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Mid-Year Investment Outlook 2019 | The World In Union?

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Summary

In this issue of Investment Outlook we examine the relationship between the USA and China as they fight for global influence. We also discuss the future role of the dollar and look at how changing demographics and behavioural insights are having an increasing impact on Government policy and our lifestyles. And we ask - does it still make sense to own bonds?

10 min read

In our Outlook 2019 published in January, despite Brexit, trade wars and Donald Trump continuing to dominate headlines, we took the opportunity to reflect on longer-term changes and developments across the globe where we saw grounds for optimism. We looked at the implications of increasing lifespans, the success of vaccines in raising life expectancy, and improvements in quality of life across the globe.

In reference to this year’s biggest film, we thought by now we would be in ‘Endgame’ for several of these negative issues; however, we seem stuck in ‘Infinity War’. This is partly because the US-China disputes go far deeper than simple disagreements over tariffs and their effect on the trade balance – they are fighting for global influence in the 21st century. It is also partly because Trump used economic nationalism to win in 2016 and will surely try the trick again to win in 2020 – it is in his interest to keep the problems in the headlines, no doubt with occasional ‘great deals for the US’.

And in the UK, political chaos reigns. Will a new Prime Minister change this? Probably not. We continue to avoid most domestically focused UK stocks on the continuing uncertainties but remain upbeat on UK-based exporters.

One issue which has eased is pressure from rising US interest rates. Markets have moved from thinking there will be rate rises in the US this year to thinking there will be rate cuts. There is a suspicion they are keeping rates low to counteract the unpredictability of the President.

Turning to this mid-year edition of Outlook, we take a closer look at the US-China relationship and ask if it is destined to be stuck in a deep freeze. We also have a look at other influences and changes we are seeing in society, such as how behavioural insights are having an increasing impact in influencing Government policy. We look at the role of the dollar in the financial system, how longer life expectancies are influencing the once linear work-life journey, and finally we look at the history of bonds, and their continued importance and role in providing diversification and income for investors.

We hope you enjoy reading our thoughts.

Graham Storrie

Managing Director, Adam & Company

  • 01

    New Cold War?

    News of the trade tariff dispute between the US and China has dominated headlines in recent months. However, it would be naïve to think this is simply about the US trade deficit.

    Thirty years on from the fall of the Berlin Wall, America is again in a Cold War with a Communist superpower. The rapid rise of China has sparked fear in the US and threatened the hegemony enjoyed by them since the end of the First World War.

    Is this similar to the USA versus the USSR in the original Cold War? Not really. Whilst the Soviets shocked the West on numerous occasions – their atomic bomb, the launch of Sputnik, the MiG-15 fighter jet – in truth the Soviet economy was no match for the American one in terms of its scale or its structure. Also, unlike with China today, there was never a flow of goods, capital and people between the US and the USSR. 

    Maybe the current situation is more like the emergence of Japan?

    In the 1980s the USA went through an existential crisis which manifested itself in their trade war with Japan. With few natural resources, Japan had pulled itself up dramatically from the ashes of war and learned how to build consumer products better and more efficiently than anyone. With the wealth they either bought out their American rivals or put them out of business, and they acquired a host of famous assets from Van Gogh’s ‘Portrait of Dr Gachet’ to New York’s Rockefeller Center.

    The US reacted badly to this upstart, but Japanese pre-eminence ended in 1990 when over-expansion finished in a huge crash, and their economic recovery has only really been seen in the past few years under Prime Minister Abe’s reforms. In the long term, the US benefitted from Japanese competition – arrogance gave way to acceptance and a generation of American managers and designers learned how to make things better.

    With the USSR disbanded and Japan’s rise halted, there was talk of ‘the End of History’ and the inevitable triumph of liberal democracy. China, with the world’s largest population but with output per head of $700 in 1996, was the last major hold-out.

    When President Clinton urged lawmakers to approve his plan for China to join the World Trade Organisation, he said “By joining the WTO, China is not simply agreeing to import more of our products, it is agreeing to import one of democracy’s most cherished values, economic freedom... When individuals have the power not just to dream, but to realise their dreams, they will demand a greater say”.

    He believed that capitalism and democracy go hand in hand and that China would be the next victory for liberal democracy – all that had to happen was for China to become rich. The quickest way of doing that was by allowing them free access to world markets.

    China, on joining the WTO, added 700 million cheap workers to the world economy, and this impact was hugely deflationary – there is little doubt it has caused many millions of job losses in manufacturing industries and to this day the US, the UK, Europe and Japan are all undershooting their target of 2% inflation.

    Profits and share prices in the West soared on low interest rates and the Communist Party of China was re-enforced in power. They had kept their side of the pact with the Chinese people: ‘trust us to rule and we will make you rich’. Economic output per head is now over $9,000 and hundreds of millions have been lifted from poverty.

    Western companies have also benefitted from outsourcing production and from rising consumption. China accounts for 20% of Apple’s sales, and, given it is now the world’s largest car market, it is similarly important to companies like Michelin, BMW and Toyota. Because of this opportunity, the US attitude seemed to have drifted from encouragement to tolerance.

    Under President Donald J Trump, the policy has clearly moved to one of containment. The tariff war is really a smokescreen for a deeper war – the battle is really for who dominates the world in the next 100 years. Trump is also using the security angle to block China from US telecom networks for example. This will cost China’s Huawei $30bn in lost sales in 2019-20 as US allies are also forced into line.

    Tariffs seem a poor way of proceeding, as they hurt the entire global economy. There are many alternatives such as offering unlimited free tourist visas to the Chinese. This would boost the American economy and close the trade gap pretty quickly. The US has disengaged from large parts of the world and China has filled the vacuum. For example, China’s ‘Belt and Road’ policy invests vast sums in road, power and technology infrastructure across dozens of developing nations, increasing their influence. Maybe the Americans should mimic these investment plans. Maybe they should revive the ‘Trans Pacific Partnership’ – a free trade pact with 11 Pacific Rim countries that Trump cancelled in his first week as President.

    To be fair to Trump, China never fully followed through on many pledges made at the time they joined the WTO. For example, one in five companies – many in aerospace and chemical industries – say that they’ve been pressured to transfer technology to Chinese partners, according to a July survey by the American Chamber of Commerce in Shanghai.

    Maybe the issue will quieten down and some good may come out of the rivalry to develop new technology – whilst 500 years of peace in Switzerland gave the world the Cuckoo clock, the first Cold War brought us satellites, the internet and James Bond.

    However, having won the last election on a campaign full of economic nationalism, Trump will likely repeat the trick for next year’s. This New Cold War might be about to get hotter.

  • 02

    A Nudge in the right direction

    There are few people – outside of a ‘University Challenge’ team perhaps – who could name a single winner of the Nobel Memorial Prize in Economics. Their work is usually on some quite obscure corners of the ‘science’. However, the work of one recent winner – Richard Thaler – is having an increasing impact on our lives, whether we realise it or not.

    Classical economics and the models it uses assume that humans are rational and always know and act in their best interests. However, the models often break down when confronted with 7.7 billion humans acting on their gut instinct and who default to the status quo and inertia over change. Thaler took insights from psychology and marketing to develop the field of ‘behavioural economics’. 

    Why is this interesting? Governments have often struggled to implement policies to drive desired behaviours. Simply banning things, making them compulsory, or imposing punishment for doing wrong, rarely wins votes. So how do you get people to change to improve their lives or that of broader society? Thaler’s work has demonstrated that sometimes we just need a ‘nudge’ in the right direction, and these insights are being increasingly used by governments and others.

    For example, we know we need to save more in retirement; however, there always seems to be something better to do with our money. The UK addressed this problem using a nudge – private sector workers are automatically enrolled in a pension savings account through their employer and you automatically start saving into this scheme, with your employer and the government contributing (as opposed to previously having to opt in).

    It is not compulsory – you can opt out – but the policy takes advantage of people’s bias to inertia. It has been a huge success and the percentage of private sector workers saving in a pension account has risen from around 47% to over 76% in the past six years.*

     

    “Putting the fruit at eye level counts as a nudge. Banning junk food does not.”
    Richard Thaler

    Studies have also shown that people are more likely to behave in a certain way if they believe those around them are also doing so, and this insight is being used to tackle energy use and climate change, forming part of the solution to achieving the government’s 2030 carbon emissions targets. In recent years, the UK ordered energy companies to offer free insulation, and made switching supplier as easy as a few clicks. But few consumers accepted the insulation and, despite the ease of switching, 23% of households have never moved energy supplier**. Inertia tends to win despite the savings on offer.

    In addition to this, over 13m Smart Meters have been rolled out, with the hope that providing more awareness of actual energy consumption and cost will influence our behaviour into actively using less. Energy providers are harnessing Smart Meter data to generate messages to customers comparing their energy use to others in their postcode. This simple nudge seems to encourage people to cut consumption – ‘why am I paying more than my neighbours? I need to change’.

    You are even starting to see this in schools, with positive encouragement taking the place of punishments. Schools encourage pupils through rewards, achievement tables and initiatives such as ‘Hot Choc Friday’ for the week’s best performer.

    Whilst these policies are designed to work to our benefit, it has also influenced marketing and how consumers are targeted, such as encouraging people to sign up to online subscription – based services. One-off offers are designed to hook us in (offering free trials for an initial time period) after which we will pay the full monthly fee unless we actively opt out or unsubscribe. Perhaps not quite the most moral of applications of Thaler’s work.

    It remains to be seen if a nudge is enough to generate a range of long term, positive societal changes, but the idea of rewarding and educating rather than rules and punishment might just be enough to lift us out of our inertia.

    *Source: Office for National Statistics, 12 April 2019

    **Data from Moneysupermarket.com, January 2018

    Source: Office for National Statistics, 12 April 2019

  • 03

    A few dollars more

    600 years ago Americans had no concept of money. For those Incas, labour was the way that value was exchanged. They did revere  gold and silver – ‘the sweat of the sun and the tears of the moon’  – but only for the beautiful shiny objects that could be made from it.

    The conquistadors changed all that. Whilst they never quite found El Dorado, they came close. For a while, Potosì in modern day Bolivia was the second largest city in the world, as the Spanish extracted silver from the Cerro Rico mountain to turn into their famous ‘Pieces of Eight’ (‘Pesos’).The coins had intrinsic value – they were backed by the value of the silver they contained. Overproduction, however, reduced this value and led to a decline of the entire empire.

    The modern day US currency is the dollar of course, but it has had no intrinsic value since its link to gold was broken in 1971. Like other currencies these days, the dollar is just a promise, and as such it doesn’t matter whether it takes the form of paper, metal, or is stored digitally on your phone. They have no value in themselves, other than what you can exchange them for.

    Whilst there is a strict separation of state and church in the US, since 1957 ‘In God We Trust’ is written on every dollar bill. In possessing dollars, you are not really trusting God, rather your fellow citizens to accept yours, and for the US Treasury not to print so many the value declines. This reference to God does suggest how highly Americans rank the dollar in their priorities. However, it is of global importance since overtaking the Pound as global reserve currency after the Second World War.

    “New faces set to appear on Dollar bills, including Martin Luther King Jr. and Eleanor Roosevelt.”

    What does this actually mean and why does it matter? Whilst not an official title, the relative size of the US economy makes it so. 62% of cash in central banks is in dollars, three times the amount in the next biggest, the Euro, and 65% of all dollars in issue are outside the US. 90% of all foreign exchange transactions are traded into or out of dollars. Furthermore, most trade is denominated in dollars, as are most commodities such as oil. Finally it also benefits from the network effect – as more people use it, so it becomes more useful.

    This status gives the US huge power and influence. They can drive policy decisions through the currency by simply banning banks from dealing with countries and entities it wishes to cut off. As banks rely on their ability to trade dollars for their US banking licence, if you don’t comply you will be committing financial suicide. Huge fines have been meted for breaches of US sanctions against Iran, Syria and others.

    It also has financial benefits for the whole of the US, seen most keenly in the relationship with China. The US consumer’s insatiable desire for goods has seen Chinese exports boom. The Chinese receive dollars for this and reinvest them into the US bond market (they own 5% of all US debt) pulling down US interest rates, and allowing them to buy more Chinese goods in a relationship historian Niall Ferguson has called ‘Chimerica’. The US government spends more than it earns knowing there will always be a natural demand for their currency.

    The power this conveys is an issue, particularly in the light of US foreign policy, where concerns are arising over Donald Trump’s ‘weaponisation’ of the dollar to promote his policy agenda, through sanctions across the globe, in part to reinforce the dominance of the US. The level of dollar – denominated debt across the world is a further explanation why economies and markets are so sensitive to interest rate rises in the US.

    Could this change in coming years? Could another currency take over?

    Every century or so, the world’s largest currency has changed – Portugal, Spain, France and Britain have all spent time as the dominant force, usually as empires have risen and fallen – and whilst the dollar dominates for now, rivals are chipping away.

    Chief amongst these is China of course. Recent trade deals ensure deals are settled in their own currencies, and they purchase oil in Renmimbi rather than dollars. As China becomes the world’s largest economy in the next 20 years, many think non-dollar trade will soar. The problem for China at this stage is that their insistence on capital controls prevents the internationalisation of the Renmimbi, with a lack of regulatory transparency also a deterrent.

     

    Source: US Federal Reserve, 31 December 2018

    Russia too is keen to ink deals in Roubles but has similar issues to China. Bitcoin can be seen as an attempt to create a purely digital currency outside the control of the US government and their central bank, as is ‘Libra’, the proposed Facebook currency backed by Visa, MasterCard and others. The US may however fight back against these innovations, especially if these new currencies are seen to be financing corruption or terror or being used as a way of getting around sanctions regimes.

    Looking to the Euro, whilst it accounts for a sizeable proportion of global reserves, fears over the sustainability and longevity of the Eurozone’s existence will continue to cast a shadow. This follows the sovereign debt crisis and the more recent trouble we have seen in Italy.

    Such is the dominance of the dollar across the globe, it will continue to act as the global reserve currency for some time yet. However, there is little doubt that, as China’s influence across the world increases along with the rise of the fast growing Asian economies, this dominance may slowly be eroded by that of China and even the Euro, particularly if Trump’s isolationist policies persist.

  • 04

    The Perennials

    Source: United Nations 'World Population Prospects 2017'

    A 69 year old Dutch motivational speaker and ‘positivity guru’ hit the headlines last year when he sought the legal right to shave 20 years off his age. ‘I don’t feel 69’ he claimed and said that being able to use his ‘emotional age’ of 49 would give him more opportunities. He even got his doctor to testify that he had the body of a 45 year old.

    Whilst the court rejected his request, no doubt he did indeed feel 20 years younger. And he is not alone.

    The ageing of society is not a new story of course; however, it tends to be viewed through the prism of how government budgets will be affected as health and social care costs soar, or how the diminishing pool of workers will need to be replaced by robots. Both these things may be true; however, one change being seen is the way people progress through their work lives.

    A generation ago, the expectation was of a simple linear journey – education, followed by work, and then retirement – hopefully at 60 and with a nice index-linked pension. However, this linear path is melting as we live longer and as pension changes make early retirement difficult. It seems that one’s working life may soon be seen as a series of stages.

    Many people will want to delay retirement, perhaps out of financial necessity, perhaps as they simply wish to stay active and in work, and realise that they may live well beyond 80. Many simply fear boredom.

    “Age is an issue of mind over matter. If you don't mind, it doesn't matter.”

    With retirement delayed, things change. People can enjoy multiple careers, have a portfolio of paid or unpaid jobs, spend time as self-employed and come back to education again and again. A person can choose to define their own path and the implications of this are only just beginning to be understood.

    In the world of work, employers need to embrace these changes and adapt to take up the opportunity. For example, in the future there may be an insufficient number of young people available for them to hire and grow their business, so they need to be more flexible around hiring and promotions. Employers may consciously or sub-consciously discriminate against hiring and promoting older staff, but a person aged 60 may have ambitions to work another 10 years or more, so age should be added to a company’s diversity goals.

    Employers should also consider more flexible working arrangements with regard to part time work, as an employee may well have another job (or two), and also be prepared to re-train internal staff and hire and train those switching career.

    From the point of view of the worker, maximising flexibility may only truly be achieved with the backing of secure finances. We will need to save and invest more and earlier to allow flexibility in later life, as well as preparing us for a life that may be much longer than we expect – if you are aged 65 today, your life expectancy is, on average, a further 19 years if you are a man and 21 years if you are a woman. Caps on pension contributions and the size of pension pots mean other pools of savings and investments will be required to support this longer lifespan.

    Finally, business opportunities will arise as companies will need to come up with new products and services. Banks will have to become more flexible around the traditional 65 year old age mortgage limit and be willing to lend into one’s 70s and 80s (already possible with Adam & Company), and more thought and advice will be needed on financial planning given, for example, the cap on pensions.

    New savings and investment products will have to be devised, especially given that low interest rates look set to be with us for many years to come.

    Age may well be an issue of mind over matter, but if you don’t plan for the future and adapt, it will matter.

     

  • 05

    No, Mr Bond

    Indices used: MSCI UK All Share (est); Bloomberg Barclays Sterling. Investment Grade Yield to Worst; UK treasury 2028 Yield (Date: 24/5/19)  

    Everyone has a favourite Bond, and it seems to correlate strongly with who was in the role when you were ten years old. Unfortunate then if you were born in the 1970s and your earliest memories are dominated by a slightly geriatric Roger Moore and his canary yellow ski suits.

    Investors also have a choice of bonds, although they are a little less exciting. With government bonds, you are effectively lending money to the UK Government, in return for your money back with interest. Given they have been issuing them and paying back since 1694 they are a pretty safe bet.

    20 years ago things were pretty easy for investors in government bonds. You collected an interest rate of 6% and inflation was under 3%. These days, however, buying a government bond with a ten year maturity will return less than 1%, with inflation at 2%. The financial crisis, low inflation, and low growth have kept interest rates at very low levels. Furthermore, rising demand for these bonds from banks and pension funds driven by regulatory changes, have forced down yields.

    With corporate bonds you are effectively lending to companies, and receive higher yields to compensate for the extra risk (compared to a government), whilst going overseas could also get you higher returns on both government and corporate bonds, albeit with the extra risk that currency moves could offset this.

    The main role of government bonds now is diversification and preservation of capital. This attractive quality was demonstrated by their positive performance in the final quarter of 2018, whilst equity markets were suffering. They are also appealing in times of disinflation and negative interest rates. Admittedly, however, it’s tough to grow wealth compounding 1% a year and the paltry income will not support many in retirement.

    For those that require a higher dose of income and are relaxed about volatility, corporate bonds and equities will be important. Rising company profitability is being returned to shareholders in the form of higher payouts. In the UK, the yield on the stock market is over 4%, with Europe at similar levels. Corporate reforms are seeing payouts rising steadily in Japan and decent dividends are on offer in many Emerging Markets too. Diversification remains key, but for those seeking higher income, equities are continuing to offer a higher yielding (albeit more volatile) option.

    Source: Bloomberg, 06 March 2019

    Source: Bloomberg, 31 March 2019

  • 06

    Biographies

    Thank you to all contributors not named above.

    For All Enquiries Please contact Susan Boyd

Key Takeaways

With trade wars and world domination on the agenda, are we really a World In Union?   

About Adam investments

We offer discretionary investment management to individuals and their families, and to charities. We take a long term approach to investing and we believe this gives us an advantage in a world where markets and media are increasingly focused on short term news.

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