wknd notes: Insights into Trump Policy

“Do you solemnly swear you will do impartial justice, according to the Constitution and laws, so help you God?” asked Supreme Court Chief Justice John Roberts, presiding over the 3rd impeachment trial in US history. All one-hundred senators stood and said, “I do.” And so began the formal end to American’s faith that their politicians are capable of either impartial justice or upholding solemn oaths. 

Overall: “Conventional economic models ignore how Trump’s tariffs boost investment and national security,” wrote Peter Navarro, the President’s Director of Trade and Manufacturing Policy. His Jan 13th WSJ opinion piece, like most things Navarro publishes, provide real insight into Trump policy/thinking. But Navarro is an annoying hothead, so most people dismiss him. I’ve condensed his piece: “Critics of Trump’s transformational trade policies continue to insist that the tariffs are hindering rather than helping the boom. Yet with each new tariff the economy remains robust, wages continue to rise, and inflation stays muted. Tariffs have spurred growth, not hampered it. Why have the gloom-and-doom forecasters been so wrong? The errors come from flaws in traditional economic models. Anti-tariff analysts typically rely on static ‘partial equilibrium’ models. While a tariff on steel might boost employment in that industry, for example, the price of steel would rise for car makers downstream, which would then suffer lower production and fewer jobs. Each tariff shrinks total employment, depresses wages, and increases inflation—or at least that’s how these forecasts typically go. Yet what is missing from these forecasts is a ‘general equilibrium’ analysis of tariffs, which would assess the whole economy, with a concomitant ‘dynamic scoring’ of their effects, to account for the new investment tariffs induce. Over time this tariff-induced investment, along with lower taxes and sensible deregulation, will boost growth and job creation. Higher domestic production will also help offset any price hikes from the tariffs. Trump’s imposition of actual tariffs has made the threat of tariffs more credible, and a variety of tariff threats have borne robust results. In addition to missing the upside of supporting American industries, critics overlook the ways the US has suffered under open trade. Expanded trade with China in the 2000s contributed to the loss of tens of thousands of American factories and millions of manufacturing jobs and the hollowing out of many communities. What followed was an associated rise in the rates of divorce, drug addiction, crime, depression and death, particularly among blue-collar men no longer able to support their families at a decent wage. The national-security externalities associated with Trump trade policy may be even more consequential. A case in point is the tariffs being used as leverage to defend America’s technological crown jewels from being forcibly transferred to Chinese companies—from artificial intelligence, robotics and autonomous vehicles to quantum computing and blockchain. These industries comprise the core of the next generation of weapons systems needed to repel threats from rivals like China, Russia and Iran. One must ask the anti-tariff forecasters: Where are the benefits of a freer and more secure American homeland counted in your models? An honest, modern analysis of the Trump tariffs would acknowledge the widespread market distortions that currently disadvantage American workers, parse the complex ways tariffs affect trade partners’ behavior, appropriately discount short-term price impacts, and dynamically score the many long-term positive effects.”

Week-in-Review (expressed in YoY terms): Mon: Chinese renminbi strengthens to 6.900 on trade optimism (+1% YTD), China/US to restart semi-annual forum to discuss economic policy, Iranian anti-regime protests turn violent, Saudi’s sell additional $3.8bln of Aramco shares, Russia reportedly hacked Ukraine’s Burisma (allegedly looking for dirt on Biden), Jordan’s King warns ISIS is regrouping in western Iraq and south-east Syria, Israeli intelligence assisted US in Soleimani assassination, France’s prime minister backs down on pension reform following weeks of labor strikes, US drops China as a currency manipulator, Cory Booker suspends candidacy, LSU beats Clemson in college football championship, S&P +0.7%; Tue: China exports +8.9 to +7.6% (imports +15.5 to +16.3%), James Murdoch criticizes News Corp for ongoing climate change denial in its reporting, Europe triggers dispute mechanism on Iran nuclear deal (pressuring Tehran with sanctions), Democratic debate (final one before voting begins Feb 3rd), US CPI +0.2 to +2.3% (core CPI unch at +2.3%), JP Morgan Chase posts record 2019 profits of $36.4bln, US will not consider additional China tariff cuts until after Nov election, Democrat’s final debate before primaries (no clear standout), Democrats release new damning email/text exchanges related to Ukraine/impeachment, S&P -0.2%; Wed: Medvedev resigns as Putin sidelines him as part of a government reorganization to allow Putin continued power, EU industrial output -1.5% (Germany -4.0%), BOE Saunders expects sluggish UK growth in 2020 (odds for Jan rate cut jump to 60%), record demand for Italy 30yr bond auction (follows record demand for Spain’s 10yr bond), US PPI +1.3% (core PPI -0.2 to +1.1%), Trump signs Phase One trade deal, House sends articles of impeachment to the senate, Empire survey jumps 1.3 to +4.8, S&P +0.2%; Thur: IEA sees 2020 non-Opec oil supply growth outstripping demand, Turkey cuts rates 75bps to +11.25% (real rates close to zero), Ukraine opens criminal inquiry into surveillance of US ambassador Yovanovitch, GAO concludes White House broke law when it withheld Ukraine military aid, Alphabet becomes 4th US company to cross $1trln valuation, Philly Fed surged 14.6 to +17.0 (exp +3.8), Senate passes USMCA trade deal, US to start issuing 20yr notes, S&P +0.8%; Fri: China 2019 GDP +6.1%, UK retail sales decline for 5 straight months, Palladium jumps to record high (+25% YTD), US Dec housing starts 13yr high, S&P +0.4%.

Weekly Close: S&P 500 +2.0% and VIX -0.46 at +12.10. Nikkei +0.8%, Shanghai -0.5%, Euro Stoxx +1.3%, Bovespa +2.6%, MSCI World +1.2%, and MSCI Emerging +0.6%. USD rose +1.6% vs Brazil, +0.9% vs Russia, +0.7% vs South Africa, +0.6% vs Yen, +0.4% vs Sterling, +0.3% vs Australia, +0.3% vs Euro, +0.2% vs India, +0.2% vs Sweden, +0.1% vs Canada, +0.1% vs Turkey, and +0.1% vs Chile. USD fell -16.3% vs Ethereum, -9.7% vs Bitcoin, -0.9% vs Indonesia, -0.9% vs China, and -0.7% vs Mexico. Gold -0.4%, Silver -0.5%, Oil -0.5%, Copper +1.3%, Iron Ore -1.7%, Corn +0.8%. 5y5y inflation swaps (EU +1bp at 1.33%, US +4bps at 2.10%, JP -4bps at 0.07%, and UK +2bps at 3.61%). 2yr Notes -1bp at 1.56% and 10yr Notes flat at 1.82%.

2020 YTD Equity Index Returns: Turkey +7.1% priced in US dollars (+6.2% priced in lira), Mexico +6.1% priced in dollars (+5.2% in pesos), Russia +5.7% (+5%), NASDAQ +4.6%, Australia +3.5% (+5.7%), HK +3.4% (+3.1%), S&P 500 +3.1%, Finland +2.9% (+4%), Denmark +2.6% (+3.7%), Israel +2.5% (+2.5%), China +2.2% (+0.8%), Canada +2.2% (+2.9%), Switzerland +2.1% (+2.1%), Korea +2.1% (+2.4%), UAE +2% (+2%), Russell +1.9%, Portugal +1.8% (+3%), Indonesia +1.7% (-0.1%), India +1.7% (+1.5%), Chile +1.6% (+4.5%), Singapore +1.6% (+1.8%), Italy +1.6% (+2.7%), Czech Republic +1.5% (+1.6%), Argentina +1.4% (+1.6%), Poland +1.3% (+2.1%), Malaysia +1.3% (+0.4%), Germany +1% (+2.1%), Sweden +1% (+3.1%), Saudi Arabia +0.8% (+0.8%), France +0.8% (+2.1%), New Zealand +0.7% (+2.7%), Greece +0.7% (+1.9%), Taiwan +0.6% (+0.8%), Netherlands +0.6% (+1.8%), Japan +0.5% (+1.6%), Euro Stoxx 50 +0.4% (+1.7%), South Africa +0.3% (+3.8%), Norway +0.3% (+1.6%), Spain +0.1% (+1.4%), Belgium +0.1% (+1.3%), UK -0.1% (+1.8%), Thailand -0.1% (+1.3%), Ireland -1.1% (+0.2%), Philippines -1.3% (-1.2%), Austria -1.5% (-0.5%), Brazil -1.5% (+2.4%), Colombia -1.8% (-0.4%), Hungary -6.2% (-3.6%).

Bipedal: “First you needed investors to recognize there was low potential US growth,” said Mercury, shape shifting his way through the market maze. “This would then lead to a decline in real yields – that was the first leg.” 10yr treasury yields fell from a Q4 2018 high of 3.22% to today’s 1.82% (CPI in that time fell just -20bps to +2.3%, core CPI rose +20bps to +2.3%). “Only then would it be possible to get a material dollar decline,” he said. “But for a large dollar bear market to actually happen, you need a material decline in ROI or ROE which requires some element of stagflationary pressures – that’s the trade’s second leg.”

Bipedal II: “Absent an innovation shock that lifts America’s potential growth rate, we are now gradually moving toward stagflation,” continued Mercury. It could come via a Fed shift to nominal GDP targeting or a massive MMT response to the next economic downturn. “But the more immediate catalyst for stagflation, is a Sanders/Warren win, that’s where things get really interesting.” Minimum wage hikes, MMT funded debt forgiveness, healthcare, etc. “Perhaps that would be good for society, but certainly not for the dollar - that’s where the 2nd leg kicks in.”

Bipedal III: “Another term for Trump doesn’t provide the catalyst for a big dollar decline,” said Mercury. “Trump means business-friendly policies, looser regulation, probably another tax cut, more of the same.” Perhaps a debt-fueled cyclical spurt. “The second leg for the dollar trade requires real cost-push inflation.” That’s only something you’ll see from Sanders/Warren. “The way Trump creates cost-push inflation is in the international arena.” Trade wars, reduced immigration, Iran war. “But we’ve kind of just lived through these and still avoided stagflation.”   

Random Numbers: The Shiller PE ratio is 31.7. Historically, when it is between 30-40 the S&P 500 forward 10yr return is negative. In Aug 2000 the Shiller PE ratio was 42.9. Ahead of the 1929 crash it was 32.6. In May 2007 it was 27.6. It bottomed in July 1982 at 6.6 and peaked in Aug 1987 at 18.3. It peaked in Dec 1968 at 22.3 (we see similarities between today and the late-1960s). GMO published their 7yr forecasts for asset prices (annualized real returns). Here goes: US large cap equities -4.9%, US small cap equities -2.2%, int’l large cap -0.8%, int’l small cap +0.9%, emerging market equities +3.5%, emerging value equities +8.2%. GMO forecast all US and int’l bond market categories (developed and emerging) to produce negative real returns.

Looking: “I look at historical relationships that appear to no longer operate as before,” said the investor. “I look at measures of valuation that are stretched to levels rarely seen,” he continued. I look at corporate share buybacks as the only meaningful inflow. I look at outflows from retail investors and the flags that this raises. Then I look at the fact that global interest rates have never been negative like this. I look at the working population and it has never before aged and shrunk like this. And I look at the world and just don’t know how anyone can be certain of anything.”

Anecdote: “Start with what we know for sure,” said Big Foot, creeping quietly through global markets, trackers desperate to front-run his every step. “If 100% of all investing is passive, then the information contained in market prices is meaningless,” continued the CEO of one of the industry’s largest investment firms. In 2009, assets in actively-managed mutual funds were 3x those of index-based funds/ETFs. In August 2019, US index-based fund/ETF assets surpassed actively managed assets. That trend continues. With each incremental dollar that moves from active to passive management, roughly five more cents flow into equities (active managers hold 5% cash buffers while passive funds generally do not). “We also know that if 100% of equity is taken private, then public markets would cease to exist.” The average institutional portfolio holds a 25% allocation in alternative investments. Of that allocation, private equity investments have surged to 25% of the assets, up from 18% in 2018. Private equity funds have $1.5trln in dry powder that will fail to pay fees unless their managers buy equity, which continues to appreciate. US equity market capitalization is $35tlrn, a record 1.55x America’s $22.3trln annual GDP. “But what we do not know for sure is whether there comes a point well before 100% of all investing is done passively, or before all public equity is taken private, that the market price becomes meaningless,” said Big Foot. You see, in a world where all investing is passive, how much would an incremental $1bln inflow move market prices up? How about a $1bln outflow? The price moves would become utterly extraordinary in such a world. And in a world where all public equity is taken private, PE managers would surely mark their holdings steadily higher, to ever more extreme multiples. “Nor do we know whether we have already reached that point.”     

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.