Something Wicked This Way Comes

By John Mauldin

TFTF Image

For a couple of years now, the economic narrative has shown a comparatively strong US against weakness in Europe and some of Asia (NOT China). The US, we are told, will stay on top. I agree with that, as far as it goes... but I’m not convinced the “top” will be so great.

Americans like to think we are insulated from the world. We have big oceans on either side of us. Geopolitically, they serve as buffers. But economically they connect us to other important markets that are critical to many US businesses. Problems in those markets are ultimately problems for the US, too.

Last week I gave you my Year of Living Dangerously 2019 US forecast, but I didn’t discuss important events overseas. Summarizing last week quickly, I think the base case is that the United States economy slows down but avoids recession in 2019. That said, there are significant risks to that forecast, mostly to the downside.

Today we’ll make another literary metaphor to frame our discussion. “Something Wicked This Way Comes” is a 1962 Ray Bradbury novel about two boys and their horrifying encounter with a travelling circus. Later it was a movie.

In our case, something wicked most certainly is coming this way. Several somethings, in fact, approaching from all directions. The real question is how much damage this circus will do before it leaves town.

Shaky China

Many of our risks emanate from China, and as I wrote this section, I realized it deserves a longer treatment. I will do that in next week’s letter. For now, let’s touch on the big picture.

By most measures, the US and China are the world’s largest and second-largest economies. They are also entwined with each other in so many ways that it can be hard to know where one stops and the other starts. Some call it “Chimerica,” which may be an apt description. That’s basically good, in my view. International trade promotes peace and prosperity for all, albeit not always smoothly, evenly distributed, or without issues. Such is the nature of great entanglements. But seen over decades? China’s growth has made the world better. Literally billions of people globally have been lifted out of poverty and destitution.

All that said, the US and China are also separate nations with separate interests. We compete as well as cooperate so differences naturally arise. While we need to resolve them, the Trump administration’s methods aren’t helping. They seem not to grasp that intentionally weakening an economy so tied to our own risks weakening the US as well.

The US is demanding (rightly, in my opinion) that China respect intellectual property rights and let foreign companies compete fairly, just as we let Chinese companies operate here. But achieving that isn’t like flipping a switch. Entire regions and industries are now optimized for a model we want to change. The change, however necessary, will cause problems if it’s not managed well.

Worse, China’s economy is already on shaky ground. Its unique blend of “communism” (whatever that now means in China) and capitalism, along with sheer size, has produced enviable growth rates and I think will keep doing so, but a slowdown is inevitable. China is still subject to the law of large numbers. They can’t maintain 6% or higher GDP growth indefinitely.

The gap between US and China GDP growth has been shrinking over the last decade.

It now appears the eventual Chinese landing could be harder than expected. We’ve seen hints in the data for some time now and they’re starting to add up. Automotive sales are rolling over, for instance. That’s partly because ride-sharing services like Didi Chuxing (similar to Uber or Lyft) are gaining popularity, but it also suggests the Chinese middle class is no longer gaining prosperity at the rates it had been. It’s also a result of “front-loading” auto sales for the previous few years. When you pull future demand forward, the future eventually demands repayment.

This isn’t just a Chinese problem. US and European automakers export vehicles to China and own factories within China. It is one reason General Motors closed several US and Canadian plants and laid off thousands of workers last year. Then you probably heard Apple’s revenue warning, in which it blamed a nasty surprise on weakening conditions in China.

The uncomfortable fact is that a great deal of world growth is directly tied to Chinese growth. And not just absolute current growth, but expected future growth. Business has built 6% Chinese growth, compounded forever, into its models. It’s baked into the forecasts and expectations that keep shareholders happy. And when that growth doesn’t meet expectations, we get surprises. Apple is just the first of many.

Yes, the US has a trade deficit with China. That doesn’t mean China buys nothing from us. They most certainly do and certain segments of our economy depend heavily on Chinese customers. Here’s a chart of China’s importance to top US semiconductor companies.

Note this is the percentage of sales, not earnings. We see here five major public companies that got a third or more of their 2017 sales from China. It would not take much change to wipe out all or most of their profits.

Similarly, lots of smaller US companies depend on China for components that have no US alternatives. Rising costs, whether due to tariffs or anything else, hit their bottom lines, too.

A significant part of US growth last year came from a rise in US inventories. In a somewhat arcane accounting methodology, building inventories is what counts for GDP, not actual sales. Many businesses that depend on Chinese materials built inventory ahead of what was feared to be a significant tariff at the end of 2018. Those inventories are going to be sold in 2019 and often not replaced. A large part of the slowing economy in 2019 will simply be a reduction of inventories. The apparent robust growth of the last half of 2018 was essentially pulling production forward from 2019.

China has its own problems, too, namely enormous debt and increasingly strapped consumers. I’ll discuss those next week. The point to remember now is that economic weakness and falling markets in China are going to hurt the US, too. And they will weigh just as heavily on Europe and especially Germany. Which brings us to the next wicked thing that may be coming.

Brexit Breakage

Last month in European Threats, I quoted Victor Hill saying “a disorderly Brexit will be that spark that sets the Eurozone tinderbox aflame.” The fire is still ready to light and, if no deal emerges before the March deadline, could certainly erupt in flames, metaphorically speaking.

Many analysts doubt this, trusting some last-minute agreement will emerge because a “hard” Brexit is in no one’s interest. It makes no sense, the logic goes, therefore it won’t happen. The problem is we are dealing with politicians who may have entirely separate interests, and in any case have been known to miscalculate. If governments always did the sensible thing we would never have wars and other international calamities. Yet we do. Politicians everywhere are perfectly capable of making terrible mistakes.

My friend Lord Matt Ridley, one of the world’s premier free market philosophers (of The Rationalist Optimist and the uber-important The Evolution of Everything fame) recently made the point that even a no-deal Brexit would be better (for Britain) than the current proposal. He has a great deal of faith in free markets to adjust quickly, as do many others in the UK, so that may prove important to the final decision. We will see.

(Incidentally, as an American, I take no position on the Leave vs. Remain question. I have long thought the EU will eventually fall apart. If so, better that it happen in the least painful way possible. A no-deal Brexit may not be the best start. But then, breaking up is always hard to do.)

The UK parliament is supposed to vote next week on January 15 on Theresa May’s Brexit plan. That vote has already been delayed once and passage is not guaranteed. As of writing this, it looks like it will not pass, but things change in politics. Even if it does, the details and implications are hideously complex, with very little time to sort them out before the March 29 departure date. The resulting confusion will, at the very least, temporarily paralyze some businesses and disrupt EU/UK trade, of which there is a lot. Here’s a handy map my friend George Friedman shared in his 2019 Geopolitical Futures forecast (Over My Shoulder members can read a summary here.)

Source: Geopolitical Futures

Some 48% of UK exports go to the EU, far more than it sells to the US. That means increasing trade with the US will have limited benefits, even if the US/UK sign a new free trade agreement. The EU is less dependent on the UK, though some regions and companies will surely get hurt.

George is among those who think a deal will get done in the next few weeks. That doesn’t mean he is especially optimistic, though. From his forecast:

Two key questions will remain: What will be the UK’s future relationship with the EU, and what will be the future of the UK itself?

The United Kingdom maintains a close security relationship with several European states. It’s also an important trade partner for major EU economies such as Germany and the Netherlands. Deal or no deal, those relationships will continue, and the UK will be an important ally for EU states on the periphery seeking to balance against Germany and France.

Its future is a different story. Much will depend on the deal, but the same forces that compelled the United Kingdom to leave the bloc threaten its unity, too. If a Brexit deal ends up disproportionately hurting Scotland, for example, it could create renewed calls for Scottish independence. Northern Ireland is also in an unstable position. The sectarian issues that led to the Troubles are still simmering, the peace held together by the 1998 Good Friday Agreement is fragile, and the economy is under significant pressure.

Businesses aren’t waiting to see how this ends. A new EY study says financial firms are in the process of moving assets worth nearly $1 trillion out of Britain to various EU domiciles. Many are moving staff as well. Look for that trend to accelerate quickly if next week’s vote in Parliament fails.

As noted, US/UK trade exposure is relatively small for both countries, but some of it is important and irreplaceable. The bigger problem is intangible. We rightly call it a “special relationship” because our two countries were once united. That split was painful, too, and took a long time to heal (see the War of 1812). Whatever hurts the UK will hurt the US, too. A Brexit-sparked recession will hinder trade, force some US companies to find other partners, and aggravate our own problems.

But the bigger problem is that the US will get hit on both sides. A hard Brexit will hit both the EU and UK economies, including China, and the damage from both will then spread worldwide, including to the US.

Helpless Europe

For years, whenever we talked about the European economy, one country drove the discussion: Germany. Yes, the UK and France are big but Germany is the giant. If Germany sneezes, the rest of the continent catches cold. And it is sneezing hard right now.

The latest GDP forecasts peg German growth at 1.5% for full-year 2019. I think that is aggressively optimistic, coming after a 0.2% contraction in Q3 2018 and only 0.5% growth the quarter before.

It’s getting worse, too. Industrial orders for export dropped 3.2% in November and Germany’s exports are what keep its economy—and the Eurozone’s and the EU’s—alive.

This is partly due to the same cyclical factors hitting US growth. Like the US, Germany had a good (although not spectacular) run since the last crisis and at some point it must end. Trump’s threat to slap tariffs on EU autos doesn’t help. But some of this is uniquely German, too.

The euro currency effectively gave Germany a stranglehold over the zone’s smaller players who bought German exports with German loans. We saw how that worked with Greece. Now a similar dynamic is unfolding in much-larger Italy—which, for its part, has some unique problems, too.

Yet with all this going on, the European Central Bank is still intent on ending its asset purchases in the coming year, even as it keeps interest rates negative. That is a formula for a wildly distorted economy, at the very least, and possibly much worse.

Meanwhile, next door in France the “yellow vest” protests reveal substantial and well-organized working-class unrest. Imagine what will happen if (when) the EU economy turns seriously south, unemployment shoots even higher than it already is, governments can’t afford their safety nets, and the population can’t afford higher taxes. It could get ugly and not just in France. Remember, many EU countries are parliamentary systems whose governments can fall anytime.

I admit, this is a gloomy outlook. Maybe it’s wrong. Gavekal’s Nick Andrews recently looked at these same issues and asked what could change Europe’s trajectory.

With monetary and fiscal policy constrained, and with domestic consumer demand weakening, any such driver—for the economy or equities—is only likely to be external. There are several possible candidates:

1. A favorable Brexit deal. Since the UK’s 2016 referendum, eurozone shipments to the single currency bloc’s second-biggest export market have stagnated. If the clouds clear in the coming months, with a no-deal Brexit avoided, then risk premiums will diminish, sterling will rally and eurozone exports to the UK are likely to pick up. For now, however, the outlook on this front remains highly uncertain.

2. Improved US-China trade relations. A deal to avert tariff increases would remove one major uncertainty hanging over the global economy. Again, risk premiums would fall.

3. A stabilization or acceleration in Chinese growth, whether as a result of a trade deal or a domestic stimulus program. A pick-up in Chinese domestic consumer demand would benefit European companies exposed to Asia, notably luxury goods stocks. However, there is little probability of a stimulus effort on the scale of 2009’s, so the effect on Europe’s economy and markets of Chinese policy easing is likely to be muted.

In short, there is little prospect of a new domestic driver of European growth emerging, and the external situation remains highly uncertain. In the absence of any clear new growth engine, the composite eurozone PMI released in the first week of January indicates that a slowdown of year-on-year GDP growth to around 1% from the ECB’s estimate of 1.9% for 2018 is possible.

Nick says this very nicely, but his implication is disturbing: Europe is helpless and will continue circling the drain unless external events (over which it has little control) go its way. That is not a comfortable position to be in.

If eurozone growth ends at 1% in 2018, it’s a good bet 2019 will be no better and possibly bring a true recession. What happens to German banks in that scenario? And if they go wobbly, what happens to US, Canadian, and Asian banks? And if Europe goes into recession, it will have a significant impact on the world and the US. Paying attention to Europe—and not just the Premier League—will be important in 2019.

Something wicked is coming, and we may see far more yellow vests or their equivalent all over the world before this is over. I see significant potential for global recession and it will bleed over into the US market. A few unforced errors upon the part of the US central bank or government could bring recession sooner rather than later.

Economics is about to get interesting.

DC, Back to Dorado, more Florida, and Boca Raton

I write the final lines of this letter while in my “office” on American Airlines flying from California to Washington, DC. I get to spend Friday afternoon with my good friends Andrew Marshall, Neil Howe, and a small group talking about world events.

For those who may not know, Andy Marshall was appointed by Richard Nixon in 1973 to head up what is now called the Net Assessment office of the US Defense Department, which was basically their futurist think tank. He was then reappointed by every president and secretary of defense until he retired three years ago at the age of 94.

Even now, surprisingly to me, Andy “adopted” me and let me into his world and his thinking. The weeks I have spent at the Naval War College working on developing contingency planning concepts for the DoD have been some of the most stimulating in my life. Andy would assemble out-of-the-box thinkers from different backgrounds, then we went at it for 12–14 hours a day for over a week. He held those events for decades, which informed his advice to various administrations and leaders. To say he has been at the center of the development of US strategic policy is an understatement. At 97, he is as intellectually strong as ever. Is it a privilege and honor to be able to spend some time with him.

Saturday I fly back to Dorado, Puerto Rico (where we now live) and meet Shane who is coming in from Dallas. I am looking forward to being back home, although Steve Blumenthal of CMG is trying to drag me back to Tampa Bay for an evening in the third week of January. Let me know if you’re in the area and would like to meet. Then at the end of the month I will be at the Tiger 21 conference in Boca Raton.

I have been with Pat Cox for the last two days in San Francisco listening to presentations from biotech companies, particularly antiaging and age reversal technologies. It is a remarkable antidote to my assessment of the global economy and politics. We are on the cusp of new biotechnology that could eclipse the global, social, and economic impact of all previous technological revolutions. I think by the mid-2030s we will look back and just marvel.

I must confess there are times when I feel a bit of mental dizziness. The profound implications and changes technology will bring are simply staggering. And then I try to wrap my head around how the world deals with the growing political, social, and economic “fingers of instability” and I am just stunned. Perhaps you have the same sense of disconnect? Maybe that combination is why I tend to be of the “Muddle Through” persuasion.

And with that confession of confusion, I will hit the send button. I wish you a great week and perhaps a little time in the warmth and sunshine of Puerto Rico will help bring a little clarity to my mind.

Your trying to absorb it all analyst,

John Mauldin
Chairman, Mauldin Economics

We must prepare now for the likelihood of a recession

Excess austerity is a bigger risk than fiscal profligacy

Lawrence Summers

A Ford employee works on the production line in Michigan, US © Bloomberg

When people are fundamentally healthy, they do not yet know what will cause their death. An economic recovery is healthy if it is not clear what will cause the next recession. By this standard, the recovery from the 2008 financial crisis, although disappointingly slow, has been healthy for most of the last decade.

This is now in serious doubt. Paul Samuelson’s quip that the stock market has predicted nine of the last five recessions cautions against overreacting to recent stock market moves. But credit spreads have widened considerably, commodity prices have softened and investors have started demanding higher yields for short-term US bonds than for those with longer terms. Unlike equity markets, “yield curve inversions” have not historically tended to produce false recession predictions. The overall judgment of financial markets is that recession is significantly more likely than not in the next two years.

Real economic indicators for the world’s largest economies, China and the US, also suggest considerable cause for concern. Almost every Chinese indicator in the last few months has come in below expectations. Beijing authorities now see the need for stimulus measures if they are to credibly report the attainment of growth targets. Revisions of economic forecasts tend to run in the same direction for protracted periods as forecasters adjust to emerging reality. This tendency is especially pronounced in China, given the extreme political sensitivity of economic statistics.

In the US, inflation is again running below the Federal Reserve’s 2 per cent target and comparisons of the yields on ordinary and inflation-adjusted bonds suggest investors expect this to continue for the next decade. While jobs growth remains strong, employment is usually a lagging statistic. Forward-looking indicators of business and consumer sentiment suggest that growth is likely to slow.

Perhaps the US economy will enjoy a soft landing: jobs growth would slow towards long run sustainable levels, and productivity growth would accelerate enough to allow continued gross domestic product growth of 2 per cent and increased wage growth without accelerating inflation. But this would require both policy skill and great luck. Given that we are starting from very high debt levels and low unemployment, a recession is the more likely outcome.

It is almost inconceivable that the global economy will remain healthy in the face of serious economic problems in both China and the US, even leaving aside their conflicts over trade and technology. Europe lacks economic energy and the uncertainties associated with Brexit, French protests, German political transition and Italian populism mean the continent is more likely to be a source of problems than a solution.

Like generals fighting the last war, too many policymakers are focused on yesterday’s problems. The global economy is much more likely to suffer from a downturn than from overheating in the next two years. There is more likely to be too little credit flow than too much, asset price deflation is more probable than a bubble and excess austerity is a bigger risk than profligacy.

The critical challenge for monetary and fiscal policy will be to maintain sufficient demand amid immense geopolitical uncertainty, increasing protectionism, high accumulated debt levels and structural and demographic factors leading to increased private saving and reduced private investment.

The Fed should signal that it is determined to avoid a downturn that would assure another decade of below target inflation. The People’s Bank of China and other central banks should also make clear that they recognise that avoiding another recession is the most important thing they can contribute to financial stability.

Fiscal policymakers should realise the very low real yield on government bonds is a signal that more debt can be absorbed. It is not too soon to begin plans to launch large-scale infrastructure projects if a downturn comes. The largest economies should try to limit trade frictions and signal that they are committed to co-operating to support global growth by assuring adequate capital flows to emerging markets and avoiding a cycle of protectionism.

Even if my recession fears are excessive, a shift towards emphasising growth will contribute to bringing inflation up to target levels and can be reversed. If I am proved right, the costs of delay in the policy response could be catastrophic. It is the irony of our moment that prudence requires the rejection of austerity.

The writer is a Harvard University economics professor and a former US Treasury secretary

Riches to Rags: Swiss Central Bank Swings from Record Profit to Large Loss

Economic and political uncertainties lifted demand for the Swiss franc, eroding the value of the bank’s foreign stock and bond holdings

By Brian Blackstone

The Swiss National Bank held over $3.5 billion in Apple shares and $2.6 billion in Amazon stock at the end of the third quarter.
The Swiss National Bank held over $3.5 billion in Apple shares and $2.6 billion in Amazon stock at the end of the third quarter. Photo: denis balibouse/Reuters

ZURICH—One year after posting a record 54 billion franc ($55 billion) profit, the Swiss National Bankswung to a 15 billion franc loss in 2018, as a double whammy of weaker global equity markets and a stronger Swiss franc eroded the value of its massive holdings of foreign stocks and bonds.

The valuation loss reported Wednesday by the SNB underscores the interplay between central banks and markets. Usually, it is central bank decisions, or hints of changes in interest rates and other policies that cause stock and bond markets to fluctuate. But this has worked in reverse for Switzerland’s central bank, whose finances are largely at the mercy of financial markets beyond its borders.

What sets Switzerland apart is that after years of currency interventions by the SNB—creating francs to purchase foreign stocks and bonds in a bid to weaken the franc—the bank has amassed over 700 billion francs worth of foreign assets, an amount that exceeds the country’s entire gross domestic product. This makes it a major asset manager in addition to being a central bank.

“In terms of absolute numbers you have these high swings, but that comes from the huge size of the balance sheet and foreign exchange reserves,” said Alexander Koch, an economist at Raiffeisen Schweiz bank.

This included over $3.5 billion in Apple Inc.shares at the end of the third quarter, according to Securities and Exchange Commission filings, $2.6 billion in Amazon Inc. stock and $2.7 billion in Microsoft Corp.The SNB’s equity investments—which comprise 20% of its foreign assets—replicate broad indexes. The rest of the SNB’s foreign-reserve portfolio is in foreign bonds. Euro assets comprise the largest share, followed by the dollar.

When equity markers rise, and when bond yields are low, the market value of the SNB’s portfolio rises. A weaker franc amplifies those gains. These forces combined to push the bank’s profit sharply higher in 2017. But they went in reverse in 2018.

The euro fell 4% against the franc last year, as economic and political uncertainties lifted demand for the Swiss currency, which is typically seen as a haven in times of global stress. The dollar was little changed against the franc over 2018, but has weakened in the past month.

Unlike other asset managers, the SNB can’t hedge its currency exposure, because doing so would undercut its efforts to weaken the franc.

Given that limitation, “they’ve done quite a good job,” said Mr. Koch, and the 15 billion franc loss only represents about 2% of the bank’s roughly 800 billion franc balance sheet, including gold holdings.

Other central banks like the Federal Reserve and European Central Bank also have amassed large portfolios consisting primarily of bonds. But those assets are denominated in their own currencies, giving them a steady source of interest income without the foreign-exchange risk.

The good news for the SNB is that it can ride out market volatility, and its loss doesn’t affect its ability to carry out monetary policy. Annual Swiss inflation was just 0.7% in December and with the franc still strong by historical measures, the SNB isn’t under pressure to sell its foreign assets to strengthen its currency. It is expected by analysts to keep its key policy rate at minus-0.75% at least until late 2019.

The danger would come if Switzerland faced a sudden inflation shock that forced the SNB to sell its foreign assets at a loss. Repeated valuation losses could also damage the SNB’s reputation at home.

Despite the 2018 loss, the SNB said it would still disperse two billion francs to the federal government and Swiss states, known as Cantons, under a profit-sharing agreement that runs through 2020. Because the SNB held on to the vast majority of its 2017 profit, it had a significant cushion to absorb last year’s loss.

Unlike most central banks, the SNB has publicly-listed shares and it pays a small, legally-capped dividend to those shareholders, who have no say in how the bank is run or how it conducts monetary policy. The SNB itself has played down the importance of its shares.

The bank’s share price attracted global attention in 2017 and 2018 when it rose more than fourfold and approached 10,000 francs a share last April. However, it has retreated since then and one share fetched just over 4,200 francs on Wednesday.

What’s Ahead for the Stock Market in 2019

Stock market

U.S. stocks ended 2018 skimming bear market territory. In the new year, the market has bounced back somewhat but remains volatile. This week, Wharton finance professor Jeremy Siegel joined the Knowledge@Wharton show on SiriusXM to discuss the market outlook, Fed rate hikes and the impact of the U.S.-China trade war. He is also co-host of the show “Behind the Markets” on Wharton Business Radio every Friday. Siegel was joined by Gad Allon, who is director of the Jerome Fisher Program in Management and Technology at Wharton and also professor of operations, information and decisions.

An edited transcript of the conversation follows.

Knowledge@Wharton: As we continue our 2019 look-ahead series we are going to focus on the markets, which have been on a rollercoaster ride the last few months. The Dow Jones Industrial Average ended up seeing a decline of more than 10% last year. Both the Nasdaq and the S&P 500 saw declines as well. The factors that led to some of this uncertainty are still in place including the U.S. trade war with China, and President Trump’s open disagreement with the Federal Reserve’s decision to raise interest rates, among other things. So what should we expect in the markets in 2019?
Jeremy Siegel: Now let’s review last year. I predicted zero to 10% return on the market, and during almost all of the year people said, ‘Jeremy, you are far too pessimistic.’ Then all of a sudden, bang, we had that near bear market. It didn’t quite get down to that 20% on the S&P from top to bottom. But I think it overreacted.

Let me say that I do think the last hike of the Federal Reserve was a mistake. I wouldn’t have [done it], but it’s not a fatal mistake. It was a close decision. But I was very encouraged, as the market was, by last Monday’s employment report [for December], which certainly dispelled any sort of immediate worries. Now the employment report is what we call a coincident indicator; it is not a leading indicator. So it is not predictive of weakness, but it does show you that we certainly didn’t end 2018 on what we would call a recession.

Given all of that, the market is selling for about 16 times last year’s earnings. That is the S&P 500. So even if earnings don’t increase at all — which is well below expectations — 16 is a very reasonable multiple, especially in a low-interest rate environment. And I don’t think the Fed is going to be tightening at all this year, or only if the economy turns out to be very strong, and only at the end of the year.

Knowledge@Wharton: That has been the question, whether there potentially could be two increases in rates or even whether there would be none.

Siegel: I wouldn’t have done the December [rate hike]. Will they take it back? Only if there is a lot more weakness. Otherwise they will be on hold — and again, they may be on hold for the whole year.

But my feeling is that the bond market, which is really where so much of the important sentiment is located, has told the Fed: ‘You tightened enough, if not more than enough.’ So it is saying ‘you’ve got to slow down,’ and I think now [Fed Chairman Jerome] Powell and the Fed are going to listen to that.

Knowledge@Wharton: Also joining us is Gad Allon, professor of operations, information, and decisions here at the Wharton School. Give us your thoughts on what you saw on Wall Street and the performance of some companies in the last few months of 2018, and maybe where we’re headed in 2019.

Gad Allon: I am not an expert on the financial markets per se, but as I look at the tech firms, specifically how in the last few years the tech firms were really the main engine that was driving the S&P, and I am worried about some of these firms — specifically after I look at the last few months, and even more so the last few days, and some of the indicators that we saw there.

For example, I am terribly worried by the last announcement by Apple [cutting projections on sales and earnings]. I think it has long-term implications – on firms doing business in China, selling in China, and having a supply chain heavily skewed towards China.

The entire tech supply chain in many ways is powered by the consumer side, but if you go downstream and you see firms like [chip designers and manufacturers] Qualcomm and Applied Materials, [they could be affected too]. So I am a little bit less optimistic than Prof. Siegel on what is going to happen in the future, primarily because I am looking at some of these firms, and I am worried about the implications.

Siegel: The saving part about that is that Apple is not priced like Netflix or Amazon. It is priced at a very reasonable P/E ratio. It is almost priced as not really a tech firm, but almost like a consumer discretionary firm. 
I agree, the slowdown is serious. [Apple CEO Tim] Cook should have warned earlier. There were signals that they were not going to make their projections there and I think a lot of the smart money began to know it, and that is why Apple was under pressure for so long even before that announcement. But right now, at today’s multiple, you don’t need it to become another super growth company. It is selling at a really reasonable [multiple] times earnings.

Now some of the other firms you mentioned are really leveraged in this slowdown, and I agree with you, there is a source of concern there. But I mean maybe Apple has another 10, 20 points on the downside but I think there is innovation at Apple. I was listening [to the news] this morning and someone said, ‘Clorox only has a 3% expectation of growth and it is selling for 20 times earnings,’ and Apple is at 10 [times earnings]. So in a way it is selling almost like a consumer stock.

Allon: That brings me to the point of why I am maybe not worried about Apple per se, but I am worried about the entire market — the worry is deeper than just one firm. I think one implication of what we see, and if you read a little bit into the announcement [by Apple], is the fact that many firms are building [their business growth] off of the discretionary spending of the new middle class in China. If in the past they were running to buy brands … we don’t see similar behavior there now.

Siegel: But don’t you think that is partially [due to] the tensions between China and the U.S. and maybe [the Chinese consumer] telling Trump, ‘We don’t necessarily need American goods?’ Do you think there is some of that in the slowdown?

Allon: There might be some of that. There might be a little bit of deciding to change purchasing behavior. For a long while, there were many U.S. brands that … did better in China than in the U.S. KFC does really well in China. One thing might be that. The second thing might be that people [might now think], ‘We don’t need any more brands, period. We actually need to spend on things that [lead to a] better quality of life. We do see much more spending on vacations, for example, in China than in the past.

Knowledge@Wharton: If there ends up being a new trade deal between the U.S. and China, what impact is that going to have on Wall Street? The expectation is we are going to see a quick pick up. Is that your expectation as well?

Siegel: I think the market expects a deal. However, if a deal is reached it doesn’t mean the market won’t go up. It does mean if a deal isn’t reached and tariffs get heightened it is going to really go down again. So, I mean that is going to be a relief rally, and with a slowdown in China there is a feeling that Trump maybe has more leverage than he had a right to have expected a year ago, or six months ago, in terms of this negotiation.

But it seems to me that with the slowdown in China, [President] Xi wants to come to some agreement, and that we expected an agreement to be made. Also, the fact that if Powell doesn’t hike anymore then it is on Trump to keep the stock market up. If he escalates a war on tariffs and the market goes down, he has only himself to blame.

Knowledge@Wharton: Gad, how confident or pessimistic are you about these “negotiations” moving forward, especially in the next few weeks?

Allon: I am with Jeremy on that. Both [sides] have realized by now that unless there is some change we are heading into a slower market, and both have nothing to [gain] from that. … I definitely don’t think that Trump realizes how entangled the two economies are.

You cannot just say, ‘Let Apple move the production to the U.S.’ [because] otherwise we will have a $5,000 iPhone. I think most of us depend so much on the supply chain that crosses [countries]. In one of my classes I show the life of a DVD player. It is such a commodity, but it takes nine countries and [crossing borders] five times … to manufacture something like that.

These are deeply long supply chains that are built on top of each other. So I cannot see [an outcome] where they both will decide not to negotiate or decide to just get entrenched into their current positions.

Knowledge@Wharton: Gad, with you following the tech sector the way you do there is also interest coming up in the markets of a couple of IPOs expected in 2019, such as Uber and Lyft.

Allon: We have these three: Uber, Lyft, and Slack. These three are probably the most anticipated in the last few years. Just to talk about Uber for a second, in my opinion Uber is probably one of the biggest experiments ever in using VC money to fund a winner-takes-all [firm] in a market that is not a winner takes all, with the belief that sometimes in the end, one can actually take all of these subsidies and all of these payments and actually create value.

… I mention Lyft as well because it is clear that it is not a winner-takes-all market. So the question is how do you value these two firms when the entire market until now was built on the fact that they can dominate their specific markets?

I add Slack to that. While we see firms like Google and Facebook absolutely dominating the consumer markets, more and more interesting firms are coming into the B2B market, and Slack is probably the most interesting player in that [space]. It will be interesting to see how the market will value them.… [B2B is] unlike the consumer market, which is the much more predictable market, with much more predictable growth. But [in B2B] they are fighting against a Salesforce and Microsoft. Again, reading the IPO [performance] will tell us a lot about what are the expectations in terms of the market in B2B versus B2C.

Siegel: I agree. I am glad for Lyft that Uber isn’t a monopoly. That is what we need everywhere. I like the fact that there is another firm that provides competition. And it’s needed. Although certainly I think Uber is several times Lyft. Lyft is there and people do use it; it’s a few dollars cheaper. You may have to wait a little longer, but some people’s time is less valuable than others and they are willing to do that.

Some people have ideological reasons for using Lyft rather than Uber. And I sometimes wish we had that competition for Facebook or Google in the same way. I mean, there have been attempts at it. I am not an expert in the tech area, but I am just sort of an observer. And of course, it also falls to the very important question about whether — and Gad, I’d like your opinion on this — you expect any antitrust action could ever be taken or severe restrictions being placed by the U.S. Congress on Google or Facebook as a result of their near-monopoly positions.

Allon: If you ask me what is the next, the other important trend that is going to happen in the next year or two is definitely much stricter regulation on Facebook and Google. You have a new Congress that leans one way, you have a Senate that leans another way, and the only thing that they agree on is the fact that the other side is better represented on social media.

I expect also a little bit [more scrutiny] with respect to Amazon, even though I should say the public perception of Amazon is much more positive than maybe [that of] observers of the market in general. But all of these firms I think are going to have much higher scrutiny.

Siegel: Actually, President Trump has been the one who has been negative on Amazon more than Facebook or Google. But because of privacy and other issues, Congress talks more about Google and Facebook than it does about Amazon. But Amazon certainly has threatened a lot of small-core sellers, and … caused disruption. Trump gets on them every so often, although I think we all love the convenience of it. I do.

Allon: Exactly. So that is the thing that will be interesting. When it comes to Facebook and Google, most of us in the tech industry have understood for a long while how they make money and how they actually can have such an amazing engine, and why it is so hard [for others] to compete. But the reality is that the main person that uses them doesn’t really know how it is being monetized.

From the hearings in Congress, it is clear our congressmen and women don’t know how they monetize their data. They very seldom sell it per se, but they monetize it in many other different ways. And any attempt to curb and regulate that is definitely going to hurt their long-term valuations.

With Amazon I think [the issue] is more about the actual scale. When you get a firm at this scale that by now controls Whole Foods, and starts to produce private label [products] to compete with firms that sell on their platform, we are going to see some [regulatory] scrutiny on what does bigness mean, what does scale mean. What type of firms do we allow, and how big do we want them to be?

Now you made a really great point, which is why do we see a competitor to Uber and we don’t see competitors to Facebook and Google? We did see early competitors but not anymore. Some of that is because Uber from the first day had to fight against regulations, usually very local regulations. In different cities, they were not allowed to operate. Having that friction resulted in the emergence of competitors that were vital. In China, they had to leave, in Malaysia and Tunisia they had to leave. In the U.S., they do well in some cities, but not in other cities.

Facebook and Google really had no friction whatsoever once they reached a certain scale.… And now it is too late. If you think about the time where Facebook was allowed to buy Instagram or buy WhatsApp — these are the kind of things that probably would not be allowed these days.

Oil in 2019: Booms, Busts and the United States

Low oil prices will help some and harm others.

By Xander Snyder       

It wasn’t that long ago that oil-producing countries were riding high. In 2014, with prices topping out at $115 per barrel, producers the world over had money to save, money to spend, and money to reinvest in what seemed to be an increasingly lucrative industry. Black gold, it seemed, brought their budgets into the black. But circumstances changed, and a year later oil prices fell dramatically, stabilizing a few months thereafter but dropping again, bottoming out at about $26 in January 2016. 
If this sounds familiar, it should. Only a few years earlier, in July 2008, at the tail end of the boom that preceded the financial crisis, oil prices peaked at about $140 per barrel. By year’s end, oil would cost just $33 per barrel. 
There’s an important distinction between the two downturns. In 2008, prices plunged because of a decrease in demand, and in 2014, they fell because of a surge in production. But if the causes were different, the outcomes were the same: Oil-producing countries languished. 

Most responsible for the new oil on the market was the United States. Harnessing technologies that had never really been cost-effective enough to use en masse, U.S. producers tapped into vast shale deposits throughout the country and, in doing so, accounted for nearly 60 percent of the increased global supply of crude oil between March 2012 and January 2016. The rest came from Persian Gulf nations, which were trying to “gain market share” – i.e. put the upstart shale producers in the U.S. out of business. The strategy worked for a time. Some debt-laden U.S. companies did, in fact, file for bankruptcy, but others began to research and invest in more cost-effective technologies, which would eventually bring the break-even price of oil down for shale producers.

Now, prices have fallen again. They peaked at $86 in 2018 but ended the year just below $51 (though they recovered slightly late last week to $57). This isn’t as severe a decline as it was in years past, but it’s enough to make oil-producing countries worry how long the downturn will last – and what kind of political pressure it will bring to bear. It’s especially concerning now that the world is approaching the end of a business cycle and moving toward a recession, one that will decrease demand, lower the price of oil and call into question how much money investors are willing to invest and how cheaply companies can borrow money.

Many countries will stand to benefit from low oil prices. Those that depend heavily on imports – especially countries whose economies are growing – will be able to fuel themselves more cheaply than they once did. The following analysis will map out how major economies will fare in 2019.



The Winners
Economically, China is in a tough spot. It’s trying to deflate a debt-fueled property bubble without generating popular unrest. The economy is still growing, albeit slowly by Chinese standards, and so long as it grows, it will need to import massive amounts of oil to fuel manufacturing and industry. (China is the largest importer of petroleum and petroleum-gas in the world in terms of dollars, at $211 billion, or slightly less than 2 percent of gross domestic product.) Beijing will take whatever break it can get, and lower oil costs certainly fit the bill.
Like China, India is a developing country with a growing economy, whose citizens are slowly getting used to a better quality of life. But unlike China, India’s economy is less dependent on exports, construction and debt, and so it boasts a slightly different energy profile. About 60 percent of India’s economy, for example, is driven by household consumption. It now consumes about 4.7 million barrels per day but produces less than 1 million bpd of its own. India fills the gap primarily with Middle Eastern oil. In dollar terms, India’s petroleum imports amounted to around $99 billion in 2017, equivalent to approximately 3.8 percent of its GDP, a much larger share of its economy than China’s. Put simply, this means that India spends more on foreign energy relative to the size of its economy than does China. Cheaper oil would help lower costs for energy-dependent businesses as well as consumers, thereby reducing some limits to growth that it could face in the coming years.
Japan, too, produces almost no oil domestically and therefore depends on foreign sources of energy. In 2017, it consumed approximately 3.9 million bpd, almost all of which came from abroad, mostly from the Middle East. But Japan has a developed economy, which means that its foreign energy needs are not likely to grow as much as India’s or China’s in the coming years. In fact, Japan’s oil demand actually shrank over the course of 10 years, from 4.9 million bpd in 2007. Since its GDP is also much larger ($4.9 trillion), its oil imports in dollar terms – approximately $117 billion (or 2.4 percent of GDP) – are smaller than India’s relative to the size of its economy. Japan may spend comparatively less for oil imports, but since it has to import all of them, lower prices mean the government can spend more in other areas of the economy. Given all the challenges to the Japanese economy, however, this benefit is likely to be moderate at best.
The Losers
Saudi Arabia
Saudi Arabia is highly dependent on oil exports. Its exports of petroleum and petroleum-gas – about $170 billion – account for approximately 25 percent of its GDP. However, of the nearly 12 million bpd of oil that it produced in 2017, it also consumed nearly 4 million bpd, which means that the oil industry – exports plus domestic sales – accounted for an even larger portion of its economy. Still, these figures understate the importance of oil to Saudi Arabia’s economy and its political regime, since non-oil industries are often indirectly tied to oil production. For example, some of Saudi Arabia’s highest earners, and therefore those who have the most to spend, work for state-run oil giant Saudi Aramco.

Though Saudi Arabia’s government was able to grow non-oil revenue from 2012 to 2017, the slump in oil prices beginning 2014 caused its budget to shrink from $330 billion to $185 billion. This is no small matter for Saudi Arabia, which relies on state-provided subsidies to maintain political order and prevent anti-regime sentiment. There are already signs that Saudi Arabia may need to cut prices in 2019. On Jan. 2, four oil refineries responding to a Reuters survey said they were anticipating that Saudi Arabia would need to reduce the price it charges for heavy and medium crude grades sold to Asia. As prices decline, Riyadh will find it difficult to allocate enough funding toward the social subsidies that keep unrest in check.

Saudi Arabia is trying to save itself essentially by doing what it did in 2014: cut production enough to drive some shale producers out of business, then raise production again. In December, OPEC and Russia agreed to cut oil production by 1.2 million bpd (800,000 bpd of which came from OPEC), and on Jan. 3 a former Saudi Aramco official claimed that OPEC may cut even more (over 1 million bpd in total) by the end of the month. But with current crude oil prices at approximately $57, Saudi Arabia has a long way to go. The International Monetary Fund estimates that Saudi Arabia’s break-even point (the price required to maintain a balanced budget) in 2018 was approximately $85 per barrel. It believes that will decline to $73 per barrel in 2019.
Russia depends less on oil than Saudi Arabia does relative to its total economy. In 2017, it exported approximately $195 billion in petroleum and petroleum gas, which amounts to approximately 12 percent of its GDP of $1.6 trillion. (Note that in our review of the Russian economy published in 2017, revenue from the oil and gas industry, according to Russian sources, amounted to 8 percent of Russian GDP. The discrepancy could be due either to the different sources or to variations in the strength of the ruble.) It’s little wonder that in 2018, Russia produced more oil – more than 11 million bpd – than it ever had before.

But as in Saudi Arabia, dependency comes at a cost. In 2016, 36 percent of the Russian federal budget came from oil and gas revenue (about 17 percent of its consolidated budget). With real wages stagnating, Putin’s approval ratings falling and pension reform fueling discontent with the government, the threat from lower oil prices in Russia will quickly become political.
Iran is under pressure from every direction. It’s facing a more concerted effort by regional adversaries to reverse the gains it made when it fought the Islamic State, and it’s reeling from U.S. sanctions at a time when its economy was already precarious. Low prices couldn’t come at a worse time for Iran, which like so many of its neighbors needs to sell its oil to survive.
Iranian financial figures are notoriously difficult to interpret, but according to U.N. data, Iran exported approximately $74 billion in oil in 2017. The World Bank estimates that in the same year its GDP was approximately $440 billion, meaning that oil exports accounted for 16 percent of its GDP. In 2017, Iran exported between 2.4 million and 2.8 million bpd of oil (its total production was 4.6 million bpd), but some believe that with the resumption of sanctions this figure will fall to 1 million bpd. Low oil prices would add insult to injury, placing an even greater strain on a regime that’s struggling to pacify a citizenry frustrated with the rising cost of living and gradual elimination of subsidies in exchange for ever more defense spending.
The United States
It’s difficult to gauge the extent to which low oil prices would hurt the U.S. There’s no question that some U.S. shale oil producers would suffer. Locations with higher break-even points would need to shut operations, and the upfront capital needed to explore the reserves at new locations would be more difficult to acquire. But the U.S. isn’t a petrostate. It may have exported about $123 billion in oil in 2017, but that amounts to only about 0.6 percent of its $20 trillion GDP.

But, considering the U.S. is the largest consumer of oil in the world, lower prices could be a good thing. When consumers pay less for oil, they have more to spend elsewhere, right? Well, maybe not. A 2016 article from the Brookings Institute showed that the boost to consumer spending resulting from the 2014 decline in prices was equal to the decline in investment in the fracking industry that resulted from lower prices. In other words, there was no net impact on the economy.

U.S. oil production in 2019 is similarly difficult to predict. The U.S. Energy Information Administration expects production to increase, and a lot of new transport infrastructure that will come online in 2019 will ease some of the current bottlenecks to production. Yet if OPEC production cuts prove ineffective and prices stay low for too long, the returns may not be there to keep producing at current levels. Either way, despite the U.S. recently overtaking Saudi Arabia and Russia to become the largest producer of oil in the world, the total impact of lower oil prices on the U.S. economy will be small. Some Americans in the oil industry may lose their jobs, but the risk of countrywide unrest is low.