Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train

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Macro Letter – No 76 – 05-05-2017

Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train

  • A corporate tax cut from 35% to 15% will cost US$200bln/annum
  • A Border Adjustment Tax could raise US$100bln/annum
  • The boost to GDP growth is unlikely to generate sufficient tax receipts to bridge the gap
  • Without fiscal austerity, total US debt is likely to rise under Trump as it did under Reagan

 

“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:-

Investment_to_GDP_-_Economist_BEA

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:-

ReaganVsObamaCumulGDPthru20quarters - Cato

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.

hk-sing-usa-growth_Maddison_Cato

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.

1980-88-laffer_Tax_returns

Source: Cato 

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.

cbo-1990-deficit-forecast_CBO_Cato 

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.

Impact of BAT - BLS, Census Bureau

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:-

US_Markets_pre-post_Trump (1)

Source: Investing.com

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.

Can a multi-speed European Union evolve?

Can a multi-speed European Union evolve?

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Macro Letter – No 73 – 24-03-2017

Can a multi-speed European Union evolve?

  • An EC white paper on the future of Europe was released at the beginning of the month
  • A multi-speed approach to EU integration is now considered realistic
  • Will a “leaders and laggards” approach to further integration work?
  • Will progress on integration enable the ECB to finally taper its QE?

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:-

ECFR FutureEU_MotiviationFlexibility

Source: ECFR

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:-

ECFR206_THE_FUTURE_SHAPE_OF_EUROPE_-_CountryMap

Source: 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:-

Greece_-_Repayment_Schedule_-_WSJ

Source: Wall Street Journal

This five year chart shows the steady rise in total Greek government debt:-

greece-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.

ECB dilemma

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:-

Long-term_interest_rates_(eurozone) Oct 09 to Nov 16 - ECB

Source: ECB

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:-

Bond_yields_and_debt_to_GDP (1)

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:-

Euro_Effective_Exchange_Rate_-_ECB (1)

Source: ECB

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.

Low cost manufacturing in Asia – The Mighty Five – MITI V

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Macro Letter – No 72 – 10-03-2017

Low cost manufacturing in Asia – The Mighty Five – MITI V

  • Low cost manufacturing is moving away from China
  • Malaysia, India, Thailand, Indonesia and Vietnam will continue to benefit
  • Currency risks remain substantial
  • Stock market valuations are not cheap but they offer long term value

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:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deliotte

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:-

MITI_V_-_Stats

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 Ideaexamines 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:-

 

Malaysia

…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.

India

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.

Thailand

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.

Indonesia

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.

Vietnam

…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.

Currency Risk

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:-

Currency_changes_MITI_V (1)

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:-

MITI_V_-_Bonds_Inflation_Fiscal

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:-

MITI_V and US_Stocks_in_20yr

Source: Investing.com

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$:-

MITI_V_-_Stock_performance_in_US_20yr

Source: Investing.com

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:-

MITI_V_PEs_etc

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:-

MITI_V_-_stocks_-_distance_to_high

Source: Investing.com

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.

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

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Macro Letter – No 71 – 24-02-2017

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

  • In 2006 NATO partners agreed to spend at least 2% of GDP on defence
  • Germany’s defence spending shortfall since 2006 equals $281bln
  • Retrospective adjustment is unlikely, but Europe needs to increase spending substantially
  • A minimum of $64bln/annum is required from Germany, France, Italy and Spain alone

Given the mutual relationship of the NATO treaty it could be argued that, for many years the US has been footing the lion’s share of the bill for defending Europe. Under the new US administration this situation is very likely to change.

The July 2016 Defence Expenditures of NATO Countries (2009-2016) presents the situation in clear terms. At the Riga summit back in 2006 NATO members agreed to raise defence expenditure to 2% of GDP. In that year only six countries met the threshold – Bulgaria, France, Greece, Turkey, the UK, and the US. Eight years later, at the NATO meeting in Wales, members renewed their commitment to this target. Last year only five members achieved the threshold – Estonia, Greece, Poland, the UK, and, of course, the US.

The original NATO treaty was signed on 4th April 1949 by 12 countries, it was expanded in 1952 to include Turkey and Greece and in 1955 to incorporate Germany. In 1982, after reverting to a democracy, Spain also joined. Further expansion occurred in 1999, again in 2004 and most recently 2009.

Back in 1949 Europe was still recovering from the disastrous social and economic impact of WWII. Today, in the post-Cold War era, things look very different and yet, whilst defence spending has waxed and waned over the intervening years, the US still spends substantially more on defence, both in absolute terms and as a percentage of GDP, than any of its treaty partners. The table below reveals the magnitude of the current situation:-

nato_expenditure_-_geopolitical_futures

Source: Geopolitical Futures, Mauldin Economics

US defence spending last year amounted to $664bln which equates to 3.61% of US GDP based on current estimates.

Setting aside the political debate about whether we should be spending more or less on defence, it would appear that the US continues to do more than its fair share, in economic terms, in defence of its NATO allies.

The next table looks at the budgetary implications of making the NATO budget equable. Firstly, all NATO countries committing 2% of GDP to defence (which would dramatically reduce the total NATO budget) or, secondly, maintaining the current level of spending, which would imply all countries contributing 2.58% of GDP. In both scenarios the US is a clear winner in economic terms:-

nato_expenditure_as_percentage_of_gdp_-_analysis-1

Source: NATO, UN, IMF

I have excluded the smaller, mainly Eastern European, countries from this analysis – their combined contribution is less than $13bln/annum. I do not wish to appear disparaging, on a percentage of GDP basis many of these countries contribute more than their larger European neighbours. My purpose in this analysis is to look at the relative increases or decreases under each scenario. Below are the Budget to GDP and Debt to GDP ratios before and after adjustment to the less demanding 2% defence expenditure target:-

nato_budget_and_debt_to_gdp_after_adjustment_to_2_

Source: NATO, UN, IMF, Trading Economics

The Maastricht Treaty incorporated certain criteria in order to satisfy Germany, along with other cautious countries, of the fiscal rectitude of all countries seeking to join the Eurozone. Although they were never really taken seriously by politicians, these fiscal restrictions included a maximum Government debt to GDP ratio of 60% and a Budget deficit to GDP ratio of less than 3%. Applying these arcane criteria, only three countries – Denmark, Norway and Turkey – are in the enviable position of being able to undertake the required defence spending increases with equanimity.

The burning question going forward is how the largest countries in Europe will react to the US compliant that they have failed to increase spending since 2006. As George Friedman of Geopolitical Futures – The Evolving NATO Alliance succinctly explains:-

…the US accounts for about 50% of NATO members’ total GDP and 32% of their total population—and yet the US makes up about 72% of defense spending.

… Western European countries (excluding the UK) account for 31% of NATO members’ GDP and 33%  of their population, and yet they contribute 16%  to NATO members’ total defense spending.

Eastern European countries, which account for 4.2% of NATO members’ GDP and 12.7% of their population, are much poorer and smaller than Western European countries. Eastern Europe contributes 2.7% to defense spending. In effect, Eastern Europe contributes closer to its share than its far wealthier and stronger neighbors to the west.

According to SIPRI Milex data for 2015, Russia spent 5.4% of GDP on defence. Other notable defenders of their realms include Pakistan (3.4%) and India (2.3%).

At the Munich Security Conference which took place last weekend, the prospect of Germany finding an extra Eur20bln per year for defence spending was raised, but, being an election year, little more was heard on the topic. The conference was fascinating however, here are some of the key quotes:-

A stable EU is as much in America’s interest as a united NATO – Ursula von der Leyen – Minister of Defence – Germany.

American security is permanently tied to European security – James Mattis – Secretary of Defence – USA.

The role of Germany in Europe is always to be a bridge – between North and South and East and West – Wolfgang Schauble – Minister of Finance – Germany.

Make no mistake, my friends. You should not count America out – John McCain – Chairman of Senate Committee on Armed Services – USA.

Let us not forget that NATO is the backbone of our value system – Jeanine Hennis-Plasschaert – Minister of Defence – Netherlands.

NATO is not an obsolete organisation. It is an organisation to which additional mandates should be added – Fikri Isik – Minister of National Defence – Turkey.

The United States of America strongly supports NATO and will be unwavering in our commitment to this Transatlantic alliance – Michael Pence – Vice President – USA.

Europe’s defence requires your support as much as ours – Michael Pence – Vice President – USA.

Things look very different if we add up our defence budgets, our development aid budgets and our humanitarian efforts all around the world – Jean-Claude Juncker – President – European Commission

The post-war generation rose to their challenge, we must rise to ours – Jens Stoltenberg – Secretary General – NATO.

The European Union is much stronger than we European’s realise – Federica Mogherini – Vice President – European Commission – High Representative for Foreign Affairs and Security Policy – EU.

No one has any clue what the foreign policy of this administration is – Christopher Murphy – Member of the Senate Committee on Foreign Relations.

From a negotiating perspective it would not be entirely unreasonable for the US to demand that the 2006 commitment of 2% spending be honoured retrospectively, in addition to the 2% commitment going forward. The table below shows how NATO members have performed in this respect since 2005, apart from the US, only Greece and the UK have been above target over the entire period. American frustration with its NATO partners is hardly surprising:-

nato_defense_expenditure_as_percentage_of_gdp_-_ge

Source: NATO, Geopolitical Futures

The tone of US comments at the Munich conference appear slightly more conciliatory than of late. Europe’s defence ministries have, nonetheless, been seriously shaken by the change in attitude which has accompanied the change of US administration.

According to commentators, who purport to have more of a clue than Christopher Murphy, US defence spending is likely to rise by between $500bln and $1trln under the new administration. This is no “Get Out of Jail Free” card for NATOs parsimonious majority, Europe will be pressured to defence spending at a time when budgets are already uncomfortably bloated. They have had more than a decade to comply with the Riga commitment.

Looking at the bigger picture for a moment, this sudden rise in spending is a small uptick in a downward trend. Defence budgets have been falling in all the major NATO countries, as the chart below indicates. In 1989 excluding the UK and US the average budget to GDP across NATO countries was 2.9% by 1998 it had fallen to 2% but since then it has steadily declined to an average of 1.4% today. This may be good from an economic perspective – as Frederic Bastiat argued most eloquently in relation to the cost of a standing army in his essay What Is Seen and What Is Not Seen:-

A hundred thousand men, costing the taxpayers a hundred million francs, live as well and provide as good a living for their suppliers as a hundred million francs will allow: that is what is seen.

But a hundred million francs, coming from the pockets of the taxpayers, ceases to provide a living for these taxpayers and their suppliers, to the extent of a hundred million francs: that is what is not seen. Calculate, figure, and tell me where there is any profit for the mass of the people.

Nonetheless, the economic burden of defence spending borne by the US is undoubtedly going to shift, or else, NATO will cease to be tenable going forward:-

defence_spending_as_a_pecentage_of_gdp_since_1949_

Source: SIPRI

Conclusion

I believe it is likely that Germany, France, Italy and Spain will find an additional $64bln/annum for Defence and Aid budgets. They may also have to pick up part of the bill for the smaller countries to their East.

Will this impact European bond markets? It seems like a drop in the ocean beside the Asset Purchase Program of the ECB. President Draghi announced in January that they will be reducing the monthly purchases from Eur 80bln per month to Eur 60bln starting in April. I suspect the impact will be limited but it might prolong the Asset Purchase Program somewhat.

The implications for defence contractors and their stock market valuations will be more direct. Here are some of the largest listed names in Europe. Not all of them have been darlings of the stock market of late:-

areospace_and_defence_companies-1

Source: Investing.com, LSE, NYSE Euronext

For those who, like myself, who prefer to analyse the sector rather than individual stocks, the STOXX Europe TMI Aerospace & Defense (SXPARO) may appeal; here is a three year chart:-

stoxx_-_europe_tmi_aerospace_defense

Source: STOXX

The combination of increased military spending by the US and the pressure being brought to bear on Europe, should see the defence sector outperform over the longer term. During the last 12 months the SXPARO has risen 15%. Its US equivalent, the iShares US Aerospace & Defense ETF (ITA) is up by 20% over the same period, whilst the Euro has declined by around 3% against the US$. As a general rule I prefer to buy Leaders rather than Laggards, but the logic of buying European if European governments are forced to honour their defence obligations remains compelling.

The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

  • Shanghai house prices increased 26.5% in 2016
  • International investment in Asian Real Estate is forecast to grow 64% by 2020
  • Chinese and Indian Real Estate has underperformed US stocks since 2009
  • Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed AssetLocation is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country Weight
Japan 32.94%
Hong Kong 26.40%
Australia 19.81%
China 9.62%
Singapore 6.30%
Other 4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and  ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

 

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

  • There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
  • Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
  • Geographic constraints – lack of space drives prices higher.
  • Planning restrictions – limitations on development and redevelopment drive prices higher.
  • Economic growth – this can be at the country level or on a per-capita basis.
  • Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
  • Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
  • Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
  • Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region 2017 Change
ASEAN* 4.90% -0.20%
India 7.20% -0.40%
China 6.50% 0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index Performance – March 09 – December 16 Performance in US$ Current Yield
S&P500 207% 207% 2%
FHFA House Price Index (US) 9.70% 9.70% 2.20%
Shanghai Composite (China) 50% 49.20% 4.20%
Shanghai Second Hand House Price Index 74% 72.85% 3.20%
S&P BSE Sensex (India) 204% 135.25% 1.50%
National Housing Bank Index (India) 58%* 38.45% 3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

india_-_national_housing_bank_-_house_price_index

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country Price/Income Ratio Rental Yield City Price/Rent Ratio City Mortgage As % of Income GDP f/c 2017
Malaysia 9.53 4.07 24.6 72.87 4%
Taiwan 12.87 1.54 64.91 78.76 1.80%
South Korea 12.38 2.04 49.1 85.47 2.40%
India 10.28 3.08 32.44 123.44 7.40%
Singapore 21.63 2.75 36.41 134.33 1.60%
Pakistan 12.09 4.08 24.51 156.97 5.10%
Philippines 16.91 3.75 26.69 162.87 6.60%
Bangladesh 12.89 3.25 30.81 181.3 6.80%
China 23.29 2.23 44.83 189.71 6.40%
Mongolia 15.77 9.78 10.22 203.47 1.80%
Thailand 24.43 3.8 26.29 212.03 3.30%
Hong Kong 36.15 2.25 44.35 224.85 1.80%
Sri Lanka 17.49 4.91 20.38 238.64 4.80%
Indonesia 21.03 4.67 21.41 247.68 5.10%
Vietnam 26.76 4.52 22.1 285.55 6.60%
Cambodia 24.32 7.44 13.44 292.43 7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager Asian AUM $Blns Total AUM $Blns
UBS Global Asset Management 9.33 64.89
Global Logistic Properties 9.26 20.14
CBRE Global Investors 8.56 91.27
LaSalle Investment Management 8.05 55.75
Blackstone Group 7.58 121.88
Alpha Investment Partners 7.48 8.70
Blackrock 7.32 22.92
Pramerica Real Estate Investors 6.84 59.17
Gaw Capital Partners 6.64 9.16
Prologis 6.08 29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.

Equity valuation in a de-globalising world

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Macro Letter – No 68 – 13-01-2017

Equity valuation in a de-globalising world

  • The Federal Reserve will raise rates in the coming year
  • The positive Yield Gap will vanish but equity markets should still rise
  • After an eight year bull market equities are vulnerable to negative shocks
  • A value based investment approach is to be favoured even in the current environment

In this Macro Letter I review stock market valuation. I conclude with some general recommendations but the main purpose of my letter is to investigate different methods of valuation and consider the benefits and dangers of diversification. I begin by looking at the US market and the prospects for the US economy. Then I turn to global equity markets, where I consider the benefits and perils of diversification into Frontier stocks. I go on to review global industry sectors, before returning to examine the long term value to be found in developed markets. I finish by looking at the recent outperformance of Value versus Growth.

US Stocks and the Yield Gap

The Equity bull market is entering its eighth year and for US stocks this is the second longest bull-market since WWII – the longest being, between 1987 and 2000. The current bull-market has differed from the 1987-2000 period in that interest rates have fallen throughout the period. Bond yields have also declined to historically low levels. The Yield Gap – the premium of dividend yields over bond yields – which had been inverted since the mid-1950’s, turned positive once more. The chart below shows the yield of the S&P500 and 10yr T-Bonds since 1900:-

yield-gap-in-a-longer-term-context-jpeg

Source: Reuters

What this chart shows most clearly is that the return to a positive Yield Gap has been a function of falling bond yields rather than any substantial rise in dividend pay-out.

The chart below looks at the relationships between the Yield Gap and the real return on US 10yr Treasuries and S&P500 dividends since 1930 – I have used the Implicit Price Deflator as the measure of inflation:-

us_yield_gap_-_real_bond_yld_-_real_div_yld

Source: Multpl, St Louis Federal Reserve

The decline in the real dividend yield was a response to rising inflation from the late 1950’s onwards. The return to a positive Yield Gap has been a recent phenomenon. The average Yield Gap since 1900 is -0.51%, since 1930 it has been -1.17%. It has been below its long-run average at -0.37% since 2008. The executive officers of US corporations will continue to favour share buy-backs over increased dividends – I do not expect dividend yields to keep pace with any pick-up in inflation in the near-term, but, share buy-backs will continue to support stocks in general.

S&P 500 forecasts for 2017

What does this mean for the return on the S&P 500 in 2017? According to Bloomberg, the consensus forecast is for a rise of 4% but the range of forecasts is a rather narrow +1.3% to +8.3%. As at the close on 11th January we were already up 1.6% from the 30th December close.

Corporate earnings continue to rise although the pace of increase has moderated. Factset Earning Insight – January 6th – makes the following observations:-

Earnings Growth: For Q4 2016, the estimated earnings growth rate for the S&P 500 is 3.0%. If the index reports earnings growth for Q4, it will mark the first time the index has seen year-over-year growth in earnings for two consecutive quarters since Q4 2014 and Q1 2015.

Earnings Revisions: On September 30, the estimated earnings growth rate for Q4 2016 was 5.2%. Ten of the eleven sectors have lower growth rates today (compared to September 30) due to downward revisions to earnings estimates, led by the Materials sector.

Earnings Guidance: For Q4 2016, 77 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance.

Valuation: The forward 12-month P/E ratio for the S&P 500 is 17.1. This P/E ratio is above the 5-year average (15.1) and the 10-year average (14.4).

Earnings Scorecard: As of today (with 4% of the companies in the S&P 500 reporting actual results for Q4 2016), 73% of S&P 500 companies have beat the mean EPS estimate and 36% of S&P 500 companies have beat the mean sales estimate.

…For Q1 2017, analysts are projecting earnings growth of 11.0% and revenue growth of 7.9%.

For Q2 2017, analysts are projecting earnings growth of 10.5% and revenue growth of 6.0%.

For all of 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 5.9%.

…At the sector level, the Energy (33.2) sector has the highest forward 12-month P/E ratio, while the Telecom Services (14.2) and Financials (14.2) sectors have the lowest forward 12-month P/E ratios. Nine sectors have forward 12-month P/E ratios that are above their 10-year averages, led by the Energy (33.2 vs. 17.9) sector. One sector (Telecom Services) has a forward 12-month P/E ratio that is below the 10-year average (14.2 vs. 14.6).

Other indicators, which should be supportive for the US economy, include the ISM – PMI Index which is closely correlated to the business cycle. It came in at 54. 7 the highest since November 2014. Here is a 10 year chart:-

united-states-business-confidence-10yr

Source: Trading Economics, Institute for Supply Management

A shorter-term indicator for the US economy is the Citigroup Economic Surprise Index – CESI. The chart below suggests that the surprise caused by Trump’s presidential victory is still gathering momentum:-

citi_cesi_index_-_january_2017_-_yardeni

Source: Yardeni, Citigroup

With both the ISM and the CESI indices rising, even the most bearish of macro-economist is likely to be “sceptically positive” on the US economy and this should be supportive for the US stock market.

Global Stocks

I have focussed on the US stock market because of the close correlation between the US and other major stock markets around the world.

As the world becomes less globalised, or as one moves away from the major stock markets, the diversification benefits of a global portfolio, such as the one Andrew Craig describes in his book “How to Own the World”, becomes more enticing. Andrew recommends diversification by asset class, but even a diversified equity portfolio – without the addition of bonds, commodities, real-estate and infrastructure – can offer an enhanced Sharpe Ratio. The table below looks at the three year monthly correlations of emerging and frontier stock markets with a correlation of less than 0.40 to the US market:-

Country Correlations < 0.40 to US stocks – 36 months
Malawi -0.12
Iraq -0.12
Panama -0.01
Cambodia 0.00
Rwanda 0.01
Venezuela 0.01
Uganda 0.01
Trinidad and Tobago 0.02
Tunisia 0.02
Botswana 0.07
Mauritius 0.07
Tanzania 0.08
Palestine 0.09
Laos 0.09
Ghana 0.10
Zambia 0.10
Peru 0.11
Bahrain 0.13
Jordan 0.15
Cote D’Ivoire 0.15
Sri Lanka 0.16
Argentina 0.17
Nigeria 0.17
Qatar 0.21
Kenya 0.21
Pakistan 0.24
Jamaica 0.24
Oman 0.25
Colombia 0.27
Saudi Arabia 0.31
Kuwait 0.36
China 0.37
Bermuda 0.38
Egypt 0.38
Vietnam 0.39

Source: Investment Frontier

Many of these stock markets are illiquid or suffer from investment restrictions: but here you will find some of the fastest growing economies in the world. These correlations look beguilingly low but remember that during broad-based market declines short-term correlations tend to rise – the illusory nature of liquidity drives this process. The price of a financial asset is driven by investment flows, cognitive behavioural biases drive investment decisions. Herd instinct rises dramatically when fear replaces greed.

Industry Sectors

The major stock markets also offer opportunities. Looking globally by industry sector there are some attractive longer-term value propositions. The table below ranks the major markets by sector as at 30th December 2016. The sectors have been sorted by trailing P/E ratio (mining and alternative energy P/E data is absent but by other measures mining is relatively cheap):-

Industry Sector PE PC PB PS DY
Real Est Serv 11.2 14.9 1 2.2 2.70%
Auto 12.1 5.7 1.4 0.6 2.50%
Banks 13.8 9.6 1.1 3.30%
Life Insur 14.2 6.4 1.1 0.7 3.00%
Electricity 14.9 5.6 1.3 1.1 4.00%
Forest & Paper 15.1 7.1 1.6 0.9 2.90%
Nonlife Ins 16.2 10.4 1.3 1 2.40%
Financial Serv 16.7 13.8 1.8 2.3 2.20%
Telecom (fxd) 17.5 5.5 2.3 1.4 4.20%
Travel & Leisure 17.6 9.1 2.9 1.4 2.10%
Tech HW & Equ 18.3 10.7 3 1.8 2.30%
Chemicals 18.8 10.1 2.4 1.3 2.60%
Household Gds 18.8 15 2.8 1.7 2.40%
Gen Ind 19 11.3 1.9 1.1 2.40%
REITs 20.4 16.7 1.7 7.7 4.50%
Construction 20.9 11.4 1.9 0.9 2.10%
Telecom (mob) 21.4 5.6 1.9 1.5 3.30%
Tobacco 21.5 21.1 9.8 4.9 3.60%
Media 21.6 10.9 2.9 2 2.10%
Food Retail 21.6 10.2 2.8 0.4 2.00%
Eltro & Elect Equ 21.7 12.2 2.2 1 1.70%
Pharma & Bio 22.4 16.3 3.4 3.5 2.30%
Food Prod 23.2 14.3 2.6 1.2 2.20%
Healthcare 23.7 13.1 3.2 1.4 1.10%
Leisure Gds 23.9 8.4 2 1.1 1.20%
Inds Transport 23.9 10.4 2.5 1.3 2.50%
Aero & Def 23.9 14.9 5 1.3 2.10%
Inds Eng 24.6 12.4 2.5 1.1 2.00%
Personal Gds 24.7 16.8 4.3 2 2.00%
Gen Retail 25.8 14 4.2 1 1.70%
Support Serv 26.4 11.9 2.8 1.1 1.90%
Beverages 27 14.9 4.2 2.4 2.70%
SW & Comp Serv 27.3 15.9 4.5 3.8 1.10%
Oil Service 73.9 11.8 1.9 1.7 3.70%
Oil&Gas Prod 116.9 8.2 1.4 1 3.10%
Inds Metal 165.7 7.7 1.1 0.7 2.40%
Mining 8.9 1.6 1.5 1.90%
Alt Energy 10.5 1.7 0.9 1.20%

Source: Star Capital

A number of sectors have been out of favour since 2008 and may remain so in 2017 but it is useful to know where under-performance can be found.

Developed Market Opportunities

At a country level there is better long-term valuation to be found outside the US, even among the developed countries. Here is Star Capital’s 10 to 15 year total annual return forecast for the major markets and regions:-

Country CAPE Forecast PB Forecast ø Forecast
Italy 12.7 9.10% 1.2 10.40% 9.70%
Spain 11.7 9.70% 1.4 8.80% 9.30%
United Kingdom 14.8 8.00% 1.8 7.20% 7.60%
France 18.3 6.60% 1.6 8.10% 7.30%
Australia 16.8 7.10% 2 6.60% 6.90%
Germany 18.6 6.40% 1.8 7.40% 6.90%
Japan 24.9 4.40% 1.3 9.40% 6.90%
Netherlands 19.8 6.00% 1.8 7.20% 6.60%
Canada 20.5 5.70% 1.9 6.90% 6.30%
Sweden 20.6 5.70% 2.1 6.20% 5.90%
Switzerland 21.5 5.40% 2.4 5.30% 5.30%
United States 26.4 4.00% 2.9 4.10% 4.00%
Emerging Markets 14 8.40% 1.6 7.90% 8.20%
Developed Europe 16.6 7.20% 1.8 7.40% 7.30%
World AC 20.8 5.60% 2 6.70% 6.20%
Developed Markets 21.9 5.30% 2 6.50% 5.90%

Source: Star Capital, Bloomberg, Reuters

I have sorted this data based on Star Capital’s composite annual return forecast. The first three countries, Italy, Spain and the UK, all face uncertainty linked to the future of the EU. Interestingly Switzerland offers better long-term returns than the US – with considerably less currency risk for the international investor.

Value Investing

Since the financial crisis in 2008 through to 2015 Growth stocks outperformed Value stocks. I predict a sea-change. The fathers of Value Investing, Ben Graham and David Dodd first published Securities Analysis in 1934. Towards the end of his career Graham opined (emphasis is mine):-

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

As we embrace the “Big Data” era, the cost of analysing vast amounts of data will collapse, whilst, at the same time, the amount of available data will grow exponentially. I believe we are at the dawn of a new age for Value Investing where the quantitative analysis of a vast array of qualitative factors will allow investors to defy the Efficient Market Hypothesis, even if we cannot satisfactorily refute Eugene Fama’s premise. In 2016, for the first time in seven years, Value beat Growth across all major categories:-

value_outperformance_of_growth_2016

Source: MSCI, Bloomberg

Value stocks tend to exhibit higher volatility than growth stocks, but volatility is only one aspect of risk: buying Value offers long-term protection, especially during an economic downturn. According to Bloomberg’s Nir Kaissar, Value has consistently underperformed Growth since the financial crisis except in US Small Cap’s – his article – Value Investing Hits Back – is insightful.

Conclusion and Investment Opportunities

When I first began investing in stocks the one of the general rules was to buy when the P/E ratio was below 10 and sell when it rose above 20. Today, of the world’s major stock markets, only Russia and China offer single digit P/Es – low ratios are a structural feature of these markets. I wrote about Russia last month in – Russia – Will the Bear come in from the cold? My conclusion was that one should be cautiously optimistic:-

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord.

Interest rates in the US will rise, though probably not by as much, nor as quickly as the market is currently betting. A value based approach to stock selection offers greater protection and greater return in the long run.

The US stock market continues to rise. The US economy looks set to grow more rapidly in 2017 due to tax cuts and fiscal stimulus, but, for international companies which export to the US, the threat of protectionism is likely to temper enthusiasm for their stocks.

US financial services firms were a big winner after the Trump election result, they should continue to benefit even as interest rates increase – yield curves will steepen, increasing return on capital. US telecommunications stocks have a performed well since the election along with biotechnology – I have no specific view on these industries. Energy stocks have also rallied, perhaps as much on the OPEC deal as the Trump triumph – many new technologies are starting to be implemented by the energy industry but enthusiasm for these stocks may be tempered by a decline in oil prices once the rig count rebounds. The Baker-Hughes Rig Count ended the year at 525 up from a low of 316 in May. The old high of 1,609 was set back in October 2014 – there is plenty of spare capacity which will exert downward pressure on oil prices.

Indian economic growth will outpace China for another year. Despite a weakening Chinese Yuan, Vietnam remains competitive – it is on the cusp of moving from Frontier to Emerging Market status. Indonesia also looks likely to perform well during 2017, GDP forecasts are around 5%; however, Indonesia’s strong reliance on commodity exports makes it more vulnerable than some of its South and East Asian neighbours.

Protectionism: which countries have room for fiscal expansion?

Protectionism: which countries have room for fiscal expansion?

400dpiLogo

Macro Letter – No 66 – 25-11-2016

Protectionism: which countries have room for fiscal expansion?

  • As globalisation goes into reverse, fiscal policy will take the strain
  • Countries with government debt to GDP ratios <70% represent >45% of global GDP
  • Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…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:-

world-bank-economist-real-income-growth-1988-2008

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:-

pricesnew

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
Japan 4,123 -0.10% -0.50% 229% 0.03
Greece 195 0.00% -0.50% 177% 6.95
Italy 1,815 0.00% -0.20% 133% 2.06
Portugal 199 0.00% 0.90% 129% 3.70
Belgium 454 0.00% 1.81% 106% 0.65
Singapore 293 0.07% -0.20% 105% 2.36
United States 17,947 0.50% 1.60% 104% 2.32
Spain 1,199 0.00% 0.70% 99% 1.60
France 2,422 0.00% 0.40% 96% 0.74
Ireland 238 0.00% -0.30% 94% 0.98
Canada 1,551 0.50% 1.50% 92% 1.57
UK 2,849 0.25% 0.90% 89% 1.41
Austria 374 0.00% 1.30% 86% 0.54
Egypt 331 14.75% 13.60% 85% 16.95
Germany 3,356 0.00% 0.80% 71% 0.27
India 2,074 6.25% 4.20% 67% 6.30
Brazil 1,775 14.00% 7.87% 66% 11.98
Netherlands 753 0.00% 0.40% 65% 0.43
Israel 296 0.10% -0.30% 65% 2.14
Pakistan 270 5.75% 4.21% 65% 8.03
Finland 230 0.00% 0.50% 63% 0.46
Malaysia 296 3.00% 1.50% 54% 4.39
Poland 475 1.50% -0.20% 51% 3.58
Vietnam 194 6.50% 4.09% 51% 6.10
South Africa 313 7.00% 6.10% 50% 8.98
Venezuela 510 21.73% 180.90% 50% 10.57
Argentina 548 25.75% 40.50% 48% 2.99
Philippines 292 3.00% 2.30% 45% 4.40
Thailand 395 1.50% 0.34% 44% 2.68
China 10,866 4.35% 2.10% 44% 2.91
Sweden 493 -0.50% 1.20% 43% 0.52
Mexico 1,144 5.25% 3.06% 43% 7.39
Czech Republic 182 0.05% 0.80% 41% 0.59
Denmark 295 -0.65% 0.30% 40% 0.40
Romania 178 1.75% -0.40% 38% 3.55
Colombia 292 7.75% 6.48% 38% 7.75
Australia 1,340 1.50% 1.30% 37% 2.67
South Korea 1,378 1.25% 1.30% 35% 2.12
Switzerland 665 -0.75% -0.20% 34% -0.15
Turkey 718 7.50% 7.16% 33% 10.77
Hong Kong 310 0.75% 2.70% 32% 1.37
Taiwan 524 1.38% 1.70% 32% 1.41
Norway 388 0.50% 3.70% 32% 1.65
Bangladesh 195 6.75% 5.57% 27% 6.89
Indonesia 862 4.75% 3.31% 27% 7.85
New Zealand 174 1.75% 0.40% 25% 3.11
Kazakhstan 184 12.00% 11.50% 23% 3.82 ***
Peru 192 4.25% 3.41% 23% 6.43
Russia 1,326 10.00% 6.10% 18% 8.71
Chile 240 3.50% 2.80% 18% 4.60
Iran 425 20.00% 9.50% 16% 20.00 **
UAE 370 1.25% 0.60% 16% 3.57 *
Nigeria 481 14.00% 18.30% 12% 15.97
Saudi Arabia 646 2.00% 2.60% 6% 3.97 *

 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.
Saudi Arabia 646 6% 3.97 38 452 581 ? ? ?
Chile 240 18% 4.60 42 168 216 15.6 ? ?
New Zealand 174 25% 3.11 43 122 157 19.3 22 4.1%
Peru 192 23% 6.43 44 134 173 12.1 ? ?
Bangladesh 195 27% 6.89 53 137 176 ? ? ?
UAE 370 16% 3.57 58 259 333 ? ? ?
Colombia 292 38% 7.75 111 204 263 ? ? ?
Norway 388 32% 1.65 123 272 349 14.2 11.5 4.3%
Philippines 292 45% 4.40 132 204 263 16.4 22.6 1.6%
Malaysia 296 54% 4.39 160 207 266 15.6 16 3.1%
Taiwan 524 32% 1.41 166 367 472 12.8 19 3.9%
Thailand 395 44% 2.68 175 277 356 13.8 17.7 3.1%
Israel 296 65% 2.14 192 207 266 9.4 14.6 2.8%
Sweden 493 43% 0.52 214 345 444 16.1 19.8 3.6%
Indonesia 862 27% 7.85 233 603 776 14.7 19.6 1.9%
South Korea 1,378 35% 2.12 484 965 1,240 9.6 13.1 1.7%
Australia 1,340 37% 2.67 493 938 1,206 15.6 16.1 4.3%
Mexico 1,144 43% 7.39 494 801 1,030 16.6 22.4 1.9%
India 2,074 67% 6.30 1,394 1,452 1,867 15.9 18.6 1.5%
4,649 8,114 10,432

 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.