trade, tariffs and Harley Davidson (HOG)

Modern economics has been founded in study of what caused the Great Depression of the 1930s, with an eye to preventing a recurrence of this devastating period.  We know very clearly that tariffs and quotas are, generally speaking, bad things.  They reduce overall economic activity in the countries that apply them.  Yes, politically favored industries do often get a benefit, but the cost to everybody else is many times larger.  We also know that the use of tariffs and quotas can snowball into a storm of retaliation and counter-retaliation that can do widespread damage for a long time.

My point is that it’s inconceivable that high-ranking public officials in Washington don’t know this.

 

HOG motorcycles are Baby Boomer counterculture icon.  The company’s traditional domestic male customer base is aging, however, and losing the strength and sense of balance required to operate these heavy machines.  At the same time, HOG has had difficulty in attracting younger customers, or women or minority groups to its offerings.  So it’s an economically more fragile firm, I think, than the consensus realizes.

HOG has been damaged to some degree by the Trump tariffs on aluminum and steel, which are important raw materials.  (As I understand them, the tariffs are ostensibly to address Chinese theft of US intellectual property, although they are being levied principally against Japan and the EU.  ???)

Completely predictably, the EU is retaliating against the tariffs.  In particular, it is levying its own 25% tariff on HOG motorcycles imported from the US.  This affects about 20% of Harley’s output.  HOG says the levy will cost it $100 million a year in lost income, implying that all of the EU-bound Harleys are now made in the US.  HOGs response is to shift production targeted for the EU to its overseas plants.  My guess is that this will take 1000+ jobs out of the US.

In contrast to the job loss from this one company, public reports indicate the total job gain from the steel/aluminum tariffs to be about 800 workers being recalled to previously idle steel/aluminum plants.

 

Mr. Trump’s response to the HOG announcement was to threaten punitive tariffs on any imports of foreign-made Harleys–a move that could threaten the viability of HOG’s network of around 700 independent dealerships.  7000 jobs at risk?

The stock market declined sharply on the day of the HOG announcement.  I think that’s because the HOG story is a shorthand illustration of how tariffs, and quotas, cause net losses to the country as a whole, although they may bring benefits to a politically favored few.

 

A second negative effect of trade protection is a long-term one.  My experience is that most often the protected industry, relieved of immediate competitive pressure, ceases to evolve.  After a few years, consumers become willing to pay the increased price to get a (better) imported product.  In my mind, General Motors is the poster child for this.

 

Stock market implications?  …avoid Industrials.  The obvious beneficiary of Washington’s ill-thought out trade policy is IT.  For the moment, however, I think that this group is expensive enough that Consumer Discretionary and Energy are better areas to pick through.

 

 

a new government in Italy

Italy has long been the weakest link among the three major continental European economies in the euro.  Its economy has deep structural flaws.  Pre-euro it had long been papering them over through heavy government borrowing.  That allowed it to live beyond its means, protecting industries of the past and giving short shrift to future possibilities.  Periodic devaluations of the lira let it continue this strategy by paying lenders back in debased coin.

Despite this checkered history, Italy became a founding member of the euro in 1999.  It got in by the skin of its teeth–and that only after enacting a violence-wracked series of important reforms just in advance of the deadline.  The hope back then was that once in the common currency Italy would continue down the reform path. Instead, however, it has used the privilege of issuing euro-denominated debt to resume a less aggressive version of its bad old ways.  The result has been a domestic economy laden with debt, that has shown almost no real economic growth over the past decade.

 

The leaders of a nativist political coalition formed after recent elections have been speaking about their economic plans.  Their idea is apparently to “solve” Italy’s problems by repudiating a portion of the national debt and withdrawing from the euro, presumably in order to substantially devalue a new currency.

…sounds a little like Greece, only ten times the size.

This development is, I think, the main reason the euro has been falling against the US$ since early April.

 

my thoughts

–although the new government hasn’t announced official policy, I think that what it ultimately says will be at best a watered-down version of what leaders have already been saying unofficially to their supporters.  If so, we’re in early days of a looming crisis

–to the degree that professional investors hold Italian stocks, I think their reaction will be to seek safety elsewhere

–it wouldn’t be surprising to see official policy end up being something resembling Abenomics in Japan in its broad outlines.  This implies the folliwing end result:  a substantial loss of national wealth, a higher cost of living for ordinary citizens and protection of traditional industry/established elites from negative effects.  There’s no reason to think Italy would end up any different

–it’s probably also worth noting that “protect sunset industries/stunt the future/lower living standards” summarizes the Trump economic playbook for the US, to the extent there is one.  This means we can already see in Japan/Italy the trailer of a future disaster movie for the US

–What to do in the stock market?  I think Italy has restored the safe haven character of the dollar for the moment.  Given the distinct policy negatives in the US, EU and Japan, China is looking a lot better.  Secular growth (i.e., IT) anywhere is probably safer than economic sensitivity

 

a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.

 

 

 

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

trade wars

Recently President Trump announced plans to impose tariffs of 25% on imported steel and 10% on imported aluminum, citing national security reasons.  He followed this up with a Twitter comment that, for the US, trade wars are good–and easy to win.

My take:

–much of modern economics stems from study of the causes of the Great Depression of the 1930s.  The key factors:  the wrong fiscal and monetary response, world wide; and the imposition of tariffs to “protect” local industry.  These did substantial economic damage, deepening and prolonging the global slump instead.  The idea that Mr. Trump may not be aware of this is the really worrisome aspect of the current situation.

 

–the first-order effects of the proposed tariffs will, in themselves, likely be miniscule.  Domestic prices for both metals will rise.  As a result of that, and of possible tariff payments to the government, income will shift from the users of the two metals to Washington and to domestic producers of steel/aluminum.  Because of this, at least some metal fabrication will shift away from the US to other countries.  One EU-based maker of appliances has already suspended plans to increase its manufacturing capacity in the US.

–second-order effects will likely be larger.  The EU, for example, is indicating it will retaliate by placing large tariffs on several billion dollars worth of goods that it imports from the US.   Presumably, other affected countries will do so as well.

 

–there was a similar incident during the Obama administration involving Chinese-made truck tires.  Economists estimate that it resulted in the loss of 3,000 American jobs.  If there was anything good about that situation, it was that it was isolated–Washington understood this was a one-off payment to a domestic union for its political support.  Today’s concern is that, despite overwhelming economic evidence to the contrary, Mr. Trump actually believes that trade wars are good–and will continue to act on that belief.

 

 

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)