Playing the Trump card

Last week I ran through the big long-term (20-40 year) economic trends (click here for the full post) that investors should be aware of, noting that a couple of these trends (women in the workforce, the ratio of workers to non-workers and maybe trade) are changing for the worse.

Stage two (today’s post) is looking at the medium term trends. I think about these trends as being relatively transient; they are imbalances that are in the system and will eventually be resolved. Some will end with a whimper, some with a bang. Sometimes they are like the tech boom or the US housing boom, up and down and all over in a few years. Sometimes they are like the Chinese capex boom and stretch over much longer periods.

After stage two we will look at the short-term trends and most importantly what is (or isn’t) priced into markets.

There are lots of mid-term trends at any one point in time, but only a few that are going to drive our key asset allocation weights. I try to keep my investment list to three or four big themes, as most of the others are peripheral. The three big ones I am following at the moment are: (1) Chinese capex/rebalancing (2) Trump tax cuts (3) European debt. I have a laundry list of minor themes that I’m keeping track of that may emerge as major themes.

The net effect of the medium-term trends is that I believe a classic boom/bust cycle driven by US tax cuts is looking likely. With the (major) caveat that it is hard to know what Trump will actually do.


Mid-Term Trend 1: Chinese rebalancing

Most MB readers will be well versed in the Chinese capex story.

China is spending just under half of its GDP on capital expenditure, new roads, bridges, factories, airports and buildings. This level is much higher than any similar country has ever spent on capex since we started keeping records – the only country that came close was Thailand shortly before the Asian Crisis (for anyone not sure how that ended for Thailand, the word “crisis” is instructive).

 

CapexToGDP

The spending, is increasingly debt funded, and each dollar of debt is having a smaller and smaller impact:

IncrementalDebtToGDP

Sometimes it’s hard to grasp that not all investment is good. Specifically, an investment that does not earn a high enough return is not a good investment. Judging returns is hard enough to measure for commercial operations but when you are building things like bridges or roads then measuring the return as a “public good” is even harder again.

The parable here is that when you first start spending on capex you choose the most efficient investments first (give or take) and as time goes on you invest in projects that earn a lower and lower marginal return. For example, the first bridge across a river is very productive as it may save hours of transit time, the second less productive as now its saving transit time from congestion on the first bridge, and by the time the third and fourth bridges are being built the benefits are more and more marginal (and harder to measure).

At some stage, if the level of investment is high enough, this return will fall below the cost of capital – the key question is when? In my view, China is likely to have surpassed this level a few years ago – as the above chart indicates.

When does this end? i.e. how much debt capacity does China have left?

Chinese debt is high at around 280% of GDP. Its government deficit is running at close to 10% of GDP if you include debts being accrued by local governments.

ChinaGovtDeficit

So, not much debt capacity left. Having said that, China could probably scrape another few years out without too many issues. But, the current path is clearly unsustainable.

If we assume at some stage the Chinese economy will rebalance, then the key questions become how and when?

For the “how” question, we are unsure – in the vast majority of similar cases, investment spending continues to increase as long as it can before ending in a crash (e.g. Russia, Japan, the Asian crisis). Basically, the level of investment spending gets so high the entire economy becomes dependent on creating investment, and it is hard politically to diversify away from this as it involves short term pain for a longer term gain.

There is some hope that this time China will be able to rebalance more gradually – they have recognised the problem at least in their five-year plan, the question is whether politically it is possible to make the change given:

  • it is likely to generate higher short-term unemployment
  • local governments have become dependent on profits from land sales
  • vested interests will likely lobby to maintain the construction spend

Forgetting the political issues for a moment, let’s make the assumption that China wanted to rebalance smoothly over the next ten years back to 50% consumption, 30% investment (which would still put them at the top of the world for investment as a % of GDP).

If consumption started growing at 12% real (say 15-16% nominal growth which is a relatively heroic assumption) and gradually edged down to 8% (11-12% nominal) per annum over the next ten years, then investment would have to grow at 0% to rebalance the Chinese economy. And investment growth is currently well above 0%.

So, on the “when” question the answer is the sooner the better. The longer it takes for the rebalancing to start, the more likely that it ends in a crash rather than an orderly transition.

FixedAssetGrowth
The real question is how much ideological conviction to Chinese politicians have in rebalancing?

While Chinese GDP growth has been impressive, the growth has not been evenly dispersed among Chinese citizens. Estimates of the Gini coefficient, which measures inequality, have grown dramatically in China and suggest that China (ironically for a communist nation) has one of the world’s most unequal wealth distributions.

The inequality creates a number of issues. I am going to ignore the potential for large-scale political upheaval, not because it is unlikely but because human beings have proven to be very poor at predicting regime change and I am unlikely to be any better. It’s a risk that needs to be kept in mind, but there is little an investor can do right now as regimes can last decades beyond expectations or fall within weeks of experts decrying any possibility.

What the imbalances do create is something MB readers are used to reading about and something I am much more comfortable forecasting – political self-interest.

The growth in wealth for a (relatively) small number of people within China has been spectacular and has been based on the existing arrangements where investment growth is high.

Additionally, local governments are highly reliant on land sales to developers. Reports about Chinese party officials owning tens or even hundreds of properties, plus that China does not rate well on most measures of corruption (on the Transparency International 2012 study China was ranked 80th, citing graft, bribery, embezzlement, backdoor deals, nepotism, patronage, and statistical falsification) suggests that the relationship between party officials and developers is unlikely to be entirely above board.

So, rebalancing means less development which then means less chance for lower level communist party officials to “supplement” their income. As rebalancing occurs, it will create (probably quite intense) political pressure for the Chinese leadership.

Does the Chinese leadership have the fortitude to stand up to vested interests?

No one knows – probably not even the Chinese leadership.

What this means for investors is that it is wise to position portfolios for a rebalancing, but to be mindful that as the rebalancing occurs that there will be a risk that leadership will cave to vested interests and begin another round of stimulus.

For Australian investors, we also need to be mindful of the reduction in demand for commodities, see Houses & Holes’ posts here, here and here and here and here. Come to think of it, if you click on any H&H post, you’ll probably see something about this.

What is the end game?

My bet is that China will follow the Japanese path – spend as long as they can, then bundle all of the bad debts up into banks and zombie companies, followed by decades of economic stagnation where the economy goes nowhere but unemployment never gets too high, household incomes keep growing, and the Communist Party stays in power. Add in a rapidly ageing Chinese population and the parallels might be a lot closer than many imagine.

The danger is that they get it wrong and either an economic crisis or a political upheaval occurs.

In the next few years, the effects could easily be overshadowed by our next theme.


Mid-Term Trend 2: Trump tax cuts

The Chinese stimulus following the financial crisis was big. Big enough to mask other economic issues and help the lack of demand for much of the world, not least in Australia.

I am thinking that Trump tax cuts could do the same. He has promised tax rates will be cut across the board (top tax rate from 39% to 33%, company tax from 35% to 15%) – and its hard to see a Republican House or Senate standing in the way of that change as they are generally pro-tax cuts.

But keep in mind that there is considerable uncertainty with anything that Trump has said.

Now these tax cuts are badly targeted by giving most of the benefit to the rich and to companies, trickle down is unlikely to work, it’s unsustainable, it’s only a short-term sugar hit, I understand all the negatives.  But if it is anywhere near Trump’s promise then it’s going to be such a huge stimulus that you don’t want to stand in the way of it as an investor.

It is almost as if Trump wants to engineer a boom/bust cycle:

trumptaxcuts

So how do you play this theme?

Round 1: Buy US stocks for the sugar hit, plus exporters in non-trade pact countries

It does look like a huge stimulus package in the US is about to be enacted.

This means that the US will go deep into debt – a good thing for global demand.

This means the end of the rate cycle (although the upswing may not last that long). The US dollar is likely to be strong, and I suspect that the US dollar will offset a lot of the benefit for the US – i.e. US demand increases, but a decent amount of that benefits the rest of the world through increased exports to the US.

In aggregate, this is a buy US equities story, probably go light on US exporters or companies that are import exposed as the US dollar strength is going to hurt them the most. In other markets, try to avoid exporters who will be hit by trade sanctions (Mexico, Canada, China) and look for those that might fly under the radar and benefit from US demand (UK, Europe, maybe even Japan). Increased demand puts a floor under a lot of commodity prices; some will rise.

Keep in mind that some of this is already priced in.

Round 2: Reduced world trade, increased protectionism, Europe splinters

Hello higher costs in the US. Net/net the average Trump voter will probably give back from a higher currency and increased inflation any gains from increased protectionism.

Are we going back to the 1930’s?

Will a US/China trade war break out or will it just be lots of noise and posturing while in the background the increased US demand benefits the Chinese economy? Hard to tell, and I’m not willing to decisively invest on this theme until things are clearer. The US House of Reps + Senate are Republican dominated and so are not “naturally” trade protectionists. If Trump’s popularity takes a hit then they may become more obstructive.

US companies will struggle with profit growth due to higher costs (with the higher USD), fading stimulus.

Europeans to continue to splinter.

Does Trump have a war in him? Quite possibly… Hopefully it’s not China. Ten years ago, if you suggested that the US might go to war with the Philippines, people would have laughed at you. I’m not saying that I think that a war between the Philippines and the US is likely, but as a sign of the times I wouldn’t rule it out…

Round 3: Unsustainability become apparent

If you don’t believe in trickle down (I don’t) then at some stage the debt becomes unsustainable and taxes need to be lifted. Hopefully it’s not too close to the time that the Chinese debt becomes unsustainable…  Anyway, that is future me’s problem – probably 2-3 years away at least, maybe 5 years away, at which time we are in a worse position that today, the core problem of too much inequality/lack of demand still exists (probably gets worse).

Maybe it is the Euro falling apart, maybe it is another external shock, but the core thesis of a lack of demand largely driven by inequality remains and in 3-5 years we are back where we started but with a much higher US debt balance.

So, investors should play the boom but don’t forget about the bust.


Mid-Term Trend 3: Europe falling apart

This post is already longer than I intended, so I’ll be brief on this one as the can has been kicked down the road (again) on Europe, and Trump tax cuts increasing world demand could paper over the cracks for a few more years.

There are structural problems with the Euro which have resulted in a depression in Greece and deep recessions in Spain and Portugal. Italy and France are struggling to meet deficit commitments. Germany is doing well (thank you very much). There has been a rise in the support for anti-euro parties in most countries across Europe and Britain has voted to leave.

I’m a subscriber to the Pettis school of thought on this one. Basically, Spain (as a representative of most of southern Europe) did not “pull” savings from diligent, pious German savers; but an underpriced Deutschmark (at the creation of the Euro) and German labour reforms caused a drop in German wages relative to German GDP. This meant German household consumption fell as a proportion of GDP which meant that German savings (being the other side of the coin) rose. These German savings were then “pushed” onto the rest of Europe.

Ordinarily, this would be solved by currencies: the Spanish currency would fall, and the German currency would rise. That way German workers would be wealthier and consume more, and Spaniards would have lower wages and be able to compete with German workers. But these countries are locked into the Euro which means that a different resolution is needed.

The solution to European problems (from Germany’s perspective) is for Spain to stop borrowing the money that German banks keep offering them. Which basically amounts to recessions in Spain until wages in Spain fall low enough for Spanish workers to compete with German workers. The Pettis solution is for Germany to increase wages and spending to create household demand that will allow Spanish workers to compete.

It looks like Europe is going to continue to down the recession route. Which means a rise in voter discord and increased likelihood that Europe falls apart.


Other trends: On the reserves bench

There are lots of other trends that I’m keeping track of, I’ll explore them in more detail later. Each has the potential to be promoted to a key theme:

Trade Imbalances: China, Japan and Germany have traditionally run large export surpluses while the US, Australia, UK and other countries have run large deficits. Over the long-term this is not a sustainable trend, and changes to this have the potential to be disruptive.

Energy Parity:  My pet theory that we are heading for energy parity where all forms of energy are (roughly) the same price with solar + batteries being the upper bound on prices. Hard to find winners, easy to find losers.

Driverless Transportation: My take is fourfold: (1) driverless transport is more likely first in constrained, known environments – which is handy because most people live in cities. (2) the cost savings are considerable for taxis/public transport as the biggest costs are the driver (removed) and depreciation (improved utilisation rates). (3) driverless cars increase the speed of electrification of vehicles due to cost and convenience factors. (4) the timing is unclear, but the proliferation of live trials suggest that it is coming sooner rather than later.

Low volatility investing: There is a small bubble here, quite possibly a (minor) blow up coming.

The next phase of monetary policy: Two decades of monetary stimulus in Japan, closing in on one decade in Europe and still few signs of inflation. Something needs to change.

Technological change: Technological changes are always happening, but they do come in waves as computing power gets cheaper and a new group of industries come under threat.  Current industries are transport and energy.

Chinese capital flight: If you are a diligent, hardworking mid-level government worker who has managed to save a few million dollars and you are worried about explaining how you managed to save that much while on a salary of a few thousand dollars a month then you need to get that money out of China.

Climate change / green energy: This post is already a little longer than I thought it would be… I’m going to leave this for later.


The Bottom Line

The outlook is a clouded at the moment, largely because of uncertainty about what a Trump presidency will mean.

My base case is that Trump gets the tax cuts through, but his trade war rhetoric is more bark than bite. If the trade wars do break out, then it is an entirely different ball-game and we will need to revisit our investment thesis.

In the meantime, tax cuts of the size Trump is suggesting will be too large for any investor to ignore. If the stimulus is in the current form, it will dominate the economic outlook for the next few years – likely overshadowing most other themes. I’m thinking it results in a classic boom/bust cycle with lots of debt-fueled spending in the short term which stops when the debt gets too high.  While I don’t like the nature of the stimulus, I don’t think it will be good for the US economy in the long term and I think it will result in a (possibly very damaging) bust, you don’t go underweight equities in fear of a bust before the boom has started.

Whether right now is the right time to be buying equities and what is priced into markets is a different issue – more on that next time.

Damien Klassen is Chief Investment Officer at the MB Fund launching in April 2017. Register your interest now.

Fill out my online form.

Follow me
Latest posts by Damien Klassen (see all)

Comments

  1. GunnamattaMEMBER

    Thanks very much. A cracker of a rundown of some of the major factors in play. Cheers.

    I buy the view that there are a lot of variables which can play a lot of different ways, and change within short timeframes, and that this reflects the breakdown of the free capital markets, globalised free trade which has ruled the roost. It must be an absolute bastard trying to find anything which delivers a return, and seems capable of continuing to do so.

    Once the developed world gets shunted by its own domestic politics off the free trade – free capital markets (and often loose migration) nexus, a more protectionist world is likely to throw up some interesting political alignments. The Americans and the Chinese will need to ‘buy’ demand, either from their own future in terms of ramping up debt, or with easily developable populations (within or nearby). The Americans (and Western world) would be coming in with a largely discredited philosophy, the Chinese would need to overcome the middle income trap – and I suspect they simply have too many people to pull it off – and if they were to push wealth too far to their own people, their model of government (a highly centralised autocracy) would start to be undermined, and you couldnt be at all sure that Russia, Turkey and Malaysia (in particular) would fare any better. So the dichotomy between growth and the (less democratic) political models may not deliver outcomes all that better than the neo liberal consensus unraveling which has delivered Trump and Brexit, and would assist in the fragmentation of Europe.

    On the incoming Trump administration I find myself wondering how he plays energy prices. The last five years have provided us with the great shale oil boom which played a large part in driving OPEC (and particularly Saudi Arabia – which has had major financial system problems this year) to first of all blow the US producers out of the water with supply, and to manage to come to some form of agreement with the Russians. Trump probably needs a strong enough demand to spur prices to spur production in the US, but having cut supply already OPEC and the Russians wont be keen to see the the US pick up again, particularly with electric cars well on the radar.

    • In (loose) response to both Damien and Gunna:

      Would discussions along these lines have taken place in the pre-1929 world economic crisis ?
      Would efforts to re balance while maintaining employment ,domestic political and geopolitical stability ?

      I think yes, of course. And it might be that the answer of that period was ‘the roaring 20’s’.

      The ultimate can kick !

    • Concur with your comment and would only add that OPEC et al does not need capex expenditure, where as in Americas case the shale and fracking has reassemble[s]d a wild boom and bust – gold rush, first in bested dressed make packet and the towns / local populations deal with the externalities+ bust. Not to mention the crumbling infrastructure to transport it, as well, as the hollowed out and past its use by date production facilities [seaborne production in the pipe line].

      Disheveled… reminiscent of the buckyballs in Stephen King’s book, where they are all running to stay in the future… lest become consumed in the pasts destruction…. which at the end of the day just becomes a loop…

      • The piece is about investment themes.

        All those you mention are major risks to a number of investment themes, but they would be pretty tough to invest of their own, or as a base case. Like any investment case has to weave around those risks, but that doesnt make those risks the investment case.

  2. “the US will go deep into debt – a good thing for global demand”. Maybe.

    The whole purpose of the US spending is to increase domestic demand, not foreign demand. Making America Great again depends on that. It’s not about Making The World Great Again.
    If the US restricts new domestic demand to new domestic supply, the World could be left with a mass of oversupply of everything – all of us fighting against each other to exports whatever we can to everyone else, except The States. That , is highly deflationary for the rest of us for both prices and….wages….

    Perhaps that thought is covered by the sentence “If the trade wars do break out, then it is an entirely different ball-game and we will need to revisit our investment thesis.”

    • America has for the majority of its history always had a national deficit, tho becoming a global reserve currency necessitates that it – always – has a trade deficit. Now that the world is full its started consuming the host in order to keep econnomic metrics and other C-corp accounting fictions moving according to the astrologers dicta.

      Disheveled… it must or the long valuations will go poof and with it the demise of the rentiers and their flexian administrators… either way… the unwashed will get the bill….

  3. Great article – enjoyable read and very close to my own thinking…

    On driverless, I had an epiphany not long ago – I couldn’t help but notice that when I imagined there was a super efficient driverless system where I could have a very affordable, reliable, significantly safer and clean mode of transport at my door within 5 minutes of requesting it, my feeling towards having my own car (that I drove myself or did not) dropped substantially… I am not one to use cars as symbols of status – or perhaps I am and I am reluctant to accept what my 14 year old camry says about me 🙂 – but that was pretty much the only reason I could begin to come up with for someone to own their own car… and it’s not difficult to imagine their power in status labelling in the middle class falling away (and replaced by new tech-related symbols or greater emphasis on traditional ones – such as education, housing)… I then had a salient reminder of how quickly things can change – I parked in the carpark of what 10 years ago was probably the biggest private photography/film processing business in south Brisbane – I hadn’t realised it was completely gone… And my son has been waiting 5 weeks for Big W to receive back from processors in Melbourne the film he took on a disposable camera while on camp!! (something that could take less than 1 hr onsite 10 years ago!!)…

    Anyhow, I think driverless will have a huge effect on a massive range of businesses and quicker than most expect…

    • Driver less cars may be a lot further away then you think. IMO maybe a 50/50 that they end up widely deployed at all. Bug free software is hard, perhaps impossible and edge cases are legion even in ‘simple’ conditions like a freeway.

    • On driverless, I had an epiphany not long ago – I couldn’t help but notice that when I imagined there was a super efficient driverless system where I could have a very affordable, reliable, significantly safer and clean mode of transport at my door within 5 minutes of requesting it, my feeling towards having my own car (that I drove myself or did not) dropped substantially…

      Why do you think your hypothetical driverless car system will be substantially different from today’s taxi systems ?

  4. “Sometimes it’s hard to grasp that not all investment is good. Specifically, an investment that does not earn a high enough return is not a good investment”

    Mate, getting heavy there … you going to impress lots of serious investors with that … I’m in … boots and all into the fund you going to manage … sign me up.

    • That was Pettis’ argument that China GDP is overstated because the PV of many of the investments is less than the cost.

  5. Great post – clear, unbiased, no idealogy. This is the type of stuff to lure new subs.

    Looking fwd to these two themes —

    Energy Parity: My pet theory that we are heading for energy parity where all forms of energy are (roughly) the same price with solar + batteries being the upper bound on prices. Hard to find winners, easy to find losers.

    And Driverless.

    Would look at a sub that gives me AU equities to buy in these themes – small SMSF here.

    Interested in any black swans – War (why US/Philipines?)

  6. The market has got ahead of itself on the tax plan.
    It’s not clear at all that it would stimulate demand.
    For example Apple; currently meant to be paying tax at a statutory rate of 12.5% (paying an effective rate of less than 1%). Why will lowerering the US corporate rate to 15% boost Apple investment? The border adjustment may encourage them to bring their intangibles back to the States, but again how does this stimulate demand? The one off 10% repatriation tax on past profits may encourage them to repatriate $200B back to the US, but again how does this boost US demand? It doesn’t, it’s all just trickle down fantasy.
    What it will do is widen the US deficit. Then there is the infrastructure talk. Will it happen? No because Republicans will block it. No question public assets will be sold off to Trump cronies, but again this has no effect on demand.
    Big questions re. Demand which haven’t been answered:
    1. How will Trump treat the Fed? Who knows. But look at the idiots he has appointed like Kudlow, who has consistently called for higher rates (because he’s a fool)
    For example:
    “So let me say this: A sound dollar and price stability should be the Fed’s only task. But Yellen is a Phillips-curver who sees a trade-off between inflation and growth. She obsesses about the jobs market as a Fed-tightening indicator. Wrong target. Having more people working does not cause inflation. Bad money does.”
    2. How will Trump act on the minimum wage.
    The Trump stimulus theme and increase in bond yields doesn’t have solid underpinnings imo.

    • Kudlow said that?
      Well that’s a relief because the sooner we get back to sound money the better.
      Extremely low interest rates have been a dismal failure.
      Floating fiat currencies have been tried and failed for 45 years.
      Even Greenspan has admitted that the US should go back to gold(the day after Brexit).
      The article above talks about traveling the way we are now could go on for decades.. l doubt that.They’ve been pulling rabbits out of the hat since 2000…
      It’s time for a further inflationary jump in assets then the big deflation and back to sound money.
      The 45-year experiment is done.

      • WOW you think gold is sound money…. chortle….

        Disheveled…. I think you need to study the 1800s up too the advent of the Fed… that looters and rentiers can operate under both Fiat and Bimetallism standards is a feature and not a bug… so the problem must reside else where… eh…

      • You are a nice bloke skippy but you do not have the smallest understanding of the importance of sound money.
        And to even imagine that the times when politicians abused the use of sound money is some reflection on gold is preposterous.

  7. Thanks Damien, nice summary. How long can it boom before the bust? so cut my bear fund losses on the USA but keep for the land of oz?

  8. Interesting article.
    Buy US? US blue chips are expensive now, with PEs over 20, except for banks.
    Buy USD? Though that seems to be the consensus now.

  9. “Are we going back to the 1930’s?”

    Yes yes we are.
    Doubt you will understand why until it has already happened.

  10. Can you elaborate on this a bit more?

    “Low volatility investing: There is a small bubble here, quite possibly a (minor) blow up coming.”

    • Oh and by the way, you definitely need to get a handle like HnH and UE.

      Happy to give you some suggestions if you are short of ideas.