Long-term economic and investment themes, Part 2

This article first appeared in The Edge Financial Daily, on May 19, 2017.
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IN Monday’s column, I laid out three of six long term economic and investment themes: fiscal stimulus, globalisation and ageing populations. Here are three more.

4) As I explored in my March 31 column, the long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalisation, the slow shift from export-led to domestic-spending-driven economies, government and cultural restraints, ageing and falling populations, and military threats. 

The fascination with Asia started with Japan’s dazzling economic recovery after World War II. Rising property and equity prices convinced many in the West that Japan would soon take over the world, but those bubbles burst in late 1989, sending the Nikkei index down 63% in less than three years and real estate prices down by 59%. Japanese economic growth has averaged just 1.1% since then.

With Japan’s decline, Western fascination shifted to the rapidly growing developing economies of the Asian Tigers, but the regional financial crisis that commenced in Thailand in 1997 started a domino-like collapse of neighbouring financial markets and economies. With the 2007-2009 recession and financial crisis, export-led Asia suffered along with the economies of the US and Europe. Yet Westerners did not abandon Asia, but shifted their admiration to China. 

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3% during the worldwide downturn, but then revived thanks to the huge 2009 stimulus programme. Easy credit fuelled a property boom and inflation, both of which were unwanted by Chinese authorities. Also, the growth in exports rebounded back to the 20% to 30% annual rates seen before the recession. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after China’s gross domestic product topped Japan’s in 2009. 

But like virtually all developing economies, China’s has been driven by exports that directly or indirectly are sold to North America and Europe. And those imports by the West are fundamentally curtailed by sluggish overall economic growth — the result of deleveraging, the working-off of excess debt built up in the exuberant 1980s and 1990s. Annual Chinese export growth dropped from 20% to 30% in the 2000s to negative territory in February.

Further, globalisation is largely completed, curbing that source of emerging-economy advance. And China’s huge total economic size had covered up its still-underdeveloped status. Even with the explosive growth in the past several decades, Chinese gross domestic product (GDP) per capita in 2016 was US$8,030, or just 14% of the US. Meanwhile, consumer spending in China amounts to just 37% of GDP compared to 68.1% in the US.

China will not shrivel up and die, but it will be a much less important actor on the global stage as it shifts from commodity-munching exports, housing and infrastructure to consumer spending and services. The same was true of Japan starting in the early 1990s.

There may well be an Asian Century, but do not hold your breath. It took about a millennium for the West to develop meaningful democracy, the rule of law, large middle classes that support domestic economies, and all the other institutions that are largely lacking in developing Asian lands at present.

5) Disinflation that started in 1980 continues with chronic deflation likely, especially as services follow goods in price retreats. The US Federal Reserve and every other major central bank have a 2% inflation target. They do not love inflation, but they fear deflation, which curbs consumer spending and capital investment along with economic growth as deflationary expectations set in. When price declines are widespread and chronic, buyers anticipate further declines so they wait for even lower prices. The resulting excess capacity and unwanted inventories force producers to cut prices further. Suspicions are confirmed, so buyers wait for still-lower prices in a self-perpetuating spiral. So deflation is self-feeding, as seen clearly for two decades in Japan.

Also, with deflation, the real cost of debts rises, making them harder to service and inducing financial problems and bankruptcies.

I remain convinced that widespread inflation results from overall demand exceeding supply, and deflation is caused by the reverse. Historically, governments create inflation in wartime with robust spending on top of fully-employed economies. That was the case in the late 1960s and 1970s, when Vietnam War outlays combined with War on Poverty spending. And that led to double-digit inflation rates by 1980. In peacetime, however, supply normally exceeds demand and deflation prevails. In the 96 years of war since 1749, wholesale prices rose 8.2% per year on average, but fell by 0.45% annually in the 170 years of peace. Assuming that the Trump administration, China, Russia and Middle East terrorists do not drag the US into a significant armed conflict, deflation is more likely in the years ahead, at least by historical precedent.

6) “The bond rally of a lifetime” that I first identified in 1981, when 30-year Treasuries yielded 15.2%, continues. Their quality is unquestioned. Treasury coupon and zero-coupon bonds, first of all, have gigantic liquidity with hundreds of billions of dollars’ worth trading each day. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they cannot be called before maturity. This is an annoying feature of corporate and municipal bonds. 

Third, Treasuries are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year bonds returned 42%, but global corporate bonds fell 8%, emerging market bonds lost 10%, junk bonds dropped 27%, and even investment-grade municipal bonds fell 4% in price.

Treasuries sold off with the “Trump Trade” after his election, but revived recently. Treasuries have also rallied lately due to their safe-haven status and thanks to having a higher yield than other developed country sovereigns, making them more attractive to foreign investors. — Bloomberg

This is the last of a two-part series.