Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. The US became the dominant economic power in the early 20th Century by having high protective tariffs and this served as a model for later day mercantilists – Germany, other European nations and most recently, China. George Washington, the first President of the United States, not only supported the protection of infant US industries, but also set an example by “buying American.” The US Presidents that followed Washington carried on the protectionist policies as they built America in the 19th Century. The Republican Party dominated the US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. History is a great thing. One just has to look back far enough to cure one of all prejudices.
Let’s face it, there is no such thing as “free trade”, only good or bad trade deals. The debate about “free trade” and capitalism can be neatly divided into two distinct camps – Liberalism and Mercantilism. Liberals see the State as predatory and Business as profiteers and the two shouldn’t be allowed to work together to the detriment of the individual consumer. Liberalism places the individual’s interest at the heart of economic policy-making, with the objective of increasing household consumption i.e. giving the individual consumer easy and unhindered access to the cheapest possible goods and services. Mercantilists, on the other hand, don’t see this separation between the State and Business as a necessary condition to benefit the individual consumer. They see the two as allies and emphasise that the aim of economic policy-making is to improve the productive capacity of the nation in pursuit of economic growth, power and independence. For the Mercantilist, a sound economy requires a sound production structure within the nation and not a cheap production structure abroad. Mercantilists believe that a robust domestic consumption can only be underpinned by high employment at appropriate wages and not cheap goods from abroad. What does the Liberal like to call the Mercantilist? A Protectionist. Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. It became the dominant economic power in the early 20th Century by having high protective tariffs and it served as a model for later day mercantilists – Germany, other European nations and most recently, China.
I often get a strange look from my friends and colleagues when I make the observation that America was a “protectionist” nation. Perhaps you are frowning at me now as well. However, please indulge me and keep reading.
From the time of its Independence, through the Civil War in the 19th Century and the Great Depression in the 20th Century, the United States of America followed a “protectionist” policy as it looked to get the better of Great Britain and establish itself as the dominant economy in the world. George Washington, the first President of the United States from 1789-1797, not only supported the protection of infant US industries but also set an example by “buying American.” He said – “I use no porter [ale] or cheese in my family, but such as is made in America.” Alexander Hamilton, President Washington’s Treasury Secretary and the founder of America’s financial system argued in favour of a national industrial policy that inspired the likes of American economic nationalists Daniel Raymond and the German-American economic thinker Georg Friedrich List. Raymond believed that the “protective tariff represented national interests and that it allowed for the nation’s people a leverage, and special treatment granted to them over foreigners” in the fields of domestic commerce and industry of the nation. List, whose vision of a united Germany with a protected market was realized later in the 19th Century, believed that “the cost of a tariff should be seen as an investment in a nation’s future productivity.”
The US Presidents that followed Washington carried on the protectionist policies, as they built America in the 19th Century. The Republican Party (led by men such as Lincoln, McKinley, Roosevelt, Harding, Coolidge and Hoover) dominated US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. The US Economist Joseph Schumpeter called tariffs the “household remedy” of the Republican Party. It wouldn’t be too off base if instead of calling the GOP – the Grand Old Party, one called them – the Grand Old Protectionists. Tariffs were used both to generate revenues as well as to protect the American economy from British and European imports. President Franklin Roosevelt summed it up well when he declared, “Thank God I am not a free-trader. In this country, pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.”
America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. It ran a trade surplus for over 30 years selling goods and services to Europe, Japan and Asia whilst helping them re-emerge from the devastation of the Second World War. The love for “free trade” didn’t last long, however. The latter half of 1970s and early 80s saw massive capital outflows from the US and migration of manufacturing and this turned the US from a trade surplus to a trade deficit nation. As trade and budget deficits mounted and Japan achieved a rival status, America strong-armed Japan into signing the “Plaza accord” in a move to shrink the US trade and budget deficits. The US had a temporary respite and deficits began to narrow in the 90s until China came along. The accession of China into the World Trade Organisation (WTO) accelerated the US trade deficit as Liberalism (Clinton, Bush, Obama) won and Mercantilism/Protectionism lost. Now, the US is back to protectionism once again and once again under a Republican President, Donald Trump. China is accused of “protectionism” and the US is heralded as a “free trader.” History is a great thing. One just has to look back far enough to cure one of all prejudices. In that, I am reminded of this Marcus Tullius Cicero quote: “To be ignorant of what occurred before you were born is to remain always a child.”
From the US point of view, over three decades of liberalism have eroded its economic might and a return to mercantilism, as Trump proposes, is like a reversion to the mean. However, can this be achieved? Is the US ready to pay the price it will take to return to its mercantilist past? That’s the trillion-dollar question. If tariffs start biting US consumers, Trump’s “Make America Great again” could simply turn into “Make America Grate.”
Markets & the Economy
Things are stirring at the Bank of Japan (BOJ). Under its “yield curve control” (YCC) policy, the BOJ committed to holding 10-year yields at around 0%. This policy has been around since September 2016 and has been successful, thus far, in staving off deflation and keeping the Japanese Yen (JPY) weak. Over the weekend, there were reports that the BOJ was looking to move this target yield higher. That was enough for the market to sell the 10-yr Japanese Government bonds (JGBs) and yields spiked up by 10 basis points, which is a big move in Japan. The yield on 10-year JGBs rarely moves more than one basis point during a day’s trading. The BOJ had to step in to prevent more of a sell-off and it offered to buy unlimited amounts of the bonds at a yield of +0.11%. This had the desired result of preventing any more sell-off in the JGBs and in fact, the Central Bank didn’t wind up having to buy any bonds. The BOJ is trying to steepen the yield curve and help Japanese banks so they can in-turn boost the economy by making more loans. It’s a dangerous game, as the BOJ is nowhere near achieving its +2% inflation target and if the market interprets this as the BOJ being a step closer to unwinding its aggressive monetary stimulus – then the Yen will rally and undo years of BOJ stimulus. The BOJ is holding a two-day board meeting beginning on July 30. I do not expect a change in the YCC target and expect the BOJ to reiterate its faith in this policy.
On July 6, President Trump imposed a 25% tariff on $34 billion of Chinese exports to the US and threatened to impose a 10% tariff on another $200 billion worth of exports, if China retaliated. China shrugged off this threat and last week imposed a 25% tariff on the same value of US products— mainly agricultural products such as soybeans, cotton, beef, pork, dairy, and nuts. This week Trump indicated that he was willing to put tariffs on all $505 billion of goods the US imports from China. You’d think that risk assets would have reacted badly to this tit-for-tat trade spat. Not really. In fact, July has been a great month for risk assets. The S&P 500 index (SPX) is up +3.75% this month and continues the uptrend off the early April lows with a series of higher highs and higher lows (see graph below) as Q2 earnings have come in thick and fast, with the majority of them either meeting expectations or surprising to the upside.
S&P 500 index: Performance 2018 YTD
Of course, the effect of US tariffs on steel and aluminium, which came into effect on June 1, is showing up as well. Alcoa reported its Q2 earnings last week and it indicated that the recently enacted US tariffs on steel and aluminium are hurting its earnings. Only 14% of Alcoa’s global aluminium output is produced in the US. The rest is imported. The stock promptly fell -13% as the market started pricing the hit to Alcoa’s earnings from more expensive imports. General Motors (GM) reported Q2 earnings yesterday and while the net income rose the stock fell -7% on the unexpected high raw-material costs in the wake of US tariffs.
As I mentioned earlier, while imposing tariffs may be Trump’s objective of returning America to its mercantilist past, the success of this policy will depend on the price American consumers are willing to pay. Tariffs on the scale of $505 billion, would inevitably lead to chaos and price rises for everyday products in the US and the retaliation that would follow would hurt the US economy and US businesses. Regular readers of this newsletter will know that I do not believe Trump will sacrifice the US economy and go for an all-out trade assault on China, the US’s biggest and most important single nation trading partner. Wages in America are not rising fast enough and are growing at an annual rate of +2.7%. A tariff of 10% on everyday goods? Trump will have to be careful to not impact US consumers too adversely, if he wants to keep playing Marshall Will Kane in the movie High Noon out to save a town.
Trump’s protectionist bark is likely bigger than his bite, particularly with respect to the US trading relationship with China. The US is on target to run a $1 trillion budget deficit by 2020 and the national debt is heading to over +100% of GDP. The US can ill-afford the extent of deficit spending it would need in case of a full-on trade war with China without adversely and terminally affecting its future prosperity. I, therefore, continue to be overweight US equities, with a preference for Healthcare (XLV), Financials (XLF) and Technology (XLK) stocks.
Despite the “deal” that Trump and Jean-Claude Juncker, President of the European Commission, announced last night, I am wary of European equities. First of all, it’s not a “deal” but a start of a negotiation to get a “tariff-free” deal and to get rid of all “trade barriers and subsidies.” Secondly, there’s no timetable for progress and that is troubling given how long it takes for the European Union (EU) to negotiate even a simple trade deal. Third, have you ever seen a La Poste or a Gendarmerie car which was not a Renault, Citroen or Peugeot? I haven’t in over a decade of my travels to France. Protectionist France doesn’t have a trade imbalance with the US. Why then would President Emmanuel Macron of France agree to remove all “tariffs, barriers and subsidies” and open the French market to competition and pick a fight with the powerful trade unions in France? His closet is already full of troubles and his popularity is sinking like a lead balloon. Finally, to understand Trump’s motivation to slap a tariff on autos you have to understand the US auto market and what it means for Trump and the US rust-belt economies.
The US auto market recorded annual sales of 17 million vehicles in 2017, of which just 4 million were produced in the US. Trump wants the US to stop importing 13 million vehicles each year and force its manufacturers to produce them in America, creating manufacturing jobs in the hollowed out American rust-belt. In that, Trump is taking a lesson from China which imports less than 1.5 million of its annual 28 million auto sales. Therefore, I will believe an EU-US “free trade” deal on autos and other industrial products when I see it. With crucial mid-term elections ahead, Trump only wants cover for his attacks on China that have brought about the tariff on US agriculture exports to China. To alleviate the pain inflicted by that tariffs on US farmers, Trump had to announce a $12 billion subsidy this week. Europe buying soybean and liquefied natural gas (LPG), at least until the mid-term elections, plays into Trump’s hand and he looks magnanimous as US farmers offload their soybeans in Europe. Post mid-term elections, he can beat up on the EU again, as public opinion will be behind Trump riding high on his mid-term success. I see this EU-US truce as temporary, and hostilities will renew post mid-term elections.
Emerging Markets have taken a beating thus far this year as the US Dollar strengthened. The MSCI Emerging Market ETF (EEM US) has underperformed the SPX by more than -10% and is due a catch up as sentiment improves and the USD rally halts. There is also the stimulus from China. At a meeting led by Premier Li Keqiang this week, the State Council, China’s cabinet, vowed to use more proactive fiscal policies to spur growth. I would however not recommend a long position in Chinese equities traded onshore, but instead would recommend the large cap Tech names that trade on US stock exchanges – Alibaba, Baidu, Tencent and JD.com. Semiconductor stocks such as Micron Technology (MU US) are another favourite of mine. China accounted for more than 50% of Micron’s revenue in fiscal 2017. The stock was hit hard due to fears of tariffs but that seems to be easing. The stock still trades at under five times forward earnings estimates and could double over the next 12-18 months.
As for Financials, which have had a bad run this year, the Q2 earnings came in strong with Q2 profits rising +16-20% year-over-year. Yet, bank stocks – JP Morgan, Bank of America and Citi – have not been well bid. This is a mistake. Results showed that demand for loans remains strong. The latest US Federal Reserve data, for the week ending May 2, shows total commerical and industrial loans outstanding up +3.1% from a year earlier, compared with +0.9% at the end of January. This is still lower than the robust growth of +10.6% and +6.5% in 2015 and 2016 respectively, but clearly way better than just+ 0.7% in 2017.
In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and political legs, forgetting that the social leg is just as important, if not more so. Unaddressed, or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies – Brexit, Trump and the populist movement sweeping across Europe are good examples of this. German Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo. The Christian Democrat Union (CDU) and the Christian Social Union (CSU) have formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades, is now at a breaking point. For the European Union (EU) and the Eurozone, the only thing worse than a strong Germany is a weak Germany. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together, as it stumbles from one crisis to the next.
Italy, the beating heart of the European Union (EU) has gone from being a cheerleader of the Euro to a vociferous opponent. The market has taken note of a potential crisis brewing in Italy as a new populist government takes office. The yields on the Italian sovereign bonds (BTP) are rising and if you are looking to insure against a default, you will have to pay more to protect yourself against default on Italian bonds than Russian government bonds. That’s because, at €2.3 trillion, Italian sovereign debt is 132% of Italy’s GDP. Italy’s problems are lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. The average annual rate of growth per head in Italy, since the adoption of the Euro in 1999, has been zero. Therefore, an Italian born in 1999 who just turned 18 and has become eligible to vote for the first time, has seen nothing but economic stagnation during his lifetime. Yet, Italy is no Greece. Italy’s GDP at €1.7 trillion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy can not only survive outside of the Euro, it can thrive. The European Central Bank is nearing the technical and political limits of Quantitative Easing, and the growth in the Eurozone is slowing down. If yields keep rising and growth doesn’t pick up, it is likely Italy will relapse into an insolvency spiral. If Rome is then asked to submit to austerity for a second time, it will likely take matters into its own hands. The Euro experiment, therefore, may be nearing its end.
In the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Donald Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world. President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues that are prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate and a low investment rate. America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. For the sake of the US Dollar and the US itself, Trump should focus on the budget deficit and the national debt and not obsess excessively with the trade deficit. If the recent tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising. It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.
From haggling over the price of tea on a quayside in Guangzhou in 1784 to trading in electronics and t-shirts today, over the course of more than two centuries, trade between the US and China has grown beyond imagination. This trade relationship is now the most significant in the global economy.
The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities.
The world’s most cost-competitive and largest electronics industry supply chain is in Shenzhen, China. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. It is my firm belief therefore that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports. The US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted
Despite its high debt to GDP ratio, Italy’s main problem isn’t that it borrows too much – the issue is its non-existent growth. Italy, the third largest economy in the Eurozone hasn’t grown in any meaningful way for over two decades. Tinkering on the edges and paying lip service to reform mean that the outlook isn’t very bright for Italy. The European Central Bank’s (ECB) easy monetary policy over the last five years, may have pushed the recent GDP growth rate in Italy to +1.5%’ but what will happen when the ECB winds down its Quantitative Easing program and interest rates begin to rise? A re-run of the rising sovereign bond yield and questions about the viability of Italy’s economy are bound to resurface. In terms of equity markets, I don’t believe we have entered a new market regime, despite the recent market move. We are probably entering a transition phase and despite the market rhetoric, it is premature to conclude that the US Federal Reserve is behind the curve. The steady rally up we have seen over recent years may be behind us and what we will see going forward are moves both up and down i.e. welcome back to the two-way market. I still expect the S&P 500 Index to notch an +8-9% return this year – at least 200 points higher from the current level. What I am more concerned about is the rapidly deteriorating political equation in Germany. For the first time, the Far-Right Alternative for Germany (AfD) party has now surpassed the centre-left Social Democrats (SPD) in a national poll. How long before the AfD becomes the largest party in Germany? Inconceivable one might say, but not impossible. As Angela Merkel has moved leftward to occupy the space formerly taken up by the centre-left, the AfD has little competition for anything right of centre.
That was a very brief US Government shutdown this week. It lasted two days. Not that I am complaining. The agreement reached keeps the US Federal government funded through February 8, but it does little to resolve the contentious issues of immigration and government spending. The deal doesn’t preclude a similar shutdown next month. Markets care more about economic data than political “noise” and the data continues to be good. On the back of US tax reform, US growth is expected to accelerate and hopes have risen of wage increases. Global GDP growth is set to accelerate to over +3.5% from +3% in 2017. The global output gap is forecast to vanish in 2018 – the first time in a decade. The International Monetary Fund (IMF) estimates that, last year, 150 out of 176 countries managed to increase their exports. That is the highest share of nations on record and slightly higher than the peak reached in 2005.
So what could go wrong? The answer is: Trade wars. We got a taste of it on Monday when the US slapped steep tariffs on imports of solar panels and washing machines. President Donald Trump now seems ready to start implementing his “America First” trade policy. Be prepared to see more such trade-enforcements in the coming months. As top exporters, Europe, South Korea, Mexico, China, and Japan are all vulnerable to US trade tariffs and the “America first” policy. However, if trade wars become a global “thing,” with nations responding with tariffs and counter-tariffs of their own in a free for all, then the European Union (and Germany in particular), Korea and Mexico are most vulnerable, given their higher reliance on exports.
2017 was yet another superb year for the S&P 500 (SPX) index and the eighth full year of the current bull market run that began in March 2009. However, sluggish wage growth in the US has been a consistent theme of this economic cycle, confounding many, who believe a falling unemployment rate should herald higher pay for workers. Hopefully, the proposed cut in corporation tax in the US will drive investments and hence wages. If corporations however, use the tax cut to buy back stock and pay a dividend (as many have done so far), the impact of the cuts on GDP growth will not be so dramatic as consumption fails to take off. Unless the coal miner in West Virginia or the single mother in South Side Chicago has more to spend, businesses will have fewer reasons to invest. This equity market Bull Run will only come to an end when the US Federal Reserve starts raising interest rates aggressively, as was the case in 2006/07 and the yield curve inverts. The rule of thumb is that an inverted yield curve indicates a recession in about a year’s time. Yield curve inversions have preceded each of the last seven recessions. On Brexit, a breakthrough last Friday in the gruelling “divorce” talks between the UK and the European Union (EU) has paved the way for talks on trade. The agreement has significantly reduced the likelihood of a “no deal” scenario when the UK leaves the EU in March 2019. Bitcoin was and still is a gamble. At this point all I would say is: A fool and his money are soon parted. A fool and his Bitcoin may take longer, but they will be parted.
Angela Merkel has loomed large on Germany and Europe for the last 15 years, yet, if Edmund Stoiber had not lost the 2002 German election to Gerhard Schroder by the thinnest of margins, the world wouldn’t know of Merkel the way it does now. Merkel’s pro-migrant policy in 2015 divided the centre-right in Germany and fuelled the rise of the far-right, which entered the national Parliament for the first time after September’s elections. While Germany is clearly going to feel the pain of an unstable political environment, following the collapse this week of coalition discussions, the bigger casualties are the Eurozone and the European Union (EU) who have come to rely on a steady and stable Germany for leadership and direction. Without Merkel it will be like the EU has lost its “good shepherd”, as it deals with growing populism in Eastern Europe and with Brexit. There is little appetite in Germany for “more Europe.” Merkel’s stint as the “leader of the free world” has been very short-lived. A wise leader knows when it’s time to go. Does Angela Merkel?
In the US, the Federal Reserve (Fed) released the minutes of its last meeting. These confirmed what the market already anticipates – an interest rate increase at its next meeting in December. All eyes, however, are on the US tax reform Bill which, if passed, could alter both the growth and the inflation outlooks and push the Fed to raise rates more aggressively than currently forecasted.
The all-important 19th National Congress of the Communist Party of China (CPC) kicked off last week in Beijing. In his bold 3 hour and 23 minute address, President Xi Jinping, outlined the party’s priorities for the next five years. If Beijing has its way, China is on a track to becoming an economic power the likes of which we have not seen in a long time. It’s not the Japan of the 1980s, it’s much larger. It’s no surprise then that even the US National Intelligence Council warns that the era of Pax Americana is “fast winding down.” To the Western eye the ascendant power of Beijing may seem a disruption to the status quo, but to students of world history and China, it is the restoration of a millennia-long equilibrium. China was the biggest economy in the world for most of the past 2,000 years, only to be overtaken by Europe in the 19th Century. The ramifications of this Chinese growth are significant. America will almost certainly come out second best if it doesn’t change tack – with Europe a long way behind.