US and China must find ways to control their elites

Success rests on heading off popular unrest, rather than winning trade fights

Rana Foroohar

Tension between the US and China is driving much of what is happening in the markets today.

The analysis has focused on tariffs, currency manipulation, strategic technologies and which country has the most to win or lose in a trade war.

But there is a more important question to be asked when thinking about the future success and stability of each nation: which country will be better able to control its moneyed elites?

In his 1982 work The Rise and Decline of Nations, the economist Mancur Olson argues that civilisations tend to decline when the moneyed interests take over politics. That has clearly happened in both countries, where the levels of wealth inequality are not dissimilar; the top 1 per cent in China own about 30 per cent of the economy; in the US, the figure is 42 per cent.

For better or worse, China is tackling this head on via President Xi Jinping’s clampdown on the country’s princelings. Thoughtful people can disagree about whether a party that jails hundreds of thousands of people and executes some in the name of a corruption purge can maintain any sense of moral superiority or legitimacy. But Communist party elites would argue that this is all in service of the higher goal of economic development.

People who have had recent conversations with Chinese leaders have told me they believe the anti-corruption probes led by Wang Qishan are essential to breaking up vested interests that want to maintain a status quo based on cheap labour and cheap capital.

Chinese leaders also believe that America’s inability to curb its own elites will be the country’s downfall.

They have a point. Last week, several important Supreme Court decisions were made that favoured the few above the many. They included the American Express ruling, which weakened antitrust enforcement; the upholding of Donald Trump’s travel ban on immigrants mainly from Muslim nations; and the Janus decision that strips funding from much of the US union movement.

This all stems from the fact that moderate Republicans, including many in the business community, supported Mr Trump despite misgivings because they knew he would appoint a friendly Supreme Court justice.

But Mr Trump was in some ways a reaction to the Democratic party’s decision over the past few decades to ally with elite interests — Wall Street under Bill Clinton, and Silicon Valley under Barack Obama.

Many of the party’s top donors and power brokers in the party blend a “greed is good” 1980s ethos with a sense of liberal entitlement that is anathema to large numbers of Democratic voters. Witness last week’s congressional primary in New York City. A veteran representative — number four in the House leadership — was defeated by a 28-year-old who favours guaranteed jobs and universal healthcare.

America’s elite business class has, for decades now, sought to distract from rising oligopoly with hypocrisy. US companies complain vociferously about unfair Chinese trade practices and intellectual property theft.

But faced with challenges in the Chinese market they usually caved in to maintain their access rather than seeking public help from the US administration to mount official challenges. (Corning backed down on a lawsuit over theft of trade secrets, and Qualcomm paid a $975m antitrust fine to China in two public examples.)

“The thought of accessing 1.3bn consumers is simply too tempting,” says Michael Wessel, a trade expert and former Democratic staffer. “They are trading America’s long-term economic future for the prospects of returns that simply aren’t as robust as promised.”

It amazes me that any western multinational thought they could win this bet. China has made it clear it intends to give more, not less, support and preferential access to its own companies both at home and in areas where China has significant geographical influence.

Yet neoliberal hope springs eternal. Markets have breathed a sigh of relief in the past few days because they believe pro-free trade advisers like Treasury Secretary Steven Mnuchin have dissuaded Mr Trump from imposing tougher bans on Chinese investment.

The respite is temporary. It remains unclear whether China’s anti-corruption campaign will restore faith in the Communist party, or ultimately undermine it.

But the US is not doing any better at curbing elite power. It is arguably doing worse, as reflected in the fact that lobbying dollars into Washington have more than doubled in the past 20 years.

The left has a choice to make between capital gains and moral certainty. The right must decide whether it still has a soul. The centre will not hold — and there will be big economic and political impact as it crumbles. The US may well be heading towards a choice between fascism driven by rural whites or socialism driven by urban millennials.

Investors know neither will be good for business. A key bond market indicator, the yield curve, is flattening and may invert. If that happens, a recession is likely.


Why foreigners are keen buyers of Chinese government bonds

A bet on the yuan’s dominance or a snare for the unwary? Actually neither 

IN MAY 1945 John Maynard Keynes wrote a memo on the post-war economy. In it he argued that Britain should seek to be in the mainstream of global commerce. It would suit finance as well as industry to have the whole world as a playground, he wrote. “We built up the pre-war sterling area because we were bankers amiable to treat with and having a long record of honouring our cheques.”

He passed over how Britain’s economic muscle had helped sterling’s dominance—perhaps because by then that muscle was wasting. Yet it is implacable economic might that leads many today to conclude that the yuan, China’s currency, will supplant the dollar, just as sterling gave way to the dollar after 1945. The yuan is already one of five constituents of the Special Drawing Right, a basket of reserve currencies created by the IMF. And China is opening up to capital flows. This year foreigners have been the biggest buyers of Chinese government bonds.

It is tempting to see this as another milestone on the way to the yuan’s preordained supremacy. But it is an error to interpret current events in the light of an imagined future. Foreign buyers of Chinese bonds are not swept along by an unseen law of history. Rather they are spurred by more prosaic considerations.

To start with, it has become a lot easier to buy the bonds. Foreign institutional investors with a presence in China have been allowed to buy them for more than two years (see chart). Last July Beijing established a bond-trading link between Hong Kong and the mainland. Since then the number of foreign asset managers with trading accounts in Hong Kong has mushroomed. In March Bloomberg-Barclays said it would add China to its main bond index next year.

The bonds have intrinsic merits, too. A year ago the yield on a ten-year Chinese government bond was around 1.5 percentage points higher than the yield on an equivalent US Treasury bond. The spread has since narrowed. Yet at 3.6% yields are still attractive, especially in comparison with the yields of under 1% offered by the safest European bonds.

Chinese bonds have many other useful qualities, notes Jan Dehn of Ashmore, a fund manager. Prices have been less volatile than those of other emerging-market bonds. Chinese bonds are valuable to portfolio managers because they tend not to move in synch with other assets. They are thus prized as diversifiers. And—yes—China’s scale is a draw. Given the size of the market, the world’s third-largest, foreigners still own rather few of its bonds.

Safety first

Still, there are dangers for the unwary. The ratio of debt to GDP in China has risen to 260%, from 160% in 2008. In other places, such a surge in credit has led to souring loans and, sometimes, financial crisis. There is a natural suspicion that China is opening its bond market so that foreigners can share in the inevitable losses. Yet so far, foreign buyers have trodden carefully, mostly buying government bonds and steering clear of riskier municipal and corporate bonds, says Zhenbo Hou of BlueBay Asset Management. The raciest bets that foreigners have made are on the bonds of policy banks, such as the China Development Bank, and on short-term paper issued by biggish provincial banks. It is telling that foreigners hold less than 2% of the overall market, but 7% of the stock of safer government bonds.

The gradual opening of the bond market is part of a step-by-step approach to financial reform. China is thus proving a little more amiable to foreign capital. And by letting foreign money in, albeit still with some hurdles, it might hope to let some domestic money out and still keep the yuan stable. The big test will be whether China will always honour its cheques—can foreigners get their money out when they want to? It has kept control of both its exchange rate and its domestic monetary policy through capital controls. But if it allows foreign bondholders to move capital in and out more freely, it must either lose control of the yuan or use interest-rate policy to support it and not the economy. Faced with this trilemma, most rich countries let the currency float freely. A volatile yuan would be a marked change—for China and its bondholders.

Perhaps in a decade or two historians will look back and point to this policy or that event as the turning-point in China’s emergence as a financial hegemon. If so, they will be kidding themselves. China is likely to open up in fits and starts. There will be mistakes, accidents and reversals. In the meantime, investors will, as always, respond to incentives. For a growing number, for now at least, the case for buying China’s bonds seems to add up.

The future of the Supreme Court

Anthony Kennedy’s retirement comes at a worrying time

The swing vote is lost just as the constitution is under strain from a norm-breaking president

FOR 12 years, Anthony Kennedy has been the Supreme Court’s swing vote. The court’s liberal and conservative quartets voted predictably. He did not—which is why those who want the Supreme Court to float above America’s partisan divide reacted with such dismay to his retirement, announced on June 27th. Justice Kennedy’s departure from the bench might sound like a minor detail set against everything else that is going on with America’s government at the moment. It is not. President Donald Trump now has the opportunity to appoint a second Supreme Court justice and with it to cement a 5-4 conservative, one might even say Republican, majority at a time when the constitution is under strain from a norm-breaking Republican president.

The high stakes herald a gigantic fight in the Senate. Democrats are still smarting from the way that Senate Republicans in 2016 ignored Barack Obama’s Supreme Court nominee for 293 days. The Republicans’ failure to give Merrick Garland a hearing before the election allowed Mr Trump to pick a judge. Democrats will bend every remaining Senate convention rather than be bested again. This will poison a polarised polity even further. But it is hard to blame them. The legislative branch has become so gridlocked that no president can expect to sign more than one or two significant laws. Far more lawmaking is therefore done by the Supreme Court, through its decisions to overturn or uphold state laws or presidential decrees. A reliable 5-4 majority will give conservatives immense power to reshape America by doing just that.

For a sense of what a court with a stable conservative majority might look like, consider the term just past. Its 63 rulings marked the most decisive shift to the right in years. The court upheld Mr Trump’s ban on travel from several mostly Muslim countries. It dealt a blow to public-sector unions by overturning a 41-year-old precedent that allows them to charge non-members for collective bargaining. And, most consequentially, it issued a series of decisions on voting laws that found in favour of entrenched (Republican) majorities.

The court declined to condemn gerrymandering. It upheld congressional and state legislative maps in Texas that, according to lower courts, discriminated against black and Latino voters. And it rejected a challenge to an Ohio law that takes voters off the rolls who stayed at home for several elections and neglected to return a postcard (voters who, by some extraordinary coincidence, were predominantly Democrats). Most of those decisions were 5-4, with Justice Kennedy, contrary to his usual pattern, voting each time with the conservative bloc.

Root and third Branch

Once a 5-4 majority becomes their worst outcome, Republicans will have an incentive to push for more radical change. Republicans have long wanted to overturn Roe v Wade, the ruling in 1973 that decided federal abortion law. Justice Kennedy’s departure will give them that chance.

His was the swing vote that decided that the federal government could regulate carbon-dioxide emission. That, too, could go. Another sally against Obamacare is inevitable. So are attempts to roll back socially liberal rulings of recent terms, such as expansions of gay rights and limits on capital punishment.

Even in normal times, activist judicial partisanship is dangerous. All the more so with a president so contemptuous of institutions. In the “Federalist Papers”, Alexander Hamilton called the judiciary the “least dangerous” branch of government, because instead of “force” and “will”, it has only “judgment”. That looks like cold comfort today.

Trump Undermines Himself on Trade

Simon Johnson

WASHINGTON, DC – US President Donald Trump recently launched a tirade against Harley-Davidson, the iconic American manufacturer of motorcycles. The cause of his outburst – accompanied by threats to impose taxes “like never before” on the company – was the news that Harley plans to invest in new manufacturing operations outside of the United States.

The company’s reasoning is straightforward and compelling. Trump has threatened to raise tariffs on imports from Europe, and some of those higher duties are already in place. The Europeans, in response, are imposing higher tariffs on imports from the US, such as motorcycles (as well as bourbon, orange juice, and playing cards). Harley-Davidson would like to avoid those extra European taxes – and it can do that by locating some of its production in places not subject to such high European tariffs.

Trump’s anger is thus misplaced and unfair: he forced the company’s hand. But his behavior on trade may quickly also become counterproductive, for three reasons.

First, this is how trade wars work. Trump has decided to increase the level of protection for various industries in the US, such as steel and aluminum. Those tariffs increase costs for companies that use metal as an input. For example, the impact on Harley-Davidson is to raise costs by about $20 million (or more than $2,000 per bike). The European Union’s retaliatory tariffs could cost the company another $45 million.

Trump’s signature theme is that, by helping business, he will help all Americans. When government policies reduce the profitability – or threaten the existence – of a company, it is only reasonable that the people running that business should respond as they see fit. Higher tariffs fragment markets and limit trade, precisely because companies want to reduce the taxes they pay – and allocate production accordingly around the world. Harley-Davidson is only responding as any company accountable to its investors would.

Second, Trump has tipped his hand. By now it should be clear to world leaders that being nice to Trump and flattering him may get you a photo opportunity at the White House, but it does not change policy. The Trump administration is all about realpolitik – meaning, in this case, who can actually get away with what.
The countries that Trump is trying to intimidate – particularly China and the EU – have substantial spending power and are run by experienced and tough people. They now see clearly how to get Trump’s attention: target their retaliatory tariffs at companies that have been praised by Trump.

It is of course easy to identify such companies – just look at Trump’s Twitter feed and who has been seen at the White House. Or target the companies of people who are known to be close to the president, such as Carl Icahn or Commerce Secretary Wilbur Ross.

This might seem like a cynical response, and a few years ago it would have been regarded as unacceptable. But Trump has undermined all the norms around international trade and how top world leaders relate to one another. Even in his behavior toward other leaders of G7 industrial countries, he has managed to baffle and offend. Every Twitter tirade enables strategists in foreign capitals to focus more clearly on what exactly will next get the US president’s attention.

And with Trump, you don’t have to wait long to see if you have pressed his buttons. His Twitter account provides instant feedback. And the more he rants, the more it encourages targeted retaliation.

Third, Trump has a major vulnerability in his incipient trade wars: American agriculture. Not only is the sector a major exporter ($133 billion of foods, feed, and beverages in 2017), but many rural areas are bastions of support for Trump and the Republicans in general. During the negotiation of the Trans-Pacific Partnership – which would have lowered tariffs and non-tariff barriers faced by US agricultural exports in participating countries – Republican members of Congress representing such districts were among the strongest supporters of freer trade (including at a House Ways and Means Committee meeting at which I testified).

The smart strategy for countries targeted by Trump includes targeting US exports of crops and food. America’s major trading partners may not want to do this in one fell swoop; sometimes threats are just as unsettling – and thus just as effective as a bargaining chip. But, given Trump’s love of brinkmanship and confrontation, it is reasonable to expect further escalation, as with China’s tariffs on US soy beans, pork, and wine.

The good news is that no one except Trump wants a trade war – so these tariffs could easily and quickly be reduced. The bad news is that Trump seems utterly convinced that a trade war would be good for the US (and presumably for him politically). Trump is apparently unwilling to listen to reason – or even to sensible companies like Harley-Davidson. A larger-scale trade war (or wars), with a significant negative impact on US manufacturing and agriculture, appears ever more likely.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

Why the Bull Market Could End in 2020

By Ben Levisohn                      

All of us, at some point, must confront our mortality. So, too, must investors prepare for the demise of a bull market that began in the depths of the financial crisis in 2009.

Yes, predictions of the end of this record run have been made before—and have been proved wrong.

The rally has so far seemed almost indestructible, thanks to stable economic growth and the Federal Reserve’s easy-money policy. 

But many market strategists and economists see powerful forces converging that could finally trip up the bull. For one, the economy has been juiced by the tax cuts and fiscal-spending package that Congress passed at the end of 2017—a stimulus that should last another year or so. Just as its effects are fading, the Fed will be continuing to push interest rates higher and shrinking its $4 trillion balance sheet.

Put them together and you have a drag big enough to slow the economy, while stamping a bright expiration date on the bull market: 2020.

And it isn’t just permabears who are gloomy of late. Ben Bernanke, the former chairman of the Federal Reserve, recently said that after two years of stimulus, “in 2020, Wile E. Coyote is going to go off the cliff and is going to look down.”

Even less-pessimistic economists and market watchers acknowledge that economic expansion will slow in 2020, while corporate profits, though still increasing, will do so at a slower pace than they had previously. Global economic growth could also feel the pinch if the European Central Bank begins raising interest rates toward the end of 2019, as it has suggested it might. These conditions are far different than what has existed in the bull market.

There’s no denying this one is getting long in the tooth. The average postwar bull market gained 161% over 1,821 days. This one, at 3,400 calendar days, is already the second-longest on record, lagging behind only the 4,494 days during the marathon run from 1987 through the peak of the tech bubble in March 2000. The S&P 500 has gained 302% since its bottom in March 2009, the second-longest run on record. During the 1987-2000 bull, the S&P 500 rose 582%. And while bull markets don’t die of old age, each day brings a reckoning that much closer.

“Like the human body, the market becomes less resistant to shocks and viruses the older it gets,” says Christopher Smart, head of macroeconomic and geopolitical research at asset manager Barings.

While a correction from its Jan. 26 highs has removed some of the market’s most egregious excesses, signs of investor complacency abound. The Cboe Volatility Index, also known as the VIX, remains below its long-term average around 20 times, and investors continue to put money into mutual and exchange-traded U.S. stock funds, even as they have fled other markets. And for investors betting that the diversity of their index ETFs will save them, the Leuthold Group’s chief investment strategist, Jim Paulsen, notes that the weight of defensive sectors in the S&P 500 has dropped to 15%, an all-time low. “Investors should be aware that defense has left the building,” Paulsen warns.

If nothing else, it’s time for investors to think about the types of companies they own, and to begin shifting away from the riskiest and most indebted toward those better-positioned to withstand a downturn. And while it may reduce short-term returns, there’s nothing wrong with holding a little extra cash to tamp down a portfolio’s volatility and deploy when stocks do fall. Because the market always falls, eventually.

To understand why 2020 should loom large in investors’ vision, keep in mind the reasons that the past nine years have been so good. Some might call post-financial-crisis growth in the U.S. lackluster; it has also been remarkably consistent, never climbing by more than 2.9% or by less than 1.5% in any calendar year since 2010. And inflation has been subdued, as well, creating the Goldilocks environment that was neither too hot nor too cold.

The latest fiscal stimulus—the tax cuts—changes that. Congress passed $1.5 trillion of them over a 10-year period, while also increasing spending by some $300 billion over two years. The Peterson Institute for International Economics puts the total impact at an additional 0.5% of gross domestic product by 2020.

Companies have used that cash to repurchase shares, increase dividends, buy competitors, and invest in their businesses. All of that activity looks set to have a big impact, though the question remains how big. Economists expect the U.S. economy to grow at a 2.9% clip in 2018, up from 2.3% in October. And that economic growth has also translated to a big boost in earnings projections, as corporations are expected to see profits rise by 21% in 2018 and 10% in 2019.

Like any artificial high, the good feelings won’t last forever. By the end of 2019, the last of the fiscal intoxication should have worn off, and the hangover could begin. Economists expect the U.S. economy to expand by 1.9% in 2020, and earnings to increase by 10%.

“The tax stimulus is designed to be very front-loaded in the lift it gives to economy,” Morgan Stanley chief U.S. economist Ellen Zentner says. “You have to deal with the hole on the other side.”

The stimulus, however, isn’t occurring in a vacuum. The Fed is already raising interest rates, and is doing so at a faster pace than some investors had counted on. At its current pace of a hike every three months, the federal-funds rate should hit a range of 3.25% to 3.5% by the end of 2019, up from 1.75% to 2% currently.

At the same time, the Fed is shrinking its behemoth balance sheet. That means monetary policy could be hitting its tightest levels just as the impact of the government stimulus begins to wear off.

Alan Ruskin of Deutsche Bank argues that fiscal stimulus has restored the “arc” to both the economy and the policy cycle. The arc refers to the rise above trend growth, followed by the decline back below it. The arc of economic growth is also mirrored in monetary policy, which should follow the same path as the economy strengthens, and then weakens.

That arc, however, is nowhere in sight. The Fed’s “dot plot,” which tracks where each member of the Federal Open Market Committee thinks rates will be over three years, suggests that fed funds will hit 3.25% to 3.5% before a gentle easing. The market, meanwhile, is pricing in rates hitting 2.6% at the end of 2019 and going sideways from there. Those paths are unlike any seen before. “What’s priced in has no modern monetary policy precedent,” Ruskin says.

Market indicators are also pointing toward 2020 as a year of reckoning for the stock market. Look no further than the so-called yield curve—that is, the difference in returns between short- and long-term Treasury securities.

In good times, the longer-term yield should be higher than the shorter because it means a bank can borrow at the lower short-term rate and make money lending at the higher longer-term one. When short-term yields rise above long-term ones, there’s no incentive to lend, and that “inverted yield curve” has typically preceded a recession by six to 24 months.

The yield curve hasn’t inverted yet—but it’s getting close. The two-year Treasury’s yield was at 2.524% on Friday, while the 10-year’s was at 2.844%. That 0.3195 of a percentage point difference is the narrowest since the financial crisis ended. If the Fed continues to raise rates at its current pace, the yield curve is likely to be flat by year end, says David Ader, chief macro strategist for Informa Financial Intelligence, and to invert during 2019’s first half. “That would point to recession in the second half of 2019 or early 2020,” he explains.

An inverted yield curve acts as a market signal, as well. Charlie Bilello, director of research at Pension Partners, notes that since 1956, the S&P 500 has dropped an average of eight months after an inversion of the one- and 10-year Treasury yields, though it took 21 months from an inversion in 2006 to the stock market’s peak in 2007. “That’s a long time to wait, exposing just one of the problems in using the yield curve to time your stock market exposure,” Bilello adds.

While 2020 may be pointing to the edge of a cliff, a lot could happen by 2020 that could either extend the cycle, or end it sooner.

The brewing trade war between the U.S. and its trading partners is the most obvious, as escalating tensions could negate the stimulus boost—and cause a selloff long before a recession. The S&P 500’s 2.2% decline during the past two weeks suggests that these worries are already having an impact.

On the other hand, the Fed might decide it would be better off slowing rate increases in light of global tariff turmoil. There’s even a possibility that the economy, which has survived so much since 2009, just keeps soldiering on—and lifts stocks with it.

“The bull market will last as long as the economy expands,” says Ed Yardeni, chief investment strategist at Yardeni Research. “I don’t know anything today that leads me to put a time frame on when this bull market ends.” That means stocks’ path to 2020 could be as rocky as 2018’s has been, or that equities could see one final melt-up before it all comes crashing down.

Investors need strategies to handle both potential scenarios.

The best way to do that could be to focus on high-quality stocks, says Brian Belski, BMO Capital Markets’ chief investment strategist. He defines quality stocks as those with an investment-grade credit rating, lower earnings-growth volatility than the S&P 500, higher return on equity than the median stock in the benchmark, and a larger-than-average cash position.

Such shares have performed quite well in all market periods. High-quality stocks have averaged a 13% gain annually since 1990, versus 7.7% for the S&P 500, according to Belski’s data. And they’ve fared even better in rocky markets with above-average volatility, rising an average of 4.2% annually, compared with 2.9% for the S&P.

“Our work suggests these stocks not only are well suited for volatile market periods, but also are an attractive long-term investment strategy,” Belski says. “As such, we believe it would behoove investors to focus on this sort of strategy as markets continue to digest what has become an increasingly complicated investment landscape.”

Stocks that meet Belski’s requirements include exchange-traded fund titan BlackRock (BLK), biotech giant Biogen (BIIB), Costco Wholesale (COST), and United Technologies (UTX).

In a similar vein, David Kostin, Goldman Sachs’s chief U.S. equity strategist, has been recommending stocks with strong balance sheets, which tend to outperform when the Fed is raising rates and monetary conditions tighten. That should pay off, regardless of whether the economy continues to expand at a strong pace, or if growth slows and heavily indebted companies struggle to cover their interest payments, Kostin observes.

“Strong balance-sheet stocks appear primed for outperformance whether economic growth remains strong or falters,” he explains. Stocks included in Goldman’s Strong Balance Sheet Basket include Facebook (FB), Intuitive Surgical (ISRG), Monster Beverage (MNST), and Verizon Communications (VZ).

But it also pays to remember that bear markets are inevitable—and not the worst thing that can happen, as long as an investor is prepared. The S&P 500, after all, dropped 57% from peak to trough during the financial crisis, but investors who held on through it had recovered their losses by the end of March 2013. The worst damage was suffered by those who couldn’t take the pain and sold near the bottom; they never made their money back.

For investors who may not have the fortitude to hang on through a run-of-the-mill correction, let alone a real bear market, Michael O’Keeffe, chief investment officer and head of investment strategy at Stifel, recommends holding a bit more cash. “Sell a little bit of your equities, and hold more dry powder,” he advises. “When the move occurs, you’re ready to redeploy.”

That sounds like good advice, especially now that it’s possible to get close to 2% on cash, a big increase since we last took the temperature of this bull market 10 months ago. With the market even longer in the tooth, that doesn’t look too shabby.