The first quarter of 2018 marked the end of a long winning streak for stock markets around the world. Since the US election results in November 2016, the S&P 500 index had gained 32 percent and seemed nearly unstoppable. But the rally came to an abrupt end with a 0.8 percent loss in the first quarter. The Dow also retreated, losing 2 percent and breaking a run of nine consecutive winning quarters. Only the tech-laden NASDAQ turned in a modest gain, rising 2.3 percent. International issues were mixed, with developed economies losing and emerging market advancing about 1.5 percent each.
Meanwhile, bonds also lost value across the board, as interest rates ticked higher and the Fed continued its steady march toward normalization.
The story of 2017 was straightforward: risk on. Despite numerous geopolitical threats from abroad and abundant chaos domestically, investors shrugged their shoulders and plowed straight ahead. A generally improving economy and consistent job creation certainly provided support, but many observers credit much of the gain to one principal factor: the promise of a major reworking of the tax structure. President Trump signed the measure just before Christmas 2017. Buy the rumor, sell the news.
In the hard light of day, the promise far exceeded the reality. As we discussed last quarter, the Tax Cuts and Jobs Act was badly flawed and is likely to have little real impact on economic growth over its 10 year span. Investors instead began to focus on the negative implications of another $2 trillion in debt.
Another leading factor in the market’s heightened volatility of late is the growing realization that the President intends to make good on his threats to impose punitive tariffs. While some temporary exemptions have been granted, several imposts have been announced against many of our trading partners, and the inevitable retaliation has already begun. The biggest risk to the markets at this point is a trade war, the prospect of which was hardly diminished when the President declared that “trade wars are good, and easy to win”. Markets have a habit of shrugging off background noise, but the notion that a US president might deliberately crash the long-established and hard-won network of mutually beneficial trading relationships rattled a lot of cages. Volatility, so quiescent during the prior year, reignited with the growing fear of that such a mistake might be repeated despite the lessons of history.
Among economists, few issues are as undisputed as the benefit, economic and geopolitical, of robust global trade. So it is evident that a simplistic and jingoistic view of a trade deficit could lead to a premature end to the economic expansion currently underway.
There is a widespread misapprehension regarding trade deficits and their potential impact. A trade deficit occurs when a nation imports more than it exports, as has been the case with the US vis-a-vis China since 1985. The monthly imbalance is presently running a bit over $30 billion per month, or a total of $375 billion in 2017. Many people, including the President, believe this sustained deficit poses an imminent risk to the US economy and is responsible for the movement of jobs from the US to China. The reality is somewhat more nuanced.
Trade deficits are generally indicative of wealth. A wealthy, mature nation like the US naturally consumes more goods and services as a percentage of GDP (fully two thirds of the US economy is accounted for by consumption spending). Americans wish to buy more of what the Chinese are selling than the Chinese desire (or are able) to procure from us. The situation is not dissimilar to the relationship most of us experience with Amazon: we send them money in exchange for products and services we desire. We each run large and increasing trade deficits with Amazon, limited only by our ability to purchase and consume more of the goods we demand, presumably in relation to our own increase in disposable income over time. Yet we do not generally rail against the perceived injustice of Amazon selling more to us than we sell to them.
The imbalance in imports and exports shows up in what is called the balance of payments accounts. This is a toting up of all capital flows into and out of the US. The trade deficit is reported on one side of the ledger as the biggest component of the “current account deficit”. The current account is defined as difference between total domestic investment and total national savings. Investment in productive assets like factories, apartment buildings, railroads and trucks, and so on must be financed by national savings amassed by individuals and the US government. If savings are insufficient to pay for investment, the difference must be made up by importing foreign capital. This difference, investment minus saving, is the current account deficit.
It should come as no surprise that the government is not a very good saver. In fact, since 1969, the US has managed a budget surplus (positive saving) only 5 times. The shortfall is projected to exceed $700 billion in 2018 and over $1 trillion next year. Private households and businesses still have positive (but declining) saving, but the gap between private saving and government borrowing is widening thanks to accelerating government budget shortfalls. This inadequacy of net saving relative to investment is the driving force behind the increase in the current account deficit.
What is the link between the savings shortfall and the trade deficit? Consider the following. A saving shortfall means that we are spending more than we set aside. Inevitably, this higher level of consumption requires that more goods and services must be imported to satisfy the demand. Hence the trade deficit which is reflected on the books of the US as a shortfall in the current account.
As in all accounting, debits must equal credits, and so an offsetting transaction to the current account deficit must be reflected in the so-called “financial account”. This is the total of net foreign investment flows into the United States from abroad. These inflows find their way into US assets like businesses, real estate, equity securities and other direct investments. One important class of foreign investment is the purchase of US Government bonds. Roughly $6.3 trillion are owned by foreign investors, with China holding $1.2 trillion.
In other words, a sustained trade deficit must be offset by some combination of selling American assets to foreigners (accepting foreign investments in the US) or borrowing from other countries (selling Treasury bonds). This is the real risk of expanding trade deficits: inadequate saving and excess consumption ultimately requires borrowing from other countries and can reach a tipping point beyond which the economy can no longer grow.
And guess who the world’s biggest borrower is. With a total national debt of $21 trillion and annual budget deficit likely to top $2.4 trillion by 2028, the US is issuing Treasury securities at a breakneck pace to cover excess spending. Already bounding out of control, the debt outlook only worsened in recent months thanks to the tax cuts, budget resolution and current year spending bill. Projections now call for debt to exceed $33 trillion in 10 years, a totally unsustainable burden that would exceed 113 percent of total US GDP. Our current debt is around 80 percent of GDP.
This concept is widely understood by economists and at least broadly accepted by most reasonable politicians. But the current administration lacks this understanding, and appears determined to implement a destructive policy of punitive trade sanctions that promise to slow the global economy, reduce the income of workers, destroy jobs in the US and curtail one of the longest bull markets on record. The greatest threat to investors at present is the specter of a trade war. There are clearly notable examples of unfair trade practices, currency manipulation and theft of intellectual property, and these issues should be vigorously addressed. But it is undeniable that the global playing field is more level than at any time in world history, and that the persistent US trade deficit is not primarily the result of “bad deals” but rather the artifact of excess consumption and massive government budget deficits.
Christopher A. Hopkins, CFA
© 2017 Barnett & Company