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July 2018: Market Viewpoints


Manish Singh - July 30, 2018

Summary

Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. The US became the dominant economic power in the early 20th Century by having high protective tariffs and this served as a model for later day mercantilists – Germany, other European nations and most recently, China. George Washington, the first President of the United States, not only supported the protection of infant US industries, but also set an example by “buying American.” The US Presidents that followed Washington carried on the protectionist policies as they built America in the 19th Century. The Republican Party dominated the US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. History is a great thing. One just has to look back far enough to cure one of all prejudices.

American Protectionism

Let’s face it, there is no such thing as “free trade”, only good or bad trade deals. The debate about “free trade” and capitalism can be neatly divided into two distinct camps – Liberalism and Mercantilism. Liberals see the State as predatory and Business as profiteers and the two shouldn’t be allowed to work together to the detriment of the individual consumer. Liberalism places the individual’s interest at the heart of economic policy-making, with the objective of increasing household consumption i.e. giving the individual consumer easy and unhindered access to the cheapest possible goods and services. Mercantilists, on the other hand, don’t see this separation between the State and Business as a necessary condition to benefit the individual consumer. They see the two as allies and emphasise that the aim of economic policy-making is to improve the productive capacity of the nation in pursuit of economic growth, power and independence. For the Mercantilist, a sound economy requires a sound production structure within the nation and not a cheap production structure abroad. Mercantilists believe that a robust domestic consumption can only be underpinned by high employment at appropriate wages and not cheap goods from abroad. What does the Liberal like to call the Mercantilist? A Protectionist. Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. It became the dominant economic power in the early 20th Century by having high protective tariffs and it served as a model for later day mercantilists – Germany, other European nations and most recently, China.

I often get a strange look from my friends and colleagues when I make the observation that America was a “protectionist” nation. Perhaps you are frowning at me now as well. However, please indulge me and keep reading.

From the time of its Independence, through the Civil War in the 19th Century and the Great Depression in the 20th Century, the United States of America followed a “protectionist” policy as it looked to get the better of Great Britain and establish itself as the dominant economy in the world. George Washington, the first President of the United States from 1789-1797, not only supported the protection of infant US industries but also set an example by “buying American.” He said – “I use no porter [ale] or cheese in my family, but such as is made in America.” Alexander Hamilton, President Washington’s Treasury Secretary and the founder of America’s financial system argued in favour of a national industrial policy that inspired the likes of American economic nationalists Daniel Raymond and the German-American economic thinker Georg Friedrich List. Raymond believed that the “protective tariff represented national interests and that it allowed for the nation’s people a leverage, and special treatment granted to them over foreigners” in the fields of domestic commerce and industry of the nation. List, whose vision of a united Germany with a protected market was realized later in the 19th Century, believed that “the cost of a tariff should be seen as an investment in a nation’s future productivity.”

The US Presidents that followed Washington carried on the protectionist policies, as they built America in the 19th Century. The Republican Party (led by men such as Lincoln, McKinley, Roosevelt, Harding, Coolidge and Hoover) dominated US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. The US Economist Joseph Schumpeter called tariffs the “household remedy” of the Republican Party. It wouldn’t be too off base if instead of calling the GOP – the Grand Old Party, one called them – the Grand Old Protectionists. Tariffs were used both to generate revenues as well as to protect the American economy from British and European imports. President Franklin Roosevelt summed it up well when he declared, “Thank God I am not a free-trader. In this country, pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.”

America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. It ran a trade surplus for over 30 years selling goods and services to Europe, Japan and Asia whilst helping them re-emerge from the devastation of the Second World War. The love for “free trade” didn’t last long, however. The latter half of 1970s and early 80s saw massive capital outflows from the US and migration of manufacturing and this turned the US from a trade surplus to a trade deficit nation. As trade and budget deficits mounted and Japan achieved a rival status, America strong-armed Japan into signing the “Plaza accord” in a move to shrink the US trade and budget deficits. The US had a temporary respite and deficits began to narrow in the 90s until China came along. The accession of China into the World Trade Organisation (WTO) accelerated the US trade deficit as Liberalism (Clinton, Bush, Obama) won and Mercantilism/Protectionism lost. Now, the US is back to protectionism once again and once again under a Republican President, Donald Trump. China is accused of “protectionism” and the US is heralded as a “free trader.” History is a great thing. One just has to look back far enough to cure one of all prejudices. In that, I am reminded of this Marcus Tullius Cicero quote: “To be ignorant of what occurred before you were born is to remain always a child.”

From the US point of view, over three decades of liberalism have eroded its economic might and a return to mercantilism, as Trump proposes, is like a reversion to the mean. However, can this be achieved? Is the US ready to pay the price it will take to return to its mercantilist past? That’s the trillion-dollar question. If tariffs start biting US consumers, Trump’s “Make America Great again” could simply turn into “Make America Grate.”

Markets & the Economy

Things are stirring at the Bank of Japan (BOJ). Under its “yield curve control” (YCC) policy, the BOJ committed to holding 10-year yields at around 0%. This policy has been around since September 2016 and has been successful, thus far, in staving off deflation and keeping the Japanese Yen (JPY) weak. Over the weekend, there were reports that the BOJ was looking to move this target yield higher. That was enough for the market to sell the 10-yr Japanese Government bonds (JGBs) and yields spiked up by 10 basis points, which is a big move in Japan. The yield on 10-year JGBs rarely moves more than one basis point during a day’s trading. The BOJ had to step in to prevent more of a sell-off and it offered to buy unlimited amounts of the bonds at a yield of +0.11%. This had the desired result of preventing any more sell-off in the JGBs and in fact, the Central Bank didn’t wind up having to buy any bonds. The BOJ is trying to steepen the yield curve and help Japanese banks so they can in-turn boost the economy by making more loans. It’s a dangerous game, as the BOJ is nowhere near achieving its +2% inflation target and if the market interprets this as the BOJ being a step closer to unwinding its aggressive monetary stimulus – then the Yen will rally and undo years of BOJ stimulus. The BOJ is holding a two-day board meeting beginning on July 30. I do not expect a change in the YCC target and expect the BOJ to reiterate its faith in this policy.

On July 6, President Trump imposed a 25% tariff on $34 billion of Chinese exports to the US and threatened to impose a 10% tariff on another $200 billion worth of exports, if China retaliated. China shrugged off this threat and last week imposed a 25% tariff on the same value of US products— mainly agricultural products such as soybeans, cotton, beef, pork, dairy, and nuts. This week Trump indicated that he was willing to put tariffs on all $505 billion of goods the US imports from China. You’d think that risk assets would have reacted badly to this tit-for-tat trade spat. Not really. In fact, July has been a great month for risk assets. The S&P 500 index (SPX) is up +3.75% this month and continues the uptrend off the early April lows with a series of higher highs and higher lows (see graph below) as Q2 earnings have come in thick and fast, with the majority of them either meeting expectations or surprising to the upside.

S&P 500 index: Performance 2018 YTD

Market Viewpoints July 2018 Graph

 

Of course, the effect of US tariffs on steel and aluminium, which came into effect on June 1, is showing up as well. Alcoa reported its Q2 earnings last week and it indicated that the recently enacted US tariffs on steel and aluminium are hurting its earnings. Only 14% of Alcoa’s global aluminium output is produced in the US. The rest is imported. The stock promptly fell -13% as the market started pricing the hit to Alcoa’s earnings from more expensive imports. General Motors (GM) reported Q2 earnings yesterday and while the net income rose the stock fell -7% on the unexpected high raw-material costs in the wake of US tariffs.

As I mentioned earlier, while imposing tariffs may be Trump’s objective of returning America to its mercantilist past, the success of this policy will depend on the price American consumers are willing to pay. Tariffs on the scale of $505 billion, would inevitably lead to chaos and price rises for everyday products in the US and the retaliation that would follow would hurt the US economy and US businesses. Regular readers of this newsletter will know that I do not believe Trump will sacrifice the US economy and go for an all-out trade assault on China, the US’s biggest and most important single nation trading partner. Wages in America are not rising fast enough and are growing at an annual rate of +2.7%. A tariff of 10% on everyday goods? Trump will have to be careful to not impact US consumers too adversely, if he wants to keep playing Marshall Will Kane in the movie High Noon out to save a town.

Trump’s protectionist bark is likely bigger than his bite, particularly with respect to the US trading relationship with China. The US is on target to run a $1 trillion budget deficit by 2020 and the national debt is heading to over +100% of GDP. The US can ill-afford the extent of deficit spending it would need in case of a full-on trade war with China without adversely and terminally affecting its future prosperity. I, therefore, continue to be overweight US equities, with a preference for Healthcare (XLV), Financials (XLF) and Technology (XLK) stocks.

Despite the “deal” that Trump and Jean-Claude Juncker, President of the European Commission, announced last night, I am wary of European equities. First of all, it’s not a “deal” but a start of a negotiation to get a “tariff-free” deal and to get rid of all “trade barriers and subsidies.” Secondly, there’s no timetable for progress and that is troubling given how long it takes for the European Union (EU) to negotiate even a simple trade deal. Third, have you ever seen a La Poste or a Gendarmerie car which was not a Renault, Citroen or Peugeot? I haven’t in over a decade of my travels to France. Protectionist France doesn’t have a trade imbalance with the US. Why then would President Emmanuel Macron of France agree to remove all “tariffs, barriers and subsidies” and open the French market to competition and pick a fight with the powerful trade unions in France? His closet is already full of troubles and his popularity is sinking like a lead balloon. Finally, to understand Trump’s motivation to slap a tariff on autos you have to understand the US auto market and what it means for Trump and the US rust-belt economies.

The US auto market recorded annual sales of 17 million vehicles in 2017, of which just 4 million were produced in the US. Trump wants the US to stop importing 13 million vehicles each year and force its manufacturers to produce them in America, creating manufacturing jobs in the hollowed out American rust-belt. In that, Trump is taking a lesson from China which imports less than 1.5 million of its annual 28 million auto sales. Therefore, I will believe an EU-US “free trade” deal on autos and other industrial products when I see it. With crucial mid-term elections ahead, Trump only wants cover for his attacks on China that have brought about the tariff on US agriculture exports to China. To alleviate the pain inflicted by that tariffs on US farmers, Trump had to announce a $12 billion subsidy this week. Europe buying soybean and liquefied natural gas (LPG), at least until the mid-term elections, plays into Trump’s hand and he looks magnanimous as US farmers offload their soybeans in Europe. Post mid-term elections, he can beat up on the EU again, as public opinion will be behind Trump riding high on his mid-term success. I see this EU-US truce as temporary, and hostilities will renew post mid-term elections.

Emerging Markets have taken a beating thus far this year as the US Dollar strengthened. The MSCI Emerging Market ETF (EEM US) has underperformed the SPX by more than -10% and is due a catch up as sentiment improves and the USD rally halts. There is also the stimulus from China. At a meeting led by Premier Li Keqiang this week, the State Council, China’s cabinet, vowed to use more proactive fiscal policies to spur growth. I would however not recommend a long position in Chinese equities traded onshore, but instead would recommend the large cap Tech names that trade on US stock exchanges – Alibaba, Baidu, Tencent and JD.com. Semiconductor stocks such as Micron Technology (MU US) are another favourite of mine. China accounted for more than 50% of Micron’s revenue in fiscal 2017. The stock was hit hard due to fears of tariffs but that seems to be easing. The stock still trades at under five times forward earnings estimates and could double over the next 12-18 months.

As for Financials, which have had a bad run this year, the Q2 earnings came in strong with Q2 profits rising +16-20% year-over-year. Yet, bank stocks – JP Morgan, Bank of America and Citi – have not been well bid. This is a mistake. Results showed that demand for loans remains strong. The latest US Federal Reserve data, for the week ending May 2, shows total commerical and industrial loans outstanding up +3.1% from a year earlier, compared with +0.9% at the end of January. This is still lower than the robust growth of +10.6% and +6.5% in 2015 and 2016 respectively, but clearly way better than just+ 0.7% in 2017.

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish