There has been a lot of news lately that has me thinking about the bigger picture of where the global economy is heading. I’ll touch on each of these separately and then tie them all together with my macro view at the end. I should say in advance that as a fiduciary of other’s money, it’s not my job to be optimistic or pessimistic or to have a certain opinion; it’s my job to be realistic and view things with an open mind for how they are. I touch on some fiscal and political points but please understand that I’m not stating my political opinion, but simply viewing the policies from an economic standpoint.
China
“Riskier” assets like stocks and commodities traded lower yesterday after news that China’s money-market rates jumped quite dramatically after the People’s Bank of China cutback on cash injections. Higher rates is one thing we must see if China is going to successfully rebalance its economy away from a debt-driven, investment led growth model. I’ve mentioned before that I believe China has already begun this process and that GDP will continually come in lower than expected. Rates in China have been held artificially low for probably 30 years now as part of this process to encourage growth through new and continued investment (at the expense of savers) but the signs of wasteful overinvestment have been showing for well over 5 years now (all the stories of ghost towns with no residents, etc.). Historically, overinvestment has always ended in either a debt crisis with a sharp contraction or a “lost decade” with little to no growth. Either way, I’m all but certain growth in China will continue to slow, putting pressure on the industries and countries that have benefitted so greatly from China to this point.
Politicians & Too Much Debt
The same issues starting to emerge in China are also plaguing just about every advanced economy in the world – namely, overbearing debt accumulated over years by debt-driven wasteful spending to benefit politicians and their agendas in the short-term with no intention of ever repaying the debt. The risk is “socialized” because the burden is absorbed by all tax paying citizens. Here in the US, we’ve been playing games with the debt since the 1990’s when Clinton decided to shorten the term structure to short-term borrowing to reduce the interest expenditures and goose up the fiscal surplus (since longer-dated bonds pay higher interest rates, you can save on interest expense by issuing a lot of short-term bills/notes instead of 30 year bonds). Ever since, we’ve been shortening the structure and continually rolling over very short-dated debt to the tune of 20% of GDP each year. This leads me to interest rates:
Monetary Policy & Interest Rates
Interest rates have been set artificially low in every major economy for two main reasons: it reduces the cost for borrowers (mainly over-indebted governments) and attempts to encourage new borrowing/investment. The issue is that low interest rates are a form of financial repression on households – it transfers wealth from the household sector to governments, corporations and banks. Yes, it has helped households by lowering the cost of a mortgage, but the negative effect of low rates on savings outweighs this in the long run. Households are effectively subsidizing the borrowing of corporations and governments, and allowing banks to recapitalize their balance sheets for free. Good for stocks, bad for households that hold their savings in cash/bonds.
We also have a new Fed Chairman starting in 2014 – Janet Yellen. Most people consider her a “dove,” meaning she prefers to utilize easy monetary policy, but we will also see a few regional presidents now serve on the board that have been openly “hawkish” members. We saw what happened this past summer when Bernanke simply mentioned that they were considering a cutback to current bond purchases. Next year should definitely be interesting in the bond and currency markets, to say the least.
Fiscal Policy
Governments never realize that when you try to control something, you typically get the opposite result. It’s like telling a kid they can’t do something. They’re just going to do it quietly behind your back once you turn around (I was one of those kids). For example, the US government has been preaching about the need to reduce the income distribution for decades. Yet today we stand at the widest gap between the top 10% and bottom 10% ever. What so many politicians fail to understand is that you can’t control the economy. The more they meddle, the worse things get. The point I’m trying to make is that every action the government is taking is going to have the opposite effect of their stated goal because self-preservation and survival of the fittest are laws of nature ingrained in humans. They want to reduce unemployment, yet they’re raising taxes, raising healthcare costs for the majority and trying to force a rise in wages by raising the minimum wage. Despite whether or not it is your opinion that these things are good or should be done, all three of these will raise unemployment or, at best, push people to part-time employees. And as long as unemployment is high, there are plenty of people available to do a job which means employers can keep wages low (good for stocks, bad for households). Europe, for example, is taking Socialism to a whole new level right now, and the effect is that unemployment continues to climb as private capital flees. It’s a vicious cycle of economic destruction.
IMF & Taxation
The IMF issued a new report earlier this month called “Taxing Times” in which it analyzes fiscal budgets of nations around the world and the “rebalancing” that needs to be done to end these annual deficits and rapid increase in outstanding debt to GDP. They propose reducing deficits over a gradual 7-year plan to 2020 and then maintain this budget for the next decade to 2030. I find these reports amusing because of how easy they make it seem. “All you need to do is X, Y and Z.” Well, most countries are still increasing their deficits beyond initial projections for 2013 and 2014. Not to mention that the IMF’s recommendations are tilted toward the revenue side – higher VAT taxes, broaden the tax base, raise property taxes, raise financial transaction taxes, etc. etc. The most interesting piece is Figure 1.3 on Page 19, which illustrates the probability that a nation will NOT reach the IMF’s medium term targets by 2030. It basically can’t be accomplished for Japan, Ireland, Spain, Portugal, Italy, Great Britain, Belgium, and France. Japan was virtually a 100% probability! USA actually scored better than anticipated.
Conclusion
Every item mentioned above will have deflationary effects, which means very low growth – the “New Normal” as PIMCO calls it. However, the sector that has benefitted the most, and I believe will continue to benefit, is the private sector. We have high unemployment because companies laid-off employees to save on expenses, and now receive the benefit of low labor and interest expense as well as falling energy costs. With the advancements in technology and governments being forced to rein in their spending, I don’t see the employment picture changing in the near future, which means zero-bound short-term interest rates are here to stay. This continues to force investors into stocks, as can be seen by pension funds that are in trouble and are being forced to shoot for higher returns by investing more heavily in stocks. The multiple expansion (valuations) that we’ve seen over the past year is clear evidence that investors are willing to pay a higher price for the claim on future earnings that stocks provide (wait longer for their return) because governments have made bonds a very troubled area to invest. This means the stock market will most likely continue higher.
Quarterly Earnings
As a side note, I’ve been very happy with this quarter’s earnings, and more importantly guidance for 2014 and beyond, from the majority of companies my clients own. This is a good sign for stocks over the next year.
Nick