The Gavekal Monthly — Preparing For The Trumped-Up Economy · Indicators “Trumpflation” Is...
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GavekalResearch The Gavekal Monthly Preparing For The Trumped-Up Economy December 2016
Transcript of The Gavekal Monthly — Preparing For The Trumped-Up Economy · Indicators “Trumpflation” Is...
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The Gavekal Monthly
Preparing For The Trumped-Up Economy
December 2016
GavekalResearch 2
The Gavekal Monthly – December 2016
Overview
Anatole’s Take Prepare For The Trumped-Up Economy Anatole Kaletsky 3
Louis’s Take Something’s Gotta Give Louis-Vincent Gave 8
Key Calls
US Economy What Could Go Wrong? Will Denyer 17
Europe The Domino Effect Nick Andrews 21
China More To Gain Than Lose From Trump Arthur Kroeber 25
Dashboard
Our Views in Brief Economies, Markets, Themes 29
Indicators “Trumpflation” Is Boosting Risk Appetites 32
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Anatole’s Take
Prepare For The Trumped-Up Economy Anatole Kaletsky
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Anatole’s Take Regime change
Trump’s victory in the presidential election signals two important shifts to the post-crisis economic regime:
1. The dominance of monetary policy is giving way to the dominance of fiscal policy. Keynesian policy: run fiscal deficits when unemployment is high and
tighten fiscal policy when unemployment is low. Republican Party policy: run fiscal deficits when Republicans are in
power, and tighten fiscal policy when Democrats are in power. The stage is set for fiscal expansion.
2. We are moving from a 35-year bull market in bonds to a potential 10 to 20-year bear market in bonds.
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Anatole’s Take Fiscal policy resurgent
• Large-scale fiscal stimulus is now likely in the US: Unified government under the Republican Party has the sole aim of
reviving the US industrial sector and generating economic and job growth in the declining Midwest which delivered Trump his mandate.
Infrastructure spending will substantially increase but so will healthcare spending, since the only way to bridge the gap between Obamacare and whatever comes next is government support.
Big tax cuts will deliver little boost to growth since they will mainly go to rich people who save rather than consume their income. But the benefit to market sentiment is already obvious.
Federal budget deficit could rise from 2-3% of GDP to 5-6%. Nominal GDP growth will rise to around 4%, mainly through increased
inflation rather than faster real GDP growth.
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Anatole’s Take Bond yields and the dollar heading up
• The return to inflationary growth in the US means higher bond yields: In addition to responding to higher inflation, yields will rise as the
Federal Reserve inevitably tightens.
• The question then becomes: can the dollar keep strengthening while yields are rising mainly because of inflation?
• The answer is yes, for a year or two: The US is moving to inflationary fiscal and tightening monetary policy
while the EU and Japan are doing the reverse, and China will need to cut rates.
So long as this holds we will see a self-reinforcing dollar rise, and a painful liquidation of short dollar positions—similar to the early Reagan years of the 1980s.
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Anatole’s Take Investment conclusions
• Who wins and who loses in a world of rising US nominal growth and inflation, higher yields, a stronger dollar, and a trend tode-globalization and weaker trade growth?
• Winners: US equities that are leveraged to domestic growth (i.e. small caps) Relatively closed EM economies with low trade exposures and limited
dollar liabilities (India, Russia, Brazil)
• Losers: EM exposed to global trade and with dollar liabilities (Korea, Mexico) Europe, which for the next 12 months will be the main source of
global political and macro risk (see pp. 21-24).
• Safe haven: Japan, which alone among rich economies is insulated from political risk
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Louis’s Take The 2016 rally, pre- and post-Trump
• For months, I contended that this year’s equity market rally was driven by two forces:
1. The unnatural compression of interest rates. With 40% of OECD bonds offering negative yields over the summer, the belief spread that investors were in a “TINA’” environment. I argued this would not last.
2. The unnatural compression of exchange rate volatility. Following the February G20 finance minister meeting in Shanghai, most exchange rates stayed within a tight band. With the removal of foreign exchange volatility as a concern, risk assets soared.
• Trump’s election and the GOP sweep in other elections has undermined both of these forces. But equity markets have responded with glee to interest-rate and exchange-rate uncertainty!
• Is this sustainable? Have we really started a new bull market based on a shift to a loose fiscal / tight US monetary policy scenario, as Anatole suggests above?
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Louis’s Take Are we really moving from top right to bottom left?
Fiscal policy loose Fiscal policy tight
Monetary policy loose
The US in the 1970s and 2001-06Inflation accelerates, equities
constantly de-rate. Massive outperformance of
value vs growth, EM vs DM/gold/materials
The US in 1994-98 and between 2013-16
Growth massively outperforms value. US$ rises.
DM outperforms EM
Monetary policy tight
The US in the early 1980sUS$ shoots up. Bonds melt down.
Commodities suffer. Financials outperform, US outperforms
1987 crashBig problems for everyone as the
lifeblood is sucked out of markets. Most contrarian trades outperform.
Can’t be in anything crowded!
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Louis’s Take What makes sense, what doesn’t
Market moves that seem logical:
Higher US interest rates => US$ outperformsHigher US rates => financials outperform, bond proxies underperformHigher US$ => EM, gold, oil underperformHigher inflation expectations => value outperforms growth
Market moves that are harder to understand:χ Higher US$ / US rates => Deep cyclicals and reflation trades outperformχ Higher US$ => US$ bonds / US bond proxies underperform other bondsχ Higher industrial metals => EM underperformsχ Outperformance of value => EM underperforms
Stating the obvious:US equities melting up + bonds melting down + stronger US$
= an unstable equilibrium!
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Louis’s Take The right questions to ask
How will the current unstable market equilibrium break? This depends on the answers to three questions:1. How much of the “Trump reflation” will be real GDP
growth, rather than price rises? (My answer: not much, unless the deregulation/tax cut agenda wins out over the infrastructure-spending agenda)
2. How much more will US interest rates rise?(My answer: perhaps not that much more)
3. How much will the US dollar rise from here?(My answer: maybe not so much)
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Trump’s economic program seems largely about increasing government spending. But periods of accelerating government spending usually end up as periods of declining trend growth.
With labor force growth slowing, and anti-immigration policies likely to shrink it further, real growth must come from productivity gains. The big hope here is for massive deregulation and tax cuts.
Even if deregulation and tax cuts deliver higher trend growth, the impact is probably at least two years away. Meanwhile, inflation is likely to keep rising for the next 12 months or so, on the back of rising commodity prices and a tight labor market.
Louis’s Take Trumpnomics: more inflation than growth?
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If what Trump delivers is mainly more inflation, rather than mainly more productivity growth, then nominal GDP growth will not be helpful to equities. Instead, it will hurt stocks, since inflation generally leads to compressed P/E multiples.
Moreover, as interest rates rise, corporates will need to clean up the balance sheets that they have loaded up with cheap debt over the past few years.
Capex growth is already hovering around zero, and inventory-to-sales ratios have risen steadily for six years to reach historically high levels.
All in all it is hard to make a strong case for a sustained US equity rally, so long as inflation and rates keep rising.
Louis’s Take Higher inflation/rates not usually kind to equities
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The hope, therefore, is that the rise in inflation, and in bond yields and the US dollar, will prove temporary.
And indeed there are good reasons to think this might be so. Our model of US long rates (above) now suggests a more neutral stance on treasuries. Moreover, technical analysis suggests that long bonds are now oversold.
To the extent that inflation does pick up over the next 12 months, this will limit the dollar’s ability to keep rising: generally speaking. Indeed, historically the dollar falls when US CPI is 1.5pp higher than a year earlier.
The one reason to think the US dollars could continue rising is that dollar reserves at the Fed are declining, which could be evidence of a global dollar short squeeze. But a liquidity squeeze would not be bullish risk assets.
Louis’s Take But bonds and the US$ could roll over soon
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Louis’s Take Decision tree: Is the US economy a coiled spring?
Is the US economy a coiled spring, ready to surge
thanks to spending, tax cuts and deregulation?
Will the Fed tighten
monetary policy
aggressively?
Will the Fed tighten
monetary policy
aggressively?
This is the scenario the market seems to be inching towards.
Sell gold, “growth at any price” stocks (FANGS).Buy US financials, US value stocks
CPI would pick up & US$ rise would be muted. Sell bonds, sell proxies.
Buy deep cyclicals, emerging markets, gold, scarcity assets (high-end real estate,
collectibles…) GBP and MXP
In this scenario, the Fed makes a mistake and pushes the economy into a deflationary bust.
Buy US$, UST, stable growth stocks.Sell cyclicals, Emerging Markets, scarcity assets
The rise in yields and the US$ put a brake on US growth and recent market moves abate.
Sell US$Buy EM debt, RMB debt, bond proxies, gold
No
Yes
Yes
No
Yes
No
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US Economy What Could Go Wrong?
What’s happening What it means
US bonds have sold off, driving 10-year UST yields up to 2.4%, from 1.8% before the US election
• Most of this move is due to a rebound in inflation expectations, while real yields have risen modestly. • The move makes sense as even before Donald Trump’s election win, the US was seeing inflationary pressure (see The End Of The Goldilocks Scenario?). Now that one party controls both the White House and Congress, increased deficit spending is likely.
US equities and the dollar are rallying
• Trump and the house Republicans both promise (albeit to varying degrees) to cut taxes on corporate income, capital gains and dividends. This would increase after-tax returns on equity. The proposed elimination of the estate tax further enhances the attractiveness, and simplicity, of US investments for foreigners (see Trump’s Tax Plans And The Dollar).
Industrials and banks areoutperforming
• US industrials are outperforming on the hope that Trump will (i) do more infrastructure spending, (ii) protect them from foreign competition, and (iii) allow the energy sector to expand more freely. • Banks are outperforming on (i) the steepening of the yield curve and (ii) hopes for financial deregulation.
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While recent market moves can be explained with reference to Trump’ s stated policy positions, investors should focus on potential timing problems.
Changes in tax policy, financial regulation and public works will likely not take effect for many months and some may not kick in until 2018 or later. Meanwhile, the market is already pushing the US dollar and interest rates sharply higher.
So, while Trump’s “reflationary” policy proposals remain just that (proposals), the market moves are already exerting deflationary pressure in the opposite direction.
And this at a time when the economic cycle already looks long in the tooth. If recession strikes soon, then the rally in equities and the sell-off in bonds will likely reverse—all before Trump has a chance to do anything.
US Economy What Could Go Wrong?
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US companies making investment decisions today face the following facts: ROIC is in decline; inventories are bloated; the US dollar (already too strong for exporters) is breaking higher; interest rates are rising.
Trump promises to help out, but he has no track record and is not yet in office. Businesses may take a wait-and-see approach. With capital spending already anemic, a contraction could help tip the economy into recession.
Similarly, homebuilding is flat-lining due to tighter lending standards (see US Homebuilders Hit A Speedbump). With mortgage rates rising, this sector too could soon be in recession territory.
For now, pare equity exposure (to, say, 30%) in favor of medium term bonds (see A Wicksellian Spread Update).
US Economy What Could Go Wrong?
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Europe The Domino EffectWhat’s happening What it means
Europe faces a risky electoral calendar
• Voters in Italy, Austria, the Netherlands, France and Germany (representing 75% of the eurozone economy) will go to the polls in the next 10 months. After the Brexit vote and Donald Trump’s win in the US presidential election, populist parties have been emboldened and the risk of another anti-establishment victory by a party committed to leaving the single currency system is significant.
Italian 10-year bond yields rise to widest spread over German bunds in two years
• Referendums usually end up as a vote of confidence on the sitting government. Italy’s constitutional referendum on December 4 is no different. Prime Minister Matteo Renzi has promised to step down if he loses, creating risk that recapitalization of Italy’s struggling banks will be delayed. Financial and political instability could follow.
François Fillon wins the French Republican primary
• Self-proclaimed Thatcherite reformer François Fillon is now the favorite to win next May’s French presidential election after winning the second round run-off to be the Republican contender. The probability of a National Front upset has fallen.
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The next 12 months could decide the future of the eurozone. It only takes one anti-euro, populist party to win power to throw the system into chaos. Votes in Italy, the Netherlands, France and Germany could produce such an outcome (see A Trumpian Europe?).
It should be assumed that opinion polls underestimate support for the populist vote and the momentum behind anti-establishment parties delivers further upsets.
Italy’s constitutional referendum on December 4 is the next great threat to Europe’s supranational project. Matteo Renzi has threatened to resign as prime minister if he loses—the most likely outcome according to opinion polls. This would greatly complicate the recapitalization of Italy's fragile banking sector. Even if an interim technocratic government is appointed, allowing near term stability, Italy could be on the road to Italexit.
Europe The Domino Effect
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In the Netherlands, the anti-euro Freedom Party leads the opinion polls, the National Front looks set to reach the second round of France’s presidential election in May and the anti-immigrant Alternative for Germany (AfD) has forced Angela Merkel to slow down moves toward more European integration. Ironically, the weakness of Merkel means she has no option but to resist calls from Brussels for a fiscal expansion (see The Lady Is Not For Turning).
However, the nomination of François Fillon as the French republican presidential candidate lessens the chance of the National Front achieving a Trumpian surprise (see Polls, Big Data And The French Primary). But a Fillon win would likely spur a period of labor actions /strikes.
Europe’s political strains are reflected in wider credit spreads. Investors should remain cautious until the political haze clears (see The Rally In European Banks).
Europe The Domino Effect
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China More To Gain Than Lose From Trump
What’s happening What it means
Trump’s victory raised the risk of a trade war with China
• During his campaign Trump threatened to impose across-the-board tariffs of up to 45% on Chinese imports, and to label China a currency manipulator.• But implementing massive tariffs would be self-defeating, as they would raise prices for Trump’s constituency of middle- and working-class consumers, and would invite strong Chinese retaliation. Trump’s trade actions will probably be just symbolic.
The renminbi has depreciated by -2% against the dollar since the election
• The fall in USD/CNY is the mirror image of the stronger dollar since the election. The renminbi has held steady against the CFETS trade-weighted basket (see Trump, Risk, And The Renminbi).• Current dollar strength is manageable; but if the dollar rises a lot more then the further fall in CNY/USD required to maintain trade-weighted stability risks triggering more capital outflows. Regulators may tighten approval procedures for big outbound FDI projects.
Trump has indicated he will pull the US out of TPP
• Trump has given conflicting signals on whether he favors a stronger or weaker US presence in Asia. This gives China space to keep building its sphere of influence (see The Advantage Shifts To China).
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The immediate risk to China from a Trump presidency is a much stronger dollar. China aims to keep the RMB stable against the CFETS basket. So when the dollar is strong (e.g. since July), the RMB must fall vs the dollar.
Global markets thus don’t worry about a weaker RMB (see The Renminbi Falls; No One Cares). Same for domestic investors: the Shanghai Composite is up 5% since the US election (see Equities Decouple From The Renminbi).
But if the promise of US reflation and higher interest rates under Trump drives the dollar a lot higher, Chinese investors could start to switch from RMB to dollar assets, and trigger capital outflows.
So far there is no evidence of this: the US$45bn decline in official reserves in October was driven mainly by valuation changes. True capital outflows (both gross and net) remain stable at manageable levels.
China More To Gain Than Lose From Trump
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Once Trump gets into office, a trade war is a worry: Trump vowed to impose a high general tariff on Chinese imports and declare China a currency manipulator.
Yet strong trade sanctions are unlikely. They would invite painful Chinese retaliation: restrictions on US exports (e.g. of soybeans and Boeing aircraft), or regulatory harassment of US businesses in China. Trump will probably content himself with symbolic action against a handful of Chinese exports, for instance steel.
In the longer run, Trump’s abandonment of TPP leaves China as the likely leader of further Asian economic integration, via its Belt-and-Road strategy.
So far the returns on that strategy have been meager. Chinese exports have failed to pick up despite currency depreciation, and revenue from overseas construction projects has flatlined (see Milestones On A Different Road). It remains to be seen whether China can translate geopolitical edge into economic benefit.
China More To Gain Than Lose From Trump
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Our Views In Brief EconomiesRegion Analyst View Read more
US Will Denyer/Tan Kai Xian
Tight bank lending standards for construction loans and higher interest rates weigh on the US homebuilding sector and add to recession risk
A Cautionary Note On US Housing; US Homebuilders Hit A Speedbump
China Andrew BatsonDomestic growth is still not a big concern, though the property market is gradually cooling
The Three Pillars Of Stability; The Holding Pattern
Eurozone Nick Andrews / Cedric Gemehl
Brexit will hurt growth. Policy will slowly shift to fiscal stimulus;construction growth a bright spot
Towards A Fiscal Union By Stealth; The Eurozone Construction Revival
Japan Joyce Poon/Neil Newman
Abenomics has not succeeded in reviving confidence. A snap election could give Abe a mandate for more drastic policies
The Next Monetary Move;Japan: Twice Bitten, Thrice Shy; That Sinking Feeling
India Tom Miller/Udith Sikand
The structural growth story remains sound, but demonetization will retard growth and delay the turn in the investment cycle.
Why India Can Move Faster; Modi Finds His Mojo; India’s Banknote Bombshell
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Our Views In Brief MarketsMarket Analyst View Read more
Global asset allocation
Charles Gave
The best hedge for Ursus Magnus: a portfolio of 40% US and UK equities, 30% 7-year UST zeros and 30% short-term GBP deposits
US Bonds As A Hedge: It’s Complicated
US dollar Will DenyerTrump’s proposed tax plan could spur capital inflows and cause a melt-up in the US dollar, as in 1984
Trump’s Tax Plans And The Dollar
Growth vs value Tan Kai XianFed rate hike should slow money supply growth, which tends to be favorable for value stocks
Riding The US Monetary Cycle
Japan Neil Newman / Joyce Poon
Tactically bullish on TOPIX due to the pro-cyclical nature of domestic financial institutions’ policies
Japanese Equities—Good For A Rally?; That Sinking Feeling
Renminbi Chen LongThe renminbi is falling against a strong dollar, but the market is calm and the CFETS basket is stable
Trump, Risk And The Renminbi; Equities Decouple From Renminbi
Eurozoneequities
Nick AndrewsTime to turn defensive on eurozoneequities; banking sector remains vulnerable
Europe’s Breakout Problem;The Rally In European Banks
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Our Views In Brief ThemesTopic Analyst View Read more
Trumpnomics Louis-Vincent Gave / Anatole Kaletsky
US fiscal stimulus could end worries of secular stagnation. However it may be bad news for equity markets
What A Trump Presidency Means For Global Investors; The Decision Tree From Here
Political risk Anatole Kaletsky, Charles Gave
The Brexit vote is symptomaticof a new era of political risk in which voters reject the elite
Everything Just Changed; Trump And The Prisoner’s Dilemma; Renzi’s Gamble
The low-rate fallacy Charles GaveZero rates are destroyingproductivity and leading to a deflationary recession
Vertigo And The US Economy; Bloodhound And Swedish Economist
Oil: lower for longer Anatole KaletskyAbundant supply means US$50/bbl is a ceiling price
Oil: Lower For Longer;Oil’s Busted Flush
China reform risk Arthur Kroeber
Xi Jinping's preference for political control over market reform could lead China into Japan-style stagnation
Making Sense Of The Economic Policy Mess;Powerhouse, Menace Or The Next Japan?
Renminbiinternationalization
Louis-Vincent GaveBeijing’s drive to globalize its currency to continue despite market turmoil
The Crocodile Mouth About To Close; The New Way To Think About China
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After a disappointing October, equity markets bounced back in November, notching up a 1.3% gain, the best month since July.
Obviously, the event that sparked this recovery was the election of Donald Trump as the next president of the US.
It is important to note that even before the presidential election, our global growth indicator had been improving markedly.
On top of this, we are now going to get much easier fiscal policies (both tax cuts and a big infrastructure investment program). Thus, at least in the short term, we should expect US growth to perk up.
Indicators Our growth indicators are rising quickly
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Indicators ”Trumpflation” is boosting risk appetites
As mentioned earlier, investors have moved into full on reflation mode on the back of Trump’s election victory.
This is particularly visible in the classical reflation plays such as banks, industrial metals, etc. But how long can this last?
One worry is rising US borrowing costs on the back of a big sell-off in treasuries and another concern is the possibility of rising divergences within Europe again.
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Indicators Will ECB QE ramp up as Fed exits and as EMU spreads widen?
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Indicators After the bond sell-off, is it time to dip ones toes into USTs?
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