The financial markets are sending conflicting signals and the behaviour of the various asset classes subject to conflicting forces.
Trying to assess the forces at play and the respective risk / reward for the main asset classes is paramount.
The Bond melt-up points to a severe economic slowdown…
Equities at all-time highs and extremes of valuation tell a different story…
The rally in Gold and Precious Metals points to either a return of inflation OR a major dislocation in credit markets
As we have highlighted many times in our various articles, the world economy was doing fine in 2017 as most economies were gaining traction at the same time and inflation was finally pointing up in a global way.
After almost 8 years of extra-ordinary monetary policies to fight deflation and recession, central bankers could finally feel less pressure and started normalising monetary policy.
The US FED raised rates 8 times and reversed its bond buying program while in Europe and Japan, the ECB and the BOJ halted their bond buying programs.
That was until the least qualified candidate won over the most qualified candidate in the 2016 Presidential elections and Donald Trump became the 45th President of the United States of America with 2’000’000 less votes than his opponent and a populist agenda.
Donald Trump unleashed two powerful trends that are detrimental to the US and to the world economy :
. A TRADE WAR
. A COUNTER CYCLICAL TAX CUT
THE TRADE WAR
In a vain attempt to contain the rise of China, Donald Trump engaged in a Trade War that delivered a significant exogenous blow to the world economy stopping it in its tracks and reversing its virtuous cycle of growth.
By questioning the logic of a globalised world, “America First” in fact truly questioned the fundamental logic of a global supply-chain that provided the fuel to the world growth since the end of the Cold War in 1990.
Indeed, many emerging economies including China, India, Korea, Taiwan, Brazil, etc.. benefitted from this new world order, but the main beneficiary was also and above all America and American corporations by making products sold to the US consumer cheaper and more readily available.
Contrary to Donald Trump’s claim that globalisation killed jobs in the USA, it actually allowed a transition from lowly-paid and non-productive jobs in declining industries to better-paid and highly productive jobs in new industries and technologies.
And the proof of the pudding being in the eating, America’s UNEMPLOYMENT RATE reached a 50-years low – YES, FIFTY YEARS – last month at 3.5 %.
Without globalisation, companies like Apple would not exist and offer Mc Book Airs at US$ 1000 and Google, Facebook, Uber and the likes would not be Billion customers companies spanning the world but US centric ATTs.
Imposing tariffs on goods imported from China in the 2000s is as stupid and ignorant as imposing tariffs on goods produced in America’s Middle West and sold in New York in the 1900s.
It goes against the time-prove laws of efficient allocation of resources and every experiment of economic isolationism in the US and elsewhere has proved to be a major mistake.
But Donald Trump listens to no one and has in fact no one to listen to …
Nevertheless, by imposing tariffs on goods sold In the US and imported from China and targeting Chinese corporations such as Huawei in December 2018 and another 7 corporations yesterday, Donald Trump dealt three major blows to the World economy in general and to the US economy in particular, killing the coincident economic recovery and normalisation that was in place before his election.
A MANUFACTURING AND EXPORT RECESSION
As we have highlighted in many of our articles as early as February 2018, Donald Trump’s Trade War had the immediate effect of creating a major uncertainty for CEO’s around the world who decided to freeze their investment plans as the logic of a global and efficient supply chain is being questioned in its fundamental principle.
Moreover, Donald Trump’s ways and methods of off-the-cuff tweets and even less predictable turn-arounds as was the case with Mexico for instance, and his New York real estate methods of rapport de force and bullying the other party to exact a better price create an environment of instability, conflict and unreliability that makes even a positive solution or resolution an unreliable certainty.
Since February 2018, manufacturing and industrial production took a dive almost everywhere, impacting major exporting economies such as Germany, Switzerland or Sweden, but also the US itself with the latest reading of the manufacturing PMI plunging to the lowest level since 2008 apart from 2016.
US Manufacturing PMI points to a sharp slowdown ahead
The interesting part of the whole thing is that Bond markets and economic indicators are heralding a US and European recession in 2020 at a time where consumption, retail sales and the job markets are strong and healthy.
AMERICA IS NO LONGER A RELIABLE RULE-OF-LAW COUNTRY
This is maybe the least talked about but the most damaging consequence of Donald Trump’s short-sighted policies.
The attacks on HUAWEI and the banning yesterday of 8 other Chinese companies have created an environment where free enterprise and equality of rights – the two founding pillars of the American Dream and the American democracy – have been replaced by political and strategic considerations.
Last night, the Trump administration placed eight Chinese technology giants on a blacklist over alleged human rights violations against Muslim minorities.
The move, which was announced after U.S. markets closed, came on the same day negotiators from the U.S. and China began working-level preparations for high-level talks due to begin Thursday in Washington. The blacklist takes President Donald Trump’s economic war against China in a new direction, marking the first time his administration has cited human rights as a reason for action. Past moves to blacklist companies such as Huawei Technologies Co. have been taken on national security grounds.
The companies on the blacklist include two video surveillance companies — Hangzhou Hikvision Digital Technology Co. and Zhejiang Dahua Technology Co. — that by some accounts control as much as a third of the global market for video surveillance and have cameras all over the world.
Also targeted were SenseTime Group Ltd. — the world’s most valuable artificial intelligence startup — and fellow AI giant Megvii Technology Ltd., which is said to be aiming to raise up
to $1 billion in a Hong Kong initial public offering. Backed by Chinese e-commerce giant Alibaba Group Holding Ltd., the pair are at the forefront of China’s ambition to dominate AI in
Entities on the list are prohibited from doing business with American companies without being granted a U.S. government license, though some have maintained relationships with banned companies through international subsidiaries.
Beyond the details of the new sanctions, the use of political and National security reasons to ban or limit the activity of foreign companies in the US has destroyed America’s main attractiveness : a true Rule of Law and free enterprise jusridiction.
As the Chairman of Japan’s Toyota stated in his address at the end of last year, foreign companies have invested hundreds of billions of dollars and created hundreds of thousands of jobs in the US over the years…
They will no longer do it because the financial risks are now too high and the ultimate losers will be US workers and the US economy at large.
If these new sanctions have nothing to do with the resumption of the Trade Talks and are not a response to China’s position that it does not want a global deal, then these new sanctions make no sense at all.
Once again, Donald Trump is like a poker player who’s bluff is being called by the Chinese and have no other response but to raise the bets. But this strategy will backfire big tome as the Chinese will certainly retaliate and this time round not in a measured way.
AMERICA WILL BE CUT OFF FROM THE WORLD’S LARGEST CONSUMER MARKET
Donald Trump’s short term advantage with his political base will have lasting consequences for US corporations, the US economy and American workers as a strong Anti-American sentiment is developing in China.
The Chinese, and particularly the younger generations were very much admiring America and the American dream and privileged American products to Chinese products as being perceived as of better quality and a symbol of success.
Since the launch of the Trade War in February 2018, the Chinese have felt victim of an unjust campaign by Donald Trump’s Trade War that goes deep into the highly sensitive memory of the lost century, the 19th century where Western powers took advantage of the weakness of the Chinese empire and of its population fed with Opium to exact territorial sovereignty and weaken China.
Today, all the surveys show that the Chinese consumer is abandoning American brands in favour of European and Chinese brands and the development of a Nationalistic sentiment goes well with Xi Jing Ping’s drive to restore the values of the Chinese Communist Party.
China is already the largest consumer market of the world in numerous products such as cars, planes, computers, semi-conductors, medical equipment, public transportation, coffee, soybean, pork and so on and American icons such as Apple Inc, Starbucks, Harley Davidson and Being are feeling the impact through weaker sales.
Yesterdays’ move by Donald Trump will unleash severe retaliation by the Chinese against specific American companies and products who stand to lose big in the future y not being allowed in the market anymore.
The trend is also visible in the number of Chinese students in American universities which represent the largest source of international enrolment for American colleges and universities with 360’000 students in 2017-2018. The numbers are already down sharply and are expected to fall by 20 % in the year 2019-2020.
Considering an average spending of US$ 50’000 per student per annum, that represents US$ 1.8 Billion of revenues that have no replacement possible.
More importantly, having large numbers of Chinese students in American Universities was probably the best way to have China and its younger generations move away from the centralised Governance of the Chinese Communist partly towards and adopt the more individualistic and individual freedom values of the western democracies.
The long term effects of having China turning its back to America are extremely far reaching, not only in political terms but also economically for the American Economy.
CHINA IS GOING TO MAKE IT ALONE
Maybe the most drastic consequence of Donald Trump’s ill-conceived Trade War is the realisation by China that it needs to do it by itself instead of relying on a globalised world and this has major strategic and economic consequences for the declining American Empire.
Up till 2017, China’s growth strategy was to integrate into the world and participate in the logic of a global supply chain where technologies are shared and benefit for all. This logic allowed America to keep its edge in terms of chip making, semi-conductors, operating systems, medical research, pharmaceutical products, entertainment and many other fields.
By having its technology embedded in Chinese products in the same way Chinese technology is embedded in Apple products, America would have kept an edge and a control over what is taking place in China.
Today, following the sanctioning of Huawei for National Security reasons China has realised that it had to develop its own technologies alone and not rely on American products anymore, effectively shutting American corporations form the vas development of the Chinese consumer market in the coming decades.
Moreover, and in a perfect illustration of how self-centered the US way of thinking is, what Donald Trump does not realize is that the US market is not key to China and that it can very well survive without it or with a lesser access to it.
However, when the rest of the world and particularly Asia will have to choose between US technological standards and Chinese technological standards, the vast majority of countries, including some Anglo-Saxon ones such as Australia, South Africa and New Zealand will actually favor China’s technology, ultimately reducing their purchases of American products.
In numerous technologies – and G5 telecommunication – in one of them, America no longer has the lead, the edge or the financial resources to compete with the Chinese giants that have built an irreplaceable expertise in their fields.
Huawei’s technological superiority is recognised world wide and the know-how and producing capabilities of component makers such as AAC Technologies, Tongda Group, Hikvision or Megvii has no equivalent in the world.
US TARIFFS ARE INFLATIONARY
Last but not least, the imposing of tariffs on Chinese made products imported in the US is going to have an inflationary impact, particularly in the fourth quarter of 2019 as retailer can no longer absorb the extra cost in their profit margin and the Yuan’s depreciation remains limited.
As most Universities and economists agree upon now, the Tariffs imposed on US imported goods amount to a tax levied on the US consumer – not the consumers of American products outside of America – and that new tax already amounts to more than the benefits that accrued to households in the form of additional spending power by the 2018 tax cuts.
In other words, by imposing tariffs on Chinese products, Donald Trump has taxed the US consumer himself and reduced his purchasing power by that much in the hope that consumers and corporations will buy the same products form elsewhere than China.
This misconceived notion of economics has already hit the wall of reality with a significant number of products that are now subject to Tariffs not being produced elsewhere – such as buckles, ski gear, sports gear, shoes, furniture and so on – and with a number of corporations, such as Apple inc, who prefer to wait it out in the hope that Donald Trump will not be re-elected rather than jeopardising complex industrial supply chains that they have built over decades and that have allowed them to become the successes that they are.
This logic is currently made even more valid by the launch of an impeachment process against president Donald Trump last month.
In other words, the ill-conceived Trade War launched by Donald Trump in February 2018 against China is sending the US economy and to some extent other parts of the world in a recession next year while at the same time exacting an inflationary price on the economy.
Stagflation is probably the worst enemy of the financial markets and neither bonds nor equities are factoring in stagflation today.
Bonds are pricing in a traditional deflationary – recession while equities don’t even want to think about the impact of an economic slowdown on corporate earnings.
But the Trade War is not the only negative trend unleashed by Donald Trump.
A COUNTER CYCLICAL TAX CUT
Without going back to MacroEconomics 101, it may be useful to remember that economic policies are globally driven by two levers :
MONETARY POLICY – i.e. interest rates and the cost of money – and
BUDGETARY POLICIES – i.e Taxes and the cost of running the State
Monetary policies are usually implemented by Independent Central Banks since the episodes of hyper inflation of the beginning of the 20th century where elected politicians were content to print money and fuel inflation until inflation became out of control and ruined the economy and the economic agents.
Budgetary policies remain in the hands of the elected politicians who decide on the level of expenses, the level of taxes -revenues – and the budge deficit or surplus that want to have.
The debate about the independence of monetary policy is vivi at the moment in the US where Donald Trump, as a truly populist short term politician, is raging against the FED because it refuses to print money and lower rates to propel the stock market higher.
It is actually fascinating to look at the following chart which depicts US inflation and US Fed Funds
For the first time since 2000, the FED LOWERED interest rates while INFLATION was still going HIGHER.
In normal monetary policies, the Central Bank waits for Inflation to change direction before changing the direction of interest rates.
The last cuts by the Fed show that despite its statuary independence, the FED has actually yielded to the pressure put on it by Donald trump who has been accusing it of causing the stock market sharp correction of the 4th quarter of 2018.
But the real problem is not there, even if lowering interest rates when inflation is rising will actually feed inflation even more and require even stronger action later on
The true problem is with budgetary policy where Donald Trump again, as a true populist politician, enacted a massive Counter cyclical TAX CUT in 2017 at the top pf the economic cycle.
Macroeconomic 101 teaches that economic orthodoxy demands that when the economy is slowing down or in recession, tax cuts and public spending – OR INCREASING PUBLIC DEBT – are needed to boost economic activity and that when the economy is booming Governments should use strong tax receipts and avoid unnecessary spending to replenish the State coffers – OR DECREASE PUBLIC DEBT -.
This is common sense and successful economic management proven time after time as the State takes over from the private sector to alleviate the consequences of a slow down and conversely avoid an overheating of the economy.
Smoothing the economic cycle and avoiding the damaging ” booms-and busts” of the beginning of the 20th century is exactly what the State should do through its two levers of Monetary and Budgetary policies, and this is exactly what Australia has managed to do for the past 26 years without a recession.
It is also very much a raging debate in Germany at the moment where the hyper inflation decades of the 1920s have instilled a culture of extreme prudence in the management of both monetary and budgetary policies.
The European Central Bank mandate, inherited from the German Bundesbank, is all about containing inflation, and it found itself completely harnessed and ineffective when the problem was to contain deflation in the 2010s and it took it five years and a certain Italian Governor named Mario Draghi to finally resort to triggering growth and inflation through quantitative easing and negative interest rates when the American FED whose mandate is both to contain inflation AND generate growth acted mcc earlier.
And today that Monetary policy is ineffective in Europe because rates are negative and that Germany has already experienced one quarter of contraction, a huge amount of pressure id being put on Angela Merkel’s administration to open the spigots of budgetary policy and allow a temporary budget deficit nested of surplus.
As the table below shows, Germany is the ONLY country of the 10 largest economies of the world to run a BUDGET SURPLUS. It also has the LOWEST DEBT TO GDP of all of them at 61 %.
The very valid question that is being put forward to the Merkel administration is why should you allow the country to go into recession if you can use fiscal measures to boost the economy.
The German economy is in a downturn, time has come for the Public finances to generate growth and when growth will return, fiscal orthodoxy will return as well and the State go back to Budget Surpluses.
This is what we call Cyclical tax cuts within the context of Keynesian economics
At the end of 2017, and as the US economy was clearly on an uptrend and unemployment on a record low level, Donald Trump enacted the biggest tax cut in decades lowering corporate taxes from 40 % to 27 % AT THE TOP OF THE CYCLE
The Chart above shows how budgetary stimulus should or could have been used in 2009 to stimulate the economy. Had a tax cut been enacted then the economy would have recovered strongly, but monetary policy proved to be good enough even if the balance sheet of the State actually ballooned through the Govt. Guarantee extended to Fannie Mae, Freddie Mac, GE and and a number of banks.
Instead, Donald Trump enacted a Tax cut when the economy was growing GDP going up in 2017 and unemployment was at the lowest in more than ten years ensuring high tax receipts.
The net result can be seen in the following chart
Up till 2016, the strong GDP and strong labor market enabled the budget deficit to diminish from -9.5 % in 2009 to -2.0 % in 2015. The 2016 slowdown largely due to the Presidential elections increased the budget deficit again, but at a stable tax rate of 40 %, the 2017 economic recovery should have sent the budget deficit lower .
Instead, despite growth accelerating towards 2.90 %, the Counter cyclical tax cut from 40 % to 27 % simply increased the budget deficit and the total public debt of the state.
Through the entire cycle of 2009-2019, a period of economic well being in the US by any standard, employment related estate prices, stock market, average earnings, average value if 401-Ks,
THE PUBLIC DEBT OF AMERICA INCREASED BY 150 %
Since the Presidency of Donald Trump, the US public debt increased by 14.3 % while economic growth was good. And that is WITHOUT the US$ 1.5 Trillion that was promised and needed to upgrade the American infrastructure that is derelict.
The real issue there is that when the US economy will slow down considerably and even maybe go into recession next year, tax receipts will decrease substantially, the budget deficit will explode upwards and the US public debt will balloon even further.
To keep things under control then, it will then become necessary to increase taxes again OR reduce public expenditures in a massive way at the worst possible time of the cycle.
America is already the most indebted country of the planet at 32 % of Total Debt
Its total debt has increased stratospherically in absolute terms and in Debt to GDP where we are back at the post war levels.
More financing needs in the next downturn will mean higher interest rates.
Today, the US public debt is financed at a low interest rate of 2.4 % on average if one is to take the US 10 Year Government Bond yield as a benchmark.
But if interest rates start rising again as we expect under the combined weight of higher inflation and high financing needs and reach the 4.1 % average of the previous ten years, then the Interest to be paid on the pubic debt will double from 560 Billion to 1.1 Trillion.
In other words, the Trump legacy in less than three years in power through his Trade war and through his counter-cyclical Tax cut is leaving America with daunting macro-economic prospects.
If you add to that the world’s highest Household debt to GDP in the world the next debt crisis will clearly come from the US and not from China and it could well be around the corner.
But where does all this leave us in terms of the behaviour of the Asset Classes :
Global and US bonds in particular are completely mis-pricing the return of inflation and te potential debt crisis. The newspapers are full of “Japanification” of America where investors and commentators expect a never-ending scenario of low to negative interest rates and the ability of the state to go to 220 % debt to GDP.
A Japanification of America is impossible because of two reasons : Japan has been in actual deflation for three decades now and is juts pulling out of it with a bare 1 % inflation rate wake America is in the midst of an inflation trend with the lowest unemployment in 50 years and wages growing at3 % per annum.
At some point the bond market will wake-up and realise that it cannot tolerate negative real rates and rising inflation for very long.
The charts below shows the negative real rates on 10 year and 30 Year bond in the USA, some thing that NEVER happened in history and is unsustainable because feeding inflation itself.
The second reason why America will never be “Japanified” with debt to GDP ratios of 220 % is that Japan is a nation of savers while America is a nation of borrowers and that the Japanese debt is held by the Japanese themselves while the US debt is held by the rest of the world and the Chinese in particular.
IF, FOLLOWING THE AGGRESSIVE STANCE OF AMERICA YESTERDAY, CHINA DECIDES TO RETALIATE BY SELLING ITS US TREASURIES AND ITS DOLLARS, OR EVEN STOP PARTICIPATING IN THE REGULAR RE-FINANCING EFFORTS OF AMERICA, THEN US RATES WILL SHOOT UP.
To be franck, the same applies to the European and Japanese bond markets where a massive stock of debt yielding negative returns – in excess of 15 trillion – because pension funds have been forced by the BOJ and the ECB to gobble negative rates will one day unwind as and when inflation increases.
There again, HIGHLY NEGATIVE REAL INTEREST RATES will ultimately force the Central Banks and bond investors to re-price inflation risk and offload their portfolios of fixed rate bonds.
The charts below also show that 10 YEAR Government bonds in Europe and in JAPAN are now in sharply NEGATIVE REAL INTEREST RATES, an UNSUSTAINABLE state of affairs, and even more so if inflation starts to rise as we expect.
Bond investors have the choice between two very bad options :
. They keep their bonds and lose 1.5 % per annum in real term every year for 10 or 30 years.
. They sell their holdings all at once to protect their capital and there is no one to buy them so prices collapse.
The situation in equity markets is very different from one country to another.
In the US, valuations are sky high, earnings are no longer growing strongly and participation rate is extremely high even if investors are not particularly bullish. The economy is looking at a significant manufacturing slowdown if the PMI is a reliable indicator and that industrial weakness is starting to spill over the labor market and consumption.
In Europe and Japan, valuations are fair but earnings growth is weak and the economies are fragile. They are highly dependent on exports and the Trade War, but some Southern European equity markets are looking better than others
In China, valuations are extremely cheap, industrial profits are still declining and stimulative measures have not yet produced their full impact on the economy. The aggravation of the Trade War may even lead to America banning US Pension funds from investing in Chinese equities and Chinese corporations from accessing the US capital markets.
Emerging markets have corrected sharply, valuations are becoming attractive but growth prospects are not there.
To us, the main area of dangers in equity markets is the US as it is the market that will give the direction to al markets until China decouples.
We are entering the 3rd quarter reporting season and the picture is not rosy, even if CEO’s and analysts have really massaged expectations to very low levels. The outcome could be one of sharply reduced earnings but still better than expectations.
The table below summarises the consensus of expectations for the SP500 in Q3 2019 and it points to an earnings recession with a -4.9 % decrease in earnings year on year for a 3.1 % growth in sales.
Justifying 30x CAPE valuation or 19x PE on declining earnings is a triumph of hope over reality, but what it means really is that investors see the current economic and earnings slowdown as temporary and limited in scope.
More worrying is the disconnect between REAL industrial earnings ( NIPA ) and Analysts and CEO Earnings which include accounting tricks in terms of intangibles, amortisation and tax advantages.
Every time there has been a disconnect between the two, equities fell subsequently.
Another worrying factor is the large influence of the FAANGs and technology on the global SP500 and any negative surprises on these companies could send shock waves to te market.
All-in-all it is difficult to see how Q3 earnings could deliver anything but a short-lived positive surprise if actual numbers are better than expectations.
Earnings will not be good, and guidance for the 4th quarter even worse. Negative surprises, especially in the FAANGS could send the markets tanking.
The ONLY true Positive for equity markets is the general state of AMAZINGLY NEGATIVE REAL INTEREST RATES almost everywhere apart from China.
NEVER BEFORE HAD WE HAD SUCH A MASSIVE SITUATION OF NEGATIVE REAL RATES AND THAT COULD PROVIDE A SIGNIFICANT BOOST TO EQUITIES.
HOWEVER AS WE MENTIONED BEFORE THE CURRENT SITUATION IN THE BOND MARKET CANNOT LAST.
We therefore see two possible scenario for Global and US equity markets :
. The Earnings season is positive, the Trade War does not degenerate and Bond markets hold where they are and there is a possibility that Equity markets try to go higher, until Bond markets crack and equity collapse
. The Earnings season is not good, the Trade War degenerate in a full blown war and bond markets break down and equity markets fall sharply from here into November.
Gold and Precious metals are actually pricing the right scenario for the tome being, one where inflation is back while economic growth falters.
This scenario is good neither for equities nor for bonds and a flight to safety into Gold and Silver is therefore on the cards.
However, a real collapse in either bonds and equities could send Gold and Precious metals much much higher if a real recession unfolds at the beginning of 2020.
Whichever one looks at it, and taking a 6 months investment horizon, time is not to take risks in bonds or in equities at the moment and cash and precious metals should be privileged.
Chinese equities could decouple at some point in the near future if the Chinese economy starts picking up steam despite the Trade War.
US Technology stocks and US small caps are the most at risk.
Some markets in Europe and Asia deserve attention as they are becoming extremely attractive.
Soft Commodities are ripe for a big move up if inflation starts moving up.
CREDIT COVER PHOTO. unsplash-logoFrantzou Fleurine