Humanity and Adversity

Change to come for the CCP?

Adversity for some often breeds humanity in others. It was not the case last week when US Commerce Secretary suggested that the coronavirus sweeping China would help bring manufacturing jobs back to the US, and in doing so would further reset the trade relationship between the US and China.

The virus is the first major domestic crisis that the Chinese authorities have faced since perhaps, the mini economic crisis brought on by the side-effects of the global financial crisis. As such it is a policy test, and a watershed moment in the relationship between the Chinese Communist Party and the people it governs. In this respect, China may join other large countries or regions where the social contract between the people and those who govern them is being severely stressed.

In the UK, the social contract has been left in tatters by Brexit, in the US the idea of the ‘American Dream’ is undercut by falling human development rates and stark inequality, while in Europe there is general confusion on the part of the grass-roots as to what ‘European values’ are in a tangible sense. So far, Asian countries have done better here, Japan is an example.

China’s social contract, which uncharitably could be referred to as a Leviathan one, is simply put, an exchange of liberty for prosperity. It has held over the past thirty years, largely due to the prosperity and startling physical infrastructure development that the CCP have engineered and very tight political control. To date, most policy challenges have been met with success, to the extent that a long article in the New York Times in 2019 referred to China as the ‘land that failed to fail’.

Given the tragic human cost and the consternation that the coronavirus is causing, there are reasons to think of this as a watershed of sorts for policy in China.

One is that the spread of the virus may highlight the limits of high economic growth in China. The intensive movement of people within the country, urbanization and a hyper connected transport network are economic assets, but also pose risks. In his book ‘How Nature Works’ the Danish physicist Per Bak likens socio-economic systems to piles of sand.

The sand piles can continue to build until, upon the addition of a marginal amount of sand, they collapse. Similarly, cities and nations grow until that growth produces side-effects (the health scares in the rapidly urbanizing London of the mid 19th century that gave us the engineering genius of Joseph Bazalgette, are another example).

There will be many side-effects of the virus crisis. One may be an economic stimulus program that is focused on upgrading healthcare infrastructure and health related education in China.

Another aspect is diet. One of the first thematic investment notes I put together (some ten years ago) was on the topic of ‘Feeding Asia’, or rather how diet in countries like China would come to resemble that in the West and as a result how demand for dairy products, fruit, meat would go parabolic (it did for a while).

This particular crisis may see another step change in diet in China, toward – and I am speculating – synthetic meats, a stronger tendency towards organic foods, greater demand for seafood related foodstuffs and for vitamins/food supplements generally.

Two other related areas are worth thinking about. The first is how this crisis reflects on China’s ‘Leviathan’ approach to government. Has technologically enabled central control of society allowed the authorities to prevent the spread of the virus? Or will this episode begin to sow doubts in the minds of Chinese in the government’s ability to safeguard them. Relatedly, China’s social media networks have both spread alarming scare stories, whilst at the same time served to coordinate people and facilitate remote family get-togethers over the holiday period.

Concomitantly, the crisis will serve the interests of those factions within the Communist Party who on one hand argue for greater central control of Chinese society, versus those on the other who argue that the next phase in China’s development is, like the USA in the 1930’s, to deepen its social welfare system. As such, it will deepen the numerus rivalries and factions within the Party.

Finally, more broadly, a few weeks ago (‘Peak Markets, Peak Trump’, 12 January) I wrote about markets ability to coldly appraise the financial impact of events. They are doing so again now with the coronavirus crisis, though it seems to me that markets are primarily pricing the cost of firm’s reactions to the crisis (i.e. cancelled flights, disrupted supply chains).

Economically sensitive assets – government bonds, copper, oil are all much weaker, and in particular emerging market currencies look vulnerable. I suspect that volatility will continue to spill over to stocks, at least till we are in mid February. ‘Peak Markets’ ay have been the right headline after all, I still wonder about ‘Peak Trump’.

Have a great week ahead,

Mike

Peak Stocks, Peak Trump?

Only way is up

I recently gave a ‘Levelling’ related talk in Paris, where one of the points I made related to the way in which markets and finance have dominated our lives. I am often sensitive to the way markets are discussed in France. In contrast to the USA, where markets are seen as a source of wealth and to a degree, a part of American culture, in France, the opposite is the case.

This, in my view has something to do with France having a much longer economic history (August Landier and David Thesmar’s book ‘Le Grand Méchant Marché is worth a read on this point), and therefore more financial crises, than the US. Indeed, when John law was blowing up the French economy, the US was a ‘frontier market’ and colony of King George I.

One perspective on markets that I think interesting is they way they act as laboratories, signalling the impact of real-world events and economic policies. Markets can be brutally honest in this regard, pricing the effect of tragedies, wars and economic blight in an unsentimental way.

Some recent market behaviour has been revealing. For instance, the price of soya beans fell once the US and China signed their ‘trade’ deal. The drop in soya bean prices likely reflects a very sceptical view on the quality and enforceability (specifically that China would buy large amounts of US agricultural produce). In my view, this scanty deal only serves to provide the President with some politically helpful headlines, eases the stress on the Chinese economy and, profoundly underlines the fracturing in the relationship between the two countries.

In contrast to weakness in agricultural commodities, there are other market price moves that tell us little about the real economy, but a lot about how the plumbing of markets works. The recent, rapid rise in the price of Tesla stock is a case in point (the value of the company has doubled in the past six months and its equity value is worth more than the likes of Volkswagen, who produce far, far more electric cars). The rise in the value of Tesla tells us little about the health of the car market (modest in the US, weaker in Germany and China), but a lot about investor behaviour and the state of banking.

First, in terms of investor behaviour, by October of last year there was a sizeable community of investors sceptical that Tesla would ever become a profitable business. This set of investors had established large ‘short’ positions in Tesla stock. However, as markets rose, they were forced to cover or buy back these short positions, pushing the price ever higher. Anyone who thinks the sharply rising price is an indicator of Tesla’s future is mistaken, it is simply a function of investor positioning.

Another reason for the hubristic move in Tesla stock is that the federal Reserve has been infusing markets with more liquidity. There was a time when earnings, corporate strategy and good governance were determinants of stock performance. Today, in the USA at least, it seems that liquidity is the pre-dominant driver. In the aftermath of the global financial crisis, the banking system has changed in that the nature or species of participants in lending markets has become more diverse.

Hedge funds, private investors and asset managers now participate in lending marketplaces that were once the preserve of banks. The other change is that regulation has pushed banks to have smaller balance sheets, so to that end they are less sizeable players in many corners of financial markets.

At the same time, the amount of debt in the world has ballooned. The effect of this debt load, the changed composition of the banking marketplace and the refinancing pressures it puts on the marketplace is that the Fed now needs to lubricate the wheels of capital markets more often.

As it does so, it adds fuel to speculative fire, which in recent weeks has taken many measures of risk taking to extremes (Tesla’s rise is one example). Regular readers will know that I hold central banks guilty as charged for encouraging people to take on, rather than calibrate risks.

One upshot of this is that strength of the stock market is being used as a self-marketing tool by President Trump (in a recent note I commented that the number of his stock market specific tweets had increased sharply since November). Trump also loudly eggs Fed Chairman Powell on to be more accommodative. As such the Fed is now losing credibility, in a way not seen since the mid 1970’s, and it is entangling itself in asset prices in a way that will compromise it and the US economy.

As for President Trump, the potential near-term peak in equities might mean we have seen peak Trump, especially given the commencement of the impeachment hearings next week. His approach is that of a classically short-term property speculator – take on debt, pump up the value of an asset and then try to sell it. As he does so he is mortgaging the pensions of future generations, and potentially, his next four years in the White House. The stock market is due a correction, and so is Trump.

Perhaps someone, even in Paris no less, will write a book called ‘Le Grand Méchant Président’.

Have a great week ahead,

Mike

Tall Tales

What’s the story?

When Robert Shiller won the Nobel Prize for Economics in 2013  (shared with Lars Peter Hansen and the great Eugene Fama), I recall being particularly pleased for him. He is, rightly I suspect, a skeptic of the antics of financial markets, having twice called the top in market bubbles (dot.com and housing crisis). He coined the phrase “irrational exuberance,” which was used to powerful effect by Alan Greenspan.

Then, famously during the dot.com crisis, he was derided by many in the financial community and on CNBC for his pronouncements that markets would collapse. He handled himself with grace and had the last laugh. In addition, he is an economist with a practical interest in markets and asset prices, and many of his housing and stock market metrics are now widely used.

Well before academics shared data publicly, Shiller made his long-term market valuation series available on the internet. This open source approach is perhaps one of the reasons why his long-term data is now widely referred to. The key metric here is what is called the Shiller P/E (price to earnings ratio) or, as he himself puts it, the CAPE, the cyclically adjusted price to earnings ratio. What this essentially does is normalize earnings across the economic cycle.

The CAPE is now at a level only previously reached in 1929 and 1999/2000. We know what happened next in both of those cases. This doesn’t seem to worry investors, largely because the market narrative is built around the notion that ‘a trade deal will be done any day now’ and that the Federal Reserve will continue to dose markets with liquidity.

Interestingly, the idea of the macro ‘narrative’ is the focus of Shiller’s most recent work (he has a book out entitled ‘Narrative Economics’ as well as several papers on the topic). Essentially, he investigates the ways in which we (households, investors, economists) tell stories about the behavior of economic events and market trends. I would argue that ‘The Levelling’ is a narrative on what is happening to the old world order and on how it would evolve.

Shiller’s ‘narrative’ based strand of research is not new. Pop economists have for a long time made sense of the world by coining understandable terms like ‘white van man’, and for an even longer time, stockbrokers have told stories around stocks and markets, and their clients have readily swallowed these stories.

I tend to classify the spectrum of the finance industry as having two ends – storytelling and quant. Story tellers are not good quants, and quants are not good storytellers. What is interesting now is that quant, be it through the provision of new and better datasets, is providing the narrative ammunition for storytellers to tell more elaborate, and possibly convincing, macroeconomic stories.

Storytelling is also a neat way of bunching together the various trends in markets. For instance, there is a notable divergence between what we might call drugged assets (assets that are under the spell of central bank liquidity) such as the Dax, quality corporate bonds, euro-zone debt and the S&P 500 index, and those like emerging market currencies, some commodities and crypto currencies (see last week’s missive) that do not have the outright benefit of central bank asset purchases, and that as a result tell a cleaner picture about the relatively weak global economy.

As we head into December expect many to continue the narrative that central bank liquidity will suppress volatility, and I suspect that in general this narrative will continue to hold into 2020.

One narrative that may pick up pace, is the idea I explored a few weeks ago of ‘Demonstration Contagion’ (link). Under this narrative, the panoply of protests around the world are both distinct and have common perceived causes such as inequality and climate damage. In particular, events in Hong Kong cut across many of these issues, and there is a great deal at stake economically and politically.

The new developments are that President Trump’s (by the way Shiller describes him as a ‘master of narratives’…Shiller is a master of irony) signing of the Hong Kong Human Rights and Democracy Act and the overwhelmingly pro-democracy tenor of last week’s council elections in Hong Kong, provide two threads to tie events in Hong Kong to the trade dispute between the US and China, and to January’s Presidential elections in Taiwan.

As such, protestors in Hong Kong have every incentive to continue to protest, and the Chinese authorities cannot but feel more uncomfortable. As crowds in Hong Kong this weekend hold aloft the image recently tweeted by Donald Trump of his head superimposed on the body of ‘Rocky’, the Demonstration Contagion narrative is only just warming up.

Have a great week ahead,

Mike

Is Trump Hoover?

Herbert Hoover in better times

Over a week ago I penned an article for Dow Jones/Marketwatch where I predicted (note that I only use this verb after the event) that the recent rate cut by the Federal Reserve would mark the top for equities. The subsequent volatility, and of course last week’s missive on the yuan, prove me to be a financial market genius.

More seriously, recent volatility is a reminder of the fragility of investor behavior and of the risks lurking in the global economy. On a longer scale, as we approach September, they are a reminder that while the global financial crisis of 2008 did not quite end in an economic depression, neither has it produced a true economic renaissance. Many of the factors that caused the crisis in the first place—indebtedness, corporate risk taking and poor governance—have simply been in abeyance, hibernating, and are now again emerging into the daylight.

One consequence of these persistence economic fault lines is that we are in a political depression. In this light, some respected commentators—notably, Madeleine Albright in her book Fascism: A Warning—draw parallels between political figures today and those of the 1920s and ’30s. Recent events in the US, and comments by the President reinforce the parallel.

In ‘The Levelling’ my intention is to avoid the gloomier comparisons with the 1920’s/30’s, but the deepening trade dispute between the US and China makes them inevitable. One reason that President Trump has been eager to push the Federal Reserve to cut interest rates is that he ‘doesn’t want to be the next Hoover’.

Other commentators have already been making this comparison with Herbert Hoover (President from 1929 to 1933). Paul Krugman recently wrote that the level of tariffs applied by the Trump administration is now close to that of the Great Depression.

Hoover was different to Trump in that he distinguished himself in various ways, notably in his humanitarian work in Belgium with the US Food and Drug Administration, and in Central Europe in the aftermath of the First World War.

In other ways, he has several things in common with President Trump: German/British parentage, a business background, and a mastery of new communications channels, in Hoover’s case the use of radio (rather than Twitter) to reach voters and the introduction of the press conference as a regular political event.

Furthermore, the trade dispute between the United States and China has excited commentators who fear that Trump may repeat the mistakes of the Hoover government. Even the Wall Street Journal editorial team warned last year that the Trump trade team is like Senator Reed Smoot and Representative Willis Hawley, promotors of the disastrous 1930 Smoot-Hawley Tariff Act. The same newspaper now talks of a ‘Navarro Recession’, in honour of Trump’s trade adviser Peter Navarro.

 The Act aided and abetted the onset of the Great Depression with the introduction of tariffs of up to 60 percent on twenty thousand types of goods imported into the United States. The net effect of the Act was to squash any hope of an economic recovery in the aftermath of the Great Depression and to cut world trade by 33 percent.

In addition, readers might tremble to know that Hoover took office with US equity valuations at very high levels. Robert Shiller’s excellent database highlights that the US market’s price to earnings ratio was at 32 in January 1929 (the highest it reached was 44 in December 1999) and that it reads 29.5 today, which is 75 percent higher than the historical average of 16 and thus puts the market in expensive territory from a valuation standpoint. Eight months into Hoover’s term the Wall Street Crash occurred, and the United States lurched first into recession and then into the Great Depression.

Whenever the market wobbles as it did last week, some investors revisit the ‘Great Depression’ hypothesis, and many others point to a coming recession. For my part I am sticking to my cautious line for a number of reasons.

First the trade war is a reminder of the many policy risks in the world (widespread negative yields are another pointer), and of the fact that as growth slows, countries will squabble more over the crumbling pie of globalization.

Second, moves in other asset classes than equities – government bonds, even corporate and high yield bonds and particularly commodities are bearish

Third, the world is becoming more fractured. South Korea and Japan are locked in a trade dispute, and there is a growing risk of some form of confrontation between India and Pakistan. Do not of course forget events in Hong Kong, and the untethering of the yuan.

With lots to watch, have a great week ahead,

Mike