Market Viewpoints

Summary

In the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Donald Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world. President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues that are prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate and a low investment rate. America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. For the sake of the US Dollar and the US itself, Trump should focus on the budget deficit and the national debt and not obsess excessively with the trade deficit. If the recent tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising. It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.

Want a trade surplus? Trade with Mars

US President Donald Trump likes to say – “The United States has an $800 Billion Dollar Yearly Trade Deficit because of our ‘very stupid’ trade deals and policies”, i.e. he believes that only with a trade surplus, can the US be on a solid economic footing.

If you look at the US trade balance data in the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world, lasting from 1929 to 1939. By 1933, when the Great Depression reached its worst mark, nearly 25% of the US total workforce were unemployed and nearly half the country’s banks had failed. The US trade surplus then was a direct consequence of the Great Depression. Alarmed by the crash of the stock market in 1929, America called in its loans to other countries and put up customs barriers to stop imports of foreign goods, resulting in a trade surplus for the US. This episode indicates that a trade surplus isn’t necessarily a sign of a healthy economy and nor does a trade deficit imply the economy is on a slippery slope to ruin.

The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. Therefore, unless governments plan to open a trade account with another planet – Mars or maybe even Venus – and convince them to run a trade deficit, all governments on planet earth cannot run a surplus at the same time. One country’s spending is another country’s income.

President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate (3.4% compared to an average of over 10% two decades ago) and a low investment rate (investment as % of GDP has fallen by over 25% in the last two decades). America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. Private Debt to GDP in the US stands at 200%, and the US budget deficit, $666 billion last year, is expected to balloon to $1 trillion by 2020. The shortfall therefore in savings to finance imports (consumption) is achieved by selling debt. Arguably it’s not that the US doesn’t export enough, in fact, one could say the US’s largest export is US Treasury bonds. Foreigners hold over 45% of US government debt and the net issuance of US debt this year is expected to be $1.3 trillion, the most since 2010.

As the US budget deficit keeps rising, necessitating an even higher amount of US Treasury bond sales, investors will demand a higher yield to continue buying the bonds. One wonders how much risk the twin deficits – budget and trade – are inflicting on the US economy. For the sake of the US Dollar and the US, Trump should focus on the budget deficit and the debt and not obsess excessively with the trade deficit. If the tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising.

It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. For most of the 1800s (with the exception of the Napoleonic Wars, when the Pound weakened, and the US Civil War when the Pound strengthened to $9.97 per Pound) every £1 was worth just under $5. At the beginning of the 20th Century, Britain’s national debt stood at around 30% of GDP. By the end of World War II, it stood at 200%. In 1947 Sterling accounted for approximately 87% of global foreign exchange reserves and over half of global trade was done in Sterling. Yet it took only another two years before the USD unseated Sterling from its perch at the top. As Britain’s cost to service the debt accumulated during the two Great Wars mounted and its fiscal position worsened, the fixed rate of $4.03 to a Pound set in 1940 proved unsustainable. The currency was devalued by 30% to $2.80 to a Pound on September 18, 1949. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.

There’s one major factor in US’s favour which will prolong the US Dollar’s status as a reserve currency. Unlike the 1940s when the US Dollar stood as a challenger to Sterling, today there is no clear challenger to King Dollar. The future of the Euro is in doubt and the Chinese Renminbi (RMB) is not fully convertible (China’s $9 trillion bond market is the third-largest in the world, but only 2% of Chinese bonds are foreign-owned). However, the internationalization of the RMB is on track and digitalization and blockchain technology threaten fiat currencies of all hues. The threat therefore to the US dollar may come from a yet unborn currency in the digital world. It will behove America to run a sensible fiscal policy if it is to prolong the US Dollar’s dominance. Today the US Dollar accounts for approximately 60% of the total global currency reserves and that is a huge advantage for Uncle Sam.

Markets & the Economy

The Q1 earnings season in the US is in full swing and the data so far has been very encouraging – not that the market has taken much notice. Despite 80% of companies reporting so far beating earnings expectation, and 64% of the companies exceeding revenue expectations, the S&P500 (SPX) has again slipped into negative territory for the year and is down -7.7% from its peak reached earlier this this year.

It seems the market is broadly divided into two camps. The first camp consists of those who believe the US cycle has peaked and is turning, with a slowdown a year or so away. The second camp (which I am firmly in) believes that a US slowdown is not around in the near term and this cycle could expand for another two to three years.

Over the past several years, the best leading indicator of a recession has been yield curve inversion – when short-term (2y) rates rise above long-term (10y) rates (the shaded red region in the chart below). Yield curve inversions have preceded each of the last seven recessions and have preceded the last three recessions by 19-36 months. The analysis of current data indicates no recession is on the horizon. Further flattening is also not a signal of a looming recession, although an inversion would raise the likelihood of a recession starting roughly 2 years from now.

Source: Bespoke Investment Group

One other stat worth noting is US Housing Starts. Every prior economic downturn in the US was preceded by a rollover in housing starts. The March number reported last week, indicates that the 12-month average increased to 1.228 million, which is a new high for the cycle. As you will see in the chart below, the current level of US housing starts is still close to levels that are typical during downturns, rather than levels we typically see during expansions – which suggests that the US economy is still moving forward.

Source: Bespoke Investment Group

I, therefore, have very little immediate concern on the yield curve inversion front. Keep your equity positions long. This equity Bull Run will only come to an end when the US Federal Reserve (Fed) starts raising rates aggressively, as was the case in 2006/07, and the yield curve inverts and re-steepens. I am of the opinion that the SPX is more likely to be at the 2800 level than the 2500 level and perhaps even go higher to the 3000 level in next twelve months.

Having said that there has been a lot of disappointment recently in the market. Financials, technology and indeed the healthcare sectors have all performed very poorly. The earnings season for US Banks is complete and, despite numbers not disappointing and indeed boosted by the reduction in the corporate tax rate to 21%, the performance of bank stocks since the earnings were reported has been poor. Bank stocks are down -7% to -10% across the board. The sell-off can be attributed to overweight positioning leading into the earnings season, a flatter yield curve and doubts about the banks’ ability to deliver increased earnings if rates increase. As I don’t see a slowdown in US growth on the horizon, I view US Banks as an attractive long at these reduced price levels.

On other topics of note at the macro level, everything is fine except for China-US trade, where both the US and China are blowing hot and cold. Upping the ante one moment and indulging in conciliatory comments soon after. This week Trump said he was sending a delegation of his top economic advisers to Beijing next week to try to settle trade disputes that have upset US-China relations. US Treasury Secretary Steven Mnuchin’s trip to China represents the clearest sign yet of a thaw in the war of words between the US and China. Separately, the Market is confident that a NAFTA deal will be agreed and confidence is high that the US-North Korea summit indicates real progress in the strained relations between the two nations. The Market has never been very sensitive to North Korea perhaps owing to the size of its economy and its relevance to world trade. Markets didn’t panic at North Korea’s missile tests and recently hasn’t been euphoric either about the thawing in US-North Korea relations.

Oil at $74 means inflation fears are creeping up again. However, for now, there are no signs of any alarm in the market. Of course, the Iran issue does cause some nervousness among investors. Will Iran and Israel engage in a direct war for the first time? Iran and Israel have been playing a game of cat and mouse, fighting each other through proxies and cyber-attacks for the last 40 years. Yet they have never fought each other face to face on the battlefield. That may be about to change and Syria could be that battlefield. Israel has learned from its mistakes in Lebanon that allowed Hezbollah to set up and operate a large missile threat on the Lebanon-Israeli border. Israel doesn’t want a repeat of that, with Iran operating a missile threat on the Syria-Israel border. Will Israel stop Iran and risk a direct war? Only time will tell.

So where does that leave investors? As I have indicated above, I am still happy to hold equity longs. The US is still my overweight and Financials (XLF), Technology (XLK), Healthcare (XLH) are my favourite sectors. The tactical overweight in Energy (XLE), as indicated in last month’s newsletter, continues as Oil continues its upward climb. In Europe, French equities are outperforming German equities, even as the Eurozone as a whole is showing signs of a slowdown. My underweight in the Eurozone continues with stocks with international exposure favoured, such as LVMH. Emerging Markets (EEM) are holding up well and as the US Dollar strengthens, Japanese equities (DXJ) should do well over the next month.

In terms of stocks I like: JP Morgan (JPM US), Bank of America (BAC US), Citi (C US), VISA (V US), Blackrock (BLK US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Schlumberger (SLB US), Halliburton (HAL US), WallGreenBoots (WBA US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Eiffage (FGR FP), Pepsi (PEP US), LVMH (MC FP), Honeywell (HON US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital