FYI: I will be talking about these topics on CNBC Power Lunch tomorrow (Friday, 3/23/18) between 1-3PM. I am looking forward to it because I get to do the spot on set with the anchors here in New York. Will send a link to the video out to the Safanad friends and family after the show.
Summary: For a guy like me who likes to chew on new ideas and turn them into investment strategies, this week was a feast: Facebook, Cambridge Analytica, the G20 meeting, a fake Russian election, a new Fed Chairman, and now Trump tariffs and a looming trade war with China that knocked 723 points off the DJIA in about two hours. Coming at a time when valuations are crazy, interest rates are rising and markets show signs of criticality, these events make me very concerned about the risk of sudden collapses in prices. This is the time to play defense with your portfolio.
New Fed Chairman: Chairman Powell ran his first FOMC meeting, held his first press conference and announced his first Fed funds rate increase this week. He did a pretty good job. He raised rates a quarter point--exactly what everybody knew he would do. He talked about markets instead of models. And he moved the FOMC to a slightly more hawkish position, signaling 4 rate increases this year.
The best thing I can say about him is he is not an Economist and not a professor. I can say that with conviction because I am an economist and I teach Macroeconomics and Finance to PhD students. Academic models of the economy--the new used by all central banks--suffer from two fatal flaws. They all think the central bank's job is to steer output and employment around with the Fed funds rate. And they think, or assume, the economy is in price-clearing equilibrium at all times. Neither make any sense.
IMHO, as the kids say, the economy is not our $20 trillion GDP; it's our $300 trillion balance sheet. Every major economic event in the past 50 years has started in the asset markets, not the GDP accounts. More on this in a later note.
And although the markets are often at or near equilibrium--full employment--nothing interesting ever happens there. All the money is made and lost during the chaotic periods we call financial crises. To a first approximation, understanding what causes temporary market failures is the only thing that matters to an investor. I teach a graduate course I call "Far from Equilibrium Economics and Finance". More on that later too.
For now let's just say Powell looks like a pretty good guy for the job and that he is aware that labor markets are very tight and prices are starting to accelerate. Conclusion: we are now firmly in a rising interest rate environment that is like to last for at least several years. Rising rates are not good for asset prices in general but not all asset classes will be affected the same way.
Tariffs and Trade Wars: The bigger topic this week is trade wars. Last week Trump announced he would impose tariffs on steel and aluminum, which triggered sharp responses from the EU. Today, he announced a ton ($60B) of new tariffs aimed at China. This was a terrible mistake and the most likely factor to trip up the financial markets.
I'm not saying this as a dogmatic free trader. Yes, I do favor market solutions over commands from politicians in most situations, but I do not buy the standard dogma that all trade makes everybody happy. Economists typically cite Ricardo's (David, not Ricky) Law of Comparative Advantage, which says that England and Portugal will both be better off (higher GDP) if England specializes in cloth, Portugal specializes in wine, and they supply each other's needs through trade.
But the Law of Comparative Advantage is doesn't work as advertised in today's world. Three pages before he laid out the cloth/wine story Ricardo explained to the reader that he had to make a critical assumption for the argument to work. He assumed that people could not trade capital; they could only trade finished goods. The reason that made the story work is that not trading capital meant that trade would not change a country's productive resources, only how they were used. That made perfect sense in Ricardo's day. Capital--think textile mills-- was prohibitively expensive to move compared with goods.
But Ricardo would not have written that today. Today it is far cheaper to ship capital than goods. When trade gets easier, as it did after China joined the WTO, it makes sense to ship capital from places where it is abundant, like the US, to places where it is scarce, like China and other emerging markets and for them to ship finished goods to us. When the owner of the capital ships a drill press from a factory in the midwest to a factory in China, though, he ships the productive capacity of the machine and the earning power of the worker who operated it on the same ship.
That's one of the reasons why the value of capital (stock prices) has increased everywhere in the world, wages in emerging markets have increased, and wages in capital exporters like the US, Japan and EU have stagnated. That doesn't mean we should not trade with others. It just means that we should think about the effects of trade on all the parts of the economy when we do it.
Whatever your views on free trade, trade wars are terrible for everybody. The worst part of Trump's tariff announcements is that they were viewed as knee-jerk moves, not well thought through before they were announced. This increases the risk that they will trigger equally knee-jerk retaliation from our trading partners. We have already seen some of the backlash, tariffs on American icon brands like Harley-Davidson and Levis. The biggest damage, however, will be to our big exports, agriculture (think soybeans), technology and capital goods. Tech companies, of course, have been the source of the lion's share of gains in the stock market. A Chinese retaliation against US tech companies would be a dagger to the heart of the stock market. A week ago, Xi Jinping was effectively anointed as China's lifetime ruler. He will be especially sensitive to anything that looks like an attack directed at China.
Bottom line: somebody in the White House should have taken a deep breath and thought some of this through before launching a preemptive strike on global trade. One more reason why I want to have a defensive portfolio today.
JR