Generally we tend to assume that markets – especially those of the same asset class – move together.
When someone asks what direction the stock market went, you typically don’t follow up by asking them which one.
If one stock market is up, it usually means most others are up as well. Equities from all over the world tend to correlate together. But that isn’t always the case.
In 2020 – the infamous Covid-19 year – returns have especially varied from one country to the next.
Even within countries, returns have varied considerably by sector:
(Sources: WSJ; FactSet, Dow Jones Market Data)
Even general regions have been very far apart.
In Asia alone, the benchmarks in South Korea and Taiwan were both up double digit percentages, weathering the pandemic damage better than most countries.
Yet Singapore and Thailand were down markedly, being harder hit for various reasons – e.g., Thailand’s dependence on tourism revenue. (Apparently the first letter of each country is not much of a factor in determining returns.)
For some countries, certain sectors had their revenues dry up to nearly zero. Companies tied to tourism or large public gatherings in many emerging countries is a good example.
Some countries also weren’t able to support their industries and individuals with income replacement support programs and other credit and liquidity measures.
Other companies, like those tied to the digital economy (a large bulk of which are US-based) have done well or even thrived.
It also forced investors to think of what kind of companies are quality stores of wealth and what stocks and assets don’t have these sorts of risk that were previously underappreciated.
Firms that provide basic goods necessary to live have also done well, as their products will always be in demand no matter where you go – e.g., Johnson & Johnson (JNJ), Proctor-Gamble (PG).
Since asset price movements in 2020 were mostly dictated by Covid-19, a trader might have looked, from a macroeconomic top-down level, for a country with a well-coordinated response to the disease.
Namely, in cases where the public health response minimized the spread of the coronavirus and economic damage was limited through appropriate containment measures.
Public health policy isn’t enough alone because business is heavily a confidence game. We even have popular indicators based on the concept (e.g., business confidence, consumer confidence).
Economic damage can last after people regain more confidence to go out and do what they did pre-Covid.
The economic response matters, as matters of economics and finances are intertwined in health issues. It’s improvements in living standards from economic activity that have brought new medicines, new services, and higher lifespans.
In the case of financial markets, aggressive fiscal and monetary programs are likely to benefit equities.
For monetary policy, that means three overarching approaches:
– interest rate cuts (maxed out in developed market countries)
– asset purchases to lower long-term rates and support funding for companies
– coordination with fiscal policy once the first two options are out of gas (some might call this “MMT“)
More liquidity generally means higher asset prices.
With zero or negative short- and long-term interest rates through the US, developed Europe, and Japan, market participants will look at fiscal policy as the way to go going forward.
We’re in an era where a lot of this debt will have to be monetized. That can mean different things.
The central bank can buy the debt using money it creates and retire it.
As you might imagine, this is not free. There’s always a trade-off somewhere.
The effect of this policy goes through the currency channel. This would mean a weaker USD for the US. Likewise, it would mean a weaker euro for the ECB’s coordination with sovereign governments in the EU.
When there’s a lot of debt relative to income, a weaker currency helps relieve debtors, who need help relative to creditors.
Historically, when we have these types of situations, policymakers will inevitably have to favor the debtors.
This is particularly true when there’s a shock that impacts overall economic activity.
A weaker currency has certain drawbacks. It is essentially a discreet tax on those holding assets denominated in that currency and a positive for those holding liabilities in the currency:
i) Makes imports more expensive. Namely, it reduces one’s purchasing power relative to the rest of the world. A weaker USD would reduce US residents’ purchasing power relative to non-US residents. (Or anyone holding US dollars would see their purchasing power decline in relation.)
ii) Supports asset prices denominated in that currency and can give a false illusion of increasing wealth.
iv) Stimulates domestic activity given effective debt relief and a higher supply of currency going into the economy (which can lead to higher savings, higher spending, and/or higher asset prices).
v) Increases a country’s inflation rate, holding all else equal.
The dollar’s role in the global economy is high (about ~60 percent of global payments and international debt) relative to the US’s role in the global economy (about 20 percent of global GDP).
This means USD holdings are higher in international reserve portfolios than what you might expect in order to remain balanced. We should expect more rebalancings over time.
This is likely to be intensified due to trade conflicts with dollar creditors. (And we should expect trade tensions to remain high irrespective of whomever controls the US Presidency or Congress going forward.)
But, for now, a weaker currency is a better option that taking these economic effects through the interest rate channel (i.e., higher interest rates). Practically all major economies want a weaker currency to create relief.
A larger issuance of debt to the private sector and international entities increase interest rates, holding all else equal.
The economy isn’t strong enough to handle higher interest rates due to the effect on debt servicing and won’t be for a long time.
Nominal interest rates need to be kept below nominal growth rates to keep debt (and especially debt service payments) from growing faster than the economy.
The US is also in a situation where a lot of debt is going to need to be rolled over in the next few years.
At the same time, the US was already running deficits of about 5 percent of GDP pre-Covid.
In the next post-Covid downturn that could easily blow out to double that.
To plug those deficits, that means selling a lot of bonds. The private demand from domestic and foreign sources won’t be there, especially with interest rates at or around zero and needing to print money.
A bond is a promise to deliver currency. So if it doesn’t yield anything (or worse than nothing) and you have to create a lot of the currency, then bonds aren’t that attractive of an investment, especially standard nominal rate bonds.
Cash is less volatile but has the same problem.
Unless you’re in a state of deflation (which would make the real return potentially positive) or you expect interest rates to decline further, then bonds are not very good investments if their rates of return are extremely low.
And when global economic growth has been anemic, that also means lesser capital availability from international sources to buy US bonds. Their reserve accumulation has been lower.
Your number one rule for tracking global financial flows is that the foreign demand for US Treasuries is a function of global reserve growth.
The lack of robust foreign demand for US Treasuries over the past few years hasn’t been hard to explain – reserves haven’t been growing.
International investors are not just concerned about the lack of yield (like domestic investors), but also have the currency question to contend with in terms of what the US’s financial situation means for the value of the dollar going forward. And what a dollar devaluation might mean for other asset classes.
Private domestic demand will be weak.
This means it will be on the Federal Reserve to recognize this and continue buying US Treasuries as a type of “perpetual quantitative easing”.
It’s either interest rates up – the Fed doesn’t buy this new supply of bonds fast enough – or you’ll see the Fed “print money” (bad for the USD) and put all those bonds on its balance sheet. Or monetize the debt directly.
At the same time, all the other developed markets have similar types of issues. So it’s not like the USD is necessarily less attractive relative to EUR or JPY, who are mostly in the same boat.
Moreover, the euro is a type of pegged currency given how it’s shared among different countries with dissimilar economic characteristics. That makes the currency too weak for some countries (e.g., Germany, giving it large surpluses) and too strong for others (e.g., Italy).
All those countries being tied together prevents changes in interest rates and currency movements in light of their own domestic economic conditions. (This is why we don’t have one international currency.)
And the liabilities faced in developed markets doesn’t include just the headline debt figure, which is the accumulation of net spending in excess of net revenue intake.
Over the coming years, due to aging demographics, non-debt obligations such as healthcare, pensions, and other unfunded liabilities will come increasingly due.
Depending on the discount rate used if these obligations were to be capitalized, they are over 10x the size of the headline debt figure, which is nearing $30 trillion in the US.
This will never get paid through tax revenue. There’s a limitation to how much money you take out of the economy and a limit to the extent to which the cons of raising taxes outweigh the benefits.
The following is now a dated chart, but it still conveys the general idea well.
The US Dollar’s Reserve Status
If the dollar’s reserve status is replaced, then the question is what is it getting replaced with?
China is an up-and-comer and its currency (the renminbi, also known as the yuan) will increase in global use as the country gets wealthier, but it’s a way off.
The euro and yen won’t take the mantle, being smaller versions of the same problems facing the US.
The US dollar is likely to depreciate relative to a hard reserve asset like gold, which has held this type of place in the global monetary system for thousands of years.
Because of the free-floating nature of today’s currencies we aren’t likely to get big “breaks” in currencies relative to gold. Like in 1933 and 1971 when the USD’s link with gold was abandoned.
These events are viewable in the graphic below tracking the past three top reserve currencies since the 1600s (i.e., Dutch guilder, British pound, and US dollar).
But over time, the US dollar is very likely to depreciate relative to the yellow metal. Gold is still the third-most held reserve among central banks globally, behind the dollar and euro.
Gold is basically the inverse of money, with its long-run price proportional to fiat reserves and currency in circulation relative to the global gold stock. The global gold stock tends to grow by only about 1-3 percent per year. Obligations coming due will be heavily in excess of that.
When gold is going up, it’s not that the metal’s utility is becoming greater. It’s essentially that the value of money is going down.
When there’s too much debt relative to income, the easiest and least controversial way to rectify this issue is through money creation.
Debt is a “short money” position. You have to cover debt with money eventually per the terms of the creditor-borrowing agreement.
Creating money is part of the “cure” to debt problems, along with debt restructurings and, to a lesser extent, austerity and wealth transfers from those who have it to those who don’t.
Gold is priced as a certain amount of money per ounce. So, when you increase the money in circulation, that tends to have a direct effect on the price.
Post-Covid, we saw stocks and gold correlate, both dependent on an influx of new liquidity to support its price.
This is not a recommendation to buy “a lot” of gold or an insinuation that its price will go up in the near future.
It’s a long-run expectation that gold has positive secular forces going in its favor. Having a small portion of one’s portfolio in gold can be a good idea, some 5-10 percent can be useful.
But the gold market also has its own set of drawbacks, such as the fact that it’s a relatively illiquid market.
There’s about only $3 trillion of gold above a certain level of purity, compared to equity markets of close to $100 trillion and credit markets that are over $300 trillion deep.
Gold lacks the capacity to accept large inflows of wealth from equity and credit markets. At the same time, if such a move were to transpire the market’s relative illiquidity could help move its price in a material way.
Gold is simply an alternative currency outside of traditional financial sources of wealth. It can be part of a balanced portfolio that is well-diversified among different asset classes, countries, and currencies.
We explained more about this process in the article on building a balanced portfolio.
Countries with better fiscal situations have an edge
Countries on better fiscal footing will have an edge, as well as those with interest rates somewhere above zero. (China, in particular, in terms of major markets still has some room above the zero bound.)
It also favors countries that have an easier time raising capital – either through external financing or from domestic savings. Like many things involving the stock market, in particular, perception of a country’s fiscal position may matter more than any metrics used to measure it.
Places that are heavily dependent on tourism were hit hard, though represent the biggest rebound candidates.
The economic mix of a country matters a lot.
A resort island is going to be hit harder than a country that has a greater mix of its business tied to the digital economy and less toward activities related to public gatherings.
That means countries that had the following characteristics:
– not as impacted by the virus
– less tied to tourism and more toward digital technology, and
– energy importers (i.e., consumers of natural resources abroad), not energy exporters…
…fared better than otherwise.
That helps describe South Korea’s and Taiwan’s outperformance with their benchmarks near the top of 2020 global rankings.
South Korea’s economy contracted about one percent in 2020 while Taiwan’s actually grew slightly. By contrast, the global economy shrunk by about four percent.
Both also have lower levels of public debt and room for fiscal expansion. Both countries’ central banks have accommodative policy in place.
Tourism doesn’t take up as much of their economies as some of their neighbors in the region.
Macro vs. Micro
The South Korea and Taiwan stories are convincing macroeconomically, but still don’t provide the complete picture.
2020 was also a year in which there was plenty of rotations among sectors and companies, giving wider than normal dispersion on a microeconomic level.
The South Korean KOSPI was up high single digits, whereas the tech-heavy version of its index, the KOSDAQ, was up around 30 percent.
You see this same pattern in the US as well, with the tech-heavy NASDAQ exceeding the performance of the more balanced S&P 500 and Dow Jones Industrial Average.
In Taiwan, semiconductors make up a big part of the country’s equity market performance. (A single semiconductor stock actually makes up about one-third of its market capitalization.) That’s a big influence in its outperformance.
Weightings of technology stocks may have something to do with the makeup of the overall economy, but also be overemphasized. Stock values are a function of discounted future value (e.g., see our analysis on Apple as an example). In other words, it’s heavily a reflection of investor preferences rather than actual economic performance.
So, in reality, it could actually be more of an interpretation of what an economy will look like many years out rather than the true composition of an economy today.
Perhaps the favoritism for certain sectors and companies is influenced by short-term preferences. And based on how discounting works, short-term performance is more influential in the calculation than short-term performance.
The graph below, based on a particular conception of company earning steady cash flows and a 10 percent discount rate, shows that half of such a company’s present value (i.e., its price) comes from its projections of the upcoming seven years. The other half of its present value comes in the remaining years.
But extrapolations can also be exaggerated.
In trading, markets tend to extrapolate what they’ve gotten used to even though the past is generally not a good guide to the future, especially when the underlying factors have changed.
The interest rate tailwind that heavily drove stock and bond returns from 1981 to 2020 is a good example. But when interest rates hit zero, the paradigm is likely to shift, given the traditional wind to the back of asset prices is gone.
Such common portfolio constructions, like the popular 60/40 stock and bond allocation, are not likely to fare as well going forward.
The US vs. China Wedge
The world’s two largest economies are at odds with each other in many ways. This is important for traders as standard correlations between markets are likely to change.
Correlation is likely to decrease, which can provide opportunity. Based on relative global economic output, US assets are probably over-owned in global portfolios while Chinese assets are under-owned.
As mentioned the USD is about 60 percent of global payments and asset denomination despite only about 20 percent of global activity now driven by the US.
In comparison, the CNY (RMB) is about two percent of global reserves yet China now accounts for about 15 percent of global output and a higher percentage of global year to year growth.
No matter who is in charge of foreign policy, the US will continue to have conflict with China. Negative attitudes toward China are largely bipartisan in the United States.
It is standard throughout history when one power comes up to challenge another power that it produces more conflict in a variety of different ways (trade, capital, economic, military, and geopolitical in most other ways).
It goes beyond just trade balances and more toward more deeply rooted issues such as:
- market competition
- market access
- cybersecurity and cyberespionage
- property rights
- intellectual property
- military power
- global spheres of influence
- bottom-up (i.e., individual-focused) economic system versus a top-down (i.e., what’s good for the individual is good for the whole) economic system
- among others
The dispute between the US and China is heavily over where and how each country will compete.
This is why matters such as having separate supply lines has come up in discussion in each country.
If and when tensions escalate, you can’t be too dependent on each other.
The US had such issues with Japan and Germany in the 1930s after the 1929 downturn before their conflict came to a head about a decade later in the late 1930s and early 1940s.
Will there be technological decoupling where neither country cooperates on building and using each other’s technology?
This could mean separate, bimodal developments in the types of leading technology going forward.
This will add global cost to the development of, for instance, 5G cellular networks, quantum computing, artificial intelligence (AI) chips, and information and data management.
China’s government is heavily involved in lending state support to companies that have the most strategic importance to the country as a whole.
The US, post-Covid, is also doing more of the same as the public sector necessarily needs to assist the private sector given traditional monetary policy’s ineffectiveness going forward. While some might not like the idea of greater government intervention for ideological reasons, it’s a type of practical evolution given the mix of circumstances.
For China, this has meant more state support toward newer digital technologies that will propel productivity improvements and less toward the indebted “old economy” sectors of the economy, such as manufacturing.
The export model grew their incomes. But in order to take the next step into a top global superpower, or the top global superpower, it will involve another type of focus.
As a result, China is shifting away from an export-based economic model toward one increasingly focused on domestic consumption and development of these newer technologies.
In the US, this process has been governed by the private sector.
But it’s also contributed toward greater social and political dispersions. When there’s a creation of new technology, it generally benefits some at the expense of others.
If a company can automate processes that were formerly taken up by low-wage labor, it’ll rationally want to do so. That increases margins, benefiting investors (and “capital” more broadly) and away from lower-skilled labor.
That drives greater disparities and wealth gaps, leading to more polarizing social and political outcomes.
It’s good for the society as a whole, but the results are unequal.
For example, Uber’s ride hailing service is great for those who want cheaper rides relative to more costly alternatives like taxes. But the business model is fundamentally based on labor and regulatory arbitrage that detracts from labor, on net, and adds to capital (i.e., the investors).
Naturally, the country that is the most technologically developed tends to be the more advanced in most other ways as well. This is true both economically and militarily.
The US-China conflict also branches into capital.
The US has relied heavily on China’s growth over the past few decades to help fund its deficits and keep borrowing costs low because of the way China buys up US Treasuries as a source of reserves.
But because of the rebalancings we discussed earlier in the article and the future long-run decline of the dollar’s value, China’s use of US Treasuries is likely to decline.
Moreover, when you have a lot of conflict with another country whose assets you own, that represents a risk. The US can unilaterally decide not to pay its debt to a certain counterparty should the conflict in its various forms become bad enough.
Cultural differences manifest in macroeconomic outcomes
Much of the underlying conflict between the two countries is a function of cultural differences.
The US has traditionally been a country that prized the role of the individual and individual rights.
People came to the US came from all over and were from different cultures and different systems. What was good for the individual has been viewed as good for the whole, a more “bottom-up” perspective.
In other words, it was viewed that this pursuit of self-interest pushed people to do the difficult things that benefit them and contribute to society.
Going back to the US’s establishment after breaking off from overseas monarchic rule, strong centralized power has been traditionally at odds with American values.
This has led to less of a role for central planning in the US relative to many other countries.
The US, for example, didn’t even have a central bank until 1913 after a series of “panics”, as they were then known back then, battered the economy due to a painful lack of public sector support. Great Britain and Sweden, as examples, had established their central banks 200-300 years before then.
But by and large, the US system of governing is more bottom-up in comparison to China, which rules heavily from the top-down.
In China, the family and broader state is held in the highest regard. What’s good for the whole is viewed as best for the individual.
With that said, China is no longer about traditional communism. In the west, there still remains a lot of preconceived notions over how exactly China is managed and what their system is.
Even though many outsiders still refer to China as “communist” and the central ruling coalition calls itself the Communist Party, it is not the type of central planning that characterized the Mao regime.
Under the Maoist system, China was heavily closed off from the rest of the world (i.e., a closed door policy, as it’s commonly called). There were no capital markets to speak of, resources were allocated very inefficiently, and poverty rates were over 85 percent.
There was little motivation to work hard as such rewards wouldn’t result in earning a higher keep to provide for a better lifestyle if one chose.
Much of China’s economy is indeed controlled by the state. That type of governing has the advantage of being able to take more control and make decisions quicker.
Some sectors are socialized and much of the rest is more or less market-based but with Chinese characteristics. There’s an emphasis on social cohesion and a type of neo-Confucian philosophy behind it.
There are pros and cons to each system of governing. There is no one “right way” and there’s a lot of gray and standard trade-offs that come with these choices.
But generally much of this conflict between China and the US arises from these disparities. It is nonetheless likely to continue to drive the countries more apart than together.
This is a big component of the 21st century geopolitical landscape and has implications for markets in terms of investments and the relative outcomes between the two.
Manifestations of these differences
As an example, we can see China investing heavily in computer chips as part of its efforts to cultivate homegrown talent and generate better technological self-sufficiency as it grapples with increased conflict abroad.
Chinese semiconductor companies are raising the equivalent of more than $40 billion per year through public offerings, private placements, and individual asset sales. In 2019, it was less than $20 billion.
On top of that, more than 50,000 Chinese companies have registered their businesses as related to chips and semiconductors in 2020, 4x the 2015 total.
A record number of Chinese firms are registering as chip companies
(Source: Tianyancha (number of companies); Chia Center for Information Industry Development (workers))
This also includes companies with otherwise tenuous relations to the chip industry. Many are originally (or still are largely or entirely) real estate developers, restaurants, constructions materials firms, and others.
Like many investment crazes that pop up, many start because of a genuine secular shift of investment flows into a particular industry undergoing expansion.
This was true with electric vehicles, solar energy, peer-to-peer (P2P) lending, and even well-established industries like real estate. But many of these trends became overly extrapolated, leading to irrational investment behavior, spending, and asset bubbles.
The start of the 2020s taught traders and investors many lessons, hopefully, about the importance of risk management, new types of risks that were underappreciated, new expectations in the monetary policy paradigm going forward, and the importance of not relying too much on the past to inform the future – at least to name a few.
For the “global macro” trader taking a top-down view, understanding that bottom-up investing is important to your portfolio’s performance.
Sector allocations matter inasmuch as regional and country-based allocation differences.
Even though Singapore and Thailand are two different parts of Asia with distinct economies, adding Singapore onto Thailand was a similar bet through the Covid-19 pandemic.
Adding cyclical Brazilian stocks probably wasn’t much different than adding US-based cruise operators and didn’t help build better diversification within an equities portfolio, in particular.
Investments that are 75 percent correlated aren’t of much diversification value after a certain point.
The basic idea is that seemingly different things might really be much of the same types of bets that already exist in a portfolio.
Economic factors are the primary drivers of markets. Politics matter to an extent as well, as it influences what types of decisions might be made.
Nonetheless, political influence on asset movements is notoriously hard to predict. You can get election outcomes correct but still have on the wrong type of bets.
But they aren’t always the primary driver of returns. Tech stocks running above more staid, value stocks from one country to another has been true going by indices that are thematically similar globally (e.g., NASDAQ “equivalents” country by country).
Top-down “global macro” traders can possibly learn more from their bottom-up counterparts.
This will become especially important as fiscal policy necessarily takes more of the reins from monetary policy with traditional monetary measures out of room.
Fiscal policy is more of a political decision that determines who gets the government’s backing and financial support and who doesn’t.
Who will get the money and who won’t get the money? How much money is coming into the country, how much money is leaving the country? And so on and so forth.
The secular shift from more globalized production – i.e., locating production where it’s cheapest – to greater self-sufficiency is another theme that is likely to create greater differentiation in markets.
Some of this driving force has to do with China’s ascent in global dominance relative to the US and developed Europe. Historically, whenever this happens, countries turn more inward and decide not to be as reliant on outsiders, especially those in which they have conflict with.