Overview
As a risk manager or manager of institutional capital, it is critical to have a firm grasp on major challenges and likely outcomes. Building and maintaining a portfolio based on false assumptions can be disastrous.
To make this installment as useful as possible, we aim to address some of the underlying assumptions making the rounds in the markets.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
-Mark Twain
“An economist is a portfolio manager who never marks to market.”
-Howard Marks
I. Hard Landing
For the past four years (i.e., since the 2019 Covid Outbreak) many have been predicting a hard recession due to the length of the prior recovery and the stress on the economy from lockdown. To the dismay of the distressed investors, the stress period lasted approximately 40 days and has not reappeared since.
Commentary: Yes, the government’s providing support via a variety of programs has helped, but that is only a partial explanation. Perhaps a more relevant factor is the incredible resilience of the economy stemming from the relentless pace of innovation in the form of AI (Artificial Intelligence) and constantly improved software and services.
II. Inflation Scare
As of 18 months ago, many were bemoaning the level of inflation and the rapid rise of Fed funds rates. More recently, inflation has eased and 10-year treasuries have assumed more moderate levels.
Commentary: While consensus on the underlying cause of inflation remains elusive, the most plausible explanation appears to be that proffered by Lacy Hunt. His view is basically a twist on Milton Friedman’s stance; inflation is caused by currency creation in excess of the real growth of the economy. Given that measure, inflation should moderate over time.
III. Japan’s Elevated Debt Levels
Japan has sovereign debt to GDP in excess of 200% which places it at the top of the developed world (the US’s is now near 120%)¹.
Figure I: Japan's Central Government Debt (% of GDP)
Nonetheless, Japan was one of the top performing markets over the past 10 years (see below).
Figure II: Annual Performance of Nikkei 225 Index Annual Performance from 1980 to 2023
Commentary: A key issue for assessing the danger poised by debt levels is to whom is the money owed and how are the governments deficits being funded. The reality is that Japan funds much of its debt via internal sources and therefore does not have to tap the international markets for funding. The Bank of Japan holds 53% of Japanese government debt². Hence, it is less subjected to the discipline of the capital markets. Regarding the performance of the stock market, Japan has benefitted from the shifting away from China as a supply base and from the avoidance of a recession.
IV. China’s Demise
Several political scientists have predicted the imminent demise of China based first on the Covid lockdown slowdown, then on the curtailment of orders based on security concerns, and now on threatened shipping links. The massive over-building and developer defaults remain a concern. Perhaps an underlying wish is one of a regime change.
Commentary: Our view is that regime changes are extremely difficult and that like Russia, China can and will endure great hardship if needed to survive. Perhaps the best example is Huawei’s rapid introduction of an advanced phone after chip exports were cutoff. Another positive is the emergence of Chinese auto manufacturers such as BYD, which appears to be on track to becoming the global leader and apparently is capable of producing an $11,000 credible vehicle (see below).
IV. China’s Demise
Over the period of written history, progress has been coupled with an increase in population; a prosperous society was a growing society. Look no farther than the typical annual report which emphasizes growth as equating with success. In contrast, many rural areas are faced with population busts whereby it appears to be only a matter of time before towns disappear.
Commentary: To a certain extent, we a treading on covered ground with Malthusian arguing that the world’s resources were limited and that it best we curtail growth lest we run out of resources. Currently, there is a different twist on the same issue whereby the fertility rate in developed countries is typically below the replacement rate. Coupled with these developments is the concern that the various social security/pension and healthcare programs will run out of funding.
Our view is that while adjustments will be painful, they will be doable and that over time people will rethink their views. For example, it is likely that self-driving trucks and vehicles will reduce the need for some workers as will robots and other machines equipped with AI.
Sources
[1] https://fred.stlouisfed.org/series/GFDGDPA188S
[2] https://www.nippon.com/en/japan-data/h01720/
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