Notz Stucki Investment Meeting – Notes 11 04 2017

by James Macpherson

china brexit us

Over the past year world economic growth has been stronger than expected, for several reasons. First China’s growth has been solid. Instead of imploding the industrial side of the economy bounced back in 2016 in response to the policy measures of a year ago. Growth in China may fade a bit this year as the stimulus wears off, but it won’t collapse. Second the Brexit shock turned out to be a damp squib. Aside from sterling’s fall it affected little, though it underlined Central Banks’ determination to underwrite the system in response to any shock. Third Trump’s election led to a surprising rally in risk assets on hopes of a reflation. There are signs now that this rally is fizzling out as Mr Trump is running into the usual Washington impasse. Meanwhile the Eurozone appears to be bottoming out and growth rates are improving. Even the southern countries are doing better. The Germans are realising that some inflation is needed, and if German wage growth outpaces wage growth of the Mediterranean countries then the long-hoped for rebalancing will be underway.

While economic growth is better, the outlook for asset markets is more complicated. Equity markets have discounted the recovery, and have been further puffed up by governments’ monetary policy. Low interest rates didn’t trigger new investment, it just raised asset prices. The rate of growth of US productivity, a vital component of growth, has been falling since 2005 as business investment has been meagre, and creative destruction didn’t happen. At the time of the crisis in 2008/09 western governments were already carrying too much debt so fiscal stimulus was unpalatable, and they had little choice but to cut interest rates and adopt quantitative easing. The resulting asset price rises did nothing for productivity. Structurally companies face more problems than in the past. The companies that should have been allowed to fail in the crisis have continued, and these zombie companies have prevented the stronger companies from taking market share. Regulation is more complex. The tax code is fiendishly complicated. All these factors favour the big company over the small start-up who faces much greater obstacles than in the past, and the steadily declining productivity growth may point to the economy being less dynamic today. In this context Trump’s promise to cut taxes and regulation are clear positives, but his cronyism (e.g. appointments of family members) and his threats of protectionism are likely to weigh on productivity.

us dollar bill

An important question will be how the US dollar behaves. It is strong already and Trump seems to want it lower. On the other hand the Fed is in tightening mode and the trade balance is starting to improve which will support it. On balance the dollar is unlikely to go much higher, and will probably weaken somewhat. Traditionally a weaker dollar is good for Emerging Markets as it allows them to loosen their liquidity. The more problematic question is who will fund the US fiscal deficit. The Fed is trying to reduce its balance sheet. The best outcome would be the consumer saving more, but Trump wants to boost consumption through tax cuts. Foreigners can usually be relied on to plug the gap but with shrinking trade deficits they have fewer dollars to invest. The fracking revolution may help on this score as the American energy sector is the most dynamic in the world, and is creating energy surpluses and jobs in the US.

China remains a conundrum for investors. Western observers worry about the debt – both the scale of it, and its alarming rate of increase. But with capital controls this is less of a problem, and there is no obvious trigger for the debt to undermine the system. For twenty five years investors have expected the Japanese bond market to blow up. Chinese debt is matched by the deposits in the banking system, but as the debt expands it will be supported by interbank funding, and as this requires more confidence in counterparties it can be more flighty. It is also likely that China’s growth will slow slightly. Slower growth and lower inflation, similar to the Japanese model, will make Chinese bonds an attractive asset. The risk is the currency but China is determined to make the renminbi the deutschemark of Asia so Gavekal see little risk of a devaluation.

If the bull market continues then investors need to start to look outside the US. European and Asian markets represent better value, and sectors like defence and financials should be favoured in equities generally, and Asian consumption and Indian financials in particular. In currencies sterling stands out as good value, and the Brexit negotiations may be smoother than the market fears. Finally after several years of lacklustre performance there is increasing evidence that stock picking is starting to work again, possibly because, with markets at expensive levels, relative valuations are more interesting than the momentum investing that has dominated recently.

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