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.

 

 

 

 

Investing in an age of deglobalization

Rana Foroohar is one of my favorite Financial Times columnists.  The subtitle of her July 21st column about deglobalization is “The wisdom of relying on the equity of US multinationals is now suspect.”  Her conclusion is that in the years to come the real economic dynamism in the world is going to come from China and emerging markets.  The way for foreigners like us to participate is to own Chinese and other emerging markets equities themselves rather than use US multinationals as proxies.

I think Ms. Foroohar’s conclusion is correct, although I don’t think the reasons she gives are.  That’s a surprising departure from her usual incisiveness.  For what it’s worth, here’s my take:

–over the past thirty or forty years, economic expansions in the US and Europe were especially robust because they were fueled not only by reviving domestic demand but also by high-beta growth in international trade.  That period is now over.  The main reason, in my opinion, is that the large, relatively open, stable economies in the Pacific have already been fully penetrated by multinationals, so there’s no extra cyclical oomph to be had.  In addition, the developed world has also become more protectionist.  And the increasingly overt racism of the administration in the US is making American goods and services things to be avoided rather than aspirationally purchased.

–the 1980s-style argument of US investment managers with no knowledge of foreign markets and no inclination to learn is that US-based multinationals are an adequate substitute.  By and large, this has been incorrect, although there have been periods, like the 1990s, when Japan was collapsing and the US was king.

–Ms. Foroohar cites Warren Buffett, a holder of American Express, Proctor and Gamble, Kraft Heinz and Coca-Cola, as an advocate of the approach in the paragraph above–and as a case study of why buying US-based multinationals no longer works.  But as I see it, these are all names with sclerotic corporate managements who have been pretending that Millennials and the internet don’t exist.  Add IBM, a former big Buffett holding, to that pile.   Multinationals like Google, Microsoft, Amazon and Disney haven’t had the same issues.  Note, too, that both MSFT and DIS had to toss out backward-looking managements before achieving their recent success.

–I do think that China should be a key element of any long-term-oriented stock portfolio.  In addition to the secular growth story, the current Washington strategy of forcing US-based multinationals to move low-end manufacturing out of China will likely end up giving China a substantial economic boost.  Similarly, the use of the dollar as a political weapon–the arrest of the Huawei founder’s daughter on money laundering charges, for example–creates a big incentive for China to speed development of its domestic capital markets, making finance easier to obtain for fledging firms there.

However, as with any other foreign market, there is a price to be paid for entry.  The rules of the investing game–the investment preferences of locals, the reliability of accounting statements and regulatory filings–are likely different from those in the home market.  All this needs to be learned.  My approach with China far has been to stick with Hong Kong-listed names, where these risks are lower.  Nevertheless, it seems clear to me that there will be greater opportunities for knowledgeable investors on mainland exchanges.  Sooner or later we’ll all have to teach ourselves, or find an expert manager to rely on.

 

 

cutting the fed funds rate

The main value you and me in Mohamed El-Erian’s observations on financial markets is that he has a knack for framing accurately, if longwindedly, the consensus view of financial professionals on topics of the day.  Nothing profound, but a solid base for figuring out how to fashion contrary bets.

In a piece for Yahoo Finance this week, however, Mr. El-Erian has neatly made a number of points about the fed funds rate cut that seems to be on the cards for later this month:

–there’s little justification for the cut on traditional economic grounds

–the reduction will likely have little impact on the real economy

–the cut won’t weaken the dollar, because other nations will reduce their equivalent rates

–at a time when financial speculation is already running hot, a rate cut risks adding accelerant to the fire

–cuts reduce the scope for the Fed to act in case of a real financial emergency

–the Fed will lose at least some credibility as an independent body whose signals should be followed by financial markets (my note: in fact, the parallels are already being drawn between Trump and Nixon, whose meddling with the Fed for political reasons in the early 1970s led to financial disaster later in that decade).

no good reason to cut, so why?

If everything’s going so well, why bully the Fed into easing?

I think it has to do with stock market earnings growth.  Last year overall eps for the S&P 500 grew by about 18%.  My back-of-the-envelope estimation is that operating earnings grew by 8% and the other 10% was a one-time upward adjustment for lower US taxes.  A reasonable guess for 2019–without including the negative effect of tariffs–would have been another 8% growth for the US portion of S&P earnings and, say, 6% for the foreign component.  Figuring that both are roughly equal in size, that would imply +7% for 2019 eps.

So far, though, eps are coming in about flat. And analyst predictions, always on the sunny side, are now for slight year-on-year dips for the June and September quarters.  Yes, Europe is weaker than one might have thought.  So that’s a (small) part of the disappointment.  But it seems to me the Trump tariffs + retaliation to them must be biting much deeper into the domestic economy than Wall Street (or I) had been expecting.   …and that’s without considering the longer-term structural harm I think they are likely to do.

If so, the solution is to find a face-saving way to reduce or eliminate tariffs.  it is certainly not to introduce further distortions into fixed income markets.

PS:  it seems to me that the best way to compete with China is to strengthen the education system and to support government-assisted scientific research.   Both are non-starters in today’s domestic politics.

 

 

 

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.

 

 

 

 

 

 

Trumponomics and Huawei

Effective May 16th, the Trump administration placed Chinese tech company Huawei on the entity list, meaning no American company can sell products, hardware or software, to Huawei without government permission.  In addition, the presumption of the administrators of the list is that permission will be denied.

Being on the entity list seems to mean no Intel or ARM-based microprocessors for Huawei-built computers and telecom equipment, and no Android software for its cellphones.

The US  had already been putting pressure on US telecoms, big and small, as well as allies around the world not to purchase Huawei offerings, especially of next-generation telecom infrastructure equipment–a difficult sell, given that Huawei products are better and cheaper than EU or US alternatives.  But the entity list move is a huge escalation.  It seems to pretty much put Huawei out of business unless/until it develops alternate sources of supply.

It seems to me that this decision is qualitatively different from taxing Chinese products entering the US.  The near-term effects are likely to be strongly negative for Hauwei; long-term consequences, in contrast, are likely to be strongly negative for the US, in a number of ways:

–by saying the US will not tolerate significant Chinese competition in tech industries, Mr. Trump is reframing a dispute about terms of trade into a struggle for cultural/economic dominance.  Arguably, this is what is really going on anyway, but making it explicit gives China a cause to rally around

–Beijing’s response to the Huawei decision will presumably be to try to jump start its domestic chip business, an area that is (oddly, to my mind) totally unimpressive despite having been a national priority for decades.  The obvious course for the US today, it seems to me, is to retrain workers and improve our education system, with emphasis on STEM subjects.  That, of course, is a non-starter for both major political parties

–US tech companies must now begin to think about whether they are American enterprises (meaning: willing to forgo Chinese business as/when Washington dictates) or multinationals based in the US.  This may not be a burning issue for mature US firms like Microsoft or Google, although Washington’s white supremacism and nativism are already compelling companies like this to locate research centers outside the US (either because the US will not admit accomplished foreign scientists or they fear for their safety).  For startups, however, Mr. Trump is making a compelling case that, say, Canada is a better place to establish themselves

–tech companies of all stripes will have to think long and hard before building new manufacturing capacity in the US

 

Pre-Huawei, one main consequence of the Trump trade strategy has been to substantially weaken the Chinese status quo’s resistance to shifting that economy away from low value-added exports.  With developing economies, such resistance is, in my experience, an almost insurmountable obstacle to progress.  Huawei gives Beijing a clear mandate to create a high-tech component industry, however.  Making it a victim of malign foreign influences only increases its power, given China’s century of humiliation (at foreign hands) historical narrative.

Taking Huawei off the entity list, which the administration now seems to be in the process of doing, does not, I think, return us to the status quo ante.  The barn door has already been opened.

 

So far as I can see, the US stock market has not reacted negatively to what I consider to be a collosal blunder.  Wall Street does continue to deal with the possibility of more tariffs principally, I think, by focusing on firms it sees to be the most immune–software, especially cloud-based, and potentially industry-transformative new market entrants in a variety of fields.

 

 

 

 

 

Trumponomics and tariffs

Note:  I’ve been writing this in fits and starts over the past couple of weeks.  It doesn’t reflect whatever agreement the US and China made over the past weekend.  (More on that as/when details become available.)  But I’m realizing that it’s better to write something that’s less than perfect instead of nothing at all..  I think the administration’s economic plan, if that’s the right word for a string of ad hoc actions revealed by tweet, will have crucial impacts–mostly negative–for the US and for multinational corporations located here.  I’ll post about that in a day or two.

 

On the plus side, Mr. Trump has been able to get the corporate income tax rate in the US reduced from 35% to 21%, stemming the outflow of US industry to lower tax-rate jurisdictions (meaning just about anyplace else in the world).  Even that has a minus attached, though, since he failed to make good on his campaign pledge to eliminate the carried interest tax dodge that private equity uses.  The tax bill also contained new tax reductions for the ultra-wealthy and left pork-barrel tax relief for politically powerful businesses untouched.

 

At its core, international Trumponomics revolves around the imposition of import duties on other countries in the name of “national security,” on the dubious rationale that anything that increases GDP is a national security matter and that tariffs are an effective mechanism to force other countries to do what we want.  (Oddly, if this is correct, one of Mr. Trump’s first moves was to withdraw the US from the Trans-Pacific Partnership, thereby triggering an escalating series of new tariffs on farm exports to Japan by  our “Patriot Farmers,” many of whom voted for Mr. Trump.  I assume he didn’t know.)

If the Trump tariff policy has a coherent purpose, it seems to me to be:

–to encourage primary industry (like smelting) and manual labor-intensive manufacturing now being done in developing countries to relocate to the US (fat chance, except for strip mining and factories run by robots)

–to encourage advanced manufacturing businesses abroad that serve US customers to build new operations in the US, and

–to retard the development of Chinese tech manufacturing by denying those companies access to US-made components.

 

The results so far:

–the portion of tariffs on imported goods (paid by US importers to the US customs authorities) passed on to consumers has offset (for all but the ultra-wealthy) the extra income from the 2017 tax cuts

–the arbitrary timing and nature of the tariffs Trump is imposing seems to be doing the expected —discouraging industry, foreign and domestic, from building new plants in the US.  BMW, for example, had been planning on building all its luxury cars for export to China here, because US labor costs less than EU labor.  The threat of retaliatory tariffs by China for those imposed by the US made this a non-starter.

–Huawei.  This story is just beginning.  It has a chance of turning really ugly.  For the moment, inferior US snd EU products become more attractive.  Typically, such protection also slows new product development rather than accelerating it.  (Look at the US auto industry of the mid-1970s, a tragic example of this phenomenon.)   US-based tech component suppliers are doing what companies always do in this situation:  they’re  finding ways around the ban:  selling to foreign middlemen who resell to Huawei, or supplying from their non-US factories.  Even if such loopholes remain open, Mr. Trump is establishing that the US can’t be relied on as a tech supplier. Two consequences:  much greater urgency for China to create local substitutes for US products; greater motivation for US-based multinationals to locate intellectual property and manufacturing outside the US.

 

 

 

 

 

 

the Fed’s dilemma

history

From almost my first day in the stock market, domestic macroeconomic policy has been implemented by and large by the Federal Reserve.  Two reasons:  a theoretical argument that fiscal policy is subject to long lead times–that by the time Congress acts to stimulate the economy through increased spending, circumstances will have changed enough to warrant the opposite; and ( my view), until very recently neither Democrats nor Republicans have had coherent or relevant macroeconomic platforms.

If pressed, Wall Streeters would likely say that Washington has historically represented a net drag on the country’s economic performance of, say, 1% yearly, but that it was ok with financial markets if politicians didn’t do anything crazily negative–the Smoot-Hawley tariffs of 1930, for example.

During the Volcker years (1979-87), money policy was severely restrictive because the country was struggling to control runaway inflation spawned by misguided policy decisions of the 1970s (Mr. Nixon pressuring the Fed to keep policy too loose).  Since then, the stock market has operated under the belief that the Fed’s mandate also includes mitigating stock market losses by loosening policy, the so-called Greenspan, Bernanke and Yellen “puts.”

recent past

We’ve learned that monetary policy is not the miracle cure-all that we once thought.  We could have figured this out from Japan’s experience in the 1980s.  But the message came home in spectacular fashion domestically during the financial crisis last decade.  As rates go lower and policy loosens, lots of “extra” money starts sloshing around.   Fixed income managers gravitate toward increasingly arcane and illiquid markets.  In their eagerness to not be left out of the latest fad product, they begin to take on risks they really don’t understand as  well as to forego standard protective covenants.

We could almost hear the sigh of relief from the Fed as the tax bill of 2017, which reduced payments for the ultra-rich and brought the corporate tax rate down to about the world average, passed.  Because the bill was so stimulative, it gave the Fed the chance to raise rates as an offset, meaning it could tamp down the speculative fires.

today

Enter the Trump tariffs.

Two preliminaries:

–tariffs are taxes.  Strictly speaking, importers, not foreign suppliers (as the president maintains (could it be he actually believes this?)) pay them to customs officials.  But the importer tries to ease his pain by asking for price reductions from suppliers and for selling price increases from customers.  How this all settles out depends on who has market power.  In this case,it looks like virtually all the cost will be borne by domestic parties.  Domestic economic growth will slow.  The relevant stock market question is how much of the pain consumers will bear and how much will be concentrated in a reduction of import business profits.

–I think Mr. Trump is correct that the US subsidy of NATO is excessive.  It represents the situation at the end of WWII, when the US left standing–or at best the time when the USSR began to disintegrate into today’s Russia (whose GDP = Pennsylvania + Ohio, or California/2).  I also think that China, with a population five times ours and an economy 1.25x as big as the US (using PPP), is a more serious economic rival than we have seen in decades.  It doesn’t have the post-WWII sense of obligation to us that we have seen elsewhere.  So we have to rethink our relationship.

Having written that, I don’t see that Mr. Trump has even the vaguest clue about how the country should proceed, given these insights.

To my mind, tariffs + retaliation mean both domestic and foreign companies will be reluctant to locate new operations in the US.  Tariffs on Chinese handicrafts may bring industries of the past back to the US, at the same time they force China to increase emphasis on industries of the future.  I don’t get how either of these moves should be a US strategic goal….

the dilemma

The question for the Fed:  should it enable the president’s spate of shoot-yourself-in-the-foot tariff policies by lowering rates?  …or should it let the economy slide into recession, hoping this will jar Congress into action?