debasing the currency

what debasing is

“Debasing” is goldbug-speak. In past centuries, when gold was actually used as money everywhere, when countries minted gold coins and kept reserves of the yellow metal as symbols of their ability to repay borrowings, governments in trouble would sometimes dilute their gold by blending in inexpensive base metals. So they would repay creditors substantially less than they’d borrowed. That’s debasing.

The modern equivalent of physical debasement is running a highly stimulative money policy, the idea being to create lots of inflation, which would allow a government to repay borrowings in inflation-debased currency.

A report from Goldman Sachs strategists came out this week suggesting that this process is at work in Washington right now, as a consequence, intended or not, of pandemic-fighting fiscal and monetary stimulus. Its conclusion: buy gold.

relevance for us as investors

I haven’t seen the report itself. I’ve only seen coverage in the financial press. (I’m not a Goldman client. For what it’s worth, I think the firm does top-notch factual research but struggles to find interesting investment conclusions from what it unearths. For you and me, Merrill Edge is the best I’ve found.)

I wrote about the gold issue in May. Except for China and India, where gold is still money, I don’t think holding gold achieves much of anything. The fact that a major brokerage house, typically a stronghold of Republican political sentiment, is willing to suggest–and seek publicity for–this idea, with its implied criticism of Trump’s dumpster-fire handling of the economy, is the most interesting aspect of its publication.

I think inflation is the least of our worries. Last year the federal government took in $3.5 trillion in taxes. Pre-pandemic, Washington was thought to be on course to spend about $1 trillion more than in 2020, due in large part to Trump’s failure to offset tax cuts with removal of special interest tax breaks for politically connected swamp creatures. The actual deficit will more likely be around $8 trillion. This would mean a total federal debt of, say, $28 trillion, or about 135% of GDP. That would place us up there with Italy among the most indebted nations in the world.

Yes, debt this high creates worries about devaluation as a way of not paying creditors back in full. Historically, however, such high levels of government debt are also associated with much slower GDP growth and emigration of the best and the brightest to make a life where economic opportunities are greater.

From a purely financial point of view, Trump’s threats to renege on government debt held by foreigners (basically making us look like Argentina) and his use of the banking system to attack political enemies are also giving new impetus to the search for alternatives to the dollar as the go-to currency for international trade and as a store of value.

I could go on about the other ways Trump continues to severely damage the US, while failing to provide any support for the left-behind rural citizens who support him. But I think the key question for the rest of the world is whether the US electing a white racist incompetent was a disastrous mistake or whether he really represents what the country stands for. If the latter proves true in November, the currency and securities markets reaction will likely be strongly negative.

inflation? maybe? …gold? no way!

I turned on CNBC in the middle of the day to look at the stock prices crawling across the screen below the talking heads.  I happened to hear the discussion, as well.

The topic was gold as an inflation hedge.  The back and forth sounded kind of like one of those Time Life infomercials selling the Greatest Hits of the (1960s, 1970s…) …or maybe the commercials that let you know you can get the same auto insurance as Snoop Dogg even if you have a bad driving record.

Even though the participants didn’t know much about gold (what a surprise), I find their unstated premise very interesting.  What do we do as investors if inflation comes back?

no sign of garden variety inflation 

The standard analysis of inflation is that it arises in an advanced economy during an employment boom when money/fiscal conditions are too loose.  Government policy stimulates firms to expand.  But there are no more unemployed workers.  So companies poach from each other, offering ever higher wages to lure workers from rivals.  Not the case, at least right now, in the US, where the administration’s white racism and anti-science stance have leading firms, if anything, figuring out how to leave.

developing world variety, though…

This is the situation where a corrupt or inept government favors politically powerful industries of the past, borrows heavily–especially from foreigners–and shows itself unwilling or unable to repay what it owes.  The local currency begins to slip as this picture becomes clearer–evidenced by government budget deficits–and foreign investors head start to pull their money out.  This raises the price of imported goods and starts an inflationary spiral.

Trump has recently invited this framing of the US situation by hinting that he will punish China by defaulting on a portion of the $1 trillion+ Beijing has lent to Washington.  He also seems to have suggested the possibility of a more general default  during his presidential campaign.

In the case of the US, past bouts of inflation have been fueled by domestic fixed income investors fleeing Treasuries much faster than foreigners.  My guess is that this would already be happening, except for two factors:

–the gigantic amount of debt the Fed is buying, and

–there’s no obvious other place to go.  Japan is a basket case, the EU isn’t much better, Brexit dysfunction rules the UK out and the renminbi isn’t a fully convertible currency.

guarding against inflation

For currency-induced inflation, the winning equity stance is to have revenues in the strong currencies and costs in the weak.  For wage-cost inflation, the economic remedy is to tighten government policy, that is, raise interest rates.  That hurts all financial instruments.  Least badly hurt would be traditional defensives.

 

 

 

 

 

 

 

 

Trumponomics—good for the economy?

Supporters of Donald Trump tend to excuse his white nationalism, his erratic policymaking, the paucity of his factual knowledge, the whiff of sadism in his treatment of immigrants, the apparent promotion of family business interests…by saying that at least he’s good for the economy.  They typically cite low unemployment, GDP growth and the stock market as proof.

Is that correct?

Yes, unemployment is low.  Yes, the economy is growing at trend–after receiving a boost from fiscal stimulation (the corporate tax cut) last year.  And the stock market did rally on the announcement of Trump’s election victory.  (We can quibble about stock market performance:  though significantly higher today, the US was pretty much the worst market in the world in 2017, when virtually everybody was up–and more than us; since the 20% boost in US corporate after-tax income it’s up another 10%–much better performance than markets where the tax rate has remained unchanged).

But I think this rationalization, offered typically by wealthy beneficiaries of income tax changes, simply deflects attention away from administration policies that can potentially do severe long-term damage to US prospects.  Here are a few:

–tariff wars.  Tariffs can be an important way to give industries of the future breathing room to develop, by insulating them from more sophisticated foreign competition.  The administration, however, is protecting low value-added manual labor jobs against competition from more efficient firms in China.  These tariffs have the perverse effect of retarding manufacturing development here while forcing China to turn to higher value-added work.  The latter is a perennial stumbling block for developing countries, so the excuse of Trump tariffs to force the move to higher value-added industry is a rare gift to Beijing.

In addition, the US has been a prime destination for multinationals’ advanced manufacturing because of the large local market and the experienced workforce.  The possibility of tariffs–and their apparently unpredictable implementation–has stopped this flow.

–retaliatory tariffs.  Tariffs don’t go unanswered. China responded to US levies by shifting purchases of soybeans to Brazil and other countries.   As/when tariff wars end, the soybean market will most likely not revert to the status quo ante; once in the door, other, arguably more dependable, suppliers will doubtless retain market share.  By the way, when the administration withdrew from the TPP, it also made US soybeans more expensive in another Pacific market, Japan.

–restrictions on immigration.  The solution for tech companies who are unable to hire foreign scientists to work in the US because they can’t get visas is to move R&D operations to, say, Canada.  Also, the administration’s white supremacism has made foreigners question whether they will be safe in the US as tourists or students, hurting both industries.  Chinese citizens may also feel it’s unpatriotic to travel here.  A bigger worry:  will this force US-based multinationals to begin to regard themselves as no longer American?

–zero/negative interest rates.  This is a weird situation in financial markets, which, to my equity-oriented mind, is bound to end badly. Ultra-low rates are also trouble for risk-averse savers, including traditional pension plans.  In the US, downward pressure on rates comes both from foreign bond arbitrage and administration demands that the Fed offset tariff damage to growth with looser money policy.

 

Meanwhile, what’s not being addressed:  infrastructure, health care including drug prices, education, retraining displaced workers (where we’re worst in the OECD)

 

 

 

autos, emissions and Trumponomics

I’ve followed the auto industry since the early 1980s, but have rarely owned an auto stock—brief forays into Toyota, later Peugeot (1986) and Porsche (2003?) are the only names that come to mind.

 

The basic reasons I see to avoid the auto manufacturers in the developed world:

–chronic overcapacity

–continuing shift of intellectual property creation, innovation, brand differentiation—and better-than-commodity profits–from manufacturers to component suppliers

–the tendency of national politics to influence company operations and prospects.

 

In addition, the traditional industry is very capital intensive, with a high capacity utilization required (80%?) to reach breakeven.  The facts that unit selling prices are high and new purchases easy to put off for a year or two mean that the new car industry is highly cyclical.

More than that, today’s industry is in the early stages of a transformation away from units that burn fossil fuels, and are therefore a major source of air pollution, to electric vehicles.  The speed at which this change is happening has accelerated over the past decade outside the US because pollution has become a very serious problem in China and because automakers in the EU have been shown to have falsified performance data for their diesel-driven offerings in a poorly thought out effort to meet anti-pollution rules.

California, which had a nineteenth-century-like city pollution problem around Los Angeles as late at the mid-1970s, has led the US charge for clean air.  It helps its clout that CA is the country’s largest car market (urban legend:  thanks in part to GM’s aggressive lobbying against public transport in southern CA in the mid-20th century).  CA has also been joined by about a dozen other states who go along with whatever it decides.  The auto manufacturers have done the same, because the high capital intensity of the car industry means building cars to two sets of fuel usage specifications makes no sense.

 

Enter Donald Trump.  His administration has decided to roll back pollution reduction measures put in place by President Obama.  CA responded by agreeing with Ford, VW, Honda and BMW to establish Obama-like, but somewhat less strict, requirements for cars sold in that state.  Trump’s reposte has been to call the agreement an anti-trust violation, to claim the power to revoke the section of the law that permits CA to set state pollution standards and to threaten to withhold highway funds from CA because the air there is too polluted (?).

 

Other than pollical grandstanding, it’s hard to figure out what’s going on.

Who benefits from lower gas mileage cars?     …Russia and Saudi Arabia, whose economies are almost totally dependent on selling fossil fuels; and the giant multinational oil companies, whose exploration efforts until recently have been predicated on demand increasing strongly enough to push prices up to $100 a barrel.

Who gets hurt by the Trump move?     …to the degree that it prolongs widespread use of inefficient gasoline-powered cars, the biggest potential losers are US-based auto firms and the larger number of US residents who become ill in a more polluted environment.  Why the car companies?  Arguably, they will put less R&D effort into developing less-polluting cars, including electric vehicles.  The desertification of China + disenchantment with diesel will have Europe and Asia, on the other hand, making electric cars a very high priority.  It wouldn’t be surprising to find in a few years a replay of the situation the Detroit automakers were in during the 1970s—when cheap, well-built imports flooded the country without the Big Three having competitive products.

It’s one of the quirks of the US stock market that it has very little direct representation of the auto industry.  So the idea that profits there will be somewhat higher as the firms skimp on R&D will have little/no positive impact on the S&P.  Even the energy industry, the only possible beneficiary of this Trump policy, is a mere shadow of its former self.  Like Trump’s destruction of the American brand—Apple has dropped from #5 in China to #50 since his election—all I can see is damaging downside.

I think the Trump policy is intentional, like his trade wars and his income tax cut for the super-rich.  The most likely explanation for all these facets of Trumponomics is either he doesn’t realize the potentially grave economic damage he’s doing or it’s not a particularly high priority.

 

 

 

 

 

 

 

 

Trump’s economic “plan”

So far the Trump administration has launched two countervailing economic thrusts:

income taxes.   

Starting in 2018, the corporate tax rate was reduced from a highest-in-the-world 35% to a more nearly average 21%.  The idea was to remove the incentive for highly taxed US-based multinationals, like pharmaceutical firms, to shift their businesses elsewhere.  In the same legislation the ultra-wealthy received a very large reduction in their income taxes, as well as retention of the carried interest provision, a tax dodge by which private equity managers convert ordinary income into less highly taxed capital gains (this despite Mr. Trump’s campaign pledge to eliminate carried interest).  Average Americans made out less well, receiving a modest reduction in rates coupled with loss of real estate-related writeoffs that skewed the benefits away from heavily Democratic states like California and New York.

Washington made little, if any, attempt to end special interest tax breaks to offset the lower corporate rates.  The result in 2018 was a yoy increase in individual income tax collection of about $50 billion, more than offset by a drop in corporate tax payments of about $90 billion.  Given the strong economy in 2018, the IRS would likely have taken in $150 – $175 billion more under the old rules than it did under the new.

What I find most surprising about the income tax legislation is that the large deficit-increasing fiscal stimulus it provides came at a time when none was needed–after almost a decade of continuous GDP growth in the US and the economy at very close to full employment.

the tariff wars.

Right after his inauguration, Mr. Trump pulled the US out of the Trans-Pacific Partnership, a trade group aiming to, among other things, fight China’s theft of intellectual property.  However, exiting the TPP for a go-it-alone approach hurt US farmers, since it also meant higher (and escalating each year) tariffs on US agricultural exports to TPP members, notably Japan.

Next, Trump presented the tortured argument that: (1) that there could be no national security if the economy were not growing,  (2) that, therefore, the presence of foreign competition to US firms in the domestic marketplace threatens national security,  (3) that Congress has given the president power to act unilaterally to counter threats to national security, so (4) Trump had the authority to unilaterally impose tariffs on imports.  So he did, in escalating tranches.

No mention of the fact that tariffs slow GDP growth, so under the first axiom of Trump logic are themselves a threat to national security.

Not a peep from Congress, either.

Recently, Mr. Trump has announced that he also has Congressional authority, based on a 1977 law authorizing sanctions against Iran, to order all US-based entities to cease doing business with China.

Results so far:

–the predictable slowdown in economic growth in the US

–retaliatory tariffs that have slowed growth further

–higher prices to consumers that have for all but the ultra-wealthy eaten up the extra income brought by the new tax law

–a sharp drop in spending on new capital projects in the US by both foreign and domestic firms

–tremendous pressure by Trump on the Federal Reserve (in a most un-Republican fashion (yes, I know Nixon did the same thing, but still…)) to “debase” the dollar.

Why?

A falling currency can temporarily give the appearance of faster growth.  But it can also do serious, and permanent, damage to a country by reducing national wealth (Japan is a good example).  Its only “virtue” as a policy measure is that it’s hard to trace cause and effect–politicians can deny they are mortgaging the country’s heritage to cover up earlier mistakes, even though that’s what they’re doing.

–an apparent shift in the goal of US trade negotiators away from structural reform in China to resuming purchases of US soybeans

my take

–if there had been a plan to Trump’s actions, tariffs would have come first, the tax break later.  The fact that the reverse happened argues there is no master strategy.  Again no surprise, given Trump’s history–which people like us can see most clearly in his foray into Atlantic City gaming.

–what a mess!

A better way to combat China?    The orthodox strategies are to strengthen the education system, increase scientific research spending and court foreign researchers to come to the US.  Unfortunately, neither major domestic political party has much interest in education–Democrats refuse to fix broken schools in large urban areas and Republicans as a party are now against scientific inquiry.  The white racism of the current Washington power structure narrows the attraction of the US in the eyes of many skilled foreigners.   The ever-present, ever-shifting tariff threat–seemingly arbitrary levies on imported raw materials and possible retaliatory duties on exported final products–means it’s very risky to locate plant and equipment in the US.

For what it’s worth, I think that were the political situation in the US different there would be substantial Brexit-motivated relocation of multinationals from London to the east coast.

investment implications

To my mind, all this implies having a focus on software companies, on low-multiple consumer firms that focus on domestic consumers with average or below-average incomes, and on companies whose main business is in Asia.  Multinational manufacturers of physical things for whom the US and China are major markets are probably the least good place to be.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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