From a trade war to a cold war?

This is the second part of a two part series on the unusual market pattern that we have been undergoing (see part one, Peak fear or Cold War 2.0). While the market may have discounted a substantial amount of the first-order effects of a trade war, the tail-risk of the loss of business confidence in a full-blown trade war is difficult to measure. In addition, the US and China may be on the verge of Cold War 2.0, which would disrupt and bifurcate technology platforms and supply chains.


Cold War 2.0?
The Economist recently devoted a special report to how a trade war is becoming a Cold War 2.0:

Fighting over trade is not the half of it. The United States and China are contesting every domain, from semiconductors to submarines and from blockbuster films to lunar exploration. The two superpowers used to seek a win-win world. Today winning seems to involve the other lot’s defeat—a collapse that permanently subordinates China to the American order; or a humbled America that retreats from the western Pacific. It is a new kind of cold war that could leave no winners at all.

This development was not a surprise. I had warned about the risk of a Cold War 2.0 in January 2018 when the US unveiled its National Security Strategy that defined China as a "strategic competitor" (see Sleepwalking towards a possible trade war). In retrospect, that publication of the NSS document was probably as historically important as Winston Churchill's "iron curtain" speech in 1946 that marked the start of the Cold War with the Soviet Union.

Viewed in that context, these trade talks represent only an initial skirmish in a globalized competition between two political and economic systems. While my base case scenario calls for a brief truce to be achieved probably in late 2019, the onset of Cold War 2.0 represents a tectonic shift in global trade and investment flows that will have multi-decade long investment implications.

The full post can be found here.

The rise of populism and the policy challenge for global elites

This week saw the two examples of the triumph of populism. The Italian election saw the rise the Five Star Movement and Lega Nord, otherwise known as the Northern League. Both are Euroskeptic parties and Lega Nord has an anti-immigrant bias. Meanwhile in Washington, the news of the steel and aluminum tariffs put Trump's America First policies front and center.

These instances of rising populism present a long-term development economic policy challenge for global elites.

The full post can be found at our new site here.

Why the Saudis will either blink...or collapse

As Saudi Arabia`s budget has come under pressure from low oil prices, I see that the Kingdom (KSA) has announced a diversification initiative into IT, healthcare and tourism (via CNBC):

Saudi Arabia outlined ambitious plans on Monday to move into industries ranging from information technology to health care and tourism, as it sought to convince international investors it can cope with an era of cheap oil.

A meeting and presentation at a luxury Riyadh hotel was held against a backdrop of low oil prices pressuring the kingdom's currency and saddling it with an annual state budget deficit of almost $100 billion - the biggest economic challenge for Riyadh in well over a decade.

Top Saudi officials said they would reduce the kingdom's dependence on oil and public sector employment. Growth and job creation would shift to the private sector, with state spending helping to jump-start industries in the initial stage.

"It's going to switch from simple quantitative growth based on commodity exports to qualitative growth that is evenly distributed" across the economy, said Khalid al-Falih, chairman of national oil giant Saudi Aramco.

What KSA faces is a classic problem in development economics. How do you create new industries and employment in an economically depressed region?

The full post is at our new site here.




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What's wrong with South Africa?

The study of emerging markets is a useful exercise in examining our assumptions about economies and markets because they sometimes operate by different rules than developed economies. As an example, Bloomberg reported today that the markets are freaking out over the firing of the finance minister:

South African markets were thrown into turmoil after President Jacob Zuma fired the finance minister, strengthening his grip on power amid differences over government spending.

The rand weakened for a sixth day in the longest streak of losses since November 2013 and bond prices dropped the most on record, pushing yields to their highest levels since July 2008. The country’s bank stocks tumbled the most in more than 14 years following the dismissal late on Wednesday of Finance Minister Nhlanhla Nene. The cost of insuring South African debt against default rose to the highest in more than 6 1/2 years.

As the chart below shows, South African assets are indeed tanking. The top panel shows the South African ETF (EZA), which is priced in USD. The bottom panel shows the relative performance of the South African Rand relative to the Aussie Dollar, which is another commodity currency.

What's wrong with South Africa?


The complete post at our new site here.

A growth plan for Canada

I try to remain apolitical on this blog, but for your weekend reading, here is my analysis of the challenges for the new government and my thoughts on the way forward.

On Monday, Canada elected a centre-left Liberal government, with Justin Trudeau as the new Prime Minister. Expectations are high and they are likely to come down to earth in the next few years. Bloomberg recently highlighted analysis by HSBC Canada David Watt of the challenges facing the Trudeau government:

"Until Canada overcomes its productivity and competitiveness hurdles, it will continue to feature cyclical behaviors similar to those of emerging-market economies," Watt wrote.

Watt had the same reservations about productivity that I did (see my past post, Uh-oh, Canada!):

In his report, Watt joins some of his peers in arguing that an economic acceleration south of the Canadian border doesn't pack the same punch it once did. Bank of America Merrill Lynch Canada and U.S. Economist Emanuella Enenajor has detailed how Canada's sensitivity to U.S. domestic demand has been on the decline, while Steven Englander, Citibank's global head of G-10 currency strategy, has connected the subdued performance of Canada's non-energy exports to the ascendance of Mexico in U.S. manufacturing. Mexico now benefits handsomely from its proximity to the U.S. and enjoys its position as an integral part of many supply chains.

Canada's weakened currency has helped the nation increase its cost competitiveness with the U.S., Watt acknowledges, but hasn't significantly shifted the calculus.

Generally speaking, HSBC economists have found little evidence of exchange rate depreciation fueling export growth since the financial crisis. And some contend the weak exchange rate actually impedes productivity growth. The increase in competitiveness through lower labor costs masks productivity shortcomings, while the soft domestic currency makes importing such materials more expensive, the thinking goes.

As an investor, I would like to see the government, any government, take steps to boost Canadian competitiveness. The "old" ideas of the former Conservative government of "get government out of the way of business" only goes so far.

The Harper-led Conservative government cut taxes and shrank services in the last 10 years, but the market did not show the desired response. A BCG study showed that Canadian manufacturing costs becoming uncompetitive with its NAFTA partners, the US and Mexico. Let's call the Harper small government plan Growth Plan 1.0.

Indeed, Macquarie recently called for a minimum target on the CADUSD exchange rate of 69c in order for Canada to be competitive:

The Liberals campaigned on a plan of running modest deficits to invest in infrastructure and stimulate growth. Call that Growth Plan 2.0. (Incidentally, I believe that one of the failures of the Tory campaign is to properly explain why deficits matter. The Trudeau plan of borrowing when the market will lend you money at 2% or less to invest in growth producing infrastructure is arguably sound.) While Growth Plan 2.0 is certainly an improvement over 1.0, the Liberal approach is very Keynesian. Though it will undoubtedly provide a short-term boost, it doesn't address long-term productivity issues facing Canada.


Growth Plan 3.0
What we need a Growth Plan 3.0 that focuses on improving productivity and innovation, which leads to sustainable quality growth. We don`t need the same-old-same-old innovation solutions of research and development tax credits, nor will the tired approach of squeezing labour costs in export industries like autos be sustainable in the long-run. It only leads to playing the game of competing with Emerging Market economies, where Canadian workers get paid at EM wages scales.

We need to think outside the box. As an example, Michael Porter showed back in the early 1990`s that Germany was able to remain a high wage country but enjoyed good growth. The secret was to create higher value-added jobs, rather than to compete with low-wage countries engaged in low value-added manufacturing.

A cheap but effective method might be to adopt the American model of the DARPA challenge to jump-start innovation. A senior DARPA official explained it this way:

DARPA’s role is to spur innovation. And we do it by focused, short term efforts. We pick things that are not impossible, but also not very low risk. So we take very high risk gambles, and those risks have tremendous payoffs. So if we’re successful it means that these robots are actually going to be able to make a difference. In particular, in disaster scenarios making society more resilient. The lesson of the original challenge [DARPA Grand Challenge - driverless cars] is that persistence pays. It’s important if you know the technology is almost there and you can sort of see the light at the end of the tunnel, a little bit of persistence will pay off. What I’m hoping for in the trials is that some of the teams will score some points. I don’t think that any team is going to score all the points that there are. Maybe no teams will even score half the points that there are. But I think some teams will do moderately well. My expectation is that the robots are going to be slow. What we’re looking for right now is for the teams to just do as well as roughly that one year old child. If we can get there, then we think that we have good reason to believe that some of these teams with continued persistence for another year will actually be able to demonstrate robots that show the utility that these things might have in a real disaster scenario. DARPA is in the innovation business, not in the development business. So, what we do is we wait for technology to be almost ready for something big to happen, and then we add a focused effort to catalyze the something. It doesn’t mean that we take it all the way into a system that’s deployed or to the marketplace. We rely on the commercial sector to do that. But we provide the impetus, the extra push the technology needs to do that.

Using a Michael Porter framework of development economics, the intent of a DARPA challenge is to create clusters of expertise. There is no point in trying to re-create Silicon Valley in your own back yard, but you can focus on specific industries that are already clusters of expertise in your regions. Examples include autos in southern Ontario, aerospace in Quebec, oil service and exploration in Calgary, mining in British Columbia and so on.

The federal government could create Canada Council administered DARPA challenge-like prizes aimed at specific problems in targeted industries, e.g. nano materials technology for the auto or aerospace industry, to encourage universities to take the lead in research. If a breakthrough were to occur, then the existing private-public partnership structures already in place at the universities can do the rest. Such an approach would be a low-cost way of encouraging innovation that highlight Canadian expertise.

Imagine, for example, if UBC became a global leader in earthquake-proofing buildings. It would create an engineering industry and expertise in the region that would be second to none. It would mean good jobs that would have no worries about competing with low labour cost countries like Mexico. What would that kind of growth be worth?

Is there anybody listening?

What would happen after a "Speech of Hope"?

Greek finance minister Yanis Varoufakis recently penned a Project Syndicate essay in which he challenged German Chancellor Angela Merkel to give a "Speech of Hope" in Greece in the manner of US Secretary of State James Byrnes did in 1946. In that speech, Byrnes' speech signaled an about face in American foreign policy towards Germany by reversing its intention to de-industrialize the conquered and shattered nation:

Byrnes’ speech signaled to the German people a reversal of that punitive de-industrialization drive. Of course, Germany owes its post-war recovery and wealth to its people and their hard work, innovation, and devotion to a united, democratic Europe. But Germans could not have staged their magnificent post-war renaissance without the support signified by the “Speech of Hope.”

Prior to Byrnes’ speech, and for a while afterwards, America’s allies were not keen to restore hope to the defeated Germans. But once President Harry Truman’s administration decided to rehabilitate Germany, there was no turning back. Its rebirth was underway, facilitated by the Marshall Plan, the US-sponsored 1953 debt write-down, and by the infusion of migrant labor from Italy, Yugoslavia, and Greece.

Varoufakis went on to challenge Merkel to deliver a similar "Speech of Hope" and presumably echo the same kinds of policies that America did with Germany in 1946. Varoufakis seems to be very good at evoking the kinds hope that Greece can embark on a growth path to prosperity:

Europe could not have united in peace and democracy without that sea change. Someone had to put aside moralistic objections and look dispassionately at a country locked in a set of circumstances that would only reproduce discord and fragmentation across the continent. The US, having emerged from the war as the only creditor country, did precisely that.

Suppose we were to fantasize for a moment and imagined that Varoufakis got everything he wanted, namely some form of debt relief and a stimulative Marshall Plan. What would happen to Greece under such circumstances?


The Competitive Advantage of Nations
To answer that question, I would use a development economics framework by following the work of Michael Porter, who wrote The Competitive Advantage of Nations, and Jane Jacobs, whose works included The Economy of Cities and Cities and the Wealth of Nations. The ideas of Porter and Jacobs are quite similar. One of Porter's formulas for success is the existence and development of industry clusters, e.g. Silicon Valley, which becomes a hub that spawns industry excellence, development and employment. Jacobs' work more or less says the same thing, except that her unit of development is the city-state instead of Porter`s focus on country-specific development.

Now consider the cases of post-war Germany and Greece today. Even though it was shattered by war, 1946 Germany was endowed with a considerable amount of human capital. The Germans had a tradition of excellence in science and engineering that went back years. As an example, German companies had a technological lead in chemicals in the late 19th and early 20th Century. Today, companies like Bayer and BASF carry on that tradition of German chemistry. The Second World War was marked by German "wonder weapons". It was therefore not a surprise that there was a scramble for former German rocket scientists after the war.

What competitive advantages does Greece have today?

A glance at the chart of GDP per capita (via Ian Bremmer) shows that Greece is one of the poorest regions in the eurozone, with the "rich" eurozone regions being Germany, northern Italy, northern Spain, the Low Countries and Ireland.

Supposing that Greece were to get some form of debt relief and growth stimulus, how could it lever its competitive advantages and get on a growth path?

The Telegraph recently featured a photo essay of the derelict factories of Greece. Perhaps we can see what industries Greece had before its economy cratered. While the photo essay may not entirely be representative of Greek industry, it does give us some idea of what was there. The photos included abandoned plants specializing in:

• Textiles
• Building supplies (marble, insulation)
• Food processing (cooking oil, grains, dry nuts)

None of these are high value-added industries. In particular, textiles manufacturing has been un-competitive in developed countries for years as most of the production has gone to emerging market economies.

With the exception of tourism and limited food processing, Greek industry has few competitive advantages to lever to return to a superior growth path.

There is one other possible competitive advantage that Greece possesses in the form of its geographical location. Various people have suggested that Athens could play the Russian card and perhaps move into Moscow`s orbit. Such a development would be an enormous blow to the EU and NATO. The accusations of "Who lost Greece" would begin. However, I would tend to discount that possibility. Russia had the opportunity to insert itself into the Mediterranean during the Cypriot crisis in 2012 at a far lower cost but declined (see Europe dodges another bullet (not the Catalan election)). Given Russia`s somewhat shaky finances, it is difficult to see how Putin could rescue Greece in a meaningful fashion.

Micro vs. macro solutions

This is the story of a Greek tragedy. Greek tragedies are marked by the clash of good vs. good, where different parties approach a situation with good intentions but end in tragedy.

It is also the story of two parties talking at each other instead of with each other. The Greek approach, which is top-down and macro oriented, rests with the idea that somehow the country can return to sustainable growth if the macro problem of excessive debt were to be lifted (and hopefully coupled with some form of stimulus plan).

By contrast, the (mostly) German plan is highly bottom-up and micro-economic oriented. Its underlying philosophy calls for getting the right market mechanisms in place, e.g. cost structures, labor market reforms, the right incentives, etc., and growth will naturally follow. The problem with this approach is that Greece, unlike countries like Ireland, has few competitive advantages. The EU mandated solution amounts to forced internal devaluation. It would mean that, in the example of textiles, that Greek wages would have to fall even further to levels that competes with the likes of China, Vietnam or Thailand.

Putting it another way, if Greece was a troubled company, Tsipras and Varoufakis believe that it has an over-levered capital structure and could be fixed with an equity injection. Merkel et al believe that it is poor operation and therefore needs to be remedied with better management and business rationalizations. They are both right and both wrong. It is both.

That`s why it`s a tragedy. The problems of Greece are very difficult and possibly intractable. The solution is well beyond my pay grade.

May Day thoughts on inequality (and development)

As Europe marks May Day with holidays, I thought that it would be appropriate to revisit the issue of inequality again.

In a past post (see Inequality and the genetic lottery: Two views), I showed that while global inequality has improved from 1988 to 2008 because of globalization as emerging market economies growth outperformed, wealth and income inequality within developed market countries have widened because the middle and working class in those countries lost because of the globalization trend. The winners were the top 1% and most of the emerging market world, while the losers were the poorest, largely because people in subsistence economies didn't participate in the benefits of globalization, and the middle and working class of developed market economies.

To me, the issue of inequality has never been about the fairness of the results, but should focus on the equality of opportunity. Imagine three people who were born at the same time named Bill Gates, all of whom had the same intelligence and abilities. Bill Gates 1.0 is the successful billionaire that we all know today. Bill Gates 2.0 was born a poor black kid in the American Deep South. Bill Gates 3.0 was born to a poor family living in a subsistence economy in Africa.


A development economies question
How can we create conditions so that Bill Gates 1.0, 2.0 and 3.0 all have equal opportunity? Given that kind of framework, the question then become a question of development economics. I have found neo-classical models of economics and the theory of comparative advantage does not explain everything. We all know about the economic miracles of China and India in the last 20-30 years. For me, the key question isn`t about India or China, but why did India and China succeed but not Kenya or Egypt, as they are all sources of cheap labor?

I have encountered a number of promising approaches. I have written about the works of Michael Porter and Jane Jacobs (Jacobs and Porter on development). The Porter book, The Competitive Advantage of Nations, asserts that competitive advantages are not static, but evolve over time. Porter went on to outline how the economies of countries evolve as they move up the value-chain.

Jane Jacobs published her work well before Michael Porter did and she is not as well known because she is more of an academic. However, her framework of moving up the value-chain framework is the same as Porter. What I find attractive about Jacobs is she identified the city-state as the unit of development, rather than a country, which makes sense to me as some countries can be highly economically diverse.

The question of how to resolve inequality isn't purely academic. The images from places like Baltimore and Ferguson are a reminder of how the effects of income and wealth inequality can boil over. Applying sound development economic solutions to the inequality problem will go a long way in alleviating much of those social tensions.


A question of culture
Despite the attractiveness of the Porter-Jacobs framework, it doesn't go fully in addressing some inequality problems. It`s may not be enough to ensure that people get equal opportunity, but how they go about attaining wealth and how they behave after they acquire wealth is also an issue.

In other words, there seems to be a cultural element to development economics.

One of the basic assumptions of economics is people are rational actors. They have rational expectations. Then how can we account for the NBER study indicating that 16% of NFL athletes go bankrupt within 12 years of retirement? Here is the abstract [emphasis added]:

One of the central predictions of the life cycle hypothesis is that individuals smooth consumption over their economic life cycle; thus, they save when income is high, in order to provide for when income is likely to be low, such as after retirement. We test this prediction in a group of people—players in the National Football League (NFL)—whose income profile does not just gradually rise then fall, as it does for most workers, but rather has a very large spike lasting only a few years. We collected data on all players drafted by NFL teams from 1996 to 2003. Given the difficulty of directly measuring consumption of NFL players, we test whether they have adequate savings by counting how many retired NFL players file for bankruptcy. Contrary to the life-cycle model predictions, we find that initial bankruptcy filings begin very soon after retirement and continue at a substantial rate through at least the first 12 years of retirement. Moreover, bankruptcy rates are not affected by a player’s total earnings or career length. Having played for a long time and been well-paid does not provide much protection against the risk of going bankrupt.

Are these people just stupid? If so, why does America spend weekends adoring people who run around a field with what amounts to the IQ on back of their sweaters?


Planning vs, winging it
It turns out that the attitudes about money therefore the behavior around wealth are cultural. Jessi Streib studied how couples from different class backgrounds interacted. In an article published in The Atlantic, she revealed that there are definite differences about how different people cope. Members of the working class have a tendency to go with the flow and "wing it":

People who grew up in households without much money, predictability, or power learn strategies to deal with the unexpected events that crop up in their lives. Often, these strategies are variations of going with the flow and taking things as they come. Sometimes there’s no other option.

By contrast, more affluent tend plan their lives a lot more:

People who grew up with parents who had more money, job security, and power grow up with more stable lives. In these conditions, they learn that managing their resources makes sense—both because their lives are predictable enough that they can plan and because their resources are plentiful enough that they can make meaningful choices. Spouses with middle-class backgrounds wanted to manage their resources by planning.

She relates an example of how couple coped (all names are have been changed):

One couple I talked to experienced these differences profoundly. Vicki grew up as the daughter of an upper-level manager while her husband John grew up the son of two factory workers. Vicki budgeted their money, making sure to save for their children’s college expenses and retirement. John thought their kids could figure out how to pay for college when they were older. People with working-class roots wanted to go with the flow and see what happened would figure out how to retire in the years to come. Vicki, a teacher, plotted how to become a superintendent. John, a restaurant manager, kept his eyes open for opportunities but did not plot how to get from one job to another.

Vicki also had her children’s lives planned before they were born—they would be good students and involved in many extra-curricular activities. John believed he should meet his kids before deciding on how to parent them and that it was not his place to decide who they should become. Vicki summed up their differences describing her own style as, “We need to plan! We need to schedule! We need to be neurotic!” and saying of John, “For him, it’s ‘It will always work out. It will always get done. Don’t worry.’”

Finance professionals know about the importance of a financial plan. "Winging it" is not a plan and can lead to disaster. Undoubtedly, that`s what happened to many NFL athletes who suddenly came into a lot of money. Were they irrational by ignoring the life-cycle hypothesis? A simpler explanation is that they were just "winging it" - and that approach creates a lot more risk to their lifestyle and future standard of living.

At the other end of the scale, there is an Old Money sub-culture who engaged in financial planning, but had Downton Abbey style taboo about talking about money (via Forbes):

The taboo among people with inherited wealth against talking about money is, like the taboo against incest, usually not spoken aloud, says Paul Schervish, director of Center on Wealth and Philanthropy and Boston College. “Most people are never told not to have sex with their brothers or sisters. You don’t hear your parents telling you that. That’s a taboo. It’s pre-vocal.”

The taboo against talking about money among people with inherited wealth has three main dimensions, he says: 1. inter-generational, in which parents and children don’t discuss money with each other, 2. publicity, in which wealth is not publicly disclosed (to the dismay of charities), and 3. peers, in which one does not discuss wealth with friends or colleagues so as not to either embarrass them or feel ashamed yourself.

Many of those with inherited wealth will have a trust official take their children aside and explain what the trust is and how much they might expect to inherit, and then teach their children to be relatively silent about that money to outsiders. “The family has enjoyed privilege financially, [so] they don’t want their children to … look down on other people,” says Schervish. “It’s part of their financial morality to not live an arrogant life about money.”

In fact, he says, those with inherited wealth often live frugally on purpose and drive Toyotas or forgo yachts because their inheritance is not growing dramatically, and the principal has to be protected from generation to generation.

Noah Smith featured the work of Roland Fryer, who has done extensive work on the black-white achievement gap in America, in a BloombergView article. The article is well worth reading in its entirety as it extensively details Fryer's research. Bottom line: Fryer also found a cultural effect:

One question Fryer has addressed is what causes the achievement gap. Along with Levitt, he found something very interesting. In kindergarten, the black-white gap can be entirely explained by a small number of variables, including socioeconomic status. But as the kids got older, a new racial gap appeared that wasn’t explained by those factors. That means that some other force is at work -- education, discrimination, cultural factors or something else.

Fryer set about trying to find those factors. For example, many have long argued that black culture discourages intellectual achievement, by branding academic pursuits as “acting white.” Along with co-author Paul Torelli, Fryer investigated the hypothesis. If academics are really considered “acting white,” then it stands to reason that getting good grades should be negatively correlated with popularity. Using data from a survey that asked students who their friends were, Fryer and Torelli constructed a measure of how popular each student was among members of his or her own race (the index is constructed so that having more popular friends confers more popularity than having less popular friends). The results fit the predictions of the “acting white” hypothesis -- as students get older, the correlation between grades and popularity goes up and up for white kids, but down for black kids.

An alternative hypothesis, of course, is that racial discrimination is the cause of the black-white achievement gap. Many teachers, if asked, will tell you that this is the case (though they will probably deny that the discrimination comes from their own classrooms!). It’s a very hard thing to measure. But, as Fryer and others have documented, racial discrimination has become less and less important in the U.S. employment market. That doesn’t prove that discrimination isn’t still the culprit at the grade school level, but it is suggestive.

Fryer’s solutions are not all politically correct. They involve specialized environments like charter schools and incentives to counteract the cultural stigma of “acting white” (emphasis added):

Taken all together, Fryer’s work suggests that educational investments, improved motivation and cultural change have a good shot at closing the stubborn achievement gap between black and white students. That isn't going to please education reform opponents such as Diane Ravitch, who denigrate charters and pooh-pooh the idea that better education could close the gap. It’s also not going to please a lot of conservatives, who typically oppose funneling more resources into government-funded education.

But Fryer’s message -- that the achievement gap isn't invincible, that it can be slain by better education -- is backed up by solid data and sophisticated empirical techniques. Those who deny Fryer’s conclusions will have a very hard time refuting the Clark Medal winner’s research.

Towards a better development economics framework
Basic training for economist involve a common framework for understanding human behavior. First and foremost, we assume that people are rational actors. The Washington Consensus, which has come to dominate economic thinking, believe in the Invisible Hand of the markets.

When the rubber hits the road in development economics, it can be very messy and un-PC. The neo-classical solutions that the markets will take care of everything risks the kind of social instability seen in places like Ferguson, Baltimore, or worse. Sometimes, even The Onion just nails a headline.

The Porter-Jacobs framework gets us part of the way there, but the results cannot be generalized. Yes, you can use comparative advantages, such as low labor costs and convenient geographic proximity to markets, to spur development. You can then leverage your position to educate your population and move up the value-chain with goods and services with more design elements and intellectual property, which creates better paying jobs. Still, it doesn't explain why India and China succeeded and Kenya and Egypt didn't.

The third element is the messy part and it is politically incorrect. It involves a study of the culture. to understand the elements of success and their impediments. Those solutions can be highly specific and may not be generalized to the rest of the human population. Consider the following question. Both the Jews and the Romani (Gypsies) have historically been outcasts in Europe. How did one group succeed and acquired power (e.g., the Rothchilds) and the other remains shunned throughout the region?

A surprising market reform in North Korea

There have been some tantalizing reports of free market style reforms in North Korea. Business Insider reported in late February about agricultural and industrial reforms:

Under a plan referred to as the May 30th measures, those [agricultural] teams were shrunk again last year, to the size of a typical family, while their share of the quota was enlarged to 60%. Even the permitted size of families' kitchen gardens, which are far more productive patches than land tilled for the state, have been expanded dramatically, from 100 square metres to 3,300 square metres. For Andrei Lankov, a longtime watcher of North Korea at Kookmin University in Seoul, the new measures, a quasi-privatisation of state land, are nothing short of revolutionary.

A second area of experimentation, in state industry, is equally striking. Under the May measures, state factory managers may appoint their own employees, set workers' salaries, buy raw materials on the market and sell part of their production there too. Like farmers, managers will need to pay their dues to the state. Yet, says Mr Lankov, that is not so different from paying corporate taxes in a capitalist economy.

In a surprise announcement, Kim Jong-un announced that the DPRK would implement a further set of market oriented reforms to open North Korea to the capitalist economy. The most important of which is to begin a series of annual auctions of its nuclear warhead arsenal and the bidding would be open to any and all parties. The specific details of the first auction, which detail the number of warheads and their specifications, would be announced later, according to a report from the Korean Central News Agency:

"These auctions would serve two purposes," according to a statement by Supreme Leader Kim Jong-un, "First, they signal the DPRK`s peaceful intentions to our neighbors in Asia in our course of development. Second, they are in accordance with our new reform initiatives to allow the market to play a greater role in the economy."

The reaction was generally positive (via Reuters):

"We welcome this development in North Korea`s market-based initiatives," said Secretary of State John Kerry, "We expect that the United States will put every resource into the auction process to ensure that we will be the successful bidder as it would be of the utmost importance to the United States and in the interest of world peace."

JP Morgan stated that, "We believe that this is a positive step in North Korea`s ongoing A successful market process. In addition, auction win for the US will be a win-win for both North Korea and the US economy. Depending on the scale of the payments, it has the potential to be a form of much needed foreign exchange reserves."

There is also speculation that the move is a response to China's rejection of North Korean membership in AIIB. The proposed initiative would undoubtedly strengthen North Korea's finances:

Emerging Markets can reveal that North Korea was rebuffed by Beijing in its attempt to join the China-led Asian Infrastructure Investment Bank because it was unable to hand over a proper snapshot of the hermit state’s economy and finances

Bloomberg also reported that analysts believe that North Korea is ramping up production of its nukes and therefore it has sufficient warheads to offer to the market for some time:

North Korea may have as many as 100 nuclear arms in five years and become capable of mounting them on a range of road-mobile missiles, a U.S. researcher said.

Joel Wit, who researches North Korea at the U.S.-Korea Institute at Johns Hopkins University, made the projection Feb. 24 at a seminar in Washington. In an e-mailed analysis to Bloomberg News, he said his moderate projection for North Korea’s nuclear stockpile is for it to grow to 50 bombs by 2020 while the country develops a new generation of road-mobile medium- and long-range missiles tipped with nuclear warheads.

The assessment paints a more-advanced scenario of the isolated state’s ability to produce nuclear arms than other estimates. Siegfried Hecker, a Stanford University professor, said last month the Kim Jung Un regime probably has 12 nuclear bombs and may have eight more by the time U.S. President Barack Obama leaves office in 2017.

North Korea probably has 10 to 16 nuclear weapons at present, including six to eight devices made from plutonium and four to eight from weapons-grade uranium, according to Wit.

Chart via Business Insider

Still, some analysts have interpreted the motives for such a move as a desperate attempt to build up DPRK`s foreign exchange reserves, as well as the regime`s failure to build delivery systems for the warheads, which render them more or less useless in their current form (via Business Insider, emphasis added):

North Korea has conducted three fairly low-yield tests since 2006 and expert estimates put its stockpile size at 10-15 warheads. (Low-yield is relative here: the fireball form North Korea's last test in 2013 was the width of five Manhattan blocks.) Those bombs are widely considered too large to be practically deliverable using the North's currently available technology.

There is still some debate on that issue, however:

It also isn't known if North Korea has succeeded in miniaturizing a nuclear weapon to the point where it would be practically deliverable. Still, Albright thinks this last scenario is likely and that miniaturization is "not that big of a step to accomplish that when you've got two decades and three tests."

Whatever the reason, Bravo to North Korea for adopting such courageous market-oriented reforms!

As a variation of Richard Nixon's famous statement of "we are all Keynesians now", Kim Jong-un has demonstrated that we are all capitalists now.

Falling inequality = Bear market?

Gavyn Davies wrote a fascinating FT article this weekend about the long-term outlook for stock prices. In essence, he attributes much of the current secular bull run to rising inequality in the developed economies:

Thomas Piketty’s work has shown that a rising wealth/income trend is not a “natural” state of affairs in the very long run. He argues that, in many economic growth models, the wealth/income ratio is broadly stable in equilibrium, and his data suggest that this has been the case in the UK and France for several centuries

The opposite has been true in recent decades. Two factors are primarily responsible: the long term decline in the global real rate of interest, and the continuous rise in the share of profits in national income.

This combination has led to rising expectations of future profits, discounted at ever lower real interest rates, a recipe for surging equity prices. Lower inflation has also reduced the inflation risk premium, which has further exaggerated the gains in both bond and equities.

Davies explains that as long as the holders of capital have the upper hand against the suppliers of labor, equity returns will continue to be elevated:

Charles Goodhart and Philipp Erfurth at Morgan Stanley suggest that these factors are directly linked. All of them are basically caused by a long term decline in the ability of labour to maintain the growth of real wages in line with productivity. Until this is reversed, the very long run trends in asset prices may survive intact.

It is obvious that the inability of workers to maintain their previous trend growth in real wages would tend to increase the share of profits in GDP, and therefore be beneficial for equities, but why has this also led to a decline in real interest rates? The reason given in the Goodhart/Erfurth paper will be familiar to readers of recent work by Lawrence Summers and Paul Krugman on secular stagnation.

Fiscal and monetary policy are then caught in a bind and their response has had the unintended effect of further raising returns to capital (emphasis added):

Essentially, the argument is that lower real wages have increased inequality in the western economies, and this has depressed aggregate demand by redistributing real income and wealth away from the relatively poor towards the rich. Since the poor have a higher propensity to consume than the rich, this redistribution reduces consumer demand.

The decline in demand is then addressed by policy makers, either by fiscal expansion (reducing taxes and increasing subsidies on the poor) or by reducing interest rates set by the central banks. Since the fiscal response results in bigger budget deficits and higher public debt/GDP ratios, more and more of the burden of policy adjustment eventually falls on the monetary authorities. It is likely that this feedback loop will tend to increase both asset prices and inequality from one cycle to the next.

A pernicious additional consequence of this loop is that private sector debt/GDP ratios are also likely to rise through time. Falling real interest rates increase the incentive to borrow, while rising asset prices, especially in the housing market, increase credit worthiness and therefore the ability to borrow.

Debt ratios rise until they cause a crash, which of course is what occurred in 2008. This causes even greater and more permanent declines in real interest rates, which adds another twist to the cycle.

Davies warned investors that this trend cannot continue forever:

In the very long run, investors should also be looking at the fundamental driving force for the entire long term process of rising wealth, i.e. the drop in the labour share in national income. If this were to reverse, demand would rise more rapidly and real interest rates could be allowed to increase, bringing down the rate of growth in private debt. Although this would be healthy from many points of view, it would also deliver a double blow to equities by reducing expected profits growth and raising discount rates.

Global vs. local inequality
By way of illustration, here is a fascinating gif chart of the evolution of American inequality which depicts the share of wealth of the top 0.1% (red line) compared to the bottom 90% (blue line, via Vox with data from The Economist). The top 0.1% share of the pie is roughly equivalent to their share roughly 100 years ago, before the emergence of the affluent middle class that began about the time of the Second World War.

As well, here is a chart of inequality by country, as measured by Gini coefficients (via Business Insider). The highest levels of inequality exists in EM countries in Africa and Latin America. Of the developed economies, northern Europe had the lowest level of inequality, while American inequality is roughly equivalent to the levels found in China and Turkey.

If the investment thesis outlined by Davies is correct, it brings up a number of interesting questions:

1. What would it take for the suppliers of labor to regain more bargaining power?
2. If labor compensation were to rise, which would result in falling inequality, does that mean necessarily mean that the returns to capital would have to fall?

The best of both worlds?

I would contend that 1) Inequality is being lessened now; and 2) Falling inequality does not necessarily mean lower returns to capital.

In a recent post (see How inequality may evolve over the next decade), I outlined research by Branko Milanovic showing the winners and losers of the globalization drive of the past few decades. The chart below shows how global inequality has progressed. The winners were the rising middle class of the EM economies and the suppliers of capital (rightmost group in chart) as they were the main beneficiaries of globalization. The losers were the people in subsistence economies who were too poor to benefit from globalization (leftmost group in chart) and the middle class in the developed economies.

Fast forward to today. China is facing its Lewis turning point and the low hanging fruit from globalization is gone. There are no Chinas in the world with a similar population size that could cause the same kind of disruptive change to the global economy.

As I pointed out in my previous post, the decision to offshore is no longer a no-brainer for multi-national companies. In fact, China is no longer the low-cost supplier of labor and onshoring is becoming a viable possibility for many companies.

Now consider the following scenario for the coming decade. Onshoring becomes a trend as the economics of offshoring jobs to low-cost countries becomes less attractive. The suppliers of labor in the developed economies then gain more bargaining power because of increased demand. Developed market economic growth improves because of higher propensity of the DM middle class to spend. 

In a Piketty framework, the owners of capital lose ground. I would contend, however, that the Piketty framework is overly narrow in that it only analyzes local (within country) inequality without paying attention to how global inequality evolves. Under the scenario that I outlined, the relative winners of the onshoring drive would be the DM middle class, the relative losers the EM middle class. But since the owners of capital directed the re-allocation of capital from one region to another, it is hard to believe that they would lose ground on a relative basis.

In effect, I would expect an American (and developed market) Renaissance over the next decade, where middle class incomes grow again but without significant impairment of returns to capital.

How inequality may evolve in the next decade

I've been meaning to write about this topic, but I didn't get the time until now. In my post Inequality and the genetic lottery: Two views, I summarized the global inequality issue this way:

Branko Milanovic, the Lead Economist at the World Bank research group, said in so many words the Left in developed countries won the genetic lottery but they didn't even know it (my words, not his). The chart below shows who won and lost in the inequality race globally. The x-axis on the bottom splits the world population from the poorest on the left in subsistence economies to the richest on the right, while the y-axis shows the real income growth in PPP terms between 1988 and 2008. 

In the thirty years spanning 1988 and 2008, the winners in the inequality race were the middle class in emerging economies, because of the effects of globalization, and the very rich, who engineered the globalization revolution. The losers were the very poor in subsistence economies, who weren't able to benefit from and the middle class in developed economies, who did not receive the benefits of the productivity gains (see Rex Nutting's analysis above) in the last few decades.

Slowing EM growth
If the winners of the globalization drive were the emerging market countries' middle class, what would happen if EM growth were to slow? Writing in Beyond BRICS, that's exactly what George Magnus projects for EM economies:

It is now clear clear that the exceptional acceleration in emerging market growth between 2006-2012 is over.

Even if the IMF predictions from 2015-2019 turn out to be correct (see chart below), the Middle East and North Africa, and Sub-Sahara Africa would be the only geographic regions where growth in those five years would be comparable with the period from the mid-1990s to 2012, according to IMF statistics.

That`s because the low hanging fruit of globalization is gone and EM countries like China are facing their Lewis turning point:

Successful economic development now looks a much tougher challenge, and perhaps only a handful of countries can expect to join the select group of 35 high income countries (income per head over $20,000), not counting the 14 low population and small island states. Countries such as Poland and Chile are knocking at the door, but the countries in this universe look increasingly like the exception not the rule.

An American Renaissance?
Considering that the Milanovic study found that the middle class in developed market economies lost ground in the globalization drive, a reversal of that effect could mean those effects get slowly reversed in the next decade. In particular, if EM economies and China, in particular, were to see slower growth rates over the next decade, then I can see the following important global effects:

• Slowing resource demand drives down commodity prices
• A greater propensity for onshoring of manufacturing once moved offshore

Lower commodity prices would amount to lower input costs for US businesses. In addition, lower oil prices amounts to an implicit tax cut for the consumer. In addition, an onshoring trend would increase US employment. All these effects could amount to an American Renaissance.

The chart below from Boston Consulting Group shows the operating costs in each country. Note that the costs for China, once the preferred go-to country for offshoring, are not very different from the US and not competitive relative to Mexico.

BCG went on to summarize the recent winners and losers in operating costs. The main conclusion drawn from this chart shows that the losers were EM countries, while the US and Mexico were the winners.

The combination of rising middle class employment, income and lower fuel spending costs would therefore see greater gains by the developed market middle class - and moderate complaints about the income inequality in the next decade.

Problems of onshoring

To be sure, the transition may not be as smooth as I postulated in the seemingly rosy scenario that I outlined. There are reports that companies that tried to onshore manufacturing have run into difficulties, largely because either labor skills sets have disappeared or decades of offshoring has moved the supply chain offshore (via the Brookings Institute):

However, it is an instructive irony that although the trends are now right for U.S. reshoring, conditions on the ground are not always so favorable. That's because 40 years of offshoring have done a lot of damage to what Gary Pisano and Willy Shih have called the nation's "industrial commons"—the shared resource base of skilled workers and supply chains upon which all manufacturers draw.

Shih conducted a couple of case studies and found labor skill and supply chain problems:

Shih injects a dose of realism into the reshoring discussion. He notes that both GE and Google’s Motorola Mobility unit faced enormous difficulties in hiring adequate numbers of appropriately skilled people for their factories. Appliance Park started with 10,000 applications for an initial 2012 posting. Of the 6,100 who passed the screening, 730 were hired but 228 were terminated in the first year. Fort Worth had to hire 6,500 workers to yield the required 2,500 employees to begin volume production. In both cases, a lack of basic familiarity with modern precision manufacturing among new hires led to a lot of turnover.

At the same time, managers at both Appliance Park and in Fort Worth faced hollowed-out local supply bases. Almost all the parts for the MotoX had to come from China, Korea or elsewhere in Asia, while GE encountered reduced capacity in its supply base for appliance parts. As of now, Appliance Park has basically succeeded in Louisville (though GE has signaled that it wants to sell its appliance division) while the Motorola—which Google is selling—said recently it will close the MotoX facility in Fort Worth due to lackluster sales and high costs for labor and shipping.

In the long term, the story of slowing EM growth, falling commodity demand and onshoring will continue in fits and starts. Nevertheless, this trend is likely to result in better developed market middle class income growth over the next decade.

The reduction of inequality appears to spur growth potential. A recent paper by Price and Boushey entitled How are inequality and economic growth connected? conducted a survey of research on the issue of inequality. They summarized the conclusions this way (emphasis added):

This paper does not contain policy advice. Instead, it contains analysis that largely demonstrates there are direct, and possibly causal, relationships between economic inequality and growth—places that begin with a lower level of inequality subsequently tend to grow faster and have longer periods of growth than those with a higher level of inequality. In future research, we will focus on the channels through which inequality could or does affect economic growth.

If inequality were to be reduced in the developed market economies, then it would mean a brighter future for these economies in the decades ahead. The current level of concern expressed about economic inequality may therefore represent the generational high tide mark of this debate.

China's rise likely, but not preordained

I got a number of responses to my last post on China that I would like to clarify (see Is China spawning an American Renaissance?). I would like to address the growth path of China, both for the next few years and next few decades.

The objections that I received were mainly in two categories. Some writers indicated that China has seen turbo-charged growth rates which far exceeded growth seen in the West and developed economies and these writers believed that Chinese growth rates will continue to grow at levels exceeding the developed markets. Others objected to the implication that my thesis suggested that somehow that America and the developed markets were "robbing" China of growth potential.


Not a zero-sum game
First of all, I would like to make clear that my last post did not represent a zero-sum game of American vs. Chinese growth. China's growth path is independent from America's and one country does not necessarily grow at the expense of the other. The growth path of any country or economy as large as China depends mainly on its own policies, rather than the action of others.

In addition, I would like to make the point that China's ascendancy. while likely, is not preordained. As the chart below from Nomura (via Business Insider) shows, China and India accounted for roughly 50% of global GDP in the 18th and the first half of the 19th Century (annotations are mine). Given their history, it would not be surprising to see these economies regain their former positions of dominance.

On the other hand, nothing is etched in stone, and the growth path of any economy depends on the proper set of economic policies. The FT documented two countries which about 100 years ago showed equal promise, but their paths diverged significantly:

A short century ago the US and Argentina were rivals. Both were riding the first wave of globalisation at the turn of the 20th century. Both were young, dynamic nations with fertile farmlands and confident exporters. Both brought the beef of the New World to the tables of their European colonial forebears. Before the Great Depression of the 1930s, Argentina was among the 10 richest economies in the world. The millions of emigrant ­Italians and Irish fleeing poverty at the end of the 19th century were torn between the two: Buenos Aires or New York? The pampas or the prairie?

A hundred years later there was no choice at all. One had gone on to be among the most successful economies ever. The other was a broken husk.

The article is well worth reading in its entirety because it details the differences in culture and openness of the two economies (also see my comments in Inequality, does it matter?):


Two challenges to growth
China suffers from two major challenges. The near-term challenge is a transition from an export and infrastructure based growth model to a consumer led growth model, while recognizing the significant tail-risk posed by non-productive infrastructure investment fueled by excessive credit growth. These problems are not insurmountable. I believe that, in the long term, China would be better off by implementing harsher reform policies of market adjustments now even at the price of a hard or crash landing, than to try to kick the metaphorical can down the road as it seems to be doing now. Such an adjustment would enable the Chinese economy to transition to a more sustainable growth path based on quality, not quantity.

The transition to consumer based growth would address the second challenged faced by China as she approaches a Lewis Turning Point. The combination of an aging demographic and the rapid utilization of cheap labor means that China cannot sustain rapid export growth based on low-cost labor. The economy need to transition to higher value-added activities, which translate to better paying jobs compared to just lots of low-paying jobs under the old growth model.

Neither obstacle is insurmountable. Even if China were to undergo a hard landing and experience a recession, which is not in anyone's spreadsheet, it doesn't necessarily mean that China growth will come to an abrupt stop.

Analysts need to differentiate between the cyclical effects of the Chinese and global economy and the long-term secular effects of China's growth policies.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is China sparking an American Renaissance?

I have been writing about the risks in China for quite some time (see previous discussions here) along with many other analysts. For newbies, Quartz has an excellent graphical primer on the risks building up in the shadow banking system:

Ed Yardeni highlighted the main risks in the combination of excessive credit growth and deflation in China [emphasis added]:

(1) Bank loans. When China joined the World Trade Organization during December 2001, the country’s banks had $1.4 trillion in loans outstanding, which was equivalent to 35% of US commercial bank loans. At the start of this year, Chinese bank loans rose to a record $12 trillion, now equivalent to 162% of their US counterparts! Those numbers don’t include the lending of the shadow banking system.

(2) Deflation. Coal companies seem to be at the epicenter of the current rising default risks in China’s shadow banking system. That’s because coal prices are falling. So are other industrial prices, according to China’s PPI, which is down 1.6% y/y through January. It has been deflating since March 2012. China’s CPI is still inflating at a moderate pace, with an increase of 2.5% y/y through January.

The combination of lots of debt and mounting deflationary pressures increases the risks of a credit crisis in China.

Ambrose Evans-Prichard, in an article entitled "World asleep as China deflationary vice", wrote about a similar theme as Beijing's latest leadership appears to be intent on slowing the breakneck pace of unsustainable growth:

China's Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.

The balance of evidence is that most powerful Chinese leader since Mao Zedong aims to prick China's $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle.

He went on to highlight the Apocalyptic scenario should Beijing fail to properly navigate its reforms:

Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75. "Investors are still underestimating the risk. Chinese credit and, to a lesser extent, equity markets would be very vulnerable," said the bank.

Such an outcome -- not their base case -- would send a deflationary impulse through the global system. This would come on top of the delayed fall-out from China's $5 trillion investment in plant and fixed capital last year, matching the US and Europe together, and far too much for the world economy to absorb.

Evans-Pritchard went on to highlight the concerns of various China analysts:

[JP Morgan analysts] Haibin Zhu says there is mounting risk of "systemic spillover". Two thirds of the $2 trillion of wealth products must be rolled over every three months. A third of trust funds mature this year. "The liquidity stress could evolve into a full-blown credit crisis," he said.

Officials from the International Monetary Fund say privately that total credit in China has grown by almost 100pc of GDP to 230pc, once you include exotic instruments and off-shore dollar lending. The comparable jump in Japan over the five years before the Nikkei bubble burst was less than 50pc of GDP.

You get the idea.


An American Renaissance?
While the world focuses on China, it's also important to think about the second order effects of all these changes that are happening.

Think about this for a minute. Let's assume that China successfully rebalances its engine of growth. Consumer spending rises while exports based on cheap labor falls; and infrastructure spending declines. Such a shift would have two significant effects. First of all, the price of labor elsewhere becomes more competitive. BoAML recently produced analysis showing how Chinese labor rates have risen in the last few years (via Business Insider):

In addition, we would see a downshift in commodity demand because of lower investment spending. Such changes would have profound changes for American manufacturers. The pace of onshoring would accelerate as the advantages of offshoring to China diminish, which implies a higher economic growth rate as jobs return to US manufacturing. As well, operating margins could expand because the cost of inputs would fall because of lower commodity prices. These are the ingredients for an American Renaissance.


The worst of all worlds
As I write these words, it appears that China may not experience neither a hard nor soft landing, but a long and bumpy landing. Every time the Chinese leadership signals its intent to reform the economy, stresses start to appear and Beijing blinks (see Will Beijing blink yet one more time?).

BCA Research took a sanguine view. They studied China's growth slowdown experience in the 1990's and concluded that, despite all of the fears, tail-risk is unlikely to substantially materialize [emphasis added]:

[C]redit tightening was clearly a headwind for growth in the 1990s. However, the sharp credit growth slowdown between 1998 and 2000 did not lead to major growth problems in the broader business activity. In fact, amid the credit crunch, the economy was able to withstand major global shocks such as the Asian financial crisis and the global tech bubble bust, and stayed largely stable without major financial stress. If history is any guide, we expect the economy and financial system to remain resilient in the ongoing tightening cycle, especially as policymakers are in no rush to hasten the “deleveraging” process, and the global business cycle is gradually on the mend.

If the Chinese leadership continues on this path of talking tough on reform but finds its initiatives watered down because they run up against entrenched interests, then China faces the worst of all worlds. While a hard landing could be avoided for a considerable amount of time, China faces a lost decade of ever slowing growth without the targeted rebalancing of growth from infrastructure spending to consumer spending as the primary engine.

At the same time, the American Renaissance would continue as rising Chinese labor costs erode competitiveness and falling commodity prices enhance the operating margin of companies based in the developed markets.


American Renaissance: Winners and losers
Before you get overly excited about the prospect of an American Renaissance, consider who the American winners and losers of such a shift might be. Despite the bright prospect of onshoring, manufacturing jobs aren't going to pay the same kinds of wages that they used to. Steven Rattner wrote a New York Times Op-Ed precisely on precisely this topic [emphasis added]:

But we need to get real about the so-called renaissance, which has in reality been a trickle of jobs, often dependent on huge public subsidies. Most important, in order to compete with China and other low-wage countries, these new jobs offer less in health care, pension and benefits than industrial workers historically received.

In an article in The Atlantic in 2012 about General Electric’s decision to open its first new assembly line in 55 years in Louisville, Ky., it was not until deep in the story that readers learned that the jobs were starting at just over $13.50 an hour. That’s less than $30,000 a year, hardly the middle-class life usually ascribed to manufacturing employment.

This disturbing trend is particularly pronounced in the automobile industry. When Volkswagen opened a plant in Chattanooga, Tenn., in 2011, the company was hailed for bringing around 2,000 fresh auto jobs to America. Little attention was paid to the fact that the beginning wage for assembly line workers was $14.50 per hour, about half of what traditional, unionized workers employed by General Motors or Ford received.

Even though jobs may return because of onshoring, globalization hasn't gone away. Shane Ferro of Reuters recently highlighted a paper by Michael Boehm of the University of Bonn:

This chart shows the changes in US employment shares by type of occupation since the end of the 1980s. The paper used two different measures, the National Longitudinal Survey of Youth (NLSY) and the comparable years and age group in the more standard Current Population Survey (CPS):

For this chart, the high-skill occupations comprise managerial, professional services, and technical occupations; middle-skill occupations are things like sales, office/administrative, and production occupations; and low-skill occupations include food, cleaning, and personal service occupations.

What Boehm found is that this erosion of middle-skill jobs is correlated with a similar erosion of middle-skill pay. This chart shows how wages were expected to grow back in 1980 (blue line), and how wages actually grew (red line):

Barry Ritholz highlighted analysis of long-term trends in a post with the following conclusion:

Manufacturing will become increasingly global, with estimates as high as 80% of manufacturers having a multi-country operation. 

The technology used on assembly lines continues to growth more and more sophisticated, making automation far easier to implement.

For the suppliers of labor, these shifts present a good news-bad news story. The good news is that there will be more jobs; the bad news is that the jobs won't pay as well as manufacturing jobs used to. American workers may welcome the return of jobs that were previously offshored, but they will largely be working either directly for a multi-national or for a company in the supply chain of a multi-national. If you are competing with Third World countries for work, don't expect First World compensation.

For the suppliers of capital, these shifts represent unabashedly good news. Operating margins are likely to get boosted upwards because of lower input costs from falling commodity prices and more responsive manufacturing because of a more educated labor force and lower transportation costs from being closer to end consumer markets. As well, the returns to capital are likely to improve as cheaper automation drive down the price of capital expenditures, which raises overall returns on assets employed.

Longer term, these changes are incredibly bullish for US equities and moderately bullish for the US economy.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Another American step to Argentina

I have written before about how America is going south to Argentina. To recap the story, the FT had an extensive article that told the story of American and Argentina well [emphasis added]:

A short century ago the US and Argentina were rivals. Both were riding the first wave of globalization at the turn of the 20th century. Both were young, dynamic nations with fertile farmlands and confident exporters.

Both brought the beef of the New World to the tables of their European colonial forebears. Before the Great Depression of the 1930s, Argentina was among the 10 richest economies in the world…

There was no individual event at which Argentina’s path was set on a permanent divergence from that of the United States of America. But there was a series of mistakes and missteps that fit a general pattern. The countries were dealt quite similar hands but played them very differently.

Elitism crept in in Argentina but early America was anything but elite. Opportunities for anyone but the elite became more and more restricted in Argentina and the economy eventually stagnated. America, by contrast, embraced the ideal of a Land of Opportunity and flourished.

European emigrants to Argentina had escaped a landowning aristocracy, only to ­recreate it in the New World. The similarities were more than superficial. In the 1860s and 1870s, the landowners regarded rural life and the actual practice of agriculture with disdain. Many lived refined, deracinated lives in the cities, spending their time immersed in European literature and music. The closest they came to celebrating country life was elevating polo, an aristocratised version of a rural pursuit, to a symbol of Argentine athletic elegance. Even then it took an elite form: the famous Jockey Club of Buenos Aires. By the end of the 19th century some were sending their sons to Eton.

America’s move westwards was more democratic. The government encouraged a system of smaller family holdings. Even when it did sell off large tracts of land, the potential for a powerful landowning class to emerge was limited. Squatters who seized family-sized patches of soil had their claims acknowledged. US cattle ranchers did not spend much time boning up on the entrance requirements of elite English schools. And as well as raising cattle, the western settlers grew wheat and corn…

 
The death of the American Dream
Fast forward to today. America's elite has become Wall Street and the Too-Big-To-Fail banks while the middle class continues to get squeezed. After I wrote my analysis in September 2009, many prominent analysts, investors and economists, such as Warren Buffett, Richard Thaler, Simon Johnson and Marc Faber. Even Ned Davis (via John Hussman) has jumped  on the squeeze the middle class story:

Market veteran Ned Davis puts it nicely "I think the Fed has punished savers and has put us between a rock and a hard place with QE2. It has kept the banking system liquid and helped goose stocks. But in that it has also provided juice for a commodity explosion that has hurt the world's poor, it has offset much, if not all, the good it did. In that real money (ex inflation) matters, the situation is not nearly as favorable as most Fed watchers believe."

Nobel laureate Joe Stiglitz recently lamented the level of income inequality in America [emphasis added]:

It’s no use pretending that what has obviously happened has not in fact happened. The upper 1 percent of Americans are now taking in nearly a quarter of the nation’s income every year. In terms of wealth rather than income, the top 1 percent control 40 percent. Their lot in life has improved considerably. Twenty-five years ago, the corresponding figures were 12 percent and 33 percent. One response might be to celebrate the ingenuity and drive that brought good fortune to these people, and to contend that a rising tide lifts all boats. That response would be misguided. While the top 1 percent have seen their incomes rise 18 percent over the past decade, those in the middle have actually seen their incomes fall. For men with only high-school degrees, the decline has been precipitous—12 percent in the last quarter-century alone. All the growth in recent decades—and more—has gone to those at the top. In terms of income equality, America lags behind any country in the old, ossified Europe that President George W. Bush used to deride. Among our closest counterparts are Russia with its oligarchs and Iran. While many of the old centers of inequality in Latin America, such as Brazil, have been striving in recent years, rather successfully, to improve the plight of the poor and reduce gaps in income, America has allowed inequality to grow.

Stiglitz makes the same arguments I made about how elitism retards American competitiveness:

[G]rowing inequality is the flip side of something else: shrinking opportunity. Whenever we diminish equality of opportunity, it means that we are not using some of our most valuable assets—our people—in the most productive way possible. Second, many of the distortions that lead to inequality—such as those associated with monopoly power and preferential tax treatment for special interests—undermine the efficiency of the economy. This new inequality goes on to create new distortions, undermining efficiency even further. To give just one example, far too many of our most talented young people, seeing the astronomical rewards, have gone into finance rather than into fields that would lead to a more productive and healthy economy.

One more sign that America is becoming Argentina
Here is one more nail in the coffin. During the current budget debate over the debt ceiling, Dean Baker of the "progressive" Center for Economic and Policy Research wrote that defaulting on debt is not the end of the world. He then went on to bring up the recent experience of Argentina as an example.
 
The difference is that the US Dollar is a major reserve currency in the global economy, whereas Argentina's currency is not. Moreover, US T-Bill yields are regarded by virtually all investors as risk-free (read: default-free) rate. If the US Treasury were to default, even briefly, it would spark a tectonic shift in global finance about the perception of risk.
 
I had dismissed the possibility of a US Treasury default as brinksmanship by the Republicans for political purposes. Baker's comments dismissing the consequences of default shows that these attitudes are becoming more bipartisan.
 
Down that road is Argentina.