Uncertainty and the countdown to the US presidential elections

Uncertainty and the countdown to the US presidential elections

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Macro Letter – No 120 – 13-09-2019

Uncertainty and the countdown to the US presidential elections

  • JP Morgan analyse the impact of 14,000 presidential Tweets
  • Gold breaks out to the upside despite US$ strength
  • China backs down slightly over Hong Kong
  • Trump berates Fed Chair and China

These are just a few of the news stories which drove financial markets during the summer: –

VOX – The Volfefe Index, Wall Street’s new way to measure the effects of Trump tweets, explained

DailyFX – Gold Prices Continue to Exhibit Strength Despite the US Dollar Breakout

BBC – Carrie Lam: Hong Kong extradition bill withdrawal backed by China

FT – Trump lashes out at China and US Federal Reserve — as it happened.

For financial markets it is a time of heightened uncertainty. The first two articles are provide a commentary on the way markets are evolving. The impact of social media is rising, with Trump in the vanguard. Geopolitical uncertainty and the prospect of fiscal debasement are, meanwhile, upsetting the normally inverse relationship between the price of gold and the US$.

The next two items are more market specific. The stand-off between the Chinese administration and the people of the semi-autonomous enclave of Hong Kong, prompts concern about the political stability of China, meanwhile the US Commander in Chief persists in undermining the credibility of the notionally independent Federal Reserve and seems unable to resist antagonising the Chinese administration as he raises the stakes in the Sino-US trade war. Financial markets have been understandably unsettled.

Ironically, despite the developments high-lighted above, during August, US bonds witnessed sharp reversals lower, suggesting that geopolitical tensions might have moderated. Since the beginning of September prices have rebounded, perhaps there were simply more sellers than buyers last month. In Europe, by contrast, German bunds reached new all-time highs, only to suffer sharp reversal in the past week. Equity markets responded to the political uncertainty in a more consistent manner, plunging and then recovering during the past month. As the chart below illustrates, there has been increasing debate about the challenge of increased volatility since the end of July: –

VIX Index Daily

Source: Investing.com

Yet, as always, it is not the volatility or even risk which presents a challenge to financial market operators, it is uncertainty. Volatility is a measure derived from the mean and variance of a price. It is a cornerstone of the measurement of financial risk: the key point is that it is measurable. Risk is something we can measure, uncertainty is that which we cannot. This is not a new observation, it was first made in 1921 by Frank Knight – Risk, Uncertainty and Profit.

Returning to the current state of the financial markets, we are witnessing a gradual erosion of belief in the omnipotence of central banks. See Macro Letter’s 48, 79 and 94 for some of my previous views. What has changed? As Keynes might have put it, ‘The facts.’ Central Banks, most notably the Bank of Japan, Swiss National Bank and European Central Bank, have been using zero or negative interest rate policy, in conjunction with balance sheet expansion, in a valiant attempt to stimulate aggregate demand. The experiment has been moderately successful, but the economy, rather like a chronic drug addict, requires an ever increasing fix to reach the same high.

In Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory – I discussed the latest scientific justification for debasement. My conclusion: –

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

As this recent article from the Federal Reserve Bank of San Francisco – Negative Interest Rates and Inflation Expectations in Japan – indicates, even central bankers are beginning to doubt the efficacy of zero or negative interest rates, albeit, these comments emanate from the FRBSF research department rather than the president’s office. If the official narrative, about the efficacy of zero/negative interest rate policy, is beginning to change, state sponsored fiscal stimulus will have to increase dramatically to fill the vacuum. The methadone of zero rates and almost infinite credit will be difficult to quickly replace, I anticipate widespread financial market dislocation on the road to fiscal nirvana.

In the short run, we are entering a period of transition. Trump may continue to berate the chairman of the Federal Reserve and China, but his room for manoeuvre is limited. He needs Mr Market on his side to win the next election. For Europe and Japan the options are even more constrained. Come the next crisis, I anticipate widespread central bank buying of stocks (in addition to government and corporate bonds) in order to provide liquidity and insure economic stability. The rest of the task will fall to the governments. Non-inflationary fiscal profligacy will be de rigueur – I can see the politicians smiling all the way to the hustings, safe in the knowledge that deflationary forces have awarded them a free-lunch. Someone, someday, will have to pay, of course, but they will be long since retired from public office.

Conclusions and Investment Opportunities

During the next year, markets will continue to gyrate erratically, driven by the politics of European budgets, Brexit and the Sino-US trade war. These issues will be eclipsed by the twittering of Donald Trump as he seeks to win a second term in office. Looked at cynically, one might argue that Trump’s foreign policy has been deliberately engineered to slow the US economy and hold back the stock market. During the next 14 months, a new nuclear weapons agreement could be forged with Iran, relations with North Korea improved and a trade deal negotiated with China. Whether this geopolitical largesse is truly in the President’s gift remains unclear, but for a maker of deals such as Mr Trump, the prospect must be tantalising.

For the US$, the countdown to the US election remains positive, for stocks, likewise. For the bond market, the next year may be broadly neutral, but given the signs of faltering growth across the globe, it seems unlikely that yields will rise significantly. Economies will see growth slow, leading to an accelerated pace of debt issuance. Bouts of volatility, similar to August or Q4 2018, will become more commonplace. I remain bullish for asset markets, nonetheless.

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AIER -U.S. Dollar Supremacy Could Quickly Fade

AIER -U.S. Dollar Supremacy Could Quickly Fade

American Institute for Economic Research

U.S. Dollar Supremacy Could Quickly Fade

As you may have seen elsewhere I have recently been invited to contribute to AIER. This article was first published in June.

https://www.aier.org/article/us-dollar-supremacy-could-quickly-fade

dollarfade

AIER also operate the Bastiat Society, a global network of business professionals committed to advancing free trade, individual freedom, and responsible governance. To find a chapter near you please click on the link below: –

https://www.aier.org/bastiatsociety/chapters

 

 

Chinese currency manipulation – Trump’s petard

Chinese currency manipulation – Trump’s petard

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Macro Letter – No 119 – 23-08-2019

Chinese currency manipulation – Trump’s petard

  • The risk that the Sino-US trade war morphs into an international currency war has risen
  • The US$ Index is up since 2010 but its only back to the middle of it range since 2000
  • The Chinese Yuan will weaken if the Trump administration pushes for higher tariffs
  • Escalation of domestic unrest in Hong Kong will see a flight to safety in the greenback

According to the US President, the Chinese are an official currency manipulator. Given that they have never relaxed their exchange controls, one must regard Trump’s statement as rhetoric or ignorance. One hopes it is the former.

Sino-US relations have now moved into a new phase, however, on August 5th, after another round of abortive trade discussions, the US Treasury officially designated China a currency manipulator too. This was the first such outburst from the US Treasury in 25 years. One has to question their motivation, as recently as last year the PBoC was intervening to stem the fall in their currency against the US$, hardly an uncharitable act towards the American people. As the Economist – The Trump administration labels China a currency manipulator – described the situation earlier this month (the emphasis is mine): –

After the Trump administration’s announcement of tariffs on August 1st added extra pressure towards devaluation, it seems that the PBOC chose to let market forces work. The policymaker most obviously intervening to push the yuan down against the dollar is Mr Trump himself.

China does not meet the IMF definition of a ‘currency manipulator’ but the US Treasury position is more nuanced. CFR – Is China Manipulating Its Currency? Explains, although they do not see much advantage to the US: –

Legally speaking, the issue of whether China meets the standard for manipulation set out in U.S. law is complex. The 2015 Trade Enforcement Act sets out three criteria a country must meet to be tagged a manipulator: a bilateral surplus with the United States, an overall current account surplus, and one-sided intervention in the foreign-exchange market to suppress the value of its currency. The Treasury Department’s most recent report [PDF] concluded that China only met the bilateral surplus criterion.

But the 1988 Omnibus Foreign Trade and Competiveness Act [PDF] has a different definition of manipulation, saying it can emerge either from action to “[impede] effective balance of payments adjustments” or action to “[gain an] unfair competitive advantage in international trade.” The United States is likely to argue that the recent depreciation was intended to give Chinese exports an edge. China would counter that it has no obligation to resist market pressures pushing the yuan down when the United States implements tariffs that hurt China’s exports.

In the past (2003-2013) China has intervened aggressively to stem the rise of its currency, since then it has intervened in the opposite direction, to the benefit of the US. Earlier this month it briefly appeared to withdrawn from the foreign exchange market, allowing the markets to set their own level based on perceptions of risk. As the Peterson Institute – Trump’s Attack on China’s Currency Policy – puts it: –

This depreciation is due to market forces: Trump’s tariffs push the dollar up against all currencies, the Chinese currency weakens as a result of the trade hit, and China will undoubtedly lower its interest rates to counter that slowdown. There is no evidence that China has sold renminbi for dollars to overtly push its exchange rate down.

Since the inflammatory pop above 7 Yuan to the US$, China has sought to calm frayed nerves, indicating that it wishes to maintain the US$ exchange rate at around current levels: nonetheless, a pre-US election sabre has been rattled.

Speculation about the next move by the Trump administration is, as always, rife, but the consensus suggests the ‘currency manipulator’ label may be used to justify an escalation of US tariffs on Chinese goods. In this new scenario, every tariff increase by the US, will precipitate a decline in the Yuan; it will be a zero-sum game, except for the US importer who will have to foot the bill for the tariffs or pass them on to the consumer. Either a weaker Yuan will mitigate their effect or the tariffs will bite, leading to either a slowdown in consumption or higher prices, or possibly both.

Barring a weaker Yuan, this sequence of events could also threaten the independence of the Federal Reserve. The central bank will be torn between the opposing policies required to meet the dual mandate of price stability and full employment. In the worst case, prices will be rise as employment falls.

Current estimates of the increased cost of tariffs to the US economy are in the region of 10%, yet during the past year the Yuan has already declined from 6.3 to 7 (11%). As the chart below shows, a move back towards 8 Yuan to the US$ cannot be ruled out, enough to significantly eclipse the impact of US tariffs to date: –

china-currency 1993-2019

Source: Trading Economics

Conclusions and investment opportunities

In the run-up to the November 2020 presidential election, US foreign policy towards China is likely to remain confrontational. China, as always, has the ability to play the long game, although the political tensions evident in Hong Kong may highjack even their gradualist agenda. Either way, the Yuan is liable to weaken, pressurising other Asian currencies to follow suit. The US$ may appear relatively strong of late but, as the chart below shows, it is more than 50% below its 1980’s peak: –

united-states-currency

Source: Trading Economics

A move above the 2016 highs at 103 would see the US$ Index push towards the early 2000’s highs at 120.

The US bond yield curve has been steadily inverting, a harbinger, some say, of a recession. The other interpretation is that US official rates are much too high. Relative to other developed nations US Treasury yields certainly offer value. I expect the Fed to cut rates and, if inflation rises above the 2% level, expect them to point to tariff increases as a one-off inflation effect. They will choose to target full-employment over price stability.

Barring a catastrophe in Hong Kong, followed a US military response (neither of which can be entirely ruled out) any risk-off weakening of stocks, offers a buying opportunity. Further down the road, when US 10yr bond yields turn negative, stocks will trade on significantly higher multiples.

Low yield, no yield, negative yield – Buy now but don’t forget to sell

Low yield, no yield, negative yield – Buy now but don’t forget to sell

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Macro Letter – No 118 – 12-06-2019

Low yield, no yield, negative yield – Buy now but don’t forget to sell

  • The amount of negative yielding fixed securities has hit a new record
  • The Federal Reserve and the ECB are expected to resume easing of interest rates
  • Secondary market liquidity for many fixed income securities is dying
  • Outstanding debt is setting all-time highs

To many onlookers, since the great financial crisis, the world of fixed income securities has become an alien landscape. Yields on government bonds have fallen steadily across all developed markets. As the chart below reveals, there is now a record US$13trln+ of negative yielding fixed income paper, most of it issued by the governments’ of Switzerland, Japan and the Eurozone: –

Bloomberg - Negative Yield - 21st June 2019

Source: Bloomberg  

The percentage of Eurozone government bonds with negative yields is now well above 50% (Eur4.3trln) and more than 35% trades with yields which are more negative than the ECB deposit rate (-0,40%). If one adds in investment grade corporates the total amount of negative yielding bonds rises to Eur5.3trln. Earlier this month, German 10yr Bund yields dipped below the deposit rate for the first time, amid expectations that the ECB will cut rates by another 10 basis points, perhaps as early as September.

The idea that one should make a long-term investment in an asset which will, cumulatively, return less at the end of the investment period, seems nonsensical, except in a deflationary environment. With most central banks committed to an inflation target of around 2%, the Chinese proverb, ‘we live in interesting times,’ springs to mind, yet, negative yielding government bonds are now ‘normal times’ whilst, to the normal fixed income investor, they are anything but interesting. As Keynes famously observed, ‘Markets can remain irrational longer than I can remain solvent.’ Do not fight this trend, yields will probably turn more negative, especially if the ECB cuts rates and a global recession arrives regardless.

Today, government and investment grade corporate debt has been joined by a baker’s dozen of short-dated high yield Euro names. This article from IFR – ‘High-yield’ bonds turn negative – explains: –

About 2% of the euro high-yield universe is now negative yielding, according to Bank of America Merrill Lynch.

That percentage would rise to 10% if average yields fall by a further 35bp, said Barnaby Martin, European credit strategist at the bank.

He said the first signs of negative yielding high-yield bonds emerged about two weeks ago in the wake of Mario Draghi’s speech in Sintra where the ECB president hinted at a further dose of bond buying via the central bank’s corporate sector purchase programme. There are now more than 10 high-yield bonds in negative territory…

The move to negative yields for European high-yield credits is unprecedented; it didn’t even happen in 2016 when the ECB began its bond buying programme.

During Q4, 2018, credit spreads widened (and stock markets declined) amid expectations of further Federal Reserve tightening and an end to ECB QE. Now, stoked by fears of a global recession, rate expectation have reversed. The Fed are likely to ease, perhaps as early as this month. The ECB, under their new broom, Christine Lagarde, is expected to embrace further QE. The corporate sector purchase program (CSPP) which commenced in June 2016, already holds Eur177.8bln of corporate bonds, but increased corporate purchases seem likely; it is estimated that the ECB holds between 25% and 30% of the outstanding Eurozone government bond in issue, near to its self-imposed ceiling of 33%. Whilst the amount in issues is less, the central bank has more flexibility with Supranational and Euro denominated non-EZ Sovereigns (50%) and greater still with corporates (70%). In this benign interest rate environment, a continued compression of credit spreads is to be expected.

Yield compression has been evident in Eurozone government bonds for decades, but now a change in relationship is starting become evident. Even if the ECB does not increase the range of corporate bonds it purchases, its influence, like the rising tide, will float all ships. Bund yields are likely to remain most negative and the government obligations of Greece, the least, but, somewhere between these two poles, corporate bonds will begin to assume the mantle of the ‘nearly risk-free.’ With many Euro denominated high-yield issues trading below the yield offered for comparable maturity Italian BTPs, certain high-yield corporate credit is a de facto alternative to poorer quality government paper.

The chart below is a snap-shot of the 3m to 3yr Eurozone yield curve. The solid blue line shows the yield of AAA rated bonds, the dotted line, an average of all bonds: –

Eurozone AAA bond Yields vs All Bonds - ECB

Source: ECB

It is interesting to note that the yield on AAA bonds, with a maturity of less than two years, steadily becomes less negative, whilst the aggregated yield of all bonds continues to decline.

The broader high-yield market still offers positive yield but the Eurozone is likely to be the domicile of choice for new issuers, since Euro high-yield now trades at increasingly lower yields than the more liquid US market, the liquidity tail is wagging the dog: –

US vs EZ HY - Bloomberg

Source: Bloomberg, Barclays

The yield compression within the Eurozone has been more dramatic but it has been mirrored by the US where the spread between BBB and BB narrowed to a 12 year low of 60 basis points this month.

Wither away the dealers?

Forgotten, amid the inexorable bond rally, is dealer liquidity, yet it is essential, especially when investors rush for the exit simultaneously. For corporate bond market-makers and brokers the impact of QE has been painful. If the ECB is a buyer of a bond (and they pre-announce their intentions) then the market is guaranteed to rise. Liquidity is stifled in a game of devil take the hindmost. Alas, non-eligible issues, which the ECB does not deign to buy, find few natural buyers, so few institutions can justify purchases when credit default risk remains under-priced and in many cases the yield to maturity is negative.

An additional deterrent is the cost of holding an inventory of fixed income securities. Capital requirements for other than AAA government paper have increased since 2009. More damaging still is the negative carry across a wide range of instruments. In this environment, liquidity is bound to be impaired. The danger is that the underlying integrity of fixed income markets has been permanently impaired, without effective price intermediation there is limited price discovery: and without price discovery there is a real danger that there will be no firm, ‘dealable’ prices when they are needed most.

In this article from Bloomberg – A Lehman Survivor Is Prepping for the Next Credit Downturn – the interviewee, Pilar Gomez-Bravo of MFS Investment Management, discusses the problem of default risk in terms of terms of opacity (the emphasis is mine): –

Over a third of private high-yield companies in Europe, for example, restrict access to financial data in some way, according to Bloomberg analysis earlier this year. Buyers should receive extra compensation for firms that curb access to earnings with password-protected sites, according to Gomez-Bravo.

Borrowers still have the upper hand in the U.S. and Europe. Thank cheap-money policies and low defaults. Speculation the European Central Bank is preparing for another round of quantitative easing is spurring the rally — and masking fragile balance sheets.

Borrowers still have the upper hand indeed, earlier this month Italy issued a Eur3bln tranche of its 2.8% coupon 50yr BTP; there were Eur17bln of bids from around 200 institutions (bid/cover 5.66, yield 2.877%). German institutions bought 35% of the issue, UK investors 22%. The high bid/cover ratio is not that surprising, only 1% of Euro denominated investment grade paper yields more than 2%.

I am not alone in worrying about the integrity of the bond markets in the event of another crisis, last September ESMA –  Liquidity in EU fixed income markets – Risk indicators and EU evidence concluded: –

Episodes of short-term volatility and liquidity stress across several markets over the past few years have increased concerns about the worsening of secondary market liquidity, in particular in the fixed income segment…

…our findings show that market liquidity has been relatively ample in the sovereign segment, potentially also due to the effects of supportive economic policies over more recent years. This is different from our findings in the corporate bond market, where in recent years we did not find systematic and significant drop in market liquidity but we observed episodes of decreasing market liquidity when market conditions deteriorated…

We find that in the sovereign bond segment, bonds that have a benchmark status and are characterised by larger outstanding amounts tend to be more liquid while market volatility is negatively related to market liquidity. Outstanding amounts are the main bond-level drivers in the corporate bond segment…

With reference to corporate bond markets, the sensitivity of bond liquidity to bond-specific and market factors is larger when financial markets are under stress. In particular, bonds characterised by more volatile market liquidity are found to be more vulnerable in periods of market stress. This empirical result is consistent with the market liquidity indicators developed for corporate bonds pointing at episodes of decreasing market liquidity when wider market conditions deteriorate.

ESMA steer clear of discussing negative yields and their impact on the profitability of market-making, but the BIS annual economic report, published last month, has no such qualms (the emphasis is mine): –

Household debt has reached new historical peaks in a number of economies that were not at the heart of the GFC, and house price growth has in many cases stalled. For a group of advanced small open economies, average household debt amounted to 101% of GDP in late 2018, over 20 percentage points above the pre-crisis level… Moreover, household debt service ratios, capturing households’ principal and interest payments in relation to income, remained above historical averages despite very low interest rates…

…corporate leverage remained close to historical highs in many regions. In the United States in particular, the ratio of debt to earnings in listed firms was above the previous peak in the early 2000s. Leverage in emerging Asia was still higher, albeit below the level immediately preceding the 1990s crisis. Lending to leveraged firms – i.e. those borrowing in either high-yield bond or leveraged loan markets – has become sizeable. In 2018, leveraged loan issuance amounted to more than half of global publicly disclosed loan issuance loans excluding credit lines.

… following a long-term decline in credit quality since 2000, the share of issuers with the lowest investment grade rating (including financial firms) has risen from around 14% to 45% in Europe and from 29% to 36% in the United States. Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability. The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.

How financial conditions might respond depends also on how exposed banks are to collateralised loan obligations (CLOs). Banks originate more than half of leveraged loans and hold a significant share of the least risky tranches of CLOs. Of these holdings, US, Japanese and European banks account for around 60%, 30% and 10%, respectively…

…the concentration of exposures in a small number of banks may result in pockets of vulnerability. CLO-related losses could reveal that the search-for-yield environment has led to an underpricing and mismanagement of risks…

In the euro area, the deterioration of the growth outlook was more evident, and so was its adverse impact on an already fragile banking sector. Price-to-book ratios fell further from already depressed levels, reflecting increasing concerns about banks’ health…

Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s. Within this group, US banks have performed considerably better than those in the euro area, the United Kingdom and Japan…

…persistently low interest rates and low growth reduce profits. Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.

Conclusion and investment opportunities

Back in 2006, when commodity investing, as part of a diversified portfolio, was taking the pension fund market by storm, I gave a series of speeches in which I beseeched fund managers to consider carefully before investing in commodities, an asset class which had for more than 150 years exhibited a negative expected real return.

An astonishingly large percentage of fixed income securities are exhibiting similar properties today. My advice, then for commodities and today, for fixed income securities, is this, ‘By all means buy, but remember, this is a trading asset, its long-term expected return is negative; in other words, please, don’t forget to sell.’

Interest Rates, Global Value Chains and Bank Reserve Requirements

Interest Rates, Global Value Chains and Bank Reserve Requirements

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Macro Letter – No 117 – 28-06-2019

Interest Rates, Global Value Chains and Bank Reserve Requirements

  • Global Value Chains have suffered since 2009
  • Despite low interest rates, financial costs remain too high
  • Bank profitability has not recovered, yet banks are still too big to fail

In a recent speech, Hyun Song Shin, Head of Research at the BIS, discussed – What is behind the recent slowdown? The speech focused on the weakening of global value chains (GVC’s) in manufactured goods. The manufacturing sector is critical, since it accounts for 70% of global merchandise trade: –

During the heyday of globalisation in the late 1980s and 1990s, trade grew at twice the pace of GDP. In turn, trade growth in manufactured goods was driven by the growing importance of multinational firms and the development of GVCs that knit together the production activity of firms around the world.

The chart below reveals the transformation of the world economy over the past 17 years: –

The Arrival Of China 2000-2017

Source: BIS, X Li, B Meng and Z Wang, “Recent patterns of global production and GVC participation”, in D Dollar (ed), Global Value Chain Development Report 2019, World Trade Organization et al.

Hyun’s next chart tracks the sharp reversal in the relationship between world trade and GDP growth as a result of the Great Financial Crisis (GFC): –

Ratio of World Goods to GDP 2000 - 2018

Sources: IMF, World Economic Outlook; World Trade Organization; Datastream; national data; BIS calculations

The important point, highlighted by Hyun, is that the retrenchment in trade occurred almost a decade before the trade war began. China, growing at 6% plus, has captured an increasing share of global trade at the expense of the developed nations, most notably the US. Europe went through a similar transition during the second half of the 19th century, as the US transformed from an agrarian to an industrial society.

Returning to the present, supporting GVCs is capital intensive. Historically low interest rates have allowed these chains to flourish, but the recent reversal of interest rate policy by the Federal Reserve has caused structural cracks to emerge in the edifice. The BIS describes the situation for multi-national manufacturing firms in this way (the emphasis is mine): –

…firms enmeshed in global value chains could be compared to jugglers with many balls in the air at the same time. Long and intricate GVCs have many balls in the air, necessitating greater financial resources to knit the production process together. More accommodative financial conditions then act like weaker gravity for the juggler, who can throw many more balls into the air, including large balls that represent intermediate goods with large embedded value. However, when the shadow price of credit rises, the juggler has a more difficult time keeping all the balls in the air at once.

When financial conditions tighten, very long and elaborate GVCs will no longer be viable economically. A rationalisation of supply chains through “on-shoring” and “re-shoring” of activity towards domestic suppliers, or to suppliers that are closer geographically, will help reduce the credit costs of supporting long GVCs. 

It is interesting to note the use of the phrase ‘shadow price of credit,’ this suggests that concern about the intermediation process by which changes in the ‘risk-free’ rate disseminate into the real-economy. In a 2014 study, the BIS Committee on the Global Financial System (CGFS) found that 65% of world trade is still financed through ‘open account financing’ or through the buyer paying in advance. For GVC’s, short-term US interest rates matter, especially when 80% of trade finance is still transacted in the US$. Even when rates reached their nadir, banks were reluctant to lend at such favourable terms as they had prior to the GFC. The recent rise in short-term interest rates has supported the US$, accelerating the reversal in the trade to GDP ratio.

A closer investigation of bank lending since the GFC reveals structural weakness in the intermediation process. Since 2009, at the same time as interest rates fell, bank capital requirements rose. The impact of this fiscal offsetting of monetary accommodation can be seen most clearly in the global collapse the velocity of circulation of money supply: –

Global Money Velocity - Tom Drake, BEA, FRED, ECB, BoJ, China NBS, UK ONS

Source: Tom Drake, National Data, Macrobond

The mechanism by which credit reaches the real economy has been choked. Banks have gradually repaired their balance sheets, but the absurd incentives, such as the inducement to purchase zero risk-weighted government debt rather than lending to corporates, have been given fresh impetus through a combination of structurally higher capital requirements and lower interest rates.

In their January 2018 publication – Structural changes in banking after the crisis – the BIS examines how credit intermediation has changed (the emphasis is mine): –

The crisis revealed substantial weaknesses in the banking system and the prudential framework, which had led to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers…

There is no clear evidence of systematic and long-lasting retrenchment of banks from credit intermediation. The severity of the crisis was not uniform across banks and systems. Weaker banks cut back credit more strongly, and riskier borrowers saw their access to credit more tightly curtailed. In the immediate aftermath of the crisis the response of policymakers and bank managers was also differentiated across systems, with some moving more decisively than others to address the problems revealed. Bank credit has since grown relative to GDP in most jurisdictions, but has not returned to pre-crisis highs in the most affected countries, reflecting necessary deleveraging and the unwinding of pre-crisis excesses. While disentangling demand and supply drivers remains a challenging exercise, the evidence gathered by the Working Group does not point to systematic change in the willingness of banks to lend locally. In line with the objectives of post-crisis reforms, lenders have become more sensitive to risk and more discriminating across borrowers

The last two sentences appear to contradict, but measuring of loan quality from without is always a challenge. The authors’ continue to perceive credit quality and intermediation, through a glass darkly (once again, the emphasis is mine): –

If anything, the shift towards commercial banking activities suggests that banks are putting more emphasis on lending than trading activities. Still, given the range of changes in the banking sector over the past decade, policymakers should remain attentive to potential unintended “gaps” in credit to the real economy. Legacy asset quality problems can be an obstacle to credit growth. Excessive pre-crisis credit growth left a legacy of problem assets, especially high levels of NPLs, which continue to distort the allocation of fresh credit in several countries…

Persistently high NPLs are likely to lead to greater ultimate losses, impede credit growth and distort credit reallocation, potentially incentivising banks to take on more risk….

Again, the evidence seems to be contradictory. What is different between the cyclical patterns of the past and the current state of affairs? The tried and tested central bank solution to previous crises, stretching all the way back to the 1930’s, if not before, is to cut short-term interest rates – regardless of the level of inflation. The yield curve steepens sharply and banks rapidly repair their balance sheets by borrowing short-term and lending long-term. In the wake of the GFC, however, rates declined yet the economy failed to respond to the stimulus, at least in part, because the central banks accommodative actions were being negated by the tightening of regulatory conditions. Collectively the central banks and the national regulators were robbing Peter to pay Paul. The result (please pardon my emphasis once more): –

Post-crisis bank profitability has remained subdued. This reflects many factors, including bank-specific drivers (eg business model choices), cyclical macroeconomic drivers (eg low growth and interest rates) and structural drivers that will have a more persistent impact. An example of this latter group includes regulatory reforms that have implied lower leverage and the curbing of certain higher risk activities, and a reduction of implicit subsidies for large or systemically important banks…

…all else constant, lower leverage and reduced risk-taking should reduce return on equity. Sluggish revenues have dampened profits and, combined with low interest rates, may have contributed to the slower progress made by some banks in dealing with legacy problem assets…

Sufficient levels of capital are needed for banks to deal with unexpected shocks, and low profitability can weaken banks’ ability to maintain sufficient buffers. Banks that lack a steady stream of earnings to repair their capital base after an unexpected loss will have to rely on fresh equity issuance. Yet, markets are usually an expensive source of capital for banks, when accessed under duress….

In this scenario banks have an incentive to extend and reschedule zombie loans in order to avoid right-downs. Companies which should have been forced into administration linger on, banks’ ability to make new loans is curtailed and new ventures are starved of cash.

The BIS go on to make a number of suggestions in order to deal with low bank profitability and the problem of non-performing legacy assets: –

If overcapacity is a key driver of low profitability, institutional barriers to mergers must be reviewed and exit regimes applied. If the problem lies with legacy assets (such as NPLs), these should be fully addressed, which might entail a dialogue between prudential authorities and other policymakers (eg those in charge of mechanisms dealing with insolvency)…

The exit of financial institutions might be politically costly in the short run, but may pay off in the longer term through more stable banking systems, sounder lending and better allocation of resources. The implicit subsidisation of non-viable business models might have lower short-term costs but could lead to resource misallocation. Similarly, any assessment of consolidation trends needs to take into account potential trade-offs between efficiency and stability, as well as examine the nature and impact of barriers to exit for less profitable banks.

These suggestions make abundant sense but that is no guarantee the BIS recommendations will be heeded.

I am also concerned that the authors’ may be overly optimistic about the resilience of the global banking system: –

Compared with the pre-crisis period, banks are better capitalised and have lower exposure to liquidity and funding risks. They have also reduced activities that contributed to the build-up of vulnerabilities, such as exposure to high-risk assets, and excessive counterparty risk through OTC derivatives and repo transactions, among others. That said, given that markets have not yet evolved through a full financial cycle, bank restructuring efforts remain under way. In addition, as many relevant reforms have not yet been fully implemented, it is too early to assess their full effect.

Thankfully the BIS outlook is not entirely rose-tinted, they do acknowledge: –

…some trends in banking systems that we have observed since the crisis, such as the decline in wholesale funding, might be affected by unconventional monetary policy and may not persist. Success in addressing prior problems does not guarantee that banks will be able to respond to future risks…

Problems of bank governance and risk management contributed to the crisis and have been a key focus of reform. Given that the sources of future vulnerabilities are hard to predict, banks need to have robust frameworks of risk governance and management to identify and understand emerging risks and their potential impacts for the firm.

The BIS choose to gloss over the fact that many banks are still far too big to fail. They avoid discussing whether artificially low interest rates and the excessive flatness of yield curves may be contributing to a different breed of systemic risk. Commercial banks are for-profit institutions, higher capital requirements curtail their ability to achieve acceptable returns on capital. The adoption of central counterparties for the largest fixed income market in the world, interest rate swaps, whilst it reduces the risk for individual banking institutions, increases systemic risk for the market as a whole. The default of a systemically important central counterparties could prove catastrophic.

Conclusions and investment opportunities

The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.

US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.

Gold – is it all that glisters?

Gold – is it all that glisters?

In the Long Run - small colour logo

Macro Letter – No 116 – 14-06-2019

Gold – is it all that glisters?

  • Uncertainty about US trade policy has truncated the rally in stocks
  • Gold remains supported by central bank buying and fears of a US$ collapse
  • Gold miners look best placed to reap the benefits regardless of direction
  • A collapse in the U$ is needed for gold to rally substantially

In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments both for gold and gold mining stocks which are worthy of closer investigation.

Central Banks

Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.

In the first quarter of 2019 central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new, central bank purchases have been rising since 2009: –

Central Banks Gold Holdings - BIS, IMF GEMS, Reuters

Source: BIS, IMF, GEMS, Reuters

Putting global reserve holdings in perspective, here is the central bank world ranking as at March 2019: –

statistic_id267998_value-of-gold-reserves-2019-by-country

Source: IMF, Statistica

Despite the substantial buying from central banks the price of gold has been broadly range bound for the past five years.

commodity-gold 10 year

Source: Trading Economics

The absence of a sustained rally suggests that many investors have forsaken the barbarous relic, however, concern that the gold price will collapse have to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000’s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below Money Metals Exchange shows Barrick (GOLD) and Newmont (NEM) average cost of production since 2000: –

saupload_Barrick-Newomnt-Production-Cost-vs-Gold-Price_thumb1

Source: SRSrocco Report, Kitco

In a July 2018 post for Seeking Alpha – Money Metals Exchange –  Never Before Seen Charts: Gold Mining Industry’s Costs Are Higher Than Market Realizes show that the amount of ore needed to produce an ounce of gold at Barrick’s (GOLD) Nevada Goldstrike and Cortez Mines has increased four-fold since 1998: –

saupload_barrick-nevada-goldstrike-cortez-mines

Source: SRSrocco Report, Barrick

The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, this is dwarfed by the 190,000 tons that have been mined throughout history according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association – Do Extraction Costs Drive Gold Prices? They conclude that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.

The US$ and inflation expectations

The rally in the gold price in 2011-2012 was linked to the Eurozone crisis, the moderation since then has coincided with a recovery in the US Dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral; an environment in which gold would not be expected to excel: –

united-states-currency DXY 2000 - 2019

Source: Trading Economics

A different approach to gold valuation is the ratio of the gold price to the total-return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.

Is gold perfectly priced or do the central banks know something we do not?

A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed currency fluctuations were substantial and the US$ lurched steadily lower: –

USD Index 1971 - 1981

Source: Trading Economics

The US$ was so little revered that in 1978 the US Treasury had to issue foreign currency denominated Carter Bonds in Swiss Francs and German Marks, such was the level of distrust in the mighty greenback.

Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about – taking away the punch bowl just as the party got started – he hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.

Today the US$ is undoubtedly the first reserve currency. In the era of digital money and crypto currencies the barbarous relic has stiff competition. Added to which it is traditionally an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US$ denominated debt, many believe this is the next challenge to the international order.

Considering the conflagration of factors alluded to above, I believe gold is destined to remain a much watched side-line. Gold mining stocks may fare better, as S&P Global Market Intelligence – Outlook 2019: US$3.9B Increase In Earnings For Majors – explains: –

…rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.

As for price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will insure the downside is muzzled too. When I have little fundamental conviction I am inclined to follow the trend. A break to the upside maybe closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.

Trade Wars, the prospects for freer trade and the impact on asset prices

Trade Wars, the prospects for freer trade and the impact on asset prices

In the Long Run - small colour logo

Macro Letter – No 115 – 24-05-2019

Trade Wars, the prospects for freer trade and the impact on asset prices

  • Will the Sino-US trade war breed contagion?
  • Will the dispute trigger a global recession?
  • Has the era of freer trade ended?
  • Will asset prices suffer?

As Sino-US trade talks ended, not only, without a deal, but with another sharp increase in tariffs, it is worth looking at what has happened and why. During 2018 the US reversed 38 years of tariff reduction with a radical abruptness, imposing tariffs on 50% of Chinese imports, China retaliated in kind, imposing tariffs on 70% of US imports. The Peterson Institute – The 2018 US-China Trade Conflict after 40 Years of Special Protection – published before the recent tariff increases, reviews the situation in detail. The author, Chad Brown, begins by looking at the tariff reductions since the late 1980’s. For the US, these tariffs had fallen from 5% to 3%, whilst for China they declined from 40% to 8% by 2017. Over the same period China’s share of US imports rose from near to zero in 1978 to 20% by 2014. By contrast, Chinese imports from the US rose steadily, reaching 10% in 2001 – which coincided with their ascension to the World Trade Organisation (WTO) – however, since then, imports from the US have declined, dipping to 8.5% by 2017. In bilateral terms Chinese imports from the US are about a quarter of her exports to the land of the free.

At first sight, it might seem as if the trade tensions between China and the US are new, but relations have been deteriorating since the bursting of the US Tech bubble in 2001, if not before. Looking at the chart below, which measures antidumping and countervailing tariffs, it appears as if the Chinese did not begin to retaliate until 2006: –

US China countervaling tariffs 1980 to 2018

Source: Peterson Institute

Analysing anti-dumping and countervailing tariffs in isolation, however, gives a misleading impression of the US response to China. Peterson research attempts to assess the entire scope of the Sino-US trade dispute, by incorporating all forms of US special protection against China over the entire period. The next chart shows the true scale of US tariff reduction on Chinese imports; seen in this light, the extent of the recent policy shift is even more dramatic: –

US special prtections against China

Source: Peterson Institute

Using this combined metric, US special protection peaked at 39% in 1986, after which these barriers declined rapidly reaching a nadir at 4.3% in 2005. On the eve of the trade war in 2017 barriers had risen to 8.1%. Prior to the May 10th tariff increase, that figure had jumped to 50%. An updated version of the Peterson chart of shown below: –

Sino-US Tariff update since May 1oth 2019

Source: Peterson Institute

The additional tariffs imposed this month will raise the average US tariff on Chinese goods to 18.3%. If Trump follows through with his threat to impose a 25% tariff on most of the rest of US imports from China, the average US tariff toward China would increase to 27.8%.

Sino-US Tariffs 2017 - 2019

Source: Peterson Institute

What is the likely impact of these actions on trade and prices? For the US, import prices will increase, but given that US inflation has tended to be below the Fed target, this is manageable; corporates and consumers will pay the cost of tariffs, the tax receipts will help to finance the cost of recent US tax cuts. In China, whilst the impact is still negative, as this recent article from CFR – China Never Stopped Managing its Trade makes clear, the majority of imports are made by state owned enterprises or by companies which have a government permit to import such goods, added to which Chinese inflation has also been reasonably subdued, despite impressive continued economic expansion: –

When the state controls the firms that are doing the importing, a few phone calls can have a big impact. That’s why China can shut down trade in canola with Canada without formally introducing any tariffs.

That’s why China can scale back its purchases of Australian coal without filing a “dumping” or “national security” tariffs case.

And that’s why—when the trade war with the United States started—U.S. exports in a number of goods simply went to zero (normally, a 25 percent tariff would reduce imports by more like 50 percent or something…]

For US companies the four largest exports to China are aircraft, automobiles, soybeans and oil and gas. Of these, only automobiles are sold directly to the private sector. Here are three charts which explain why, for the US (at least in the near-term) there may be less to lose in this global game of chicken: –

Auto Exports to China

Source: US Census Bureau, Haver Analytics

Soybean Exports to China

Source: US Census Bureau, Haver Analytics

Ooil and Gas Exports to China

Source: US Census Bureau, Haver Analytics

The decline in US imports has been driven by a combination of substitution for imports from other sources and a rising domestic capability to manufacture intermediate goods. Faced with a dwindling market for their exports, the US might be forgiven for wishing to retire from the fray whilst it still has the advantage of being the ‘consumer of last resort’.

To date, US government receipts from tariff increases have amounted to an estimated $2bln. A study by the World Bank and the International Finance Corporation, however, estimates the true cost the US economy has been nearer to $6.4bln or 0.03% of GDP. The chart below shows the already substantial divergence between prices for tariff versus non-tariff goods: –

tariffs-inflation

Source: Financial Sense, US Department of Labor, Commerce department, Goldman Sachs

The impact on China is more difficult to measure since Chinese statistics are difficult interpret, however, only 18% of Chinese exports are to the US – that equates to $446bln out of a total of $2.48trln in 2018, added to which, exports represent only 20% of Chinese GDP – all US imports amount to 3.6% of Chinese GDP.

The scale of the dispute (bilateral rather than multilateral) should not detract from its international significance. One institution which seen its credibility undermined by the imposition of US tariffs is the World Trade Organisation (WTO) – Chatham House – The Path Forward on WTO Reform provides an excellent primer to this knotty issue. Another concern, for economists, is that history is repeating itself. They fear Trump’s policies are a redux of the infamous Smoot-Hawley tariffs, imposed during the great depression. Peterson – Does Trump Want a Trade War? from March 2018 and Trump’s 2019 Protection Could Push China Back to Smoot-Hawley Tariff Levels published this month are instructive on this topic. These tariffs were implemented on 17th June 1930 and applied to hundreds of products. To put today’s dispute in perspective, the 1930’s tariff increase was only from 38% to 45% – a mere 18% increase – this month tariffs have increased from 10% to 25%: a 150% increase. Those who note that 25% is still well below 1930’s levels should not be complaisant, China remains a WTO member, were it not, US average tariffs would now be 38%. Back in 2016 President Trump talked of raising tariffs on Chinese imports to 45%, a number cunningly lifted from the Smoot-Hawley playbook.

One of the counter-intuitive effects of the 1930’s tariff increase was price deflation, in part due to many tariffs being imposed on a per unit cost basis. Today, per unit tariffs apply to only around 8% of goods, added to which, due to monetary engineering, by central banks, and the issuance of fiat currency by governments, the threat of real deflation is less likely.

Another risk is that the Sino-US spat engulfs other countries. The EU (especially Germany) has already suffered the ire of the US President. Recent trade deals between the EU and both Canada and Japan, have been heralded as a triumph for free-trade, however, they are an echo of the trading blocs which formed during the 1930’s. To judge by Trump’s recent tweets, for the moment, China has been singled out, on 13th May the President said: –

“Also, the Tariffs can be completely avoided if you buy from a non-Tariffed Country, or you buy the product inside the USA (the best idea). That’s Zero Tariffs. Many Tariffed companies will be leaving China for Vietnam and other such countries in Asia. That’s why China wants to make a deal so badly!”

Even if the trade dispute remains a Sino-US affair, there are other unseen costs to consider, on productivity and investment, Bruegal – Implications of the escalating China-US trade dispute takes up the discussion (emphasis mine): –

The direct aggregate effect of the tariffs on the welfare of the US and Chinese, while negative, is likely to be very small… because they represent a transfer from consumers, importers and partner exporters to the government… sooner or later, the American consumer will bear much of the cost of the tariff though higher prices, but also that tariff revenue will return to American residents in some form. The negative aggregate welfare effect of tariffs thus arises because, at the margin, they displace more efficient producers by less efficient ones… because, at the margin, tariffs artificially reduce the consumption or use of imports in favour of domestic goods or goods imported from third parties…

The distributional effect of tariffs is likely to be very uneven and severely negative on some people and sectors… while the Treasury will see increased revenue, and some producers who compete with imports will gain, small companies that depend on imported parts from China are likely to be very badly affected by tariffs…

Larger importers will also be adversely affected… US farmers who depend on Chinese markets have already been badly hurt by Chinese retaliation…

The biggest adverse effects of tariffs on aggregate economic activity is through investment. Lower investment is the natural result of the tariffs’ big distributional effects… and the uncertainty they engender. This effect on ‘animal spirits’ is difficult to model and impossible to quantify with precision… The extraordinary sensitivity of stock markets to trade news and their volatility is just one manifestation of this effect. The widening growth gap between the global manufacturing and services sectors evident in recent quarters is another, as is the slowdown in investment in many countries.

Bruegal go on to discuss the risk to the international trading system and the damage to the credibility of the WTO. Finally they suggest that the trade dispute is a kind of proxy-war between the two super-powers: this is much more than just a trade dispute.

Putting the Sino-US dispute in an historical context, a number of commentators have drawn comparisons between China today and Japan in the 1980’s. I believe the situation is quite different, as will be the outcome. Again, I defer to Bruegal – Will China’s trade war with the US end like that of Japan in the 1980s?  The author’s argue that Japan chose to challenge the US when it was close to its economic peak and its productivity was stagnating. China, by contrast, has a younger population, rapidly improving productivity and, most importantly, remains a significant way below its economic peak: –

…Because China is at an earlier stage of economic development, it is expected to challenge the US hegemony for an extended period of time. Therefore, the US-China trade war could last longer than the one with Japan. With China’s growth prospects still relatively solid –  it will soon overtake the US economy in size and it does not depend on the US militarily – China will likely challenge US pressure in the ongoing negotiations for a settlement to the trade war. This also means that any deal will only be temporary, as the US will not be able to contain China as easily as it contained Japan.

If you are looking for a more global explanation of the current dispute between the US and China, then this article from CFR – The Global Trading System: What Went Wrong and How to Fix It is instructive: –

As economist Richard Baldwin lays out in his book The Great Convergence, the Industrial Revolution of the 19th century had launched Europe, the US, Japan and Canada on a trajectory that would see their wealth surge ahead of the rest of the world. In 1820, for example, incomes in the US were about three times those of China; by 1914 Americans would be 10 times as wealthy as Chinese. Manufacturing clustered in the technologically advanced countries, while advances in containerized shipping and the lowering of tariffs through trade negotiations made it possible for these countries to specialize and trade in the classic Ricardian fashion.

The information technology revolution of the 1990s turned that story upside down. With the advent of cheap, virtually instant global communications via the Internet, it became possible – and then imperative for competitive success – for multinational companies to take their best technologies and relocate production in lower-wage countries. Manufacturing output rose in middle-income countries like China, India, Thailand, Poland and others, while falling sharply in the US, Japan, France, the UK and even Germany…

The global great convergence, however, coincided with a great divergence within the wealthy countries (and many developing countries as well). The new technologies and the disappearance of trade barriers upended the balance between labor and capital in the advanced industrialized countries, and contributed to soaring economic inequality…

In the US in 1979, an American with a college degree or higher earned about 50% more than one who had only a high school education or less. By 2018, American workers with a four-year college degree earned almost twice as much as those with just a high-school education, and were unemployed half as often, while those with a professional degree earned nearly three times as much.

The author goes on to liken today’s tension between the US and China with the situation which existed between the UK and US at the beginning of the 20th century: –

The world today again faces the same governance gap – a US that no longer has the economic muscle nor the political will to organize the global system, and a rising China that is reluctant to play a greater role.

CFR ask what the prospects maybe for renewed globalization? They identify three key elements which need to be addressed in order for de-globalisation to be reversed: a trade war truce (once both sides wake up to the extent of the empasse they have engineered), a filling the Leadership Vacuum (caused by both sides turning their backs on the WTO – they need to reengage and lead the world towards a solution) and, especially for the US, meeting the challenges at home (Trump cannot rely on a trade war in the long-run to solve the problem of inequality within the US).

Conclusions and investment opportunities

What is the likely impact on financial markets? To answer this question one needs to know whether the current trade war will escalate or dissipate: and if it escalates, will it be short and sharp or protracted and pernicious?

Alisdair Macleod of Gold Money – Post-tariff considerations identifies the following factors: –

The effect of the new tariff increases on trade volumes

The effect on US consumer prices

The effect on US production costs of tariffs on imported Chinese components

The consequences of retaliatory action on US exports to China

The recessionary impact of all the above on GDP

The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury

Leading, in MacLeod’s opinion, to: –

Reassessment of business plans in the light of market information

A tendency for bank credit to contract as banks anticipate heightened lending risk

Liquidation of financial assets held by banks as collateral

Foreign liquidation of USD assets and deposits

The government’s borrowing requirement increasing unexpectedly

Bond yields rising to discount increasing price inflation

Banks facing increasing difficulties and the re-emergence of systemic risk

The author suggests that, all other things equal, tariffs should lead to price increases, but, with the US consumer already heavily burdened with debt, consumption demand will suffer.

I am less bearish than MacLeod because, if the Sino-US trade war threatens to puncture the decade long equity bull-market, we will see a combination of qualitative and quantitative easing from the largest central banks and aggressive fiscal stimulus from the governments of G20 and beyond. I wrote about this scenario (though without reference to the trade war) earlier this month in Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory. My, perhaps overly simple, prediction for assets in the longer-term is: bonds up, stocks up and real estate up.

In an alternative scenario, we might encounter asset price deflation and consumer price inflation occurring simultaneously. Worse still, this destructive combination of forces might coinciding with a global recession. The severity of any recession – and the inevitable correction to financial markets that such an economic downturn would precipitate – will depend entirely on the time it takes for US and Chinese trade negotiators to realise the danger and reach a compromise. I believe they will do so relatively quickly.

Attempting to predict what President Trump might do next is fraught with danger, but, due to the inherent weakness of the democratic process, I expect the US administration to concede. The US President has an election to win in November 2020; the President of China has been elected for life.