Saturday, September 15, 2018

The Macroeconomics of Trump's Trade Policy and Portfolio Implications

One of my ex-students, who is now working for a prestigious Financial Services sector company, contacted me to ask me about the US$ and tariffs and if there was any relationship between the two.

Why is this important?  Well it is important for several reasons, perhaps most notably because the effects of a higher dollar actually appear to work against the objective of the Trump adminstration's trade policies of reducing trade imbalances between the US and the rest of the world.  How is this the case?  Well a higher dollar means that our exports appear more expensive to foreigners, but our imports then appear cheaper to domestic residents.  So in fact (depending on price elasticities and what is called the Marshall Lerner condition), our exports could fall and our imports increase, which everything else remaining constant would worsen the trade deficit.

But any student of economics who has completed an intermediate macroeconomics course actually knows that there is a more fundamental macroeconomic link between trade policy and the exchange rate, which is presented in perhaps its most simplistic form in Greg Mankiw's Intermediate Macroeconomics textbook (see Chapter 6).  So let's deal with the hard stuff first and tackle the macro theory.  To those of you who are more "wonkish" out there, this is known as the Mundell Fleming model, which got its name from the two Canadian economists who originally constructed the model.

The idea of the chart is that there are 2 relationships which govern our external sector.  The first is that our real exchange rate is related to our trade balance, and that relationship is embodied by the downward sloping curve labelled NX. The second is that our Balance of Payments must balance.  This means that whatever happens on the current account, which can be mostly represented by our trade balance Net Exports = (Exports - Imports), must be matched by what happens on our Financial account, which is determined by the imbalance between our savings and our investment.  So all the vertical line says is that if we have a given level of Savings (the funds available to firms) and Investment (the amount that firms need to fund their investment expenditure), then that means that this must be the amount that is made available through money flows in or out of the country.  In this simplified setup, this is not dependent on the exchange rate.  So in equilibrium we should be where the 2 blue lines cross, so where the current account and the financial account of the Balance of Payments match with opposite signs (so that their sum is zero and hence we are in balance - a constraint that every country has to satisfy).

So what happens when we have a change in trade policy, which is essentially what has happened with the Trump administration's imposition of tariffs and threat of imposition of tariffs ( - as financial markets react in terms of expectations of future events)?

As you can see from the diagram from Mankiw's textbook, the theoretical implication is that imports fall as one would expect, but that leads to an imbalance on the Balance of Payments, so the exchange rate will appreciate, which in turn will choke off exports and stimulate imports, which ultimately leads us back to the same level of net exports.  

President Trump is causing the US$ to appreciate simply because of his tariff talk and in some instances his tariff actions.  So the flow of causation definitely runs from the threat of imposing large tariffs on our  trading partners through to currency appreciation.  And why is he doing this?  Because his main objective is to improve the US trade imbalance.  Economic theory suggests, however, that this is completely futile, as all it does is appreciate our currency and leave our trade balance at roughly the same level.

But of course this is just theory, and it relies on a raft of unrealistic assumptions.  So can we glean something from the actual data?  Below I have plotted real Net Exports of Goods and Services vs the Trade Weighted US dollar on the same graph, to give you an idea of how these two variables move over time.  [And for those of you who say I should be using the real exchange rate (RER), the RER essentially follows almost exactly the same path as the nominal trade weighted version]. 

Clearly sometimes the currency and Net Exports move together, as during the "great recession" and sometimes they move in different directions, as they have done in recent years.  Clearly it largely depends on what is causing the change in Net Exports, as this variable is the net result of a complex combination of different factors.  Nevertheless, the sharp move upwards in the real value of the US dollar in 2015 through the beginning of 2016 has definitely been reflected by a deterioration in the Real Net Exports of goods of services.  What is also clear here is that there has been a jolting rebound upwards in the exchange rate since President Trump took office, which will likely be reflected in little improvement in the Real Trade Balance of goods and services for the next while.

Now let's move beyond the economics here, and think about the implications for the valuation of financial assets outside of the US.  I listen regularly to CNBC and there has been a lot of talk there about how emerging markets have not performed well so far this year and whether there is any likelihood of a rebound.  Obviously a strong US dollar makes for foreign stocks of any type to look cheap in comparison to US stocks, and given the cyclical nature of movements in the US dollar, over the long haul it makes sense to accumulate (good) foreign stocks when the dollar is strong so that when the dollar weakens you enhance your returns by getting a double whammy return (from the stock and also from the gain in the foreign currency against the US dollar).  That is one reason why, when you look at the chart above, emerging markets did very well last year as the US dollar weakening gave an extra boost to foreign stocks.

So while we have an exceptionally strong dollar as we do now, I think it is actually sensible to start accumulating good foreign stocks ( - not necessarily in emerging markets incidentally), and preferably ones that pay a secure and decent dividend so as to pay you while you wait for US dollar to do a reversal.  If you have to go for an emerging market, I still suggest that India is the brightest spot right now, mostly because it still has huge potential from a growth perspective, but also because it is not in the cross-hairs of the Trump administration's trade policies.

Lastly, the next obvious question to ask is what might cause the US dollar to initiate a depreciating trend again.  My first answer would obviously be some satisfactory resolution on the trade issues confronting the global economy right now.  That might entail some brokered compromise or it might entail some other event that diverts the Trump administration away from its focus on trade issues.  

Sunday, April 1, 2018

The bell tolls on NAFTA - so what are the "known unknowns"?

Donald Rumsfeld
Donald Rumsfeld, the U.S. defense secretary in the George W. Bush administration, once stated (back in February 2002) that "there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know".  At present, the situation with whether NAFTA (North American Free Trade Agreement) exists this time next year is one of these "known unknowns".  In fact the date for deciding whether NAFTA will exist next year is about a month away, due to mid-term elections north of the border and the Presidential elections south of the border, which will hamper any further progress in the negotiations beyond May.  Not only that, but some decisions are to be taken also before May on the extent of the tariffs to be taken against China, in addition to the ones already announced.

Larry Kudlow - Speaking at CPAC 2015
With the new tariffs on steel and aluminium, plus the resignation of Gary Cohn as the head of the National Economic Council and President Trump's top economic adviser, there is little now to stop the advance of US economic nationalism in the US administration.  Even the new appointment of Larry Kudlow as Cohn's replacement is unlikely to change things on the trade front, as Kudlow clearly sees the bigger picture and wants to keep his new appointment and much greater political influence than he has pontificating on CNBC.  Plus in the grand scheme of things these tariffs are not that important compared to the regulatory rollback favored by Kudlow and his ilk.

In general though, the US media seems to be at a loss to understand why President Trump is pushing ahead with this agenda, and is predicting doom and gloom with the potential for trade wars to emerge, rolling back the advances made towards a fully globalized trading system.  But they do not seem to understand what is at stake here, and nor do they seem to understand the economics surrounding globalization and how financial markets are to a certain extent tied to the fate of globalization over the next month or so.  The way I tended to view the President's stance on tariffs was that it was mostly a case of "bluster" to prompt other countries to yield on their trade positions so as to obviate the need to implement tariffs. But recent events have proved that position to be wrong - President Trump is indeed willing to bypass the WTO, and implement tariffs, particularly on China (there is a good article on the growing irrelevance of the WTO from the FT here)

But the President's position on NAFTA is a little different.  President Trump was partially elected on his campaign promise to either repeal or renegotiate NAFTA, and so far the re-negotiation has been hung up on various of the US demands, most notably: i) rules of origin for autos - 85% NAFTA and 50% US for those autos sold in the US; ii) scrapping of the investor-state system, where investors from another NAFTA country can sue the government of that country if they are treated differently from how they would be treated in their own country; iii) scrapping of the trade dispute settlement mechanism whereby a panel of experts decides which country wins a particular trade dispute case; iv) an end to Canada's agricultural supply management system; v) the introduction of a sunset clause whereby all 3 countries have to renew NAFTA every 5 years.

So what is likely to happen here and what are the potential "known unknowns" here?  First, how far is President Trump likely to want to compromise to save NAFTA. Well so far the negotiations have been making slow progress, but as one might imagine, some of the US demands are proving difficult for the other NAFTA countries to accept and/or compromise around.  The investor-state system has been updated, and as the US wants it scrapped, Canada and Mexico have decided to just make it apply to them, effectively giving the US an opt out from the system.  Recent news from the talks in Mexico City appear to show that the US has now dropped all it's demands on auto content (see here), which was also a major sticking point.  While that seems like a reasonable compromise, there are still other issues like the trade dispute mechanism and the sunset clause, where it is hard to see how the different parties can come together in a deal, despite what is at stake.
The Mexican border at Yuma, AZ

As the President stated in a Reuters interview last year: "A lot of people are going to be unhappy if I terminate NAFTA. A lot of people don't realize how good it would be to terminate NAFTA because the way you're going to make the best deal is to terminate NAFTA. But people would like to see me not do that". The big problem for President Trump is not Canada, although the Canadians have taken issue with the US position here (see this recent article in their national newspaper, The Globe and Mail here), but  on the other hand Mexico is seemingly the biggest problem as far as President Trump is concerned, and largely because of the trade deficit that the U.S. runs with Mexico . Even just this morning on his way to Church, the President stopped by reporters to announce that as well as there being no DACA deal that he was still considering pulling out of NAFTA (see here) if border security did not improve. So this is clearly a huge "known unknown", and if President Trump appears not to be able to get his cherished wall on the Mexican border by a deal with the Democrats on DACA, then this appears to be the President's next best hope - allowing Mexico to remain in NAFTA, only if it pays (in part or wholly) for the new border wall.  It also perhaps is a signal that the President was not happy with the concession that his negotiators made in regard to the trade in autos.

U.S. Trade Representative Lighthizer's comments at the conclusion to the 7th round of talks in Mexico City were also revealing. He stated "As President Trump has said, we hope for a successful completion of these talks, and we would prefer a three-way, tripartite agreement. If that proves impossible, we are prepared to move on a bilateral basis, if agreement can be made."

Texas is very much involved now in trying to save NAFTA - as Canada's Financial Post pointed out in an article this week (see here), but clearly the President is not keen to compromise on NAFTA without there being some quid pro quo in the case of Mexico.

But what is at stake is probably bigger than any talk of tariffs with China, as although China is a large trading partner, the embedded nature of the trading relationships with both Mexico are far reaching. The actual size of the trading relationship with both Canada and Mexico can be seen in the figure above, which shows the flows of trade in and out of the country for 2016,  Now of course the trade relationship with Canada is unlikely to be threatened, as President Trump will likely revert to what was known previously as CUFTA (the Canada-US Free Trade Agreement), but for US States along the border with Mexico the implications are much more serious if Mexico is prohibited from continuing in NAFTA.  The figure below shows the exports by State to Mexico and it is clear that although all the border States would be hit by any new trade restrictions introduced between the US and Mexico, it is Texas that would suffer by far the most of any State.
Now it is likely that the US has a surplus on services which should likely redress some of the imbalance on the trade in goods (i.e. a trade deficit).  The latest figures we have for the U.S. Services exports were $33.3 billion; services imports of $26.3 billion, giving a U.S. services trade surplus with Mexico of $7.0 billion in 2017.  This figure also seems small to me, considering how many Mexicans come on vacation to the U.S. and also considering the dominance of the internet by U.S. multinationals, but in any case, those benefits would likely mostly flow to one U.S. State: California.

So what are the possible outcomes here?
i) First the worst scenario, with a complete withdrawal from NAFTA. No special trade relations with either Mexico or Canada.  This is now extremely unlikely, but the effects on the North American markets would definitely be highly negative if it were to occur.
ii) Second, a more likely scenario would be a withdrawal from NAFTA while at the same time an invitation to Canada to continue negotiating on a CUFTA deal.  This I think is highly likely if no concessions are made by Mexico regarding border security, and in particular, some funding for the wall. Clearly Mexican markets would take a big hit if this were to occur, and the Texan economy in particular could potentially be badly hit. In the U.S., the auto sector and the energy sector would be particularly vulnerable.
iii) Third, another possible scenario which has just appeared due to the President's retreat from doing a DACA deal with Democrats, that of the NAFTA being successfully concluded due to a side deal that the President does with the Mexicans such that they partially agree to some unspecified payments so that the President gets a partial victory.  Although unlikely, due to Mexican opposition to any acquiescence on the wall, it is possible and would likely have no effect on the U.S. markets but would see a relief rally in Canadian and Mexican stockmarkets.
iv) Fourth, a successful conclusion to NAFTA without any side agreement, but with some of President Trump's signature demands embedded into the agreement, notably reformed dispute settlement mechanism and a sunset clause on the agreement, subject to a review and further revisions at some point in the future.  A relief rally in all 3 participant countries would likely occur on such news.

If I were forced to choose, I would say that outcome ii) and iv) are most likely, but in fact I think for electoral reasons I think President Trump's instincts will be to withdraw from NAFTA, unless certain key concessions are won.  . 

Wednesday, January 10, 2018

Happy New Year for 2018!! Economic outlook and investment strategy

Happy New Year to all my Econoblog readers, and readers through the syndication to Seeking Alpha. As usual, I will try and distill my "top down" macro views for prospects for 2018 in terms of economic growth, the stockmarket, and interest rates.


As we enter the 10th year since the last downturn, the global economy is living on borrowed time - and I mean that literally!  As I explored in my last Econoblog posting (see here), the business cycle is elongating, for either temporary or permanent reasons.  My own predilection is for a permanent elongation (mostly due to the findings from my own academic research agenda), but either way, an elongation is now occurring for this phase of the business cycle as we move into 2018.

So the real question is what will perform best as we move into the late stages of the business cycle expansion, and how to hedge the uncertainty of the coming downturn whenever it is. Well there are several different approaches one can take to answering this question, so I will first do a review of what I see are the prospects for the different regions of the world, and then focus in on what I think makes sense for my own investment strategy.

A quick aside. 2017 has been an exceptional year in the stockmarkets, and the performance of the major stockmarkets in the world has been positive almost everywhere. In the US, the S&P 500 was up 19.4%, the DJIA up 25.1% and the Nasdaq up an astounding 28.2%, while the 10 year US government bond yield is still under 3%.  But although the US performed well, many other countries outperformed the US.  The chart below shows the return of different stockmarkets (in US$ terms), and if we use the S&P 500 as probably the best overall barometer for the entire US stockmarkets, then the US is near the bottom of the list in terms of performance for 2017.

Novel Investor International Markets Returns Table
Source: Novel Investor

But this also doesn't consider other classes of assets, and the website Novel Investor once again has this covered with a chart that shows that emerging market stockmarkets outperformed all other classes of stocks.  This is due to the fact that emerging market stockmarkets have had a fairly tepid performance throughout this business cycle upswing, so in the late stages of the upswing in growth, obviously this will boost commodity prices for many things, which will allow emerging market stockmarkets to outperform.

Novel Investor Asset Class Returns TableSource: Novel Investor

But what of individual emerging markets?  Where performed the best?  Well once again, Novel investor has us covered here too.

Novel Investor Asset Class Returns Table


So Poland, China, South Korea and Hungary were the big winners for 2017.  And Pakistan, which several commentators said would perform very well in 2017, was the big loser.  And that really highlights a problem with emerging market economies and individual emerging markets - they are very volatile and it is really a fools game trying to pick which market will be the winner in any particular year.  But there again, that's why anyone interested in investing in emerging markets would be wise to buy an emerging market mutual fund rather than stocks in any individual country.

Back to my thoughts about 2018.  So with the backdrop of the current phase of the business cycle and the fact that US interest rates are likely to rise in 2018, let's look at each region in turn and then devise an economic outlook and investment position for 2018.

North America

The US has had a great run in 2017, but with rising rates, and an erratic President, with the good news for US corporations now delivered in terms of the tax reform, further progress with President Trump's agenda will be difficult.  The President will need cooperation from democrats if he is to pursue his plans to pass an infrastructure spending package, and the impasse on immigration doesn't seem to bode well for cooperation in that or in any other area for that matter.  So I can only conclude that most of the good news for stocks has already now been achieved, and there will be little more coming down the pipeline.  If there is more and I am wrong, then clearly the infrastructure and construction companies will do well.  Given the political uncertainty in the US surrounding the mid-term elections and the ongoing investigations together with rising interest rates and withdrawal of QE, I think the US will underperform compared to other parts of the developed world and certainly with respect to the emerging markets.

I think NAFTA will likely collapse in 2018, which will mean that Mexico is probably not a stable place to invest, but Canada will likely outperform both the US and Mexico, given that the US has made it clear that if NAFTA is terminated, then the US would still be open to falling back to the original CUFTA trade deal that was the precursor to NAFTA.  So in general, I think that Canadian stocks are a safer bet than US stocks for 2018 and should be bought on any signs of weakness.

The other factor that has had very little press so far this year is that yes, we have a new Chair of the Fed, Jay Powell.  As with all Fed Chairs, Jay is likely to have an early stumble or mishap in the job as he finds his feet.  That may unnerve the markets as well.  I would expect that maybe the FOMC might act too aggressively to increase rates than is necessary, or may "fall behind the curve" at some point.  Either way, there are clearly consequences for the stockmarkets here.

The US dollar is also a bit of a conundrum for 2018.  Rising interest rates usually portend a stronger currency, and that's what we have seen so far but with the protectionism proposed by the Trump administration and the possibility that the Chinese may no longer buy so many bonds, that in turn will have an uncertain effect on the currency.  As can be seen from the plot of the trade weighted US dollar, despite the recent depreciation, we are close to all time highs already.  Obviously from international economics that means that the markets have already discounted further rate rises, and are perhaps now looking for reasons not to push the US currency any higher.


European stockmarkets generally had a great year in 2017, and as QE continues in 2018, it is likely that this will continue at least until the second half of the year.  If you look at the performance of the European stockmarkets in recent years, they nearly all had downturns in 2014 and/or 2015, so they are basically still catching up with the US, and of course the banking sectors in the EU are still fragile but improving as time goes on.  The Mifid2 directive, which was supposed to come into force at the beginning of this year will likely (when implemented in March) increase transparency and efficiency in EU stockmarkets which will tend to increase confidence and spur greater stockmarket returns.

The two areas where there are significant risks are Brexit and Greece.  With Brexit, there is no certainty yet that a trade deal between the UK and the EU will be achieved before the exit date of March 2019.  Although Prime Minister Theresa May has successfully concluded the conditions of the breakup by agreeing to a hefty payment to the EU and safeguarding the right of EU nationals to remain in the UK after March 2019, this does not ensure that a trade deal will be struck in time.  The current policy of "gradual divergence" (see here) does not bode well for a consensus on any new trade deal as the EU does not see this as consistent with having a trade deal that would create a level playing field between the UK and the EU - it is seen as cherry-picking the areas where the UK would not want to diverge for fear of losing business, while having the right to diverge in other areas.  Also the Chancellor, Philip Hammond, who is much more in favor of a "soft" Brexit, has broached the idea of a new customs union with the EU (see here), but this would not allow the UK much independence when negotiating trade deals with other countries as the UK's hands would already be tied in relation to trade policy because of the EU customs union.   The second area of risk remains Greece.  Greece is now experiencing growth again, but the political situation is still not completely stable, as an elections must be called by October 2019, and the current government is unlikely to want to wait that long, so a general election is likely to be called in the second quarter of 2018.  The outcome of the election is likely to determine whether Greece continues to follow the path of fiscal consolidation insisted upon the rest of the EU, or a new government pushes the country in a different direction.

From an investment standpoint probably the Nordic countries are most insulated from these risks, although probably Central and Eastern Europe stockmarkets are still likely to be the most volatile and may yet again outperform the Western and Southern European member states.


The news from Japan has basically been good in 2017.  The efforts to stimulate the economy using QE appear to be now paying off, with economic growth now positive for the 7th consecutive quarter (see here), but mostly due to external factors rather than domestic growth ( - consumption was still in decline in the last quarter reported).  Nevertheless recent revisions to 3rd quarter GDP suggest that the economy was growing faster than previously thought, which allowed the stockmarket to remain buoyant, but it does mean that without the external demand stimulus and the continuing QE, the economy would likely have experienced only tepid growth.

The Japanese economy therefore does appear to have achieved "escape velocity" which means that deflation is now in the rear view mirror, despite the fact that inflation is still falling short of the Bank of Japan's inflation targets.  This should allow the Japanese stockmarket to make further gains in 2018.  In fact, if correct, a recent FT article (see here) suggests that the labor market is now in a state of severe shortage, which should allow wages to start to rise in a more sustained.  That, in turn, will boost the stockmarket.

Rest of Asia

My views on China are relatively well known after my recent presentation on OBOR (One Belt One Road).  But to recap, I think that China will grow in 2018, but substantially less rapidly than it did in 2017 as OBOR projects take production out of the country ( - remember that GDP only includes production within the borders of a country).  OBOR is clearly long term geopolitical and economic investment project, so it is expected that GDP would slow...GNP, on the other hand, will stay relatively robust.  Anyone who has been to China can attest to the fact that although investment is still high, it is clearly slowing as there is now a substantial amount of "infrastructure slack" in the economy ( - visible in terms of "ghost" trade and logistics inland ports, empty buildings and relatively empty new highways and fast speed trains out in the rural west).  And although consumption is now clearly on display in the major cities, I think that China's next push must be to modernize it's agricultural sector based in the rural areas, and that will not be easy.

As for India, 2017 was quite rocky (what with the monetary reforms and the unpopular new VAT tax), but as long as tinkering with major part of the macroeconomy do not continue under the Modi government, the prospects for an uptick in growth appear quite good.


The election of Cyril Ramaphosa as ANC Chair and therefore leader of the party, caused a relief rally
in late 2017, and I believe this will continue through 2018, with much more business friendly approaches making an appearance in South Africa and hopefully a more pragmatic approach to achieving the lifting of all boats through more sensible economic policies for the whole economy will start to bear fruit.

Investment Strategy

So given my macroeconomic views detailed above, what does this imply about investment strategy?  I have produced the cyclically adjusted price to earnings ratios (CAPE ratio) for all the countries discussed above in the figure below.  The data ends in November of 2017, so although we are missing one datapoint it is clear that the US has, since early 2016, had the highest CAPE.  That means that the US firms' stockmarket prices were highest compared to their earnings at this stage of the business cycle.  Then comes Japan, which is not far behind.  At the bottom of the CAPE rankings are UK and China, while the countries sandwiched in the middle are India and collectively the European countries. 

But what does that mean then?  I think what it means is that stocks in both China and the UK are valued at roughly half the amount that US and Japanese stocks are.  That in turn tends to suggest that i) if stockmarkets globally continue to climb, it is likely that those with lower CAPEs will grow faster than those with higher CAPEs; and ii) that if there were to be a pullback, the amount of the pullback is likely to be less in both the UK and China simply because those two markets have not climbed to nearly the same levels as have both the US and Japan.

So for an investment strategy based around the viewpoint expressed here, I would suggest:
i) underweight on US and Japanese stocks
ii) overweight on UK and Chinese stocks
iii) some weight in India and European stocks
iv) underweight on US government bond holdings
v) overweight on foreign bonds, particularly of those countries where China might want to substitute  holdings.
vi) overweight on other EM stocks, as these countries try to catch up with the phenomenal pick up in the US stockmarket.

And yes, I have already rearranged my own portfolio to put my proverbial money where my mouth is!

Featured Post

Free Trade on Trial - What are the Lessons for Economists?

This election season in the US there has been an extraordinary and disturbing trend at work: vilifying free trade as a "job kille...

Popular Posts

Search This Blog