The Investor October 2018

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A lesson about bonds

By Richard Cluver

A phone call recently from a nonagenarian reader set me thinking about the secrets of investing in sovereign bonds; those supposedly safest of all investments which advisers always argue should form a substantial part of the investment portfolios of the elderly.

The reason a substantial bond conclusion is regarded as vital for retired folk is that it is presumed that the elderly are simply too old to earn a living for themselves should the worst thing happen and they should lose all their accumulated savings through an improvident investment.

Bonds are, however, far from safe investments if they are misunderstood as was the case of my nonagenarian because nobody had taken the time to explain to him the realities of such an investment when he was advised to put most of his savings into an inflation-linked RSA bond.

So let us start with the basics by understanding that a sovereign bond is a promissory note issued by a government promising to pay interest at a specified rate for a specified period and a promise to refund the entire sum upon completion of the specified period. If the government in question is one of a First World nation like the USA, Britain or Germany which have been subject to very little monetary inflation over very long periods, it has the great advantage of being able to raise loans from investors at extremely low rates, but it nevertheless is obliged to go to the market offering such bonds at market-related prices.

During the post 2008 global economic crisis, the US Federal Reserve, together with a series of other central banks indulged in a process they described as “Quantative Easing” in which they agreed to accept massive quantities of such government promissory notes at ever-reducing interest rates in order to effectively produce new money out of nowhere in order to flood world markets, thus making money very cheap and hopefully encouraging business to borrow in order to spend on job-creation developments.

As my graph of US 30-year bonds accordingly shows, yields in the marketplace accordingly fell from a peak of 4.82 percent in April 2010 to a low of 2.11 percent in July 2016. Thus, should you have been fortunate enough to have identified that peak yield and bought US Bonds at that time and held them until they bottomed, you would have more than doubled your money.

If that puzzles you, you need to understand that the interest rate attached to a Sovereign bond is usually fixed at the time of issue. So, for example, let us assume a government issues a ten-year bond at a fixed yield of ten percent. If investor A thus bought it at issue, he would continue to receive interest at 10% a year for so long as he held the bond.

Now, let us assume that interest rates in general fall over the next few years until the going rate for the bond that he holds is now 5%, a would-be buyer of the 10% yield bond would consequently only be expecting to receive 5% for his money and it consequently follows that he would be willing to lay out twice the capital sum that Investor A paid for the bond. Thus, a 50% fall in a bond yield represents a 100% capital gain for an investor who bought at peak yield.

The converse equally applies, should in the following years the prevailing interest rate rise again to 10% then our second investor would only be able to receive half of the sum he invested if he decided to sell. Clearly then, if you want to trade in bonds you should only buy them when the yield is high and only sell when the yield is low. To do the reverse is guaranteed to lose you money.

So why would pension funds want to invest in Sovereign bonds? Well of course they are only interested in buying in order to hold to maturity. That way they can fix a return for the entire duration of the life of the bond. Thus, to simplify things, if you wanted to buy a guaranteed annuity from a commercial pension fund at a time when the prevailing interest rate is 10% and the pension you sought was R1 000 a year, then the pension fund would require you to pay them R10 000 and with that money they would go out and buy a 10% yielding government bond.

Of course they would probably charge you something like R12 500 which would assure them that they also gave themselves a profit of R250 a year for providing you with the service. Furthermore, since the majority of pensions die with the prime beneficiary, had the pension fund bought a 30-year bond and you died after 15 years, they would continue to draw the full benefit of R1250 for the following 15 years.

Or, more profitably for themselves, had interest rates fallen to 5% at your death, they would be able to use that same bond that they bought for you in order to provide TWO other pensioners with R500 a year at no cost to themselves while collecting initial premiums of R10 000 from each of the new clients.

Clearly it’s a license to print money for yourself if you are able to take the long view as insurance companies can.

Of course bonds come in many varieties and the governments issuing them suffer differing constraints. Thus, for example, the South African Government has long been unable to live within its means and so with every year the risk rises of Mr. Ramaphosa’s Government proving unable to pay back the money it has borrowed. Would-be investors in RSA bonds accordingly demand a risk premium which explains why the current yield on a 30-year USA long bond is 3.33 percent while that of an RSA bond is 9.32 percent.

South Africa’s current inflation rate is 4.9 percent while the US rate is 2.1 percent so if you subtract the one from the other you will see that the inflationary risk to a US investor who buys South African bonds is 2.8 percent greater. Thus, if he decided to buy a RSA bond he would expect a yield of 3.3 percent plus the inflationary differential of 2.8 which implies that if there was an equal default risk that he would be content to buy an RSA bond at a yield of 6.1 percent. The fact that the current market yield is 9.32 percent means that in addition to the inflation premium of 2.8 percent, would-be investors in RSA bonds are demanding a further risk premium of 3.22 percent.

So, is now a good time to invest in RSA bonds? Well possibly in the next month or two. As my graph below indicates, the yield on the R186 has risen from a March low of 7.8 percent to a current 9.32 percent and ShareFinder calculates that in the short-term it will peak on November 9 at 9.624 percent. So if you are a trader it might be worth taking a view.

That said, however, the US Federal Reserve is committed to raising interest rates on a regular basis for the foreseeable future and each time they do so South African bonds should rise simultaneously in order to maintain the currency and risk premiums. So if you should invest now you will be taking a view that the world might perceive our risk to have diminished, possibly following the commitments made at last week’s investment conference.

Debt Alarm Ringing

By John Mauldin

Is debt good or bad? The answer is “Yes.” Debt is future spending pulled forward in time. It lets you buy something now for which you otherwise don’t have cash available yet. Whether it’s wise or not depends on what you buy. Debt to educate yourself so you can get a better job may be a good idea. Borrowing money to finance your vacation? Probably not.

Unfortunately, many people, businesses, and governments borrow because they can, which for many is possible only because central banks made it so cheap in the last decade. It was rational in that respect but is growing less so as the central banks tighten their policies.

Earlier this year, I wrote a series of articles predicting a debt “train wreck” and eventual liquidation—an event I dubbed The Great Reset. I estimated we have another year or two before the crisis becomes evident.

That’s still my expectation… but I’m beginning to wonder again. Several recent events tell me the reckoning could be closer than I thought just a few months ago. Today, we’ll review those and end with a few suggestions on how to prepare.

As noted, debt can be appropriate—even government debt, in some (rare) circumstances. I am glad FDR issued war bonds to help defeat the Nazis, for instance. Now, however, governments go into debt not because they face existential threats, but simply to keep their citizens and benefactors comfortable.

Similarly, central banks enable debt because they think it will generate economic growth. Sometimes it does, too. The problem is they create debt with little regard for how it will be used. That’s how we get artificial booms and subsequent busts.

We are told not to worry about absolute debt levels so long as the economy is growing in concert with them. That makes sense. A country with a larger GDP can carry more debt. But that is increasingly not what is happening. Let me give you two data points.

Lacy Hunt tracks Bank for International Settlements data that shows debt is losing its ability to stimulate growth. In 2017, one dollar of non-financial debt generated only 40 cents of GDP in the US and even less elsewhere. This is down from (if memory serves) more than four dollars of growth for each dollar of debt 50 years ago.

Source: Hoisington Investment Management

This has significantly worsened over the last decade. China’s debt productivity dropped 42.9% between 2007 and 2017. That was the worst among major economies, but others lost ground, too. All the developed world is pushing on the same string and hoping for results like we saw 40–50 years ago. As my friend Rob Arnott constantly reminds me, hope is not a strategy.

Now, if you are accustomed to using debt to stimulate growth, and debt loses its capacity to do so, what happens next? You guessed it: The brilliant powers-that-be add even more debt. This is classic addiction behaviour. You have to keep raising the dose to get the same high.

At this point, Paul Krugman and others usually call me a debt curmudgeon and argue the debt doesn’t matter. I point them to Ken Rogoff and Carmen Reinhart’s book from 10 years ago, This Time Is Different, which demonstrates that in every prior debt run-up, over centuries of history, accumulated debt clearly eventually made a difference. There is always an eventual Day of Reckoning.

The US economy is so huge and powerful that our current $24.5 trillion government debt (including state and local) could quite easily grow to $40 trillion before we meet that day. We are one recession away from having a $30 trillion US government debt total. It will happen seemingly overnight. And deficits will stay well above $1 trillion per year every year after that, not unlike now.

Some argue the US has almost $150 trillion of personal and corporate assets to offset that debt. That is true enough, but I think there might be some slight resistance if the government demanded 15% of your total assets, including your house, real estate, investment assets, furniture and goods, to pay off the debt. That would be in addition to your regular taxes, and then they begin accumulating more debt.

Even though you are reading about a budget deficit of under $800 billion this year, the actual amount of debt added last year was well over $1 trillion. That is due to “off budget” items that Congress, in its wisdom, thinks shouldn’t be part of the normal budgetary process. It includes things like Social Security and Medicare—which vary from time to time and year to year—and can be anywhere from $200 billion to almost $500 billion.

And here’s the point that you need to understand. The US Treasury borrows those dollars and it goes on the total debt taxpayers owe. The true deficit that adds to the debt is actually much higher than the number you see in the news. It brings to mind the scene in the Wizard of Oz, when they wizard says, “Pay no attention to the man behind the screen.”

Household and corporate debt is growing fast, too, and not just in the US. Here’s a note from Lakshman Achuthan.

Notably, the combined debt of the US, Eurozone, Japan, and China has increased more than ten times as much as their combined GDP [growth] over the past year.

Yes, you read that right. In the last year, the world’s largest economies are generating debt 10X faster than economic growth. Adding debt at that pace, if it continues, will boost the debt-to-GDP ratio at an alarming rate.

Lakshman continues.

Remarkably, then, the global economy—slowing in sync despite soaring debt—finds itself in a situation reminiscent of the Red Queen Effect we referenced 15 years ago, when tax cuts boosted the US budget deficit much more than GDP. As the Red Queen says to Alice in Lewis Carroll’s Through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

I am trying to imagine a scenario in which this ends in something less than chaos and crisis. The best I can conceive is a decade-long (and possibly more) stagnation while the debt gets liquidated. But realistically, that won’t happen because debtors won’t let it, and they outnumber lenders. Hence, something like the Great Reset will happen first.

The rational course would be to delay the inevitable as long as possible. Yet in the US, at least, we’re hastening it.

Lost Exorbitant Privilege

 This month, the US Treasury closed the books on Fiscal Year 2018. It was a success in the sense that the government is still open and doing the things it should. Financially speaking, it was another debt-financed failure.

Source: US Treasury

The federal government spent approximately $4.1 trillion in FY 2018, of which it had to borrow $779 billion on budget and a few hundred billion more off-budget (amount TBD). And over 40% of the on-budget deficit went simply to pay $325 billion in interest on previously-issued debt.

Obviously, the government should spend less. But where to cut? There is no political agreement on that and little prospect of one. Nor, barring an economic boom of a magnitude and duration I think unlikely, are we going to grow out of this. So, I expect continued and even bigger deficits.

Deficits mean the Treasury has to borrow cash, which it does by selling Treasury bills, notes, and bonds. This wasn’t a problem for most of the last decade but is rapidly becoming one as the amounts grow larger.

Thanks to the “exorbitant privilege” the US has long had many foreigners willing to buy our debt. Now they are losing interest (forgive the pun) because hedging their currency exposure costs more. There are some complex reasons behind this, relating to swaps and the differentials between the US economy and others, but here’s the bottom line: European and Japanese investors can no longer buy US Treasury debt at a positive rate of return unless they want to take currency risk, which most do not. This is a new development.

This might be fine if US investors made up the difference, but that’s not happening, either, and might not be great anyway. Capital that goes into Treasury debt is capital that’s not going into bank loans, corporate bonds, mortgages, venture capital, stocks, or anything else in the private sector, which generates the growth we’ll need to pay off the government’s debt.

Treasury auction data shows it is getting harder to attract buyers. According to Bloomberg, last month’s two-year note auction matched the lowest bid-to-cover ratio for that maturity since December 2008.

Source: Bloomberg

The problem is manageable for now, and Treasury will always be able to borrow at some price… but the price could get awkwardly high, with interest costs rising dramatically.

Given the debt’s maturity structure, it could be sooner than you might think. Treasury took advantage of lower short-term rates in recent years, which reduced interest costs, but also created refinancing risk. Here’s a Torsten Slok chart (via my friend Luke Gromen on Twitter).
Source: Luke Gromen

Looking only at federal debt not held by the Federal Reserve, Treasury will need to borrow something like 43% of GDP over the next five years just to rollover existing debt at much higher interest rates. That’s not counting any new debt we accumulate, which could be quite a lot if we enter recession or (God forbid) another war.

But set aside the hypothetical possibilities. Just the things we know are already locked in, like Social Security and Medicare, are enough to blow up the debt. Somebody has to buy all that Treasury paper. If it’s not foreigners, and not the Fed, and not American savers, we are out of prospects.

Now, buyers will appear at the right price, i.e. some higher interest rate. Barring recession-induced lower rates (which would be a different problem), government borrowing could get way more expensive.

Which is more likely: a double-digit ten-year Treasury yield or a worldwide debt liquidation? Neither will be fun. But I’ll bet that we see one or the other at some point in the 2020s.

Trigger Points

My renewed fear comes from the very real possibility the global economy breaks down in the next six months. Anything could trigger a crisis, and it could well be something no one presently foresees, but here are three candidates.

Corporate Credit Crisis: As a whole, US companies are significantly more leveraged now than they were ahead of the 2008 crisis. We saw then what happens when the commercial paper market seizes up, and that was without a Fed in tightening mode. Now we have a central bank both raising short-term rates and slowly ending its crisis-era accommodations. Recent comments from FOMC members say they have no intent of stopping, either. A few high-profile junk bond defaults could ignite fears quickly.

There are trillions of dollars of low-rated corporate debt that can easily slide into the junk debt category in a recession. Since most public pension, insurance, and endowment programs are not legally allowed to own junk-rated debt, I can see where it could easily cause a debt crisis along the lines of the previous subprime crisis.

Trade war: One reason the US economy seems to be booming right now is a surge in imports. Companies are rushing to build inventory ahead of the 25% tariff on Chinese goods that takes effect January 1. Coming on top of usual holiday season stockpiling, it is jamming ports, highways, and warehouses—generating many jobs in the process.

That’s all good right now, but those truck drivers and warehouse workers will no longer be necessary once the shelves are stocked. Working down that inventory will take months, at least, and the resulting slowdown could ease the economy into recession next year.

We might avert that outcome if the US and China reach some trade resolution, but that doesn’t appear likely. The latest reports say the Trump administration is digging in for a long siege and, if anything, may get even more aggressive against China. Nor does China seem likely to bend.

You may have heard the tennis term, “unforced errors.” Those are mistakes of your own, not a result of your opponent’s good shots. I think the tariffs may be an unforced error in US economic policy that could cause a serious growth decline, or worse.

European Slowdown: This week, we got October PMI reports from Markit. Its Eurozone manufacturing and services index dropped to the lowest point since September 2016, with export-dependent Germany particularly weak. Meanwhile, Italy’s new budget is wildly out of line with its revenue and growth prospects. This threatens to set off another euro crisis. And then there’s the serious possibility of a hard Brexit in early 2019.

In short, Europe (at least some of it) is in real danger of entering recession next year. If that happens, the impact will spread around the globe as the continent reduces imports from the US, China, and elsewhere. Not to mention the potential fireworks if Italy or anyone else actually defaults on debt payments to foreign lenders, i.e. German, French, and other European banks with minimal loss reserves.

If the European Central Bank won’t buy Italian bonds, and the Italians won’t do it themselves, then Italian interest rates could jump dramatically, precipitating a crisis. This is essentially what forced the ECB into its first quantitative easing program.

In theory, the Italians were then in compliance. That is not the case today. I have been pointing my finger at Italy for years. It is the linchpin in the whole euro experiment on debt and solidarity.

I could go on, but you get the point. The US economy looks fine just ahead, but problems lurk over the horizon. Bad things could happen soon.

So, what do you do? I have three suggestions.

  1. Build a cash reserve: I know every financial advisor says that, but disturbingly few people actually do it. Have several months of living expenses readily available in risk-free cash equivalents. Cash is also an option on buying discounted assets at lower prices in the future.
  2. Deleverage: If you carry business or personal debt, reduce it as much as you can and don’t assume you will be able to refinance. Banks can cut your credit lines in a heartbeat, and they will.
  3. Have a plan for your longer-term investments, whether they are stocks, real estate, or anything else. Decide now what you will sell, and to whom, because buyers may not be there when you need them. At the same time, decide what you plan to hold through any slowdown. I have assets in private companies and even a few public ones that I truly consider “for the long term.”

I sincerely hope I’m wrong. Maybe I’m jumping the gun here and 2019 will be another banner year. But I see major risks ahead, and I want you to be ready for them.

Ramaphosa “understands our needs”

By Brian Kantor

The economic policy intentions announced by President Ramaphosa were encouraging if only because it made clear that the President fully understands the imperative of faster economic growth. As indeed he should. It was not obvious that his predecessor cared at all about growth. He had a very different agenda.

The economic diagnosis offered was apposite – for example, to quote the President ‘…Businesses are not struggling with lack of access to cash. It is due to lack of confidence and a dearth of viable investment opportunities that businesses have been reluctant to spend money on fixed capital. These obstacles require policy and regulatory action that provided clarity and raise efficiency …”   

One might have added—or willing to add working capital that might have been applied to employing more people and improving their capabilities.

It is important to recognize how JSE listed companies have increased their dividend payments- cash paid out – relative to their after tax earnings in recent years – for want of investment opportunities that offered high enough – risk adjusted returns. Since 2011 dividends have grown 2.5 times while earnings have increased by only 1.6 times

JSE All Share Index Earnings and Dividends per Share (2011=100)


 Source; Iress and Investec Wealth and Investment

 The economy and the share market would have done much better had the cash flow been saved by the listed firms and invested by them in what in more normal times might have proved to be cost of capital beating investments. That is realised returns on capital invested that exceeded required returns of the order of 14% a year. With hind sight shareholders should be pleased that the firms invested as little as they did.  Since 2011 the JSE All Share Index, adjusted for inflation, has gained 21%, the real SA GDP is up a dismal 11% (equivalent to an average 1.4% p.a. rate of growth, while real JSE earnings have not increased at all over these seven and a half years.

The real JSE compared to the real GDP (2011 =100)2

Source; Iress, Stas SA and Investec Wealth and Investment

Over recent years the expected returns of SA business have receded with the slower growth expected and realized while the risks to these expected returns have risen. As objectively reflected by the sovereign risk premium demanded of RSA dollar denominated debt.

 In the fast growth years between 2004 and 2008 (GDP growth averaged over 5% p.a. between 2004 and Q2 2008- ( not fast enough to keep Thabo Mmbeki in his job) the RSA risk premium for five year RSA dollar denominated debt averaged about 0.67% p.a. Since 2014 the yield on SA dollar debt has had to offer on average an extra over 2% p.a. on average compared to the yield offered by five-year US Treasury Bonds. Put another way returns on an investment in SA assets now have to offer at least an extra 2% p.a. in USD to appear worth making.

The South African sovereign risk premium3

Source; Bloomberg and Investec Wealth and Investment

In the service of growth this risk premium has to be reduced, as the President appears to understand. He also appears to recognize that the risks to SA rise and fall with realized growth. The rating agencies remind us constantly of this – and as the currency debt and equity markets also do so. They reacted negatively in response to the disappointing latest GDP growth estimates for Q2 2018. Clearly capital flows in, in response to faster expected growth and out with slower growth expected.

With growth, more capital becomes available on better terms, to support the exchange value of the ZAR. A stronger rand therefore means less inflation, lower interest rates and so further support from the demand side of the economy for growth. A virtuous circle presents itself with growth encouraging policies.

One of more growth expected with less inflation given rand strength as opposed to slower growth- a weaker rand – and so more inflation accompanied by higher interest rates. This has been the vicious circle SA has been trapped in for many years now.

One can express the hope (though the President is well advised not to question the independence of the Reserve Bank nor its judgment) that the Bank fully understands the link between growth, inflation and the exchange rate – over which it has such minimal influence anyway. Three unnamed members of its monetary policy committee (happily not a majority) voted for higher short term interest rates at its last meeting. With demand as depressed as it is and inflation, outside of regulated prices as low as it is, given the very limited pricing power of firms, one can only wonder at the logic that called for even less demand – that inevitably follows higher interest rates. Perhaps it is the theoretical notion that more inflation expected leads to more inflation- regardless of the state of demand. For which there is no evidence.

South Africa is suffering from both a lack of supply and a want of demand. Fixing the demand side would simply take lower interest rates. Stimulating more demand would also soon bring faster growth now and less – not more inflation. Fixing the supply side of the economy will take longer but would permanently raise the growth potential of the economy.

Our economy could also do with a bit of luck that has been absent since the end of the metal and mineral price super cycle that lasted beyond the Global Financial Crisis of 2008- and only ended in 2011. The SA mining price deflator, converted into US dollars increased by 2.5 times between 2004 and 2011.

Prices in USD in early 2016 were about 40 per cent off the 2011 peak, before they turned up again- slowly.  Stronger metal prices in USD and more favourable economic trends in Emerging Markets generally would do much to help the rand and the SA economy. These are however global forces over which we have no influence but to which the rand and the JSE and bond yields inevitably react. A mining charter that recognized the trade-offs between growth in output and the distribution of its benefits, beyond those who take on the risks of investment, would be a way of helping ourselves – and is an early test of Ramaphosa realism.

Positive numbers for SA retail

By Brian Kantor

A striking feature of current price trends in SA is that price increases at retail level are running well below headline inflation and are forecast to remain so.

Fig.6: Consumer and retail price inflation


 Source; Stats SA, SA Reserve Bank and Investec Wealth and Investment

Clearly retailers and their suppliers have had very little pricing power and operating profit margins and remain under pressure given the weak growth in volumes of goods and services sold to households. No doubt the higher charges for petrol and diesel in the wake of a weaker rand and higher oil price in US dollars have contributed further to currently weak demand at retail level and may continue to do so.

The growth in the supply of cash – adjusted for inflation – has proved a very good predictor of retail spending in South Africa. The real cash cycle has consistently led the retail sales cycle as we show below. Though, as should also be noted, these trends parted company in late 2017. They continue to point in an opposite direction- with the cash cycle showing a pick up while retail sales volumes continue on a declining path. These opposing trends may well reverse, given no further shocks to the confidence of households in their income earning prospects- and subdued inflation. Hopefully too, higher interest rates will be avoided that could depress household demands further.

Fig. 7: The real cash and real retail sales volume cycles


Source; Stats SA, SA Reserve Bank and Investec Wealth and Investment

The indicators point to a positive rate of growth in spending and output over the next twelve months. Rand strength and lower interest rates and less inflation would help stimulate the economy further. Rand weakness will do the opposite. The outlook (hopefully an improving one) for emerging market economies and especially the Chinese economy could move emerging market exchange rates and the rand in a direction, helpful to household spending. Less political risk attached to investing in South African assets would be an additional source of stimulus.

An Empire of Debt

By John Mauldin

There are many good things happening in China. Businesses are prospering while living standards rise as well. The country’s vast interior is still quite poor but life is improving (with the notable exception of the Uighurs, a Muslim minority in Western China).

How they are financing this progress? The answer is, “with a lot of debt.” You often hear about China’s government and corporate debt, but less about households. So let’s start there.

Back in 2015, I wrote about China’s insanely leveraged farmers and others who bought stocks with borrowed money. Most regretted it, some sooner and more intensely than others. But that period seemed to convince the government to keep tighter control over consumer credit.

But note, controlling credit isn’t the same as eliminating credit, or even reducing it. Beijing wants consumers to borrow in sustainable, productive ways, as Beijing defines them. So overall household debt growth has not slowed. Source: Gavekal

Chinese consumer debt is growing quite a bit faster than Chinese GDP. This means that consumer debt is a growing percentage of the economy. It’s not a big problem now but at this rate will become one soon.

This chart shows how Chinese household debt is growing compared to other economies.

Source: Gavekal

Household debt relative to GDP is near-flat or declining in the US, Japan, Germany, and France. In China, it’s grown from 40% to 50% of GDP in just two years. Yes, those developed countries have higher absolute debt levels, but they also have higher household incomes. So this trend, if it continues, will get more worrisome.

Now, what happens when these indebted Chinese consumers find living costs rising due to a trade war with the US?

One possibility is “not much” because they don’t really need our goods. They have plenty of domestic alternatives in most categories. Nevertheless, removing or limiting US competition could raise prices in some categories.

But the bigger problem is that a trade war will mean lower exports, probably affecting the jobs of some indebted consumers. How many is unclear. China has both domestic demand and other countries it can trade with, should the US decide to raise barriers. Domestic demand might weaken if exporters have to reduce employment and the government doesn’t step in with some kind of stimulus.

The problem here is that any stimulus would probably increase government debt, a problem we haven’t even discussed yet. Not to mention corporate debt rising as companies try to keep operating with lower revenue.

Debt in Pictures

Like everything else about China, its debt is hard to visualize. There’s a lot of it. Here is a chart from Bloomberg that projects three scenarios out to 2022. Source: Bloomberg

Bloomberg’s base case shows Chinese debt-to-GDP reaching 330% by 2022, which would place it behind only Japan among major economies. It might be “only” 290% if GDP growth stays high.

Here’s another look from Citi Research (via my friend Steve Blumenthal). This is private sector credit creation. The US series is only bank credit, by the way, so this isn’t an apples-to-apples comparison. But then much of Chinese debt is bank credit. The “shadow banks” are relatively new. Xi seems to be trying to reduce their influence. However you look at it, China has huge private debt.

Finally, here’s a “Total Credit to Private Non-Financial Sector” graph we made on FRED using Bank for International Settlements data. That means it excludes bank debt. The US has the most such debt at $29.5T as of year-end 2017, but China is not that far behind with $26.5T. China’s debt of this type was quite a bit more than Japan, the UK, and Canada combined. Source: St. Louis Federal Reserve Bank

Even so, Chinese growth has been largely funded by debt. Make no mistake, loans have fuelled almost everything. You can argue those loans have funded a great deal of useful infrastructure and housing, with a stimulative effect. But that debt will eventually have to be repaid, and debt is future consumption brought forward. That means at some point Chinese growth is going to slow down. Maybe not for a decade or so, but they have to pay the piper.

Like the US, China also has off-the-books debt that may not show up in the totals. For instance, its social security plan is underfunded amid an aging population and shrinking prime-age workforce. The 29% payroll tax (yes, you read that right) that should be funding it often goes uncollected and the debt goes higher still. One analyst estimated strict enforcement would cut corporate profits by 2.5% and shave 0.6 percentage points off nominal GDP growth. With the Chinese government now making aggressive efforts to collect the tax, which it clearly needs, growth could falter.

Any way you look at it, China has a staggering amount of debt. Maintaining it will grow more difficult if the economy turns down. The same is true for the US, of course. Which country is better equipped to survive a trade and currency conflict?

Wargaming the Trade War

President Trump has ordered more tariffs on an expanded list of Chinese imports. The rate will be 10% and rise to 25% at the beginning of 2019, unless China agrees to new trade policies before then. (Notably, he excluded consumer electronics products like smartphones, which shows the administration is not entirely tone deaf to the impact tariffs have on US consumers.)

Let me be very clear on one thing: I totally agree with the president that China has taken unfair advantage of global trade rules. Its requirements for foreign companies to disclose intellectual property (that then finds its way to Chinese state-owned enterprises) is outrageous. That must stop and we need to resolve assorted other differences. The question is how to accomplish it.

I had hopes Trump’s business negotiation skills would enable more productive trade negotiations. It doesn’t seem to be happening that way. To me, the best strategy would have been to assemble a united front of other top economies and demand China change its ways. We are not the only major country that has a trade problem with China. Then I would have pivoted to seeking better terms with Canada, Mexico, the EU, and others. Instead, he has aggravated allies and made working with them difficult, at best.

Part of negotiating is to have realistic demands. You will never succeed by demanding your adversary cut his own throat. Xi Jinping can be flexible on many things but he still presides over a Communist government and a command economy. That leopard is not going to change its spots. They are never going to abandon their technology goals embodied in their “Made in China 2025” program, nor would any other country.

I am not the only one who thinks this. Check out this unusually blunt tweet from former trade diplomat Harald Malmgren, who literally wrote the book on US trade policy, serving under presidents starting with JFK. He’s retired now but remains “plugged in” to global finance better than almost anyone I know.

Now, it may be that the White House team is less talented than they think. Peter Navarro’s continued presence, and the President’s apparent confidence in him, is not reassuring. I said when his name was first mentioned that Navarro understands neither economics nor trade. He has done nothing to change my opinion.

But another possibility is they have an entirely different strategy than we think. Some of my contacts believe the real goal is to make US businesses pull back from operating in China at all. If that’s the goal, they are off to a good start. But that is not good for US businesses or for the US.

For the moment, the US side is negotiating from a marginally stronger position. Our economy is growing nicely and can withstand some tariff pain—though it will hurt certain sectors. This is already happening, in fact. But in the long run we are playing a very dangerous game.

International trade is like plumbing. Goods and money flow around through pipes and you can only squeeze so much through them. When the US imports goods from China, we simultaneously export dollars to China. We can do that because our currency is what everything else is settled in. Reducing imports would mean we also reduce dollar exports, leaving the rest of the world with less water in its pipes. That’s not good at all, if we want to maintain our position on top of the food chain.

In researching this letter, I ran across a nice, short explanation of the threat by currency expert Taggart Murphy. I can’t say it better myself so I’ll just quote him (emphasis mine).

Trump is doing everything he can to bring on the end of the days when the US can borrow whatever it wants in whatever amounts it wants. To be sure, there is no recipe book. The dollar is now so entrenched as the world’s money that if your assignment were to bring the curtain down on that—and thus the ability of the US to borrow whatever it wants whenever it wants—it’s not at all clear what you would do.

But you’d start by doing everything that Trump is doing—pick fights with all your allies, blow the government deficit wide open at the peak of an economic recovery, abandon any notion of fiscal responsibility, threaten sanctions on anyone and everyone who seeks to honor the deal Obama struck with Iran (thereby almost begging everyone to figure out some way to bypass the US banking system in order to do business), [Which they are openly doing –JFM] throw spanners into the works of global trade without any clear indication of what it is precisely you want for a country that structurally consumes more than it produces and thus by the laws of accounting MUST run trade and current account deficits.

That’s strong language but exactly right, especially the last part. Trade deficits are President Trump’s bugaboo, yet he might as well complain about the weather. It is what it is. The US will run a trade deficit unless we accept some combination of higher savings and lower consumption. That’s not my opinion; it’s math. Threatening China will not change it.

Trying to wean the US public off of consumption and force higher savings is just not going to work, either, which means we are going to run trade deficits.

But that is just fine. As long as we have the world’s reserve currency, we can run trade deficits with essentially no consequences. We aren’t comparable to Argentina or other countries that get into trouble because of their trade deficits. Nobody, not even their citizens, wants to hold the Argentine dollar or the Venezuelan bolivar.

This brewing trade war, if it continues, will initially favour the US but we will gradually lose the advantage as the rest of the world builds new pipes to bypass us. Something similar happened to the United Kingdom, our predecessor hegemon. We don’t know what a new world financial order would look like but the US dollar would not be on top of it.

This might be an interesting parlour game if it weren’t happening against the backdrop of populist politics, enormous debt, mass refugee migrations, and rapid technological change that could put millions out of work. Talk about “who wins” is really misleading.

Think about a boxing match. Who’s “winning” in the early rounds? Whoever threw the last punch is ahead for a moment. But then they take a punch and the lead changes. It’s only later in the match that you see which fighter has staying power.

I think the US-China trade war will be something like that. It will take a long time to see how it shakes out, and meantime we’ll see both sides alternately throwing and absorbing punches. The lead will change often and the winner could even be a third party that may not exist yet.

It is my fervent hope that China makes a genuine effort to reduce their most abusive practices, and that President Trump takes that for a “W” and calls off the tariffs. I think that is the most likely outcome. One of my most inside sources in China, whom I spoke with this week while he was in Shanghai, believes that to be the case, and most Chinese do, too. Which is why the markets are being rather sanguine about the whole process. We should learn more in the coming months.

Some Thoughts on Getting Through the Great Debt Reset

Debt is certainly one of the main challenges facing China and many nations around the globe today. The decades-long growth of debt in many countries from small, manageable levels to excessive levels is coming to an end. Bond markets will eventually rebel. We will have to restructure the debt and it will have a profound impact on how we meet future investment challenges.

As an investor, you will have to think differently to accumulate and maintain your wealth. If you’re an investment professional, you are entering one of the most disruptive periods the industry has ever seen. In either case, meeting these challenges will require thinking beyond a traditional stock-and-bond approach. Core holdings in the bull markets of our youth will no longer suffice in the future. Investors will need a better asset allocation approach.


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