I like to look back on old investor reports I have saved to remind myself that prediction of the future is nearly impossible, and to find some gems of enduring value. Of the latter, one of the better investment readings of 2017 came from BaML’s January 25th Thundering Word “The Last 100 Days”. In it Michael Hartnett, the Chief Investment Strategist and his team took stock of the implications of the Trump administration for money-runners.
The note introduces a colorful metaphor to distinguish the Trumpian future from the Obama days: “Davos Man” (they weren’t the first to coin this, Samuel Huntington did) versus “Joe Six-Pack”. There is, I think, some depth in this distinction compared to the “Trump trade”, “Trump stocks” jargon because it points to something deeper.
The global economic structure is based on a few key principles. The United States has been operating under reverse mercantilism. America consumes other countries’ exports and prints paper assets—mostly debt—to pay for them. Most emerging market and some developed countries instead makes things and accept American debt in return. This is, of course, unsustainable and ten years ago led to the financial crisis. Economic policies for about a decade have been focused on shoring up specific countries’ financial systems and mitigating and forestalling the impact of widespread deleveraging of US households and the export sectors built to service them. This economic structure is now in transition, and Trump is merely putting a fine point on the inevitability of this. In this sense, it is the end of Davos Man—at least for the United States as it takes tentative steps toward monetary normalization.
The Davos man is largely preoccupied with the financial system. The impact of Basel III and the future of a heavily regulated financial industry on markets is by and large the primary occupation of Davos Man. The financial system is seen as the horse that pulls the economic cart, and the cause of the secular stagnation theme. Policies under the Trump administration are viewed as favoring Joe-Six Pack, the guy on Main Street that has for the last 30 years give-or-take seen his purchasing power diminished. In short, the economy comes first, and the financial system must act as its servant.
The big take-aways? The dollar will not be made great again. This would be a big policy failure. With the Fed leading the world in tightening monetary policy, the dollar would skyrocket and make imbalances worse without countervailing factors. Second, the shift necessitates big changes in portfolio positioning. The note provides a handy “shopper’s guide” which I replicate.
So… there is an expected rotation, couched in terms that imply Davos Man is an unsavory bureaucrat figuring out how to survive the long cold winter of deflation. The reversal is into assets that benefit inflation, wages, and the everyday guy. A shift from technocratic administration to budget-busting populism.
But is it a rotation or a Great Rotation? The start of a big trend away from the past decade or just short-term noise around that secular stagnation and its malaise will ultimately engulf it?
These are the questions worth asking from an investment standpoint.
Bureaucrat versus populist: No doubt that Trump is the anti-technocrat. He is a CEO through and through. He doesn’t want to deal with problems, and if a problem gets to him, it is time for wheeling and dealing to get it off the plate. Trump has not enjoyed the White House lackey’s general lack of initiative in dealing with problems. He is fine with public dress-downs of staff and appointees. What is becoming clear through polls is that voters are generally very fine with that as well. They think he is morally challenged, but transparently so, at least more than other shady equally morally challenged alternatives. What should have been a blow-out ended up as a GOP sigh of relief. Now that the banking sector is reasonably shored-up and bloated on TLAC, CET1, and HQLA programs that snort up government debt like cocaine, it is high time to address growth, inequality, and stagnant or dropping wages. Call that populism if you wish, it is here to stay.
Whether bureaucrat or populist stimulus, what is true and has always been true is that the state rules the market. Policy changes alter the economy in fundamental ways at all scales. Regulations like Basel III influence market making activities in enormous ways. Likewise, fiscal tax reforms that facilitate corporate repatriation of earning stored abroad influences money market behavior just as much. Central bank rate setting can create an ocean of liquidity or a desert. They all impact money markets, and money markets impact financial markets, and financial markets impact the real economy.
Beyond that rough directionality, knowing at all scales the upstream and downstream effects is impossible for two reasons. Even assuming policy changes work as expected to address one problem downstream they can have an adverse effect. Add to that, there’s no certainty they work as expected. The long-term downstream impact can more than overwhelm the short-term intended effects.
The focus must be at the periphery: credit and equity. At this macro-scale, it is easy enough to understand the distinction between a fiscal-powered government and an economy driven by monetary stimulus when it comes to leverage and risk-aversion. And I think this is the key to the right portfolio mix.
Proposition: Different areas of the world embody a Davos Man worldview and some a Joe Six-Pack worldview.
Emerging market countries have always been Joe Six-Pack economies coupled to a limited capacity for fiscal expansion: they are unable to take on the traits of a Davos man economy because their currencies take such a hit. There are some other defining features, like fluid ownership that lacks recorded title and courts to uphold the sanctity of private ownership against claims of the state. These two features are why cryptocurrencies are touted as game-changers. The dealer sales-spin is that they leap-frog the development of legal and institutional hurdles that don’t fully exist in emerging markets. Cryptocurrencies keep transactions private and outside of government surveillance, control, and FX volatility (hahaha).
The United States under Trump is a true vision of the Joe Six-Pack economy. Limited institutional hurdles and clear asset protection under commercial code. Add to this, discontent with financial repression hardened public opinion. In current public opinion, the losses attributed to globalization are more obvious than the benefits, and this implies a reaction. Trump is that reaction. His task is to combine social conservatism with a fiscal boost, made possible because the US financial systems is stable enough to go off live support. In effect, there is a shift from monetary policy that transmits stimulus via Wall Street to fiscal policy that delivers stimulus directly to Main Street. One inefficiency is traded for another type of inefficiency.
Which leads us to the EU. Clearly this is an economic habitat that has not shored up its banking system, at least to a level of stability seen in the United States. As a result, the EU continues to focus on Davos man, forestalling as hard as they can the ultimate bank balance sheet and liquidation cleansing needed. EU public funds to Jacques Heineken have been going on for decades already and there is limited ability to offer even more largesse under EU budget rules. The EU situation is further complicated by how fragmented it is. Italy clearly wants to go the fiscal-driven recovery approach, and ultimately to go this route is to buck German hegemony, but it can't. The Italian banking system remains unresolved, and a fiscal blast without ECB support to Italian banks and Italian sovereign debt carries pain like a wrecking ball. This bind keeps the EU in thrall to Davos Man.
Remark: The Davos/ Six Pack framework just doesn’t work in developed Asia. Japan is a mystery that policy-wise just can’t control the USD/JPY cross and I suspect rising rates will hammer large-cap and bank balance sheets. Korea is clearly taking big shots of fiscal stimulus, but it is only a palliative as it works through a big household debt problem. Assets in Asia have a place in a portfolio, but they require different decision criteria.
Proposition: The portfolio implications are straightforward: € and allocations need a Davos-man slant, $ allocations need a Joe Six-Pack focus. Emerging markets always need to be bought when they look like a basket case, balancing equities and credit.
Automation and artificial intelligence will be a sore point for Joe Six-Pack. Joe Six-Pack not having kids is a worry for Davos Man.
Joe Six-Pack may get a reprieve before the next recession hits the US, but they get a deficit worth 6% of GDP in return, not counting entitlements (making it more like 10%). At some point, this will matter, and bond yields will reflect it. Which is to say that on our current road we will begin to resemble Italy before the turn of the next decade.
Trump (or anybody else in office) will deal with this contingency differently, of course: The Fed will print money to pay for the deficit, inflation would follow, and the dollar would REALLY decline. Bonds would be burned to a crisp and stocks would certainly be toast due to their long duration. The U.S. would no longer be the gravitational center of the global finance and there would be damage aplenty, not just to the U.S. but to the global financial system itself which for 40 years has depended on the US dollar as the global medium of exchange.
At that point, we’ll need another framework.