Why David Blond is Wrong on Trade

We thank readers for their thoughtful responses to David Blond’s guest paper on trade and tariffs, Winners and Losers from Global Trade. That paper triggered debate. Below is Bob Brusca’s rebuttal. Enjoy the debate as each person can decide her/his own viewpoint.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Why David Blond is Wrong on Trade

 

I have just been sent a link to this paper, Winners and Losers from Global Trade, by David Blond. Reading it so upset me that I have prepared a rejoinder…

There is nothing an economist likes more that to use a number of quantitative techniques and numbers to dazzle people when some simple understandable observations would do just fine.

I do not need to think about input-output tables or to look at employment output vectors to know that the US is more trade dependent on the import side than just about anybody else and will be hurt a lot by a trade war.

The US has been riding massive consistent deficits on current account since the early 1980s.

There are several points to be made about trade and Free trade quite apart from Mr. Blond’s approach.

The first is to note that however you want to think about a trade war, the best way is to consider that it is being contemplated by adults with some understanding of the process and not to plow straightaway into a ‘I hit you’, ‘you hit me’, so ‘I hit you back’ exchange. We know where that leads.

Before Daniel Ellsberg was known for the Pentagon Papers he was known for some insightful thinking about statistics and for thinking about thermonuclear war. Ellsberg pointed out that the ‘usual approach’ to look at the expected value from this conflict made no sense since the condition really had no real probability distribution. It was not an ‘experiment’ that would be run over and over. It either would happen or it would not. It was binary in nature. And that if it happened the destruction would be terrible all around and if it did not happen, life would go on untainted by it. So he concluded that you have to think about thermonuclear war in a different way and one cannot think in terms of expected values.

I would argue that the same is true of trade and trade wars. You do not threaten one to start one any more that Kim Jung Un is really threatening that he will launch a missile at the US. He has a different objective in mind. He is trying to get our attention. Job done.

Trump did push Europe over NATO. And this I think is the model for trade. The US was in the right on NATO. Europe and Germany were in the wrong. The US funds most of NATO but each member is supposed to spend monies on defense as well. Obama had pushed Germany to no avail. Other US presidents before him had pushed them to spend more too. But Trump put his foot down prompting Angela Merkel to call Trump and the US a bad ally. Really? I bet that that is not how history will see it.

So this is a similar strategy to the NATO gambit applied in another situation where the US (or Trump and his advisors if you prefer) think America has gotten a bad deal.

One thing Blond does not do is to look at the trade system or result and critique it. He runs models and accepts today’s factor prices as a baseline…WHY?

The export-led growth model
The world matrix of trade we have today is not what any free trader would have expected or would recognize. We have countries that run unstoppable deficits and others with relentless surpluses. The question is not can a country get better growth by having export led growth. It is think obvious that an export led growth economy is easy to maintain and one of the easiest ways to jump-start growth in an underdeveloped region. That does not make it right. You get foreign technology and capital to come in and combine it with your cheap labor. They train your labor force that uses their technology. If you are unscrupulous you also steal their technology… They make stuff export it cash rolls in, Viola! The exporting nation needs to manage its exchange rate so that it does not get too strong from all the exporting. And it needs to make sure wages do not rise too fast. But there is not much internal balancing required.

Unbalanced prices and wages stem from unbalanced development!
Blond speaks of the imbalance between wage and prices. Well this is a problem if you run a balanced growth model. You need wages cheap enough to continue to export but high enough to afford a domestic demand for your people to buy some of the things they make. I don’t think that because China wanted to develop so fast that it should be allowed to run roughshod over what used to be free trade rules. Blond seems to want to defend that. But in free trade with a market-determined exchange rate, rapid production in China would cause its exchange rate to rise and increases wealth in China would permit the consumption of more good including imports and likely undercut competitiveness and lower the proportion of growth that could be achieved by an export-led program. Blond seems to be looking at China’s numbers and arguing BACKWARD that because China has done this we have to let it go on because the export to price ratio is out of whack. Really? What else could have happened under that strategy?

I refuse to take the current ‘market’ prices and wages as given. Why do China’s actions that have created all these factor price relationships become enshrined? China has acted in a very, shall I say, China First fashion. And some will say that developing economies have always been allowed to play by ‘special rules.’ And I will not deny that. But China, as such a huge country, has a much more pronounced impact on the global economy than Thailand or Taiwan or South Korea.

The knock against Trump is not that he wants to start a trade war although I am aware that he says that they are good and easy to win. They are not good nor are they even winnable.

The fact that a tit-for tat trade war makes everyone worse off is not the point either. There is plenty of literature from collective bargaining that shows that strike behavior by unions usually makes both the firm and the union worse off in the long run even if the union gets better benefits for its members. There is the loss of income/output from having a strike to be considered.

Strike or trade confrontations are usually about a lack of information or about credibility. I think that as in the case of NATO, the US complaint that trade is not free or fair is obvious. That US jobs are lacking because of it is obvious- so obvious as to not even need any statistical work to prove it! What is it about 35 years of unrelenting current account deficits that does not look like free trade to you?

What has been expected?
When fluctuating exchange rates were considered it was thought that exchange rates would shift to balance current account deficits. But that is not the case. Countries with export-led growth models hang on to their ‘excess dollars and reinvest them in the US effectively doing an end run around the exchange rate adjustment mechanism. The Chinese do not buy our treasury securities because they are trying to help us. They are trying to help themselves (…to our demand and to our jobs). And if they could find a way to do it without buying so many US securities you can bet they would!

My point is that you cannot BEGIN to understand the current global trading system without understanding what drives it and what sustains it. And if you want to be an advocate for manipulated trade you can join Mr. Blond and support China and others. You may support Germany with the largest current account surplus to GDP ratio among all developed countries.

I suppose one problem with ex-ante thinking about the exchange rate system is that it was done by academics in a fixed rate regime/gold standard where current account balance really meant something.

Many actors and interests
The politics of trade are complicated. US multinational corporations have been active forces in using cheap production locations overseas to beat down unions in the US and curtail wages. Why do you think that the Phillips curve no longer works. XYZ Corp, Inc. can just pick up the phone and order output from China instead of paying a penny more in the US.

Chuck Schumer every year would rattle his saber on FX manipulation then do nothing as he and fellow Democrats pocketed millions in campaign donations from multinational ‘free trade loving’ (wink, wink) corporations.

If there were a real trade war I doubt that anyone would fare well – I don’t need a model to see that. China would be less affected because its import side is not so stacked, But its exports (read jobs, output and income generation) would come to a halt and that would not be good. Americans would spend more time trading with one another on eBay. We have so much surplus stuff a fashion industry could rise up on the idea of recirculation. We have food and oil. We are militarily strong. Really who is going to be hurt the most?

No I do not think the input-output tables tell the tale of who gets hurt in a trade war-not really.

But I still think that this is not about trade warfare. I think Trump picked a few innocuous industries to make a point. The Chinses previously were flooding the market with cheap solar panels. And yes it was nice to buy them cheap- but it’s not fair. China has been dumping steel made in outmoded plants forever!

I think it is very hard to envision a world with real fair trade.

Dollar supply?
As for the argument that we need to supply dollars to the world, that is bogus. Right now so many countries are adding dollar assets only because they have to in order to keep their desired foreign exchange peg. Dollars are not created by a current account deficit they are created by the Federal Reserve and by a fractional reserve banking system. His dollar supply argument is upside down and wrong. We do not need to ‘supply dollars through our current account deficit. Besides… the current account deficit implies a capital account surplus: monies are flowing INTO the US to fund our Current Account deficit and to fund our fiscal deficit and to keep our interest rates low and to keep the dollar from falling and becoming cheap and undercutting competiveness overseas.

A lot of observers try to salve our pain about having a large deficit by arguing that the strong dollar gives the US great purchasing power. Well that is great if you have dollar assets and dollar income and want to buy stuff. But if you are a worker and need a job that strong dollar prices you OUT of the global labor market. The strong dollar does make imports cheap and that encourages us to over consumer and to under save. And it reinforces a lot of bad habits we need to break. So where is the advantage?

Hoodwinked?
This past week I wrote about the consumer sentiment index with some record high standing components. How is that possible? Real wage growth has been stunted. Real wages are not growing well at all. There are myriad jobs available but few of them good. Yet since Trump took office and started to verbally warn companies about going overseas and targeting Mexico and trying to stop the outflow of manufacturing, the growth in manufacturing employment has been rising more rapidly. The service sector job creation rate has slowed but goods sector job creation is up. Still, it is such a small portion of the economy that it will win Trump few plaudits and does not explain the reading for consumer sentiment which to me is a reflection of reduced expectations. Young people do not realize how much the President and Congress are mortgaging their future based on the debit profile we now have and the off balance sheet liabilities of government. How can people claim to feel so good when things are so mediocre?

I do not think that the markets the public or the Fed have much of a handle on what is going on. And I think that many people dislike our President and for that reason have too easily fallen into the trap of hatting Trump and hating what he does.

But I not think he is wrong on trade. The unemployment rate does not tell the real story because too many people have dropped out of the labor force. It’s become a labor farce.

In Adam Smith’s famous treatise known by its short title ‘The Wealth of Nations’ at the very beginning cites ‘the proportion of the population that is engaged in commerce’ as an important determinant of the wealth of a nation. The chart above recasts the unemployment rate as a ‘not employed rate (red). I plot the conventional U3 number of unemployed VS the whole of the age 16+ non institutional population eschewing the notion of a labor force. Then also, using the same denominator, I calculate the number of people NOT employed (those unemployed plus those not in the labor force and not working). The result is stunning. Since the early 1980s the two series have roughly the same behavior but for very different rates (note the right sale left scale differences). But until this cycle the signals for each one for policy were roughly the same. Now the signals are very different.

Trade and technology together have been huge disruptive forces. Some nations have used very self-serving policies to preserve or to expand their growth environment at home while pushing the adjustment off to the overseas markets. The Trump Administration has just terminated a set of ongoing trade talks with China because it no longer sees China as making progress but as backtracking. I agree with this my article (here). In it I argue that China’s belt and road policy is big red herring for backsliding. I think that taking a more aggressive posture on trade is appropriate.

Let me close with an example. I love basketball and ‘tis the season for it. But it is more than one kind of game. The game you see on TV is one kind of basketball. In that game there are officials and they interpret and enforce the rules. If someone slaps you while you are shooting the referee does not blow the whistle, then you were not fouled. Its simple: what the refs say goes. But there is another kind of basketball called pick-up, it’s played informally without referees. If someone grabs your shirt while you are shooting then you grab his while he is shooting. If someone steps in your foot to keep you from jumping and you let him get away with it then that’s on you, not on him. Trade is more like a pick-up game even though there is a WTO. Some of the rules and market practices are hard to enforce. The most difficult one is about exchange rate values. But there is nothing in trade like the study of Industrial Organization and its mantra of “structure conduct and performance.” If there were, maybe more people would look at long strings of surpluses and smell a rat. But people are instead schooled in the counterargument to protect and defend our current system and to call it free trade. Well you can call my cat a dog he still is not going to bark. In this scheme of things the US must stick up for its own interests or it will be exploited and marginalized.

When we were a wealthier country and before we had gotten used to our economic mortality there was a lot that we used to do that we can no longer afford. Some want Trump to continue to dole out foreign aid in fistfuls and for the US to continue to be the great benevolent nation it used to be. But the government’s own deficits are huge; its off-balance sheet liabilities are shockingly large. And our ability to the play the role we used to play is more limited. We need our allies to pitch in and pay their fair share. We no longer can look the other way when they game us on trade. I understand that other countries like playing the game under the old rules, but they just do not work for us anymore. If America is going to keep its place in the world it must first preserve its own economic strength. And having 2% to 5% worth of GDP siphoned off into foreign economies each year through a hole in the current account no longer works for us. Trade/Current Account deficits are neither good nor bad. But these deficits of ours have only financed current consumption at an excessive pace and at the cost of leaving a bigger legacy of debt for future generations. That violates a whole lot of economic rules on fair play. Our deficits are bad because they do bad things to us now and because they are instrumental in placing the debt for today’s good times on the backs of future generations. Something has got to give and Trump is on the right track. It may be for the wrong reasons but he is the right track.

Robert Brusca – Chief Economist – FAO Economics
Email: Robert.Brusca@verizon.net


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Q1 2018 Municipal Credit

Ratings, Teachers’ Strikes, Pensions, Higher Education

During the quarter, Moody’s and S&P reported that upgrades of municipal bonds continued to dominate downgrades in 2017. For S&P it was the sixth year in a row, with California leading the way in the number of upgraded issuers, followed by Florida and Texas. For Moody’s it was the third year in a row that upgrades surpassed downgrades. Moody’s noted, however, that the dollar amount of downgrades did exceed that for upgrades. The downgrades of New Jersey, Illinois, Connecticut, Puerto Rico, and related issuers accounted for almost 70% of downgraded debt. As our readers know, we have avoided the mentioned issuers’ bonds – except for selected insured bonds of Puerto Rico. Overall, the positive ratings environment is expected to continue with projected economic growth, although S&P notes that the tax reform limits on the deduction of interest for mortgages larger than $700,000 could constrain home prices in high-cost places like California (limiting the flexibility to raise property taxes); and the cap on federal deductions for state and local taxes could also produce stress in high-tax states, thus limiting upside ratings movements and potentially resulting in downgrades. Notwithstanding the positive growth, outlooks show that pockets of weakness are expected to remain in healthcare and higher education.

State Ratings

We noted in our last quarterly municipal credit commentary (http://www.cumber.com/q4-2017-credit-commentary-taxes-pensions-ratings/) that state rating activity had waned; and now the first quarter of 2018 is the first quarter in at least seven when there was no rating action on any state by Moody’s, S&P, Fitch, or Kroll; and that includes trend changes.

There was plenty of state news, however, focused on teachers’ strikes.

The West Virginia teacher’s strike closed all schools in the state for nine weekdays ending March 6th. The teachers prevailed and secured a 5% pay increase for public employees and a pledge to review healthcare coverage. The raises will likely come from reductions in other services. Oklahoma teachers have a strike planned for April 2nd, and although the state did grant a pay raise to public employees on March 26th, as of this writing the strike has yet to be called off. The pay increase will be funded by increasing taxes on oil and gas production, hotels, tobacco, diesel fuel, and gasoline. Arizona teachers are looking for pay raises, too, and a strike could be on the horizon after teachers’ success in West Virginia. There are also rumblings from teachers in Kentucky, who are worried about potential changes to their health and pension benefits. K–12 education is one of the largest spending items for states, second only to Medicaid, though it declined from 22% of states’ spending in 2008 to 19.4% in 2017, according to a report by the National Association of State Budget Officers. Overall spending on education increased 3.9% in 2017; however, the growth in Medicaid spending was 6.1%.

Pensions and OPEB 

Wages are only one form of compensation that public teachers receive. They also receive pensions and other post-employment benefits (OPEB) such as healthcare. For the past three years, governments have been required to report pension liabilities in greater detail, with historical information and illustrations of how their pension liabilities will change with changes in assumptions (such as a 1% change in the discount rate). As we have commented in the past, the lowering of the discount rate increases a future pension liability and raises the annual amount that must be paid into the pension plan to keep the liability from growing further. This factor is important, as the funded level of many plans is below 100% and the average was just 72% for fiscal 2015, as reported by Pew Charitable Trust. According to the Government Accounting Standards Board (GASB), accounting standards 67 and 68 are designed to improve the decision usefulness of reported pension information and to increase the transparency, consistency, and comparability of pension information across state and local governments. Starting in fiscal years ending June 30, 2017, GASB statements 74 and 75 require similar reporting of OPEB obligations. Although OPEB obligations are less contractual than pension promises are, they are not politically easy to reduce, and they are generally lower-funded or not funded and paid on a pay-as-you-go basis.

Reducing benefits is one way governments have been trying to reduce growth in unfunded liabilities. As governments are challenged by the decline in the ratio of current employees to retirees, as well as by competing demands for resources, the greater transparency required by GASB is welcome to analysts and stakeholders alike.

Speaking of Education

In February, Moody’s published an article, “Declining international student enrollment dampens US universities’ tuition revenue growth,” that cited two studies showing declines in international student enrollment. The Council of Graduate Schools found that international undergraduate applications declined by 3% and enrollment at the graduate level fell by 1% in 2017, reversing a decade-long expansion. In a January report, the National Science Foundation (NSF) found that international undergraduate enrollment declined by 2.2% and international graduate student enrollment declined by 5.5% 2017. Variations in the two studies are attributed to the different samples used. International students generally pay full tuition; and although international students account for less than 5% of overall enrollment, they represent good business in the margin. Declines were most noticed in schools with less brand recognition and in non-research-intensive programs. The NSF report concludes that the effect of new immigration policies, changes to visa regulations, and uncertainties around job opportunities post-graduation may continue to hamper application and matriculation rates of international students over the next several years. In January 2017 we noted the potential risk to higher education in a commentary “Higher Grounds for Higher Education” (http://www.cumber.com/higher-ground-for-higher-education/) and emphasized that our strategy is to invest in larger, well-established institutions with strong demand characteristics.

Notwithstanding the international student effect, increased competition due to declining student populations and ever-rising tuition costs have caused some smaller private colleges to struggle financially. In an early March article, Bloomberg noted that these challenges have led to some schools merging with each other or being absorbed into larger institutions. There were at least 55 merger and acquisition transactions among colleges and universities between 2010 and 2017. The Northeast is particularly affected since it has a high concentration of colleges while the number of high school graduates is expected to decline. A number of years ago we decided to avoid small private colleges noting declining enrollment trends, higher costs, and increased competition from public institutions.

Cumberland is sponsoring the second annual Financial Literacy Day on April 5th at the University of South Florida Sarasota Manatee campus. The event is open to public participation. All are invited and welcome. You can make your reservation online and learn more at https://www.interdependence.org/events/second-annual-financial-literacy-day-update-financial-markets-economy/.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Asia Equity Markets: Solid Economic Growth Versus Political Risk

Asian economies have begun the year with continued solid – and in some cases robust –performance. Yet the major Asian stock markets have diverged, with some significantly outperforming and others underperforming. In this note we focus on Japan, China, and India.

As this note was written, President Trump announced his administration’s intention to impose tariffs on $450 billion of Chinese imports, lodge a WTO dispute against China, and impose restrictions on Chinese investments in the US. Global markets tumbled last Thursday and Friday as fears of a world trade war surged. We share those fears, regretting that the Trump administration had not done as US allies had urged and taken a less risky, multilateral approach, which would have had a better chance of success. Then China responded in a surprisingly moderate way, and over the weekend the US reported that positive talks with China were underway. Also, an important bilateral trade agreement was announced between the US and South Korea, covering steel, autos, and other areas. In addition the European Union, Brazil, and Argentina were exempted from the steel and aluminum tariffs, joining Canada, Mexico, and Australia in that regard. Global equity markets, including those in Asia, recovered since the weekend as fears of a trade war have receded. They then declined again, this time on concerns about the technology sector. We will be writing separately on global markets and trade developments.

While all the stock markets in Asia together do not reach the size of the US equity market, some of them are quite large. Using data provided by the World Federation of Exchanges for year-end 2016 domestic market capitalization (reported in millions of US dollars), China’s equity markets, at $7,311,460 million, are the region’s largest. Japan’s equity market is second largest, at $4,955,300 million. Hong Kong’s market, at $3,193,235 million, is third, with fourth place India being very close at $3,106,267 million. Fifth and sixth largest are Australia, at $1,268,494 million, and Taiwan, at $928,366 million. It is noteworthy that the aggregate capitalization of China, Hong Kong, and Taiwan’s markets is about the same as the aggregate capitalization of all the European equity markets.

The Japanese economy has looked relatively robust in the first quarter, although the pace of improvement in business conditions appears to have moderated somewhat. In the manufacturing sector, output, new orders, and employment growth rates have all slowed. Looking ahead, firms are anticipating increased skill shortages in a very tight labor market. Yet according to the HIS Markit Japan Business Outlook for February, firms are optimistic about demand growth and profits and expect to increase their workforce numbers and capital expenditures. Despite some slowing in the first quarter, then, overall economic growth for the calendar year 2018, as measured by real GNP, could well surpass the 2017 pace, 1.8% versus 1.7%. While these growth rates look quite modest compared to those of many other advanced countries, they represent full-capacity growth for Japan, with its aging population. The forthcoming March Bank of Japan Tankan report should give further information as to whether business sentiment is becoming more negative.

The slight slowing recently in the still strong pace of economic activity in Japan probably is not the most important negative factor affecting business and equity market sentiment. Rather it has been the political storm winds confronting Prime Minister Abe and concerns about whether his economic policy, “Abenomics,” which has been very beneficial for the Japanese economy, is now at risk. The so-called Moritomo Gakuen scandal, which involved possible political influence exerted by Prime Minister Abe’s wife in a land deal, worsened when it was reported that Ministry of Finance officials admitted to a cover-up attempt by altering public documents. Abe’s voter support, as indicated by several polls, plummeted with this news; and fears grew that Abe might be forced out of office. Should that happen, he would very likely be followed by a more fiscally conservative successor. Abe’s expansive economic policies probably would not continue.

This is a risk confronting Japanese markets, and it is still evolving. However, we have not yet altered our base-case assumption that Abe will survive politically and be able to win his LDP Party’s leadership election in September. Moreover, and perhaps more importantly, the governor of the Bank of Japan has been reappointed to a second five-year term, along with two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe. The three share a strong determination to continue the Bank’s reflationist policy, which has been the most effective element in Abenomics. A continuing feature of that policy is the Bank’s periodic significant purchases of Japanese equity ETFs in addition to bonds. ETF purchases by the Bank in March have been at a record level.

Last week Japanese equity markets joined the global market pullback in response to increased fears of a possible trade war. Foreign investors were reported to have sold over 2 trillion yen of Japanese stocks during the week.The iShares MSCI Japan ETF, EWJ, fell about as much as the 3.8% drop in the benchmark MSCI All Country Ex United States ETF, ACWX and is participating in this week’s global recovery. Before last week, Japan’s equity markets had been underperforming other Asian markets since the beginning of the year, with EWJ’s increasing barely 0.025%, compared with the 4.29% gain for the iShares MSCI All Country Asia ex Japan ETF, AAXJ. The political scandal, the softness in some economic indicators, and the almost 7% year-to-date strengthening of the yen have all been headwinds. We are maintaining our Japan positions in our International and Global portfolios, as we anticipate stronger economic performance in the coming months and a continuation of Abe’s and the Bank of Japan’s expansionist economic policies.

China, Asia’s largest economy, continues to expand at a rapid rate, contrary to predictions by some for a sharp slowdown. China’s macroeconomic fundamentals remain robust. Economic growth has accelerated in the opening months of this year and looks likely to average 6.7% for the year, just slightly below last year’s 6.9% pace and above the government’s target of 6.5%. Strong global trade momentum will permit exports to continue to support the economic expansion. The government is taking measures to gain better control over excessive credit growth and to reduce financial risks, which have been an area of concern. Yi Gang, China’s new central bank chief, has stressed his intention to address the challenge of the high debt levels of state-owned companies, local governments, and households. Reforms to further open the economy to promote competition and to cut excess capacity are continuing.

Up to last week’s global equity tumble, China’s stock markets had been outperforming strongly this year. For example, the iShares MSCI China ETF, MCHI, was up 8.5% year-to-date. Last week it dropped 7.5% in the wake of Trump’s announcement of trade measures against China. This week China’s stocks joined in the recovery as trade war fears eased but then joined the tech sector swoon that started in the US.

India’s economy is likewise expanding rapidly. Indeed, it led the globe in the final quarter of 2017 with a growth rate of 7.2%, an expansion to which all sectors except mining contributed. The economy is recovering from a marked slowdown in the first half of 2017, triggered by a new goods and services tax and the government’s demonetization action in November 2016, which required most cash holdings to be deposited at banks. The latter move was intended to reduce India’s huge informal economy. Growth in the first half of this year looks likely to accelerate further to a 7.8% annual pace and then possibly moderate to a 7.6% rate in the second half of the year and in 2019. This growth performance would still lead the globe.

There have been some indications that business confidence among Indian firms softened in the first quarter, despite the strong macroeconomic prospects. That may have been one factor behind the underperformance of India’s equity markets in the first quarter. The iShares MSCI India ETF, INDA, was down 5.4% year-to-date before last week, when it lost an additional 2.8%. Probably more important was the unexpected return of the long-term capital gains tax in the budget. Also, there was a major fraud case involving the second largest state-run bank. This scandal countered the positive effects on market sentiment of a $32 billion capital infusion for state-run banks. We are maintaining our India positions in our International and Global portfolios.

We are also our maintaining our positions in the iShares MSCI All Country Asia ex Japan ETF, AAXJ. This ETF provides wide exposure to Asia, excluding Japan and Australia. Over the past 12 months, including this year’s volatile period, this ETF gained 19.9%, much better than the benchmark ACWX’s gain of 12.2%. The country weights in AAXJ for the top six markets are China, 39%; South Korea, 17.5%; Taiwan, 13%; India, 10%; Hong Kong, 5.75%; and Singapore, 4%. Note that China’s 39% weight appears to consist of about 7% Chinese firm stocks listed in Mainland China markets and 32% Chinese firm stocks listed in Hong Kong. We use this ETF to add to our China market exposure while diversifying risk. In last week’s market swoon, the positions in less volatile markets such as Taiwan, India, and Hong Kong certainly helped moderate the fall in AAXJ. Going forward, the substantial South Korea position should benefit from the US–South Korea trade agreement and the appearance of some easing of the political tension with North Korea.

Overall, Asian economies are likely to continue to play a leading role in the global economic expansion, which we expect to remain robust despite some recent signs of deceleration, mostly due to seasonal and weather-related factors. Asian equity markets should benefit from fundamental growth forces, but individual national markets will continue to have differing performances due to domestic developments. We expect market volatility in the emerging markets of Asia to continue to be relatively high.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




SPIVA and Active Bond Management

Active Equity Fund Managers Stuck in the Rough, While Active Bond Managers Tend to Stay on the Fairway

Since the launch of the State Street Global Advisors S&P 500 exchange-traded fund (SPY) in 1993, passive, index-replication portfolio construction has been widely adopted and represents the common investing experience of John and Jane Q. Public. Passive equity index investing has been a boon to investors small and large, enabling the ownership of thousands of individual issues at a low cost[1], through a single trade.[2] In the quarterly publication S&P Indices Versus Active (SPIVA) Scorecard, S&P Dow Jones Indices monitors the performance of actively managed mutual funds and ETFs relative to their stated benchmarks.[3] Across 17 domestic equity management styles, from large-cap to multi-cap blended fund, 63.43% of actively managed funds underperformed their benchmarks in 2017. Over 10 years, on an annualized basis, an average of 86.65% of actively managed equity funds underperformed their benchmarks through 2017. Thus, individual investors have embraced passive indexing, and with good reason.[4]

The narrative is different for active bond managers. A supermajority of actively managed investment-grade intermediate bond funds, benchmarked against the Barclays US Government/Credit Intermediate Index, bested their bogey last year. Specifically, 68.63% of the investment-grade intermediate bond funds monitored by the SPIVA Scorecard generated returns superior to their benchmark. On a 10-year annualized basis, 48.94% hit a birdie. Drawing from Morningstar historical statistics, research compiled by PIMCO tells a similar story: “The percentage of active bond funds and ETFs outperforming their median passive peers over the past 1, 3, 5, and 7 years all exceeded 50%; more than half outperformed their median passive peers over the past 10 years.”[5]

Perhaps “bond-picking” is the new “stock-picking”? With the Fed winding down QE and pushing short-term rates upward, can active bond managers #MakeBondsAttractiveAgain?

Over the last year, core inflation has remained muted – under 2% – while the 2-year Treasury note has broken out from 1.35% to 2.34% during the same time period – meaning that the real rate of interest has increased while inflation has held steady. For Baby Boomers looking at retirement and adding new money to their fixed-income allocation, this is welcome news. Millennials taking on a mortgage to finance their starter home may look at signing on to another year’s lease instead.

A survey of literature on active bond management reveals a consensus around certain factors that researchers believe may contribute to index-beating returns:

  1. (*) The bond market comprises thousands of different issues with varying maturities, which seldom trade. A bond deal to finance the construction of a new high school may have multiple tranches, maturing over 20 years. This single project generates a dozen new marketable securities. There are thousands of school districts in the United States, as compared to 500 companies in the S&P 500. As time marches on, a 10-year bond turns into a 5-year bond, and a 5-year bond matures. Wash, rinse, repeat. This inherent dynamism in the bond market, paired with infrequent trading across the thousands of different issues, can lead to asset mispricing, price negotiations, and opportunities for alpha. Bond indexes and the passive ETFs that track them are constantly refreshed with new securities. As PIMCO states: “The market is an ever-evolving set of assets that need to be traded actively for replication purposes. This is more acute with securities that have finite lives and regularly return capital.”[6]
  2. (*) Unconstrained, actively managed bond strategies can allow the manager flexibility to capitalize on market dislocations, increase or reduce weightings among sectors, and move up and down the yield curve to capture relative value. As the 2017 tax bill moved through Congress, there were provisions in both the House and Senate versions that would eliminate a municipal refinancing technique known as pre-refunding. The House bill went further and called for an end to private activity bonds, which allow private organizations such as nonprofit hospitals, colleges, and charter schools to access tax-free financing. The uncertainty caused issuers to rush deals to market before the rules were changed. Supply flooded the market, pushing up rates. Cumberland extended durations across our taxable and tax-free portfolios. Our traders were able to purchase municipal bonds at or near par with a 4% tax-free coupon, while similarly dated Treasuries were yielding 2.70%.  http://www.cumber.com/the-muni-take-on-the-tax-bill-round-two/
  3. (*) Bond managers who deploy their strategy across a composite of separately managed accounts are less vulnerable to forced selling during times of panic. Mutual funds and ETFs typically resort to selling their higher-quality assets that are more liquid, in order to quickly meet redemptions. Conversely, separate account managers are not beholden to the emotions of thousands of shareholders. With each separate account comprising individual bonds, the manager can sell less-volatile, shorter-dated paper to fund the purchase of issues unwillingly unloaded by mutual funds and ETFs at fire-sale prices. Managers of open-ended mutual funds and ETFs are subservient to one price, that of the net asset value (NAV).

The idiosyncrasies of the largest market in the world – the sovereign and corporate debt markets – continuously generate new opportunities for the active manager. At Cumberland Advisors we actively manage both municipal bond and taxable bond strategies, both guided by a total-return objective and limited to credits with an A rating or better. For individuals and organizations seeking a long-term buy-hold-rebalance approach, Cumberland Advisors manages a strategy, dubbed Active Taxable Bonds/Passive Equity, that joins passive equity exposure with active bond management.

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


[1] “The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74%, according to Morningstar Investment Research.” http://guides.wsj.com/personal-finance/investing/how-to-choose-an-exchange-traded-fund-etf/
[2] The Schwab® S&P 500 Index Fund (SWPPX) is available to investors at a net expense ratio of 3 basis points (.03%). https://www.schwab.wallst.com/schwab/Prospect/research/mutualfunds/summary.asp?symbol=SWPPX
[3] S&P Indices Versus Active Scorecard. “The SPIVA Scorecard is a robust, widely-referenced research piece conducted and published by S&P DJI that compares actively managed funds against their appropriate benchmarks on a semiannual basis. We offer scorecards reporting on actively managed funds in the following countries and regions: Australia, Canada, Europe, India, Japan, Latin America, South Africa, and the U.S.”  https://us.spindices.com/search/?ContentType=SPIVA&_ga=2.244572805.1865916684.1522156867-1827973429.1522156867
[4] We note that indexes do not include expenses associated with the acquisition and disposition of securities, personnel costs, compliance, legal, shareholder administration, etc.



Dovish or Hawkish?

Chairman Powell held his first press conference following the FOMC meeting. It was more concise but just as informative as those of his predecessor. As expected, the FOMC raised the target range for the federal funds rate by 25 basis points, and Chairman Powell delivered a message consistent with his recent testimony, reflecting a continuity in policy. His words may have been somewhat different from Yellen’s, but the message was essentially the same: the economy continues to improve; labor markets are tight; inflation is below target; and the return to policy normality will be gradual.

Interestingly, although the FOMC rate hike was widely anticipated, pundits and markets had a range of reactions to the hike and the message delivered. Some interpreted the decision and related materials as dovish:  “Dollar Tumbles After Expected Rate Hike Due to Dovish Fed ‘Dot Plot.’”[1] Others put a hawkish spin on the action: “3 Utilities Stocks to Brave Powell’s Hawkish Rate Stance.”[2] How could such divergent reactions be derived from the same press conference and SEP data that accompanied the FOMC’s decision? Part of the answer may lie in what information was given the most weight. Those who put a hawkish spin on the decision concentrate on the fact that the FOMC’s dot chart for 2018 kept three rate hikes penciled in, and 2019 showed four more hikes, with the median federal funds rate peaking at 3.4% in 2020. The more dovish interpretation focused more on Chairman Powell’s press conference, where he indicated that the FOMC would be willing to see inflation run somewhat above its 2% target and noted that growth may have moderated a bit from what it appeared to be late last year.[3]

Perhaps the most relevant aspect of Chairman Powell’s press conference was the fact that he emphasized that the pace of policy normalization would be gradual and data-dependent. Furthermore, he stated that the FOMC would be flexible, that the risks to the forecasts were roughly balanced, and that there was considerable uncertainty as to whether there was, at present, a strong linkage between tight labor markets, wage increases, and inflation. He did not see signs of an incipient run-up in inflation that would put the Committee at risk of being behind the curve.

What has not gotten the attention that it deserves, however, is the curious pattern in the various components of the SEP forecasts. That pattern raises questions about how the FOMC sees the relationship between policy changes and their impact on growth and inflation dynamics. To illustrate, the following table shows the median projections for the federal funds rate, GDP, unemployment, and inflation rates over the forecast horizon. Note that despite Powell’s claim that the economy is showing strength, the median GDP growth estimate declines sequentially year by year and bottoms out at 1.8% in the intermediate term. This is an outcome consistent with less than 1% growth in the labor force and a 1.2% rate of increase in productivity and is not at all in line with the administration’s goal of 3% growth.

It is true that the Committee revised up its growth projection for 2018 from 2.5% to 2.7% and for 2019 from 2.1% to 2.4%, but it should be noted that the Atlanta Fed’s GDPNow forecast now sits at 1.8% and has been continually marked down during this first quarter of 2018. Furthermore, the GDPNow projection tends to close in on the actual number as the end of the quarter approaches. If that first-quarter 1.8% GDPNow number is realized, then the remainder of 2018 will have to sustain an annualized rate of growth of over 3.3% rate for each of the remaining three quarters of the year. It is not clear how this result could be realized unless there is a substantial kick from the tax cut and stimulus packages, but Chairman Powell tended to discount those for 2018. And this is also reflected in the face of a declining real GDP growth for 2019 in the SEP forecasts. Note, too, that while growth is expected to slow in 2019, 2020, and over the intermediate term, unemployment is still projected to decline further, to 3.6%, which is substantially below the 4.5% rate expected to prevail in the intermediate term, and many economists believe 4.5% to be a reasonable approximation of the natural rate of unemployment. What would cause unemployment to continue to fall as GDP growth declines, and then what is the scenario that would see unemployment reverse itself to settle in at 4.5% as growth slows to 1.8% after 2020? One possibility would be a reversal in the recent increases in the participation rate, but that is speculative at this point. Is there a recession hidden in the forecasts after 2020, since a recession is normally the only time when unemployment increases and inflation declines? Finally, this scenario of declining GDP, declining unemployment, and a negligible increase in inflation is supposedly to be brought about by substantial and continual increases in the federal funds rate from 2.1% in 2018 to 3.4% in 2020. The dynamics of this odd scenario are not only outside the bounds of past experience but are also implausible. The only rate scenario that is consistent with the forecasts is a much more gradual and cautious approach to tightening, and even then there is a gap between 2020 and how the Committee sees the economy evolving to its intermediate term projection. And that gradual, more cautious scenario is made even more likely by the passage of the spending bill and the tariff decisions made after the FOMC meeting.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] https://www.fxstreet.com/analysis/dollar-tumbles-after-expected-rate-hike-due-to-dovish-fed-dot-plot-march-2108-201803220214
[2] https://www.zacks.com/stock/news/296553/3-utility-stocks-to-brave-powells-hawkish-rate-hike-stance



Taxable Total Return First-Quarter Review

The first quarter of 2018 provided some long overdue volatility to equity markets while Treasury yields rose across the board. The long end of the yield curve underperformed during the month of January. Roughly 75% of the 35-basis-point move upward in the 30yr Treasury yield took place in the first month of the quarter, while the short end lagged the upward movement in yield. After experiencing steepening in January, the Treasury market reverted to a flattening trend as T-Bills and short-term Treasuries experienced the majority of their movement upward during the months of February and March, providing outperformance for the long end of the yield curve in those months.

This outperformance on the long end of the yield curve over the last two months demonstrates why we favor a “barbell” approach and maintain an allocation to longer-dated securities. While the weighting is small at this time, we are currently targeting new-issue longer taxable and tax-free municipals that have either an attractive spread over Treasuries (taxable) or an attractive muni/Treasury ratio in the 125–140% range (tax-free munis). New issues tend to offer a concession to the secondary market to ensure deals get done and provide a cushion against the increase in rates we have been experiencing. The chart below shows why we think the inclusion of tax-free municipals is beneficial to taxable portfolios in light of our expectation that the muni/Treasury ratio will correct itself as we move forward with the Fed hiking cycle.

Source: Bloomberg
On the short end of the barbell we continue to maintain the defensive assets we started purchasing at the beginning of the Fed’s hiking cycle. They include Treasury floating-rate notes, agency multi-steps, and T-bills that, as they mature, we will look to replace them, or reinvest the proceeds in better-yielding opportunities, depending on market conditions. We have also started to include a heavier weighting in investment-grade corporate bonds on the short end of the barbell as spreads have started to widen in that space. The Bloomberg Barclays US Corporate Index OAS hit its tightest level since 2007 on 2/1/2018 at +85 before widening out to +105 currently. In contrast, taxable municipals have not experienced this level of widening, creating an opportunity to allocate more cash to short-term corporate bonds. The chart below shows the change in the Bloomberg Barclays US Corporate Index OAS so far in 2018.
Source: Bloomberg

The Fed held its FOMC meeting on March 21st and delivered a widely anticipated quarter-point rate hike, lifting the fed funds target rate to 1.50–1.75%. The statement accompanying the meeting stated that job gains have been “strong” while economic activity has experienced “moderate” growth. The statement also discussed inflation remaining low, but the expectation is that it will move up and should stabilize around 2% over the medium term. The median forecast from the Fed’s “dot plot” currently predicts two more rate hikes this year, which is unchanged from the December outlook and in line with our projections.

As we move into the second quarter of 2018, Cumberland’s projection that the Fed will raise rates two or three times in 2018 remains unchanged. The FOMC will continue to take a judicious approach with regard to raising short-term interest rates and will focus on economic data and overall market conditions to determine whether to continue increasing rates. Our goal is to remain defensive in our approach to investing as we navigate a rising-interest-rate environment. We will continue making our investment decisions conservatively while extending durations and picking up additional yield as opportunities in the market develop.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Banks and April 5

Banks and the banking system are a big part of the April 5 Financial Literacy Day to be held in Sarasota at the Selby Auditorium on the University of South Florida Sarasota-Manatee (USFSM) campus.

We are going to hear from Federal Reserve President Raphael Bostic, whose Atlanta-headquartered district includes the State of Florida. So by definition the Federal Reserve Bank of Atlanta is the central banking authority of every bank in the greater Sarasota-Bradenton region. Major changes in bank supervision and regulation are underway; and new legislation is changing the playing field because requirements differ for the community banks, the small and mid-sized banks, and the very large banks. Hundreds of thousands of individuals, businesses, and other organizations in the greater Sarasota-Bradenton region interact with banks daily.

Attendees will also hear from Chris Whalen, who will offer his views on the banking system. Chris has a distinguished career in credit ratings and in bank analysis. His newsletter, the Institutional Risk Analyst, is famous; and his bank-rating mechanism has been well-known to investment professionals for decades. He frequently appears on Bloomberg TV and CNBC.

On the municipal bond panel there will be room for discussion about the forthcoming changes that allow banks to count their holdings of munis as high-quality liquid assets in determining their capital requirements. Many see this change as bullish for Munis and for the investing public. Attendees at the April 5 event will be able to question experts on the rule changes and what those changes may mean for an investor or a broker-dealer who sells munis. Disclosures are also forthcoming about broker markups, and they, too, will have an impact. The sessions are designed to give the public a real window of opportunity to learn about these issues and to pose their questions to experts.

The Financial Literacy Day stock market sessions will also include discussion of banks, bank stocks, and related securities. Banks and financials make up about 15% of the American stock market weight, looming large in the US investing landscape, and they have been strong performers in the recent stock market rally. Will that trend continue? Why or why not? Are there credit issues on the horizon? What will the implications be for banks as the Federal Reserve changes its monetary policies?

When it comes to banks, there is plenty to talk about on April 5th.

Registration is now open for the April 5 all-day event. Financial Literacy Day is an open forum: Individual investors, state and local officials, financial institutions, pension trustees, philanthropy activists, policy makers and policy wonks – all are welcome. At Cumberland we believe everyone benefits from increased financial education.

The cost is only $50 to register ($25 for students), and that is just to help cover GIC’s and USFSM’s expenses. Cumberland is sponsoring the event and hosting lunch and the closing reception. Attendees are welcome for the whole day or part of the day.

Please reserve your spot soon – we expect to have a full auditorium. The event is open to public participation. All are invited and welcome. You can make your reservation online and learn more at https://www.interdependence.org/events/second-annual-financial-literacy-day-update-financial-markets-economy/.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio

 




Market Volatility ETF Portfolios 1Q 2018 Review: Equity Premium

The US stock market had a long overdue correction in the first quarter, a response to the concern that the market had become overvalued in the raging post-election bull market. Many sophisticated investors would probably agree that a healthy pullback can propel the market forward in the long run. One of the arguments for that view is that the pullback brings an overheated market back to a so-called bargain level so that more cash will participate. However, how can one identify a market that is truly overvalued? We recommend a close look at the equity risk premium. (Data source: Bloomberg)


Figure 1. Trailing and Forward S&P 500 Equity Risk Premium Comparison

Figure 1 demonstrates the equity risk premiums in both trailing and forward measures for the past two decades. We define the trailing equity risk premium using realized volatility, and use perceived future volatility to calculate the forward equity risk premium. The first takeaway is that the trailing premium is less volatile than the forward premium. This suggests that the market tends to overestimate the future violence of market movements. More importantly, this fact indicates that oftentimes the market turns out to be not as overvalued as many investors have believed. However, overestimating equity risk does not necessarily translate into overestimating volatility. In fact, forward volatility overshoots and undershoots for almost equal amounts of time, as shown in Figure 2.


Figure 2. Realized Volatility vs. Forward Volatility

Now, did the market seem to be overly valued in the month of January? The market itself thought so, according to the forward risk premium. Nevertheless, bearing in mind the evidence that the market tends to miscalculate volatility during significant price movements, we advise investors not to just simply stampede with the herd. After all, panic selling and FOMO (fear of missing out) buying will only dampen overall returns.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Winners and Losers from Global Trade

David L. Blond, Ph.D, has a distinguished career in international economics and particularly on the issues of trade. He is the president of QuERI-International, Washington, D.C.

He has assessed President Trump’s Tariff and Trade barrier initiative and has articulated some strong opinions. His views are his. They are worth reading and considering in what is about a ten page paper on this subject. Readers may note the documentation and data depiction which are his work.

When it comes to the views of a number of us at Cumberland you can find them here at www.cumber.com/category/market-commentary/.

We thank David Blond for permission to offer his paper to our readers.

A rebuttal to David Blond’s commentary has added to the conversation. You can read that here: Why David Blond is Wrong on Trade

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Winners and Losers from Global Trade

In a grand effort to change the subject of the political discussion from Russia to something else, President Trump fired the opening shots in a new trade war. Not content to destroy the solar industry by adding costs without adding supply to solar panels, or making South Korean washing machines more expensive without making American consumers more willing to buy US made (with foreign parts) machines from the one remaining American producer, President Trump fired off the big guns to try to save what remains of the US steel and aluminum industries with new tariffs. The response was, of course, expected.

Over the past twenty years or more I’ve tried to slow the steady erosion of the US industrial base against the tide of history, but right now, at this time, it is far too late to stop what is the inevitable shift in the global distribution of manufacturing. To have saved the US Steel industry we would have had to force US companies to invest in the new furnaces and the US steel workers to cut their wages in a vain effort to gain advantages of scale and compete on price. Our companies chose not to try to fight against the subsidies – from government direct aid to massive amounts of nearly free capital – but to regroup around a few, higher profit, subspecialties. Steel has become highly specialized in more technology interesting and profitable alloys, leaving the lower end, construction steel and non-specialty steel to foreign producers with their massive scale economies. The cost of this change has been, felt, in the secondary industries that transformed commodity steel in small operations scattered across the industrial rust belt. The downstream industries have failed as the few remaining US steel companies with specialized products have maintained their shares. The US Aluminum industry also has made changes that allow it to maintain its position in the world while fulfill its obligations to the environment. Less aluminum for cans, but more for aircraft and even military vehicles has left the industry largely with the same share of the world as it had in the past.

Looking at the chart we can see that while the US lost its nearly preeminent position in both industries that it had coming out of the Second World War over a long period of decline. Over this period the US companies shifted capital from less productive to more productive and profitable industries and also invested overseas. The failure of US capitalism has been borne by the workers and the communities that have been damaged by this neglect. Social morays matter and US capitalism with its emphasis on shareholders value rather than that of all stake-holders is to blame, but what we see today, as the graph illustrates, is a slow erosion, but not the disappearance of entire industries.

In the chart all values have been corrected for changes in prices and in changes in exchange rates. The US share of world output of steel and aluminum metals stabilized around 2010. In the case of US steel the import share is forecast to decline relative to demand for steel in US manufactures as the product mix changes. There is also some growth in import share in non-ferrous manufactures demand. Tariffs will not suddenly return either industry to health. Based on the factors driving consumption the import share of foreign aluminum will likely continue to increase as overall demand shifts from aluminum to more exotic low weight materials like carbon fiber while the foreign aluminum may continue to be imported for low value uses such as cans and other commodity materials made of aluminum. Again not all aluminum is the same for all uses and American companies remaining in the industry have shifted to the higher value output. This is a natural progression as we should see as countries move towards more service and information/science intensive specialties and away from the high impact on the environment and low skill product categories within the industry classification code.

Winners and Losers from Global Trade Chart (1)

What Happens If Trump Gets His Way on Trade

Global trade patterns have been modified over the last fifty years by a series of trade agreements. Largely tariffs in the richest and most important markets are low enough to be barely noticeable in most manufactured commodities. Tariffs against emerging markets have been reduced through special efforts by advance countries to open potential flows to help in the development process. Efforts to reduce tariffs have been, as a result, concentrated on eliminating tariffs on agricultural commodities with limited results since food, unlike manufactures, is one of the essentials to guarantee along with shelter to a people. Much of the progress on reducing tariffs has concentrated on reducing prohibitive tariffs in the emerging and developing country markets.

America has been at the forefront of this effort. But tariffs and non-tariff barriers not just rules for companies to deal with, they are also part of the nation’s foreign strategy. The Trans-Pacific Partnership Agreement was less about tariff levels and more about maintaining long-term trading and political connections. The failure of President Trump to see America’s role as the essential nation for global cooperation is a problem. His rhetoric has damaged our standing with our natural trading partners. But in this article we are looking less at the political and social implications of the failure to keep the momentum going, and more at how difficult reversing the trends that have reduced American manufacturing in some sectors. The reason for this is that industrial capacity has been lost in many industries and technology has made replacing suppliers far more complicated. When I was the Senior Economist at the Pentagon and studying our capability to expand rapidly our defense industrial base, this problem of technological interplay became readily apparent. A landing gear on an F-15 takes at least a year to produce even as the labor hours may be just a third or less of that time. Each time a cut is made in the high tensile alloy, the unfinished billet had to be slowly heated and slowly cooled to release the tension to allow more machining. The unique parts used on military aircraft had to meet mil-specs that made it costly to replace one supplier or open a second source without testing of the replacements. The same is true for much of what passes as new products. While consumer goods might be easier to copy, the margins on these make the cost of the new factory expensive. The advantage of Asian suppliers was not just their low labor costs, but their excess, flexible, engineering and manufacturing capabilities that are not easily duplicated. America’s manufacturing capacity has not declined even as employment in manufacturing has collapsed. Productivity explains most of the loss of jobs , but gains in productivity have come from the inclusion of more foreign sourced inputs in finished products thus real gains in productivity may be an illusion induced by this shift from a vertical to horizontal company organizational approach. The result is that fewer workers are needed as the foreign labor inputs once made in-house or with locally sourced suppliers is not counted when measuring total factor productivity. This pattern of hollowing out companies is likely responsible for most of the gains in productivity and fewer workers producing products for sale domestically.

Measuring the Cost of Anti-Globalization

Simulations are one of the few ways to measure the cost of retreating from the world that has emerged from the steady advance of trade liberalization. As we have shown, the benefits and the costs of this advance are not evenly shared opening the door to protectionist sentiments. But reversing the course also comes with costs. The QuERI Integrated Global Model measures this interconnectivity through a series of equations linking trade with production. Statistically based, econometrically derived, equations reflect the production function including stock of capital to labor ratios, and two major trade components – imports which are in nearly all cases negative to domestic production and exports which are positive. In rare cases the positive export elasticity is greater than the negative import one. Unlike most macroeconomic model for a single country, the QuERI model set is based on a 72 country and 25 year sample of data that allows for countries to pass through various stages of economic development. Lastly results are linked together across industries using input-output linkages and across the world using international trade relationships. Like the best econometric models, the coefficients are related to one another independent of prices and exchange rates. The underlying QuERI data set is likely the largest and most fully integrated long-term reading on industrial, trade, employment, prices, and consumption patterns available anywhere in the world.

The question at hand then is what would be the impact of a full blown, 1930’s style, trade war. The tariffs President Trump has initiated against good advice will not lead to a recovery in US manufacturing or in the core industries he’s targeted. As I said at the start, the train left the station long ago, and it is too late to reverse the integration, only to slow it, adding risk, rather than supporting faster growth in all countries. A model like the QuERI model, however, can be used more selectively to measure the effect of tariffs on a single industry or on a collection of industries. In the example below we want to not pick any one industry, but rather to assume that all countries apply the same tariff increase across all products. We can then measure two things – the impact on exports and imports and the impact on production.

A 10% Tariff Increase – the Global Implications

Integrated global supply chains are not simply between advanced countries and emerging markets, they also exist between countries in each group so any disruption is a major change and can lead to loss of irreplaceable capacity and capabilities. The cost of qualifying a new supplier is often high and the risk to existing business increases if the replacement products are more prone to error or failure. In this example we assume that the imposition of a 10% tariff in the United States creates a chain of causality that expands so that a similar tariff is applied in all other countries. The goal is to find out what the costs of this kind of modest increase in international prices pose to trade and production.

The broad based assumption is that globalization reverses slightly as a result of this added cost for imports. The impact is greatest within the group of advanced country due to their greater integration with the world. The calculated impact is based on the point elasticities for imports and export prices against changes in trade. To insure that we are not over or undercounting the effect we average the total export adjustment from the model and the total import adjustment for each ISIC3 commodity. The share of global trade adjustment is based on the share of the adjustment in individual country imports or exports against the average global trade adjustment. Not all countries are sensitive to changes in price for trade goods. We assume that higher prices will not increase imports although it is possible there is some precautionary trade influenced higher prices. When the price elasticity for imports is positive it suggests that demand is not sensitive to price changes. The assumption of the model is that these changes are modest and it is likely that temporary reductions can take place if the price shoots up too rapidly to be accommodated in the overall cost function for the finished products. The price sensitivity of a country on a rapid development trajectory, like China, is less than for advanced countries with more flexibility of supply or simply to reduce domestic production and import more of the finished manufactures for resale and rebranding (common practices).

Emerging and Developing Nations Came to the Party Late

The pooled-cross sectional model for trade and industry used in my model is based on a “stage of development” so that countries at the start of period of rapid industrialization are assumed to follow paths similar to more advanced countries. In the early stages a country is more dependent on foreign sources of supply. The actual volume of imports is defined by the countries capacity to export or attract inbound foreign investment. Tariffs in these countries tend to be supportive of local business and often are higher than they need to be and these limits can impede real growth and development. Much of the theoretical literature on tariffs is based on the assumption that tariffs dampen imports, but may limit the growth of domestic industries despite the intent. The higher prices for the locally manufactured products may limit the market size and limit growth of the economy as a whole. It was factually true that in the early periods of industrialization the advanced countries had high tariffs to encouraged industrialization. That strategy is not replicable despite the fact that globalization as it stands has failed the emerging and developing nations primarily because the price of finished goods is influenced by the higher prices of the advanced countries. Thus the steel that might have gone into an automobile is priced at the world market prices consistent with the costs of finished products sold in advanced countries. For a country to grow rapidly then wages and prices have to be in line. Today the cost of living in rich and poor countries is often significantly different. We measure these differences through the purchasing power parity index. The cost of living in China is today around .33, while the wages paid to workers even at $ 5.00 an hour (2016) is just .13 of the wages in the United States. In the next graph we see how the advanced countries prices and wages generally are in line so that growth can be sustained from domestic demand and supply alone if need be.

Why is this critical – without a strong alignment between real wages and real prices then internalized, self-initiated, growth is difficult to be maintained without external sources of demand. Export-led growth encourages the import of new technologies while suppressing wages and encouraging the import of foreign luxury goods suppressing local supply. The result is that for many emerging and developing countries there is no simple solution and higher tariffs may not encourage the development of domestic sources of supply. Of course there are exceptions—protection of agricultural products may be important for reasons of the keeping peasants on the farm and insuring that domestic producers continue to stay in the rural communities and maintain food self-sufficiency.

In the charts we can see how the wage rate, represented by 1/wageindex (1.0 = US wages) and the PPP Price index are not fully in line in the emerging markets group. It costs less to live in China than the United States, but the wages in the United States are in line with the cost of living, the wages in China today are suppressed by the need to be competitive on world markets by international trade, so it is hard to sustain growth without exports or government subsidies. If that were not the case then the index for wages and the index for prices would be equal to one another.

Using the Model to Measure the Impact of Tariffs on Trade –the Cost of Reversing Sixty Years of International Trade Liberalization

The QuERI Global Model has a number of advantages when measuring the impact of changes in prices, in this case, ad valorem tariff changes, on trade, industrial activity, and employment. The two charts illustrate the disconnect between relative wages and relative prices. Globalization has widened this gap in rich and poor countries alike. At the same time the dependency between countries for vital raw materials, energy supplies, and intermediate inputs has increased. Disturbing markets and plans can only lead to a disruption in an economy until companies and economies adapt. But during the period of adaptation production is impacted, employment growth reverses, and real wages may decline further as companies attempt to maintain profits.

Trade and Industrial Production Linkages

Within the model there are a number of links between trade and production. The industrial production of traded products includes a variable reflecting the foreign content of factor inputs based on estimates from the QuERI IO models. Foreign content is based on the import share of apparent consumption times the total factor input. For example if to make a car in the United States it takes $ 1000 worth of steel based on the IO column coefficient at the intersection of steel (selling) and automobiles (buying) and if import share of foreign steel is 50%, then $ 500 is allocated to foreign content of steel. Going further down the column of the IO for automobiles we see the share of electronics is $ 1500 and the foreign share of imports of these products is 65% then the foreign content is $975. Adding all of the foreign content value up the total import value is used as an independent variable in the industry production function for automobiles. Repeating this process we can calculate then the likely sensitivity of the industry to the replacement of foreign with domestic sources of supply. In the US the foreign content share for automobiles is 40% of the total value of automobile production. For footwear the foreign share is over 78%. For China the foreign share of production for automobiles is just over 5%. So in any trade war who’s domestic companies would be more seriously impacted?

Reducing foreign inputs to US production will slow growth or even reverse growth in US manufactures so long as substitutes are not available. Given the complexity of much of what is sold as factors of production or as finished goods in retailers, replacement of foreign content will be a slow, painful and possibly impossible process. Adding tariffs will in the short-run reduce demand as some American production may be lost. In the model then the production function has three elements whose interplay determines if production will increase or decrease.

(1) Net Change in Production = Net Change in Foreign Content $ + Net Change in Exports – Net Change in Imports.
(2) Net Change in Exports = function of Impact of Foreign Tariff Changes on US Exports (positive)
(3) Net Change in Imports = function of Impact of US Tariff Changes on Imports (negative)

President’s Trump’s idea that a tariff might reduce or eliminate or dependence on foreign suppliers is a myth born as much out of ignorance as political calculation. The American manufacturing base has been hollowed out and is a part of the global supply chain of global companies with markets in all parts of the world. Fifty years of continuous efforts to reduce tariffs have been successful creating a world market and worldwide production system. But the emergence of China and its low cost wages and lower cost capital and ideal location in the heart of an emerging Asia has changed the balance. Higher tariffs will end up damaging the American economy more than China. The foreign content in US manufacturing, investment goods purchased, and consumer products sold by retail and wholesalers makes any effort to disrupt trade self-destructive. The next table illustrates this in the starkest terms – the share of foreign content in US domestic manufacturing has been growing year by year. The share of foreign content in US investment expenditures for machinery and equipment has also been growing over this period. Any effort to enter into a broad based trade war would lead to the destruction of American industries ability in the short-run to manufacture almost anything except, perhaps, rubber mats for automobiles.

Foreign content in finished products is significant. Clothing and apparel 71% in 2015, household operations 48%, furniture, finishing and other equipment 37%, other transportation and communications 48%, medical care and health including pharmaceuticals 45%, entertainment and cultural expenditures 48%. Place tariffs on imports from China and in the short-run there will be empty shelves and limited consumer choices in the stores, ultimately small and large stores will close leaving millions of people from warehouse workers to sales people out of work.

Foreign content in finished products is significant.
Foreign content in finished products is significant.

Foreign content in finished products is significant.
Foreign content in finished products is significant.

Using the model we can simulate how a 10% change in tariffs as measured through a 10% change in import price will impact the world economy. In this example the 10% unilateral change in US tariffs – pushing them up to closer to 12 to 14% from around 2 to 4% where they currently are. In this scenario we assume that the world reciprocates and applies a similar increase in cost to imports from all sources. If globalization is the problem and its impact on countries ability to manufacture has been substantial, then we should expect that the change is universal, the beggar thy neighbor approach usually leads to higher tariffs across the board worldwide. The question we ask – who wins and who loses from this change. The degree of dependence, however, varies and the weights of imports and exports vary in all countries. The net impact then will be different for rich and poor, trade intensive and trade neutral countries.

10% Tariff Impact on All Countries & Regions
10% Tariff Impact on All Countries & Regions

As table shows if there is a trade war and it settles down to around a 10% increase in tariffs levied against all countries imports and exports, given the dependency, the impact of this symmetrical war (unlikely as countries will more selectively target the industries and countries imposing the added tariffs) which does not bias the impact against one country and not another, the United States with its greater dependence on foreign imports will be more directly impacted than other countries. The differences in shares between US and Germany are a function of the mix of products imported and not from differences in the product specific price elasticities. The cost of President Trump’s trade war for the United States could be a 1.1% decline in real production of manufactures, a nearly 1% decline in output of primary products including soybeans and corn exports. The most important loser from any trade war is the United States. Imports would be 5.5% less while exports would be 2.2% less so that the net trade deficit could be smaller as a result of the tariffs. It would cut around 1.1% from US manufacturing output and reduce employment in manufactures by 1.3%. These results are the build-up from the bottom-up at the industry level (more than 170 industries including services).

This modeling exercise only takes into account the impact on production from the reduction in imports used as intermediate inputs to production. A more complete analysis will use the full inter-relationships within the model to measure the effect on production of less foreign products for sales to consumers and less capital goods able to be deployed to growth productive capacity. It is likely that given the significant, sometimes 30 to 50% shares of foreign content for personal consumption and business investment that the full effect of a trade war will be greater. Perhaps more damaging is that the war would be concentrated against a single country, the United States, while other countries and groups of countries maintain their past trade relationships. Like dropping out of the Trans-Pacific Partnership, threatening to pull out of NAFTA, canceling negotiations on the European US trade agreement, the net result will be to isolate the United States from the world.

Benefits and Costs of Global Specialization – How to Measure Trade Displacement.

Much of the debate over the past years about the benefits and the costs global specialization, primarily the rapid advance of China as a major manufacturing center has been less about the financial costs – the $ 12 trillion dollars of additional liquidity that the US consumers offered to the world (the cumulative US trade deficit from 1990 through 2015 compared to the over $ 3 trillion dollars in trade surplus run-up by China over this same period—and more in terms of the jobs lost and the impact of foreign products on American wages in manufacturing.

The flow of US dollars has is the lubrication for the world economy adding liquidity to rich and poor countries alike. Without the US acting then as the little blue engine that ‘could’ for the world economy, the miracle that has lifted a billion people from poverty to wealth or near wealth could not have happened, it came at a cost to America’s massive, post-war, industrial base. It came as a benefit to American consumers and companies (and investors) in the form of supporting a higher standard of living at a lesser cost than internal resources alone could support, and a better margin on sales for companies supporting the growth in the stock market values of companies even as old name companies in commodity type industries such as steel and aluminum suffered.

There are many ways to measure the trade deficit. The nominal deficit is driven by differences in relative prices of exports and imports. A price index is an approximation of the changes in the price of the components of the commodity group. The BLS, the government agency that develops price and wage indices based on surveys, but there are some major product groups where absolute prices have declined even as the capabilities offered for these prices have increased. For example computers and chips available are multiples of prior computers and chips in terms of capabilities for the same basic prices paid in the past. In the BLS indices for these technology intensive products prices are assumed to decline so real value increases. This potentially distorts the relationship between nominal and real deficits. Another problem comes from exchange rates which vary over time distorting the real value changes from the nominal cost changes. Our primary focus then will be, like in the case of macroeconomic models, changes in real activity with price changes and exchange rate changes excluded.

With the dollar as the numeraire currency through which much of world trade flows, the need for dollars is great. If the US fails to run a large trade deficit each year, the cost of buying and selling dollars would necessarily increase leading to higher costs to support the larger amount of world trade that is dependent upon using dollars for the transaction. Dollars are also needed to repay debts denominated in dollars or support other financial flows. The following chart perhaps illustrates that there could be a causal link between the size of the US trade deficit in constant dollars as a share of total US exports and imports and the rate of change in world real GDP output excluding US real GDP growth. The Asian crisis that sent the Emerging Countries into a tailspin and collapsing stock markets over the 1997-99 period may have been due to a liquidity shortage as the US deficit pushed towards closer balance starting in 1993 and reaching an apex in 1996 with world output (excluding US) for three years between 1994 and 1997 was 3%, but as the US fiscal stimulus from our trade deficits declined over those years, and without alternatives to replace the extra liquidity, raw material prices growth collapsed and world output slowed dramatically from 3% to 1%, and 2% in the following year. Fearing a global depression, the Clinton economic team combined with the Federal Reserve stepped in to stimulate growth in US trade and the US deficit grew strongly as world trade growth reached over 10% and the deficit reached a low point of -3.5% while world output growth expanded strongly until as the US deficit relative to total trade declined year by year until we reached the Lehman Brothers in 2007-08 and world output suddenly went from positive to negative in one year. The US recovery has been followed by a return to past periods of the US running trade deficits. In the QuERI model, like non-US world output, these stabilize in the long term at around -25% and world output stabilizes in the 2-3% range.

If the global growth depends upon the US running a stable, long-term, trade deficit, then the industrial base in the US will necessarily suffer from a shortage of demand or a steady drum beat of competition that keeps real wage growth in check. In short we may be locked into a damned if we do and damned if we don’t pattern. When I was at the Pentagon during the period of the Reagan build-up, I would explain to the critiques back in 1982-84 that economies have a natural structure that may adjust over time as defense contractors shift resources form military to civilian needs, but no economy can adjust fast enough to accommodate a sudden cessation of demand without dire consequences. Thus the world depends upon US surplus demand. The Chinese government would gladly burn the excess reserves in dollars than spend them in buying US steel or aluminum. The demand for dollars is greater today than when the idea was first suggested back in the 1970’s. The dollar is not just the transaction currency for trade, but more importantly the transaction currency for world debt denominated in dollars. The failure to provide sufficient excess liquidity shrinks the amount available. It drives up the price of the currency, but even a strong dollar and a growing trade deficit will add enough free exchange especially if the US domestic demand increases from a stronger economy.

Renegotiating Trade Agreements Doesn’t Add Industrial Capacity in the United States

I pointed out in an earlier paper on the future of globalization, that there is nothing that President Trump has said or tweeted about the failure to protect American manufacturing from the ravages of unfair trade practices of some countries or the willingness of American companies to outsource supply to foreign subsidiaries at the cost to historic relationship with workers and communities. I have been saying for years. But I’m enough of a realist (or powerless) to know that these business decisions can’t be easily reversed. Once a company chooses to leave, shutters a factory, lays off workers, then the capacity is gone. If it is reformed it will be with more capital and fewer workers or a new advanced product no longer able to be built in an old style plant. The US government owns vast reserves of machine tools in massive factories built during World War II and no longer needed. When I was at the Pentagon I visited many of these factories mothballed except for a few, new, style machines doing what work remained. The private sector is less forgiving and older plants simply rust away or is torn down to build track houses(1).

Everything in the Republican plan for rebuilding American manufacturing hinges on stimulating investment in the US. In theory this should reduce demand in real terms, but in practice it may not. The significant share of foreign content in US made manufactures today – well over 25% in nearly every sector. A stronger dollar may come from the effort to protect US companies. If the trade deficit declines and if there is a surge of foreign investors taking advantage of the reduced tax burden and the threat of more American protection, then the stronger dollar will make imports cheaper and exports dearer, limiting the effect of the Trump-Republican plan for protecting US industry from foreign competition. It is the expected future strength of the dollar that make US exports uncompetitive in more markets and the less cost to foreign imports that changes the trade balance from negative to positive in dollars but adds to the problem caused by the real trade balance that impacts employment.

Don’t Mess with What’s Working – Mr. Trump, Do No Harm

We can measure the trade deficit in many different metrics. A more interesting approach to measuring the trade deficit or surplus is in terms of the total loss or gain associated with the intermediate inputs that are not included in the export and import data. If the United States or any country could make everything needed to manufacture all the products without trade it would be autarkic (standing alone). To make a car you need, however, the contribution of other companies selling the steel, plastic, engine parts, and even consulting services. If we add these indirect sales in we have a total full-in trade value for exports and imports. In the table following we summarize the impact of the trade balance on the United States economy including the direct and indirect trade and the total number of jobs in manufacturing and in other industries lost as a result of the deficit. The cost to the economy is just 3 million jobs.

Revised Balance of Trade
Revised Balance of Trade

A Trump-like world view of “America First” might assume that everything you need should be made here. If the rest of the world assumed the same then we can measure the “Shadow” deficit or surplus by including the indirect or intermediate sales that are lost when an automobile is imported from Germany. As is indicated in the table following this one, the actual share of foreign content in US factor inputs that can be traded across borders is 35%. For purist, however, full independence from the world would mean that everything that is made here comes from here. The other side of the same coin is that US exports are zeroed out. Adding in the indirect sales the size of the deficit increases in the case of real trade, but actually decreases slightly in nominal terms. The difference is which industries benefit from the alternative. When all this is translated, industry-by-industry into employment losses due to the trade deficit the cost is around 3 million jobs. This works out to 2.2 employees per million dollars in deficit.

Productivity versus Trade – Where Did the Manufacturing Jobs Go?

Productivity is a dual edged sword, it gives with one hand and takes with another. In November 2002 I published an article in The Manufacturer titled “The Double Edged Sword” dealing with the give and take that comes from productivity improvements:

We live in a world where efficiency is God. Magazines — even The Manufacturer –glorify the benefits of “lean manufacturing”, yet productivity growth is a double-edged sword. It gives to some and takes from others. We are caught in a jobless recovery (2003-4) caused, in part, by the down side of productivity improvements in manufacturing and business services – over supply, low prices, and lay-offs.”

Unlike manufacturing in many other advanced and emerging markets, the share of traded goods in the United States economy is less than in other economies. Two forces are at work here – the United States economy has shifted towards a service intensive economy faster than others with specialization allowing efficiency gains as in-house or vertical parts of the production process are outsourced to more efficient or lower cost suppliers (some owned by these same companies and others at arm’s length). The second force is the specialization within the supply chains, breaking production into more sub elements with each of these made by companies with unique technologies or lower cost labor and capital. This means that the last step in the manufacturing process may be done in the United States but the inputs come from outside. The labor used to make these inputs is not counted in the employment totals with the labor associated with managing a worldwide supply chain (the non-traded goods inputs and the management costs) included. The output or domestic sales are the total sold so the full factor productivity is higher. For a country with a healthy export of these factors of production to other countries the traded good share of production is higher as these companies are being directed in their production by the firms they supply to and who sell their products.

In the tables following we see the share of traded goods in the United States versus some of its major competitors and then the foreign content share. In general China’s traded goods share is higher than for the United States while its foreign content share of traded goods is less so that a trade war will hurt the US more than it will China.

Traded Goods
Traded Goods

 

Measuring Employment Losses – Deficit versus Productivity

The hollowing out of the manufacturing sector for large companies has continued to reduce the share of traded goods in the domestic manufacturing input-output formula. The cookbook recipe described in tables for the US, China and Mexico illustrates this quite well. The proportion of factors needed to make something should be about the same in each country except it is not the same. The differences come in part from the degree to which the companies rely upon outside suppliers – domestic and foreign – to do what used to be done in-house. The vertical integration of the past has given way to a more distributed system relying upon global supply chains and outside sources of supply for semi-finished manufactures.

There are many ways to measure trade’s impact on employment. Given the better data available only from 1996 we use the employment/output factor for this year to fix the employment and compare this to the yearly employment per unit of output. If the productivity had stagnated then the actual damage to US employment from the deficit would have been significantly larger – 4.3 million jobs compared to 1.6 million direct employment losses alone. At most around 3 million jobs are lost due to the trade deficit. This is a full in cost including intermediate transactions lost. Productivity improvements in manufacturing, many due to the transfer of lower value intermediates to foreign suppliers may account for the drop in manufacturing employment. In 2015 if there had been no change in productivity the total employment would be 29.7 million compared to 10.9 million jobs actually reported. Jobs per million 1995 dollars declined from 4.3 to 1.69. Manufacturing job loss, while possibly as much as 3 million jobs in 2015 taking into account indirect measures, is only one factor in explaining the number of manufacturing jobs lost. In 1996 there were almost 17 million employed by the manufacturing sector. That number in 2015 is just 10.8 million. If productivity per unit of output had remained fixed at the productivity as of 1996 the total number of manufacturing jobs would have been 29.7 million. The trade deficit –$ 700 billion in 1995 $s ($ 1085 billion with indirect sales included) – reduces employment by 3 million jobs, however, looking at the table below we see without including the second order effects the employment costs of the trade deficit in 1996 was just 1.4 million jobs and in 2015 with the improvements in productivity it was 1.6 million.

Final Thoughts on Trade and Employment

We can’t disengage from the world, the US as we have observed is, at least in terms of trade, the one essential nation. Our currency is the underlying currency used for trade and finance, our companies are engaged in operations worldwide so that there is no single product group that can be made without some kind of foreign content included. The products we buy and sell are more complex, more protected by patents, and often relying on patented inputs that can be made only by one supplier in one country. So any effort to save a 1000 jobs in steel or aluminum will yield higher profits, temporarily for companies protected by these barriers, but in the long run they will be losers as well, as the open markets on which we depend become more compartmentalized.

Over the past forty years that I’ve been working with trade data and developing models to understand at the most basic level how the world operates, I’ve seen it all. I watched, when I built the first commercial model for trade at a commodity and bilateral or trade route level to help the ocean shipping and air freight industries plan, how changes in the Japanese yen’s price from 300 to 100 yielded little in the way of changes in the US-Japanese trade balance due to the Japanese exporters cutting prices to match the loss of dollar purchasing power in the Yen. At the same time, I observed too how discussing trade barriers against automobiles and semi-conductors shifted meant that Japanese companies began to build operations in the United States. Frictions with respect to trade caused by Trump like threats may be useful, at least in some cases, to change industry behavior.

As the chart shows the 1990’s into the first part of the next century were periods of rapid and sustained growth in world trade. The high point came in 1998-2000. The United States economy was booming and the formerly rapidly growing countries of Asia, Latin America, and Eastern Europe had slowed with currencies collapsing as roaring stock markets turned south. Over the next nearly ten years, until the 2007-09 financial crisis, there was a gradual increase in the share of world consumption of traded products that came from outside the country. This period of sustained integration helped more countries out of the poverty trap, but at a cost to jobs and incomes in the advanced countries. In some ways the slower growth observed since 2011 through today should have been expected. There is a maximum rate of substitution of traded products for domestically manufactured products and we are reaching a saturation point. The ratio of trade growth to GDP growth no longer averages to 2.0, but is now closer to 1.0. It may creep up after 2025 to around 1.3, but without some sudden explosion in demand and supply, it is unlikely to ever reach 2.0 or greater for more than one year or two over the next decade.

World Trade Share of Consumption / World Trade Real Growth
World Trade Share of Consumption / World Trade Real Growth

President Trump’s heart is in the right place with respect to wanting to rebuild manufacturing here as it once existed. That style of business organization is dead, not just here, but in other parts of the world as well. Everyone benefited from the specialization that has occurred over the past thirty years. It is not an impossible task, nor is it not prudent to try to reduce the imbalances we have in world trade as a longer term goal, perhaps replacing the dollar as the necessary underpinning to maintain global liquidity with IMF SDR’s as was once the goal. There are good ways of doing this that are less disruptive and less prescriptive. In the past I’ve suggested a couple solutions to reduce the US trade deficit and preserve US manufacturing by slowly winding down the size of the US trade deficit without selecting winners and losers:

(*) A system of import warrants given to exporters or directly issued by the government setting some limit to imports relative to exports. An importer would need to buy on the open market an import warrant before importing the products so that the free market price of the warrant is set by the market. Such a system could slowly push the trade deficit down without choosing winners and losers.
(*) Changing the corporate tax code so that companies buying more in the United States and selling more outside the country would pay a lower tax rate on profits, while companies selling more in the US and buying less here would pay a higher marginal tax rate.
(*) Working with the rest of the world to change WTO rules making it mandatory that countries running a trade deficit more than 1% of their GDP must impose a 10% surcharge on imports; while a country running a surplus more than 1% of GDP must impose a 10% surcharge on export prices. With these rules applying to both chronic deficit and chronic surplus countries we expect a gradual adjustment and reduction in global trade imbalances.

David L. Blond, Ph.D
President, QuERI-Internatonal, Washington, D.C.

Dr. David Blond has been studying, using sophisticated models and quantitative methods, the impact of trade on a countries growth and development for more than forty years. The QuERI Global Trade and Industry model is the most complex model of the global economy covering 72 countries and more than 400 industries. It can be used to more precisely measure the impact of tariffs, including the 25% steel and 10% aluminum tariffs on the US and other economies in a multi-sector world. For more information on the model and for developing consulting assignments, please contact David. Blond at 301-704-8942 or davidblond2000@gmail.com.

Queri-International specializes in developing models and providing analysis for companies and governments using econometric techniques using proprietary data from its large global data bases combined with other data from public and private sources. For more information contact Dr. Blond at davidblond2000@gmail.com, www.queriinternational.com.


(1) In my economic trilogy, The Phoenix Year, Wattle Publishing, 2014, fiction of course, I make companies in the final volume do what is unnatural, hire when there is a deep recession, invest and hire, all in the name of cooperative growth. To do this I have to destroy private wealth concentrating the ownership of 200 plus of the largest companies in a single Trust dedicated to solving problems globally. In the real world, however, no CEO can afford in this highly analytical financially driven economy to take losses in the hope that other companies follow the same path in order to grow the economy when there is a recession or worse, a depression.


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First-Quarter 2018 Munis: Challenging

The first quarter of 2018 was a wobbly one for municipal bonds. Supply, as we know, was taken from this quarter and moved up to December of 2017 in order to beat the tax bill. Most of this “moved up” issuance was in the form of advance refunding issues (which were not allowed under the new tax law) and private activity bonds (which ended up being allowed). The result was a December with over $65 billion of issuance – a record. It did not hurt markets, as retail and institutional investors snapped up supply, aware that there would be a dearth of offerings come January.

Both Treasury scales and tax-free scales moved higher during the quarter:

 

The rise in yields earlier this year was due in part to the bond market’s catching up to offer competing yields with stock markets, and munis did move up smartly in January. Of the 30-basis-point rise in long yields, half happened in January and the other half in the six weeks since February 1. So the upward movement of yields has slowed down.

We continue to emphasize a “barbell” approach on the muni side because of its relatively steeper yield curve.

 

The muni yield curve has almost always been steeper than the Treasury yield curve. Often it is a function of the different segments of buyers in the muni universe, with banks and insurance companies being segmented in the “belly” of the yield curve and bond funds and individual accounts being traditionally longer-term buyers. We think the longer end has offered an extra yield premium because of the volatility associated with bond funds in the longer end of the market – think the taper tantrum of 2013 and the Trump sell-off in late 2016 as the latest iterations of this volatility. We remain hopeful that muni bonds will be included in the new definition of high-quality liquid assets. (See last week’s commentary: “A Short Note on Bank Muni Holdings” – http://www.cumber.com/a-short-note-on-bank-muni-holdings/). Assuming Congress passes this measure, the development should spur on municipal bond demand in the belly of the curve and potentially longer.

Many bonds in the A and AA categories are trading at yields substantially higher than the corresponding US Treasuries. We believe this cheapness eventually evaporates as short-term yields move higher and the economy continues to return to “normal” – in other words to an economic environment akin to the one we experienced before the financial crisis: a Fed that is raising short-term interest rates because the economy is growing, employment expanding, and companies prospering. In the 2004–2006 period when the Fed raised short-term interest rates, long-muni/Treasury yield ratios declined from over 100% to approximately 85%. We believe this should happen again, partly because only about 75-80% of the rise in a Treasury yield is needed to approximate the same rise in the taxable equivalent yield of a municipal bond, and partly because the drop in supply should eventually work into lower ratios on a long-term basis.

The forward calendar visible supply has moved higher in March, as depicted below.

 Municipal Visible Supply

 

So far 2018 has been marked by a supply drop, with total municipal bond issuance down through the first two months of the year from $59.4 billion in January-February 2017 to $36.5 billion this year. This reduction in supply did not keep prices from being volatile in January. The lack of supply ($17 billion in January 2018 – down from $36 billion last year) meant that most prices (as marked) on municipal bonds were essentially moved down because of the rise in Treasury yields during January. The ten-year Treasury rose from 2.41 to 2.70 during January, and the lack of municipal issuance meant that evaluators used the change in Treasury prices to change muni prices and clearly overreacted. Since that time we have seen municipals perform better as supply has picked up and evaluators have had a sufficient amount of municipal bond trades to be able to base muni pricing on movements in municipal bonds, not Treasury bonds.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
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