the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

Trump on trade: unintended consequences?

A straightforward analysis of what Mr. Trump is doing would be:

–tariffs slow overall growth and rearrange it to favor protected industries.  There’s no reason I can see to believe something different might happen in the US

–apart from the third world, protected industries tend to have domestic political clout but to be in economic trouble.  In my experience, these woes come more from bad management than from foreigners’ actions

–the go-it-alone approach is a weak one, since it provides ample scope for a target country to shop tariffed goods through an intermediary

–the apparently arbitrary way the administration is acting will cause both domestic and foreign corporations to reconsider future capital investment in the US.

 

There are, however, two other issues that I think have long-term implications but which aren’t discussed much.

–tariffs may cause industries that have moved abroad to retain labor-intensive work practices (and continue to use dated industrial machinery) in a lower labor-cost environment to return to the home country.  If such firms come back to the US, it won’t be with the old machinery.  New operations will be very highly mechanized. In other words, one likely response to the Trump tariffs will be to accelerate the replacement of humans with robots in the US.

–as I see it, China is at the key stage of economic development where, to grow, it must leave behind labor-intensive work and develop higher value-added industries.  This is very hard to do.  The owners of low value-added enterprises have become very wealthy and powerful.  They employ lots of people.  They have considerable political influence.   And they strongly favor the status quo.  The result is typically that the economy in question plateaus as labor-intensive industries block progress.  In the case of China, however, the threat that the US will effectively deny such firms access to a major market will kickstart progress and deflect blame from Beijing.

 

If I’m correct, the effect of trying to restore WWII-era industry in the US will, ironically, achieve the opposite.  It will accelerate domestic change in the nature of work away from manual labor.  And it will run interference against the status quo in China, allowing Beijing’s efforts to become a cutting-edge industrial power to gather speed.

 

 

slowdown in China

In the late 1970s Deng Xiaoping was forced to tackle the gigantic mess that central planning had made of the Chinese economy during Mao’s rule.  The problem:  highly inefficient, loss-making, corruption-infested, Soviet-style (feel free to add more negative, hyphenated adjectives) state-owned enterprises dominated the industrial base.  The products were poor;  the books more fiction than not.  Deng’s solution was to adopt Western-style capitalism under the banner of “Socialism with Chinese Characteristics.”  This meant pulling the plug on bank credit and political favor for state-owned enterprises and redirecting support toward the private sector.

The result has been 30+ years of economic growth so strong that it has vaulted China from nowhere into first place among world economies.  In fact, the PRC is now 10%+ larger than #2, the US, using Purchasing Power Parity as the yardstick.

According to an astute observer of China, Nicholas Lardy, writing in the Financial Times, however, current Chinese leader Xi Jinping has not simply been cracking down on the cumulative excesses of the private sector over the past couple of years.  He has also reversed Deng’s policy in favor of building up the state-owned sector again.  Lardy thinks this decision is reducing China’s annual GDP growth rate by a whopping two percentage points.

I’m not sure why this is happening.  But for China, the highest economic principle has never been about achieving maximum sustainable GDP growth.  Rather, it’s whatever is necessary to maintain the Communist Party in power.  Reduction in GDP growth is a secondary concern.

 

I don’t know how this affects China’s stance in tariff negotiations with the US, especially since White House economists seem to be suggesting that the US economy is already beginning to contract under the weigh of current tariffs plus the government shutdown   (increased tariffs slated for March will only deepen any decline).  From a longer-term point of view, though–and assuming Chinese policy doesn’t change–for a company to simply have exposure to China will no longer be any guarantee of success.

 

steering through the shoals

issues for the S&P 500 in 2019:

–about half the earnings of the S&P come from outside the US.  For 2019, that’s not a good thing, since China is slowing down (more tomorrow) and the UK’s ham-fisted approach to Brexit is stalling business activity in the EU

–in the US,

—-last year’s corporate tax cut is no longer a source of year-on-year aftertax earnings growth

—-tariffs continue in place.  Tariffs redistribute,  but in the aggregate also slow, economic growth. The current ones are designed to shift economic energy toward sunset (often private) industries and away from ones with better prospects.  Some, like those on steel and aluminum, appear arbitrary, adding a layer of uncertainty to the whole process

—-the government shutdown is already pushing the US economy from a plodding advance into reverse, according to White House economists.  The central issue is a border wall, which, if news reports are correct, was originally intended only as a memory aid for a candidate who couldn’t remember his key policy positions very well

—-the lack of sensible–or even coherent–economic strategy from Washington is making corporations accelerate domestic restructuring plans and to question future investment in the country.  The administration’s hostility to admitting highly skilled foreign workers based on their religion/ethnicity is making the shift of r&d activity across the border to Canada an easy decision

In short, an embarrassing parade in Washington of own goals/self-inflicted wounds.

 

where to look for growth

The business cycle isn’t going to be much help.  In times like this, the defensive sectors–utilities and telecom, and, to a lesser extent healthcare and consumer discretionary–typically come to the fore.  But utilities + traditional telephone now amount to much less than 10% of the S&P.  More important, both areas are in the throes of fundamental alteration that is damaging to incumbents.  This leaves us with healthcare and consumer discretionary.

In both these areas, I think it’s important not to implicitly take a business cycle approach.  A key factor here is Millennials vs. Baby Boomers.

In very rough terms, a Baby Boomer earns about twice what a Millennial does.  But Millennials are entering a period of rapid growth in wages.  In contrast, as Boomers retire, their incomes are typically cut in half.  It seems to me that in all consumer areas it’s important to concentrate on firms that serve mostly Millennials, and avoid those (department stores are an easy example) that serve mostly Boomers, no matter what the level of current profits is.

My personal belief is that Americans don’t approve of making money from others’ illnesses.  That’s the simplest reason (there are others) I can give for avoiding hospitals or nursing care or other healthcare service providers.  But the premise of no business cycle help implies as well looking for smaller, more innovative, say, medical treatment development, firms    …early-stage companies with the potential for explosive growth.

In the tech area–a more business cycle-sensitive area than healthcare–I think seeking out smaller, more innovative firms is also the way to go (but I always say this).  In a so-so economy these should continue to prosper.  The big risk is that they would likely be hurt very badly if the administration continues to add to the damage to the domestic economy that it is already doing.

 

 

 

 

threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

 

 

 

 

 

 

the business cycle, interest rates and the tax cut

past cycles

The garden-variety business cycle since WWII has played out over about four years.   Stock market rises and falls have typically led this cycle by about six months.  Movement breaks out into around 2 1/2 years of up followed by 1 – 1 1/2 years of down.

The driving factor in the cycle has been government policy, in the form of Federal Reserve’s control of short-term interest rates.  Half a century ago, conventional wisdom held that fiscal policy took effect with such long lags that extra government spending or tax changes might end up addressing a problem that was no longer there.  So, the argument went, Congressional action would do more harm than good.  More recent Congresses have been dysfunctionally unable to pass potentially helpful bills.

a typical pattern

Let’s look at the beginning of an up cycle.  The economy has been sputtering–perhaps even declining–so the Fed lowers short-term interest rates.  In the world outside the US, lower borrowing costs make economically viable industrial projects that were previously on the shelf.  So companies build new plants and then hire new workers.  This leads to a pickup in consumer spending, which leads to more investment, which leads to more hiring…

At some point, the economy runs out of workers.  Companies still want to expand, so they begin to poach staff from rivals by offering (a lot) more money.  In advanced economies, inflation is always wage inflation, so price increases start to accelerate at unhealthy speed.

The Fed reacts by raising interest rates to cool the economy down.  Typically, the central bank goes too far.  Monetary policy doesn’t simply return to neutral.  It becomes restrictive, meaning the economy begins to sputter again.  Realizing its mistake, the central bank reverses course  …and an upcycle begins once more.

The US is different.  For whatever reason, consumer spending here doesn’t wait for new jobs to materialize.  Unlike the rest of the world, consumer doesn’t lag investment; it leads.

stocks and bonds

As the upcycle matures, bonds start to weaken because interest rates are beginning to rise.  Stocks, on the other hand, have an initial hiccup but then tend to go sideways to up.  That’s because earnings growth continues to be strong, offsetting the negative impact of rising rates.  Eventually, if/as the central bank become restrictive, stocks begin to decline as well–both because rates are continuing to rise and because investors begin to anticipate future profit declines.

this time is different

Normally, those words send chills up and down the spines of investors.  This time, however, the business cycle really is way different than the garden variety, in three ways:

–interest rate policy has been extremely stimulative for most of the past decade, as a necessary aid to rebuilding the economy after the (Washington-induced) financial crisis,  and because Congress has failed to help through fiscal policy.   Because short rates have been starting from essentially zero, they can rise a long way before beginning to damage the economy

–a little more than a year ago, as the Fed was continuing to withdraw stimulus to counter overheating (evidenced by crazy financial speculation), Congress passed tax cuts that, ten years too late, added over $100 billion annually to net stimulus

–the administration has implemented a hodge-podge of restrictions on trade, which appear, to me at least, to be much more damaging to the domestic economy than the consensus believes

the upshot

–if the trend of annual nominal GDP growth in the US is 4% – 5%, the tariffs may depress the figure for 2019 below that level

–it’s also up in the air as to how much the tariffs will take the edge off the earnings energy stocks need to fend off the negative effect of higher rates

–tax cuts boosted corporate eps in the US by about 20 percentage points.  The overall earnings gain will likely be about +25%.  Because both 2019 and 2018 figures contain the tax benefit (but 2017 numbers didn’t), the yoy eps gain for 2019 will likely drop to be on the order of +5% – +10%.  On the surface, then, earnings growth in 2019 will fall off a cliff.

Decelerating earnings growth like this is normally a sell signal.  On the other hand, the market traditionally doesn’t pay attention to one-off items, however large.  If this holds true again, the market should go sideways from here.

What are the algorithms thinking?  Better said, how are the algorithms programmed?