29 Jan 2020
2020 and Beyond
Happy New Year and the WealthMaker team wish you are very successful 2020.
As you will be aware we spend a lot of time considering global macro-economic and geo-political factors and what those mean to investing. This newsletter is longer than normal because we see a lot of factors in play and its important to provide some explanation and context.
Geo-political and global economic environment
Global interest rates are very low (money is free or as Ray Dalio of Bridgewater recently said “cash is trash”) and central banks are boxed in. They can’t significantly increase rates to historical normalised levels or decrease rates as they are close to zero or in some cases negative (after adjusting for inflation). So for the foreseeable future rates will remain low. The Price Earnings Ratio on the S&P 500 index is around 19 which is historically expensive, but not so when viewed on a discounted cash flow basis against the 10 year US treasury. Does that mean that equity markets may go higher? Possibly, if the US economy continues to perform and business confidence remains high and Trump’s proposed tax cuts 2.0. Interestingly, historical analysis shows that after a high performing return year, the S&P 500 index the following year does well again.
China and US have signed a phase 1 trade deal which I believe Trump needed more than China, as it is a Presidential election year. The announcement came with a lot of hype and without substance, as tariffs remain in place while the Chinese have committed to possibly increasing their purchases of US farm product in 2 years’ time. Simply, no change in the current situation where the average tariff on imported Chinese goods continues to be 20% when before the trade war it was 3%. Furthermore, the World Trade Organisation now has no dispute resolution process because Trump has refused to appoint a new US representative.
The Middle East and in particular the tension between Iran and the US could lead to a formally declared military war which is the last step in their current undeclared cyber/economic and proxy wars. The US will need to determine whether it really wants to be in the Middle East, as Arab/Persian countries have found a rallying point in asking the US to leave the Middle East.
In the short term the British economy will be negatively impacted by BREXIT, as the EU have made it very clear they will not allow Britain to be “half pregnant” in regards to leaving. Fortunately, for the UK, they never joined the monetary union, so the pound can adjust (devalue/revalue) as required, although with most countries wanting lower value currencies this may be easier said than done. This is particularly so for the UK because of the of QE program being undertaken by the European Central Bank.
US and global economy
Trump needs the US economy to be booming to improve his re-election prospects. It is important to remember that the US and China combined make up about 35% of world GDP and there is a global economic shift to Asia (including India) happening. For example, about 25 years ago the Chinese per capita income was about USD300 per annum, it is now around USD11,000. The same trend is occurring across Asia and notably India. As we all understand this transition will take a number of years to play out.
Trump has indicated that they are working on tax cuts 2.0 which are focussed on the middle class. These will also improve his chances of re-election although the great wealth divide in the US may produce a surprise Democratic candidate, and this time some swing voters will not be voting against Hillary Clinton, as they did in 2016.
The US budget deficit is increasing and is now running at about USD1 trillion per annum (or 4.7% of GDP which is double its historical average 2.9%) and on an accumulated basis about USD23 trillion. The growth in US national debt is significantly greater than growth in nominal GDP. If the US Government (fiscal stimulus) and US Federal Reserve were not expanding US national debt there would be negative nominal GDP. The US Secretary of the Treasury, Steve Mnuchin says that he believes that the US economy will grow to fund the debt (and tax cuts V2.0) and that they are looking at launching a 20 year bond as part of this exercise. The question is will the rest of the world notably China, Arab countries and Japan continue to support the US deficit at the same time that the US Federal Reserve adopts policies to fund it that could impact on the value of their holdings?
So where is the bubble?
Sovereign debt where central banks are undertaking quantitative easing and government debt is negative yielding (Eurozone and Japan). Why would you buy a negative yielding asset? It may take 10 years to fully understand the implications of QE which has been going on for over 10 years.
In September 2019, the US Federal Reserve was forced to intervene in the US repo market (overnight interbank deposit/lending market) as there was a liquidity event as arguably the market participants no longer accept the US Federal Reserve interest rate settings. The intervention has resulted in an expansion of the Fed’s balance sheet back to near end of QE levels. Does this mean that interest rates must rise? (see point above on foreign investors continuing to support US debt).
With the high levels of US corporate and OECD sovereign debt there must be a pick-up in global growth, as secular dis-inflation forces will more than compensate cyclical inflation forces. The yield curve continues to switch between normal, flat and inversion. Arguably it would be inverted, if it was not for activities of the US Federal Reserve. An inverted yield curve is an indicator of a future recession.
The Impeachment trial appears to be going down party political lines, so Trump at this point in time appears very unlikely to be removed from office. This matter will likely haunt Trump and the Republican Party for many years as evidence will leak out blotting their legacies.
As outlined on many occasions we see Australia as a yield play with growth coming from overseas markets and themes, as our investment approach is macro economically based. We will continue to diversify across asset classes and economies while identifying themes, e.g. robotics, cyber security, etc. that reflect structural economic changes.
If you wish to discuss the above or any other matters, please feel free to call us at +61-2-9233-1111.
All the best for 2020!