In past letters we have written about a coming trade war with our economic partners and how we plan to deal with it. In this letter we will write about some of the problems the United States is facing in trade and how we think they might be solved. We will also give you some details about a new stock we bought called Banco Macro.
It has been our view for the last 10 years that we will get into an economic trade war with the world. We think that trade war is here and it’s going to last awhile. The primary target of that trade war will be China. We want to show you in graphical form one problem the U.S. is facing.
The chart above depicts our trade deficit with the world excluding industrial materials (this index excludes oil). The United States is running the world’s largest trade deficit ever in industrial goods. To try to fix this problem the Trump administration placed a 25% tariff on $50 billion of Chinese imports. Trump is considering an additional 10% tariff on another $200 billion of Chinese imports ($250 billion total). Currently the United States only exports $133 billion to China while importing $521 billion. This trade deficit of $388 billion is what Trump is upset about. If Trump decides to place a tariff on another $200 billion of imports from China, it will be interesting to see what China does. China only imports $133 billion from the U.S., which means China can’t match Trump dollar for dollar on tariffs. Something will have to give.
It has been our position (and still is) that THIS trade war will be inflationary and not deflationary. Most economists disagree with us on this issue. They site the passage of the Smoot-Hawley bill in 1930 as proof of what happens economically in a trade war. That bill restricted trade using tariffs. Those tariffs are blamed for causing the depression. We agree that the Smoot-Hawley bill helped accelerate the depression but it’s more complicated than that. We like to remind those same economists that Richard Nixon and Paul Volker placed a 10% tariff on ALL imports (not just Chinese) coming into the U.S. in August of 1971. That trade war was the beginning of a 10-year run of inflation, not deflation.
How can you have two similar economic actions but dramatically different results? The answer is that focusing on just one variable (trade) is too simplistic. Here are a few of the questions that need to be answered to compare the two periods.
• Was the Fed printing money or restricting money?
• Was the banking system extending credit or calling in loans?
• Was the collateral banks held increasing in value or decreasing?
• Was the country starting the trade war a net creditor in trade or debtor?
• Was the world on the gold standard?
• Did the country that has a trade surplus get it by suppressing the consumption of its citizens?
We won’t elaborate on all these points. However, we will review the responsibilities of being a creditor nation on the gold standard during the Great Depression.
In 1930 the United States was on the gold standard (we are not now). This meant that every dollar issued by the government had to be backed by a certain amount of gold. Going into the crash of 1929 most countries were on the gold standard. The United States ran a huge trade surplus with the world (similar to what China is running today). It has been estimated that the United States and France in 1930 controlled over 60% of the worlds gold supply. They got most of that gold by running large trade surpluses with the rest of the world. Most of that gold was in the U.S. When the United States decided to restrict trade using the Smoot-Hawley bill, it also restricted the world’s ability to get access to gold to pay back their debts. The Smoot-Hawley trade war made it very difficult for debtors to get gold through trade to pay their creditors back. Today we don’t have that situation.
If we were in a similar situation with China today, the Chinese would have the ability to demand we pay them back in gold or some asset that our federal reserve can’t print. They can’t do that. Hence the U.S. could at any moment as a debtor country simply print $2 trillion and give it to the Chinese. In 1930 debtor countries could not print gold so it restricted their ability to create inflation. Today we don’t see that restriction. This is a big difference in why we think this trade war is more like 1971 that 1930.
The Chinese aren’t stupid. They are aware the U.S. could just print dollars to settle our debts. Accepting those dollars from the United States isn’t as great a deal as it was in the previous 20 years. Lately, China has been trying to buy our companies with their trade surplus rather than invest it in our treasury bonds. The problem with that idea is this administration will not allow them to buy out American companies. The Trump administration at every turn is blocking Chinese acquisitions of U.S. companies. The Chinese can buy our bonds but not our companies.
To make matters worse for the Chinese, in 2018, our Congress decided to cut taxes and increase spending. Those actions will cause the U.S. to run the largest peacetime budget deficit in modern history (around 6%). We are not only restricting what the Chinese can do with their U.S. dollars; we are making them less valuable by creating another trillion-dollar budget deficit.
At some point in this trade war China will have some tough decisions to make. We don’t think three years from now China will have a $400 billion surplus in trade with the U.S. How will China replace that lost income? There are no other countries willing or able to replace the U.S. as a net trade debtor. Therefor, China will have to replace that lost demand by printing more money in China to stimulate their GDP. Its citizens’ consumption as a percentage of GDP has dropped from 50% a decade ago to around 35% today. In the U.S. it is around 70%. That will have to change. If you can’t sell to the U.S., you must sell to your citizens.
Make no mistake about it, the game of world trade won’t be the same after this is over: new rules, new winners and new losers. We have placed our bets on who some of the winners will be. We think inflation will increase and stocks will do better than cash. If China decides to sell its U.S. treasuries it will cause rates in the U.S. to go up (which will slow down our consumption), but it will also FORCE China to increase their consumption to offset that. It will also cause the value of China’s currency to go up, which is one of Trump’s goals. It also will matter who buys those bonds. Will it be our Fed or the private market? We won’t know those answers until it happens (if it happens).
We think Trump has the stronger hand in this fight. We like to use this analogy to help prove our point. If a company’s largest client fires it to make a certain product in house, who initially suffers from this? It’s the company that lost the business (China) that suffers and not the client (USA). To survive, the company will have to take measures such as firing workers, cutting salaries and looking for new work. That takes time to do. We think this is the position China will be in soon. Fortunately for China, a government has the luxury of printing money to create work and pay its bills. A private company does not have that privilege. That helps. We think when they print more money it will help increase the odds of worldwide inflation.
Every day brings a new press release on trade. We can’t write about all of them. If you have any more questions on this topic call us. We are following the ebbs and flows of this fight very closely.
New stock: Banco Macro
We bought a new stock this quarter, Banco Macro. This is the first time we have bought an individual bank outside the United States. Banco Macro (BMA) is an Argentine bank. The country of Argentina has been an economic basket case this century. Its currency has declined from 3 pesos to the dollar to 28 pesos to the dollar in the last 10 years. The previous president was more of a socialist than a capitalist and she horribly mismanaged the economy. We really like the new president and hope he wins re-election. That said, we want to point out how well Banco did financially under both styles of government. During the previous presidency BMA had a return on equity of 25%, during the current presidency it has averaged over 28%. A good bank has a return on assets of around 1%. We own Wells Fargo and its ROA is around 1.25%. BMA averaged 3.85% under the previous presidency and 4.58% under the current pro markets administration. These are fantastic numbers. Most U.S. banks are leveraged 10 to 1. BMA has its leverage under 5. When you put it all together you get a stock with a 400% higher return on assets while using half of the leverage trading at half the price a U.S. stock would trade at. The dividend yield at the time we bought it was 3.6%.
So why did we only buy a one percent position? The political risk still scares us. Even though BMA has done well in both administrations, it’s still a wild card. What could happen politically five or 10 years from now? Should the stock decline into the 50s, we may add another one percent.
BGC Partners spinoff
We want to give you an update on BGC Partners (BGCP). Sometime this year the stock is going to split its real estate and financial business into two separately traded stocks. The real estate division is called Newmark Group. The finance division will continue to be called BGC Partners. We mention this because the stock exchanges are going to treat the spinning off of Newmark as an “ex-dividend” exchange. What that means to you is someday you will look at your account and see you own BGC Partners and Newmark stock. We place the value of Newmark at about $6 per BGC share. If BGC Partners stock price was trading at 12 on Monday and it spins off Newmark on Tuesday, you will see your BBC stock drop from 12 to 6 because of the dividend. Don’t be alarmed; this is how ex-dividend spinoffs work. The value of the two stocks in totality on Tuesday when added together would be 12. We don’t want you to be surprised to see BGC Partners drop 50% in one day because of the ex-dividend.
At today’s prices we think the new BGC Partners would trade around 6 bucks and have a 52-cent dividend (dividend yield 8.7%). We find that an attractive yield. We think we will hold onto both stocks after the Newmark spinoff. We do expect both stocks to go up. It is possible we might add to our BGC position after the split if it should drop versus Newmark.
The equity markets are slightly up for the year. Our managed accounts are slightly down for the year. We think the markets are going to be more volatile than they have been the last three years. This volatility won’t be a lot of fun to watch on a day-to-day basis. The markets are trying to sort through the Trump trade war and what it means. We think its inflationary and negative for the dollar. The markets are betting the opposite of what we think which has hurt our performance this year. We will continue to work hard on this subject and keep you informed on what we think is the subject for 2018 and 2019.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR