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?)

the state of play in US stocks

down by 12% 

From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium.  If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade.  That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well.  If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4%  — or 115 basis points from where it is this morning.  Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town.  PEs contract.

Stocks are not totally defenseless during a period like this.  Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong.  If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago.  So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program.  It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment.   It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive.  However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead.  This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months.  I’m assuming this trend doesn’t reverse itself, at least until the end of the summer.  But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks.  If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any  individual stock mispricing that algorithms may cause.

corporate taxes, consumer spending and the stock market

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so.  The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration.  Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes.  The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks.  And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects.  Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

 

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season.  We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade.  It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time.  I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.

internet companies vs. state-owned enterprises in China

Recently Beijing announced it wants to take equity positions in the major internet companies in China and place Communist Party officials on their boards of directors.

What’s going on?

I see two general possibilities.

Some background first.

Deng’s economic reform

In the late 1970s, Deng Xiaoping realized that the Chinese economy was too big to be controlled through central planning.   To grow it had to adopt Western economic (but not political) methods.  So he began to allow the market, not doctrinally-correct political cadres, to dictate the direction of expansion.

A major issue he faced in doing so was that, say, three-quarters of Chinese industry was owned by the state.  These companies were rudderless, and hopelessly inefficient–but they employed tons of people.  If large numbers lost their jobs all at once, the ensuing social instability might threaten the rule of the Party.  Therefore, economic progress had to be tempered by the need to avoid this outcome.  And this in a nation without sophisticated macroeconomic tools to control the pace of growth.

The result over three+ decades has been a Chinese economy that lurches between boom and bust, depending on the temperature in the state-owned enterprises.  The strategy has generally been successful, I think, with the state-owned sector now representing less than a third of China’s overall output.

possibilities

–China’s internet companies have become large enough that their actions, intentional or not, can accelerate the speed at which state-owned companies shrink.  So they need to be monitored much more carefully than in the past.  This is the benign interpretation, and the one which share prices suggest the market has adopted

–China’s internet companies have become large enough to generate “creative destruction” in large enough amounts to threaten the economic control over China exercised by the Communist Party itself.  If this is the case, then the oversight over domestic internet conglomerates will be much more draconian than the consensus expects.  That would presumably result in considerable PE contraction for the firms being controlled.

My guess is that the first possibility is much more likely to be the case.  But I think we should watch the situation closely for new hints about Beijing’s intentions.