The economy continues to meander towards recovery, with financial markets doing likewise.  The consensus is that we are well past the crisis point and will gradually see more economic sunshine.  While we generally agree, there are a couple factors that are prompting us to keep a conservative posture.  In particular, we are concerned with China’s large trade surplus and the prospect of rising interest rates in the U.S.

There are only a couple instances in modern times of countries building trade surpluses of such outsized proportions as China currently has:  the United States in the 1920s and Japan in the 1980s.  The periods subsequent to these eras were extremely difficult, with both countries entering into lengthy depressions.  Will the same happen in China?  We do not know the answer to this question, but a look at history may help us understand the issues a bit more clearly.

For much of the latter 19th century and into the early 20th century, America spent heavily to build its infrastructure (railroads, steel plants, telephone networks, electricity grids, manufacturing plants, etc.), while also pioneering efficient mass-manufacturing techniques.  The U.S. became a global manufacturing powerhouse, especially after the Great War.  There was a huge population migration from farms into America’s burgeoning cities where manufacturing jobs were plentiful.  Consumer finance was going mainstream as manufactured goods such as refrigerators, automobiles and radios became more widely available and people borrowed to acquire them.  The stock market was also aided by America’s rising world dominance.  As U.S. stocks rose, people borrowed to buy those too.  The U.S. went into manufacturing and export overdrive and amassed a huge trade surplus.  These were heady times in America.

The crash of 1929 was not the cause of the depression, but merely the first step toward correcting the economic imbalance.  After 1929, jittery politicians were eager to protect the country’s leading position and protectionism reared its ugly head.  America had become very dependent on exports, and these politicians wanted to protect the large manufacturing base from foreign competition.  Despite widespread opposition from economists and business leaders, as well as threats from many of our trading partners, President Hoover allowed the Smoot-Hawley Tariff Act to pass in 1930.  The law raised tariffs on a broad spectrum of imported goods.  The retaliatory response by our trading partners caused trade to decline precipitously.  This kick-started the Great Depression from which we did not truly emerge until the start of the Second World War.

Fifty years later, Japan similarly built itself into a manufacturing powerhouse.  By the 1980s, it had moved beyond mere trinkets and dominated such industries as consumer electronics, steel and automobiles.  It, too, pioneered efficient manufacturing techniques.  Additionally, their supply chain was vertically integrated through a system of cross-ownership, known as the Keiretsu, which aligned their interests “as one.”  This was a not so subtle form of protectionism, effectively shutting out foreign suppliers.  Everyone rushed to study the Japanese “manufacturing miracle.”  Surplus trade capital flooded into the country, savings rose and, given its insular nature, a good part of that surplus was recycled back into the Japanese economy.  Real estate values soared, bolstered by the belief that the country’s finite land mass warranted high prices.  The Japanese equity market more than quintupled in value between 1982 and 1990.  Bank valuations rose dramatically as the worth of their cross-share holdings soared, and they lent heavily on real estate valued at exorbitant levels.  This was a classic asset price bubble.  The Keiretsu, initially a strength, eventually became a weakness as global demand fell during the 1990 recession.  This cross-ownership became a yoke from which escape was nearly impossible.  What grew “as one” now shrank “as one” and the pain was felt throughout the economy.  Banks’ equity was essentially wiped out.  They became known as the walking dead, unable to lend and unwilling to write off loans.  So began a long and painful price deflation process from which Japan has not yet fully emerged some twenty years later.  The Nikkei 225 Stock Index declined from its peak of nearly 39,000 Yen in 1990 to 11,000 Yen at quarter end – about the same level as it was in 1984.

The Chinese situation today bears many similarities with that of the U.S. in the 1920s and Japan in the 1980s.  Long a cheap manufacturer of simple consumer wares, China has grown at an astounding pace and now manufactures a broad range of sophisticated goods.  Early on, cheap labor, substituted for expensive capital, allowed them to undercut foreign competition, grow exports and build a trade surplus.  Like the U.S. and Japan before it, China is now a global manufacturing powerhouse.  As manufacturing complexity has risen and labor has become increasingly skilled, wages have also risen.  As wages have grown, so have the ranks of the middle class.  Demand for better housing, education, food, clothing, consumer electronics and cars has increased.  The government’s long range plan to move hundreds of millions of people from rural areas to newly expanded cities has been nothing short of astounding given their compressed time schedule for doing so.  This has required building an enormous manufacturing base for steel, aluminum, cement, wallboard, etc. to help supply the build-out of their cities, and the infrastructure to support their growing populations.  Excess capacity in these industries has spilled over into the export market and made them a force to be reckoned with.  Their stock market has recovered nicely from the 2008 lows, and urban real estate prices are strong.  Unlike the U.S. in the early 20th century, however, but similar to Japan, raw materials need to be imported.  This has created global fears of rising food and raw materials prices, as well as an increased vulnerability to shortages around the world as Chinese appetite seems to occasionally outstrip supply.  As we are now seeing with rising iron ore and steel prices, inflation within Chinese borders can spill out to other regions of the world and remains a concern for policy makers globally.

A key difference, however, is that unlike Japan and the U.S., China has chosen to peg its currency to that of its largest single trading partner, the U.S.  Here is where it gets interesting.  Typically when a country’s economy grows faster than those of its major trading partners, there is usually a commensurate rise in the value its currency, which acts as a natural dampener to excessive growth.  This has not happened with China and, as a result, it has amassed a huge trade surplus of Dollars and Euros, and its economic growth continues at a very high rate.  The rhetoric between the two countries is becoming increasingly less cordial.  The U.S. is contemplating declaring China a currency manipulator, which would bring severe trade sanctions with it.  If China does not relent, their course of action in the face of U.S. antagonism is unknowable.  What we believe is clear is that stepped up protectionist actions would be in no one’s best interest.  If, in fact, China does relent and upwardly revalues its currency, it may calm tensions but it may also cause their export engine to sputter due to the sudden rise in the cost of their exported goods.  As we have seen in the past, economies that depend on exports, when faced with recessions and protectionism, have not fared well despite having huge trade surpluses.  If China falters, we may see another flight to quality, making us believe it is prudent to selectively shorten duration.

In addition to the risks that the Chinese economy may stumble or that it may begin exporting inflation, we are concerned about the possibility of rising U.S. interest rates.  Short-term interest rates remain at very low levels and the yield curve is very steep (long-term interest rates are significantly higher than short-term rates).  Our major concern is when and by how much do rates move up?  Estimating the timing and magnitude of the move is tricky, but we feel that interest rate risk is increasing and could be the largest single impediment to investment grade bond performance near term.  Therefore, we continue to underweight Treasuries and longer dated investment grade bonds, which are more sensitive to moves in interest rates.

The recent wave of new bond issues is another factor prompting us to invest in short-term bonds.  As the high yield and equity markets grind higher, many companies have opportunistically refinanced their debt and pushed out their maturities at what they consider to be attractive terms.  To the extent that investors sell shorter maturity paper to fund purchases of newly issued, longer dated paper, we have begun selectively zigging as they zag, by buying one-year to three-year maturity bonds that other bond investors have been selling.  A shorter maturity profile should help insulate against a myriad of future events that may increase volatility.  Since we are able to invest in these shorter term bonds at only slightly less yield than their longer duration brethren, we believe this is the prudent course of action.  While the market may remain buoyant for some time as the economy recovers, we do not believe there is much opportunity cost at this time in taking a more conservative posture and waiting for the next good buying opportunity.  We thank you for your support.

 

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Past performance is no guarantee of future results.  This commentary contains the current opinions of the authors as of the date above which are subject to change at any time.  This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

 

The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. 

 

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