Market Comment Q3 2016
The outcome of the US Presidential election may not have large economic consequences, as the behavior of markets and economies is simply influenced by too many factors. But the election hints at a potential sea change in the underlying political economy, in particular regarding free trade and globalization. In addition, both candidates have expressed support for large scale fiscal stimulus, such as infrastructure investments, an option that has been off the table for these last eight years. In this context, it is useful to consider what the campaign and election might augur.
Both parties are seeking to appeal to those who are dissatisfied with the current political economy. Bernie Sander’s supporters hoped for a larger welfare state financed by higher taxes on corporations and the wealthy and by claw backs from the military budget. He opposes what he calls “unfettered free trade,” which he believes largely benefits multinational corporations at the expense of middle class jobs and income.
Signe Wilkinson Editorial Cartoon used with the permission of Signe Wilkinson, the Washington Post Writers Group and the Cartoonist Group. All rights reserved.
The Democratic nominee, Hillary Clinton, also decries the lopsided benefits of our trade agreements in favor of corporations. And the Republican nominee, Donald Trump, expresses the view that our trade agreements were poorly negotiated. If elected, he promised in July, “The era of economic surrender will finally be over.”
Trade and trade agreements are suddenly prominent in our public discourse. This summer, Britons voted to leave the EU. This marks perhaps the first major casualty of globalism at the hands of those feeling dispossessed. In the aftermath, Britain and the EU will need to come up with a new trade agreement or else do business on terms specified by the WTO, a prospect that leaves so many questions unanswered that Britain’s economic road to the future remains very murky. Germany and France have signaled that the pending US-EU treaty, dubbed TTIP, is “dead”, though for different reasons. Meanwhile, the EU and Canada are nearing agreement on the CETA, but final opposition is heating up. It is getting ever more difficult to do trade deals.
Though free trade has been a political target since at least 1999, when protesters in Seattle made headlines protesting the World Trade Organization conference, it was not a galvanizing national issue until this election cycle. A potential bipartisan revolt against free trade—and its cousin, globalization—marks a major break from a 30-year old bipartisan consensus.
Free trade is almost universally extolled by economists. The theory of comparative advantage, first published by David Ricardo in 1817, holds that certain regions benefit from cheaper access to raw materials or labor or transport. Trade with such countries expands the global pie, allowing greater aggregate consumption according to economists, even though some will be worse off. For these, some sort of compensating policy may be offered but, as the cartoon above suggests, what has been offered so far does not strike all those affected as sufficient.
Free trade and the more general framework of globalization pose concerns that are getting more difficult for our political system to moderate. We cannot offset the impact of plants moving overseas by subjecting foreign sovereigns to our minimum wage or environmental regulations. The political forum is so inadequate to mediate these conflicts that mechanisms such as fast track negotiating authority and non-negotiable up-or-down votes have evolved. When New England’s textile mills and Detroit’s auto factories moved South, it was still Americans getting the jobs, even if unions lost out. Now, capital is perceived as the beneficiary of globalization, not labor, which poses an even more divisive and irreconcilable conflict than union vs nonunion. The world is unquestionably better off with globalization, as hundreds of millions of people in China and elsewhere have risen from poverty, but these accomplishments are not necessarily considered beneficial by those Americans who may have lost out.
As a result, the political pendulum has swung against a long-standing consensus, finally breaking out of localized squabbles into a national political debate. Indeed, while global trade has almost always grown faster than global GDP, in the past five years it has struggled to keep up. Perhaps this is merely the result of low cross-border investment, but it could also be the impact of trade-constricting policies.
Rising protectionism and anti-trade measures will most likely prove inimical to the interests of many, but there seems to be no way to address the legitimate concerns outside the framework of some world government, which is not in the cards. As a result, the risk is rising that our political system will resolve the issues posed by globalization and trade in a way that appeases the masses in the short-term but fundamentally hurts in the long-run. Mindful as we may be of the detrimental impact of rising barriers to trade such as Smoot Hawley, there may be no way around at least a temporary retreat from trade.
Secular Stagnation or Deleveraging?
The current uproar against the perceived hollowing out of the middle class and job losses resulting from globalization is louder given the slow-growth aftermath of the Great Recession. In the recently released annual World Economic Report, entitled Subdued Demand: Symptoms and Remedies, the IMF lowered its forecast for global growth to 3.1% for this year and 3.4% in 2017. From 1998-2007, global growth averaged 4.2% per year. In the period starting with the Financial Crisis in 2008 through 2015, global growth slowed to 3.2%. The slowdown was even more pronounced in advanced economies, where growth slowed from 2.8% to 1%. Emerging Markets held up better, but still declined from 5.8% average annual growth in the 1998-2007 time period to 5.2% since.
Our commentary on the sluggish rate of growth following the Financial Crisis has highlighted the role of excess debt as a suppressant of economic growth. The solid line in the chart below shows the ratio of household debt to disposable personal income. After rising slowly but steadily for two decades, indebtedness began rising sharply in 2000. This sharp increase reflects the housing boom that followed the collapse of tech stocks in 2000-2002. Easy credit, rising home prices, and perhaps an unwillingness to say good bye to good times and high living led to peak indebtedness of over 130% relative to income.
When the bubble burst, the debt needed to be dealt with. The chart shows that a good portion of the debt has been worked off, but that indebtedness has not yet been worked down to pre-boom levels. The dashed line shows debt service relative to income, which has fallen much faster—in fact, to the lowest levels in 35 years. It is unclear which of these two measures is more meaningful for future consumption, but on balance, our view is that the debt seems to weigh more heavily than the cost of servicing it may imply.
In the closing years of the Great Depression, economist Alvin Hansen coined the “secular stagnation” hypothesis, which held that a decline in population growth and an oversupply of savings were suppressing aggregate demand. Recently, economist Larry Summers and others have revived the hypothesis to explain economic performance since 2008. Population and workforce growth in the advanced economies has slowed to nearly nothing. Meanwhile, baby boomers nearing retirement are reigning in spending to boost savings, as are those who seek to work out from under excessive debt. Rising inequality may also be shifting income to the wealthy, whose marginal propensity to consume is much lower than that of the populace as a whole. Low aggregate demand was finally overcome in the Depression by federal war spending and, after the war, by renewed population growth in the form of the baby boom. Those who now subscribe to the secular stagnation hypothesis certainly do not hope for war, but they do hold that monetary ease alone is insufficient to boost growth.
The Obama stimulus program in his first year in office was significant but apparently not enough to meet the needs of the situation. In any event, a global drive to fiscal austerity soon supplanted it, similar to Hoover’s fiscal austerity in the face of the Depression. But now both Presidential candidates have voiced support for fiscal stimulus in the form of infrastructure spending.
It was only three years ago that the US Congress imposed the sequester in response to cries for austerity. But three more years of subpar growth, and a US Presidential election, may have cleared the way for fiscal stimulus, such as Larry Summers advocates. It is too early to tell if politics will lead us in that direction, but can we all admit that Quantitative Easing is not bringing about the desired results?
The US stock market has performed well this year, despite lackluster earnings results and high international and domestic tensions. The S&P 500 stock market index remains within a few percentage points of its all-time high and has returned 5.9% to investors through October through price appreciation and dividends. Other broad stock market averages have performed similarly.
The performance of international stock markets has been uneven. While emerging market stocks this year have outperformed those in the US, performance of many developed market stocks has been poor. In general, both European stocks and currencies have fallen, depressing returns to US investors. Japanese stocks have fallen too, though since the currency rose, returns have been positive. The reverse is true of the UK market.In most of our portfolios, we hold between 15-25% of the target equity allocation in international stocks. The primary reason for US-based investors to invest in developed country international stocks is to gain diversification advantages. The long-term expected returns are no higher than from stocks in the US, but since the ups and downs do not coincide, investors can realize these returns with lower overall volatility. This is particularly important if investors are regularly spending from their investment portfolios.
One factor that roils the water, however, is fluctuating currency values. Since the advent of freely floating fiat currencies, an era that began in the early 1970’s, investors in international stocks have had to take the risk of currency fluctuations along with the risk of the underlying equities themselves. Since then, the dollar has fallen a bit against a trade-weighted basket of currencies, helping dollar-based investors, but there have been significant fluctuations in the meantime, both up and down.
In late 2014, the dollar broke out of a relatively tight multi-year range and rose significantly against the foreign currency basket. The effect has been to reduce the returns from holding international stocks. Is there a reason to re-evaluate the desired diversification advantage?
Our opinion is no. To quote David Swensen, the renowned Chief Investment Officer at Yale University, “Sensible investors invest in foreign equity markets through thick and thin, regardless of recent past performance.”1 Abandoning the strategy now would likely only lock in losses and damage returns.
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