Will China ever drive global growth again? Can interest rates ever rise again? Does the mountain of debt matter? Let us dare look at the sobering risks of a post-Covid world.
After having partied (the Biden voters) or mourned (the Trump fans) for a while, let us look at the highlights of a Biden presidency from an investor’s point of view, with respect to the main risks to the economy and markets.
First, will a Biden administration reverse the deglobalization course? Not really, says the consensus. If we take the UBS Monthly letter, and quote their downside scenario, US-China trade tensions could even «re-escalate, with the fundamental geostrategic rivalry between the US and China not tempered by the new US administration». Rivalry will remain.
The problem is that the world needs an engine for economic growth. China played this role for the last decade, as it was transitioning from a third-world country to an economic powerhouse. As the world will gradually come out of the pandemic crisis, it will desperately need a growth driver, the kind that causes «secular booms» as we have known them at the turn of the millennium.
But this time around, China’s growth may not benefit the rest of the world that much. After four years of heightened trade tensions and protectionism, the paradigm is lastingly changed. Chinese exports had been on a stagnating trajectory already since 2015. Since 2016, China has been rebalancing its exports away from the US. Now they are picking up more towards Europe and Asia.
As a BBVA research paper explains, China is now clearly focusing on stimulating internal demand and internalizing supply chains (thereby reducing reliance on foreign suppliers in key technology fields). One important indicator is that workers in China will see a real salary increase of 3,6% in 2020, which will benefit domestic demand. True, as China slowly resumes its growth in the third quarter, Swiss watchmakers are feeling the bounce back in their watch sales and thanking Chinese consumers for it.
However, the general mood is retrenchment. So, «Should my portfolio deglobalize?», asks Northern Trust in a recent research paper. Their answer is No: «In fact, less economic globalization may increase the diversification benefits of a global portfolio, as regional economies become less synchronized and aggregate earnings become more domestically oriented. Those invested globally should stay the course, and if not, there is a nice opportunity to broaden international exposure».
Second, can the US economy come roaring back after the coronavirus hit and become that growth engine? Probably not. Biden will inherit an economy laden with too much national debt, and with inflation risk.
Since 2008, America's national debt has surged nearly 200%, reaching $ 27 trillion as of October 2020. That’s five times as much as twenty years ago, when it was $ 5.7 trillion. Should it matter? Of course. So far, low interest rates on US government debt signal that bond market participants agree to hold US sovereign debt and don’t fear default. But that could change.
China has reduced its holdings of US debt to $1.07 trn from 1.3 trn in 2011. With these low rates, the government can borrow indefinitely. However, as we explain below, this is a problem.
Coming now to inflation, readers usually understand consumer price inflation. The official CPI measure has remained quite low this year, due to crashing energy prices and low consumer demand. However, when using the government’s 1980 statistical method for calculating CPI, the October measure (taken from Shadowstats) rose by 8.9% year-to-year (vs. 9.1% in September and 9.0% in August).
Current methodologies understate the rate of inflation. This is a disputed point, but we need to report that methods for calculating inflation have changed in the 80s, and then again in the 90s. We refer to this 1980 government method only to show that, depending on how you measure consumer price inflation, it will have a completely different impact on salaries and on cost-of-living adjustments in the US.
For instance, if the 1980 method was taken, the Social Security Cost of Living Adjustment would have been 9%. Instead, what happened is that the adjustment was 1.3%, based on the September 2020 CPI.
If the US (like other OECD countries) is understating inflation, then it could explain the constant loss of purchasing power and the stagnation of middle to low salaries in the US. This has an impact on US GDP, consumption and growth. Even more debt will be the result, both private and national.
Turning to monetary inflation, by year-end the Fed will have created about $7 trn in new money to buy as much assets in the US bond markets. In such a case, how to be certain that the rise in stock indices is not simply the reflection of a dollar devaluation? The gold price has doubled over five years against the greenback, which means you need twice as many dollars to buy the same ounce of gold, and it has almost tripled since the Fed started its quantitative easing program in 2009. The Nasdaq is up 600% over the same period. But that's in devalued dollars, not viewed in gold terms.
«Gold is not a safe haven from Covid, gold is the safe haven from the monetary and fiscal policy mistakes, and Fed money printing, which means inflation running out of control», says Peter Schiff, from Euro Pacific Capital and long-time advocate of Austrian economics.
Given the US debt burden, it is clear that Joe Biden has inherited a situation where interest rates will need to remain artificially low for an indefinite period. Central banks (of the US and probably the Eurozone) are not going to respond to an uptick in economic activity by tightening conditions, raising rates, doing more quantitative tightening. That would pop the sovereign debt bubbles that they inflated even more during the Covid days.
As shown in the charts below, the last time the Fed made a timid attempt at tightening interest rates between 2015 and 2018, the Treasury’s interest charge increased by 30%. The more the debt grows, the less you can afford higher interest rates. The effect is so costly on such a huge pile of debt, that it would require more indebtedness only to pay for interest. More sovereign bond issuance requires finding more buyers and leads to an ever bigger dependency on creditors.
At the same time, indebted markets had seen margin calls in 2018-2019 and were showing high volatility and signs of instability. That is why the Fed – under Trump’s vocal pressure as he needed to display booming indices – quickly reversed course during 2019 and started easing aggressively, way before the Covid crisis started.
It is inconceivable to allow interest rates to rise to any level of normalcy with that amount of debt, says Peter Schiff: «If the Fed started raising rates because we have a Covid vaccine, the stock market would actually crash, even though we have a vaccine!»
To all that we can say: Good luck, Mr. Biden. You'll need it.