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A “Once In A Generation” Shift

Today’s relentless bull market in everything rests partly on two pillars:

1) Thanks to big data, artificial intelligence and globalization, firms can optimize just-in-time production chains and minimize inventories. To maximize return-on-invested-capital and profits, they are encouraged to shrink their balance sheets, increase debt and reduce equity.

2) Because the world has so much overcapacity, there is no risk of system-wide inflation. As such, central banks can continue printing money willy-nilly, thereby boosting asset prices.

Independently, these two notions make sense. But they do not add up when taken together or viewed over any sustained period of time. If the premise of #1 is that firms use big data and smart management to “right-size” their production, how does the #2 idea of “constant overcapacity” and depressed prices make sense? Such apparent dissonance assumes that half the world’s firms are getting smarter—right-sizing their balance sheets and optimizing production—while the rest are as dumb as ever by adding capacity at the wrong point of the business cycle (for others to exploit) and investing with scant regard for future returns.

In recent years, a number of US clients have made this point to us. Why, they say, bother investing in Asia, where companies are often run by knuckle-headed management teams that over-invest in the hope of building an empire. The alternative is to invest in the US, where corporate managements aim to right-size the business and maximize profits.

We are sympathetic to this view, for it was pretty much the thesis of our first Gavekal book, Our Brave New World (downloadable for free). However, in recent months we have started to wonder if this framework is now breaking down (see A Brave New New World and The Questions For The Coming Year). For those who are interested in the underpinnings of this work it may be worth reading the first ever Gavekal paper (see Theoretical Framework For The Analysis Of A Deflationary Boom). For anyone who has to manage a portfolio, the significance of this (potential) macro shift could end up being enormous.

Why we are getting uncomfortable: the theory

Since our default position over the years has been to downplay risks emanating from China, we have been variously labelled China permabulls or even apologists (see A Happy Apologist). Now, given that the last two bouts of synchronized global growth (2009-2010 and 2016-17) were first and foremost engineered by Chinese stimulus and rebounds in Chinese domestic growth, this position has so far served us decently well.

And behind our almost constant bullishness on Chinese growth has sat a simple premise, first brought to our attention by Charlie Munger; namely, “show me the incentives, and I’ll tell you the outcome”. Indeed, throughout both our careers, the incentives facing the typical Chinese Communist Party cadre were simple: “Generate high growth in your province/county/district/town and you too can aspire to climb the CCP’s greasy pole. In fact, generate enough growth in different jobs and one day you may say goodbye to the boonies and make your way back to Beijing”.

Given these incentives (and having spent time in the Chinese countryside ourselves, we fully understand the urge to “move on” to the next job!), our default assumption has been that China could always be counted on to generate growth. Local building permits would be approved, as would plans for new factories, oil wells, steel mills or coal mines.

But did things recently change? At the 19th Party Congress in October, Xi Jinping made it clear that henceforth Party officials would not be judged on growth alone (see The Reconstruction Of The Administrative State, or The New Era Of Chinese Socialism). Pollution control would be a factor as would healthcare, education and the general population’s housing conditions (see The Rental Housing Solution).

Now imagine being, say the mayor of Wuhan, or the governor of Anhui province and having just received your marching orders from Xi Jinping himself in the Great Hall of the People. Do you:

a) Go home and assume that Xi didn’t mean what he said, and keep going as you did before.

b) Go home and tell your local power producers “no more coal, just burn gas and tell your local steel mill “you are shut down” and your local property developer “I’ll give you this permit, but you first need to increase production of social housing”.

If you have made it this high in the party hierarchy and survived Xi’s purge, it’s probably safe to assume that you have a disposition towards not questioning authority and an inclination to obey orders. Thus, option b seems most likely. And sure enough, as the delegates to the CCP Congress started to head home, the first thing we witnessed was a rapid doubling of natural gas prices, while steel output rolled over.


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In the same period, output from the highly polluting cement industry also rolled over into negative annual growth. The really interesting thing is that this shift in output occurred despite cement prices having shot up.


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So is this a case of “show me the (new) incentives, and I’ll tell you the (different) outcome”?

For years, the incentive structure in China almost guaranteed overcapacity in pretty much everything. Then China would export this overcapacity, earn US dollars and re-invest the dollars into treasuries and so keep US (and global) interest rates low. More than a decade ago we dubbed this a “circle of manipulation” but is the characterization still apt? For starters, China is clearly no longer keen to re-invest excess dollars into treasuries, but is instead trying to make the renminbi a trade and reserve currency (see The Most Important Change And Its Natural Hedge).

And for seconds, it seems that the incentive structure in China may be shifting, so that too much output does not automatically get produced. Take the above example of cement. The rising price should have led to higher production (more demand triggering a supply response). Yet, in a clear break from previous historical precedents, China’s cement production is not responding to the signal of higher prices. 

Why we are getting uncomfortable: the practice

Baseball sage Yogi Berra once said “In theory, there is no difference between theory and practice. But in practice, there is.”  With this in mind, the following makes us uncomfortable “in practice”.

The first is that as oil prices spike higher, the likes of Japan, Korea and China (all big oil importers) are generating impressive equity performance. It is unusual, if not unprecedented, for these three markets to rise in unison. What characterizes China, Japan and Korea is that they have been the ones who have generally piled on extra capacity, regardless of that capacity’s return. Put another way, these three countries account for the apparent contradiction reviewed in our introduction lasting for so long.

Yet, we also know that China has in recent years embarked on “supply-side reform” (in China, this actually means supplying less rather than a Thatcherite reduction in government meddling!), Japanese corporates have become marginally more efficient capital allocators, and the Korean won has appreciated such that its competitiveness must be questioned.


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So let’s imagine that China (supply-side reforms and changed incentive structure), Korea (overvalued won) and Japan (finally looking out for shareholders) are no longer adding capacity hand over fist. Hence, if north east Asia isn’t adding capacity, who is? It isn’t the US, where corporates are busy buying back their shares, while private equity and venture capital firms scramble to fund the next “overcapacity-optimization” platform (Uber, Lyft, Airbnb…). It isn’t Europe either, where until recently, investment trends were rather pedestrian. So if the conclusion is that no-one is adding productive capacity, what should we expect?

A turn in the outlook for northeast Asia

The first obvious consequence would be a rise in producer price inflation. Interestingly enough, this seems to be unfolding—at the very least, China, Japan and Korea have all stopped exporting deflation.


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Another potential consequence is that the guys who for years added excess capacity and reaped few rewards for their efforts, all of a sudden receive outsized returns as the capacity they do own gets bid up. Funnily enough, 2017 was the year when Chinese, Korean and Japanese equity markets all decisively “broke out” from long established trading ranges.


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Perhaps we would be willing to discard all of the above as sheer noise if it wasn’t for one uncomfortable recent development, namely the growing dichotomy between a falling US dollar and rising treasury yields. Doesn’t this tell us that something doesn’t “smell right”? Rising yields and falling exchange rates are usually more the hallmarks of fragile emerging markets than the issuer of the world’s reserve currency.

The specter of inflation, and why inflation matters

Our more faithful (or older) readers will remember the diagram below, which Charles first published in 1978 during his Cecogest days.

Back then the prices of the marbles Louis used to play with at school were rising rapidly and the aim of every economist was to figure out whether the coming year would bring an “inflationary boom”, or an “inflationary bust”. Yet the shift that ended up mattering for the next 30 years was not that from the left of the diagram to the right (these shifts tend to occur every five to seven years), but the move from the top of the diagram to the bottom (these seem to occur every 30 to 50 years).

These shifts from left to right (bust to boom) and from top to bottom (inflation to deflation) are illustrated in the chart below:


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  • The red periods represent “disinflationary busts”, or phases of falling growth and falling inflation. These were bad times for equity investors and horrible for commodity investors.
     
  • The green bands represent “disinflationary booms”, or periods of rising growth and falling inflation. These were great times for equity investors, especially growth investors, although bonds also did well. In such an environment, the best risk-adjusted returns often came from portfolios half in long-dated bonds and half in aggressive growth stocks.
     
  • The yellow bands represent “inflationary boom” periods, or times of rising growth and inflation. At such times, the best place to be was usually value stocks, commodities and emerging markets.
     
  • The blue bands represent “inflationary bust” periods, or phases of rising inflation and falling growth. At such times, investors should have taken refuge in gold, or in the cash of countries running large current account surpluses and/or large fiscal surpluses.

As mentioned above, the past 30 years have basically been spent in red and green territory; either disinflationary booms or disinflationary busts. Yet for much of 1960-87 there was rising inflation (yellow and blue in the chart). Hence, a key question for investors is whether the disinflationary boom environment suffers from a collapse in growth (a move from green to red) or a pick-up in inflation (a move from green to yellow).

In the upper half of the diagram, asset classes behave very differently than in the bottom half of the diagram. For a start, inflation tends to be a slayer of multiples. The higher the inflation rate, the lower the market’s price/earnings ratio.


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The weight of inflation on equity valuations probably explains the legendary 1979 BusinessWeek cover on “The death of equities”. For, to be fair, equities over the previous 15 years, with dividends re-invested, had returned less than compounding cash (see the first chart below). Though at least, that was better than bonds. This situation  would be turned on its head in the following decades as inflation made way for disinflation (see the second chart below). In a disinflationary world, such as that of the last four decades, bonds and other fixed income instruments offer the natural hedge for equities. But it an inflationary environment, cushioning equity risk with fixed income does not work. Instead, the hedge becomes cash, or gold. Thus, readers who, like us, are starting to fret that the risk to the current disinflationary boom is not yet another deflationary bust, but instead a Lazarus-like revival of inflation, will need to start reviewing their entire portfolio construction process.


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The portfolio construction process

We tend to think of “well-built” portfolios as being divided between three baskets:

  • A structural growth basket comprising “growth stocks” such as technology, healthcare, consumer staples and consumer discretionary. These “long duration” assets tend to fare best in deflationary booms, when interest rates and oil prices are falling and the US dollar is strong. In “structural growth” periods US equities tend to outperform.
     
  • A cyclical growth basket made up of financials, materials, energy and industrials. It tends to outperform in the latter part of the cycle, when interest rates and oil prices creep up, and the US dollar heads south.
     
  • A defensive basket. All good things come to an end. As interest rates and oil prices rise and the dollar falls, growth expectations are generally downgraded (the system moves into a disinflationary bust), or inflation picks up (an inflationary boom unfolds and finally an inflationary bust). Hence the question confronting investors today is what “defensive basket” should they use to cushion their “cyclical growth basket”?

Investors who fear that the currently falling US dollar will break the back of the nascent European recovery (say, by pushing Italy back into recession), will tend to favor the dark blue “defensive basket #1” as a cushion against their current “cyclical basket”. Meanwhile, investors who fear that the recent pick-up in inflation is the start of a new trend, and who fear that oil prices will continue to rise until high energy costs break the back of the current recovery, may favor the pink “defensive basket #2”. So which to pick? And when should the shift from “cyclical growth” to “defensive basket #1” or “defensive basket #2” occur?

The answer to these questions may partly be provided by the markets themselves, specifically by the relative performance of gold to long-dated treasuries. Indeed, in a “disinflationary boom”, bonds would be expected to outperform gold (and so investors would continue to benefit from diversification). However, indications of a looming “inflationary boom” or “inflationary bust” would be flagged by bonds underperforming gold.

With that in mind, we seem to be approaching an important crossroads as the gold/bond ratio is hovering very close to its four-year moving average. And historically, the ratio has tended to be rather “trending”, meaning that after it broke through the four-year moving average it has tended to stay there for quite a while. Most importantly, these periods have tended to coincide with our inflationary/deflationary boom/bust framework described above.


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In short, we are on the threshold of a change-of-state, but have not moved across it. For now, our indicators still point towards a continuing deflationary boom. But given the proximity of the gold/bond ratio to its four-year moving average, it makes sense for investors to consider a “different” type of defensive basket from the one that has been commonly deployed for the last 30 or so years.


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Conclusion

All prices are “equal” and all prices carry important information. Nonetheless, like the animals in George Orwell’s Animal Farm, some prices are more equal than others. Specifically, changes in oil prices, or US interest rates, and changes in the value of the US dollar tend to cast a long shadow.

A couple of years ago oil was tanking, US interest rates were on the floor and the dollar was surging. Fast forward to 2018 and this situation has fully reversed: oil prices and US interest rates are both rising while the dollar is weakening. Clearly, the investment landscape has changed and, at the very least, a shift in the relative performance of sectors, markets, and asset classes should be expected? Any student of the markets know that rising interest rates and oil prices will, over time, suck the fun out of any equity bull market. The only question is how long this takes. With that in mind, what should investors fear most today?

  • A higher oil price, which breaks the back of the current economic expansion (see The Drains On Liquidity).
     
  • A rise in interest rates, which saps the market’s animal spirits.
     
  • A fall in the US dollar, which would push the weaker economies in the system (Italy, South Korea, China) into an unexpected growth slowdown.

For now, it still seems too early to worry about these concerns. At least, that is the message provided by our internal country-risk monitoring system Track-Macro (available to download on www.gavekal-intelligence-software.com). See the diagram below.

Nonetheless, we do note that the air seems to be coming out of the crypto-currency speculative bubble, the world’s “safe-harbor” currencies (yen and Swiss franc) have been bid up and gold and gold miners have stopped underperforming. To be sure, this does not validate a full-blown change in the investment environment and abandonment of the “cyclical growth” basket. But it may be time to start building a “defensive basket” and more importantly to think hard about the key risk that one is seeking to hedge: rising inflation, or falling growth?

10 Comments

  • >Anonymous

    Anonymous

    24/01/18

    Is Asia really the only source of deflation? Or does balance sheet shrinkage because of technological change in fact lead to deflation? Imagine you own two wig it factories working at full capacity. Sales demand rises at 5% per annum, but technology allows you to produce with 6% fewer assets and people every year. You will face deflation even if no one is adding capacity. Also, Chinese producer prices were increasing from 2004-2012. Is this consistent with Asia being the major source of deflation? Thank you.

    Reply
    • On the last point, the increase in Chinese PPI is almost entirely a function of upstream commodity sectors - coal, ore, metals and minerals - of which the vast majority was consumed by domestic demand. The  capital goods and manufactured items which flowed to the rest of the world tended to experience very low or negative sector PPI throughout this period.

      Reply
    • Dear Sir

      thanks for participating in our reader forum.

      No doubt: there have been several deflationary forces unfolding around the world. China was one of them. The ageing of Western populations another (see my colleague Will Denyer's excellent work on demographics for more on this). And of course technology is a third one. 

      I wrote about all these various trends in my books, whether Our Brave New World (published in 2005), a Roadmap for Troubling Times (published in 2009) and most recently Too Different For Comfort (published in 2013). All these books can be downloaded for free from the book section of our website.

      For all these reasons (and others besides), we as a shop have been structural deflationists. in fact, the very first piece we wrote back in 1998 was entitled 'Theoretical Framework for the Analysis of a Deflationary Boom'.

      The reality of course is that capitalism is a deflationary force. the whole point is to produce more stuff at a cheaper cost than the next guy.  

      But having said all this, and using your example of the factory above: production in any factory can definetly be optimized and improved. But once that it is done, then if you want to produce more, you need a new factory.

      And this is why we have been somewhat uncomfortable in recent months: at heart, we remain deflationists. But increasingly, anecdotal evidence seems to be pointing to the fact that the little investment that was made in the past decade were investments to 'optimize' the existing production base rather than add to the existing production base. But what if we have now reached the point where our existing production base is ALREADY optimized (very high margins along with very high valuation on the existing asset base would tend to suggest that?) and there is not much left to optimize?

      Then logically, performance should drift away from the guys allowing you to optimize production (tech?) towards the guys actually owning the production base (Asia?).

      Is this not what we are starting to see in the markets?

      Best

      Louis

      Reply
  • >Anonymous

    Anonymous

    24/01/18

    Thank you for this excellent framework for thinking about asset allocation. Indeed I agree that deflation has been coming mainly from Asia: Japan first, then the Asian tigers and finally China attracted capital and channeled it into investments (most other EM channelled funds into consumption or bribery). This leads to a different type of crisis: when a country that has borrowed to consume suffers a sudden stop in financing, it has to curtail consumption and most of the "suffering" stays in this country (Argentina, Brazil, Greece). If the sudded stop hits a country that has overinvested, the currency devaluation makes the products of this country competitive vs RoW and the "suffering" spreads all over (certainly to the direct competitors), spreading deflation. I might possibly be too optmistic, but maybe we are currently in a "positive" transition period, when overinvestment is reduced (stopping deflation) without yet pushing inflation too high. Eventually we shall move to a full fledged inflationary situation, but it might take a few years (in the meantime this will be negative for risk-free bonds, neutral for spread fixed income and positive for equities)

    Reply
    • >akaletsky

      akaletsky

      25/01/18

      In addition to all these structural, supply-side factors very convincingly described by Charles and Louis, there is another reason to believe that the world is moving from a deflationary to an inflationary long-term trend. This is the reversal of central bank philosophy that has occurred all over the world. I am personally very persuaded by Charles and Louis arguments, but most traditionally-trained economists (and bond investors, many of whom were recruited from central banks or the IMF) deny that inflation is influenced in the long-term by structural supply side factors. Instead they follow Milton Friedman's dictum that "inflation is always and everywhere a monetary phenomenon". For these faithful monetarists, the outlook for inflation should be even more disturbing than Charles and Louis suggest. This is why I have been emphasizing the reversal of central bank philosophy in my meetings with clients and Gavekal articles in the past few years. 

      From 1980 untll 2009, central bankers all over the world, from Paul Volcker downwards, reacted to the inflationary crisis of the 1970s by dedicating themselves to killing inflation and making sure that it would never again rise into double digits or anywhere near that. To do this they kept policy rates far above the rate of inflation (on average by about 3 percentage points) except for brief periods during recessions.

      In 2009 the purpose of central banking did not just change - it completely reversed. The purpose of monetary policy became reviving nominal GDP growth (both inflstion and real eocnomic activity) and making sure that it would never again fall below 3 per cent or anywhere near that. This was a perfectly rational response to the deflationary banking crisis of 2007-09.

      As a result, policy rates have been kept far below the rate of inflation and are unlikely to become significantly positive in real terms, except in brief periods when inflation appears to be accelerating out of control.

      In other words, monetary policy will probably remain consistently behind the curve of rising inflation, just as interest rates remained consistently behind the  curve of falling inflation for the 30 years after 1980 . This will not be because central bankers are stupid or incompetent or afraid of political pressure (even if all these things happen to be true). It will be mainly because the job descritpion of central bankers is now completely different - in fact opposite - to the job description of central bankers from 1980 to 2009. 

      So if you are an investor who believes in traditional monetarist theory, you should be a long-term bond bear, regardless of whether you fully share the concerns about structural supply-side concerns that Charles and Louis have laid out. 

      Reply
  • >Anonymous

    Anonymous

    25/01/18

    Dear Anatole, Charles and Louis,

    I am guessing that this topic was not an ad hoc debate over coffee, but rather a lengthy set of discussions and email chains.  You laid out two very plausible and convincing arguments for inflation and a shift from a deflationary environment to an inflationary one, as you say “once in a generation”.  I’m assuming you all played devils advoate.   What are the scenarios or set of circumstances that made the top of the list where your projections and assessments might be wrong?  I tend to agree with your assessment and you can see the rotation in “finite capacity” value stocks already.  Was just curious your thoughts or concerns about why this shift might not pan out?

    Regards, Jeff  

    Reply
  • >Anonymous

    Anonymous

    25/01/18

    Excellent points in this article. The inflationary boom/bust period in the chart was before my time so I'd be interested to get a perspective on globalization's effect on disinflation during the inflationary/disinflationary cycles. Theoretically, globalization and free trade should have kept a lid on prices by shifting production to the lowest cost producer. This notion would seem to jive with "overcapacity-optimisation" theme that Louis presented where developed economies farmed out work to maximize capacity and where developing economies built capacity to take in the work.

    With the US now pursuing protectionist and anti-free trade policies (but to which extent still remains to be seen), the impact on trade could also be another catalyst for inflation.

    Reply
  • >Anonymous

    Anonymous

    25/01/18

    Essential to be readed in those times. Thanks for this piece!

    Reply
  • >Anonymous

    Anonymous

    16/03/18

    ​Reading this post I noticed that your four quadrant model shown here has remained in a disinflationary environment since 1990 whilst previous illustrations of your four quadrant model has shown infaltionary periods around 2000,2005 and 2014. Have you changed the methodolgy with which you use to build the quadrant model?

    Reply
    • Dear Sir,

      We have fine tuned this chart over the years... Which previous chart are you referring to? So that i can compare and contrast?

      Best

      Louis

      Reply