankoz for the BRI insight

October 7, 2021

End game for the Dollar

The end game for the Dollar: China vs the US, with Grant Williams and Luke Gromen:

June 16, 2021June 17, 2021

Productivity not population key to Aussie living standards | Macrobusiness

From Leith van Onselen at Macrobusiness:

Former ALP minister Craig Emerson has penned an article in The AFR calling on the Morrison Government to tackle Australia’s declining productivity growth, which is central to boosting the nation’s living standards:

“Productivity growth has contributed 95 per cent of the improvement in Australians’ material living standards since 1901”.
“From the turn of the century, Australia’s productivity performance began to slide and the longer it has gone on the worse it has gotten”.
“Over the period from 2015 until the COVID-19 pandemic struck, actual productivity growth was worse than the low-productivity scenario included in the 2015 intergenerational report”.
“In the decade since 2010 – even excluding last year – Australia recorded its slowest growth in GDP per capita of any decade in at least 60 years”.
“Without a comprehensive economic reform program, Australia will inevitably have weak growth in living standards during the remainder of the 2020s and into the 2030s”.

Craig Emerson’s assessment is broadly correct, as evidenced by the stagnant real per capita GDP, wage and income growth experienced over the past decade (even before the coronavirus pandemic).

Sadly, however, the Morrison Government with the help of the Australian Treasury seems hell bent on leveraging the other ‘P’ – population growth – to mask over Australia’s poor productivity performance and to keep headline GDP growing, even if it means per capita GDP, income growth and living standards deteriorate.

Rather than using the coronavirus pandemic as an opportunity to reset the Australian economy to focus on quality over quantity, the Morrison Government is intent on repeating the policy mistakes of the past by returning to the lazy dumb growth policy of hyper immigration.

Rebooting mass immigration will inevitably contribute to Australia’s poor productivity growth by:

Crush-loading cities, increasing congestion costs and rising infrastructure costs;

Encouraging growth in low productivity people-servicing industries and debt creation, rather than higher productivity tradables; and

Discouraging companies from innovating and adopting labour saving technologies.

It’s time to put the Australian Treasury’s Three-Ps framework to rest once and for all, along with the snake oil solution of mass immigration.

Policy makers must instead focus first and foremost on boosting productivity, followed by lifting labour force participation. These are the two Ps that actually matter for living standards.

We agree with the concern over poor productivity growth, but focusing on labor force participation is putting the cart before the horse. The key cause of low productivity growth is declining business investment.

Business Investment

Without business investment, new job creation and wages growth will remain low. The way out of this trap is to prime the pump. Boost consumption through infrastructure programs — investment in productive infrastructure that will boost GDP growth (to repay the debt). Boost business investment through strong consumption, a lower Australian Dollar and tax incentives (like accelerated write-off) for new investment.

The lower exchange rate is important to rectify a serious case of Dutch disease¹ from the resources industry. There are only three ways to achieve this:

Increase imports, which would be self-defeating, destroying jobs;
Reduce exports; or
Export capital, of which Australia has little.

China is doing its best to help us with the second option, by restricting imports of a wide variety of Australian resources, but that has so far achieved little. David Llewellyn-Smith came up with an interesting alternative:

If we accept that the CCP is the latest manifestation of the historical tendency to give rise to political evils intent on dominating the lives of freedom-loving humanity, then why don’t we cut the flow of iron ore right now…….

The results would be instant. The Chinese economy would be structurally shocked to its knees. 30% of its GDP is real estate-related. 60% of the iron ore that drives it is sourced in Australia. Roughly speaking that is 18% of Chinese GDP that would virtually collapse overnight. Vast tracts of industry would fall silent. An instant debt crisis would sweep the Chinese financial system as its bizarre daisy chain of corruption froze. Local governments likewise. Unemployment would skyrocket.

…..What we can say with confidence is that it would pre-occupy the CCP for many years and hobble it permanently. Its plans for regional domination would be set back decades if not be entirely over.

The problem is how to convince the old boys around the boardroom table at BHP that this would be in their interest as well as in the country’s interest.

Notes

Dutch disease is a term coined by The Economist to describe the impact on the Netherlands’ economy of a resources boom from discovery of large natural gas fields in 1959. The soaring exchange rate, from LNG exports, caused a sharp contraction in the manufacturing sector which struggled to compete, in export markets and against imports in the domestic market, at the higher exchange rate.

February 1, 2020

The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.

January 18, 2020January 18, 2020

Trump gets his Deal

Donald Trump signed the Phase One US-China trade deal with China’s Vice-Premier Liu He in Washington D.C. on Wednesday.

The deal is important for Trump politically as he needs to disrupt media focus on his impeachment playing out in the Senate.

China attempted to downplay the significance of the deal by sending their Vice-Premier rather than Xi Jinping for the signing ceremony. But the deal is no less important for them in order to halt/slow the relocation of manufacturing jobs by multinationals to avoid US tariffs.

Trivium China sum up the outcome:

We are still in a trade war. Tariffs remain levied on hundreds of billions of USD worth of goods.
A phase two deal looks dead in the water. US President Trump has already said that he might wait until after the November election to negotiate the next phase. More importantly, there is little appetite in China to make concessions on any of the remaining issues.
Third countries are getting screwed. China’s overall import bill is unlikely to jump by USD 200 billion over the next two years, so increased purchases of US goods will come at the expense of producers in other countries.
This deals another blow to the multilateral trading system. The world’s two largest economies just bypassed the multilateral rules-based system to negotiate a deal that undermines the principles of free trade.
China is downplaying the deal. The fact that Liu He – not Xi Jinping – signed the deal sent a strong signal domestically that this is not a big deal. And Chinese officials have said that most of these measures would have happened irrespective of a deal.
Finally, the deal is a positive for stability. This will serve to halt – or at least slow – economic decoupling. That’s a positive for the global economy and security.

Rhodium Group in The Good, The Bad and The Missing focus on what should have been in the deal but isn’t:

Chapter 1 Pledges greater protection for a handful of specific products – pharmaceuticals, medicines and unlicensed software – and generally more enforcement against counterfeit products but the concerns of other industries are not addressed
There are no robust enforcement mechanisms in Chapter 7. It provides a forum for discussion and consultation but not arbitration. If unable to resolve the issue, the aggrieved party can withdraw from the Agreement. This creates little incentive to resolve issues and may result in a logjam.
The managed trade approach does not even start to remedy systemic concerns like the predominance of state enterprises, the prevalence of foreign investment limitations in the vast set of industries that did not get early attention in this deal, the lack of consistency in competition policy treatment and the general asymmetry of information and the playing field for private firms foreign and domestic.
Phase One fails to address growing challenges at the intersection of economics and national security: Huawei and 5G telecommunications, detentions and pressure on expatriates and travelers from the other side, foreign investment screening and export controls, and the threat of financial decoupling.

Rhodium concludes:

The agreement is a limited one, primarily capping the potential for further escalation of protectionism on both sides rather than taking serious steps to address long-standing issues in Chinese trade practices. The managed trade outcomes in which China promises additional US imports are the most significant substantive commitments made, but China’s capacity and willingness to meet these targets remains in question. Significant tariffs remain in place on both sides, uncertainty about the future path of the US-China relationship will persist, and the broader decoupling trends in security-sensitive areas of the bilateral relationship will continue. Progress toward any Phase Two agreement is likely to be minimal in 2020. (The Chinese side immediately said after the January 15 signing that it wanted to go slow before any further talks.)

The deal attempts to head off further escalation but falls well short of addressing long-standing issues with Chinese trade practices. Trade tensions and decoupling are likely to continue.

December 14, 2019December 14, 2019

Trade deal announced

Donald Trumps latest tweets on a trade deal with China:

As Trish Nguyen predicted, Trump was never going to introduce the Dec15 tariffs as they directly impact on US consumers, not producers as in earlier rounds of tariffs.

Prof Aaron Friedberg (Princeton) gives an interesting summary of the impact this deal will have. The bottom line is that China will not change its ways:

CCP-ruled China has long exploited advanced industrial economies – by pursuing a variety of predatory and market-distorting policies
The CCP is exceptionally unlikely to offer any fundamental concessions on these policies – they are deeply embedded in China’s economic system and the CCP views them as essential to its hold on power
Even if CCP-ruled China were to modify some of its more objectionable economic practices, so long as its domestic political regime remains unchanged, it will continue to pose a serious geopolitical and ideological challenge to the U.S.
In light of these realities, the U.S. should pursue a four-part strategy for defending U.S. prosperity and security, by moving toward a posture of partial economic disengagement from China.

De-coupling will continue.

October 12, 2019October 12, 2019

S&P 500 and Europe: New deal or a false dawn?

Donald Trump and is making noises about an interim trade deal with the CCP, while Boris Johnson appears to be making progress on a Brexit deal with Ireland premier Leo Varadkar.

Trump’s announcement is little more than a sham, intended to goose financial markets, with nothing yet committed to writing:

“Trump said the deal would take three to five weeks to write and could possibly be wrapped up and signed by the middle of November….”

…what could possibly go wrong?

The economy continues to tick along steadily, with unemployment and initial jobless claims near record lows.

Unemployment & Initial Jobless Claims

But high levels of uncertainty are likely to create a drag on consumer spending and stock earnings.

At the outset of Donal Trump’s presidency, value investor Seth Klarman, who runs the $30 billion Baupost Group hedge fund, predicted the impact that Trump would have on financial markets:

“The erratic tendencies and overconfidence in his own wisdom and judgment that Donald Trump has demonstrated to date are inconsistent with strong leadership and sound decision-making…..

The big picture for investors is this: Trump is high volatility, and investors generally abhor volatility and shun uncertainty…. Not only is Trump shockingly unpredictable, he’s apparently deliberately so; he says it’s part of his plan.”

In his letter, Mr Klarman warned: “If things go wrong, we could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst.”

While not entirely prescient — we have low interest rates and low inflation — Klarman was right about the decline in dollar hegemony and the rise in global angst.

Markets are clearly in risk-off mode.

US Equity ETFs recorded a net outflow of $824m this week, compared to a net inflow of $2,104m into US Fixed Income. Year-to-date flows present a similar picture, with a 3.3% inflow into US Equity compared to 13.9% into US Fixed Income (Source: ETF.com).

ETF Flows YTD

Long tails on the S&P 500 candles indicate buying support. Expect another test of our long-term target at 3000. Volatility remains above 1%, however, indicating elevated risk. Breach of 2800 is unlikely at present but would offer a target of 2400.

S&P 500

According to Factset, the S&P 500 is likely to report a third quarter this year with a year-on-year decline in earnings.

The Nasdaq 100 paints a similar picture, with another test of 8000 likely.

Nasdaq 100

It is becoming impossible to justify current heady earnings multiples when reported earnings are declining.

Europe

If Johnson’s “free trade zone” for Northern Ireland can break the Brexit impasse, then there may be room for optimism over the future UK – EU relationship.

Europe seems to be stirring. Trailing a distant third, to North America and Asia in terms of investment performance, there are some early encouraging signs. A higher trough indicates buying pressure and breakout above 400 on DJ Stoxx Euro 600 would signal a primary advance.

DJ Euro Stoxx 600

The Footsie shows similar early signs of a potential recovery. A higher trough on the trend Index indicates buying pressure. Breakout above 7600 would signal a primary advance.

FTSE 100

Let us hope that this is not a false dawn and the UK and EU are able to resolve their differences.

For the present, our outlook for the global economy remains bearish and equity exposure for International Growth is a low 34% of portfolio value.

October 12, 2019October 12, 2019

Trade talks: ‘Extend and pretend’

Donald Trump

Donald Trump has been weakened by the impeachment process, with more than half the respondents in a recent Fox News poll wanting the troubled President impeached:

“A new high of 51 percent wants Trump impeached and removed from office, another 4 percent want him impeached but not removed, and 40 percent oppose impeachment altogether.”

Criticism in the right-wing press is growing, with Judge Andrew Napolitano on Fox News:

“A CIA agent formerly assigned to the White House – and presently referred to as the “whistleblower” – reported a July 25, 2019 telephone conversation that Trump had with Ukraine’s President Volodymyr Zelensky. That conversation manifested both criminal and impeachable behavior.

The criminal behavior to which Trump has admitted is much more grave than anything alleged or unearthed by Special Counsel Robert Mueller, and much of what Mueller revealed was impeachable….”

In an attempt to shore up his ratings, the embattled President has softened his stance towards an interim trade deal with the Chinese.

“President Donald Trump said Friday that the U.S. and China had reached a “substantial phase one deal” on trade that will eliminate a tariff hike that had been planned for next week.

Trump announced the deal in the Oval Office alongside members of his economic and trade teams, as well as Chinese Vice Premier Liu He and his team, who were in Washington for negotiations.

Trump said the deal would take three to five weeks to write and could possibly be wrapped up and signed by the middle of November….”

The deal is likely to be limited in scope, which will suit China. More from NBC News:

“The White House and China are expected to announce that Beijing will buy more agricultural products, particularly pork and soybeans, from the U.S.

“It seems like they’ve already begun to buy pork,’ said Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics, pointing out that a swine fever epidemic has decimated China’s domestic pork industry. “They want to contain domestic prices,’ he said. “They’re not doing this just to please Trump. They’re doing this because it suits them.’

While there is little expectation that the Trump administration would roll back existing tariffs, a further delay of two looming deadlines would send a key signal to the markets about the trajectory for future trade relations……”

None of the hard issues will have been addressed and an interim deal is effectively a retreat by the Trump administration:

Thornier — and more fundamental — trade issues pertaining to intellectual property protections, market access and America’s push for China to change its legislation around these and other contentious issues would likely fall by the wayside, analysts said. “There aren’t going to be any of these other issues addressed, unless Trump caves,’ Kirkegaard said. “It certainly doesn’t address any of the structural issues…he went to war for.’

….“It’s a ceasefire. It’s not a peace treaty,’ Kirkegaard said. “It’s what the Chinese wanted all along.”

This was always the likely outcome, with the US economy in a stronger position to withstand a trade war but Xi and the CCP stronger politically and able to absorb more domestic pressure than the fragile Trump administration.

What we are likely to get during Trump’s remaining time as President is more ‘extend and pretend’ — a ceasefire rather than a resolution of the underlying issues regarding protection of intellectual property and reciprocal market access.