SPEED READ: Five structural reversals will make sure that the next decade is nothing like the last one: (1) Demographics will reverse the fall in inflation and real interest rates, and consequently put politics rather than central banks in the driver’s seat – parts of EM are clear beneficiaries and the US has a fantastic opportunity too, but policies like a border tax could hurt US equities (no typo) more than many think; (2) The world will move from secular stagnation to structural stagnation – the US already has, parts of EM and Europe haven’t; (3) China’s hard landing is already behind us; (4) EM structural change will remain dependent on structure (EM-like or DM-like structures) and change (our ‘Triple Unwind’); and (5) The myth of the middle income trap will be exposed – good governance and the right structural change are key.
This note is a blatant pitch-book for the way we work, what we intend to focus on and our latest high-conviction calls. Readers will excuse us for not substantiating our claims or explaining how we think these calls are best played in the market, because that is something we intend to keep for our subscribers. Can’t give away the cow, but we’re very happy to share some of the milk.
What’s different about us?
· We never try to sound outlandish to get noticed. If our calls do, that’s not the intention. We’ve always had calls that sounded outrageous at the time, and were they ever risky when we made them. The broken EM growth model call nine months before the Taper Tantrum; the US as a competitor rather than a consumer for a structural horizon; picking the Fragile Five and even Mexico during the worst of the turmoil; doubling down on downgrades to Russia (Dec ’13) and Brazil (Jan, Jun ’15); commodity producers to be the biggest beneficiaries of the collapse in commodity prices, which is still playing out; upgrades to India (Dec ’13), Russia (Sep ’15) and Brazil (Jan ’16) when EM sentiment was poor; warning about US inflation and a Triple Taper Tantrum in mid’15; no US recession or China devaluation in the worst of the turmoil early last year – all risky calls when we made them, but all consensus now.
· We know we’re early, sometimes by six months or more. If you think being early is the same thing as being wrong, perhaps we’re not the right fit. But if you think early calls are opportunities, the timing becomes a luxury few have.
· Why? Because we look at second derivatives of structural change. That means getting the diagnosis right, knowing what indicators matter to see if the second derivative is turning, and then having the confidence to make that bold call.
· EM, US, and global political and economic themes that will have a market impact over the next 12 months, and beyond: 70% of our focus will be on EM, but our differentiated EM calls cannot exist without our out-of-consensus calls on US and global themes.
· Finding trades for the next 6-12 months via the right ‘mix’ of structural and cyclical, markets and academia, and history and the future: It’s very dangerous to look at only structural or cyclical themes, and most look at the latter only. To understand structural change, theories need to be judiciously selected (for example, Ramsey’s commonly assumed link between potential output growth and the equilibrium real rate simply doesn’t hold in practise). Comparing with history helps, but not controlling for the structural backdrop (direction of globalisation, real rates, politics) produces erroneous conclusions.
· Productivity at the centre of everything we do: GDP growth is a misleading metric – we dig one layer deeper to find out where the spending comes from, how it is financed, and whether it will raise productivity. Sustainable growth and support for asset prices can only come from productivity. Rallies will come from policy support and risk compression, but these have a finite shelf life.
· Our publication stream: Thematic notes once a week, a ‘headstart’ every Sunday, and 4-5 deep dives a year. We will always have a speed read and have more videos/podcasts for those who are pressed for time. Our forthcoming “SchEMatics” series will explain how we design our thinking on the world and EM. Our monthly EM “BaroEMeter” will track and summarise EM exposure to domestic and external developments. We will also regularly report on the stage and conditions of the EM economic cycles.
OUR THEMES: WHY THE NEXT DECADE WILL BE NOTHING LIKE THE LAST – STARTING NOW
We’re in the midst of massive and wrenching structural change – much of that is a long term story, but we concentrate on structural issues that are relevant over the next 12 months.
1. Demographics and Political Dominance – Reversing the Last 30 Years The conventional wisdom is so far off track that the shock to markets is bound to be brutal – demographics will raise inflation and the real interest rate.The political scalpel to drive productivity: Politicians for the last 35 years have been very happy to let central banks carry the economy’s baton. That’s because demographics have been driving inflation and real interest rates lower since the 1980s, pushing up growth and helping incumbents get re-elected.
No more. Demographics will raise inflation and the equilibrium real interest rate in the future, and the 35-year fall in both has already come to an end. That’s why politics will have to take centre stage – to drive productivity and growth in a way that central banks no longer can.
The global swerve to the right is not bad news everywhere: There are winners – some key EM economies that are set to outperform for a decade, and the US if Mr. Trump revives capex. There are losers – the UK and parts of Europe that disengage heavily from immigration (Germany doesn’t fit that trend as much) will see real rates and asset prices move against them. And Japan lies somewhere in between.
2. Secular vs. Structural Stagnation – Of Taper Tantrums and Deflation Mr. Summers was right about secular stagnation, but in the wrong set of countries. His description of secular stagnation – aptly described as chronic demand deficiency – fits parts of North Asia and to a lesser extent parts of continental Europe very well. It doesn’t fit the US at all – or Germany, Japan and the UK for that matter. What this latter set of economies has to deal with is what we call ‘structural stagnation’ – a decline in potential output growth that goes beyond just a decline caused by demographic change. This is a supply deficiency.
‘Global’ matters: The world is still split between those with structural and secular stagnation, but both camps have strong or at least benign growth right now. That’s pushing us right down a path we predicted over a year ago – a Triple Taper Tantrum.
3. China – the Hard Landing Has Already Happened You can shoot someone twice, but you can only kill them once. Don’t hold your breath. The hard landing in China has already happened. China will continue to slow down again but the implications for the global economy are very different from what has transpired in the past. What’s more, shorting China in China’s markets is a recipe for getting burned – there are ways to play for a slowing China, but they lie elsewhere and the playbook for that is very different from the 2011-15 storyline.
4. The Structure and Evolution of EM Structural Change The structure of EM economies (EM-like vs. DM-like economies) and the change (the ‘triple unwind’ of three surges that distorted EM).
Three surges (capital flows, terms of trade, and monetary and fiscal spending) distorted the structure of EM over the last two decades. The end of structural stagnation in the US, China’s hard landing and the enforcement of domestic discipline in EM are all unwinding those distortions but at different speeds. Economies that look more EM-like economies have seen more change, and some large EM economies have seen their second derivative turn (but it has turned positive in only some places). The ones that are DM-like still have a huge amount of their adjustment ahead of them.
5. The Myth of the Middle Income Trap There is no middle income trap, only a governance trap – in conjunction with the ‘right’ economic structural change, a select few EM economies can show persistent growth again.How did advanced economies become advanced (hint: it did not take centuries)? How did Korea, Taiwan and Chile reach per capita incomes and build institutions that look like advanced economies? Good governance that creates administrative change, and economic structural change – these are the two key building blocks for an economy to transition to a superior profile. But which ones?