Given what has happened this month, this video might seem out of date but this was my roundup from 6th February.
Given what has happened this month, this video might seem out of date but this was my roundup from 6th February.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.
An overview on financial and commodity markets for last month
Linear Talk – Macro Roundup – 17th October 2017
Financial market liquidity returned after the thin trading which is typical of August. Stocks and crude oil were higher and the US$ made new lows. But a number of individual markets are noteworthy.
The S&P 500 and the Nasdaq 100 both achieved record highs last month (2519 and 6013 respectively). In the case of the S&P this is the sixth straight month of higher closes, even as flow of funds data indicates a rotation into international equity markets.
The Eurostoxx 50 took comfort from the US move, closing the month at its high (3595) yet it remains below the level seen in May (3667) tempered, no doubt, by the strength of the Euro.
German Elections, showing a rise in support for the nationalist AfD and the prospect of an unconstitutional independence referendum in Catalonia, made little impression on European equity markets. The DAX also closed at its high (12,829) but, it too, failed to breach its record for the year of 12,952 witnessed in June.
Spain’s IBEX 35 was more susceptible to the political fracas in its north eastern region, but with other markets rising, it traded in a narrow range, closing at 10,382 on the eve of the referendum, having actually begun the month lower, at 10,329.
The Japanese Nikkei 225 remained well supported but still failed to breach resistance, making a high of 20,481 on the 18th. It has since taken out the old high. This move is supported by stronger economic data and revised growth forecasts from the IMF (released after month end).
Currency markets have been dominated by the weakness of the US$ since January. Last month was no exception. The US$ Index made a new low for the year at 90.99 on the 8th but swiftly recovered, testing 93.80 on the 28th. Technically, this low breached the 50% correction of the move from the May 2014 low of 78.93 to the January 2017 high of 103.81. Further support should be found at 88.43 (61.8% retracement) but price action in EURUSD suggests that we may be about to see a reversal of trend.
EURUSD made a new high for the year at 1.2094 on the 8th, amid rumours of ECB intervention. By month end it had weakened, testing 1.1721 on 28th. This has created a technical ‘outside month’ – a higher high and lower low than the previous month. For this pattern to be negated EURUSD must trade back above 1.2094.
EURGBP also witnessed a sharp correction the initial Sterling weakness which was a feature of the summer months. From an opening high of 0.9235 Sterling steadily strengthened to close at 0.8819. Nonetheless, Sterling remains weaker against the Euro than in 2013, amid fears of a ‘No Deal’ on Brexit and continued expectations of an economic slowdown due to the political uncertainty of that exit.
US 10yr Treasuries made a new low yield for the year at 2.02% on 8th. This is the lowest yield since the November 2016 election, however, expectations of another rate hike and the announcement of a planned balance sheet reduction schedule from the Federal Reserve, tempered the enthusiasm of the bond bulls. By month end, yields had risen 32bp to close at 2.34%.
In Germany 10yr Bund yields followed a similar trajectory to the US. Making a low of 0.29% on 8th only to increase to 0.52% by 28th. Increasing support for the AfD in the election, was largely ignored.
A trade which has been evident during 2017 has been the convergence of core and peripheral European bond yields. The larger markets such as Italy and Spain have mostly mirrored the price action of Bunds, their spreads widening moderately in the process. The yield on Portuguese and Greek bonds, by contrast has declined substantially, although there was a slight widening during September. Greek 10yr bonds, which yielded 8.05% at the end of January, closed the month at 5.67%. Over the same period 10yr Bunds have seen yields rise by 6bp.
UK 10yr Gilts also had an interesting month. From a low of 0.97% on 7th they reached 1.42% on 28th amid concerns about Brexit, the recent weakness in Sterling (which appears to have been temporarily reversed) and expectations that Bank of England Governor, Carney, will raise UK interest rates for the first time since June 2007. It is tempting to conceive that either the rise in Gilt yields or the recent rise in Sterling is wrong, these trends might both continue. Long Sterling and Short Gilts might be a trade worthy of consideration.
Perhaps anticipating the IMF – World Economic Outlook – October update, in which they revised their world growth forecasts for 2017 and 2018 upwards, the price of Brent Crude rallied to a new high for the year on 26th – $59.49/bbl. Aside from expectations of an increase in demand, the effect of two hurricanes in the US and a strengthening of resolve on the part of OPEC to limit production, may be contribution factors.
Copper also hit a new high for the year, trading $3.16/lb on 4th. Technically, however, it made an outside month (higher high and lower low than August) a break above $3.16/lb will negate this bearish formation. I remain concerned that Chinese growth during 2017 has been front-loaded. Industrial metal markets may well consolidate, with a vengeance, before deciding whether increased demand is seasonal or structural.
Macro Letter – No 78 – 02-06-2017
Trade and protectionism post globalisation
The success of free-trade and globalisation has been a boon for less developed countries but, to judge by the behaviour of the developed world electorate of late, this has been at the expense of the poorer and less well educated peoples of the developed nations. Income inequality in the west has been a focus of considerable debate among economists. The “Elephant Chart” below being but one personification of this trend:-
Source: Economist, World Bank
If the graph looks familiar it’s because I last discussed this topic back in November 2016 in – Protectionism: which countries have room for fiscal expansion? This is what I said about the chart at that time:-
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.
It can be argued that this chart is not a fair representation of the reality in the west. This excellent video by Johan Norberg – Dead Wrong – The Elephant Graph – makes some important observations but, as a portfolio manager, friend of mine reminded me recently, when considering human action one should not focus on absolute change in economic circumstances, but relative change. What did he I mean by this? Well, let’s take income inequality. The rich are getting richer and the poor are…getting richer less quickly.
In the dismal science, as Carlyle once dubbed economics, we often take a half-empty view of the world. Take real average income. Since 2008 people have become worse-off as the chart below for the UK shows:-
However, in the long-run we have become better-off for generations. What really drives prosperity, by which I mean our quality of life, is productivity gains: our ability to harness technology to improve the production of goods and services.
Financial markets are said to be driven by fear and greed. Society in general is also driven by these factors but there is an additional driver: envy. Any politician who ignores the power of envy, inevitably truncates his or her career.
The gauntlet was thrown down recently by the new US administration: their focus was on those countries with trade surpluses with the US. Accusations of trade and currency manipulation play well to the disenfranchised American voter.
Well before the arrival of the new US President, however, a degree of rebalancing had already begun to occur when China adopted policies to increase domestic consumption back in 2012. A recent white paper entitled – Is the Global Economy Rebalancing? By Focus Economics – looks at the three countries with the largest persistent current account surpluses: China, Germany and Japan. As they comment in their introduction, a current account surplus may be derived by many different means:-
Decades of conflicting perspectives over the causes and effects of global trade imbalances have been thrust back into the spotlight in recent months by Donald Trump’s brazen criticism of almost every country with a significant current account surplus with the U.S. His controversial accusation that big exporter countries are deliberately weakening their currencies to gain a competitive advantage taps into an issue that has perplexed and divided economists and policymakers ever since the mid-1990s. At that time, countries such as the U.S. were starting to build up large current account deficits, while others such as China, Germany and Japan were accumulating large surpluses.
Put simply, a country’s current account balance measures the difference between how much it spends and makes abroad. Trade in goods usually—but not always—accounts for most of the current account, while the other components are trade in services, income from foreign investment and employment (known as ‘primary income’), and transfer payments such as foreign aid and remittances (known as ‘secondary income’).
A current account surplus or deficit is not necessarily in and of itself a good or bad thing, since a number of considerations must be factored in—for example, in the case of deficit countries, whether they make a return on their investments that exceeds the costs of funding them. A large current account surplus can be considered a desirable sign of an efficient and competitive economy if it comprises a positive trade balance generated by market forces. And yet such competitiveness can also be falsely created to an extent by policy decisions (e.g. a deliberate currency weakening), or may alternatively be a sign of overly weak domestic demand in a highly productive country. Therein lies the crux of the controversy, or at least one of many.
Global imbalances were a critically important contributing factor to the financial crisis, although they did not in themselves cause it. Even if the precise nature of that connection has sparked different interpretations, there is at least more or less agreement on the fundamentals of the part played by trade relations between the U.S. and China, the two countries traditionally responsible for the lion’s share of global imbalances. Credit-fueled growth in the U.S. encouraged consumers to spend more, including on products originating in China, thereby further increasing the U.S. trade deficit with China and prompting China to “recycle” the dollars gained by buying U.S. assets (mostly Treasury notes). This, in turn, helped to keep U.S. interest rates low, encouraging ever greater bank lending, which pushed up housing prices, caused a subprime mortgage crisis and ultimately ended in a nasty deleveraging process.
Services and investment balances can be difficult to measure accurately; trade data is easier to calculate. Here are the three current account surplus countries in terms of their trade balances:-
Source: Trading Economics, Chinese General Administration of Customs
Interestingly, China’s trade balance has declined despite the recent devaluation in the value of the Yuan versus the US$.
Source: Trading Economics, German Federal Statistics Office
The relative weakness of the Euro seems to have underpinned German exports. On this basis, the weakening of the Euro, resulting from the Brexit vote, has been an economic boon!
Source: Trading Economics, Japanese Ministry of Finance
The Abenomics policy of the three arrows whilst it has succeeded in weakening the value of the Yen, has done little to stem its steadily deteriorating trade balance. The Yen has risen ever since the ending of Bretton Woods, it behoves Japanese companies to invest aboard. The relative strength of the current account is the result of Japanese investment abroad.
Trade data is not without its flaws, even in a brand dominated business such as automobiles the origin of manufacture can turn out to be less obvious than it might at first appear. According to the Kogod – Made in America Auto Index 2016 – at 81% the Honda Accord ranks fifth out of all automobiles, in terms of the absolute percentage of an entire vehicle which is built in the USA, well above the level of many Ford and General Motors vehicles.
Conclusions and Investment Opportunities
The financial markets will react differently in each country to the headwinds of de-globalisation and the rise of protectionism. The US, however, presents an opportunity to examine the outcome for a largest economy in the world.
The US currency’s initial reaction to the Trump election win was a significant rise. The US$ Index rallied from 97.34 on the eve of the election to test 103.81 at the beginning of January. Since then, as the absolute power, or lack thereof, of the new president has become apparent, the US$ Index has retraced the entire move. Protectionism on the basis of this analysis is likely to be UD$ positive. In the long run protectionist policies act as a drag on economic growth. The USA has the largest absolute trade deficit. Lower global economic growth will either lead to a rise in the US trade deficit or a strengthening of the US$, or, perhaps, a combination of the two.
Interest rates and bonds may be less affected by the strength of the US currency in a protectionist scenario, but domestic wage inflation is likely to increase in the medium term, especially if border controls are tightened further, closing off the flow of immigrant workers.
US stocks should initially benefit from the reduction in competition derived from a protectionist agenda but in the process the long run competitiveness of these firms will be undermined. The continual breaching to new highs which has been evident in the S&P 500 (and recently, the Nasdaq) is at least partially due to expectation of the agenda of the new administration. These policies include the lowering of corporation tax rates (from 35% to 15%) to bring them in line with Germany, infrastructure spending (in the order of $1trln) and protectionist pressure to “Buy American, Hire American”. Short term the market is still rising but valuations are becoming stretched by many metrics, as I said recently in Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train:-
Pro-business US economic policy will continue to drive US stocks: the words of Pink Floyd spring to mind…we call it riding the gravy train.
Macro Letter – No 76 – 05-05-2017
Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train
“Our country needs a good ‘shutdown’ in September to fix mess!”
Donald J. Trump
The current US debt ceiling is set at $19.8trln. Debt levels are already close to that level and special accounting measures have already been implemented by the US Treasury. This year alone total federal expenditures will be $3.7trln – leaving a tax shortfall of $559bln. Meanwhile, last week, Treasury Secretary, Mnuchin announced the long awaited tax cut plan. It included a proposal to reduce the US corporate tax rate to 15% from the current level of 35%. This, it is estimated by the Committee for a Responsible Federal Budget, will increase the government deficit by $5.5trln over the next decade.
The Trump administrations other spending plans remain on the agenda, including $1trln for infrastructure, $54bln for the military and – assuming the Mexican’s can’t pay and won’t pay – $10bln for the Southern Border Wall.
How can this possibly add up? Through spending cuts, is the simple answer. Cuts have already been made to the budget for the Environmental Protection Agency, Inland Revenue Service and Department of Education but around 65% of government expenditure, in areas such as welfare and healthcare, have been ring-fenced – they will remain off-limits. Balancing the books is going to be an awesome conjuring trick.
Even by the more conservative estimates of the Tax Foundation, the proposed tax cut will cost $2.2trln over the next 10 years. They estimate economic growth would increase by 0.4% as a result of the tax reduction, but point out that +0.9% annual GDP growth is required to offset the estimated decline in tax revenues. The sums do not appear to balance.
The chart below looks at US investment as a percentage of GDP going back to 1950, the era of Reaganomics (1981-1989) when the last substantial tax cuts occurred, suggests that the positive impact of tax reduction on economic growth, if Art Laffer is correct, may be, to borrow a phrase from Milton Friedman, long and variable:-
Source: The Economist, BEA
The Cato Institute – Lessons from the Reagan Tax Cuts which was published at this week, makes a number of observations (see below) but this chart, showing the GDP growth in the Reagan and Obama recessions, is instructive:-
Source: Cato Institute
One may argue that the Reagan period was an era of much higher inflation and therefore dispute the real-GDP growth differential, but the Cato Institute produce further evidence to support their argument, that tax cuts boost economic growth. Here are some of the highlights:-
Lesson #1: Lower Tax Rates Can Boost Growth
We can draw some conclusions by looking at how low-tax economies such as Singapore and Hong Kong outperform the United States. Or we can compare growth in the United States with the economic stagnation in high-tax Europe.
Source: Maddison, Cato
We can also compare growth during the Reagan years with the economic malaise of the 1970s.
Moreover, there’s lots of academic evidence showing that lower tax rates lead to better economic performance
The bottom line is that people respond to incentives. When tax rates climb, there’s more “deadweight loss” in the economy. So when tax rates fall, output increases.
Lesson #2: Some Tax Cuts “Pay for Themselves”
The key insight of the Laffer Curve is not that tax cuts are self-financing. Instead, the lesson is simply that certain tax cuts (i.e., lower marginal rates on productive behavior) lead to more economic activity. Which is another way of saying that certain tax cuts lead to more taxable income.
It’s then an empirical issue to assess the level of revenue feedback.
In the vast majority of the cases, the revenue feedback caused by more taxable income isn’t enough to offset the revenue loss associated with lower tax rates. However, we do have very strong evidence that upper-income taxpayers actually paid more to the IRS because of the Reagan tax cuts.
This is presumably because wealthier taxpayers have much greater ability to control the timing, level, and composition of their income.
Lesson #3: Reagan Put the United States on a Path to Fiscal Balance
I already explained above why it is wrong to blame the Reagan tax cuts for the recession-driven deficits of the early 1980s. Indeed, I suspect most leftists privately agree with that assessment.
Source: CBO, Cato
But there’s still a widespread belief that Reagan’s tax policy put the United States on an unsustainable fiscal path.
Yet the Congressional Budget Office, as Reagan left office in early 1989, projected that budget deficits, which had been consistently shrinking as a share of GDP, would continue to shrink if Reagan’s policies were left in place.
Moreover, the deficit was falling because government spending was projected to grow slower than the private sector, which is the key to good fiscal policy.
The Border Tax
One of the ways the Trump administration intend to balance the books is through the imposition of border taxes. They may become embroiled in the quagmire of legal challenges, that they are in contravention of World Trade Organisation rules, but I shall leave that topic for another time.
This February 2017 article from the Peterson Institute – PIIE Debates Border Adjustment Tax is an excellent primer on the pros and cons of this controversial policy proposal. The Peterson conference delegates did manage to concur that the corporate tax rate should be lower – the Trump proposal would merely bring the rate in line with the current level of corporate tax in Germany. The delegates also agreed that some form of ad valorem tax should be introduced to make up the tax shortfall, although they accepted that this would directly encroach on individual State taxation systems. Peterson’s Adam Posen raised the valid concern that VAT tends to fall most heavily upon the poorest in society, thus increasing income inequality still further. Adjusting the tax system is always fraught with dangers.
At the heart of the Peterson debate was the impact a Border Adjustment Tax (BAT) would have on US businesses:-
Figure 1 below shows net exports to total trade in a sector, relative to how labor intensive the sector is. The size of the bubbles reflects the size of total trade in the sector. Two things are important: (1) Most industries are net importers, thus they believe they will be forced to raise prices under the proposal. (2) The industries that will gain the most—those with a relatively high labor cost share and positive net exports—are largely absent in the United States. The aerospace industry is the lone exception. This breakdown implies that many more big lobbies will be against the BAT than in favor.
Source: BLS, US Census Bureau
BAT revenues are estimated to be around $100bln per annum, about half the cost of the corporate tax cut, using the more conservative Tax Foundation estimate, however, this assumes that the trade deficit remains unchanged in response to the imposition of BAT. Whilst some countries will see their currencies decline versus the US$ the recent plight of the Mexican Peso begs caution. It depreciated from USDMXN 18.2 to 21 versus the US$ in the aftermath of the US election but has since recovered to around USDMXN 19.
Financial Market Response and Investment Opportunities
The table below shows the level of the US$ Index, S&P500 Stock Index and the US 10yr Government Bond Yield on elections week and yesterday:-
It is worth noting that the US$ Index initially strengthened into the end of 2016, testing 104. It has subsequently moderated. 10yr bond yields also rose sharply, reaching 2.64%, but have since consolidated. It is the US stock market, which continues to achieve new all-time highs, which maintains faith in the pro-business credentials of the new administration.
The US bond market is dogged by the twin concerns of the fiscal profligacy of the government on the one hand and the hawkish intentions of the Federal Reserve, determined to normalise interest rates whilst they still can, on the other.
US GDP growth moderated in Q1. Commodity prices for staples, such as Iron Ore, Copper and Oil have diminished, as Chinese demand has waned of late. Meanwhile rising purchasing managers indices seem to be correlating with a rise in inventories. Personal income continues to growth slowly and personal savings has remains subdued, household debt to GDP is rising slightly but it remains well below the levels seen early in the decade. Consumers are unlikely to increase spending dramatically until they are more confident about long-term employment prospects. I wrote, last month about the impact of technology on jobs, in – Will technology change the prospects for emerging market growth? The impact on developed market employment will also be profound, but, I believe, it is also influencing the consumers’ response to higher prices. As prices rise, demand will fall. Central Banks should not target an inflation rate because it distorts the efficient working of the economy, but wage inflation, about which they are inclined to obsess, is likely to be subdued for a protracted period – years rather than months – by the effects of new technology.
Where does this leave stocks and bonds? Bond yields may rise if the US government deficit explodes: and a significant increase in bond yields will inevitably detract from the allure of the stock market. For the present, however, we continue to make new highs in stocks – the Nasdaq finally breached its, dot-com induced, 2000 highs at the end of April, after sixteen years – S&P500 valuations are high (a PE of 23 times and a CAPE of 27 times earnings) and yet “Buy American, Hire American” is a compelling slogan. As an international firm, hoping to continue selling your products to the United States, it makes sense to invest there. Pro-business US economic policy will continue to drive US stocks: the words of Pink Floyd spring to mind…we call it riding the gravy train.
Macro Letter – No 73 – 24-03-2017
Can a multi-speed European Union evolve?
At the Malta Summit last month German Chancellor Angela Merkel told reporters:-
We certainly learned from the history of the last years, that there will be as well a European Union with different speeds that not all will participate every time in all steps of integration.
On March 1st the European Commission released a white paper entitled the Future of Europe. This is a discussion document for debate next week, when members of the EU gather in Rome to celebrate the 60th anniversary of the signing of the Treaty of Rome.
The White Paper sets out five scenarios for the potential state of the Union by 2025:-
Scenario 1: Carrying On – The EU27 focuses on delivering its positive reform agenda in the spirit of the Commission’s New Start for Europe from 2014 and of the Bratislava Declaration agreed by all 27 Member States in 2016. By 2025 this could mean: Europeans can drive automated and connected cars but can encounter problems when crossing borders as some legal and technical obstacles persist. Europeans mostly travel across borders without having to stop for checks. Reinforced security controls mean having to arrive at airports and train stations well in advance of departure.
Scenario 2: Nothing but the Single Market – The EU27 is gradually re-centred on the single market as the 27 Member States are not able to find common ground on an increasing number of policy areas. By 2025 this could mean: Crossing borders for business or tourism becomes difficult due to regular checks. Finding a job abroad is harder and the transfer of pension rights to another country not guaranteed. Those falling ill abroad face expensive medical bills. Europeans are reluctant to use connected cars due to the absence of EU-wide rules and technical standards.
Scenario 3: Those Who Want More Do More – The EU27 proceeds as today but allows willing Member States to do more together in specific areas such as defence, internal security or social matters. One or several “coalitions of the willing” emerge. By 2025 this could mean that: 15 Member States set up a police and magistrates corps to tackle cross-border criminal activities. Security information is immediately exchanged as national databases are fully interconnected. Connected cars are used widely in 12 Member States which have agreed to harmonise their liability rules and technical standards.
Scenario 4: Doing Less More Efficiently – The EU27 focuses on delivering more and faster in selected policy areas, while doing less where it is perceived not to have an added value. Attention and limited resources are focused on selected policy areas. By 2025 this could mean A European Telecoms Authority will have the power to free up frequencies for cross-border communication services, such as the ones used by connected cars. It will also protect the rights of mobile and Internet users wherever they are in the EU.A new European Counter-terrorism Agency helps to deter and prevent serious attacks through a systematic tracking and flagging of suspects.
Scenario 5: Doing Much More Together – Member States decide to share more power, resources and decision-making across the board. Decisions are agreed faster at European level and rapidly enforced. By 2025 this could mean: Europeans who want to complain about a proposed EU funded wind turbine project in their local area cannot reach the responsible authority as they are told to contact the competent European authorities. Connected cars drive seamlessly across Europe as clear EU-wide rules exist. Drivers can rely on an EU agency to enforce the rules.
There is not much sign of a multi-speed approach in the above and yet, on 6th March the leaders of Germany, France, Italy and Spain convened in Versailles where they jointly expressed the opinion that allowing the EU to integrate at different speeds would re-establish confidence among citizens in the value of collective European action.
There are a couple of “general instruments”, contained in existing treaties, which give states some flexibility; ECFR – How The EU Can Bend Without Breaking suggests “Enhanced Cooperation” and “Permanent Structured Cooperation”(PESCO) as examples, emphasis mine:-
Enhanced cooperation was devised with the Amsterdam Treaty…in 1997, and revised in successive treaty reforms in Nice and Lisbon. Enhanced cooperation is stipulated as a procedure whereby a minimum of nine EU countries are allowed to establish advanced cooperation within the EU structures. The framework for the application of enhanced cooperation is rigid: It is only allowed as a means of last resort, not to be applied within exclusive competencies of the union. It needs to: respect the institutional framework of the EU (with a strong role for the European Commission in particular); support the aim of an ever-closer union; be open to all EU countries in principle; and not harm the single market. In this straitjacket, enhanced cooperation has so far been used in the fairly technical areas of divorce law and patents, and property regimes for international couples. Enhanced cooperation on a financial transaction tax has been in development since 2011, but the ten countries cooperating on this have struggled to come to a final agreement.
PESCO allows a core group of member states to make binding commitments to each other on security and defence, with a more resilient military and security architecture as its aim. It was originally initiated at the European Convention in 2003 to be part of the envisaged European Defence Union. At the time, this group would have consisted of France, Germany, and the United Kingdom. After disagreements on defence spending in this group and the referendum defeat for the European Constitution which meant the end of the Defence Union, a revised version of PESCO was added into the Lisbon treaty. This revised version allows for more space for the member states to decide on the binding commitments, which of them form the group, and the level of investment. However, because of its history, some member states still regard it as a top-down process which lacks clarity about how the groups and criteria are established. So far, PESCO has not been used, but it has recently been put back on the agenda by a group of EU member states.
These do not get the EU very far, but the ECFR go on to mention an additional Schengen-style approach, where international treaties of EU members can be concluded outside of the EU framework. These treaties can later be adopted by other EU members.
As part of their research the ECFR carried out more than 100 interviews with government officials and experts at universities and think-tanks across the 28 member states to discover their motivation for adopting a more flexible approach. The chart below shows the outcomes:-
Interestingly, in two countries, Denmark and Greece, officials and experts believe that more flexibility will result in greater fragmentation. Nonetheless, officials and experts in Croatia, Finland, Germany, Italy, Latvia, and Spain are in favour of embracing a more flexible approach. Benelux and France remain sceptical. Here is how the map of Europe looks to the ECFR:-
The timeline for action is likely to be gradual. President Juncker’s plans to develop the ideas contained in the white paper in his State of the Union speech in September. The first policy proposals may be drafted in time for the European Council meeting in December. It is envisaged that an agreed course of action will be rolled out in time for the European Parliament elections in June 2019.
Can Europe wait?
Two years is not that long a time in European politics but financial markets may lack such patience. Here is the Greek government debt repayment schedule prior to the European Parliament Elections:-
Source: Wall Street Journal
This five year chart shows the steady rise in total Greek government debt:-
Source: Tradingeconomics, Bank of Greece
Greek debt totalled Eur 326bln in Q4 2016, the debt to GDP ratio for 2015 was 177%. Italy’s debt to GDP was a mere 133% over the same period.
The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016. The chart below shows the evolution of Eurozone long-term interest rates between October 2009 and November 2016:-
In 2011 the Euro Area debt to GDP ratio was 86%, by 2015 it had reached 91%. The table below shows the highest 10yr yield since the great financial crisis for a selection of Eurozone government bonds together with their ratios of debt to GDP. It goes on to show the same ratio at the end of 2015. Only Germany is in a stronger position today than it was during the Eurozone crisis in terms of its debt as a percentage of its GDP:-
Source: Trading Economics
Since these countries bond markets hit their yield highs during the Eurozone Crisis, Greece, Italy and Spain have seen an improvement in GDP growth, but only Spain is likely to achieve sufficient growth to reduce its debt burden. If the ECB is to cease killing the proverbial fatted calf, a less profligate fiscal approach is required.
Euro Area GDP averaged slightly less than 1.8% per annum over the last two years, yet the debt to GDP ratio only declined a little over 1% from its all-time high. Further European integration sounds excellent in theory but in practice any positive impact on economic growth is unlikely to be evident for several years.
EU integration has been moving at different speeds for years, if anything, the process has been held back by attempts to move in unison. There are risks of causing fragmentation with both approaches, either within countries or between them.
Conclusions and Investment Opportunities
Another Eurozone financial crisis cannot be ruled out this year. The political uncertainty of the Netherlands is past, but France may yet surprise. Once Germany has voted in September, it will be time to focus on the endeavours of the ECB. Their asset purchase programme is scheduled to end in December.
I would expect this programme to be extended once more, if not, the stresses which nearly tore the Eurozone asunder in 2011/2012 are likely to return. The fiscal position of the Euro Area is only slightly worse than it was five years ago, but, having flirted with the lowest yields ever recorded, bond markets have considerably further to fall in percentage terms than in during the previous crisis.
Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero. German Bunds are always likely to act as the safe haven in a crisis and their yields have risen substantially in the past year, yet at less than ½% they are 300bp below their “safe-haven” level of April 2011.
The Euro is unlikely to rally in this environment. The chart below shows the Euro Effective Exchange Rate since 2005:-
The all-time low for the Euro is 82.34 which was the level is plumbed back in October 2000. This does sound an outlandish target during the next debacle.
Euro weakness would, however, be supportive for export oriented European stocks. The weakness that stocks would initially suffer, as a result of the return of the Euro crisis, would quickly be reversed, in much the same manner that UK stocks were pummelled on the initial Brexit result only to rebound.