23 Sept 2020
Global Macro-economic and Geo-political Update
Prior to the end of the last financial year we undertook portfolio re-structuring. The driver being capital protection given the global economic uncertainty.
At the heart of this decision was reducing your exposure to equities. Of course in hindsight we recognise that this meant you have not fully ridden the recent stock market rally. A closer examination of the rally reveals that the increase in the S&P500 index has been driven by the FANG stocks, i.e. Amazon, Google, Netflix, Microsoft, Apple and Facebook whose Price Earnings ratios are at extraordinary levels. These companies make up 25% of the S&P 500 index up from 16% in March 2020, and their market capitalisation is greater than the whole German equities market. The rest of the stocks comprising the S&P 500 index have fallen over the same period.
For the first time ever in the week ending 18 September 2020, US derivatives markets (call options) was driving the equities (physical) markets. This shows that the equities markets are currently highly speculative.
The stock market boom has been driven by central bank activities, while at the same time Governments have been “bridging the income gap” through fiscal policy initiatives like Job Keeper. Despite this unemployment is still around 6.8% in Australia; whereas in the US there are 30 million folks out of work.
There are a few critical issues that are upmost in my mind:
US Presidential elections
US national debt and budget deficit
Will there be inflation? And if so what steps should we take?
China/US power struggle
US Presidential Elections
Regardless of whether Trump or Biden wins, it is likely that the Republicans will continue to control the Senate, unless there is a landslide to Biden. The Democrats shouldcontinue to control the House. With the divisive nature of US politics at the moment, it is unlikely that the national debt problem ($27 trillion and growing) will be addressed through increases in taxation. So the US Federal Reserve (Fed) is addressing this issue by inflating the value of the debt away.
US National Debt and Budget Deficit
When Trump took office in 2017, the US National Debt was just under $20 trillion. Today its nearly $27 trillion and growing, as further fiscal stimulus between $1 and $3 trillion is being considered by US Congress. The US National Debt/GDP ratio is now 136% and increasing. In 2000, it was 56% and 1984 it was 35%.
Comparatively, Australia’s National Debt as a percentage of GDP is about 50%, and also increasing as the budget deficit blows out.
The Trump tax cuts increased the US budget deficit to nearly $1 trillion in FY 2019 (ending 30 September) and it is expected to be around $4.5 trillion for FY 2020. With record unemployment, the US budget deficit is likely to increase further adding to the National Debt.
Who funds America’s lifestyle? China. See comments below on China reducing its holdings of US treasuries.
Will there be inflation?
Firstly, it is important to understand inflation. Everyone normally thinks of increases in the Consumer Price Index (CPI) as being inflation, where the CPI measures price increases of a basket of products. Inflation can also be created when money supply growth increases faster than economic growth. This is what central banks are trying to do at the moment.
The Fed has clearly stated that it wants inflation as the economic system is built around it; however through globalisation and technology we have seen deflation, i.e. your purchasing power is increasing, e.g. costs of laptop computers today versus 5 years ago in many products over the years.
So if the Fed wants inflation what does that mean for Australia? As the USD is the world’s reserve currency the US can export inflation and we are seeing this with the AUD appreciating in value against the USD. Since March the AUD/USD exchange rate has increased from 55 cents to 73 cents. The increase in value of the AUD means that imports are cheaper in AUD terms, and as yet we have not seen price inflation showing up in CPI or money supply figures. We do not anticipate wage push inflation because of the high unemployment rate.
At this stage we do not see inflation in the US being at 1970s levels. Rather with zero or near zero interest rates and based on the Fed statements we expect inflation (if they can achieve it) of 2% plus, although it is important to note that for 10 years now the Fed has trying to generate inflation, without success. This level of inflation is hard to identify as it is not readily apparent in price changes.
Importantly the RBA is the only major central bank in the world to rule out negative interest rates. The Bank of England on 18 September 2020 indicated again it was seriously examining this option. With negative real rates in Japan and the Eurozone, and the RBA holding out we see this as a positive (in the short term at least) for holding Australian Government Bonds even though there is yield curve control being practiced.
We understand that holding bonds when there is inflation is not a sound investment strategy. So rest assured if we start seeing increases in inflation coming through in official figures we will take steps to move out of bonds into stored value investments, including gold and other precious metals, inflation linked bonds, equities and property.
China/USA Power Struggle
History is repeating itself where an emerging power (China) is challenging the existing dominant power (US) in 3 areas. There is a trade war, intellectual property war and there is a geo-political war. Hopefully, there will not be a military war, although historically there is a strong possibility this could occur even though both parties have indicated they do not want one.
Nearly 45% of world trade is between China and the US. Full disengagement is not possible in the medium term and it certainly will be inflationary for the US to move supply chains back to the US or to other countries.
China is the second largest holder of US treasuries and they have said they will reduce their holding from USD1.3 trillion to $850 billion. This is China saying it will no longer fund the US “credit card”.
On the Geo-political front China/Russia/Iran who are all under US sanctions are teaming up to create their own trading bloc outside the US monetary system (SWIFT). China has made no secret of its long term desire for the Yuan to be one of the world reserve currencies. USD being the primary, then Euro and Yen. There are second tier reserve currencies being CHF, CAD and AUD. Importantly, China gets energy (oil) from Russia and Iran which are two of the world’s largest oil producers and it aids with its Belt and Road Initiative.
On a Geo-Political level, analysis shows that historically Iran has pivoted to the “west”, however US sanctions are pushing Iran to the “east” and in the long run this is not in America’s interests.
As usual if you wish to discuss this article or any other matter please feel free to reach out.