Globalised business is a US security issue

A broad group of experts think economic integration with China should be reversed

Rana Foroohar




When Donald Trump upsets free-market liberals with new tariffs, the US president’s critics tend to pin the blame on him alone. “Trump’s trade war”, as the shorthand goes, is either a “negotiating position” (the optimistic view, now increasingly defunct with the introduction of broader tariffs on China) or the latest manifestation of what many see as a full-blown personality disorder.

The truth is both more complicated, and less flattering to Mr Trump’s ego — there is a much broader group of people in both the public and the private sector who would like to reverse the economic integration of China and the US for strategic reasons.

This was evident at a two-day event sponsored late last month by the National Defense University, which brings together military and civilian leaders to discuss the big challenges of the day. Dozens of experts, government officials, and business leaders gathered to talk about the decline in the post-second world war order, the rise of China, and how the US could strengthen its manufacturing and defence industries. The goal would be to create resilient supply chains that could withstand not just a trade war, but an actual war.

Amid the broad and varied discussion, speakers shared a general sense that the laissez-faire approach to globalised business was over, and that there would be serious ramifications for US industry.

“If you accept as your starting point that we are in a great power struggle [with China and Russia], then you have to think about securing the innovation base, making viable the industrial base, and scaling it all,” said Major General John Jansen, the event organiser.

Included on the event’s reading list was Freedom’s Forge, which outlines the role that US business — notably carmakers — played in gearing up the US for war in the early 1940s. At that time, because of the depth and breadth of the auto industry’s manufacturing and logistical might, the sector was viewed as being just as important to national security as steel and aluminium.

That is not to say the US security community is pro-tariffs or trade war — or that Detroit will be asked to turn over its spare capacity to the Pentagon anytime soon. But there is a growing group of thoughtful people who believe that American national security interests will require a forcible untangling of the investment and supply chain links between the US and China. They point to high-tech areas like artificial intelligence, robotics, autonomous vehicles, virtual reality, financial technology and biotech as important not only to the military but also for private sector growth.

In January, the Defense Innovation Unit Experimental, a US government entity that funds private sector technology of interest to the military, put out a report looking at Chinese tech investment at home and in Silicon Valley. It concluded that Chinese companies now own key technologies and parts of supply chains that touch US military equipment and services, which have for years been increasingly outsourced to the private sector. Chinese companies participated in 16 per cent of all US venture capital deals in 2015.

The US Department of Defense has also issued a separate report to the White House that takes the supply chain issue further. We are likely to hear more alarming stories like the 2013 revelation that the US was relying on a factory in China to make a key propellant chemical for the hellfire missile. After the publicity, the DoD found a US factory to make the ingredient.

While America’s military is still figuring out how make sure its supply chains are not controlled by strategic adversaries, the Chinese have played a much more sophisticated long game. The difference can be summed up in two words: industrial policy. China has one. The US doesn’t. The US has always steered away from a formal policy because critics see it as the government “picking winners”. But the Chinese don’t so much pick winners as use a co-ordinated approach to harnessing the technologies they need. They do it not only through investments and acquisitions but also through forced joint ventures, industrial espionage, and cybertheft.

No one is arguing that multinational companies should adopt that approach. But it is hard to imagine them continuing to do business as usual in this environment. Well before Mr Trump’s election, the reputational and financial risks of globalisation were becoming clear.

Walmart’s decision to contract out clothing production to third-tier suppliers in Bangladesh stopped making sense when the Rana Plaza collapse killed 1,100 garment workers. Boeing outsourced 70 per cent of its Dreamliner to save money, but the project ran over budget and behind schedule. No wonder many multinationals were shortening their supply chains even before the current trade conflicts.

It is a trend that will probably speed up. Multinational companies, much more than domestically focused ones, will suffer collateral damage from tariffs. They will also be a major target of Chinese backlash. Anecdotally, this is already leading some groups to shift production from China to other countries, like Vietnam. If the military-industrial complex in the US has its way, those supply chains might move even closer to home.


BoJ defies global move to roll back crisis-era stimulus

Global bonds rally as changes to Japan’s vast easing programme prove minor

Leo Lewis and Kana Inagaki in Tokyo and Emma Dunkley in Hong Kong


Haruhiko Kuroda, BoJ governor, said the decision would 'counter speculation . . . that the bank is heading towards an early exit or an increase in rates' © AFP


The Bank of Japan made clear it would not join the world’s other major central banks in rolling back crisis-era stimulus policies on Tuesday, announcing it would maintain “extremely low” interest rates for an extended period.

After being forced three times in a week to intervene to cap bond yields amid expectations policymakers would signal a willingness to tighten its easy money regime, the central bank instead declared it was strengthening the framework for “continuous powerful monetary easing”.

Reinforcing its commitment to its programme, the BoJ introduced a forward guidance for policy rates for the first time, saying that the extremely low levels would remain “for an extended period of time”.

“This will fully counter speculation among some market participants that the bank is heading towards an early exit or an increase in rates,” Haruhiko Kuroda, BoJ governor, said at a news conference in Tokyo.

Analysts agreed he had bought himself at least six to nine months before the market again began to speculate about further changes to the programme.

Having been on edge in the days leading up to Tuesday’s announcement, bond markets rallied during the Tokyo trading day, with the yield on Japan’s benchmark 10-year debt falling 5 basis points to 0.04 per cent. In the early European afternoon, the 10-year US Treasury yield declined 1.5bp to 2.9598 per cent and the equivalent German Bund was unchanged, yielding 0.452 per cent.

The yen weakened by as much as 0.5 per cent in the approach to the start of US trade, reaching ¥111.58 per dollar, a six-session nadir. Tokyo-listed banks fell, with the Topix closing down 0.8 per cent, the biggest decline among Asia-Pacific indicies. Banks led the selling, as hopes were dashed for more of a move away from ultra-loose monetary policy, which has hit profits in the financial sector.

The BoJ’s changes announced involved efforts to make its huge stimulus programme more flexible.

The bank repeated its pledge to continue to purchase bonds so that 10-year JGB yields remained “at around zero per cent”, though it added the line that “the yields may move upward and downward to some extent”. Mr Kuroda later revealed that the bank would allow the 10-year JGB yield to move up and down 0.2 percentage points around zero — an informal measure that doubled the previous flexibility.

Chart showing Central banks' balance sheets as a % of GDP

Analysts were surprised that the BoJ’s forward guidance had a specific reference to uncertainties linked to the planned consumption tax increase next October.

“The phrasing around the forward statement is stronger than we expected. If you read the statement literally, it sounds as if the BoJ is saying they won’t raise rates until 2020,” said Masamichi Adachi, economist at JPMorgan in Tokyo.

The BoJ also said it would alter the balance of its ¥6tn ($54bn) per year exchange traded funds buying programme so that a much greater proportion was focused on ETFs that track the broader, market cap-weighted Topix index. The scale of its Topix-linked ETF purchases would rise from ¥2.7tn to ¥4.2tn per year, the bank said in its statement.

Inflation in Japan remains subdued with prices, excluding fresh food and energy, up only 0.2 per cent in June. That prompted the BoJ to lower its inflation forecasts on Tuesday, which predicted price rises of 1.6 per cent in the year to March 2021 compared with 1.8 per cent that it projected in April.

“The momentum toward achieving the price stability target of 2 per cent is maintained but is not yet sufficiently firm,” the BoJ said in a statement.

Analysts have warned that the BoJ’s vast monetary stimulus programme might not be sustainable over the long-term. The size of the BoJ’s balance sheet, as a percentage of GDP, is 98 per cent, compared with the US, which is just over 20 per cent.

Kerry Craig, a global market strategist at JPMorgan Asset Management, said: “Five years ago the BoJ said it would get inflation to 2 per cent, and it hasn’t happened, so there were some big questions on sustainability on how much more quantitative and qualitative easing they could do.”

He said the BoJ has created the forward guidance to show that it was committed to reaching its inflation target, to help keep the currency under control. “The longer these QE programmes run, the more likely central banks will run out of things to buy . . . if they tweak it to make it look sustainable, it buys them some credibility.”




Additional reporting by Edward White in Taipei


Political displacement activity

How policy debates in Europe become untethered from reality

Symbolic rows blaze while real ones are ignored



IN 2016 the election of an American president with a wilful disregard for the truth inspired some observers to return to “On Bullshit”, a monograph on hot air written in 1986 by Harry Frankfurt, a philosopher. Europeans delight in this sort of thing. They enjoy contrasting the “fake news” and “alternative facts” that characterise the Trump administration with their own, more honest, brand of politics. Yet they should not be so sanguine. Worryingly, bovine waste seems to be spreading in Europe.

Take the recent spat in Germany, where Horst Seehofer, the interior minister, came close to blowing up the coalition between his Bavaria-based Christian Social Union and Angela Merkel’s Christian Democratic Union. Although migrant arrivals in Germany have plummeted, Mr Seehofer wanted to turn back from the southern frontier asylum-seekers registered in other countries, an action that could have triggered a domino effect of border controls elsewhere. Denied by Mrs Merkel, Mr Seehofer resigned, unresigned, huffed and puffed, and finally struck a compromise to accelerate screening procedures which, by one measure, might apply to fewer than ten migrants a day. His strutting had nothing to do with managing immigration and everything to do with boosting the CSU’s standing before Bavarian elections in October. (Polls suggest his gambit has backfired.)

Mr Seehofer’s psychodrama troubled the rest of the European Union, too; a mini-summit was arranged to help resolve it. “It cannot be that some Bavarian party decides how Europe works,” sniffed Luxembourg’s prime minister. But other Europeans should not be too haughty about Germany’s debate, for their own rows on asylum are barely more rational. For three years the EU’s leaders have locked horns over how to distribute asylum-seekers across the EU. The contest has become a pure power play, decoupled from the reality of irregular migration. One estimate is that a realistic relocation proposal would have applied to a mere 16,000 asylum-seekers over two years. “Do you really want to break Europe for this?” asks a frustrated official.

Another case in point is a new proliferation of ambiguous phrases designed to paper over political disagreements. To add to its already-impressive lexicon, the migration debate has lately thrown up “control centres”, “regional disembarkation platforms” and “transit centres”. The purpose of such proposals is rarely elaborated, the details never worked out. That means leaders can all provide their own interpretations and claim victory at home, while hapless officials are left to work out how to transmute the empty phrases into meaningful policy. When they inevitably fail, the political argument returns, usually in fiercer form.

European politicians have developed a habit of turning thorny substantive debates into poisonous symbolic ones. France recently came close to torpedoing the start of EU membership talks for Macedonia and Albania. Its fine words about corruption and the rule of law were really cover for fears of handing nativist French politicians a vote-winning argument before next year’s European elections. On the debate over euro-zone reform, which has momentum for the first time in years, the German and Dutch parliaments groan with deputies who threaten to blow up deals over a “transfer union” that no one is proposing.

To a degree this is nothing new. Insoluble domestic disputes have long been outsourced to “Europe”, or simply dumped on neighbours (Austria was infuriated not to have been consulted about the Seehofer-Merkel deal, which assumed that it would take back Germany’s rejected migrants). But in a more fractured electoral landscape, politicians have bigger incentives to wage largely symbolic battles. These in turn are boosted on social media, riling the base and drowning out moderate voices.

And Europe’s posing leaves real casualties. French intransigence means Macedonia’s government will find it harder to win a tricky autumn referendum on the deal it recently struck with Greece to rename itself. The euro-zone debate may yet be derailed or diluted by restive parliaments in creditor countries battling ghosts of their own imagination. On Europe’s migration rules, no one pretends a solution is easy. But governments are wasting precious political capital on disputes that succeed only in setting them against each other.

Enter the expert

As for Mr Trump, his particular brand of baloney is now affecting Europe. At this week’s NATO summit he launched a fusillade against America’s allies, especially Germany, for not meeting their promise to spend 2% of GDP on defence. But if Mr Trump genuinely cared about this he would parade the growth in defence budgets across NATO as a personal triumph, rather than berate allies for not doing more. His real gripe is America’s trade deficit with the EU; military free-riding just offers an excuse to press his case that America is being stiffed. “The bullshitter is faking things. But this does not mean that he necessarily gets them wrong,” writes Mr Frankfurt. Mr Trump is indeed right that Germany should spend more on defence.

But that should be the start of the debate, not its conclusion. The nature of the security threat to Europe is changing, and America has growing commitments in Asia. This should lead to a serious discussion in Europe over how the allies can best pool military resources, spread risk and exploit national specialisms to take more responsibility for their own defence. Germany is well overdue a national debate over its security strategy. Instead, the discussion has been eclipsed by a fixation on a number that is a poor proxy for how NATO allies should share military burdens.

The challenge posed by Mr Trump demands a clear-eyed and unified response. Instead, Europe finds itself bogged down in squabbles that have become increasingly untethered from reality. If Europe has had enough of Mr Trump’s nonsense, it might help to stop peddling so much of its own.


The Real Growth Numbers to Watch in China

Slowing investment and contracting shadow bank credit are reliable signs of difficulties ahead

By Nathaniel Taplin


SHADOW BOXING
Change from a year earlier 
*Including shadow banking, corporate bonds, and equity finance.

Source: CEIC



Chinese second-quarter growth is out and—lo and behold—it came in exactly as predicted at 6.7%, a hair lower than the first quarter’s 6.8%.

Implausibly smooth headline growth aside, a relatively strong second quarter isn’t surprising: Exports have held up well despite the trade fracas, and domestic industry benefited from the end of winter pollution controls in March. 
The thing to watch is the steep slowdown in investment: For the first half of 2018, overall investment growth was up just 6% from a year earlier, a post-1990s low. Real growth is even slower, because the nominal headline figure is being flattered by a land-price bubble.
There are increasing signs that the critical real-estate sector—which often drives the overall trend in corporate profits—has become collateral damage of China’s crackdown on shadow banking. Shadow-banking credit outstanding, still growing at close to 10% in January, was down marginally in June from a year earlier, central bank numbers show.

That’s worrying because investment in real estate tends to follow the trend in shadow banking closely—so a small uptick in traditional bank lending last month may not be enough to arrest the collapse in spending on buildings and equipment.The air is coming out of business investment. Photo: china stringer network/Reuters 


Small businesses are also feeling the heat: After an uptick in mid 2017, the purchasing managers’ indexes for China’s small and midsize manufacturers are now both in contraction.

China’s central bank has already begun cautiously loosening the screws. Following two reductions in the cash reserves banks must keep on hand, the key short-term borrowing rate has fallen around 0.2 percentage point since April, while the banking regulator has reportedly asked banks to “significantly” reduce small-business lending rates.

To ensure that deposit-starved small banks have sufficient cash for lending, more steps to push down interbank rates—including further reserve-ratio cuts and potentially cheaper loans from central-bank lending facilities—are likely in the months ahead.

With a trade war gathering and a corporate-bond selloff still gaining pace, such steps are probably necessary—but they risk undermining both the yuan and the regulatory push to make small banks less dependent on risky interbank borrowing. 
A trickier second half now looks baked in the cake for China.


Who's Left?

by: The Heisenberg

 
- One persistent question keeps popping up lately in some of the analysis I spend my time perusing.

- That question is this: "Who will be the marginal buyer of equities?"

- There's a sense in which that only matters if the two pillars (buybacks and earnings growth) of the current rally crumble.

- Here's a hopefully useful assessment of equity demand.

 
I don't have children, but if I did, I imagine I'd love them all equally, but like some of them more than others.
 
In that respect, my posts are like my hypothetical kids - I love them all, but I like some more than the rest. That preference shows up in the number of times I refer back to some posts relative to others.
 
One recent post I find myself linking to pretty often is called "When A Walk To The Park Isn't A Walk In The Park". I chose to present that originally on this platform, but I've written several riffs on it for my site since it was published early last month.
 
The overarching point in that unnecessarily long piece is that back in January, the trek higher for U.S. equities (SPY) could be properly characterized as a dead sprint. In late January, the Conference Board survey (which goes back some three decades) showed that a record percentage of Americans thought equities would rise in the year ahead. Here's what the chart on that looked like at the time:
 
(Bloomberg)
 
 
That ebullient sentiment was fueled in part by the assumption that the tax cuts in the U.S. would fuel a final, glorious leg higher in stocks - the fabled "blowoff top".
 
For a minute there, that assumption was borne out, as the S&P blew through half of Wall Street's year-end targets in the space of just three weeks. Global equities were similarly buoyant. For instance, at one point the Hang Seng China Enterprise Index rose for a record 19 consecutive sessions (H-shares are now in a bear market along with their counterparts on the Chinese mainland).
I recounted the evolution of markets in 2018 in a chart-heavy, first half review called "Requiem For A Rally", so I'm not going to subject the folks who read that post to a paraphrased version here. But just to drive the point home about January marking peak euphoria, do note the following two charts I highlighted in that piece which show, from left, that through January 25, the S&P had gone a record 398 days without a 5% pullback and the MSCI world broke a similar record:
 
(Goldman)
 
 
In the five months since January, the trek higher for U.S. stocks has morphed into a slow, arduous affair akin to trudging uphill, against the wind, where the "wind" is comprised of seemingly incessant headlines about, to name a few, regulatory risk in tech, worries that inflation in the U.S. will accelerate forcing the Fed to lean more hawkish than the market anticipates, emerging market woes tied to the tightening of U.S. monetary policy and, of course, trade wars. The trek higher for ex-U.S. stocks has halted altogether and, depending on the locale, gone into reverse.
 
Amid the headline risk, one question which has come up time and again, is this: Who will be the marginal buyer of U.S. equities?
 
Honestly, I'm not a huge fan of that question because it's only relevant if you assume the corporate bid (i.e., buybacks) disappoints and if you believe that earnings growth in the U.S. is likely to decelerate meaningfully in the near term. I don't think either of those things are particularly likely.
 
Let's take buybacks first.
 
I don't normally quote mainstream media outlets other than Bloomberg, but I think it's notable that CNN Money has made it a point to highlight the buyback story. They've hardly been the only national news outlet to point out the discrepancy between, on one hand, what was implicitly (and in some cases explicitly) promised by the GOP in terms of what the tax cuts would entail for corporate cash usage and, on the other, reality. I'm not going to get into the political debate for the purposes of this post, but suffice to say the media is pretty keen on letting the public know that while wage growth is still stubbornly refusing to reflect what the Phillips curve would dictate, corporations have not hesitated to plow money into buybacks. The following is from a CNN article published earlier this week, and again, the reason I use it is to illustrate how this has become a national discussion:

Corporate America threw Wall Street a record-shattering party last quarter. Flooded with cash from the Republican tax cut, US public companies announced a whopping $436.6 billion worth of stock buybacks, according to research firm TrimTabs. 
Not only is that most ever, it nearly doubles the previous record of $242.1 billion, which was set during the first three months of the year.

There's an argument to be made that if you're looking to explain how it is that U.S. equities held up in Q2 amid all the headline risk, buybacks are a good place to start. I highlighted the following chart from JPMorgan in a previous post, but I'll use it again here in the interest of backing up that contention:
 
(JPMorgan)
 
 
Normative discussions aside (that's another way of saying I'm not going to debate the social utility of buybacks here), the corporate bid is in place and that's a form of real-life "plunge protection". You don't need any conspiracy theories to employ the "plunge protection" characterization. Recall that back in February, amid the equity rout, Goldman's buyback desk had its second busiest week in history. Here's a quote from a note dated February: 
The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017.
Moving on to earnings growth in the U.S., you should already know the story: Q2 is likely to reflect well on corporate profitability. That's thanks in no small part to the tax cuts. Consider these excerpts, from a Goldman note published on Friday:
Despite valuation risk, strong corporate profitability continues to support equity prices.  
S&P 500 return on equity (ROE) increased by 36 bp to 16.6% in 1Q, its highest level since 2011. Profitability is even more impressive excluding Financials. ROE ex-Financials rose by 44 bp to 19.9%, the highest level on record except for 4Q 1997. 

 
Three of the five DuPont factors were tailwinds to S&P 500 ROE in the first quarter.  
Lower corporate taxes was the largest tailwind to S&P 500 profitability following the enactment of tax reform in December. A lower tax rate accounted for 25 bp of the total 36 bp increase in ROE in the quarter. Margins also continued their upward climb, providing a 13 bp tailwind to index-level return on equity.
The point here, is that when it comes to the "who will be the marginal buyer of U.S. equities?" question, I'm not entirely sure it needs answering in the near term as long as buybacks continue and as long as earnings continue to come in strong. Additionally, you can expect the buyback bid to be even more pronounced in the event there's a selloff.
 
So that's my effort to balance things out with the bull case.
 
With that out of the way, it's entirely possible that corporate profitably has either peaked or is close to peaking. Eventually, margin pressure is going to show up (it's already here in Consumer Discretionary), and if trade frictions end up denting the outlook for growth and prompting guidance cuts from management, well then, the earnings tailwind could abate, even if it doesn't disappear entirely.
 
On the buybacks, it's important to remember that what incentivized the latest iteration of a years-long bonanza was the tax bill. Once that incentive rolls off, it's likely that the pace of authorizations and executions will slow in the absence of further incentives to employ financial engineering. The backlash against buybacks will gather steam in the event of a Democratic sweep in the midterms.
 
That's not a prediction about how the midterms will turn out, it's just to say that if they turn out well for Democrats, the issue of corporate cash usage will be a hot topic on Capitol Hill.
 
It's therefore possible that the "marginal equity buyer" question will become relevant more quickly than some folks think, and if it does, the following chart and accompanying color from JPMorgan doesn't bode particularly well:
 
This sharp downshifting in equity and bond fund flows can be seen in Figure 4 which shows the monthly flows across both ETFs and mutual funds at a global level. What Figure 4 also shows is that June was even weaker relative to previous months with practically close to zero flows for both equity and bond funds.
 
That's a proxy for retail and "hot" money, but what about institutional investors and systematic re-risking?
 
One thing worth noting is that the idea of trend followers adding to exposure depends on momentum signals and also on volatility. While an in-depth assessment of that is well beyond the scope of this post, the bottom line is that sideways markets pose a challenge to the systematic re-risking thesis. Here's SocGen, from a note out last month:
Markets are pulled by the promises of late stage economic growth boosted by monetary and fiscal stimulus. They are also contending against the risks of rising geopolitical tensions and the likelihood of potential recession. So they end up moving up and down with no clear direction. Such sideways markets are challenging for convex strategies such as trend following systems.
 
Meanwhile, from an asset allocation perspective, there's reason to believe that globally, investors are bumping up against the limits of their prospective equity exposure. This is another one of those instances where I'm not sure how much detail readers on this platform are prepared to stomach, but what I've discovered recently is that people here seem to appreciate it when I hit the high points and provide a reference link for anyone interested in exploring things further.
 
Here's the short version. According to a recent analysis by JPMorgan's Nikolaos Panigirtzoglou, global non-bank investors have an equity allocation of about 45%, which he reminds you is “well above both the 40% post Lehman average and the 43% longer term historical average”.
 
(JPMorgan)
 
 
That, in turn, means that non-bank investors' allocation to bonds and cash is below the post-Lehman average. With the burden on private investors vis-à-vis absorbing fixed income supply set to rise as G4 central banks normalize their balance sheets, it's not clear that it's realistic to expect global equity allocations to have much upside from here.

Coming full circle, what's needed for U.S. stocks to get back to the dead sprint higher that characterized the January rally is a resumption of steady retail flows, a decisive shift in momentum indicators coupled with a durable collapse in realized volatility that together green-light systematic re-risking and, perhaps, a sign from Jerome Powell that the Fed is prepared to slow the pace of rate hikes in the event trade frictions warrant a rethink of policy.
 
In the absence of those conditions, you're left to lean on buybacks and earnings growth.

The good news, for now, is that those two pillars have virtually never looked stronger.