The Race to the Bottom

Monetary authorities around the world are using an old playbook: lowering interest rates and the value of their currency in the hopes of stimulate growth in their region. Unfortunately, it won’t work in today’s VUCA (volatile, uncertain, complex, and ambigous) environment. 

Our blog last week, “Global Uncertainty Trumps Lower Interest Rates” was on the mark. It may be helpful to read it again. Our thesis was that there was little or no corporate demand for money no matter what the interest rate was due to global uncertainty centered around trade. Who wants to spend in today’s uncertain environment? We blamed Trump and his administration’s actions—not monetary policy—for holding back growth here and abroad. That view has only been reinforced by the key events of last week. There were continued moves down in interest rates around the world. Global growth continues to slow with deflationary forces rising. Risks remain to the downside without trade deals. 

Three major countries: India, Thailand and New Zealand, “lowered interest rates (last week) in a series of unexpected moves that shook the currency markets just two days after China allowed the renminbi to weaken” above 7 to the dollar which prompted Trump to label China a currency manipulator claiming they are ratcheting up the tensions between our two countries as well as rattling global markets. Why shouldn’t the renminbi weaken as growth in China is slowing, monetary policy is easing, and the government wants to sustain export growth? China is just using the same playbook that all countries utilize to sustain growth. Why not? And don’t forget the tensions in Hong Kong, too, hurting their currency! The key question remaining is whether the trade conflict will turn into something much larger—a currency war. If so, there are no winners. We doubt that will occur but the markets are on pins and needles worrying about one.

While we continue to believe that the U.S. is best positioned to weather the trade storm, we are growing increasingly cautious short term as we expect Trump to go to the wall raising tariffs the full 25% in the fall on all Chinese exports hoping to lower them next winter/spring prior to elections after some sort of a deal is reached. Trump recognizes that now is the time for maximum pressure on China knowing full well that the financial markets will suffer only to reverse course next year before the election if/when a deal is reached, and tariffs come down. Unfortunately, we expect that the Chinese recognize Trump’s playbook too, so they must decide whether they are better off dealing with Trump today or a Democratic president in 2021 if that occurs. Biden would take a more accommodative stance toward China than Elizabeth Warren who seems even further to the right on dealing with China than Trump. Is it better for China to deal with the devil they know or take the risk of dealing with an unknown? That’s a good question. We think that the Chinese will decide to deal with Trump in the end. And, Trump is likely to accept a deal even if not a really good one if it helps his election chances. No deal would hurt him for sure as the economy and financial markets would only continue to suffer. The bottom line is that we expect a deal over the next 6-8 months. You can easily guess what happens then to all financial markets around the world. We would use any further weakness ahead to build positions in great global companies selling at recession level valuations. We are setting up an options strategy to do just that to minimize the risk if we are wrong. Right now, we own defensive stocks with high dividend yields, super-growth companies that do not have exposure to China and many special situations. 

Our current view remains that there is no place like home, but we do see risks rising globally including in the U.S.. While our market is statistically undervalued for investors with a longer time frame, we do see rising short-term risks geopolitically that could create an unusual opportunity for us to take advantage of as we look over the valley.

We do not believe that lower interest rates globally as the race to the bottom escalates will boost global growth without trade deals.

Let’s look at the most recent data points that support/detract that the U.S. economy is best positioned to weather a potential trade storm next month if the U.S. begins tariffs on an additional $300 billion of Chinese exports. 

1.) The U.S. consumer along with government fiscal stimulus remains the bedrock of strength underlying our economy for the foreseeable future. Remember that consumer expenditures plus government spending make up over 85% of GNP and both remain in strong uptrends. The number of job openings (JOLT) remains over 7.1 million as of the end of June. The U.S. has created well over 2 million new jobs over the last twelve months with hourly wages rising well in excess of inflation at 3.2%. It does not hurt that the core PCE price index, which is favored by the Fed, increased by 1.6% in June, undershooting the Fed target of 2.0% for the 10th year. Wouldn’t you consider that a pretty good backdrop for continued growth in consumer spending? And then add that the Senate just signed off on the new budget resolution increasing government spending by well over $200 billion over the next two years increasing the fiscal deficit to over $1 trillion.

Now, do you understand why we expect the U.S. economy to continue to expand by 2+% over the next twelve months? But we do see risks to our forecast rising if the trade conflict escalates out of control. It could then clearly impact consumer sentiment which could dampen spending intentions as we enter the all-important Christmas season. Is Trump that foolish? We don’t think so! But we are watching the situation closely and hedging our bets.

We remain convinced that the Fed will lower rates by an additional 25 to 50 basis points before year-end as insurance against the potential negative impact of further global slowing, escalating trade conflicts and rising deflationary forces. Do we feel that the cuts will lead to accelerating domestic growth? Not really as it won’t change business psychology/spending intentions one bit. We do believe that the rate cuts will push investors further out on the risk curve which should be the objective/concern of the Fed.

2.) There is no doubt in our minds that growth in China is slowing rapidly despite the recent surprise export number reported last week showing an increase of 3.3% year over year reversing a negative number reported in June. Trade patterns are being impacted by the negative trade rhetoric and we doubt that China can offset weakness on exports to the U.S. by increasing them enough to Europe and Southeast Asia. Continued weakness in imports, down 5.6% from a year ago, was more telling to us and reveals the true weakness in China. China has to worry about rising deflationary forces as evidenced by a 0.3% decline in producer prices from a year ago. It is clear that China must pump up its economy by easing monetary policy further and increasing fiscal stimulus or growth will likely slow to less than 6% before year-end and employment may fail to increase which is now a real risk. That is a formula for pressure on its currency which was evident last week as the yuan plunged past 7. The currency will continue to weaken further unless the PBOC intervenes spending a lot of its reserves which declined by over $15 billion in July alone to $3.1 trillion. Problems in Hong Kong as not helping its currency for sure.

There is no doubt that China needs a trade deal more than the U.S.. Corporations continue to shift their supply chains to other countries at an accelerating rate despite assurances from the government that they will not retaliate against foreign companies.

3.) We were surprised that Japan’s second-quarter GNP rose by 1.8%. We believe that the threat of increased taxes in October has pulled forward consumer spending (approx. 50% of GNP) and may also help the third quarter results too. The 10-day holiday to celebrate the enthronement of Emperor Naruhito also boosted consumption in the quarter.  We clearly expect a sharp shortfall in spending in the fourth quarter and early next year.

We do not believe that the BOJ has must left in their arsenal to stimulate growth but at least Japan is benefitting from a stable currency. We doubt whether a trade deal between the U.S. and Japan by the end of the summer will do much improve business sentiment/spending/hiring without the U.S. and China reaching a ceasefire at a minimum.

4.) We remain very pessimistic about the prospects of the Eurozone especially with the risks of a hard Brexit rising daily. Germany, the engine of Europe, reported a 1.5% decline in industrial output in June driven by much weaker production of intermediate and capital goods than expected. It appears that Germany may report negative growth in the second quarter. What does that say about the prospects for the rest of Europe? Maybe that explains why German rates fell further into negative territory last week. Does anyone really believe that lower rates and further monetary easing by the ECB will do much for growth in the Eurozone? Nada!

By the way, growth in England has turned negative already too. And what happens if there is a hard Brexit in the fall? Lower rates by the BOE won’t do much to save England.

5.) India, the third largest country in Asia, continues to ease monetary policy aggressively to offset a weakening domestic economy but so far it has not helped one bit. Growth in India has slowed to less than 6% which is very disappointing to say the least. Inflation, here too, is running well below the government’s targets and fears of deflation are on the rise. India’s main problem is a lack of private investment as domestic demand and global growth slows. 

The common thread occurring around the world is slowing growth despite significant monetary ease. There is a race to the bottom occurring globally as each nation/region is virtually doing the same thing (lowering rates plus weakening the currency) but to no avail. Have lower rates and a weakening currency helped the Eurozone and Japan? Will China benefit if they let the yuan fall in value offsetting tariffs? Think about all the debt globally that now has negative rates and/or is dollar denominated. And what about our Fed! We doubt that lower rates and even negative real rates will do much to stimulate growth at this point here.

We are convinced that there will not be any acceleration in global growth until trade deals are finalized so that business confidence to spend is rekindled. Here us Trump and Xi!

The bottom line is that we have moved defensively in the last few weeks after Trump tweeted about the additional Chinese tariffs effective September 1st. Global growth will NOT accelerate until there is an end/cessation to the trade conflict so that business can plan/spend/hire once again. And the U.S. will NOT be totally immune either although the real impact will be far less than virtually everywhere else as our Fed has lots of ammo to spend offsetting economic weakness, our consumer remains in good shape and our government is spending way more than they should too as we enter a Presidential election year.

Lower rates globally will force investors further out on the risk curve.

Paix et Prospérité has navigated pretty darn well during these turbulent times. We sold economically sensitive companies including global industrials/capital goods producers; the financials for obvious reasons; and commodity companies. We used the proceeds to buy some utilities including telecommunications; consumer non-durables; retailers, airlines, and healthcare companies. We have maintained/increased our exposure to high growth technology companies that sell at reasonable multiples and have no exposure to China, cable with content like Comcast and Disney, and finally to several special situations with high dividend yields selling at ridiculously low valuations to earnings and cash flow. Our cash positions have increased meaningfully too.

As we said earlier, we are preparing an options strategy that would quickly shift our portfolio if a trade deal is reached.

Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do independent research and…

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC


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