The Forest for the Tree
April was a month of significant volatility for the stock market. The volatility index (VIX) surged to the 50s at the beginning of the month, (which is more than double its average level), before returning to the mid-20s at the end of the month. On April 2nd, President Trump imposed reciprocal tariffs on all countries, and during each of the next two trading days, the S&P 500 stock index declined by 5%. Then, on April 9th, President Trump announced a 90-day pause on all reciprocal tariffs, except China. Investors interpreted this as a signal that the administration did not intend to start a trade war with the rest of the world, just a trade negotiation. The S&P 500 subsequently surged 9.5% in a single day! That’s what we call a “face ripping rally.” The average stock market return for a typical year was had in a single day. An investor who misses a move like that is left chasing returns the rest of the year…
The stock market remained volatile for the rest of the month, with daily movements of at least 1% up or down. Despite such huge daily moves, the market really didn’t move that much for the month of April. The S&P 500 was at 5,611 at the end of March and at 5,569 at the end of April. This type of price action is indicative of investor fear and of a market seeking direction.
The key issue investors are wrestling with at the moment is whether we are experiencing just a temporary dislocation of trade, which once resolved will allow us to return to another market rally mode, or we are undergoing a new structural economic change like the one following the Great Financial Crisis of 2008, which takes longer to resolve and is prone to sizeable market downturns. To find an answer to this key question, we need to look past the media dominating discussion topic of tariffs. Focusing on tariffs alone is the equivalent of missing the forest for the tree.
Tariffs are desperate attempts of countries to deal with their serious economic problems, like large debt loads or high unemployment levels. Countries try to pay their way out of debt or find work for their people by exploiting other countries, through well-known “beggar-thy-neighbor” trade practices of currency devaluation, import quotas, import tariffs, and other non-tariff trade barriers. The goal is always to limit imports from other countries while at the same time increasing domestic production and exports to other countries. The problem with such practices is that by allowing a country to continuously export its excess production to other countries, it is also exporting its economic problems to them. For example, If country A subsidizes domestic manufacturers to keep hiring workers to produce more than the country needs to consume, then it will have to export the excess production to country B, which will now have to produce less and suffer higher unemployment. Country A didn’t really solve its high unemployment problem. It simply exported it to country B. Obviously, this cannot be allowed to continue for long. To protect its own workforce, country B will impose trade barriers to country A, which could lead to retaliation from country A. Escalating retaliations and trade wars typically ensue. Tariffs therefore are not the main problem. They are only a tool to address serious economic problems, like the high debts and deficits in the West and high unemployment in the East. There are other tools to deal with such problems, like reducing deficit spending in the West and increasing domestic spending and consumption in the East, but these may be politically difficult to implement. Thus, the easier option is often to pass the problem to other countries.
The US after World War II was a net creditor and enjoyed a trade surplus with the rest of the world. To give a chance to other countries to rebuild their economies and production capabilities, the US allowed its trading partners to apply trade barriers to US-made goods while also artificially weakening their currencies against the US dollar to make their goods appear cheaper to US consumers. A quarter of a century later, the US was running both a trade deficit and a budget deficit (twin deficit problem). In other words, the US produced too little and consumed too much, while the rest of the world produced too much and consumed too little. This led to the 1971 closing of the “gold window” by President Nixon, which devalued the mighty dollar and made it a pure fiat currency. This helped rebalance world trade for a while, until China joined the rest of the world by engaging in international trade.
China had a problem finding work for some 500 million of its people, so they exploited the free trade arrangements by engaging in all possible unfair trade practices. Trade imbalances returned to the world economy with a vengeance. China produced mass quantities of everything it could possibly produce to achieve economies of scale (the more it produced, the lower the per unit cost), which made it possible to dump these low-cost products to the rest of the world. For the last three decades countries around the world enjoyed the cheaper Chinese-made goods, raising the standard of living of their people. China found work for its people and through trade surpluses enjoyed large capital inflows in the country. Unfortunately, China did not allow for these funds to be spent in China enriching its people and allowing them to consume more of their domestically produced goods as well as foreign made goods. Instead, China decided to keep recycling these capital flows back where they came from by purchasing other countries’ debt and equity securities. This way, China maintained a cheap currency and provided other countries more funds to keep buying more Chinese goods. This was a form of vendor financing but on a global scale.
It seems elementary that countries cannot keep borrowing and spending indefinitely. Deficits better give their way to surpluses at some point, because debts need to be repaid. Fast forward to today, the US has $36.5 Trillion debt, a $2 Trillion annual budget deficit, and around $1.5 Trillion trade deficit. The US is at the brink of insolvency (inability to service its debt) and must keep borrowing just to pay interest on the debt. We have written many times before in our newsletter about the explosive problem the US debt presents for the world economy. Meanwhile, the US manufacturing capacity has been hollowed out. Why produce anything domestically when it can be imported cheaper from China? Combined with a long list of environmental sensitivities and the US has shut down mines, power plants, steel mills, shipyards, and factories. The US has reached the point that it can barely put one war ship on the water annually, while the Chinese shipyards can produce one every month! Just a few weeks ago, the Department of Defense announced it received a proposal by Hyundai Heavy Industries to produce 5 destroyers annually for the US Navy to partially meet the Navy’s need of 12 new ships per year. South Korea, a country with only 51 million people, can produce 5-6 times the number of warships the US can produce per year. This points not only to the sad current condition of US industrial capabilities but also to a glaring national security threat, which needs to be addressed urgently.
The situation is possibly worse in Europe. The Ukraine-Russia war has exposed the magnitude of European de-industrialization. Former European superpowers like France, Germany, and United Kingdom seem unable to replenish the materials they provided as military aid to Ukraine. At one point last year, the French defense minister revealed that France was down to 3 days’ worth of ammunition. Worse, perhaps, the German defense minister admitted that about half of Germany’s heavy weaponry (tanks, planes, ships) were out of service due to lack of maintenance or parts. Apparently, seven decades of peace and prosperity in Europe have bred complacency and hubris.
Make no mistake however, this is not simply about national security. It is about the future allocation of employment, income, and prosperity around the world. After all, there is no strong military without a strong economy.
Back in the mid-1990s, former President Bill Clinton declared the US had progressed from the industrial age to the information age. Young Americans would need a college education to participate in the service sector of the economy. This may have sounded good at the time, but it was really misguided. Sure, why work in a steel mill or a factory when you can work in an office building? However, not every high school graduate has the desire or inclination for higher education. We need good employment opportunities for those choosing not to pursue college degrees. Moreover, it is unrealistic for everyone to be employed in the technology or service sector, as this is only the third sector of the economy that must be supported by the primary sector (agriculture and mining) and the secondary sector (manufacturing and construction). In other words, food, materials, tools, and structures are higher priorities than services. We need healthy primary and secondary sectors to have a strong economy. Try to imagine an economy where everyone is employed only as dentists, physical therapists, software developers, and bankers— There would be a lot of hungry, cold, and homeless people.
Even if President Bill Clinton was correct in the mid-1990s about future Americans working in the information age and making a living based on the knowledge from their extensive college education, today we have entered the age of artificial intelligence (AI). This changes everything. Even at this early AI stage (the assistant or bot stage) we all have a wealth of information for free on our cellphones and laptops. In the next 3 to 5 years, as the next AI stage evolves (the agent stage) we will have knowledge of every field, at a doctoral level, at our fingertips making inferences and decisions for us. Will it even make sense to pursue college education at that point? People could make a living in the information age, but they will not be able to make a living in the free information age. Advanced AI stages will significantly limit the number of lucrative service jobs from the information age. Where will future generations of Americans find good employment opportunities if we allow the de-industrialization to continue?
It should be obvious by now that this is not a simple tariff dispute to be resolved in a few short weeks. We believe this is more about the US asking the rest of the world to join a coalition that will limit their consumption of Chinese-made goods. This is an effort to limit over-production and over-employment in China and reallocate production and employment to the rest of the world. This is the type of long-term structural re-alignment of the world economy.
If you have any doubts about the China focus of the US policy, notice that several counties like Vietnam, Taiwan, South Korea, Thailand, Israel, Argentina, and even the European Union have responded to President Trump’s tariffs with offers to reduce their tariffs on US goods to 0%. President Trump has rejected these offers, seeking “more comprehensive” treaties. What do you think the term “more comprehensive” means? We believe it means that in order to get access to the US market, countries will have to agree to limit their purchases of Chinese-made goods. Will they agree to it?
For its part, Chinese President Xi Jinping has embarked on a campaign of “carrot and stick” to other countries, offering more favorable terms if they decline to participate in the US coalition, while threatening punitive measures if they do.
Will the US prevail in its quest to limit the Chinese production machine and bring production and jobs back to the rest of the world, or will China prevail and dominate the world economy?
We are reminded by the lyrics of a 1969 Rolling Stones song, “You can’t always get what you want, but if you try sometime…. you get what you need.” Probably none of the negotiating parties will get exactly what they want. The US will push hard to get what it needs for its national security and economic future. That is the re-shoring of heavy industry (steel production, shipbuilding, car production), high tech manufacturing (chip making, server making), and pharmaceutical production. These areas will be among the future investment opportunities to consider. Certainly, given the labor cost differentials between the US and China (US minimum wage is 4 times higher than the Chinese one) we should expect that re-shoring industries will rely heavily on the use of robotics in their facilities. Humanoid robots, robotic arms, sensors, and AI controlling software will be heavily involved in the re-industrialization effort of the West. Therefore, we expect the companies that produce these items to comprise the next Magnificent Group of stocks that will mint new fortunes.
How will we know if the US or China is prevailing in this contest?
We’ll need to see several key countries sign treaties with the US, then the rest will follow. We believe the first countries will be India, Japan, and then the European Union. If these countries sign, then Mexico, Australia, Canada will follow as well. While it may take years to re-industrialize the West, the treaties signed will provide the needed visibility for business executives to create their new supply chains. The sooner this happens, the greater the chance the stock market will move to a new bull phase. Alternatively, if it takes more than 2 to 3 months for such important treaties to be signed, it may become impossible for the US and the rest of the world to avoid an economic downturn, thus further market downside could be possible. The first quarter of US GDP is flat to negative, so without any meaningful progress in the trade negotiations, it will not be a stretch to see a second quarter of negative GDP growth, which is the definition of a recession. Pay attention to the size of countries that sign a trade deal with the US and how quickly they do so for your clues about the market direction and your risk-on or risk-off approach to your investments.
As always, we are here to answer your questions, offer you our insights, and assist you in your investment journey.
Stay Fierce!
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