depreciating the dollar

When a country is having economic problems–slow growth, outdated industrial base, weak educational system, balance of payments issues–there are generally speaking two ways to fix things:

–internal adjustment, meaning fixing the domestic problems through domestic government and private sector action, and

–external adjustment, meaning depreciating the currency.

The first approach is the fundamentally correct way.  But it requires skill and demands a shakeup of the status quo.  So it’s politically difficult.

Depreciating the currency, on the other hand, is a quick-fix, sugar-high kind of thing, of basically trying to shift the problem onto a country’s trading partners.  The most common result, however, is a temporary growth spurt, a big loss of national wealth, and resurfacing of the old, unresolved problems a few years down the road–often with a bout of unwanted inflation.  The main “pluses” of depreciation are that it’s politically easy, requires little skill and most people won’t understand who’s at fault for the ultimate unhappy ending.

Examples:

the Great Depression of the 1930s;

the huge depreciation of the yen under PM Abe, which has impoverished the average Japanese citizen, made Japan a big tourist destination (because it’s so cheap) and pumped a little life into the old zaibatsu industrial conglomerates.

 

It’s understandable that Donald Trump is a fan.  It’s not clear he has even a passing acquaintance with economic theory or history.  And in a very real sense depreciation would be a reprise of the disaster he created in Atlantic City, where he freed himself of personal liabilities and paid himself millions but the people who trusted and supported him lost their shirts.

Elizabeth Warren, on the other hand, is harder to fathom.  She appears to be intelligent, thoughtful and a careful planner.  It’s difficult to believe that she doesn’t know what she’s supporting.

 

 

 

Mexico in the 1980s vs. US today

bull market = strong economy?

Does stock market strength always mean a booming economy?

The short answer is no.

Mexico in the 1980s

The best illustration I can think of is Mexico in the 1980s.  That economy was a disaster, which played out first of all in the currency markets, where the peso lost 98% of its value vs. the US$ during that decade.  Despite this, in US$ terms the Mexican stock market was hands down the best in the world over the period, far outpacing the S&P 500.

How so?

…a domestic form of capital flight is the short story.

An incompetent and corrupt government in Mexico was spending much more than it was taking in in taxes but was loathe to raise interest rates to defend the peso.  Fearing  currency depreciation triggered by excessive debt, citizens began transferring massive amounts of money abroad, converting their pesos mostly into US$ and either buying property or depositing in a bank.  This added to downward pressure on the peso.  In September 1982 the government instituted capital controls to stem the outflow–basically making it illegal for citizens to convert their pesos into other currencies (Texas, which had been a big beneficiary of the money flow into the US, will remember the negative effect stemming it had).

With that door closed, Mexican savers turned to the national stock market as a way to preserve their wealth.  They avoided domestic-oriented companies that had revenues in pesos.  They especially shunned any with costs in dollars.  They focused instead on gold and silver mines or locally-listed industrial companies that had substantial earnings and assets outside Mexico.  The ideal situation was a multinational firm with revenues in dollars and costs in pesos.

today in the US

To be clear, I don’t think we’re anything close to 1980s Mexico.   But it trying to explain to myself what’s behind the huge divergence in performance between companies wedded to the US economy (bad) and multinational tech (good) I keep coming back to the Mexico experience.  Why?

I don’t see the US economic situation as especially rosy.   Evidently, the stock market doesn’t either.  In tone, administration economic policy looks to me like a reprise of Donald Trump’s disastrous foray into Atlantic City gambling–where he made money personally but where the supporters who financed and trusted him lost their shirts.

What catches my eye:

–tariff and immigration actions are suppressing current growth and discouraging US and foreign firms from building new plant and equipment here

–strong support of fossil fuels plus the roadblocks the administration is trying to create against renewables will likely make domestic companies non-starters in a post-carbon world outside the US.   Look at what similar “protection” did to Detroit’s business in the 1980s.

–threats to deny Chinese companies access to US financial markets and/or the US banking system are accelerating Beijing’s plans to create a digital renminbi alternative to the dollar

–the administration’s denial of access to US-made computer components by Chinese companies will spur creation of a competing business in China–the same way the tariff wars have already opened the door to Brazil in the soybean market, permanently damaging US farmers

–not a permanent issue but one that implies lack of planning:  isn’t it weird to create large tax-cut stimulus but then until it wears off to launch a trade war that will cause contraction?

Then there are Trump’s intangibles–his white racism, his sadism, his constant 1984-ish prevarication, his disdain for honest civil servants, his orange face paint, the simulacrum he appears to inhabit much of the time, the influence of Vladimir Putin…  None of these can be positives, either for stocks or for the country, even though it may not be clear how to quantify them.   (A saving grace may be that the EU can’t seem to get its act together and both China and the UK appear to be governed by Trump clones.)

 

my point?

Two of them:

1.If you were thinking all this, how would you invest your money?

Unlike the case with 1980s Mexico, there’s no foreign stock market destination that’s clearly better.  China through Hong Kong would be my first thought, except that Xi Jinping’s heavy-handed attempt to violate the 1984 handover treaty has deeply damaged the SAR.  So we’re probably limited to US-traded equities.

What to buy?

–multinationals

–that are structural change beneficiaries

–whose main attraction is intellectual property, the rights to which are held outside the US,

–with minimum physical plant and equipment owned inside the US, and

–building new operating infrastructure outside the US, say, across the border in Canada.

As I see it, this is pretty much what’s going on.

 

2.What happens if Mr. Trump is not reelected?

A lot depends on who may take his place.  But it could well mean that we return to a more “normal” economy, where the population increases, so too economic growth, corporate investment in the US resumes, domestic bricks-and-mortar firms do better–and some of the air comes out of the software companies’ stocks.

 

 

Hong Kong riots

a brief-ish history

During the first part of the 19th century the UK’s stores of gold and silver were being depleted (in effect contracting the country’s money supply) to pay for tea imported from China.  London suggested to Beijing that they barter opium from the British colony India instead.  Beijing sensibly refused.  So in 1841 the British army invaded China to force the change.  The UK seized Hong Kong to use as a staging area and kept it once China submitted to its demands.  During a second Opium War (1856-60), launched when China again balked at the mass shipment of narcotics into its territory, the UK seized more land.

In 1898, China granted the UK a 99-year lease over the area it occupied.  This legalized the status of Hong Kong, which remained under the practical control of the “hongs,” a newer form of the old British opium companies, for much of the 20th century.

In the late 1970s Deng Xiaoping made it clear that the lease would not be renewed but that Hong Kong would remain a Special Administrative Region, with substantial autonomy, for fifty years after its return to China on June 30, 1997.  (For its part, the UK parliament decided Hong Kongers would find the climate of the British Isles inhospitable.  So these soon-to-be-former British subjects would be issued identity cards but no other legal protections–citizenship, for example–within the Commonwealth on the handover.  This is a whole other story.)

Hong Kong’s importance today…

The conventional wisdom at that time was that while Hong Kong China’s main goal in triggering the return was to set the stage for the eventual reintegration of (much larger) Taiwan, where the armies of Chiang Kaishek fled after their defeat by Mao.

Today Hong Kong is much more important, in my view, than it was in the 1980s.  Due, ironically, to the sound, and well-understood worldwide, legal framework imposed by the UK, Hong Kong has become the main jumping-off point for multinationals investing in China.  It’s also an international banking center, a transportation hub and a major tourist destination.  Most important for investors, however, is that its equity market not only has greater integrity than Wall Street but is also the easiest venue to buy and sell Chinese stocks (Fidelity’s international brokerage service is the best in the US for online access, I think, even though the prices in my account are invariably a day–sometimes three–old).

…and tomorrow

Mr. Trump has begun to weaponize US-based finance by denying Chinese companies access to US capital markets, US portfolio investors and, ultimately, the dollar-based financial system.  China’s obvious response is accelerate its build up of Hong Kong as a viable alternative in all three areas.  As with the tariff wars, Trump’s ill thought out strategy will most likely galvanize these efforts.

the riots…

Hong Kong has 27 years left to go as an SAR.  For some reason, however, Xi seems to have decided earlier in 2019 to begin to exert mainland control today rather than adhering to the return agreement.  His trial balloon was legislation under which political protesters in Hong Kong whose statements/actions are legal there, but crimes elsewhere in China, could be arrested and extradited to the mainland for prosecution.  This sparked the rioting.  These protests do have deeper underlying causes which are similar to those affecting many areas in the US.

…continue to be an issue

The recent change in Hong Kong’s stock listing rules (to allow companies whose owners have special, super voting power shares) and the subsequent fund raising by Alibaba seem to me to show that Beijing wants Hong Kong to become the center for international capital-raising by Chinese companies.  From this perspective, Xi’s failure to minimize disruptive protests by withdrawing the extradition legislation quickly is hard to understand.

One might argue that Xi, like Trump, is trying to reestablish an older order, purely for the political advantage it gives.  In China’s case it entails reviving the Communist Party’s traditional power base, the dysfunctional state-owned enterprises that Deng began to marginalize in the late 1970s with his move toward a market-based economy (i.e., “Socialism with Chinese Characteristics”).   I find it hard to believe that Beijing is as impractical and dysfunctional as Washington, but who knows.

My bottom line:  I think the Hong Kong situation is worth monitoring carefully as a gauge of how aggressively China is going to exploit the opening Trump policies have haplessly given it to replace the US as the center of world commerce–sooner than anyone might have dreamed in 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

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)

 

 

 

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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

fr

Macroeconomics for Professionals

Starting-out note:  there’s an investment idea in here eventually.

I’ve been going through Macroeconomics for Professionals:  a Guide for Analysts and Those Who Need to Understand Them, written by two IMF professionals, with the intention of giving it, or something like it, to one of my children who’s getting more interested in stock market investing.  I’m not finished with the book, but so far, so good.

counter-cyclical government policy

The initial chapter of MfP is about counter-cyclical government policy, a topic I think is especially important right now.

Picture an upward sloping sine curve.  That’s a stylized version of the pattern of economic advance and contraction that market economies experience.  Left to their own devices, the size of economic booms and subsequent depressions tend to be very large.  The Great Depression of the 1930s that followed the Roaring Twenties–featuring a 25% drop in output in the US and a decade of unemployment that ranged between 14%-25%–is the prime example of this.  National governments around the world made that situation worse with tariff wars and attempts to weaken their currencies to gain a trade advantage.  A chief goal of post-WWII economics has been to avoid a recurrence of this tragedy.

The general idea is counter-cyclical government policy, meaning to slow economic growth when a country is expanding at a rate higher than its long-term potential (about 2% in the US) and to stimulate growth when expansion falls below potential.

 

applying theory in today’s Washington

Entering the ninth year of economic expansion–and with the economy already growing at potential–Washington, which had provided no fiscal stimulus in 2009 when it was desperately needed, decided to give the economy a boost with a large tax cut. Although pitched as a reform, with lower rates offset by the elimination of special interest tax breaks, none of the latter happened.  Then, just a few days ago, Washington gave the economy another fiscal boost.  Mr. Trump, channeling his inner Herbert Hoover, is also pressing for further interest rate cuts to achieve a trade advantage through a weakened dollar.

This is scary stuff for any American.  The country faced a similar situation during the Nixon administration, which exerted pressure on the Fed to keep rates too low during the early 1970s.  Serious economic problems that this brought on didn’t emerge until several years later, when they were compounded by the second oil shock in 1978 (that was my first year in the stock market; I was a fledgling oil analyst).

why??

Why, then, is Mr. Trump trying to juice the US economy when he should really be trying to wean it off the drug of ultra-low rates?

I think it’s safe to assume that he doesn’t understand the implications of what he’s doing (the thing Americans of all stripes recognize, and like the least, about Mr. Trump, a brilliant marketer, is how little he actually knows).   If so, I can think of two reasons:

–as with many presidents a generation ago, he may see ultra-loose money as helping his reelection bid, and/or

–the “easy to win” trade wars may be hurting the US economy much more deeply than he expected and he sees no way to reverse course.

If I had to guess, I suspect the latter is the case and that the former is an added bonus.  I think the main counter argument, i.e., that this is all about the 2020 election, is that the administration seems to be systematically eliminating any parties/agencies that want to investigate Russian interference in domestic politics.

Either would imply that software-based multinational tech companies that have led the stock market for a long time will continue to be Wall Street winners–and that the weakness they are currently experiencing is mostly an adjustment of the valuation gap (which has become too large) between them and the rest of the market.

In any event, interest rate-sensitives and fixed income are the main areas to avoid.  If the impact of tariffs is an important motivating factor, then domestic businesses that cater to families with average or below-average incomes will likely be hurt the worst.

 

 

 

 

shrinking global bond yields

valuing bonds   …and stocks

Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken.  For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.

If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.

Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.

last Friday

the 10-year

Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!

Austria

Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%.  Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since.  Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.

Trumponomics

Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates.  I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration.  If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection.  One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year.  In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly.  More forethought is likely out of the question for the administration   …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.

???

I’ll happily confess that I’m not a bond expert.  For what it’s worth, I don’t like bonds, either.  But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation.  The last thing we need is higher taxation through tariffs and even more distortion of yields.

 

What would make someone want to buy the proposed Austrian century bonds anyway?

…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?

…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?

…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?

…I’m shorting negative yield bonds against this long position?

 

global/demographic/government influences on yields

aging populations…

Another general principle:  as people get older and as they get wealthier they become more risk averse.  Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.

The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years.  The remainder goes into stocks.  For example, for a 65-year old, 65% of the portfolio should be in fixed income.  (I don’t think this is a particularly good rule, but it’s simple and it is used.)

What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force.  In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds.  At the end of last year, the total was $681 billion, of which 40% was in equities.  Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.

national economic policy

For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy   …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.

The chief characteristic of expansive monetary policy is the suppression of interest rates.  The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.

 

More tomorrow.