You Can Only Worry For So Long

Doug Nolan

 
 
Ten-year Treasury yields jumped 11 bps this week to 2.66%, moving decisively above the key 2.60% technical level - to the highest yields since July 2014. Two-year yields ended the week up seven bps to 2.07%, the high going back to September 2008. Five-year Treasury yields jumped 10 bps to 2.45%, the high since April 2010. Has the long-delayed bond bear market finally commenced – with barely a whimper? Markets fretted over a potential spike in yields over recent years. I suppose You Can Only Worry For So Long.

The S&P500 has gained 5.1% in three weeks. If this return is lacking, one could have made 6.5% in the Dow Transports, 6.9% in the Nasdaq100, 6.8% in the Nasdaq Composite, 7.0% in the KBW Bank index or 9.5% in the Semiconductors (SOX) – all in the 2018’s first 13 trading sessions.

With equities deep into parabolic melt-up, let’s not expect market participants to be all too fixated on Treasury yields at a mere 2.64%. Why worry over where market yields might be in a few months, not with huge gains to harvest on an almost daily basis in equities markets. No reason to worry about the ECB winding down QE later this year. No basis for fretting a few Fed rate increases spread over many months. Clearly, the Bank of Japan is in no hurry either. Government shutdown - no issue. With tax cuts achieved, gridlock is fine. Liquidity abounds – might abound forever. Meanwhile, the reality is that global bond markets could be ending a three-decade bull market that changed the world.

January 17 – Financial Times (Kate Allen): “Governments are set to increase their borrowing from private investors this year for the first time in four years as central banks step back from the market, underlining market concern that the era of ultra-low bond yields appears vulnerable. The net debt of developed nations is expected to rise this year, chiefly driven by an increase in US bond sales, according to… JPMorgan Chase. The European Central Bank is scaling back its bond-buying programme and the Federal Reserve is shrinking its balance sheet… The Fed is set to roll off $222bn of its holdings of Treasuries this year, the analysis shows, while the ECB’s purchases of eurozone sovereign debt will drop to $221bn from $622bn last year. The US will raise a net $828bn of new issuance after the effects of the scaling back of quantitative easing are taken into account, according to JPMorgan — up from $357bn in 2017.”

January 16 – Bloomberg (Sid Verma): “A ‘dramatic’ increase in U.S. bond supply over the next year risks unhinging global markets from their bullish foundations, warns Torsten Slok at Deutsche Bank AG. The supply of U.S. government debt will almost double to $1 trillion this year to finance a widening budget deficit as the Federal Reserve whittles down its holdings. Unless new buyers emerge, the overhang could be far-reaching. ‘If demand for U.S. fixed income doesn’t double over the coming years then U.S. long rates will move higher, credit spreads will widen, the dollar will fall, and stocks will likely go down as foreigners move out of depreciating U.S. assets,’ the chief international economist at the German lender wrote… ‘And this could happen even in a situation where U.S. economic fundamentals remain solid.’”


Markets have grown comfortable with uncertainty. I would posit that markets have come to adore myriad uncertainties. After all, they ensure the certitude of interminable aggressive monetary stimulus. As the bullish thinking goes, it’s wasted energy to contemplate a spike in yields when, obviously, central banks won’t tolerate one. Waiting anxiously to perform another act of heroism, QE can be revived in an instant.

Unless something dramatic transpires, global central bank balance sheet growth will slow significantly in 2018. At the same time, governments are geared up to issue more debt. Central banks accommodated years of (“counter-cyclical”) massive deficit spending, and now big deficits are the (structural) norm.

Supply/demand dynamics will be shifting substantially, yet bond prices are expected to adjust slightly. The U.S. will be financing a huge fiscal deficit as the Fed pares back its balance sheet. Moreover, there’s an unusual degree of uncertainty surrounding future U.S. fiscal deficits. Tax cuts pay for themselves with bountiful prosperity, or perhaps this a replay of the late-nineties Bubble Mirage that had the U.S. paying off all its debt. There’s a scenario – a not outlandish one at that - where the Bubble bursts and deficits skyrocket toward $2.0 TN. For now, there is also the risk of trade battles coupled with a global economic boom and market Bubbles that create unusually uncertain inflation prospects.

Extraordinary: The end of an unparalleled bull market that saw $14 trillion of experimental “money” printing, along with zero/negative rates, push global yields to historic lows, in the face of unprecedented government debt issuance and record corporate debt sales. There is as well the issue of unquantifiable speculative leverage and derivative exposures, along with a now enormous ETF complex untested in bear market dynamics. Reasons aplenty to take a cautious approach with long-term bonds globally.

When it comes to uncertain 2018 prospects, China joins bond yields near the top of the list. Similar to their approach with bonds, equities buyers are today comfortable with China and feel no compunction to ponder beyond the present. Markets over recent years fretted over a Chinese financial accident. I suppose You Can Only Worry For So Long.

January 12 – Reuters (Fang Cheng and Kevin Yao): “China’s bank lending halved in December as the government kept up its campaign to curb financial system risks, but banks still managed to dole out a record amount for the year amid the tighter scrutiny. Chinese authorities are trying to walk a fine line by containing riskier types of financing and slowing an explosive build-up in debt without stunting economic growth. Banks extended 584.4 billion yuan ($90.46 billion) in December, data from the People’s Bank of China (PBOC) showed…, well below expectations of 1 trillion yuan and November’s 1.12 trillion yuan. But banks lent a record 13.53 trillion yuan of new loans in 2017.”

Total Social Financing (TSF) dropped in December to a weaker-than-expected 1.140 TN yuan (estimates 1.500), or about $178 billion. This was down 30% from both November and from December 2016. The fourth quarter marked a significant slowdown in TSF. Quarterly growth in TSF averaged 5.216 TN yuan ($815bn) during the first three quarters of 2017, but then dropped to 3.795 TN yuan ($593bn) during Q4. For the year, growth in TSF (which excludes government borrowings) was 9.2% ahead of 2016 levels to 19.443 TN ($3.038 TN). Yet for the first three quarters of 2017 TSF was expanding at a rate 16.3% above comparable 2016. The fourth quarter actually saw the growth in TSF 12.7% below that of Q4 2016.

Financial institution loans to Chinese households surged 21% in 2017, with lending remaining strong through year end. Lending to corporations slowed markedly last year, with December lending half of November’s level. Mortgage loans dominate Chinese household borrowings. And with housing prices inflated after years of easy finance, China is becoming increasingly susceptible to a self-reinforcing downturn in both apartment prices and mortgage Credit growth.

China traditionally begins the year with blockbuster Credit growth. January lending data will provide some indication of whether the fourth quarter slowdown was chiefly seasonal or rather the beginning of a more determined effort by Beijing to rein in Credit excess. Chinese regulators this month toughened their crackdown on off-balance sheet “shadow” lending.

January 14 – Bloomberg: “China’s banking regulator pledged to continue its crackdown on malpractice in the $38 trillion industry in 2018, vowing to tackle everything from poor corporate governance and violation of lending policies to cross-holdings of risky financial products. The China Banking Regulatory Commission unveiled its regulatory priorities for the year… Inspecting the funding source of banks’ shareholders and ensuring they have obtained their stakes in a regular manner. Examining banks’ compliance with rules restricting loans to real estate developers, local governments, industries burdened by overcapacity, and some home buyers. Looking into banks’ interbank activities and wealth management businesses.”

Chinese exports were up 10.9% in December. China ran a $54.69 billion trade surplus in December, the largest since January 2016. Foreign reserves rose to a larger-than-expected $3.140 TN, the highest level in 16 months. Fourth quarter GDP was reported at a stronger-than-expected 6.8% - putting 2017 growth at an above target 6.9%.

Chinese 10-year yields closed Friday at 3.98%, the high going back to October 2014. With the global economy humming along and global finance bubbling along, it’s not an inopportune time for Beijing to finally assume an assertive stance in reining in Credit. They will, of course, seek to avoid a shock. Beijing will, as well, focus on assuring productive Credit is readily available to sustain economic expansion. Productive enterprises should be supported, while speculative endeavors will be starved of finance. Easy to plan, not so straightforward to execute (Federal Reserve 1928/29).

“Houses are built to be inhabited, not for speculation,” President Xi proclaimed back in October during the 19th Party Congress. The problem is that tens of millions of Chinese have made fortunes in real estate. Hundreds of millions more aspire to. Not only has housing become the epicenter of Chinese speculative excess, mortgage Credit has inflated to the point of becoming a majority of total Credit growth - as well as a prevailing source of finance for the real economy. It all evolved into a full-fledged mortgage Credit Bubble, surely an expanding black hole of malinvestment, fraud and bank losses.

January 19 – Reuters: “China’s yuan-denominated outstanding housing loans rose 20.9% from a year earlier to 32.2 trillion yuan ($5.03 trillion) at end-December, China’s central bank said... Outstanding individual mortgages at the end of December grew 22.2% to 21.9 trillion yuan…”


January 18 – Bloomberg: “China’s home sales surged to a record high last month, despite a prolonged government campaign to curb property speculation. Sales by value, excluding affordable housing, jumped to a record 1.45 trillion yuan ($225 billion) in December, gaining 21% at the fastest pace in six months… Earlier today, home price data pointed to a similar acceleration. The upswing comes even as officials have sought to tame resurgent buying sentiment in a market that’s seen home prices skyrocket. The resurgence defies predictions that China’s property market will slow amid China’s moves to tackle excessive leverage and maintain curbs on purchases.”


January 16 – Wall Street Journal – “China’s Hot Housing Market Begins to Cool” (Dominique Fong): “China’s housing market has defied gravity and government restraints for two years, floating on a tide of bank loans and speculation. Until now. In Beijing and Shanghai—two of the country’s largest markets—and other megacities, sales have stalled and prices have dropped, falling slightly in some pockets and dramatically in others. Demand has dried up in these areas as a result of government measures including higher mortgage rates, higher down-payment requirements and limits on buying a second or third home. Would-be sellers are increasingly putting plans on hold in hope that prices will rebound.”

January 16 – Reuters: “China's banking regulator chief warned that a ‘black swan,’ or an unforeseen event could threaten the country's financial stability, official People's Daily reported… Guo Shuqing said that while risks in the financial system are manageable, they are still ‘complex and serious.’ Since his appointment as the head of the China Banking Regulatory Commission early last year, Guo has introduced a flurry of new rules to reign in lender risks including from curbs on shadow banking activities to the crackdown on loan fraud. Guo said the dangers stem from the pressure of rising bad debt, imperfect internal risk systems at financial institutions, the relatively high levels of shadow banking activities and rule violations.”


It’s curious to see Chinese housing transactions and prices plateau (in key markets) in the face of rampant mortgage Credit excess. Markets’ lack of concern notwithstanding, we can remind ourselves that this is China’s first mortgage boom – and a rather long and spectacular one at that. And I’m all too familiar with the view that Beijing is adept at managing oh so many things. Yet they’ve sure made a historic mess of mortgage finance – the extent of which will begin to surface as soon as lending slows. It’s one of history’s great ongoing manias, one that these days barely garners attention in The Age of Equities and Cryptocurrencies.

At this point, it’s not clear how Beijing possibly succeeds in reining in housing speculation without bursting an epic apartment Bubble (makes bitcoin look so tiny). With global yields on the rise and Chinese regulators on the case, the Chinese apartment market could be a critical development to monitor in 2018. Hard for me to believe there’s not a black swan holed up in there somewhere. And that goes for global bond markets as well.


What Does the End of The Liberal International Order Mean for Markets?

By John Mauldin

Globalization [has] overshot and produced a quite legitimate backlash. While people like me were enjoying Davos and Aspen and saying how marvelous the Liberal International Order was, a rather large number of ordinary Americans were not feeling quite so chipper.” 
—Niall Ferguson
 
Niall Ferguson is not the kind of historian who suffers from understatement. He writes big, muscular books with high-concept ideas that target current concerns through the prism of the past. They are pull-yourself-together warnings to the present by way of arresting historical precedent.” 
—The Guardian

If there is a sentence (or two) that encapsulates my thoughts on globalization, it is the William Gibson quote I’ve used many times at the opening of my letters: “The future is already here. It’s just not evenly distributed yet.”

The benefits of globalization have been unevenly distributed, and those who have been on the short end of the curve are pushing back. Given the dire situation millions of Americans are in today, I don’t wonder why they are doing so; I wonder what took them so long.

According to a 2017 study by the Federal Reserve, 44% of Americans wouldn’t be able to cover an unexpected $400 expense without borrowing or selling something. Yes, nearly half the country can’t come up with $400 cash in an emergency. That’s stunning. The slightest mishap—a toothache, a minor car problem—will send them into debt or force them to sell something.

This situation is the result of decades of stagnant wage growth. Since 1979, real (inflation-adjusted) hourly wages for the bottom quintile of earners fell by 1%. Worse, the inflation adjustment is based on the CPI, which as I’ve said many times, understates the real cost of living for most people. But wages haven’t stagnated for everybody. As the below chart shows, real hourly wages for the top quintile of earners have increased by over 27% in the same period.



Source: Brookings Institute
 
 
Income gains for the top 10% of the population rose roughly in line with that of the bottom 90% from 1930 to 1970. What happened in the 1970s to cause this divergence? The chief suspect is China’s opening to world trade and the onset of globalization.

Over the past four decades, globalization has enabled the transfer of millions of jobs from the US to various emerging-market countries. It changed the relative value of capital and labor all over the world. The top earners started getting a larger share of their income from investments than from their labor. They own the “means of production,” and the producers did increasingly well from the ’70s forward. 

Nobody paid much attention to the unevenly distributed benefits of globalization, until around 40 million Americans lost their jobs in the 2007–2009 recession. Now, the backlash has begun, and it’s not going to stop until the situation improves for those who have been left behind.

Globalization has lost its political support, and that raises an important question about the future of the global economy. If globalization has fallen out of favor with large swaths of the voting public, what does the future look like for the American-led order which has promoted economic liberalization and liberal values around the world since the end of WWII?

This system, defined as the Liberal International Order, is the framework of rules, alliances, and institutions that is credited with the relative peace and prosperity the world has enjoyed since 1945.

So, if the order has lost support, will the world plunge into beggar-thy-neighbor protectionism?

Worse, without the threat of military intervention by the US and its allies, will regional powers start to challenge one another?

One man answering these pressing questions is my good friend, Niall Ferguson. I’m sure most of you have heard of Niall, but for those who haven’t, it is my great pleasure to introduce him to you.

Niall Ferguson is a senior fellow at Stanford University, and a senior fellow of the Center for European Studies at Harvard, where he served for twelve years as a professor of history. Niall is one of the finest economic historians on the planet; but he isn’t only an academic. What many people don’t know is that he works with a small group of elite hedge fund managers and executives as the managing director of macroeconomic and geopolitical advisory firm, Greenmantle.

Niall has made a habit of tackling topics that have significant importance in his career. But in my opinion, this is the most critical question Niall is attempting to answer: “Is the Liberal International Order over?”

Before we dive in, I want to make clear that the goal of this letter is not to say whether liberal internationalism is good or bad, or defend the backlash against it. My objective is to highlight the current state of the order and give insight into Niall’s argument behind why he believes it is over. As investors, it is imperative we understand this trend because it has major implications for financial markets we need to think about. With that being said, let’s dive straight in.

The fate of the Liberal International Order rests on Pax Americana

In a recent interview, Niall pointed out the potentially fatal flaw in the Liberal International Order:
If the world has been more peaceful since WWII, the main reason is not because of the Liberal International Order, it’s because the United States had decided to play a leadership role. The big story after 1945 was the Pax Americana. The big story since 9/11 has been its crumbling.”
While the Liberal International Order and its institutions are credited with the relative peace the world has enjoyed since 1945, Niall says, “That's a very implausible argument.” He believes the world has been more peaceful because of the will and capacity of the US to be the principal guarantor of the system. This is often referred to as Pax Americana, in which the US employed its overwhelming military power to shape and direct global events.

This reliance on US strength hasn’t been a problem for the past seven decades, but times are changing. Since the financial crisis, the US has been less willing to bear the costs needed to be the guarantor of the international order. Niall highlights the inaction over Russia’s annexation of Crimea in 2014, and the “little more than cosmetic” strikes against Syria as signs that the US is starting to take a more ambivalent approach to global conflicts.

Without US willingness to use military power to establish balance across the world, it’s likely the liberal order will buckle under the unrestrained competition of regional powers. As the below chart shows, there has already been a sharp rise in the number of armed conflicts around the world.



Source: RAND Corporation


As Niall pointed out: “Things are becoming quite disorderly for the liberal order.” Before we go on, I want to make a critical point. Whether you support military intervention, or not, isn’t the issue here.

The issue is that without the US playing the role of guarantor, we are likely to see a rise in conflicts.

That is going to affect financial markets and your portfolio.

The second “pillar” of the Liberal International Order, economic liberalization, is also under strain.

Peak globalization is in the rearview mirror.

Niall points to falling global trade and capital flows as another symptom of the Liberal International Order being over:
Peak globalization is already behind us. Trade is no longer growing at the rate it did prior to the financial crisis, and international capital flows have fallen too.”
Since peaking in 2007 and 2008, respectively, trade and foreign direct investment as a percentage of world GDP have fallen sharply. McKinsey Global Institute found that global flows of goods, finances, and services have declined by 15% since peaking in 2007.



Source: World Bank


I believe “peak globalization” is in the rearview mirror. I say that not only because cross-border flows have declined precipitously, but because we are headed into a period of protectionism. US withdrawal from the Trans-Pacific Partnership is the most high-profile instance so far, but there are several more.

The governments of Australia and Canada have taken measures to curb foreign ownership of real estate. New Zealand has taken this a step further by outright banning foreign ownership of real estate.

In Europe, there have been several “behind the border” restrictions enacted by countries, which are designed to bolster domestic industries. Thus, it seems to me even the most liberal of countries are realizing globalization has overshot.

The rise of protectionism has serious implications for investors. We have become used to companies being able to break into new markets and the idea of “multinational corporations.”

This may not be the case going forward. Investors will have to pay a lot more attention to where the companies they choose to invest in operate, and where their sales come from. In short, protectionism is on the rise and investors must prepare accordingly.

Longtime readers will know that I’m second to no one in defending free trade—but I also see the reality, which is that it has had a dark side. And that dark side is another symptom Niall has pointed to as proof that the International Liberal Order is over.

Globalization has killed the goose that lays the golden eggs

Although the Liberal International Order has benefited some, Niall points out that it has been very bad for millions of ordinary Americans:
While it's great to say that 300 million Chinese people have been pulled out of poverty, the reality is that there has been, at the same time, a significant erosion of living standards for middle-class and working-class Americans.”
I mentioned at the beginning of this letter that the benefits of globalization have been unevenly distributed. As the below chart shows, the big losers have been the American middle and working classes.



Source: Harvard Business Review


Globalization has been bad for these sections of society because it changed the relative value of capital and labor. When capital and goods could flow freely between the US and emerging market countries, the value of labor in the US fell dramatically. Today, we are at a point where labor share of income has fallen to an all-time low of 57%. That means a growing fraction of the gains have been going to capital, and those who have it.

This has resulted in the loss of millions of US jobs. Since 1979, manufacturing employment has dropped by approximately seven million jobs. Studies show that technology accounts for around half of these losses. But Niall makes a very succinct point about these findings:
The distinction [between globalization and technology] is arbitrary. What distinguishes the technological revolution is precisely that things like iPhones could be designed in California but made in China. The paradox of the Liberal International Order is that it made a lot of technology affordable, while at the same time destroying manufacturing jobs.”
The hardship experienced by millions of Americans has happened at a time when the wealthy have done increasingly well. Today, we have a situation where the top 0.1% of the population has roughly the same share of the US national wealth as the bottom 90%. Cue: the re-emergence of populism.


Source: Ray Dalio, Bridgewater Associates
 
 
It’s not a coincidence that populism emerged as a political force in both the 1920s–1930s, and again today. In each case, people at the bottom could tell the economy wasn’t working in their favor. The best tool they had to do something about it was the vote, so they elected FDR then, and Trump now.

Two very different presidents, but both responsive to the most intensely angered voters of their eras.

You only have to observe how the word “globalist” has become a slur to see that people have turned against liberal internationalism and those who support it. Globalization has been terrible for millions of middle- and working-class Americans, and they are very unlikely to vote for politicians who support it. By lowering the living standards for millions of Americans, the Liberal International Order has become the architect of their own downfall.

Niall has also highlighted events taking place on the other side of the Atlantic as another sign that the Liberal International Order is indeed finished.

The European Union has a crisis of confidence

Niall says the EU’s mishandling of the financial and migrant crises have resulted in a total loss of confidence in the institution:
The European Union is a perfect illustration of why the Liberal International Order is over. The EU wholly mismanaged the financial crisis, massively amplifying the effects on member states. But it will turn out to have committed suicide because its leaders got the immigration issue wrong. The Europeans forgot that borders are really the first defining characteristic of a state. As they became borderless, they made themselves open to a catastrophe, which was the uncontrolled influx of more than a million people. The most basic roles that we expect a state to perform, from economic management to the defense of borders, were flunked completely by the EU over the past 10 years.”
The EU’s incompetence in both situations has ignited a wave of populism across the continent:
  • Austria elected a 31-year-old, anti-immigration candidate as Chancellor.
  • Italy’s populist Five-Star movement are leading in the polls for the general election, which takes place March 4.
  • The Visegrad group, which consists of the governments of Poland, Hungary, Czech Republic, and Slovakia, have strongly opposed the resettlement of refugees and are battling with the EU over the issue.
  • Angela Merkel did win the German elections, but four months later, she hasn’t been able to form a government because of the strong showing by the populist Alternative for Germany party.
The empirical evidence supports Niall’s thesis, and so does the academic research. A 2017 study from the Brookings Institution found that there is a high correlation between jobs losses which occurred as a result of the financial crisis, and increased support for anti-establishment political parties in Europe.

This populist backlash shouldn’t come as a surprise to us. During a recent discussion, Niall pointed out that: “If one looks at all the elections back to 1870, financial crises lead to backlashes against globalization that erode to the political center.” Here’s a chart which shows this trend:


Source: Funke, Schularick, Trebesch (2015)
 

This is why I love talking with Niall. He makes sense of current trends by providing a historical perspective. Getting Niall’s insight not only allows you to understand what is currently happening, but how things are likely to unfold in the future.

While the EU’s handling of the financial crisis hasn’t been good for business, I believe their mismanagement of the migrant crisis will prove to be their real downfall. According to Frontex, the EU border surveillance agency, over the course of 2015 and 2016, more than 2.3 million illegal crossings into Europe were detected. This influx of migrants hasn’t gone unnoticed.

A recent survey by Paris-based think-tank, Fondapol, found that nearly two-thirds of EU citizens surveyed believe immigration has a negative impact on their countries. As the below chart shows, a similar percentage of respondents said they are “very worried/worried” about Islam.


Source: Fondapol, Financial Times


Despite the concerns of people all across Europe about immigration, EU officials continue to push refugee resettlement on member states. The EU’s actions in the face of these concerns proves that there is a complete disconnect between those in Brussels and ordinary Europeans.

I can’t see how this doesn’t cause a further increase in support for populism around Europe, and ultimately lead to the demise of the EU—which would certainly prove that the Liberal International Order is over. To be clear, I don’t think the collapse of the EU is imminent, but it is certainty on a downward trajectory.

We saw this movie before, will it have the same ending?

As I mentioned, Niall has a special ability to dissect historical trends and extrapolate out what they can tell us about the future. He did this recently with the Liberal International Order:
The big lesson of history is that we have run the experiment of hyper-globalization before. In the late 19th century, many of the forces we are seeing [today] were at work: International migration reached levels we have begun to see again, the percentage of the US population that was foreign born reached 14%, and free trade and international capital flows reached new heights. At the time, the 1% were tremendously happy. Unfortunately, they underestimated the backlash that happens when globalization runs too far. The populist backlash [in the late 19th century] was just the beginning of a succession of crises that culminated in 1914 with WWI. War can be global too, and we will know the Liberal International Order has failed when it does what the last one did, and that is to produce a major conflict.”
I’m not sure if the Liberal International Order will end in war, but the current state of affairs can’t last much longer. Globalization has jumped the shark, and as a result, we are seeing a powerful backlash from those who have been hurt by it. There is no way to predict how this situation will unfold. But I know that I want to be the first to hear about any developments, because they have serious implications for financial markets and the societies we live in.

I have so many questions I want to ask Niall about this trend and many others. That’s why I’ve invited him back to give a keynote speech at my Strategic Investment Conference in San Diego this March.

Niall last spoke at my conference two years ago. He was bullish on the global economy at a time when almost everybody—including me—was bearish. I really don’t know what Niall is thinking about right now, or what new insights he has in store for SIC attendees. I am truly excited to welcome him back and I hope you can be there with me to experience it, first-hand. If you would like to learn more about attending the SIC 2018, and about the other speakers who will be there, you can do so here.
I told my sister about the conference and why I was going. She said, "Of course! Not going would be like standing around and missing 1968 in San Francisco."  
C. Cayes (past SIC attendee)

That concludes the fifth and final installment in this series. I hope you have enjoyed reading my insights into these “big ideas” as much as I have enjoyed writing them. Although it’s over, I do have something special to send you in the coming days. It’s a personal video message that I just finished recording. Think of it as a stepping stone to taking these “big ideas” to the next level.

I’ll tell you more about it in my series recap email, tomorrow.


 John Mauldin
Chairman


American politics

The one-year-old Trump presidency

Is it really this bad?




ALMOST one year into Donald Trump’s presidency, you have to pinch yourself to make sense of it all. In “Fire and Fury”, Michael Wolff’s gossipy tale of the White House, which did not welcome Mr Trump’s anniversary so much as punch it in the face, the leader of the free world is portrayed as a monstrously selfish toddler-emperor seen by his own staff as unfit for office.

America is caught up in a debate about the president’s sanity. Seemingly unable to contain himself, Mr Trump fans the flames by taking to Twitter to crow about his “very stable genius” and, in a threat to North Korea, to boast about the impressive size of his nuclear button.

Trump-watching is compulsive—who hasn’t waited guiltily for the next tweet with horrified anticipation? Given how much rests on the man’s shoulders, and how ill-suited he is to the presidency, the focus on Mr Trump’s character is both reasonable and necessary. But, as a record of his presidency so far, it is also incomplete and a dangerous distraction.

To see why it is incomplete, consider first that the American economy is in fine fettle, growing by an annualised 3.2% in the third quarter. Blue-collar wage growth is outstripping the rest of the economy. Since Barack Obama left, unemployment has continued to fall and the stockmarket to climb. Mr Trump is lucky—the world economy is enjoying its strongest synchronised upswing since 2010. But he has made his luck by convincing corporate America that he is on its side. For many Americans, especially those disillusioned with Washington, a jeremiad over the imminent threat to all of America from Mr Trump simply does not ring true.

Despite his grenade-throwing campaign, Mr Trump has not carried out his worst threats. As a candidate he spoke about slapping 45% tariffs on all Chinese goods and rewriting or ditching the North American Free-Trade Agreement with Canada and Mexico. There may soon be trouble on both those fronts, but not on that original scale (see article). He also branded NATO as obsolete and proposed the mass deportation of 11m illegal immigrants. So far, however, the Western alliance holds and the level of deportations in the 12 months to September 2017 was not strikingly different from earlier years.

In office Mr Trump’s legislative accomplishments have been modest, and mixed. A tax reform that cut rates and simplified some of the rules was also regressive and unfunded. His antipathy to regulation has invigorated animal spirits, but at an unknown cost to the environment and human health. His proposed withdrawal from the Paris climate agreement and the fledgling Trans-Pacific Partnership was, in our view, foolish, but hardly beyond the pale of Republican thinking.

His opportunism and lack of principle, while shameful, may yet mean that he is more open to deals than most of his predecessors. Just this week, he combined a harsh plan to deport Salvadoreans who have temporary rights to live and work in America with the suggestion of a broad reform to immigration. He also said that he will be going to Davos, where he will rub shoulders with the globalists.

The danger of the Trump character obsession is that it distracts from deeper changes in America’s system of government. The bureaucracy is so understaffed that it is relying on industry hacks to draft policy. They have shaped deregulation and written clauses into the tax bill that pass costs from shareholders to society. Because Senate Republicans confirmed so few judges in Mr Obama’s last two years, Mr Trump is moving the judiciary dramatically to the right (see article). And non-stop outrage also drowns out Washington’s problem: the power of the swamp and its disconnection from ordinary voters.

Covfefe and other mysteries

As we have written repeatedly over the past year, Mr Trump is a deeply flawed man without the judgment or temperament to lead a great country. America is being damaged by his presidency. But, after a certain point, raking over his unfitness becomes an exercise in wish-fulfilment, because the subtext is so often the desire for his early removal from office.

For the time being that is a fantasy. The Mueller probe into his campaign’s dealings with Russia should run its course. Only then can America hope to gauge whether his conduct meets the test for impeachment. Ousting Mr Trump via the 25th Amendment, as some favour, would be even harder. The type of incapacity its authors had in mind was a comatose John F. Kennedy had he survived his assassination. Mr Trump’s mental state is impossible to diagnose from afar, but he does not appear to be any madder than he was when the voters chose him over Hillary Clinton. Unless he can no longer recognise himself in the mirror (which, in Mr Trump’s case, would surely be one of the last powers to fade) neither his cabinet nor Congress will vote him out.

Neither should they. Alarm at Mr Trump’s vandalism to the dignity and norms of the presidency cuts both ways. Were it easy for a group of Washington insiders to remove a president using the 25th Amendment, American democracy would swerve towards oligarchy.

The rush to condemn, or exonerate, Mr Trump before Mr Mueller finishes his inquiry politicises justice. Each time Mr Trump’s critics put their aim of stopping him before their means of doing so, they feed partisanship and help set a precedent that will someday be used against a good president fighting a worthy but unpopular cause.

That logic holds for North Korea, too. Mr Trump is not the first president to raise questions about who is fit to control nuclear weapons—consider Richard Nixon’s drinking or Kennedy’s reliance on painkillers, anti-anxiety drugs and, during the Cuban Missile Crisis, an antipsychotic. Ousting Mr Trump on the gut feeling that he might be mentally unstable smacks of a coup. Would you then remove a hawk for being trigger-happy or an evangelical for believing in the Rapture?

Mr Trump has been a poor president in his first year. In his second he may cause America grave damage. But the presidential telenovela is a diversion. He and his administration need to be held properly to account for what they actually do.


Citi’s travails come at a critical time for the banking industry

The push to let big institutions police themselves has observers worried

Brooke Masters



For Citigroup, the past few weeks have not exactly been kind. Just before Christmas, the US bank had to shell out $11.5m over a faulty data feed that caused its brokers to mislead retail customers about what analysts thought of specific stocks. For four solid years, Citi’s computer system spat out inaccurate or incomplete information on 1,800 stocks to its salespeople. In the worst cases, Citi brokers told investors that companies were rated “buy” when in fact they were considered “sell”.

A week later, the Office of the Comptroller of the Currency hit Citi with a $70m penalty for a completely different issue. It said the bank had failed to fix problems with its anti money laundering programmes, despite signing a consent order promising to do so back in 2012. The bank says it is precluded from discussing details, but Citi’s AML processes still are not up to scratch today.

To make matters worse, the bank’s leaders have also estimated that its profits will take a $20bn hit from new US tax law when it announces results next week — far more than most of its Wall Street competitors.

As enforcement cases go, the two recent ones are small potatoes. The fines are tiny when compared with the billions of dollars big banks have shelled out for rigging interbank lending rates and foreign exchange benchmarks. And the actual harm done is strictly limited. The analyst case brought by Finra, the industry regulator, includes $6m in customer compensation for mis-sold shares, and the real cost may be lower. The OCC case, meanwhile, does not include any allegations that actual money laundering occurred.

But Citi’s latest fine comes just eight months after it paid $100m and admitted to criminal violations for “wilfully” failing to maintain proper controls over international transfers between Mexico and one of its California-based subsidiaries, Banamex USA.

Similarly, the error-filled research feed comes against a backdrop of other small Finra fines. A review of the regulator’s Brokercheck system finds that Citigroup Global Markets had 20 enforcement actions last year, compared with 10 for Goldman Sachs and 13 for Bank of America’s Merrill Lynch arm.

Taken together, the recent string of problems calls into question the bank’s ability to get basic control issues right. That is no small concern, given that Citi required a $45bn taxpayer bailout during the 2008 financial crisis and failed the US Federal Reserve stress tests as recently as 2014.

In some ways it is unfair to single out Citi. Over the past few years, the OCC has also fined JPMorgan Chase and HSBC for failing to live up to the terms of past consent orders. And the $20bn hit to profits is largely an accounting issue: Citi’s results have long factored in plans to use its huge losses from the crisis to reduce the taxes it has to pay on future earnings. Now that corporate tax rates are going to be lower, the value of that deduction has dropped significantly.

Citigroup has come a long way since the dark days of 2008 or even 2014. The bank passed the 2016 tests with flying colours, and in July it set out a plan to return $60bn to shareholders in dividends and share buybacks over the next three years.

In another important milestone, Citi was the first of the really big US banks to win regulatory approval of its so-called living will, the plan that shows how it could be wound up in a crisis without requiring taxpayer support.

Bank spokesman Mark Costiglio makes this point clearly: “By any measure, Citi has become a simpler and stronger firm than it was before the crisis . . . In the past four years, we have added more than 9,000 employees dedicated to enhancing compliance and controls across the firm and we continue to invest in systems to prevent money laundering and otherwise protect the integrity of the financial system.”

But the flurry of small issues comes at a critical time for big US banks. After nearly a decade of providing rigorous oversight, the US bank and market watchdogs are dramatically paring back. President Donald Trump’s appointees at the Federal Reserve, Securities and Exchange Commission and elsewhere have made clear that they believe financial groups should be given more freedom to take risks to help the economy grow and to police themselves.

The Fed is considering conducting stress tests every two years, the SEC is reining in the issuance of subpoenas used to build enforcement cases, and Mr Trump has moved to defang the Consumer Financial Protection Bureau, which looks after retail customers harmed by banks.

Such shifts are common when a Republican president succeeds a Democrat. Historically, risk-taking shoots up and investment in compliance goes down. Given how much has been spent in recent years, many banking executives see that as a healthy correction and a welcome boost to their bottom lines.

But consumer groups and industry critics, who remember that the last big regulatory relaxation was followed by the financial crisis, are far less sanguine.

If banks like Citi are still getting the little stuff wrong after a decade of investment, what is going to happen if they stop feeling pressure to invest? Maybe this is a time when investors should be sweating the small stuff.

 Walmart Giveth, And Walmart Taketh Away 

Walmart made two announcements yesterday that perfectly illustrate the dilemma facing the developed world.
 
First, the omnipresent retailer raised its minimum wage to a respectable-sounding $11/hr:

Walmart is raising its minimum wage and handing out tax cut bonuses 
(WGNO) – Walmart is raising its minimum wage and handing out tax cut bonuses because of the new Republican tax law.
The retail company said the wage hike to $11 an hour would roll out in February. Employees are also getting a one-time bonus of up to $1,000. 
Walmart previously raised its minimum pay for most employees to $10 an hour in 2015. As of December, the average pay for full-time workers was $13 an hour. 
“Today, we are building on investments we’ve been making in associates, in their wages and skills development,” Walmart president and CEO Doug McMillon said in a news release. “It’s our people who make the difference and we appreciate how they work hard to make every day easier for busy families.” 
He added that “tax reform gives us the opportunity to be more competitive globally and to accelerate plans for the U.S.”
The bonus amount will be based on length of service, according to the company.  
Workers who’ve been there for at least 20 years will get the full $1,000. 
Because of the tax reform law, Walmart says it’s also creating a new benefit to assist associates with adoption expenses. The benefit, which will be available to full-time hourly and salaried workers, will total $5,000 per child. 
The company, which is the nation’s largest private-sector employer, said it’s also expanding its parental and maternity leave policy. Full-time hourly workers in the United States will get 10 weeks of paid maternity leave and six weeks of paid parental leave.
The changes affect more than 1 million hourly associates. 
“Thanks to the passage of historic tax cuts, American workers and their families are winning!” tweeted Ivanka Trump, the White House senior adviser and daughter of President Trump. 
McMillon also said the company is “early in the stages of assessing the opportunities” that tax reform creates for Walmart. The company said it will share further details when it releases quarterly results next month.
But then it announced the closing of a bunch of Sam’s Club warehouse stores, resulting in thousands of layoffs:
Walmart plans to close 63 Sam’s Club stores 
(UPI) – Walmart announced Thursday it is closing 63 Sam’s Club stores across the United States, leaving workers at the membership club without Jobs. 
Ten locations for the warehouse club spinoff of Walmart closed immediately and will become e-commerce distribution centers, according to Business Insider, which listed store closings it knows about. The remaining places will remain open for a few weeks. 
“After a thorough review of our existing portfolio, we’ve decided to close a series of clubs and better align our locations with our strategy,” Sam’s Club posted on Twitter.  
“Closing clubs is never easy and we’re committed to working with impacted members and associates through this transition.” 
Employees in some cases were informed of the closings while arriving to work Thursday, KHOU-TV in Houston and KENS-TV in San Antonio reported. 
“Club is closed today so we could inform our associates so we gave them the day off and closed the club. We will reopen the club tomorrow,” Anne Hatfield, director of communications for Walmart’s public affairs, said in a statement to KENS. 
At one Sam’s Club in San Antonio, employees told KENS the store will close for good on Jan. 26. On Friday, it will offer 25 percent off on everything except for alcohol, tobacco, batteries and tires. 
Sam’s Club, which has 100,000 associates, operates more than 650 membership warehouse clubs in the United States, according to its website. The first Sam’s Club, founded by Sam Walton, opened on April 7, 1983, in Midwest, Okla.

There are two problems here: First, rising wages increase the “wage inflation” measure that the Federal Reserve watches to decide whether inflation is becoming a problem and needs to be smacked down with higher interest rates. See Walmart wage hike may show wage pressures building for lowest paid. The eventual result of rising interest rates in the late stages of an expansion is a recession in which millions of people are thrown out of work, thus canceling the minimum wage boost.

The second, much bigger problem is that next-gen automation becomes more attractive when wages rise. Walmart converting Sam’s Clubs to regional ecommerce distribution centers is, in effect, replacing store clerks with warehouse robots and a relative handful of website designers.

To the extent that wages rise, so do automation-related layoffs, once again cancelling out those higher paychecks.

Automation has of course been around since the start of the industrial revolution, but this latest phase is vastly more pervasive and powerful than anything that’s come before.

The result: Life gets better for those who own the robots and harder for those the robots replace. And government encourages the 99% to borrow to make up the difference, until that trend also hits a wall.