Interview with Chris Watling of Longview Economics – Reducing Equity Risk – 6 to 24 month forecast.
Interview with Chris Watling of Longview Economics – Reducing Equity Risk – 6 to 24 month forecast.
Macro Letter – No 100 – 13-07-2018
Canary in the coal-mine – Emerging market contagion
As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?
To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.
In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –
Source: Trading Economics, Investing.com, IMF, World Bank
For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.
Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.
Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.
Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.
This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –
Source: Trading Economics, Investing.com, IMF, World Bank
In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.
India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.
Is Turkey the canary?
The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.
Conclusion and investment opportunities
In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –
…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.
Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.
If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.
Macro Letter – No 97 – 18-05-2018
Robots, employment and the mis-measurement of productivity
The subject matter of this Macro Letter is broad, so I shall confine my investigation to the UK. It was, after all, one of the first countries where services became a larger percentage of GDP than manufacturing. The crossover between manufacturing and services is estimated to have happened around 1881. When Napoleon Bonaparte described England as, ‘A nation of shopkeepers,’ his intension may have been derisive, but his observation was prescient. Of course, M. Bonaparte was actually quoting Adam Smith, who first coined the phrase in his magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776: now, he really was prescient.
As we stare into the abyss, anticipating the huge percentage of manufacturing – and now, many services – jobs which are expected to be replaced by machines, it behoves us to begin by reviewing the accuracy with which we measure services in general. A recent paper from the Centre for Economic and Business Research does just that for one sub-sector, although it suggests that mis-measurement of economic activity in services, always difficult to define, may be a factor in the poor productivity record of the UK. I have often described Britain as a post-industrial nation but this research, into one of the most vibrant corners of the economy, makes fascinating reading – The True Value of Creative Industries Digital Exports – CIC, CBER – March 2018 – finds, among other things that: –
The UK’s creative industries exports are: –
£46bn in goods and services – 24% higher than the official figure
£31bn of total creative exports are services – 41% higher than the official figure
£21bn of these creative services are digital services – 40% higher than the official figure
The CEBR goes on to point out other weaknesses in current measurements of economic activity: –
…estimated official figures for 2016 highlight that the majority of creative industries sub-sectors are exporting digital services. The IT, software and computer services sector, for example, exports £8.95bn in digital services. However, according to these figures, the crafts and museums, galleries and libraries sectors’ digital services exports are zero – which we know is not the case.
Many UK YouTube channels, for example, are watched by millions of viewers across the world. It is through these types of platforms that the creative industries export audiovisual content, music, and tutorials. Such platforms and the content they offer, however, may not be registered as a service export. This is due to difficulties capturing data for business models such as those offering free content and based on advertising revenues.
There are also structural challenges with collecting data on such exports. Often, it is difficult for digital intermediaries to determine the point of sale and purchase. The borderless way in which many global firms operate presents additional complications and the origin of the creative content, and of those who consume it, is frequently hard to track.
This brings me to the vexed question of productivity growth in the new machine age. In the Deloitte – Monday Briefing – Thoughts on the global economy – from 30th April, the author reflects on the discussions which occurred at the annual global gathering of Deliotte’s economic experts. I’m cherry picking, of course, the whole article is well worth reading: –
Despite discussion of recession risks I was struck by a cautious optimism about the long-term outlook. There was a general view that the slowdown in productivity growth in the West has been overstated, partly because of problems in capturing gains from technological change and quality improvements. As a result most of us felt that Western economies should be able to improve upon the lacklustre growth rates seen in the last ten years.
We agreed too that apocalyptic media stories about new technologies destroying work were overcooked; technology would continue to create more jobs than it destroys. The challenge would be to provide people with the right skills to prosper. The question was, what skills? We had a show of hands on what we would recommend as the ideal degree subjects for an 18-year-old planning for a 40-year career. Two-thirds advocated STEM subjects, so science, technology, engineering and maths. A third, myself included, opted for humanities/liberal arts as a way of honing skills of expression, creativity and thinking.
Mr Stewart ends by referring to a letter to the FT from Dr Lawrence Haar, Associate Professor at the University of Lincoln, in which he argues that poor UK productivity is a function of the low levels of UK unemployment. In other words, when everyone, even unproductive workers, are employed, productivity inevitably declines:-
…it does not have to be this way. Some economies, including Singapore, Switzerland and Germany, combine low unemployment and decent productivity growth. The right training and education can raise productivity rates for lower skilled workers.
This theme of productivity growth supported by the right education and training is at the heart of a recent paper written by Professor Shackleton of the IEA – Current Controversies No. 62 – Robocalypse Now? IEA – May 2018 – the essay cautions against the imposition of robotaxes and makes the observation that technology has always created new jobs, despite the human tendency to fear the unknown: why should the adoption of a new swath of technologies be different this time? Here is his introduction: –
It is claimed that robots, algorithms and artificial intelligence are going to destroy jobs on an unprecedented scale.
These developments, unlike past bouts of technical change, threaten rapidly to affect even highly-skilled work and lead to mass unemployment and/or dramatic falls in wages and living standards, while accentuating inequality.
As a result, we are threatened with the ‘end of work’, and should introduce radical new policies such as a robot tax and a universal basic income.
However the claims being made of massive job loss are based on highly contentious technological assumptions and are contested by economists who point to flaws in the methodology.
In any case, ‘technological determinism’ ignores the engineering, economic, social and regulatory barriers to adoption of many theoretically possible innovations. And even successful innovations are likely to take longer to materialise than optimists hope and pessimists fear.
Moreover history strongly suggests that jobs destroyed by technical change will be replaced by new jobs complementary to these technologies – or else in unrelated areas as spending power is released by falling prices. Current evidence on new types of job opportunity supports this suggestion.
The UK labour market is currently in a healthy state and there is little evidence that technology is having a strongly negative effect on total employment. The problem at the moment may be a shortage of key types of labour rather than a shortage of work.
The proposal for a robot tax is ill-judged. Defining what is a robot is next to impossible, and concerns over slow productivity growth anyway suggest we should be investing more in automation rather than less. Even if a workable robot tax could be devised, it would essentially duplicate the effects, and problems, of corporation tax.
Universal basic income is a concept with a long history. Despite its appeal, it would be costly to introduce, could have negative effects on work incentives, and would give governments dangerous powers.
Politicians already seem tempted to move in the direction of these untested policies. They would be foolish to do so. If technological change were to create major problems in the future, there are less problematic policies available to mitigate its effects – such as reducing taxes on employment income, or substantially deregulating the labour market.
Professor Shackleton provides a brief history of technological paranoia. Riccardo added a chapter entitled ‘On Machinery’ to the third edition of his ‘Principles of Political Economy and Taxation,’ stating: –
‘I am convinced that the substitution of machinery for human labour is often very injurious to the interests of the class of labourers’.
While Marx, writing only a few decades later, envisaged a time when man would be enabled to: –
‘…to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticise after dinner… without ever becoming hunter, fisherman, herdsman or critic.’
As for Keynes essay on the, ‘Economic Possibilities for our Grandchildren’, his optimism is laudable if laughable – 15 hour working week anyone?
The paranoia continues, nonetheless – The Economist – A study finds nearly half of jobs are vulnerable to automation – April 2018 – takes up the story:-
A wave of automation anxiety has hit the West. Just try typing “Will machines…” into Google. An algorithm offers to complete the sentence with differing degrees of disquiet: “…take my job?”; “…take all jobs?”; “…replace humans?”; “…take over the world?”
Job-grabbing robots are no longer science fiction. In 2013 Carl Benedikt Frey and Michael Osborne of Oxford University used—what else?—a machine-learning algorithm to assess how easily 702 different kinds of job in America could be automated. They concluded that fully 47% could be done by machines “over the next decade or two”.
A new working paper by the OECD, a club of mostly rich countries, employs a similar approach, looking at other developed economies. Its technique differs from Mr Frey and Mr Osborne’s study by assessing the automatability of each task within a given job, based on a survey of skills in 2015. Overall, the study finds that 14% of jobs across 32 countries are highly vulnerable, defined as having at least a 70% chance of automation. A further 32% were slightly less imperilled, with a probability between 50% and 70%. At current employment rates, that puts 210m jobs at risk across the 32 countries in the study.
For a robust analysis, if not refutation, of the findings of Frey and Osborne, I refer you back to Professor Shackleton’s IEA paper. He is more favourably disposed towards the OECD research, which is less apocalyptic in its conclusions. He goes on to find considered counsel in last year’s report from McKinsey Global Institute (2017) A Future that Works: Automation Employment and Productivity.
The IEA paper highlights another factor which makes it difficult to assess the net impact of technological progress, namely, the constantly changing nature of the labour market. As the table below reveals it has hardly been in stasis since the turn of the millennium: –
Percentage change in employment 2001-2017, selected occupations
Notes: April-June of years. Figures in brackets are April-June 2017 levels of employment.
Source: Author’s calculation from ONS
The job losses are broadly predictable; that technology has usurped the role of the travel agent is evident to anyone who booked a flight, hotel or hire-car online recently. For economists there are always challenges in capturing the gains; back in 1987 Robert Solow, a recipient of the Nobel prize from economics, famously observed, ‘You can see the computer age everywhere but in the productivity statistics’ – perhaps the technology has been creating more jobs than thought. Does the 170% rise in Animal Care and Control owe a debt to technology? You might be inclined to doubt it but the 400,000 Uber drivers of London probably do. We are still seeking signs in the economic data for something we know instinctively should be evident.
Between the mis-measurement of economic activity (if technology is being under-estimated to the tune of 24% in the creative industries sector to what extent are productivity gains from technology being underestimated elsewhere?) and the ever changing employment landscape, I believe the human race will continue to be employed in a wide and varied range of increasingly diverse roles. If some of the more repetitive and less satisfying jobs are consigned to robots and machine learning computer code, so much the better for mankind. For more on, what is sometimes termed, the routinisation of work, this working paper from Bruegel – The impact of industrial robots on EU employment and wages: A local labour market approach – April 2018 is inciteful. They examine six EU countries and make comparisons, or highlighting contrasts, with the patterns observed in the US. Their conclusions are somewhat vague, however, which appears to be a function of the difficulty of measurement: –
We only find mixed results for the impact of industrial robots on wage growth, even after accounting for potential endogeneity and potential offsetting effects across different population or sectoral groups.
…We believe that future research on the topic should focus on exploiting more granular data, to explore whether insignificant aggregate effects (on wages) are to the result of counterbalancing developments happening at the firm level.
Bruegel refrain from proposing cuts to personal taxation as favoured by the IEA, suggesting that a more complex policy response may be required, however, their conclusions are only marginally negative. I am inclined to hope that market forces may be allowed to deal with the majority of the adjustment; they have worked well if history is any guide.
Conclusions and investment opportunities
Ignoring the fact that we are nine years into an equity bull market and that interest rates are now rising from their lowest levels ever recorded, the long term potential for technology remains supportive for equity markets, for earnings growth and for productivity. If history repeats, or even if it simply rhymes, it should also be good for employment.
With interest rates looking more likely to rise than fall over the next few years, companies will remain reticent to invest in capital projects. Buying back stock and issuing the occasional special dividend will remain the policy du jour. Assuming we do not suffer a repeat of the great financial recession of 2008 – and that remains a distinct possibility – the boon of technology will create employment with one invisible hand as it creatively destroys it with the other (with apologies to Smith and Schumpeter). If governments can keep their budgets in check and resist the temptation to siphon off investment from the productive sectors of the economy (which, sadly, I doubt) then, in the long run, the capital investment required to create the employment opportunities of the future will materialise.
A monthly review of the macro themes and drivers of markets for March 2018
Macro Letter – No 94 – 06-04-2018
What to expect from Central Bankers
As financial markets adjust to a new, higher, level of volatility, it is worth considering what the Central Banks might be thinking longer term. Many commentators have been blaming geopolitical tensions for the recent fall in stocks, but the Central Banks, led by the Fed, have been signalling clearly for some while. The sudden change in the tempo of the stock market must have another root.
Whenever one considers the collective views of Central Banks it behoves one to consider the opinions of the Central Bankers bank, the BIS. In their Q4 review they discuss the paradox of a tightening Federal Reserve and the continued easing in US national financial conditions. BIS Quarterly Review – December 2017 – A paradoxical tightening?:-
Overall, global financial conditions paradoxically eased despite the persistent, if cautious, Fed tightening. Term spreads flattened in the US Treasury market, while other asset markets in the United States and elsewhere were buoyant…
Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.
The authors go on to observe that the environment is more reminiscent of the mid-2000’s than the tightening cycle of 1994. Writing in December they attribute the lack of market reaction to the improved communications policies of the Federal Reserve – and, for that matter, other Central Banks. These policies of gradualism and predictability may have contributed to, what the BIS perceive to be, a paradoxical easing of monetary conditions despite the reversals of official accommodation and concomitant rise in interest rates.
This time, however, there appears to be a difference in attitude of market participants, which might pose risks later in this cycle:-
…while investors cut back on the margin debt supporting their equity positions in 1994, and stayed put in 2004, margin debt increased significantly over the last year.
At a global level it is worth remembering that whilst the Federal Reserve has ceased QE and now begun to shrink its balance sheet, elsewhere the expansion of Central Bank balance sheets continues with what might once have passed for gusto.
The BIS go on to assess stock market valuations, looking at P/E ratios, CAPE, dividend pay-outs and share buy-backs. By most of these measures stocks look expensive, however, not by all measures:-
Stock market valuations looked far less frothy when compared with bond yields. Over the last 50 years, the real one- and 10-year Treasury yields have fluctuated around the dividend yield. Having fallen close to 1% prior to the dotcom bust, the dividend yield has been steadily increasing since then, currently fluctuating around 2%. Meanwhile, since the GFC, real Treasury yields have fallen to levels much lower than the dividend yield, and indeed have usually been negative. This comparison would suggest that US stock prices were not particularly expensive when compared with Treasuries.
The authors conclude by observing that EM sovereign bonds in local currency are above their long-term average yields. This might support the argument that those stock markets are less vulnerable to a correction – I would be wary of jumping this conclusion, global stocks market correlation may have declined somewhat over the last couple of years but when markets fall hard they fall in tandem: correlations tend towards 100%:-
Source: BIS, BOML, EPFR, JP Morgan
The BIS’s final conclusion?-
In spite of these considerations, bond investors remained sanguine. The MOVE* index suggested that US Treasury volatility was expected to be very low, while the flat swaption skew for the 10-year Treasury note denoted a low demand to hedge higher interest rate risks, even on the eve of the inception of the Fed’s balance sheet normalisation. That may leave investors ill-positioned to face unexpected increases in bond yields.
*MOVE = Merrill lynch Option Volatility Estimate
Had you read this on the day of publication you might have exited stocks before the January rally. As markets continue to vacillate wildly, there is still time to consider the implications.
Another BIS publication, from January, also caught my eye, it was the transcript of a speech by Claudio Borio’s – A blind spot in today’s macroeconomics? His opening remarks set the scene:-
We have got so used to it that we hardly notice it. It is the idea that, for all intents and purposes, when making sense of first-order macroeconomic outcomes we can treat the economy as if its output were a single good produced by a single firm. To be sure, economists have worked hard to accommodate variety in goods and services at various levels of aggregation. Moreover, just to mention two, the distinctions between tradeables and non-tradeables or, in some intellectual strands, between consumption and investment goods have a long and distinguished history. But much of the academic and policy debate among macroeconomists hardly goes beyond that, if at all.
The presumption that, as a first approximation, macroeconomics can treat the economy as if it produced a single good through a single firm has important implications. It implies that aggregate demand shortfalls, economic fluctuations and the longer-term evolution of productivity can be properly understood without reference to intersectoral and intrasectoral developments. That is, it implies that whether an economy produces more of one good rather than another or, indeed, whether one firm is more efficient than another in producing the same good are matters that can be safely ignored when examining macroeconomic outcomes. In other words, issues concerned with resource misallocations do not shed much light on the macroeconomy.
Borio goes on to suggest that ignoring the link between resource misallocations and macroeconomic outcomes is a dangerous blind spot in marcoeconomic thinking. Having touched on the problem of zombie firms he talks of a possible link between interest rates, resource misallocations and productivity.
The speaker reveals two key findings from BIS research; firstly that credit booms tend to undermine productivity growth and second, that the subsequent impact of the labour reallocations that occur during a financial boom last for much longer if a banking crisis follows. Productivity stagnates following a credit cycle bust and it can be protracted:-
Taking, say, a (synthetic) five-year credit boom and five postcrisis years together, the cumulative shortfall in productivity growth would amount to some 6 percentage points. Put differently, for the period 2008–13, we are talking about a loss of some 0.6 percentage points per year for the advanced economies that saw booms and crises. This is roughly equal to their actual average productivity growth during the same window.
Source: Borio et al, BIS
Borio’s conclusion is that different sectors of the economy expand and the contract with greater and lesser momentum, suggesting the need for more research in this area.
He then moves to investigate the interest rate productivity nexus, believing the theory that, over long enough periods, the real economy evolves independently of monetary policy and therefore that market interest rates converge to an equilibrium real interest rates, may be overly simplistic. Instead, Borio suggests that causality runs from interest rates to productivity; in other words, that interest rates during a cyclical boom may have pro-cyclical consequences for certain sectors, property in particular:-
During the expansion phase, low interest rates, especially if persistent, are likely to increase the cycle’s amplitude and length. After all, one way in which monetary policy operates is precisely by boosting credit, asset prices and risk-taking. Indeed, there is plenty of evidence to this effect. Moreover, the impact of low interest rates is unlikely to be uniform across the economy. Sectors naturally differ in their interest rate sensitivity. And so do firms within a given sector, depending on their need for external funds and ability to tap markets. For instance, the firms’ age, size and collateral availability matter. To the extent that low interest rates boost financial booms and induce resource shifts into sectors such as construction or finance, they will also influence the evolution of productivity, especially if a banking crisis follows. Since financial cycles can be quite long – up to 16 to 20 years – and their impact on productivity growth quite persistent, thinking of changes in interest rates (monetary policy) as “neutral” is not helpful over relevant policy horizons.
During the financial contraction, persistently low interest rates can contribute to this outcome (Borio (2014)). To be absolutely clear: low rates following a financial bust are welcome and necessary to stabilise the economy and prevent a downward spiral between the financial system and output. This is what the crisis management phase is all about. The question concerns the possible collateral damage of persistently and unusually low rates thereafter, when the priority is to repair balance sheets in the crisis resolution phase. Granted, low rates lighten borrowers’ heavy debt burden, especially when that debt is at variable rates or can be refinanced at no cost. But they may also slow down the necessary balance sheet repair.
Finally, Borio returns to the impact on zombie companies, whose number has risen as interest rates have fallen. Not only are these companies reducing productivity and economic growth in their own right, they are draining resources from the more productive new economy. If interest rates were set by market forces, zombies would fail and investment would flow to those companies that were inherently more profitable. Inevitably the author qualifies this observation:-
Now, the relationship could be purely coincidental. Possible factors, unrelated to interest rates as such, might help explain the observed relationship. One other possibility is reverse causality: weaker profitability, as productivity and economic activity decline in the aggregate, would tend to induce central banks to ease policy and reduce interest rates.
Source: Banerjee and Hoffmann, BIS
Among the conclusions reached by the Central Bankers bank, is that the full impact and repercussions of persistently low rates may not have been entirely anticipated. An admission that QE has been an experiment, the outcome of which remains unclear.
Conclusions and Investment Opportunities
These two articles give some indication of the thinking of Central Bankers globally. They suggest that the rise in bond yields and subsequent fall in equity markets was anticipated and will be tolerated, perhaps for longer than the market anticipate. It also suggests that Central Banks will attempt to use macro-prudential policies more extensively in future, to insure that speculative investment in the less productive areas of the economy do not crowd out investment in the more productive and productivity enhancing sectors. I see this policy shift taking the shape of credit controls and increases in capital requirements for certain forms of collateralised lending.
Whether notionally independent Central Banks will be able to achieve these aims in the face of pro-cyclical political pressure remains to be seen. A protracted period of readjustment is likely. A stock market crash will be met with liquidity and short term respite but the world’s leading Central Banks need to shrink their balance sheets and normalise interest rates. We have a long way to go. Well managed profitable companies, especially if they are not saddled with debt, will still provide opportunities, but stock indices may be on a sideways trajectory for several years while bond yields follow the direction of their respective Central Banks official rates.
Linear Talk Macro Roundup for February
Given what has happened this month, this video might seem out of date but this was my roundup from 6th February.
Macro Letter – No 89 – 19-01-2018
The risk of a correction in the equity bull market
Since March 2009, the US stock market has been trending broadly higher. If we can continue to make new highs, or at least, not correct to the downside by more than 20%, until August of this year it will be the longest equity bull-market in US history.
The optimists continue to extrapolate from the unexpected strength of 2017 and predict another year of asset increases, but by many metrics the market is expensive and the risks of a significant correction are become more pronounced.
Equity volatility has been consistently low for the longest period in 60 years. Technical traders are, of course, long the market, but, due to the low level of the VIX, their stop-loss orders are unusually close the current market price. A small correction may trigger a violent flight to the safety of cash.
Meanwhile in Japan, after more than two decades of under-performance, the stock market has begun to play catch-up with its developed nation counterparts. Japanese stock valuation is not cheap, however, as the table below, which is sorted by the CAPE ratio, reveals:-
Source: Star Capital
Global economic growth surprised on the upside last year. For the first time since the great financial crisis, it appears that the Central Bankers experiment in balance sheet expansion has spilt over into the real-economy.
An alternative explanation is provided in this article – Is Stimulus Responsible for the Recent Improved Trends in the U.S. and Japan? – by Dent Research – here are some selected highlights:-
Since central banks began their B.S. back in 2001, when the Bank of Japan first began Quantitative Easing efforts, I’ve warned that it wouldn’t be enough… that none of them would be able to commit to the vast sums of money they’d ultimately need to prevent the Economic Winter Season – and its accompanying deflation – from rolling over us.
Demographics and numerous other cycles, in my studied opinion, would ultimately overwhelm central bank efforts…
Are such high levels of artificial stimulus more important than demographic trends in spending, workforce growth, and productivity, which clearly dominated in the real economy before QE? Is global stimulus finally taking hold and are we on the verge of 3% to 4% growth again?…Fundamentals should still mean something in our economy…
And my Generational Spending Wave (immigration-adjusted births on a 46-year lag), which predicted the unprecedented boom from 1983 to 2007, as well as Japan’s longer-term crash of the 1990s forward, does point to improving trends in 2016 and 2017 assuming the peak spending has edged to 47 up for the Gen-Xers.
The declining births of the Gen-X generation (1962 – 1975) caused the slowdown in growth from 2008 forward after the Baby Boom peaked in late 2007, right on cue. But there was a brief, sharp surge in Gen-X births in 1969 and 1970. Forty-seven years later, there was a bump… right in 2016/17…
Source: Dent Research
The next wave down bottoms between 2020 and 2022 and doesn’t turn up strongly until 2025. The worst year of demographic decline should be 2019.
Japan has had a similar, albeit larger, surge in demographics against a longer-term downtrend.
Its Millennial generation brought an end to its demographic decline in spending in 2003. But the trends didn’t turn up more strongly until 2014, and now that they have, it’ll only last through 2020 before turning down dramatically again for decades…
Source: Dent Research
Prime Minister Abe is being credited with turning around Japan with his extreme acceleration in QE and his “three arrows” back in 2013. All that certainly would have an impact, but I don’t believe that’s what is most responsible for the improving trends. Rather, demographics is the key here as well, and this blip Japan is enjoying won’t last for more than three years!..
If demographics does still matter more, we should start to feel the power of demographics in the U.S. as we move into 2018.
If our economy starts to weaken for no obvious reason, and despite the new tax reform free lunch, then we will know that demographics still matter…
A different view of the risks facing equity investors in 2018 is provided by Louis-Vincent Gave of Gavekal, care of Mauldin Economics – Questions for the Coming Year – he begins with Bitcoin:–
…a recent Bloomberg article noted that 40% of bitcoins are owned by around 1,000 or so individuals who mostly reside in the greater San Francisco Bay area (the early adopters). Sitting in Asia, it feels as if at least another 40% must be Chinese investors (looking to skirt capital controls), and Korean and Japanese momentum traders. After all, the general rule of thumb in Asia is that when things go up, investors should buy more.
Asia’s fondness for chasing rising asset prices means that it tends to have the best bubbles. To this day, nothing has topped the late 1980s Taiwanese bubble, although perhaps, left to its own devices, the bitcoin bubble may take on a truly Asian flavor and outstrip them all? Already in Japan, some 1mn individuals are thought to day-trade bitcoins, while 300,000 shops reportedly have the capacity to accept them for payment. In South Korea, which accounts for about 20% of daily volume in bitcoin and has three of the largest exchanges, bitcoin futures have now been banned. For its part, Korea’s justice ministry is considering legislation that would ban payments in bitcoin all together.
At the very least, it sounds like the Bank of Korea’s recent 25bp interest rate hike was not enough to tame Korean animal spirits. So will the unfolding bitcoin bubble trigger a change of policy from the BoK and, much more importantly, from the Bank of Japan in 2018?
Mr Gave then goes on to highlight the risks he perceives as under-priced for 2018, starting with the Bank of Japan:-
In recent years, the BoJ has been the most aggressive central bank, causing government bond yields to stay anchored close to zero across the curve, while acting as a “buyer of last resort” for equities by scooping up roughly three quarters of Japanese ETF shares. Yet, while equities have loved this intervention, Japanese insurers and banks have had a tougher time. Indeed, a chorus of voices is now calling for the BoJ to let the long end of the yield curve rise, if only to stop regional banks hitting the wall.
So could the BoJ tighten monetary policy in 2018? This may be more of an open question than the market assumes. Indeed, the “short yen” trade is popular on the premise that the BoJ will be the last central bank to stop quantitative easing. But what if this isn’t the case?
The author then switches to highlight the pros and cons. It’s the cons which interest me:-
I doubt the risk of BoJ tightening is very great – they made the mistake of tightening too early on previous occasions to their cost. In any case, raising short-term rates will more likely lead to a yield curve inversion making the banks position even worse. The trade surplus remains small and the Yen remains remarkably strong by long-term comparisons.
This brings us to the author’s next key risk (which, given Gavekal’s deflationist credentials, is all the more remarkable) that inflation will surprise on the upside:-
Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanization growth was always bound to slow. Combine that with China’s aging population and the fact that a rising share of rural residents are over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.
Reduced excess capacity in China is real: from restrictions on coal mines, to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10mn industrial workers have lost their jobs since Xi’s took office (note: there are roughly 12.5m manufacturing workers in the US today!).
To say that most “excess investment” China unleashed with its 2015-16 monetary and regulatory policy stimulus went into domestic real estate is only a mild exaggeration. Very little went into manufacturing capacity, which may explain why the price of goods exports from China has, after a five-year period, shown signs of breaking out on the upside. Another part of the puzzle is that Chinese producer prices are also rising, so it is perhaps not surprising that export prices have followed suit. The point is, if China’s export prices do rise in a concerted manner, it will happen when inflation data in the likes of Japan, the US and Germany are moving northward…
…The real reason I worry about inflation today is that inflation has the potential to seriously disrupt the happy policy status quo that has underpinned markets since the February 2016 Shanghai G20 meeting.
Mr Gave recalls the Plaza and Louvre accords of 1985 and ‘87, reminding us that the subsequent rise in bond yields in the summer of 1987 brought the 1980’s stock market bubble to an abrupt halt.
…for the past 18 months, I have espoused the idea that, after a big rise in foreign exchange uncertainty – triggered mostly by China with its summer 2015 devaluation, but also by Japan and its talk of helicopter money, and by the violent devaluation of the euro that followed the eurozone crisis – the big financial powers acted to calm foreign exchange markets after the February 2016 meeting of the G20 in Shanghai.
…as in the post-Louvre accord quarters, risk assets have broadly rallied hard. It’s all felt wonderful, if not quite as care-free as the mid-1980s. And as long as we live under this Shanghai accord, perhaps we should not look a gift horse in the mouth and continue to pile on risk?
This brings me to the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?”
Again the author is at pains to point out that, for the bubble to burst an inflation hawk is required. A Central Bank needs to assume the mantle of the Bundesbank of yesteryear. He anticipates it will be the PBoC:-
…(let’s face it: the last two upswings in global growth, namely 2009 and 2016, were triggered by China more than the US). Indeed, the People’s Bank of China may well be the new Bundesbank for the simple reason that most technocrats roaming the halls of power in Beijing were brought up in the Marxist church. And the first tenet of the Marxist faith is that historical events are shaped by economic forces, with inflation being the most powerful of these. From Marx’s perspective, Louis XVI would have kept his head, and his throne, had it not been for rapid food price inflation the years that preceded the French Revolution. And for a Chinese technocrat, the Tiananmen uprising of 1989 only happened because food price inflation was running at above 20%. For this reason, the one central bank that can be counted on to be decently hawkish against rising inflation, or at least more hawkish then others, is the PBoC.
Mr Gave foresees inflation delivering a potential a triple punch; lower valuations for asset markets, followed by tighter monetary and fiscal policy in China, which will then trigger an incendiary end to the unofficial ‘Shanghai Agreement’. In 1987 it was German Bunds which offered the safe haven, short-dated RMB bonds may be their counterpart in the ensuing crisis.
This brings our author to the vexed question of the way in which the Federal Reserve will respond. The consensus view is that it will be business as usual after the handover from Yellen to Powell, but what if it’s not?
…imagine a parallel universe, such that within a few months of being sworn in, Powell faces a US economy where:-
Unemployment is close to record lows and government debt stands at record highs, yet the federal government embarks on an oddly timed fiscal stimulus through across-the-board tax cuts.
Shortly afterwards, the government further compounds this stimulus with a large infrastructure spending bill.
As inflationary pressures intensify around the world (partly due to this US stimulus), the PBoC, BoJ and ECB adopt more hawkish positions than have been discounted by the market.
The unexpected tightening by non-US central banks leads other currencies higher, and the US dollar lower.
The combination of low interest rates, expansionary fiscal policy and a weaker dollar causes the US economy to properly overheat, forcing the Fed to tighten more aggressively than expected.
Gave proposes four scenarios:-
…In the first two scenarios, the US dollar will likely rise, either a little, or a lot. In the latter two scenarios, the dollar would likely be very weak. So if this analysis is broadly correct, shorting the dollar should be a good “tail risk” policy. If the global economy rolls over and/or a shock appears, the dollar will weaken. And if global nominal GDP growth accelerates further from here, the dollar will also likely weaken. Being long the dollar is a bet that the current investment environment is sustained.
The final risk which the author assesses is the impact of rising oil prices. It has often been said that a rise in the price of oil is a tax on consumption. Louis-Vincent Gave gives us an excellent worked example:-
…assume that the world consumes 100mn barrels of oil a day…Then further assume that about 100 days of inventory is kept “in the system”… if the price of oil is US$60/bbl, then oil inventories will immobilize around US$600bn in working capital. But if the price drops to US$40/bbl, then the working capital needs of the broader energy industry drops by US$200bn.
The chart below shows the decline in true money supply:-
The Baker Hughes US oil rig count jumped last week from 742 to 752 but it is still below the highs of last August and far below the 1609 count of October 2014. The break-even oil price for US producers is shown in the chart below:-
Source: Geopolitical Futures
If the global price of oil were entirely dependent on the marginal US producer, there would be little need to worry but the World Rig Count has also been slow to respond and Non-US producers are unable to bring additional rigs on-line as quickly, in response to price rises, as their US counterparts:-
Source: Baker Hughes
An additional concern for the oil price is the lack of capital investment over recent years. Many of the recent fracking wells in the US are depleting more rapidly. This once dynamic sector may have become less capable of reacting to the recent price increase. I’m not convinced, but a structurally higher oil price is a risk to consider.
Conclusion and investment opportunities
As Keynes famously said, ‘The markets can remain irrational longer than I can remain solvent.’ Global equity markets have commenced the year with gusto, but, after the second longest bull-market in history, it makes sense to be cautious. Growth stocks and Index tracking funds were the poster children of 2017. This year a more defensive approach is warranted, if only on the basis that lightening seldom strikes twice in the same place. Inflation may not become broad-based but industrial metals prices and freight rates have been rising since 2016. Oil has now broken out on the upside, monetary tightening and balance sheet reduction as the watch words of the leading Central Banks – even if most have failed to act thus far – these actions compel one to tread carefully.
A traditional value-based approach to stocks should be adopted. Japan may continue to play catch up with its developed nation peers – the demographic up-tick, mentioned by Dent research, suggests that the recent breakout may be sustained. The Federal Reserve is leading the reversal of the QE experiment, so the US stock market is probably most vulnerable, but the high correlations between global stock markets means that, if the US stock market catches a cold, the rest of the world is unlikely to avoid infection.
High-yield bonds have been the alternative to stocks for investors seeking income for several years. Direct lending and Private Debt funds have raised a record amount of assets in the past couple of years. If the stock market declines, credit spreads will widen and liquidity will diminish. In the US, short dated government bond yields have been rising steadily and yield curves have been flattening, nonetheless, high grade floating rate notes and T-Bills may be the only place to hide, especially if inflation should rise even as stocks collapse.
There will be a major stock market correction at some point, there always is. When, is still in doubt, but we are nearer the end of the bull-market than the beginning. Technical analysis suggests that one must remain long, but in the current low volatility environment it makes sense to use a trailing stop-loss to manage the potential downside risk. Many traders are adopting a similar strategy and the exit will be crowded when you reach the door. Expect slippage on your stop-loss, it’s a price worth paying to capture the second longest bull-market in history.
Macro Letter – No 72 – 10-03-2017
Low cost manufacturing in Asia – The Mighty Five – MITI V
The MITI V is the latest acronym to emerge from the wordsmiths at Deloitte’s. Malaysia, India, Thailand, Indonesia and Vietnam. All these countries have a competitive advantage over China in the manufacture of labour intensive commodity type products like apparel, toys, textiles and basic consumer electronics. According to Deloitte’s 2016 Global Manufacturing Competitiveness Index they are either among, or destined to join, the top 15 most competitive countries in the world for manufacturing, by the end of the decade. Here is the Deliotte 2016 ranking:-
The difficulty with grouping disparate countries together is that their differences are coalesced. Malaysia and Thailand are likely to excel in high to medium technology industries, their administrations are cognizant of the advantages of international trade. India, whilst it has enormous potential, both as an exporter and as a manufacturer for its vast domestic market, has, until recently, been less favourably disposed towards international trade and investment. Vietnam continues to benefit from its proximity to China. Indonesia, by contrast, has struggled with endemic corruption: its economy is decentralised and this vast country has major infrastructure challenges.
The table below is sorted by average earnings:-
Source: World Bank, Trading Economics
India and Vietnam look well placed to become the low-cost manufacturer of choice (though there are other contenders such as Bangladesh which should not be forgotten when considering comparative advantage).
Another factor to bear in mind is the inexorable march of technology. Bill Gates recently floated the idea of a Robot Tax, it met with condemnation in many quarters – Mises Institute – Bill Gates’s Robot Tax Is a Terrible Idea – examines the issue. The mere fact that a Robot Tax is being contemplated, points to the greatest single challenge to low-cost producers of goods, namely automation. Deliotte’s does not see this aspect of innovation displacing the low-cost manufacturing countries over the next few years, but it is important not to forget this factor in one’s assessment.
Before looking at the relative merits of each market from an investment perspective, here is what Deliotte’s describe as the opportunities and challenges facing each of these Asian Tigers:-
…has a low cost base with workers earning a quarter of what their counterparts earn in neighboring Singapore. The country also remains strongly focused on assembly, testing, design, and development involved in component parts and systems production, making it well suited to support high-tech sectors.
…is challenged by a talent shortage, political unrest, and comparatively low productivity.
Sixty-two percent of global manufacturing executives’ surveyed rank India as highly competitive on cost, closely mirroring China’s performance on this metric.
…highly skilled workforce and a particularly rich pool of English speaking scientists, researchers, and engineers which makes it well-suited to support high-tech sectors. India’s government also offers support in the form of initiatives and funding that focus on attracting manufacturing investments.
…challenged by poor infrastructure and a governance model that is slow to react
…As 43 percent of its US$174 billion in manufacturing exports require high-skill and technological intensity, India may have a strong incentive to solve its regulatory and bureaucratic challenges if it is to strengthen its candidacy as an alternative to China.
When it comes to manufacturing exports (US$167 billion in 2014), Thailand stands slightly below India, but exceeds Malaysia, Vietnam, and Indonesia. This output is driven largely by the nation’s skilled workforce and high labor productivity, supported by a 90 percent national literacy rate, and approximately 100,000 engineering, technology, and science graduates every year.
…highly skilled and productive workforce creates relatively high labor costs at US$2.78 per hour in 2013.
…remains attractive to manufacturing companies, offering a lower corporate tax rate (20 percent) than Vietnam, India, Malaysia or Indonesia. Already well established with a booming automotive industry, Thailand may provide an option for manufacturers willing to navigate the political uncertainty that persists in the region.
Manufacturing labor costs in Indonesia are less than one-fifth of those in China.
…The island nation’s overall 10-year growth in productivity (50 percent) exceeds that of Thailand, Malaysia, and Vietnam,
…manufacturing GDP represents a significant portion of its overall GDP and with such a strong manufacturing focus, particularly in electronics, coupled with the sheer size of its population, Indonesia remains high on the list of alternatives for manufacturers looking to shift production capacity away from China in the future.
…comparatively low overall labor costs.
…has raised its overall productivity over the last 10 years, growing 49 percent during the period, outpacing other nations like Thailand and Malaysia. Such productivity has prompted manufacturers to construct billion-dollar manufacturing complexes in the country.
Deliotte’s go on to describe the incentives offered to multinational corporations by these countries:-
(1) numerous tax incentives in the form of tax holidays ranging from three to 10 years, (2) tax exemptions or reduced import duties, and (3) reduced duties on capital goods and raw materials used in export-oriented production.
Forecasts for 2017
In the nearer term the MITI V have more varied prospects, here are Focus Economics latest consensus GDP growth expectations from last month:-
Malaysia Economic Outlook 2017 GDP forecast 4.3%
…GDP recorded the strongest performance in four quarters in Q4, expanding at a better-than-expected rate of 4.5%.
…acceleration in fixed investment and resilient private consumption. Exports also showed a significant improvement, growing at the fastest pace since Q4 2015, thanks to a weaker ringgit and rising oil prices. However, the external sector’s net contribution to growth remained stable as imports also gained steam. Government consumption, which contracted for the first time since Q2 2014, was the only drag on growth in Q4, reflecting the government’s commitment to its fiscal consolidation agenda for 2016.
India Economic Outlook 2017 GDP forecast – 7.4%
Economic activity is beginning to firm after demonetization shocked the economy in the October to December period. The manufacturing PMI crossed into expansionary territory in January and imports rebounded.
…Despite the backdrop of more moderate growth, the government stuck to a market friendly budget for FY 2017
…which was presented on 1 February, pursues growth-supportive policies while targeting a narrower deficit of 3.2% of GDP…
…five states will conduct elections in February, with results to be announced on 11 March. The elections will test the electorate’s mood regarding the government after the economy’s tumultuous past months and ahead of the 2019 general vote.
Thailand Economic Outlook 2017 GDP forecast 3.2%
Growth decelerated mildly in the final quarter of 2016 due to subdued private consumption and a smaller contribution from the external sector. The economy expanded 3.0% annually in Q4, down from 3.2% in Q3.
…January, consumer confidence hit a nearly one-year high, while business sentiment receded mildly. On 27 January, the government announced supplementary fiscal stimulus of USD 5.4 billion for this year’s budget, which ends in September. The sum will be disbursed specifically in rural areas in a bid to close the growing inequality between urban and rural infrastructure and income. This shows that the military government is set to continue providing fiscal stimulus to GDP this year, which should spill over in the private sector via higher employment and improved economic sentiment.
Indonesia Economic Outlook 2017 GDP forecast 5.2%
…economy lost steam in the fourth quarter of last year as diminished government revenues caused public spending to fall at a multi-year low.
…household consumption remained healthy and the recent uptick in commodities prices boosted export revenues.
…for the start of 2017…momentum firmed up: the manufacturing PMI crossed into expansionary territory in January and surging exports pushed the trade surplus to an over three-year high.
…poised for a credit ratings upgrade after Moody’s elevated its outlook from stable to positive on 8 February. All three major ratings agencies now have a positive outlook on Indonesia’s credit rating and an upgrade could be a catalyst for improving investor sentiment.
Vietnam Economic Outlook 2017 GDP forecast 6.4%
…particularly strong performance in the external sector in 2016. Despite slower demand from important trading partners, merchandise exports, which consist largely of manufactured goods, grew 9.0% annually. The manufacturing sector is quickly expanding thanks to the country’s competitive labor costs, fueling manufacturing exports and bolstering job creation in the sector.
…industrial production nearly stagnated in January, it mostly reflected a seasonal effect from the Lunar New Year, which disrupted supply chains across the region.
…manufacturing Purchasing Manager’s Index, though it inched down in January, continues to sit well above the 50-point line, reflecting that business conditions remain solid in the sector. Moreover, the New Year festivities boosted retail sales, which grew robustly in January.
The table below shows the structural nature of the MITI V’s exchange rate depreciation against the US$. The 20 year column winds the clock back to the period just before the Asian Financial Crisis in 1997:-
Source: Trading Economics, World Bank
Looking at the table another way, when investing in Indonesia it would make sense to factor in a 4% annual decline in the value of the Rupiah, a 2.2% to 2.4% decline in the Ringgit, Rupee and Dong and a 1.3% fall in the value of the Baht.
The continuous decline in these currencies has fuelled inflation and this is reflected to the yield and real yields available in their 10 year government bond markets. The table below shows the current bond yields together with inflation and their governments’ fiscal positions:-
Source: Trading Economics
Indonesian bonds offer insufficient real-yield to cover the average annual decline in the value of the Rupiah. Vietnam has an inverted yield curve which suggests shorter duration bonds would offer better value, its 10 year maturity offers the lowest real-yield of the group.
Whilst all these countries are running government budget deficits, Malaysia, Thailand and Indonesia have current account surpluses and Indonesia’s government debt to GDP is a more manageable 27% – this is probable due to its difficulty in attracting international investors on account of the 82% decline in its currency over the past two decades.
Stock Market Valuations
All five countries have seen their stock markets rise this year, although the SET 50 (Thailand) has backed off from its recent high. To compare with the currency table above here are the five stock markets, plus the S&P500, over one, two, five, ten and twenty years:-
For the US investor, India and Indonesia have been the star performers since 1997, each returning more than six-fold. Thailand, which was at the heart of the Asian crisis of 1997/98, has only delivered 114% over the same period whilst Malaysia, which imposed exchange controls to stave off the worst excesses of the Asian crisis, has failed to deliver equity returns capable of countering the fall in its currency. Finally, Vietnam, which only opened its first stock exchange in 2000, is still recovering from the boom and bust of 2007. The table below translates the performance into US$:-
Putting this data in perspective, over the last five years the S&P has beaten the MITI V not only in US$, but also in absolute terms. Looking forward, however, there are supportive valuation metrics which underpin some of the MITI V stock markets. The table below is calculated at 30-12-2016:-
Source: Starcapital.de, *Author’s estimates
Conclusion and Investment Opportunities
Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.
Thailand and Malaysia look less expensive from a price to earnings perspective, than India and Indonesia. Their dividend yields also look attractive relative to their bond yields, perhaps a hangover from the Asian Crisis of 1997.
Technically all five stock markets are at or near recent highs:-
The Vietnamese VN Index is a long way below its high and on a P/E, P/B and dividend yield basis it is the cheapest of the five stock markets, but it is worth remembering that it is still regarded at a Frontier Market, It was not included in the MSCI Emerging Markets indices last year. This remains a prospect at the next MSCI review in May/June.
Given how far global equity markets have travelled since the November US elections, it makes sense to be cautious about stock markets in general. Technically a break to new highs in any of these markets is likely to generate further upside momentum but Vietnam looks constructive both over the shorter term (as it makes new highs for the year) and over the longer term (being well below its all-time highs of 2007). In the Long Run, I expect these economies to the engines of world growth and their stock markets to reflect that growth.
Macro Letter – No 66 – 25-11-2016
Protectionism: which countries have room for fiscal expansion?
…But now I only hear
Its melancholy, long, withdrawing roar…
Matthew Arnold – Dover Beach
Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.
The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?
Anti-globalisation – the melancholy, long, withdrawing roar
The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-
Source: The Economist, World Bank, Lakner and Milanovic
This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.
What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.
The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.
An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-
Source: American Enterprise Institute
At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.
Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.
Which countries will lose out from protectionism?
It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.
Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.
The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21st November:-
|Country||GDP||Base Rate||Inflation||Debt to GDP||10yr yield||Notes|
*Estimate from recent sovereign issues
**Estimated 1yr bond yield
***Estimated from recent US$ issue
Source: Trading economics, Investing.com, Bangledesh Treasury
Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.
If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).
Most Favoured Borrowers
Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.
The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-
|Country||GDP||Debt to GDP||10yr yield||Gov. Debt||70% Ratio||90% Ratio||12m fwd PE||CAPE||Div Yld.|
Source: Trading economics, Investing.com, Bangledesh Treasury, Star Capital, Yardeni Research
The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to Reinhart and Rogoff in their paper Growth in a Time of Debt.
Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.
Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.
Despite US debt to GDP being above 100%, the new US President-elect has promised $5.3trln of fiscal spending during his first term. Whether this is a good idea or not is debated this week by the Peterson Institute – What Size Fiscal Deficits for the United States?
Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.
Conclusions and investment opportunities
Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.
Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.
Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.
According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.
Indian bond yields actually fell in the wake of the US election – from 6.83% on 8th to 6.30% by 21st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.
Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.
A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.