Executive Summary
1. Trade deficits aren’t the big issue with China — fraud and theft are. Some of the U.S. administration’s public comments on the trade conflict with China have focused on the trade deficit between the two countries. Wall Street Journal contributor and former Chair of the Council of Economic Advisors for the Reagan administration Martin Feldstein points out that the most important issues are deeper — basically, Chinese industrial policy unfairly subsidizing domestic firms, and the forced transfer and theft of intellectual property. The U.S. administration is probably determined to make as much progress as it can on those critical issues, so if a deal is announced on easier trade agenda items, we can expect negotiations and pressure to continue until an acceptable settlement on the tougher items is reached.
2. China — when will the big stimulus come? The trade conflict is grabbing the attention of media and investors, but China’s economic troubles are both older and more difficult. During the country’s long economic boom, many corners of its financial system accumulated levels of debt that will someday threaten a financial crisis if they are not curtailed and reduced. The Chinese government, since the global financial crisis, has gone through periods of loosening, to boost growth and keep their citizens happy, and tightening, to reduce debt and the risk of a financial crash. 2016, 2017, and the first half of 2018 were a period of tightening, and this is responsible for the growth slowdown China is currently experiencing. The government began to loosen midway through last year, some say that so far, the stimulus measures have been too modest to have much effect. If the past is a guide, when the pain from slowing growth increases, the stimulus will be ramped up, and then after a lag, growth will accelerate — which will benefit multinationals with exposure to Chinese consumer and industrial demand.
3. Bolsonaro — the Brazilian people turn a new leaf. Despite quite negative coverage in the foreign press, new Brazilian president Jair Bolsonaro enjoys support from a broad cross-section of the Brazilian electorate — far beyond his base of social conservatives. Many Brazilians have been in despair as the Workers Party era reached a nadir of corruption, economic decline, and crime, and view Bolsonaro’s free-market and law-and-order platform as a chance to regain prosperity. If he makes the difficult decisions to reform entitlements and privatize corrupt state industries, the voters who supported him will likely not be disappointed. We are bullish on Brazil: stocks, bonds, and currency.
4. Market summary. Trade negotiations between the U.S. and China seem to be bearing fruit as the sides come closer together; whether an agreement is produced before March remains an open question. U.S. growth remains strong; 2018 will come in at a GDP growth rate over 3%. As U.S. companies begin their season of earnings reports, we think many will give conservative guidance for 2019; the stock market’s reaction to this conservatism will be important. We don’t see a recession beginning in 2019, so we are encouraged by the availability of the stocks of good companies at more reasonable prices following the recent correction. Overseas, we like prospects for Brazilian stocks and bonds and for the Brazilian real. We also believe that the Japanese yen will rise against the dollar in 2019. We like gold and silver. Inflation abroad will benefit gold this year; many commodities will appreciate in 2019 if the dollar is weak. Despite the bear market in cryptocurrencies, technical developments and new projects show that blockchain and digital currencies continue to mature.
Trade Deficits Aren’t the Issue With China — Fraud and Theft Are
Two weeks ago, Martin Feldstein — the chairman of the Council of Economic Advisors in the Reagan administration — wrote an opinion piece in the Wall Street Journal on the current trade conflict with China. He made two key points.
First, the central concern with China is not the trade deficit with the United States. (As Milton Friedman pointed out many years ago, if another country wants to exchange tangible goods for U.S. dollars, we should generally feel pretty good about the deal.) Rather, the real problems are (1) China’s state subsidization of their companies; (2) formal and clandestine intellectual property theft by Chinese businesses, state entities, and criminals; and (3) the likelihood of deceptive and ineffective half-measures as a response to U.S. insistence that these issues be addressed.
Second, Feldstein points out what we have often pointed out: China has much the weaker hand in this game. It may well be that stiffer and broader tariffs will be needed to correct the abuses noted above — but a 25% tax on $200 billion in imports will have a very small objective effect on a $20 trillion U.S. economy. Headline news will make more of the issue than it deserves.
Investment implications: We believe President Trump will continue to press aggressively for the best corrective action he can wring out of China. The immediate interests of both sides favor an agreement being reached by the March deadline or before. However, the most important aspects of the deal — China’s industrial policy, technology theft, and desire to evade meaningful change on these issues — will be very difficult to address. The president’s desire to be seen as a dealmaker is unlikely to trump his long-expressed desire to see China’s trade malfeasance brought to heel. Therefore if a deal is reached on the easy items — such as ameliorating the trade balance — the conflict will continue, though perhaps at a lower temperature, over the deeper issues.
The Chinese Slowdown, and the Coming Stimulus
Trade talks have the public’s attention when it comes to China. However, that public view has little or no impact on the economic and financial fundamentals that are driving the performance of the Chinese economy.
It was not trade issues that caused the significant weakness in Chinese consumer demand noted by Apple [NASDAQ: AAPL] in the surprise earnings pre-announcement that shocked markets a week ago. That weakness reflects the critical and difficult balancing act in which the Chinese government has long been engaged, and which we have reported to you on many occasions over the past several years.
In essence, that balancing act is managing the economy’s growth while incrementally reducing the enormous debts that have accumulated in many parts of China’s financial system during its recent boom years. Those excesses, primarily in local government debt and the unofficial banking sector which provides liquidity to non-state-owned enterprises, have the potential to create a serious financial crisis at some point in the future if they are not curtailed and reduced. However, curtailing and reducing them depresses economic growth. That in turn risks the anger of China’s rising middle class, who are aspiring to the wealth and living standards captured in the relatively highly developed first-tier cities of China’s coastal regions. This is the Chinese government’s basic existential dilemma: maintain social stability by supporting growth, but also reducing the risk of a future financial catastrophe.
Since the global financial crisis, China has responded to this challenge with periods of intense stimulus, and then periods of tightening to attempt to rein in the financial excess. Typically, the tightening goes on until real growth pain begins, and then there is a period of loosening, such as occurred in 2009, 2012, and 2015. We are just now coming off a period of tightening which lasted from 2016 to the middle of 2018. That period is essentially what has been responsible for the current Chinese slowdown — not the trade actions of the United States. (Of course, the U.S. administration knows that China is in a weak position, and this is probably one reason why it is using the current opportunity to press its advantage and secure fairer trade terms.)
China’s financial system is “leaky” (that is, there are ways that funds can get out of the country in spite of the government’s efforts to control capital flows). However, it is still largely separate from the more open financial systems of the rest of the world. China’s “contagion,” if there were to be an economic or financial problem, would thus be largely economic rather than directly financial. And that is what has had observers worried recently. China is now a significant enough part of the global economy that a slowdown there is of great significance for many U.S. multinationals and the growth of their profits. Our view is that China will not create a contagion in 2019 but one may come in a few years.
China’s stance began to shift from one of tightening to one of loosening midway through last year, the December meeting of the Central Economic Work Conference (CEWC), one of the main policy-setting organs, reiterated the goal of “structural deleveraging” — the gradual reduction of debt. Thus, the loosening measures enacted so far are seen by many analysts to be weak — too weak to have a significant effect on the path of Chinese economic growth. One critical area where tightening remains in effect is liquidity for housing; the CEWC, contrary to expectations, retained language that “housing is for living in, not for speculation,” suggesting that no big easing in this sector is on the horizon.
During the post-2007 cycles of loosening and tightening, the government has usually been behind the curve, and it seems to be so now. In past cycles, strong stimulus has occurred when circumstances force the government’s hands. Although that time seems to be approaching, it has not yet arrived.
Further, after the consolidation of power which occurred in 2017, the regime may be more tolerant of growth shortfalls than before, and aiming its policy trajectory further in the future. The regime’s anti-corruption program may also have resulted in local and regional officials being more reticent to enact stimulus policies within their jurisdiction.
When will we know that the government has begun a really significant stimulus in earnest? Analysts suggest two basic signs: first, a loosening of the measures that have curtailed growth in local government debt, together with a general loosening of the measures that have curtailed the growth of unofficial, “shadow” lending in general; and second, and more importantly, policies to boost property demand. If the U.S. administration keeps up the pressure, it may hasten the arrival of these stimulus programs.
Investment implications: Slowing Chinese growth is a drag on world GDP growth and a drag on profit growth for many multinationals with exposure to Chinese consumer and industrial demand. When China begins a large-scale stimulus, the Chinese economy will begin to respond with accelerating growth. We will keep you apprised of the arrival of major stimulus in China.
Brazil’s New President: His Popularity May Run Deeper Than Foreign Media Suggest
The first time we heard about Jair Bolsonaro was from a Brazilian ex-pat taxi driver several years ago. He was a fervent supporter and said that a Bolsonaro presidency would be Brazil’s “only salvation” from corruption and the endemic crime that has made life all but unlivable in Brazil’s metropolises.
Foreign media coverage of Bolsonaro has tended toward demonization. Certainly the new president is polarizing and has made various troubling and ill-considered comments in the past. However, anecdotally, he does seem to have broader support among Brazilians than some foreign media suggest — including many Brazilians who fall outside his apparent core support demographic of social conservatives.
He won with 55% of the popular vote. Beyond his base, this figure includes Brazilians of many persuasions who feel desperate and betrayed after the socialist policies of the Workers Party reached their denouement in the widespread corruption, scandals, economic collapse, and crime of the past several years.
President Bolsonaro is not an economist, but so far, his ministerial picks — especially Chicago-trained economist Paulo Guedes, who is heading a new economics super-ministry — have encouraged investors.
Most encouraged, though, seem the voters of Brazil, as the country turns the page on a difficult period and attempts to begin a new phase in its development. Should the changes go well, many Brazilians who have fled in recent years might return to participate in the country’s reconstruction.
Bolsonaro faces some difficult struggles, including especially the reform of Brazil’s unsustainable pension and retirement programs and the privatizing of state-owned companies. It remains to be seen whether he truly has the inclination to give those who voted for him the bitter medicine they will need to see Brazil prosper again, but so far although it is early, the signs are positive.
Brazil may be exiting a long period of economic and political troubles and is making a turn towards responsible government, the rooting out of corruption, and the restoration of social order. If the Bolsonaro administration is able to make progress towards realizing the mandate it has been given, we believe prospects are excellent for investing in Brazil.
Investment implications: We are bullish on Brazilian assets, including stocks, bonds, and the Brazilian real.
Market Summary
U.S. and World Outlook
The trade meeting in China between the U.S. and China went well, with some narrowing of differences on several topics. The event did not produce an agreement, but it did narrow differences, and was a good step toward an agreement — which might take place by March 1, or could drag on for much longer.
The U.S. economy remains strong, and employment data and retail sales data are the strongest parts of the economy. We will continue to see a steady growth rate in the U.S. with GDP probably slightly below 3% in the last quarter of 2018. This will lead to economic growth of over 3% for 2018 as a whole.
The U.S. stock market has rallied since around Christmastime, and could rally further until we come into corporate profit season reporting season next week. At that time we will get a good picture of the outlook for numerous companies in a large variety of industries.
Our expectation is that most companies will be somewhat conservative in their predictions for growth rates in 2019, and it will be important to see how the stock market reacts to this conservatism. Since we see no recession in 2019, we are interested in using periods of market correction as opportunities to buy very good companies at newly reasonable prices.
Within the U.S., we are finding growth companies with reasonable valuations and strong visibility for profit growth for the next few years. Finding such companies is a pleasure that was denied to investors while stocks were overpriced.
We believe that the Federal Reserve will support stock prices with reasonable behavior; we believe that weakness in overseas markets is not leading to a global recession in 2019; and we believe that U.S. companies can grow and extend their growth abroad if they are wise and frugal.
Global Markets: Brazil
Brazil, as mentioned above is an important part of the opportunity set that we see. We are bullish on the Brazilian currency, the Real; on Brazilian government bonds; and on Brazilian stocks. See above for our reasoning on Brazil.
Japanese Yen
We believe that the Japanese yen will rise in value versus the U.S. dollar this year, and we remain bullish on it.
Gold and Silver
Gold and silver are havens that we like at this time. Gold will benefit from inflation abroad, although there will be little inflation in the U.S. this year. The outlook for gold depends greatly upon the value of the U.S. dollar; a weak dollar will cause gold, silver, and other commodities to rise; absent that, we anticipate modest appreciation for gold in 2019.
Cryptocurrencies and Blockchain
We continue to read stories suggesting that the technologies underlying digital currencies are making strides in spite of the crypto market’s sharp decline, and in spite of the unclear nature of many of these markets. Particularly significant to us was the launch of a European-regulated exchange in Estonia which is executing trades in several U.S. technology stocks using a security token on the Ethereum blockchain. We feel this is an early harbinger of the transformation that blockchain technologies will ultimately accomplish in financial markets. A recent analyst report noted headwinds in cross-border transaction revenues from increasing adoption of cryptos for this purpose. This signals to us that digital currencies are achieving real, scaled use-value in cross-border exchange.
Thanks for listening; we welcome your calls and questions.
