The Independent Investor: Currencies & Trade Wars
What's up with the dollar? The greenback is strengthening and is having its best quarter since 2016 against an array of foreign currencies. Is this an accident, or is it something far more dangerous?
Economists will tell you that the Trump tariff crusade is responsible. New trade barriers, which the president is suggesting, would usually lead to higher prices at home, according to economic doctrine. Products we import would cost more, whether we are talking about steel, automobiles, or baseball caps.
As prices increase, so should the U.S. inflation rate. As inflation rises, bondholders will demand higher interest rates to keep up with inflation. In turn, higher interest rates would normally lead to a stronger dollar. In the real world, this explanation is not so cut and dried.
There could be any number of macro scenarios that I could spin, which could alter the dollar's rise. For example, the Fed (which controls U.S. interest rates) could decide not to raise interest rates for other reasons. The impact of tariffs might also end up being so minor that prices barely budge. In other cases, breakthroughs in technology (such as oil and gas fracking) or in a manufacturing process could lower the cost of certain products even while others are going up due to the tariffs.
The dollar's strength or weakness will also depend on what is happening overseas. The economic conditions of other nations will impact their own currencies relative to ours. In many countries, the exchange rate is not determined by market forces, as is the greenback. In many cases, currencies are controlled by a central government. A currency could be "pegged" to the U.S. dollar, or to a basket of currencies. It could rise and fall in a pre-set range pre-determined by the government's central bank. Governments can also control how much of any currency their citizens may own.
In a trade war, like Donald Trump appears to be waging, a country can use its currency to countervail the price impact of tariffs on their exports. Let's say you are a Chinese manufacturer of Major League baseball caps. You compete with one of two American companies. They may make a better product, but also charge more for it, let's say 10 percent.
So, being a great patriot and baseball fan, the president decides to slap a 10 percent tariff on all baseball caps imported from China. Now, the Chinese manufacturer has neither a price or quality advantage. His sales suffer and America "wins." However, the Chinese government could alleviate the situation by allowing their currency to devalue by that 10 percent. In this case, the cost to the American importer of Chinese baseball hats remains the same, because it now costs him 10 percent less (in U.S. dollars) to buy the hats.
Fast forward to today. The latest salvo in Trump's trade war is to threaten to raise the amount of Chinese goods taxed by the U.S. to $450 billion. That would mean that tariffs would be applied to nearly all the $505 billion in goods that China exported to the U.S. last year. That would be a real blow to the Chinese economy. To soften that blow, China could decide to let their currency, the yuan, weaken to the point that the impact of tariffs would be erased.
In the past two weeks, the yuan has fallen three percent against the dollar. It is still up about 5 percent against the greenback over the last year, but that can easily change. Is the Chinese government deliberately causing the decline?
If they are, you can't prove it. Going back to the economic models, one could argue that the tariffs Trump is planning to impose would damage the Chinese economy, slow growth, and weaken their currency. The recent decline could only reflect that fear among currency traders.
Whatever the case, China is not the only player that may be tempted to play this game. All of Europe and Asia will be hurt by American tariffs. It makes economic and political sense for nations to protect their own fortunes and those of their people in the event of a trade war. Some would argue that it is their duty to do so.
Since all is fair in love and war, deliberately weakening a nation's currency in relation to the dollar in response to tariffs could be a smart move. Some might even argue it is the patriotic thing to do.
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The Independent Investor: The Next Recession
Over half the economists on Wall Street believe that by the end of 2020, we will experience our first economic downturn in years. If so, when might you begin to prepare for a rocky two-year period for all of us?
The good news is that we still have another year or so of stock market gains, job growth and more importantly, wage growth. As it stands, the U.S. is currently enjoying its second-longest economic expansion in history with an unemployment rate that hasn't been this low in decades. Wage growth, after languishing for years, is expected to top 3 percent by the end of 2018, while GDP could achieve greater than 3 percent this year and a further 2.5 percent next year.
So how does an economy go from blue skies to dark clouds in so short a time? This economic expansion is now entering its final stage, according to economists. As the good times grow, investors and consumers tend to overborrow and overspend. That's human nature, but it almost always leads to inflation rising, which touches off a rise in interest rates that ultimately slows the economy.
By that time, consumers are back in debt and paying more interest on that debt, while corporations are stuck with an overabundance of goods produced that no one wants. So, everyone pulls back, causing the economy to slow, and the rest is history.
Normally, a recession will span a year or two before the economy recalibrates. In the meantime, the stock market falls anywhere from 15-30 percent and the mood is somber. I have seen it repeatedly in my career. And yet, for some reasons, investors always act as if this is some new startling new development.
The timing of a recession can always be called into question. Any number of things could prove to be a tipping point in ushering in a recession sooner than expected. In 1991, skyrocketing oil prices proved the culprit. In 2001, the dot-com bubble caused a year or two of declines, in 2007, it was a housing bubble. This time around there are several "what ifs" that could hasten our demise.
Right now, a global trade war, instigated by Donald Trump, could tip the economy (both here and abroad) into recession. Trump's latest threat: levying tariffs on almost $200 billion in Chinese imports, would certainly elicit a like response from the Chinese. Tariffs on goods of that proportion would drive both economies into recession.
A crisis in Europe could also hit us hard. Italy is none too stable right now. Populists forces might set in motion their exit from the European Community. That would cause a great deal of instability among European nations, the Euro, and their economies. That, too, could tip our country, as well as their own, into recession.
Oil prices might prove to be our downfall once again if geopolitical events among countries in the Middle East (Iran, Syria and Saudi Arabia) come to blows. An escalating conflict there would surely send oil prices back over $100/barrel with negative consequences for the U.S., as well as other global economies.
Finally, U.S. interest rates could move higher in direct response to our president's actions towards our global allies and enemies. In the last two months, foreigners have reduced their U.S. Treasury holdings by about $10 billion. Russia has reduced their holdings by half. That is a relatively small amount, but as more and more governments realize that "Making America Great Again" will be at their expense, why should they hold our bonds?
China, for example, in response to Trump's tariff threats, could respond by dumping our treasury bonds. That would cause interest rates here at home to spike higher. That would cause even more panic among foreign holders, who would be happy to sell more of our bonds. I could see a nasty chain reaction, a sort of dot. com-like bond sell-off, which could spread throughout the economy and the stock market.
Barring any of these worries, however, we still have some clear sailing ahead for our economy. The stock market usually begins to discount a recession 6-9 month ahead of time, so it won't be for a year or more before we need to prepare for the inevitable, which would be just in time for the next election.
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The Independent Investor: How to Avoid Recession? Emigrate to Australia
"Give me your tired, your poor,
Your huddled masses yearning to breathe free,
The wretched refuse of your teeming shore.
Send these, the homeless, tempest-tossed to me,
I lift my lamp beside the golden door!"
— "New Colossus" by Emma Lazarus (Statue of Liberty)
This "land down under" has escaped an economic recession for 26 years in a row. An open immigration policy in a nationalist world that demands just the opposite is one of the key drivers to their success. An abundance of natural resource wealth has also helped.
Readers would need to go back to the late 1980s, early 1990s, to find two quarters of negative growth (the definition of an economic recession) in Australia. Back then, Australia was noted for its boom and bust economy. Throughout their 160-plus year history, mining booms in gold, gas, sheep and other commodities left investors rich and confident for a couple of years, only to be followed by devastating shocks to the economy as commodity demand declined, throwing workers on the streets and companies into bankruptcy.
This writer has a special fondness for Australia. Early in my career, I spent years investing in Western Australia's iron ore and Queensland's coal. Following in my footsteps, my daughter also spent a couple of years in Australia as an exchange student. Back then, the government tightly controlled the exchange rate. Today, the central bank is free to set interest rates without political interference and the exchange rate is no longer fixed.
Investments in industries outside of the mining areas were also encouraged. Aided by the government, businesses were encouraged to seek out new, non-mining investments, thereby reducing Australia's dependence on commodity exports. Since most of the mining is done in the outback, where population and infrastructure are scarce, it made sense to focus investment on those areas where most of the population lives. That bet has paid off. Today, natural resources represent only 7 percent of the economy.
At the same time that government spending picked up, Australia's immigration policies were reversed. From 1901 to the 1970s, Australia was known for its "White Australia" policies where the country only allowed immigrants of European descent to permanently set foot on its shores. Since then, Australia liberalized its immigration policies. On the back of that decision, the population has grown by 50 percent.
Australia has also created a "points" system for assessing potential migrants. Skilled workers, ranked by the country's needs, count especially high. Immigrants must also pass health and character tests, and before becoming citizens, must pass an English-language quiz on the nation's constitution, history and values. The largest source of skilled labor is coming from India (21 percent), China (15 percent), and the U.K. (9 percent).
The country, which boasts a population of 25 million, welcomed 184,000 new arrivals last year. A government-commissioned study indicates another 11.8 million immigrants are expected to make Australia their home over the next three decades. Most of the new entrants are
expected to settle in Sydney, Melbourne, Brisbane and Perth. Economists credit this continued migration with creating long-term demand, higher consumption, lower unemployment, and continued economic growth.
The facts are that if a country has strong population growth, it is harder to go backward in economic output. Their economy will most likely grow at around a 3 percent rate this year, which is higher than their long-term average rate of around 2.5 percent. The labor force participation rate is at a seven-year high, while overall unemployment is around 5.5 percent.
While global nationalism's favorite whipping boy is immigration, just over half of the population in Australia thinks the total number of immigrants is either "about right" or "too low." While four in 10 believe the number is too high.
I am sure Australia's example will rub some readers the wrong way. So many of us mistake this new-found nationalism for patriotism. That is a fallacy. Throughout history, it has always been easier to blame a foreigner for a nation's woes (Jews in pre-war Germany, the Ottoman Empire's genocide of Armenians, the Tutsis in Rwanda), rather than face the real reasons.
My suggestion is that we sell the Statue of Liberty to the Aussies and use the proceeds to build that wall on our southern borders. Why not, since it appears we have very little use for the Statue of Liberty, or what it stands for, in today's America.
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The Independent Investor: Trump's trade war
Over the weekend, the G-7 group of nations met to denounce the recent actions of the United States. This coming Friday, these same leaders convene in Quebec. President Trump will attend and seems determined to face them down.
Ever since the Trump administration announced plans to raise tariffs on imported steel and aluminum by 25 percent and 10 percent respectively, our allies have been livid. Some are referring to the upcoming meeting as the G-6, plus the United States. You've got to hand it to the president, he doesn't back off, but given the circumstances, maybe he should.
I doubt that anyone in this country believes the present trade agreements we have signed throughout the years are even remotely fair. They should be renegotiated, but there are different ways of going about it. Unfortunately, Trump used a rather "trumped-up" excuse for his actions by claiming "national security" as justification for the tariffs. Given that the tariffs will be levied principally against America's strongest allies, is it any wonder that the G-7's response was what it was?
They rightfully believe that the Trump Administration's blatant attempt to circumvent the World Trade Organization (WTO) is illegal. As an example, Canadian Prime Minister, Justin Trudeau, responded to the claim by saying that "Canadians have served alongside Americans in two world wars and in Korea. From the beaches of Normandy to the mountains of Afghanistan, we have fought and died together."
"Canada," the president claims, "has treated our agricultural business and farmers very poorly for a very long period of time." How that squares with national security is anyone's guess.
My point is why confuse the issues? This is not about national security; it is about unfair trade practices. If Trump were to stick to the facts, our trading partners would need to re-examine their own policies. And what we can do in the name of national security, other nations can do as well. The irony is that the World Trade Organization was originally set up after WWII at the prodding of the U.S. to handle just these issues.
Back in 1930, the Smoot-Hawley Tariff Act was passed despite stiff congressional opposition. The law is widely believed to have exacerbated the severity of The Great Depression. The act was intended to save the nation's factories by raising tariffs on imports to record levels. Instead, other nations responded in kind. A global trade war developed, which ultimately led to a shooting war. And the rest is history.
No one of rational mind wants to see that history repeated. It may be that the president's administration lacks the knowledge and expertise required to navigate the established WTO channels. Few, if any, of his men have any experience in negotiating far-reaching trade deals.
It could be that Trump lacks the patience to wait for these deals, some of which could take years to hammer out. After all, most of the world's truly successful trade agreements required years of negotiations. Or maybe he thinks he needs a "win" in time to influence the mid-term elections.
By circumventing the WTO, Trump raises the risk that a trade war could develop. President Trump has started with steel and aluminum but has now expanded his list of potential tariffs to food, lumber, automobiles, technology, and whatever else he can fit into his tweets. But tweets are not diplomacy, nor are they trade negotiations. Both need to be developed if we are truly serious about getting better trade deals.
Trump is preaching to the choir when he demands a fairer share of the trade pie, but where's the beef? Where are the specific plans to right those wrongs? They are noticeably absent. Bluster and bravado has worked for Trump thus far. Let's cross our fingers that his unorthodox tactics can carry the day.
Wilbur Ross, his commerce secretary, just returned from China empty-handed. The Chinese were ready to negotiate with specific ideas. They floated an offer to purchase a massive amount of U.S. goods worth $70 million next year if Trump backed off his tariff threats on Chinese imports.
Evidently, the offer was not good enough, but there were no counter offers. Donald Trump has been complaining about the unfair trading practices of our friends and foes for decades. He campaigned on these issues and won. The problem is now that he is in charge, he needs to not only point out the problems but come up with the solutions. You can't negotiate with tweets.
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The Independent Investor: Italy's Crisis Threatens Financial Markets
A political crisis in the fourth largest economy in Europe has spilled over into the financial markets. Global stock exchanges greeted Italy's present political dysfunction by registering major declines — and the crisis may just be getting started.
Back in 2010 through 2012, readers may recall a similar eurozone calamity. Greece was at the center of that maelstrom and, at its worse, threatened the viability of the European Union and its currency, the Euro. This time around, many of the same issues are now bedeviling Italy. The country has the third largest debt load in the world after the U.S. and Japan. It still suffers from double-digit unemployment while their economy continues to stagnate.
At times like this, voters usually look for something to blame. Most Italians have focused on their membership in the EU as the cause for all of their woes. After an inconclusive election several months ago, Italy has been in a no man's land of political inertia. Two opposing parties: a far-right party (The League) and a populist party (the Five Star Movement) share power. They recently proposed a new government to break the deadlock.
The problem was that their candidates presented a threat to those who still wanted to maintain membership in the EU. Their proposed finance minister, for example, was a confirmed foe of both continued membership in the EU and the Euro. He scared the bejesus out of officials throughout the EU.
As a result, Italian President Sergio Mattarella vetoed the appointment and instead appointed a technocrat, whom he hoped would reassure the financial markets and the rest of Europe.
Both opposition parties are furious. It appears that their ire is backed by the voter population. The League has nearly doubled in popularity, while the Five Star Movement is maintaining its 30 percent political base. Comments from several EU establishment members this week have only fueled the fire of outrage among Italians.
Threats of serious financial repercussions if Italians encourage more populism within their government has had the opposite effect. Most politicians are now calling for yet another round of new elections. Financial markets are afraid that the results could be a referendum on whether Italy will remain or exit the EU.
The lessons learned after the Greek Crisis have not been forgotten. Neither Germany nor the rest of the EU want any further cracks in the Eurozone, especially after Brexit. Europe's central bank has a lot of experience defending the Euro in times like this as well.
Italy, as one of the founding members of the union, also knows the consequences of exiting the EU. Given their debt load and sputtering economy, Italy would most assuredly see a run on their banking system, which could spike inflation, riots, demonstrations, deaths and most likely a severe recession and even higher unemployment.
Many political analysts argue that the Italian crisis is a simple extension of a broader global trend. On one side are the populists or "have-nots" that have been left out of a generation of booming international trade. To them, that economic model has simply left the rich richer and the poor poorer.
On the other side are those riding a new wave of nationalism fueled by a wealthy establishment, whose only objective is to keep their place in the sun. These radical right-wingers are promoting an extreme form of an economic model that the opposition believes is not only obsolete but generating even higher levels of inequality and injustice. It is a global contest of two extreme movements. The winner has yet to be announced.
So far, most of the financial damage has been contained to Italy. Both their stock and bond markets experienced hefty losses this week. The financial contagion that occurred during the Greek Crisis five years ago, which spread to the rest of Europe and ultimately the world financial markets, has yet to materialize.
Most financial experts believe that things won't get to that point. Both sides are aware of what is at stake and hopefully will back away from a gunfight at high noon. Although I hold with the consensus view for now, I will be watching events closely in the days and weeks ahead, so keep reading.
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