CROSSINVEST: 2017 GLOBAL ECONOMIC OUTLOOK
The USA has come full circle, all the way back to Lincoln’s economic stand from 169 years ago.
Lincoln introduced protective tariffs late 19th century on the back of fear that the US was losing their momentum to cheaper manufacturers, mainly Britain. While Lincoln toyed with tariffs, Britain embraced trade agreements, kicking off a period in which global trade grew at twice the speed of GDP, and Britain.
The British Raj as a global (trade) leader came to an end post-WW1, the war effectively exhausting their capital. While the US’s momentum began during this time through manufacturing, its focus was more pinned on rebuilding the nation rather than making the most of a global leadership vacuum, leaving the world with no clear economic leader between WW1 and WW2. Global trade slipped from around 30% to just 10% of GDP. The US took over the helm after WWII, by which time they had built sufficient infrastructure, trade superiority and capital. Over the subsequent 70 years, free trade has stood as the cornerstone of the global economy. By 2008, global trade represented 60% of GDP.
The results have been extraordinary – the beneficiaries initially were only those holding the capital, which principally were the United States and then Europe and Japan, once rebuilt. Rapid increase in income levels in those countries led to a flow of capital offshore, looking for cheaper labour. This then led to a flow of benefits to emerging economies. Consequently the IMF Global Poverty Ratio tumbled from over 40% in 1980 to less than 10% in 2015, a staggering achievement. This also lead to the emergence of pockets of wealth in countries previously linked to only masses and poverty – China and India. There has been nothing sinister about this re-distribution of wealth – China and India simply doing what the British did in late 19th century and what the Americans did the better part of the 20th century. As is so often the case, however, passing on the baton of (global) leadership is not as easy as it sounds.
Passing on the baton requires leadership and maturity or the world will be buffeted about by the forces of each country’s self-interest. The baton is not likely to be passed without a fight – “how dare another country do what we have been doing for years?”
“We will make America great again”
The world has benefited significantly from globalisation and free trade whenever there has been a clear world economic superpower – free trade alone though is not enough. Globalisation spreads wealth by allowing production and capital to shift to the most efficient labour markets. Thanks to more open trade markets, the United States’ share of global manufacturing grew from 7% in 1860 to 32% in 1913 despite the US having the highest tariff barriers in the western world. Britain’s prosperity at the same time meant that it was no longer competitive in terms of labour costs and its share of manufacturing fell by 34% in the latter half of the 1800's with most lost to the US and Germany.
Inevitably that led to political pressure in Britain and an anti-globalisation movement. Similar movements started across Europe and the US. Then came WWI, the end of British leadership, and trade went sharply into reverse.
Sound familiar?
Plainly, we now risk this pattern repeating. The parallels between the UK then and the US now are obvious. The US has lost 40% of its global manufacturing share, now slightly behind China at 19% of global output. The gradual exporting of this wealth from the US, and Europe for that matter, to emerging economies will eventually create too much pain, if it has not already, for western democracies to bear without them trying to protect their self-interest.
Middle class voters in the US and Europe have seen little increase in their incomes since the 1990's, around the time that China’s manufacturing investment boom took hold. Pressure on free trade escalates during a recession when self-interests peak and so the Global Financial Crisis in 2008 created the beginning of the end for globalization’s 60-year run.
2017 TRADE WARS:
CHINA AND GERMANY WILL COME UNDER ATTACK
We may now face another ‘vacuum’ period as the US appears, once again, to be shifting back into isolationism. Globalization is under attack and in desperate need of a global leader to defend its merits. The people of the United States have voted not to be that global leader any more. They elected a president on a platform of “America First”, specifically stating that the US can no longer afford to put global interests ahead of its own. While Trump will bring jobs back home (albeit at a significant impact on overall prices and hence impact on consumers), the people of Britain have voted they want to protect their turf. Similar sentiments are being floated across Europe.
China by comparison wants to be the leader, but is it ready?
Until a clear global leader emerges, which is not likely to happen any time soon under the circumstances, protectionism and self-interest may be the order of the day. Political leaders like Boris Johnson (Brexit), Donald Trump (US), Marine Le Pen (France) and Beppe Grillo (Italy) have capitalized on anger in the developed world about their falling incomes and the impact on the standard of living. They have effectively played on “globalization”, “immigration”, “free-trade”, as the root causes of their predicament and in the process made an enemy of China, India, Mexico and any other nationality or group seen as “taking my job”, when all these countries are doing what the economic powers have been doing for centuries.
“But how dare they take what is rightfully mine?”
In a democracy, when enough people want change, they get it. And there are large movements of people led by wily, powerful politicians who are demanding anti-globalization, even though most don’t understand what this really means.
This new phase of de-globalization will likely be dominated by rising tariffs and non-financial trade barriers. Moreover, it will be characterized by global political tensions, particularly between exporters and protectionists. The two largest net exporters globally are China and Germany. Their combined trade surplus of US$760bn is larger than the next 20 countries in total. Since the start of the GFC, China has increased its surplus by a massive 280% and Germany by 107%. These staggering numbers are fuelling the coming trade attacks from the developed western world.
The case against each of China and Germany is unique but with one common element - both have been accused of manipulating the open global trade and economic system:
1. China
China’s growth model has involved controlling capital flows to force investment in manufacturing capacity and subsidising its exporters whilst erecting unfair tariff and non-trade barriers to imports, and
2. Germany
Germany has used its power in the EU to force an inappropriate austerity on its members so worsening an extended recession and helping to hold down the value of the Euro boosting Germany’s trade competitiveness. It also has refused to reflate its domestic economy, despite running a fiscal surplus, thereby limiting EU’S aggregate demand.
Trump initially singled out China as the villain - US imports twice as much from China than from Mexico and most Mexican exports are from US controlled companies such as Ford or General Electric. While in Europe, the villain is seen to be Germany with its control over the EU and the austerity measures being forced on southern Europe in particular. Then in just the first few days of Trump’s reign, he turned his attack on Germany, claiming they were devaluing the Euro for their own benefit. It is no accident that this headline-grabbing attack in turn boosts the European anti-trade, anti-EU leaders such as Marine LePen in France.
Our analysis isn't about what is right or wrong. Instead, we must examine what the likely ramifications will be for the world and for us, as investors.
CHINA
China’s Growth Model: The Recipe for Success…
Until 2009, China’s secret recipe for creating a miracle economy worked wonders:
1. Start with one billion potential workers, the greatest asset for any economy.
2. Stir in a dose of controlled capitalism to unlock the potential of that vast human capital asset.
3. Boost the savings rate by leaving social security safety nets very low.
4. Through centralised control, keep interest rates on savings accounts low.
5. Trap savings in the country in low interest accounts by shutting the door on capital flows out of the controlled environment.
6. Encourage banks to lend those same low interest funds to investment projects in infrastructure, property and factories.
7. Thereby creating more jobs for the one billion potential workers to take up, creating even more savings to pour back into the engine room.
Of course, this is grossly over-simplified. But even so it doesn't detract from our central thesis....…but things changed:
To maintain growth in the face of the collapse of the Western World’s demand for their exports, China stepped up its investment spree. Centrally controlled local governments and state-owned enterprises borrowed more than ever to fuel investment projects and China’s GDP continued at 10%+ a year. By mid-2016, China’s total debt to GDP ratio passed 250%. This was around the same level as the US and Europe, but an unprecedented level for a country of the low GDP per capita levels of China.
By 2016, US$4 trillion in new debt was required each year to keep fuelling their target GDP growth rate of 6.5 - 6.7% per annum which represented an additional 40 - 45% of GDP. And then out of the blue, along came Trump. Initially he was ridiculed, but the American people spoke and Trump won the US election on an “America First” campaign with anti-free trade as its centrepiece.
China’s growth model is facing testing times as it transits from an investment/export-led model to rely more on consumption/services. They face a difficult period as this transition takes place that requires de-leveraging, structural reform and careful balancing of GDP growth vs. indebtedness. While Trump is unlikely to get his proposed 45% tariffs on Chinese imports over the line, there is no chance he will tolerate a rise in US imports from China in his first year of Presidency. And while the US is not the only importer of Chinese goods, they are the largest and so achieving such a huge jump in China’s trade surplus while the US is trying to reduce imports is therefore very unlikely.
Is China preparing for global leadership?
Trump’s mantra is “America First”. Based on the anti-free trade bias he has built into his administration already, Trump’s strident promises to retreat from global trade agreements seem likely to eventuate.
Meanwhile, and despite China’s woes mentioned earlier, China is turning up the heat on its long-held ambitions to be the new global economic leader. Premier Xi Jinping has positioned China as a “champion of global free trade” since Trump’s election, adding to the momentum they have already built with their foreign investment strategy (“One Belt/One Road”), the Asian Infrastructure Investment Bank, its unexpected leadership in the war on climate change, and a frenzy of bilateral trade agreements in 2016. Under Xi Jinping, China has abandoned the ‘Deng doctrine’ of deliberately downplaying its strength to take a much more aggressive foreign and security policy approach, it is developing a ‘blue sea’ naval capability and is already the largest player economically in manufacturing, commodities, travel and in many consumer items from cars to smartphones.
So, despite the bold pronouncements by Trump and his team, it could be assumed that Trump would be happy to hand over the often-expensive responsibilities of the world’s economic superpower to China. And it also could be assumed given their aspirations that China is both willing and able to take it on.
So is China ready to become the world’s next economic leader?
The short answer is a ‘no’, at least not in the short term as it lacks the military power that is a requisite to be the global superpower. In addition, China’s addiction to growth at any cost means they are now too reliant on investment, have too much debt, and have fueled too much global anti-trade sentiment to allow them to export their way out of trouble, particularly with the impact of the anti-imports/buy-American mantra of Donald Trump. Tariff imposed on China is likely to hurt them (and the region) in the short term, irrespective of China’s size and GDP growth.
While we are of the view that China’s ascendancy to world leadership is not going to take place in the next few years at least, we think there is a strong chance that they might take over the helm eventually, or at least share global leadership with the USA. China’s capital markets, already the second largest equity market and the third largest bond market, is likely to take up a far greater role going forward as China opens up to foreign investors. China is already the largest creditor nation in the world with important implications for FDI and portfolio flows whilst CNY is gaining importance as it becomes more volatile.
All said and done, a leadership vacuum will remain through 2017 and is likely to have a significant impact on the global markets. Trump wants less trade and seems prepared to pick a fight in order to achieve his goals. This year will see a colossal trade battle that may spill over into financial markets and impact the real economies of the rest of the world. As Wall Street has already priced in all of the positives from Trump’s presidency, the negatives from this sort of battle may cause significant volatility for equities and commodities in particular.
Implications for Investors: China led 2017
This battle between the US and China may damage Chinese interests far more than US interests in the short term but, ultimately, will hurt USA as well. A threat China holds over the US is that they could sell off their massive US debt holdings. But that would weaken their own capital reserves, further weakening their already precarious position, so they are unlikely to do this. And even if they do, the world is awash with yield-seeking capital, so the US will have no trouble finding alternative sources of debt.
We feel that there will be no winners from this battle. Instead we are just talking about varying degrees of loss. US corporations selling into China and those buying components from China will suffer a loss of earnings that could vary from minor to devastating, from company to company. Overall, equities will fall, but the impact on individual stocks will vary. Investors should therefore take a high conviction approach. But it must be founded on a genuine understanding that this trade war, and the likely resulting damage to the global economy, will result in a range of risks which will potentially impact earnings over the next decade.
Cautious Investors might look to defend against this possible scenario by reducing Chinese assets including the yuan and shifting capital into non-financial assets such as Yield assets that are not traded on volatile markets, such as property, infrastructure and farmland, that offer diversification and a ‘hedge’ vs. ‘stagflation. Please see Crossinvest’s proposed investment strategy below.
GERMANY
The chances of an EU breakup have been constantly rising since the GFC and Brexit in 2016 simply increased the odds. The so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) are either bacon in the case of Greece or only just still oinking in the case of the rest. Even France now is suffering from massive unemployment. As a result, populism is strong and on the rise. Populist policies are calling for the end of austerity measures, to freedom of migration and, in most cases, a departure from the EU.
Populism is the result of nearly a decade of record highs in youth and long-term unemployment. 50% of unemployed people in Europe have now been looking for work for more than 12 months, compared to 18% in the US. Youth unemployment is 20% across the whole of the EU and at around 50% in Spain, Italy and Greece. These sustained, high levels of unemployment will have longer term societal impacts which will increase economic and political strain. The burden on social infrastructure is immense. And while able-bodied people are immigrating to more prosperous countries, those left behind are angry and looking for answers.
There has been as much literature about issues faced by the European economies as there has been about Germany’s economic strength. Germany is either complicit in its role in the creation and perpetuation of Europe’s issues, or has become a victim of its own success. There is no doubt that Germany has gained great advantage from its place in the EU - but at what cost to the rest of Europe?
Since 2009, Germany has improved on all metrics relative to the other major EU economies of France, Italy and Spain. In fact, so extreme is the imbalance on trade that Germany is now in violation of the Maastricht Treaty which requires that no EU member state should have a surplus of more than 6%.
Germany’s motive for stricter constraints and trade barriers within the EU are not hard to understand. When they joined the EU they had the strongest manufacturing base in Europe and they were the region’s strongest exporter. Before the EU their biggest challenge was the appreciation of the Deutsche mark which was weakening export competitiveness. As a member of the EU however, Germany participates in a currency which is weakened by the economic issues facing many of the other EU members. This has allowed Germany to strengthen their manufacturing economy and exports and while each year the rest of Europe remains relatively weak, Germany gets stronger.
This is a case made by the populist movements in countries like France, Italy and Spain. Prior to the EU, the Italian lira, the Spanish peso and even the French franc, would have suffered significant depreciation by this stage given their weak economies, rising debt and crippling unemployment rates. Yet a weaker currency would have at least strengthened their competitiveness in trade markets. But under the EU they have no benefit from a weakening currency. Worse still, they are severely hamstrung when it comes to controlling socially sensitive issues such as migration, employment laws or bailing out their banks. Under the EU structure, Germany benefits from free trade and continues to strengthen economically more than any other EU member.
All of these factors combine to strengthen the anti-EU populism movement. The longer Germany continues to push austerity onto other nations, to demand strict EU policies that are perceived as restricting other countries from mending their economies (such as the rules preventing Italy from bailing out its banks), and at the same time run their own budgets with a surplus rather than spending on infrastructure or supporting other countries in the EU, the more likely these imbalances breakup of the EU.
Our base case remains EU will stay united but there will be significant headwinds:
However whilst we have set out the possible reasons for EU disintegration our base case remains that EU will remain together over the next few years. Populist parties only command a minority of votes in most EU countries whilst polls show the majority still wish to remain in the EU and use the Euro, support a liberal culture and want open borders. Doom-sayers forget the EU was never primarily an economic construct but came about after the ruinous WW2 as a political union to prevent any future such conflict. Recent developments in Italy make it less likely anti-EU parties can win an election likewise in Netherlands whilst the odds remain Le Pen will be defeated in the second round run-off in May. Furthermore voters are aware chaos might well ensue should core-EU countries seek to follow UK out.
We are staying mostly away from Euro assets until the French election is over but should, as we expect, pro-EU parties prevail in the important elections, we see greater opportunities as the underlying economies are slowly improving, unemployment is falling and even Italy’s banking sector is being gradually recapitalized. We see greater risks for the UK should the EU remain united and Brexit proceed as looks ever more likely resulting in considerable uncertainty.
Implications for investors: Germany led 2017
Financial market volatility is the most significant result of rising EU tensions. This could be particularly dangerous at a time when equity markets, particularly in the US, are trading at high valuations. Imagine what will happen if fears continue to escalate about a possible exit from the EU of a more meaningful economy than Greece.
While few non-European investors will have a meaningful direct exposure to European assets, many hold fixed income funds that have meaningful exposures to European government debt with investors across the globe tracking the popular Barclays Global Aggregate Index of which 31% is made up of European sovereign bonds.
Whilst European bond yields are artificially low thanks to Quantitative Easing (QE), there is a risk of deteriorating credit quality coinciding with the ramping down of the European Central Bank’s QE program. If this happens, yields on many of the major EU sovereign bonds, particularly in countries like Spain, Italy and Greece, could rise very quickly causing losses for unwary investors.
Now is not the time to be investing in index-following or passive managed funds. This is true for equities and bonds. You simply will not be paid for the array of sovereign risks that exist in this strange global economic environment.
WEALTH IS BEING CREATED BY THOSE THAT SEE OPPORTUNITY IN THE ABOVE
While the world is glued to everything Trump, and despite our grim outlook for 2017, wealth is still being created. We covered this within the Crossinvest Thought Leadership series towards the end of 2016.
We are of the view that six major economic themes are likely to drive the new world economy over the coming 20 years, and therefore define the next generation of family dynasties if they are ahead of the curve:
1. Low demand could continue to mean low economic growth, despite massive monetary policy stimulus;
2. The huge debt positions that have been built up leave little flexibility to stimulate an economy, creating unpopular fiscal austerity;
3. Protectionist movement as the middle classes of the western world respond to this austerity and low employment prospects by voting ‘no’ to global trade agreements and immigration;
4. The inevitable populist politics that follows protectionist governments may favour fiscal stimulus such as tax cuts and infrastructure spending, creating inflationary pressures;
5. The volatility and pain for financial markets that lies ahead as the world attempts to withdraw from cheap leverage; and
6. The dramatic effects of the digital revolution, changing lives, destroying entire industries, and creating wealth for those that invest in the disrupters.
Taking into account the above themes, we are of the view that the core make up of a Smart Investment portfolio this year and beyond should comprise the following:
? The inevitable end to QE and rise of populist Trump-economics means inflation risk is coming back and why diversification into non-listed public assets like infrastructure, agriculture and health related investments are increasingly becoming important;
? Digital revolution, like the Industrial revolution is creating inter-generational wealth (up to 90% of wealth is being created already before a company is listed). A researched backed allocation to PE / VC in underlying themes that will define the next generational investment assets therefore is critical;
? High conviction investing, a must as equity prices remain high despite weak economic outlook.
OUR PROPOSED INVESTMENT STRATEGY – 2017 & BEYOND
For reasons outlined, we are of the view that the next few years may prove volatile and traditional risk assets might only deliver sub-optimal low single digit returns. This is an environment in which portfolio diversification has never been more important in order to protect capital and provide solid risk-adjusted returns.
At Crossinvest we recognize this need for diversification but it is also important to select the right type of investments and work with proven strategic partners to deliver these returns by matching duration to liquidity and undertaking appropriate due diligence. The timeless principles of investing govern that one should establish and build a smart, well diversified portfolio of assets that have very little or even zero co-relationship with other assets within the portfolio.
Taking into account the likely economic impact of the inevitable trade wars, the expected turbulence in Europe, and in particular taking into account the six major economic themes, we are of the view that it is critical that investors are well diversified across the following asset classes within their portfolios:
- Real Assets: As we foresee rising inflation, traditional financial assets, such as equities and bonds, may well lose out to real assets ranging from infrastructure to agriculture that are better inflation ‘hedges’ and offer diversification benefits.
- Pre-IPOs, Private Equity: Another asset class for growth investments will be pre-IPO investments through Private Equity and Venture Capital.
- Listed equities: We feel that while an obsession with equities made sense in rising market conditions, pre GFC, we need to now let go of this obsession. Listed equities are likely in for a tough year. They however look to be more attractive than fixed income in coming years within traditional assets. The key is to be selective as there will be winning countries – we favour those with solid domestic demand as USA and selective emerging markets as India, Indonesia and Vietnam – and sectors. We continue to like quality companies which can achieve growth in their own countries. High conviction stock pickers may finally win out over passive index funds for the first time since GFC.
- Alternatives: A basket of diversified alternative strategies offer low correlation and reduce volatility compared to traditional risk assets and tend to benefit in period of rising rates and opportunities to generate alpha.
- Unlisted assets and private debt: For more defensive investors seeking reliable yield as an alternative to fixed income, we like shorter duration unlisted investments into strategies as trade finance and to insurance linked securities as well as selective private debt opportunities.
We understand these forecasts are strongly worded - you have our assurance all observations, theories and recommendations have been derived from deep analysis of economic data. Most importantly, these are independent views which are not influenced by an alignment to any particular asset class, investment vehicle or asset manager.
Today the most important question is for an investor is whether to choose to follow the crowd, or be well positioned to protect their capital and benefit from the opportunities that might arise. Crossinvest has the expertise, experience and access to the full breadth of global assets to help you to build an investment strategy and portfolio.
We urge you to abandon the crowd and join us at Crossinvest (crossinvest.com.sg).
