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.

Backdrop

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.


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.

Source: Novel Investor

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

Source: NovelInvestor.com

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.

Europe

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.

Japan

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.

Africa

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. 

Source: http://shiller.barclays.com/SM/12/en/indices/static/historic-ratios.app

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!

Are "Trump Trade Wars" Inevitable?

President Donald Trump, at his joint address to Congress on February 28th 2017 stated: “I believe strongly in free trade, but it also has to be fair trade. It’s been a long time since we had fair trade. The first Republican president, Abraham Lincoln, warned that the abandonment of the protective policy of the American government would create want and ruin in the country… It’s time we heeded his advice and his ways.”

Free trade has been at the cornerstone of capitalist democratic economies now for many years, so this statement from the President of the biggest trading country in the world looks to President Lincoln to justify a return to protectionism and a reversal of the trend to ever freer trade that has been characterized by the post World War II international economic consensus. This has economists somewhat aghast at what is going on with the Trump administration, as after the new President immediately withdrew from the progressive Trans-Pacific Partnership (TPP) agreement, we also know that the Trump administration is now looking to not only renegotiate NAFTA but also has explored the idea of perhaps bypassing World Trade Organization (WTO) rules so as to impose a border adjustment tax (we'll come to what that is below).

So how will this all play out? Well there is already a battle inside the administration about how protectionist the policy pronouncements will be (see here), and it looks like the battle between the two factions will continue for a while yet, despite the fact that Steve Bannon has left the White House staff. In a recent NYT article (see here) there is doubt that President Trump will be able (or want) to follow through on his campaign promises with as much gusto as he suggested he would on the campaign trail. And in an article in the FT (see here) there were signs emerging that the Beijing relationship has now becoming badly frayed as the Trump administration initiates several unfair trade practices investigations. The danger though here is that the "soft-liners", although they might win in the short run, will not hold the upper hand as we approach the mid-term elections in late 2018 and beyond, as the administration realizes they are being punished at the ballot box for not fulfilling on these commitments. So let's take stock of where we are in terms of President Trump's campaign promises. In not particular order, they were:

1. Withdraw from TPP

2. Halt T-TIP negotiations

3. Renegotiate or scrap NAFTA

4. Institute a border tax (tariffs) with Mexico so as to pay for a wall on the Mexican border

5. Declare China to be a currency manipulator

6. Impose a border adjustment tax (BAT) as part of the tax reform package that should be forthcoming from the administration.

The first 2 on the list have now been completed, but the third is the one that has everyone guessing as to the consequences, so let's look at NAFTA first. 

NAFTA is now embedded into the North American economy, so changing the basis of the Treaty that established NAFTA requires a summit with both Canada and Mexico, and the negotiations for this summit are now taking place. 

President Trump has made it clear that he wants a complete rewrite of NAFTA, and that led to a tense start to the negotiations, which got underway this week (see here). The Canadian foreign minister, Chrystia Freeland, noted that “We pursue trade, free and fair, knowing it is not a zero-sum game”. She added that: “it is worth pointing out that we are the biggest client of the United States. Canada buys more from the U.S. than China, the UK and Japan combined.” 

Perhaps the US team in the negotiations, led by U.S. trade representative Richard Lighthizer, sees trade bilateral deficits ( - and the US does run a small deficit with Canada) as a measure of fairness of trade with that entity.  Any student of international economics understands that this is not the case - it is simply a component of the overall trade balance, and reflects a balance of comparative advantages between the two countries. Also it should be noted that Trump's ire has not been directed at Canada (with the isolated case of the softwood lumber issue) but in the NAFTA context his ire has largely been directed at Mexico. This is because whereas the U.S. ran a goods and services trade surplus with Canada in 2016 of about $12.5bn, the U.S. ran a goods and services trade deficit with Mexico of $55.6bn.  But as we shall see below, the trade deficit with Mexico is dwarfed by the trade deficit with China.

Now although the topics to be discussed are rules of origin, managed trade (read more quotas), and so-called "Chapter 19" dispute resolution, whatever is in NAFTA 2.0 better reduce the U.S.'s trade deficit with Mexico, otherwise this will likely prompt President Trump to threaten withdrawal from NAFTA. But given the fact that much of the trade between the U.S. and Mexico is intermediate goods trade, it does make sense that the biggest part of the cross border trade would be the finished product (for example a vehicle), rather than the sum of all the parts that might be produced in the U.S. that are exported to Mexico (where the vehicle is then assembled). Given then that it is unlikely that trade with Mexico could ever get to close to in balance (or in surplus), I think that President Trump, given that he has made such a big issue of either pulling out of NAFTA or completely rewriting it, may decide to pull out if the Mexicans don't walk out first.  

What I think will possibly transpire is a return to CUFTA, which was the free trade agreement with Canada that formed the original basis for NAFTA. Although other economists might not agree with my assessment, I believe that President Trump will feel that he has to deliver on this particular promise if he is to stand any chance of re-election.  In order for NAFTA 2.0 to eliminate the trade deficit with Mexico would be import quotas.  I think these will be rejected by Canada, as they would also affect Canadian exports to the US. So there is no way forward that would satisfy all 3 parties and therefore this will possibly lead to withdrawal. Since the announcement of Steve Bannon's ouster as a Trump advisor, the probability of withdrawal has gone down, but the trade representative will still have difficulty delivering what the President wants out of a re-write of NAFTA.

When campaigning, Donald Trump also mentioned a 35 percent tariff on autos made by U.S. companies in Mexico. This tariff was originally mentioned with regard to also funding construction of the wall. This tariff would currently go against the rules of NAFTA so is unlikely to be implemented while the U.S. remains inside NAFTA. So if the U.S. does leave NAFTA then this idea might get resurrected as a means to deter manufacturing or assembly going south of the border.

On the campaign trail President Trump also promised to name China as a "currency manipulator".  But having met with Premier Xi Jingpin, Trump declared that China had manipulated its currency in the past, but was moving to correct the level of the yuan, and hence it would not be necessary to name China as a "currency manipulator".  So this is now off the table.  President Trump did, however, decide to pursue several probes against China, most notably on intellectual property (see here), but also on steel. Although the U.S. has not imposed steel tariffs yet, it seems that they are likely to do so (see here).  This so-called "section 232" review ( - that was initiated because of fears that threats to the U.S. steel industry from imports would not be in the interests of national security) has to be made public by mid-January. Then President Trump will have 90 days to react, perhaps implementing a steep tariff on steel imports principally from China, but also from all other steel producers.

The Border Adjustment Tax (BAT) has now also been abandoned as a proposition, but just to keep my readers fully informed, I will explain exactly what a BAT is. A BAT is essentially an import tariff coupled with an export subsidy by means of making exports tax free.  

So that is the current state of play on international trade policy and the Trump administration. As mentioned above, the current administration appears to be particularly concerned about turning the overall U.S. trade deficit into a surplus, or at least reducing it.  In the table below from the BEA, the bilateral trade deficit or surplus for the U.S.'s main trading partners is shown, and it can be seen that the majority of the deficit is with China, and this is fairly consistent over time. 

Source: US Census Bureau, Dept of Commerce

Of course what really matters here is the trend in the data, so I thought I would download the data and see exactly how a long term perspective can show that actually China is pretty much the only problem. 

Data source: Dept of Commerce; Graphic by blog author

Now the graphic clearly shows that although there was a deterioration in the trade balance with countries like Japan, Germany and Mexico over the early 2000s, it is the trade deficit with China that really takes off in the early part of the century, and although for countries like Canada the trade balance has actually improved, for China, with only a brief respite during the great recession, the overall trend has been towards a widening of the deficit.

Chinese President Xi Jinping and U.S. President Donald Trump shake hands

So from an economic assessment, if one agrees with this approach, the President should really focus mostly on China, as this is where much of the trade deficit originates from. But what is the best way to tackle this? The U.S. trade representative has a detailed list of objectives which can be found here, but of course these only state objectives and not solutions.  

On a recent trip to China I visited a large container port off the coast of Shanghai ( - in fact it is at present the largest container port in the world), and was surprised to hear that half of the containers travel to China empty, but every single container is full leaving China. So the main problem with trading with China (and this goes for the EU too), is that China's trade with most of the rest of the world is unbalanced.  

This highlights the fact that although half of this problem is the U.S.'s problem, the flip side is that China clearly has a lack of consumption of imports in the sense that savings are high and when the Chinese do consume, much of their urban dwellers consume Chinese goods. The China issue prompted President Trump and President Jinping to set up a "US - China Comprehensive Dialogue", but as reported in the Financial Times last month (see here), this dialogue is a talking shop regarding the issues to be tackled, but nothing concrete to make it happen, and definitely no sign of agreement on the way forward. 

Clearly the Trump administration has changed tack and instead of calling the Chinese currency manipulators, has decided to go after the Chinese on various fronts by launching probes in specific problematic areas. The results of these probes though, if acted upon, will likely prompt reprisals, and perhaps WTO arbitration cases against the U.S. Certainly the Chinese appreciate that although the U.S. is not their largest trading partner ( - the EU is), that there are considerable risks to domestic economic growth if there is a trade war with the U.S.

So is a trade war inevitable with China?  I think that the answer here is still up in the air, but I still think the most likely outcome is narrowly in favor of a trade war. This is the case particularly if we see a degradation in the NAFTA talks appearing over the next few weeks.  A sign pointing in a different direction has also appeared though, and that relates to the earlier probe on steel which the President launched. There has still been no announcement as to the results of this probe, and this is likely because the announcement has been held back as it would be damaging to trade with China. How to handle this will definitely require some diplomacy, as President Trump will not want to make outright enemies of the Chinese.   

My thoughts on economic prospects for 2016

Welcome to 2016, and of course a very Happy New Year to all my blog readers!  As usual at this time of year, I like to reflect on the events of 2015 and what 2016 might bring in terms of the global macroeconomy and the capital markets in general.

So let’s start our global tour by first looking at the US. 2 factors were surprising in 2015: firstly the continuing fall in oil prices down to the mid-$30s – of course the fall started in 2014 but it has continued to fall as OPEC’s indecision has weighed on the oil markets; and secondly, the lack of any Fed tightening until December, despite the fact that there were expectations that rates would rise much earlier in the year.  All this suggests that growth in the US will, if anything, accelerate in 2016, and it implies that the US economy will continue to perform well as the country settles into the later part of the business cycle. Although some regard 2015 as a lackluster year, the markets are really not a good reflection of the surprising resilience of the US consumer, who is not only saving more, but also is spending more, but notably on different types of products than previously.  In particular, the tech sector still has strong potential growth given that this remains a comparative advantage for the US, and the housing sector continues to perform well, as the demand for housing is still masked by unreasonably strict credit conditions and the fact that ageing boomers are living longer and therefore inheritances are being delayed to the younger generations.  The Biotech sector has had a miserable year in terms of stockmarket performance, and this will likely continue and if anything worsen until the US elections are over, as drug pricing remains a politically divisive issue.  

In terms of the increase in interest rates, the Fed has made it clear that it will likely hike rates 4 times next year, which, as I stated in my last blog, likely reflects the fact that the Fed wants to normalize and realizes it has fallen behind the curve in terms of adjusting rates to appropriate rates ahead of the next downturn in the economy.  In other words, the Fed has prioritized rate hikes over withdrawal of quantitative easing (QE), which still leaves a lot of extra funds sloshing around the financial system.  Most financial market economists have forecast fewer rate hikes, and therefore little likelihood that the US dollar will further strengthen, but I think that this is a mistaken view – the Fed knows that January 1^st sees a raft of increases in minimum wages across the country, and so wage pressures are picking up, which coupled with extremely loose monetary policy implies that inflation pressures will likely build in the US economy, which will justify the rate increases, plus the fact that the QE will still largely be in place will also continue to act as an economic stimulus.  The wild card here though is the US dollar, which could appreciate, capping any inflationary pressure due to import price pass through to items like clothing and retail items, and also putting further dents in export performance by US multinationals. Any fall in the US dollar would therefore work in the opposite direction – to likely stimulate exports, adding to economic growth, but raising import prices thereby leading to greater certainty regarding Fed interest rate hikes.  Another potential factor stimulating the US economy will be largely dependent on Congress going forward – the Trans-Pacific Partnership or TPP.  If this does get passed by Congress and signed into law, the impact could be significant in the latter part of 2016. 

Next, let’s move on to Europe.  For 2015 Europe has had a good year in economic terms, with the exception of a few countries (for example Greece and Portugal), but near all-things non-economic in Europe have not gone according to plan in 2015.  The reason for the good news is largely down to the ECB and Mario Draghi’s “whatever it takes” QE, which has spurred stronger economic growth in the euro area core and periphery, giving stockmarkets such as Germany’s and Ireland’s a pretty good year.  The depreciation of the euro appears to have had little effect on import prices, largely because any increase in non-oil import prices has been more than offset by the (much) lower oil and other commodity prices. This is the reason that I have heard many economic commentators say that Europe is now “mid-cycle” compared to the US’s “late-cycle” position, but I think that although Europe lags behind the US in terms of business cycles, there is an “international business cycle” effect which does tend to tie Europe closely to the US business cycle – in other words, I think that Europe, although it has struggled to record significant economic growth rates, still only lags marginally behind the US in terms of its (natural) business cycle.  Given the ECB’s continuing stimulus through QE, the less fiscally profligate economies in Europe will continue to do well in 2016.  On the Transatlantic Trade and Investment Partnership (T-TIP) with the US, I think this will get put on hold in 2016, given the Presidential elections.

One side note on Europe here concerns the UK in 2016.  In the UK, there is a referendum planned on continuing membership of the European Union (EU) in June, in which Prime Minister David Cameron will make the case for sticking with the EU (but continuing to stay out of the euro). There are various forces in the UK now aligned against continuing membership of the EU – that is one reason why the UK stockmarket is down for 2015 when most EU stockmarkets are up over the same year.  Obviously the outcome of this referendum on the EU will colour the performance of the UK economy and of the UK stockmarket in 2016.

The Japanese economy saw continued signs of response from the QE being tried there by Prime Minister Shinzo Abe, but the US dollar’s strength coupled with the yen’s weakness meant that unhedged returns were muted, despite the fact that the Nikkei was up by over 9% last year.  Given the continuance of QE in Japan and Abe’s reforms, Japanese growth should be positive again, and that should lead to further stockmarket gains, although the direction of the currency is less certain in 2016, as the yen is now seen as more of a “safe haven” currency, and could be buoyed by inflows from China.

Turning to China, although markets there were positive over the previous year (up over 9%), the continuing devaluation of the yuan will sap confidence over “directed” economic policy.  Furthermore, as global growth will be under par as a whole, China will continue to slow, and this will be reinforced by the collapse in Chinese investment. I would expect the Chinese stockmarket could be down significantly in 2016, particularly if the Chinese government does not stimulate the economy.  In India, if Modi can continue to push through meaningful reforms, then the stockmarket could be one of the better performers in 2016.

Other than the major economies already covered above, I believe that unless there is an escalation conflict in the Middle East, oil prices will continue to be extremely low in the first part of 2016 and may move even lower than the high $30s, but in the second half of the year, there will be some rebound in prices as bankruptcies in the US leads to less supply on world markets.  In terms of commodity prices, they will continue to be weak into the first half of 2016, but once again, there could be some rebound in the second half as there is “overshooting” which leads to bankruptcies in this sector.  

The Global Economy in 2015

Happy 2015 to all my Econoblog readers!  I spent NYE in London by Tower Bridge enjoying a distant view of the spectacular fireworks display (see image on left) that London put on this year ( - but for the first time with a charge for the best viewing spots). Being in London certainly gives you a reminder of how globalized the world has become, as I heard at least 10 languages being spoken in the space of one particular day there. And of course these days the global economy is interconnected as never before with people and funds flowing freely across borders. A few years ago, when we hit the "great recession", there was talk of the reverse of globalization, and although some firms might have pulled back from such a large commitment of resources to international projects and expansion, I believe that this was only a lull, and not a reversal. Today, I was greeted in a British restaurant by a Danish front of house manager, served by a waittress from the Czech Republic and my table was cleared by a Hungarian. This would be almost unimaginable even ten years ago.

The reason why I bring this up is that I believe that the state of the global economy and trends at the global level are very important.  Paul Krugman also emphasized this in his most recent blog (see here) which shows that recent trends have basically transferred income from the developed country working classes to the developing country middle classes (in countries such as China and India). But those are long term trends, trends that will continue slowly over future decades.

Our focus here is what really matters in 2015. In my previous blog posting (see here), I have made the case that oil prices will stay reasonably low for at least 18 months, so that for the most part of 2015 oil prices will not be on an increasing trajectory.  So let's deal with each continent in turn.

Source: Wall Street Journal, Jan 2, 2015

In North America, the Fed has said it will begin to tighten, but will only do so slowly, which means that growth will accelerate here, leaving the Fed further behind the curve, as lower oil prices give a deflationary impulse to the CPI until the end of June.  This will allow the housing market to properly recover, as even with the upward move in interest rates, the amount of the rise will be relatively small, leaving mortgage rates still close to historic lows. In my view, this, coupled with the relaxation of mortgage conditions, will lead to increased demand for mortgages as rental rates are now very high compared with costs of home ownership. That means that although a very modest rise in interest rates will occur, it will still allow strong growth, falling unemployment and a buoyant stockmarket, with the retail and technology sectors doing particularly well.

In Europe, Greece remains the big problem. The "renegotiation of austerity" promised by the leftist party there, Syriza, led by Alexis Tsipras, has already sparked major fears in Europe of a showdown over the so-called Stability and Growth pact and the economic pain and suffering it has inflicted upon Greece. Although an exit from the euro (or "Grexit") has apparently been taken off the table for the moment ( - perhaps to make the leftist coalition more electable?), there is no reason why it could not be put back on the table once Syriza is in a position of power. That would leave the EU with a very interesting problem: do they make concessions to the Greeks and risk having the Portuguese, Spanish and Italians insisting on similar loosening of fiscal austerity conditions?  Or do they just allow the Greeks to then openly talk about exit from the euro, with all the instability that that would cause. Clearly, until the Greek situation is resolved, the uncertainty in Europe will prevent the euro area from emerging from its economic torpor anytime soon.  This means that the euro will remain under considerable pressure.

On monetary stimulus in the euro area, I think that Mario Draghi will continue to try and talk the euro area out of a mild recession, but there is just no consensus on how to do a really large and effective QE in Europe (despite what the pundits say -see here on this), so that although the limited measures still in place in Europe will continue, and may be expanded, no dramatic new programs will be announced unless things take a serious turn for the worse.  Worse here means either deflation appearing or a Grexit occurring and other member states threaten to leave the euro area. This is not beyond the realm of possibility, given that Germany it appears, thinks that the euro area could cope with a Grexit (see here).

The situation in the UK in particular, will also be rather uncertain in 2015.  Elections will occur in May of 2015, and there is considerable uncertainty as to which party or parties will take power. This means that the pound could depreciate in the first part of the year, and then could depreciate further in the second part of the year if a Labour government is formed, or rebound if some form of Conservative government is elected. The Bank of England will only change interest rates in the second half of the year, depending on how fiscal policy changes after the elections. Nevertheless, the UK should have accelerating economic growth as house prices continue to rise in the London area, and the wealth effect takes hold inducing higher levels of spending.

Source: http://krugman.blogs.nytimes.com/2015/01/02/britains-success-story/

The chart above to the left shows how the UK has fallen behind both the US and France due to the austerity measures imposed by the Conservative-Liberal coalition government. The trajectory shown in the figure though suggests a rate of growth of income in the UK similar to that in the US has now emerged. Note how weak income growth is in France though. Both Italy and Spain are experiencing worse rates of economic growth, which gives you a picture of how bad things are right now in the euro area.

Done by author: Data sourced from BoJ and FRED

In Japan, Abeonomics has not really yielded results yet, but there are promising signs that with the hefty new QE announced late last year that Japan's economy will finally emerge from the deflationary slump it has been in over the past couple of decades.  Unfortunately though the other half of the sales tax hike should moderate any uptick in growth coming from the monetary side, which means that even though a new stimulus package was unveiled in Japan on Dec 27th (see here), with a public debt to GDP ratio just under 250%, there is really very little room for any more action here. What is more promising is that there might be further monetary stimulus, which in my judgement is still needed to really get us on a path to achieving the Bank of Japan's 2% inflation target.  The chart on the right above shows that in fact although base money has been significantly stimulated by qualitative and quantitative easing (QQE) in Japan, M2 as a % of GDP appears to have now bottomed in the first quarter of 2014 (right hand axis, in %), and so although real GDP growth is still negative (left hand axis in YOY growth in % using seasonally adjusted data), there appears to be dogged determination by the central bank governor, Haruhiko Kuroda, to stimulate the economy by QQE until Japan finally starts moving in the right direction again. In my view perhaps in 2015 the QQE monetary stimulus may finally have some tangible effect, as expectations of the general public and the financial markets begin to change.

As for the rest of Asia, I see the Chinese economy still growing at a rapid clip, but until the euro area recovers (as it is the biggest customer for the Chinese), the Chinese economy will still have some headwinds. India is probably the most interesting place to invest in Asia right now, although of course whether Narendra Modi can actually achieve the reforms that he wishes to put in place, given the fractious nature of democracy in the country, is anybody's guess. But the potential is nevertheless there, with India now starting to emerge out of the shadows I believe that India will begin to catch up with China in terms of its economic growth trajectory.

In the rest of the world, I think Africa's economy will improve in 2015, as will that of South America, given that 2014 has delivered some hard lessons in how governments and political ambitions can often interfere with delivering and then maximizing economic growth.  

2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?

First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 

In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 

Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!

Is a “Perfect Storm” heading our way?

The NYU economics professor, Nouriel Roubini just went on record in Singapore a few days ago about his long term prediction for world growth – and it wasn’t wonderful!  According to Bloomberg reporters he said that there was roughly a third chance of a perfect storm in 2013, where China slows down significantly because of lack of consumption and the unwinding of the real estate bubble there, the US also struggles to break free from its current headwinds of mounting debt and the housing malaise to return to historical levels of economic growth and the EU finds itself revisiting the PIGS (Portugal, Ireland, Greece and Spain) debt problems time and time again which slows that continent down as crowding out occurs from increases in interest rates.  According to Roubini by that time Japan would also have exhausted the extra fiscal stimulus given to the economy after the Tsunami from earlier this year, which adds the icing to a cake that clearly has refused to rise to the occasion. 

So what are the other two-thirds of Roubini's probabilities?  The second scenario with a weighting of roughly a third is a resumption to more usual levels of growth is one of them – clearly a soft landing in China, an upturn in growth in the US and better news from Europe plus a more permanent boost in growth in Japan could all combine to move things along faster than the pessimists expect.  And the third scenario with a weighting of a third again is an intermediate “anemic but OK” growth scenario where the factors in the “perfect storm” scenario are much less severe. 

Forecasting the global economy is, I would assert, harder than forecasting the weather.  At least with the weather you know there are going to be seasons – with the economy you don’t have any idea about when these “seasons” are going to occur. There is the “business cycle” of course, but the consensus for the length of the business cycle is anywhere between 3 and now 10 years.  Once you are 3 years beyond the end of the last recession (which ended in June 2009) which means we’re at June 2012, then it’s anyone’s guess when the next recession will occur. At the other extreme we’re pretty sure that something will happen by 2019, as we have never had a period of more than 10 years of uninterrupted economic growth in the US. 

If we look at the gap between recessions though, it has grown since the Second World War, and so the next recession is more likely to be later, rather than earlier. Given this, I would place less probability on Roubini’s “perfect storm” than the other two scenarios he came up with.  Also the rosy scenario is a little too “rosy” for my liking, in that not all policymakers get it right, and particularly in both China and Japan there is not much of a record of getting the correct mix of policies to really optimize economic growth, plus we now know that there is not a lot that policymakers can do once a bubble has really built up in an economy, so the Chinese might really have difficulties dealing with the aftermath of a popping of their property bubble.

So I would disagree with Professor Roubini’s main forecast, which is of a “perfect storm” brewing for 2013, and would predict that we are much more likely to see problems in one part of the world and growth in other parts over the next few years, but that the “perfect storm” in the form of the next recession is some way down the road, and rather unlikely, mainly because of business and growth cycle factors in 2013. My most likely scenario would consist of more of a divergence in growth around the world, which is not to say that I don't believe in an international business cycle, but more because each region of the world has a different focus and different views about the effectiveness of government policies. These perceptions, I believe, in and of themselves can produce different outcomes.

So a more interesting question from an investment standpoint is where there is most potential for a resumption in economic growth.  Although policymakers do not determine economic growth rates, they do, in my view, have a significant impact on setting the appropriate environment for growth to occur. The developing economies in the form of the emerging markets certainly have the most to gain, but if the US gets this mix of fiscal rectitude and continued modest monetary stimulus from the Fed right, then it too will also benefit. Non euro area European countries still have extremely bright prospects and of course the euro area, if it bites the bullet and develops a Euro area bond or decides to let Greece go, could also benefit. I, like several other commentators, am now bearish on China as their economic problems appear to presage a bursting bubble, and Japan, as I have already stated in this blog, might just be the biggest surprise of them all if they can only get their politicians to act sensibly.

Goodbye 2010, Hello 2011!

I have been reading lots of forecasts about 2011 – some in the local South African Sunday papers just say that the emerging economies are the place to put your money, and others, such as the Economist warn that the emerging economies will become more risky as some of them become dangerously overheated and recommend reconsidering the US given the new stimulus from the Tax bill recently passed through the US Congress. The general consensus in terms of investment in stocks is that emerging markets will continue to be the preferred location for stocks, but if US economic policy signals a change towards greater growth in the developed world then this will trigger large capital flows from emerging to developed markets.


In this posting I want to review 2010 in terms of the financial markets and consider the various (geographic) alternatives for a good portfolio strategy for 2011. From an economics perspective, economic growth refers to growth in the size of the economy which should therefore increase the profits of companies in dollar terms as quantities of goods produced increase. Stockmarket prices should be an indication of future profits, so one might expect stock prices and economic growth to be correlated, but interestingly their correlation is not that high. Nevertheless this is more likely due to a variable lag relationship between the two which would not show up in a simple correlation. Common sense tells us that there must be some kind of relationship there, otherwise it would imply complete irrationality on the part of the markets.

There is general consensus now that the US economy is now beginning to recover from the economic downturn, as are the European and Japanese economies. Obviously the continuing US economic recovery is key to a general global recovery given that the US tends to drive global economic growth and therefore the stockmarkets, but there are other considerations for 2011. As of December 15th US economic growth was forecast to be 2.8% for 2010 with stockmarket appreciation of 10%. Growth is likely to accelerate next year, so stockmarket gains should continue into next year, but probably not at an accelerating pace.

The big question marks in terms of where to put your money are Japan and Europe. I do not agree with the cynics on continental Europe and the future of the euro, but stockmarkets are probably not the best place gamble when probabilities are uncertain, as sometimes markets themselves can precipitate crises. In the UK the prospect of cuts and political uncertainties do not make both Southern and middle Europe an attractive proposition in 2011, but northern Europe and in particular the Nordic countries still look very attractive going into 2011, with Sweden the leader of the pack in 2010 ( - growth of 4.6% and stockmarket appreciation of 27%).

Japan, I believe, might be the big surprise of 2011. Japan is still in the throws of deflation with current year over year inflation running at around -2.5%, but growth is now picking up, with the Japanese economy growing at a projected 3.2% in 2010, far ahead of most of Europe, and prices are actually now rising on a month to month basis. Japanese stockmarkets have advanced around 8.3% this year, ahead of all European stockmarkets with the exception of Germany’s DAX index. If this trend continues then Japan may outperform most of Europe, and with a resumption of healthy growth, the Japanese stockmarket could incorporate a sharp upward correction in 2011.

Now to the emerging markets. Although China has been a hot market in 2010 with estimated 10.2% economic growth and its stockmarket up by nearly 22% in dollar terms, I believe that China is now a risky prospect for 2011, with possible strikes, an unfortunate (lack of a coherent) foreign policy, and a rapidly increasing inflation rate. We do not really know what the economic growth rate in China is, as state factories always have an incentive to meet or surpass their targets, so in fact growth may not be as fast as reported. The main point is that a continuing “cultural clash” between the communist run political state and a free market economy could quite possibly lead to greater unrest, human strife and uncertainty in 2011.

Apart from the other smaller South East Asian economies (like Thailand, Malaysia and Indonesia – countries that all experienced double digit stockmarket gains and) which all grew at phenomenal rates in 2010, India with an 8.8% growth rate and a 15.3% (in dollar terms) stockmarket rise, is, in my opinion, a much better long term bet than China. Larger Indian companies are now making their mark in many other emerging markets ( - I’ve seen a surprising number of Tata vehicles on the road in South Africa, for example), and their emphasis on technology and software development all bodes well for the future.

What about the rest of the world? South America continues to surprise, with Argentina, Chile and Columbia leading the pack, and here I would say Brazil is likely the country to watch, as their stockmarket has really not gained this year partly because of fears of overheating, but clearly there is still a lot of potential here. Africa, Eastern Europe and Russia are the wild cards. Africa probably has the greatest growth potential but political instability (as so vividly shown in the Ivory Coast and soon to be seen again in Zimbabwe) is the big problem here. Eastern Europe and Russia also have a lot of potential, but once again politics also plays a big hand, although some countries in Eastern Europe, particularly those that sank fastest and most dramatically in the economic downturn (the Baltic states), are likely to be good places to invest in 2011.

Last, the commodity and bond markets. The commodity markets (and particularly gold) make me nervous right now. There is no real reason for gold to be at the level it is ( - and incidentally that is a good reason not to put money into Australian or South African mining stocks right now), and the fundamentals really do not support further increases in the price of crude oil either. In terms of the bond markets, stay away from developed economy markets as the timing of when interest rates will start to rise are very uncertain, but emerging market bond markets likely will continue to offer good yields, particularly at the long end.

China and Africa – not a win-win situation?

Every time I visit South Africa at some point I end up in a store called Woolworths.  Now for people in the US Woolworths is synonymous with a failed chain of stores that catered mainly to the working classes and might be thought of as the Walmart of the 1960s.  There was also a Woolworths in the UK which went out of business but the Woolworths in South Africa used to be owned by the venerable UK chain store of Marks and Spencers known for its quality merchandise and good value for money.  In the 1980s Marks and Spencers decided to go global opening chains in Canada, South Africa and even France – in South Africa it decided to use the Woolworths brand name. When Marks and Spencers downsized in the 1990s it sold off its Woolworths chain in South Africa but the store still has the reputation of supplying quality merchandise.

On my latest trip to Woolworths I was surprised by certain changes.  For example, on previous visits there were always clothes and other items made in South Africa, Lesotho, Swaziland and Mozambique ( - all Southern African countries) – but this time I struggled to find anything that wasn’t made in China.  I eventually found some linen shirts made in Bangladesh, but absolutely nothing that was made in Southern Africa.  Now to me this is extremely disconcerting.  It means that African manufacturing companies are struggling to compete with Chinese manufacturers.  In fact the latest manufacturing output statistics for South Africa show a decline in output which continues a worrying trend for a country that relies on commodities and should be the manufacturing engine for most of the rest of Africa.  Recent statistics on capacity utilization at http://www.engineeringnews.co.za/article/low-capacity-utilisation-weighs-on-sas-2011-investment-outlook---absa-capital-2010-12-14 also underscore this.  

So why is this?  Unskilled wage rates are hardly high in Africa so this must be mostly to do with the Chinese exchange rate.  Now there has been plenty written about China’s undervalued exchange rate on the US and Europe, but not a lot has been made of the effects of China’s undervalued exchange rate on the rest of the world.  But China’s exchange rate policy has impacted developing countries as well, with Mexico’s maquilladoras struggling to compete and Indian companies also struggling with competing with China’s rapidly expanding industrial complexes. But although the US and Europe have criticized China, not much has been forthcoming on the issue from African politicians.  One of the most important reasons why Africa is not as anxious to criticize China as the developing world is that huge amounts of money have been flowing into Africa to buy up land and upgrade infrastructure – money that probably wouldn’t have flowed to Africa otherwise. 

The trade off with China in Africa (and indeed in other parts of the world) is a different one from that in the developed world.  In Africa the influx of money from China is not in the form of loans to fund the trade deficits run with China by the US and European countries, but instead is in the form of foreign direct investment in mining and mineral companies and land.  Either way the trade off is not a good one – it is a matter of short to medium term convenience to allow China to buy US and European bonds to keep interest rates low in the developed world, but the purchase of land and foreign direct investment in Africa, although supporting factor prices, is not easily reversed and comes with a major decline in the industrial base and also a sizeable loss of manufacturing jobs. Of course this differs by country with some of the extremely poor agrarian African economies benefitting from the inflow but not losing any industrial base ( - as they never had one to begin with), but the losses for other more industrialized countries (like South Africa and Nigeria) are likely to be much more serious in the long term.

In my mind there is another really important question here which is largely ignored by economists.  Is it in the rest of the world’s interest to have so many products made solely in China and hardly anywhere else?  What happens if there is major political unrest in China or striking workers limit output?  With virtually only one (monopoly) producer of certain articles this means that prices for these articles would skyrocket around the world until manufacturing capacity could be expanded elsewhere.  It would then be in the rest of the world’s interest to allow the Communist authorities to suppress any unrest on economic grounds, while on political grounds there would unlikely be much support for what the authorities end up doing ( - given their record on human rights). 

The Developing World and the Recovery Phase

As we enter the recovery phase of the business cycle, it is becoming increasingly apparent that there are big differences from a macroeconomic perspective between what is going on in the developed world and the developing world. The economist highlighted this in a recent issue which talks about the economic advances made in South America (cover on left).

It seems obvious to me that although there is a lot of hand-wringing about what is going on in the US (QE2, November elections, corporate stockpiling of cash), the fact remains that the US housing market has been the source of the global economic downturn, so that means that until that is sorted out and confidence fully returns, US economic growth will remain skittish. 

Of course that is not the case elsewhere.  As the Economist makes clear for South America, things have changed there in the last decade, and the outlook for growth and prosperity is much brighter than it was even 10 years ago.  Lula is now the hero of Brazil, having brought stability and prosperity to a once hyperinflation-plagued country, and despite the media focus on Hugo Chavez of Venezuela, there are other success stories (such as Chile, Belize and Costa Rica) south of the Rio Grande. 

And while I've been enjoying the great 9.4% return on my Latin American mutual fund, I am not unaware of the fact that in other parts of the world growth has been much more spectacular.  India must be the standout here, with even The Economist (once again) highlighting this fact on its most recent cover ( - "How India's growth will outpace China's").  To me, China has always been problematic as a trading partner, not only because it is still officially a communist state, but also because it manipulates its currency and it's virtually impossible to hold any Chinese stocks ( - all the China mutual funds you see are really Hong Kong mutual funds).  So yes, India will likely be the place to be over the next expansion phase of the business cycle.

In all this Africa is a bit of a "dark sheep".  Although South Africa is a great place to invest, and the Zuma government hasn't turned out to be as nasty as it might have been - partly because of people like Helen Zille in the wings, making sure that the government doesn't get away with too much - it's future is more uncertain.  Mandela's influence is clearly waning, and what happens after his moderating influence is absent is anyone's guess.  Hopefully Zimbabwe will not be the example to follow!  Elsewhere in Africa, long-term stability is still not assured.

But what about Europe?  More about this next time.