Goodbye BWII

The following article is from my colleague, Dr. Michael Dooley. It lays out our current macro thesis driving markets, and underpins our investment thesis. I'd welcome differing views here!

Dr. Michael Dooley

August 3, 2020

For equity investors deploying a top down macro strategy, persistent outperformance is driven by thematic insights about the real economy, financial markets, fiscal and monetary policy, capital flows, and behavioral considerations. Macro themes can be cyclical or secular and tend to play out over a period of months or years. This piece will be the first of several detailing our long time horizon view of the international financial system: its organization and guiding principles over the last 30 years, what may be changing now, and our view over the next decade.

International financial systems emerge as responses to the political and economic constraints of the time. Our view is that the most important events in the post-World War II world economy were the reindustrialization of Europe and Japan following World War II and the industrialization of China and other emerging markets after 2000. In both instances the main driver was a rare political consensus that allowed a relaxation by the United States of barriers to industrialization in war torn Europe and then China and emerging markets. The political climate encouraged both the export of industrial capital and know how from the US and the opening of US markets to Japanese/European and later Chinese/emerging market industrial output. For a more detailed description of the globalization dynamic post 2000, which we call the Bretton Woods II (BW II) framework, please see: An Essay on the Revived Bretton Woods System.

The development strategy of China (and the rest of emerging Asia) and the choices they made to mitigate the shortcomings of the strategy determined the patterns of net flows in both goods and capital since the early 1990s. These patterns, namely China as the hub for an immense offshore supply chain created to supply consumer goods to the U.S. and as provider of capital to finance the latter’s immense trade deficit, led to winners and losers. Notably, emerging market equity drastically outperformed US equity in the 2000s. However, after the Global Financial Crisis there was a large retrenchment in global trade. As China has grown, the applicability of the development strategy has diminished and we have not seen China’s current account surplus return to previous levels. This decrease in global trade, and China’s part in it, has not been good for emerging market equity over the last decade.

Figure 1: A tale of two decades. MSCI Emerging Markets Index and the S&P 500 total return, rebased to 100 at the beginning of each sample. Source: Bloomberg

The political consensus behind what is often called globalization is in full retreat in the United States and other industrial countries. While the Covid-19 pandemic has rightly captured our attention in recent months, we believe that the radical shift away from globalization will be the more fundamental driver of winners and losers in the years ahead. The US presidential election in November will determine the pace of change but will not generate a return to the BW II framework. On a secular level, then, this portends relative underperformance in those markets dependent on international trade and continued relative underperformance in emerging markets.

How to reduce poverty

Economist Arthur Lewis won the Nobel Prize for his work on economic development with “unlimited” supplies of labor. The mechanism was clear for policymakers in developing countries: move labor from subsistence agriculture to manufacturing. This results in sustainably higher wages (and wage growth) as these workers combine their labor with machines to produce significantly more output each hour. With higher wages, there can be improvements in healthcare, education for children, and public infrastructure (due to increased tax revenue). Over several generations these improvements lead to an increase in wealth across the economy and graduation from developing country status to developed. 

There was one small problem, as Lewis discussed in his Nobel Lecture and we discussed in an earlier paper with coauthors. You need someone to buy the goods that are being manufactured in order for the process to work. Developing country consumers are not wealthy enough (yet) to purchase those manufactured goods; they must be sold to wealthier consumers in developed countries (i.e. exported).

When developed countries were growing quickly and unemployment was low, this process worked well. However, once growth slowed and unemployment began to rise, policymakers in those developed markets did what was necessary to shift consumer purchases back to domestically made goods, shutting out foreign producers through trade embargos or costly tariffs. This clamping down of developing country exports prevented most of those countries from reaching anything resembling escape velocity to sustainable, domestic-led, economic growth.

Figure 3: The Low-Income Trap: Here presented in relative terms. In theory capital-poor developing nations should be able to grow quickly as they adopt technologies widely available. In practice, not so much. Source: FRBSTL and sources cited therein.

Enter China and The Revived Bretton Woods System

China, however, found a unique twist on the Lewis Development Strategy. They, and other Asian countries following a similar growth strategy, allowed developed market capital to invest and participate in the immense profits created by pairing their low-cost supply of labor with ever more productive capital. By giving developed market capital skin in the game, they ensured a voice in Washington D.C. would be there to push back against tariff and trade restrictions as demand for manufactured goods, and therefore demand for manufacturing labor, shifted from the U.S. to China. Thus, China solved the problem of political economy discussed by Arthur Lewis above and for a long time there was no political response to protect U.S. labor.

Still, there were other constraints. To absorb such a large workforce and truly graduate to a first world country, China required exports to grow exponentially. But export markets could only grow so fast. China needed American demand for its products to grow significantly faster than American incomes were growing. The answer then, was for China to finance U.S. consumption. At an aggregate level, the U.S. consumer purchased goods and paid for them with Treasury bonds. Any traditional macroeconomic analysis would suggest this could only go on for so long. After all, an entity (whether a corporation or country) can only issue so many IOUs before it becomes impossible to pay back. The absence of enforcement mechanisms in sovereign debt make the situation even less tenable (or so we thought!). China, however, was not assessing risk using the same calculus as other lenders.

Figure 4: Current Account as % of GDP for China and the US. The large current account surplus in China was mirrored by a large deficit in the U.S. Source: FRED

Labor is not truly unlimited, and as demand for Chinese manufactured goods grew so did the wages required by Chinese labor. Unchecked, the increase in wages would make Chinese goods more expensive than those from other exporting nations. To counter this, China kept its exchange rate undervalued and goods artificially cheap. How did it keep that exchange rate cheap in the face of strong external demand for its currency? It printed more yuan. What did it do with the yuan it printed? It bought U.S. Treasuries.

Figure 5: China’s international reserves, overwhelmingly U.S. Treasuries until recently. The result of both their large current account surplus and exchange rate policy. Source: FRED

After having solved the political problem of export led growth through FDI, China was then able to solve two economic problems (grow demand for its products faster than income growth in the destination market and remain competitive as labor costs rose) by pegging its exchange rate at an undervalued rate and essentially lending the dollars it bought as a result of its peg back to the very consumers who were buying its goods.

The Result

1.    Low real interest rates in the US and thus worldwide: good for asset prices (crisis excluded of course!).

2.    Relative economic outperformance of emerging markets that were part of the global supply chain.

3.    Stagnation of wage income in industrial countries.

One and three above contributed to the redistribution of income in the US to rich from poor and in turn a rise in the populist political climate, reinforcing a move towards diminished world trade that had begun during the financial crisis and China’s gradual (extremely!) move away from export led growth.

In the next post in this series we will go into more detail on the breakdown of the BW II framework, the rise of populist political movements, and implications for various regions and countries.

The content of this post is for informational purposes only, and should not be construed to provide tax, legal or investment advice, nor does it constitute an offer to sell, a solicitation of an offer to buy, or a recommendation for any security, portfolio of securities, or investment strategy. The author of this post may, directly or indirectly, have or may acquire a position or other interest in stocks or sectors that are mentioned in this post, or may take positions that are different from the views expressed in this post.