If you find it too heavy, leave the "Help From Washington" section out; it does give a good background to how hard it may be to get some policies through, but is not really useful for the exams.
The following sections cover China, energy markets, Europe and AI; these sections all contain the sort of elements your essays cry out for - strong contextual justification for the sorts of statements you love making, but never back up. There is potential for a one-grade lift in this material alone, if you get the right question (most questions are open enough that you have a range of topics you can discuss).
Your choice to read (as ever), but time is running out and you need to beef up your essays from AS to A2:
“The shift from sailing ships to telegraph was far more radical than that from telephone to email.”
– Noam Chomsky
I’ll organize this letter around four key themes that I think we will discuss frequently in the next 12 months: US politics, energy, China, and Europe. Then I’ll wrap up with an overarching problem that’s also an opportunity – if we treat it as one.
Let’s begin with good thoughts. Markets have rallied since November on the expectation that Trump and the Republicans will quickly enact a growth-oriented economic agenda, including tax cuts, regulatory relief, and targeted economic stimulus projects. As I talk to people involved in the transition, I am gaining more confidence that a good part of that agenda will actually be realized. It’s clear to me that the right people want it to happen, at least. Whether they will get what they want is a slightly different question.
One reason I’m encouraged is that the Republican majority doesn’t have to start over. They already did some of the heavy lifting in the bills that passed Congress for the last two years, only to see them vetoed by President Obama, and in bills that never got that far because a veto was assured. The Republicans know who does and who doesn’t support these bills. With some minor updating, they can quickly pass the bills again, with a better White House reception this time.
The GOP is also intent on hacking back some of the regulatory tentacles that have impeded progress (and especially job growth) in some industries. They intend to employ a rarely used law called the Congressional Review Act to reverse some of the Obama administration’s regulations. They are also considering legislation that would require federal courts to stop accepting federal agencies’ statutory interpretations and defer to Congress instead.
Tax cuts are almost 100% certain, though their beneficiaries are not certain at all. Constitutionally, all tax bills must originate in the House, and their impact on the deficit will be important to some House Republicans. Passing a tax cut may depend on having a corresponding set of spending cuts ready. Seriously, we simply have no idea how the tax issue is going to play out. Fixing taxes could be problematic: Every dollar the government now spends (or gives in tax benefits) helps somebody, and whoever it is almost certainly has lobbyists on retainer. Nevertheless, we will get a tax cut, though we may not know the nitty-gritty details for a while.
I’m told the Republicans have a long list of relatively uncontroversial (at least on their side of the aisle) bills that they can pass very quickly. They want to show progress, and they think quick passage of some popular measures will buy them credibility to use later. I expect an initial burst of activity after January 20, probably followed by a lull as the Congress moves into more contentious issues like Social Security and healthcare reform. Things will keep happening, but we may not see as many votes.
The hard part is getting agreement on the big items like taxes and healthcare reform. I love seeing Trump and Pence and Ryan and McConnell and all the guys holding hands and acting as if they’re all ready to walk into the bright new future together, but the reality is that there are some quite different ideas in Washington about what serious reforms should look like, and a lot of congressmen want to put their personal stamp on the final bills.
The reform effort could fall apart for various reasons. The Senate majority is narrow enough that just a handful of GOP defectors will be able to stop any given bill, assuming Democrats stay united in opposition. I think Republicans should be on guard against hubris, as well. The decision last week to kick off the year by softening ethics rules was a terrible idea. They accomplished nothing and energized an opposition that was otherwise on its heels. (And I know that many of us are uncomfortable with the concept of a Tweeter-in-Chief, but all it took was one tweet to kill that really bad idea. I mean, Trump stopped it dead in its tracks. Which I believe the vast majority of us will think was a very good thing.)
Finally, as I cautioned last week, there is always the chance that some “bolt from the blue” could change everything. An international crisis, a large bank failure, terror attacks – any one of a long list of unforeseeable events could conceivably derail this train. Not to mention the endemic problems of Europe and China, which we will deal with below and which are entirely foreseeable. But if we can get through the first 100 days with this administration, then I think its agenda will have enough momentum to keep rolling.
Assuming no major surprises, I think the tax and regulation changes can boost GDP growth in the final half of 2017 toward the 2½ percent range. That will be a small improvement from this year and could set the table for a bigger feast in 2018 and beyond. Much also depends on how the Federal Reserve responds, as well as on any changes in its composition.
But here again, if the Republicans get all timid or can’t cooperate and end up settling for the usual tinkering around the edges with tax reform and healthcare reform; and if they are stymied by an entrenched bureaucracy that doesn’t want to see its regulatory powers dismembered, then we can’t expect to get the economic boost that everybody is anticipating. If a policy-driven boost doesn’t materialize, the markets, which have jumped on the anticipation of Real Change, will reverse just as quickly.
That’s why I say, “Proceed with caution.” If my base case plays out and we get reasonable progress on healthcare reform along with regulatory reforms, the stock market could end the year higher, even from today’s elevated valuations; and earnings could really be improving by the third and fourth quarters – if the reforms are actually put into place in time.
If the reforms get hung up or are watered down and not really effective, this market could tumble out of bed so fast that it will make your head spin. I will be saying much more by March about how I think portfolios should be constructed, but my current core portfolio is basically long most of the US market (and long selectively all over the world as well) and has sidestepped the bond market (with some exceptions). All of that could change quite quickly – it’s no surprise to longtime readers that I think portfolios should be actively managed.
That said, passive management will also continue to work if my base-case scenario comes about, and that outcome will just convince more people to move their portfolios to passive management. A market mentor of mine, who had already been trading the markets for 50 years when he began to tutor me, always treated the markets as if they are a personality.
“The market will do whatever it takes to cause the most pain to the most number of people,” was the litany he repeated to me, over and over. The more people that are lured into the grip of passive investing, the greater the pain will ultimately be – which means that this market can go sideways for a lot longer than many of us who have a cautious nature can imagine. We are truly in new territory.
Energy stocks have been tearing higher since the election on bets that the Trump administration will relax environmental restrictions and open more federal lands to oil and gas drilling. Crude oil’s staying north of $50 hasn’t hurt, either. It is up there in part because OPEC threw in the towel and agreed to production limits. Unfortunately for OPEC, those limits don’t apply to US and Canadian shale producers. And the history of OPEC is that they all cheat like crazy.
My friend Art Cashin has an internal “friends and family” list to which he generally sends one or two short, pithy notes per day. For quite some time now, he has been noting the high correlation between the price of oil and the stock market. That correlation is why I have moved my thoughts on energy closer to the front of the letter. The price of energy is important to our portfolios in ways that are not clearly understood but can be observed.
I think it is entirely possible that we will see oil prices climb somewhat further by mid-year, possibly approaching $60, and then pull back as capped US production comes back online. Look at the chart below to see the wide variation among forecasts of major energy analysts working for the big banks.
I also think that this year we’ll start to see a new pattern: Production could keep rising even as prices fall. Conventional wisdom says that producers stop pumping at some point when it becomes unprofitable, but I think that is about to change.
If you are an oil producer – or really, any commodity producer – two things can improve your profit margin: higher selling prices for the resource you produce, or lower production costs. Some combination of both works as well.
Now, selling prices are mostly outside the producer’s control, though adept hedging can help. Cost reduction is therefore the place to concentrate your attention. Back in 2015 I wrote about new drilling techniques and other technology that promised to bring oil and gas production costs significantly lower. Now, in the last few weeks, people in the business have told me these technologies are moving rapidly toward deployment. They foresee considerably lower drilling and production costs by the end of this year.
I had a confidential briefing recently about some new energy production processes that are coming online in the oil patch. Let me just say that production from an oil well drilled with these new techniques is getting ready to increase substantially. In some cases the amount of oil produced per dollar spent on drilling is going to more than double. There are significant chunks of the petroleum-producing parts of the United States where $40 oil will not be a barrier to drilling and new production. Eventually – in a few years – these techniques will begin to show up in wells around the world, and there will be an explosion of oil.
Even as many oilfields dry up, there will be new fields developed from previously unprofitable sources. As I’ve been saying for 15 years, the whole Peak Oil thing is nonsense. I used to think that it simply meant the price of oil would go up to justify the cost of drilling, but I didn’t really understand how much technology would lower the cost of drilling.
This technology trend means that the current oil price range may well break lower, perhaps this year but certainly within this decade, without energy companies losing profits. Not every company will reap the rewards equally, of course; but the industry as a whole is excited. Energy exploration and production is quickly becoming a technology-driven industry, with the US as world leader. If Trump permits construction of more pipelines and natural gas export terminals, we could see North American exports rise considerably in the next few years.
Obviously, over time, a falling energy price will not be good for OPEC or for Russia. Those lower prices will create geopolitical challenges as well as economic ones. I don’t know how it will all shake out. We will likely see some big, energy-driven changes in the world order in the coming decades. But that is beyond the scope of an annual forecast.
Sidebar: every time I write about energy I get the following questions: “What about the environment? Won’t more oil and gas production aggravate climate change?”
Many wonder whether I care about the environment or accept the reality global warming. The simple and very short answer is that I can see the data as well as anyone, and I believe the Earth is in a warming cycle. I very much care about the environment. I don’t want to see the air I breathe or have polluting chemicals in the water I drink. We only get the one Earth, and we have to take care of it.
My full answer is longer and, as you might suspect, more complex. It will end up being a chapter (or a significant part of one) in the book I am writing, called The Age of Transformation. It will be out this year, and hopefully by the time of my conference, if I can at all get it all wrapped up. If you meet me at SIC and we have time for an extended conversation, feel free to ask about these issues. No one-paragraph answers will suffice. Now back to our forecasting.
This is going to be a pivotal year for China. Having to deal with a US president who refuses to play by Beijing’s rules is only part of it, and not necessarily the most important part. China has defied gravity in more ways than I can count. We will see if it can levitate another year or whether it falls back to Earth in 2017. My base case is that they continue the levitation act, but we are going to see an increase in volatility.
I’m not sure how many people are aware that the overnight rate for offshore yuan reached an incredible 105% at one point last week. The Chinese created a massive short squeeze, trying to maintain the value of the yuan. They have spent hundreds of billions of dollars in that effort and are likely to spend more this year.
The natural direction for the yuan, if it were allowed to float, would be significantly lower against the US dollar than it is today. The Chinese are manipulating their currency, but they are manipulating it to maintain its current value and allow it to slowly fall to its natural rate. Any precipitous move in the yuan can unsettle markets quickly.
Further, some $2 trillion worth of Chinese currency has been converted into dollars and moved offshore in the last few years. Think about that in the context of quantitative easing and realize that individual Chinese wanting to move their money out of the country have almost as great an effect on the amount of money sloshing around the developed world as our central banks have. The sources of that money are another subject entirely, but it is enough to note that that money is out in the world, much of it in North America, much of it looking for a home, driving up prices of real estate and other assets.
The Chinese Communist Party will hold its 19th party congress in the fall and will almost certainly give Xi Jinping another five years at the helm. He has become China’s most powerful leader since Deng Xiaoping and could well surpass even Mao before he departs. It could be awhile before he does, too, if this party congress goes according to script.
Xi may need to exercise all his power if he is to maintain both economic growth and domestic order. Sagging exports and rising labor costs are causing manufacturers to turn to automation, but that shift creates unemployment. Xi’s government is doing all it can to keep the masses happy, mostly by handing out generous benefits and subsidies to the usual suspects, including state-owned enterprises. This help makes it very hard to tell which of China’s many state-owned enterprises are actually turning a profit vs. operating at a loss because officials have ordered them to. That is why state ownership is problematic, of course, but for China the alternative may be worse.
A major side effect is that all the stimulus sloshing through an economy with few international exits has nowhere to go. The Chinese have fairly serious limits on the amount of money that individuals can take offshore in a given year. That means there is a lot of money in China looking for a home.
The results are predictable: asset bubbles rolling through regions and asset classes whose valuations follow no discernable logic. These imbalances can’t continue indefinitely, but I don’t know how the Chinese will arrest them. The direct route would be a currency revaluation. That seems to be what they are attempting, albeit very slowly. Ironically, I believe that both Xi and Trump agree they don’t want the yuan to move downward all that much in the coming years.
Xi’s hands are tied: Propping up the value of the yuan is going to force him to use his dollar reserves or to raise interest rates in an already volatile market. The Chinese are getting to a place where manipulation will be a lot more difficult than it has been in the past.
China is trying to do something that would be hard no matter who is in charge. The US is the world’s largest economy because we create most of our own supply and demand. It took us many decades to reach that point; China is trying to do it in about two decades. Their export-heavy model can’t work much longer, but they don’t yet have a way to create sustainable internal demand.
A consumer economy is the opposite of what China has been for the last 30 years of its journey toward becoming a capitalistic society. The export-led model works for the first three stages of national economic development, but it is not what you need to get to and through the last two stages, as I have written in the past. This transition is going to be far more difficult than anything China has faced for a very long time.
Maybe Xi will balance his massive economy perfectly and skip right over the painful adjustments that developing nations (including the US several generations ago) typically go through. I certainly wouldn’t bet against that possibility. The Chinese have been doing things that nobody thought they could do for quite a few decades now. But I won’t bet for it, either, especially this year. All the conditions are in place for major problems in China. That 6.5% GDP growth rate, even if it’s close to correct (and I don’t believe it is), can’t go on forever.
China’s problems are everyone’s problems. I saw a report last week estimating that $1.5 trillion, yes trillion, in corruption proceeds escaped China between 1995 and 2013. That is in addition to the legal money coming out of the country. Most of it landed in the US, Australia, Canada, and the Netherlands, where it has helped to inflate some of our own asset bubbles. In my travels, I constantly run into people who tell me they manage Chinese money. Not trillions, just $50 million or $100 million here and there. It adds up. How much is really out there? I don’t think anyone knows, but it’s a big and growing number.
Our fifty states are essentially what the European Union’s founders wanted: a giant free-trade zone with a currency union and fiscal union. It’s working for us in part because our states, while unique, don’t have the centuries of cultural and linguistic diversity that Europe’s do. I think we underestimate how important our common language and heritage have been to our economic development.
The separate languages, cultures, and histories of its nations don’t mean Europe can’t develop better ways cooperate economically; but the EU structure, specifically the European Monetary Union and the euro, clearly isn’t the answer. I think 2017 will make this fact increasingly obvious to everyone – and possibly undeniable if the worst happens in Italy. Let’s start there.
Italy’s banks are holding something like €350–400 billion in nonperforming loans, depending whose numbers you believe. The vast majority of that amount is not just temporarily NPL; it’s dead money, up in smoke. The banks are pretending otherwise, and the government is letting them. So is the ECB. This is a fact Europe must face. Yet no one wants to face it, and so the leadership is trying to pull off an increasingly ludicrous shell game.
We forget sometimes that banks are themselves borrowers. Most of their lending capital is not equity. They get it by taking deposits and issuing bonds. If a bank can’t collect on the loans it made, it can’t repay the money it has borrowed, and the whole edifice collapses. Bank collapse is ugly, and minimizing the ugliness is one reason we have central banks. We expect our central bankers to remain sober even while everyone else imbibes.
The European Central Bank may be sober, but I’ll bet more that than a few of its member countries would like a drink. Especially in Italy. They are in a near-impossible situation. Huge imbalances exist within the eurozone with no mechanism to resolve them, and Italy is one of the southern-tier countries that is bearing the brunt. That’s not the ECB’s fault. The system was never going to work. Now people are realizing it’s broken, and they are fighting to get out with what they can.
Inflation last month finally reached 1.7% in Germany. You can bet the drumbeat for tighter monetary policy, in place of the all-out massive quantitative easing that we are currently seeing, is going to grow louder in Germany and most of the other northern countries. That is exactly the opposite of what Italy and the southern countries need. See the potential for conflict?
Last week I saw a Spectator article that was not encouraging. I can’t say the following any better than the writer, James Forsythe, did, so I will just quote him.
After the tumult of 2016, Europe could do with a year of calm. It won’t get one. Elections are to be held in four of the six founder members of the European project, and populist Eurosceptic forces are on the march in each one. There will be at least one regime change: François Hollande has accepted that he is too unpopular to run again as French president, and it will be a surprise if he is the only European leader to go. Others might cling on but find their grip on power weakened by populist success.
The spectre of the financial crash still haunts European politics. Money was printed and banks were saved, but the recovery was marked by a great stagnation in living standards, which has led to alienation, dismay and anger. Donald Trump would not have been able to win the Republican nomination, let alone the presidency, without that rage – and the conditions that created Trump’s victory are, if anything, even stronger in Europe.
European voters who looked to the state for protection after the crash soon discovered the helplessness of governments which had ceded control over vast swathes of economic policy to the EU. The second great shock, the wave of global immigration, is also a thornier subject in the EU because nearly all of its members surrendered control over their borders when they signed the Schengen agreement. Those unhappy at this situation often have only new, populist parties to turn to. So most European elections come down to a battle between insurgents and defenders of the existing order.
As James Forsythe says, the conditions that won Donald Trump the presidency exist in Europe as well and are possibly even stronger there. They manifest differently under parliamentary systems, but I see no chance that they will go away. They’re getting stronger, and I think we’ll see proof when France, the Netherlands, and Germany hold national elections this year. It is likely that the Italians will also have to hold snap elections because of the banking crisis, and it is not entirely clear that a majority would support a referendum on remaining in the euro (which is different from remaining in the European Union).
The anti-EU, anti-immigration parties may not win outright control in any of the four countries, but they can still exert enormous influence. These parties may not have the solutions, but the incumbents definitely don’t have them. Given a choice between unlikely and impossible, you have to go with unlikely. That’s what Europeans are doing.
I expect 2017 to bring many changes to Europe, but I’m not convinced it will be the end just yet. “Delay and distract” has worked well for the pro-EU, pro-euro forces ever since the sovereign debt crisis hit in 2010. The europhiles are true believers who simply won’t give up. At some point their determination may not matter, but I suspect they can keep doggedly kicking the can down the road until 2018 or later. It is just not clear when they will run out of road.
When they do, the result will likely be a very severe recession in Europe, which will embroil the world and could push the US into recession if it happens too quickly. Perhaps if we muster the reforms we need here in the US and actually get some sustainable growth going, then a fragmenting Europe might just knock that growth back to the sub-2% or even sub-1% range. But if China, too, loses the narrative in 2017, then all bets are off.
Like it or not, we have entered an era in which machines are learning how to do much of the work that now provides our incomes and, in many cases, our self-worth. This is a topic we will explore in depth in future letters. But a brief summary needs to be interjected here.
The US is manufacturing more materials and goods than ever. Manufacturing is increasing at a fairly serious rate, well over 2% a year. The problem is, manufacturing jobs are not. A Ball State University study calculated that it would take more than 8 million additional jobs to produce what we currently produce today if we were merely at the productivity levels of 15 years ago.
Investment in automation and software has doubled the output per U.S. manufacturing worker over the past two decades. Robots are replacing workers, regardless of trade, at an accelerating pace. “The real robotics revolution is ready to begin” writes BCG and predicts that “the share of tasks that are performed by robots will rise from a global average of around 10% across all manufacturing industries today to around 25% by 2025.” (Source: fortune.com/2016/11/08/china-automation-jobs/)
This is a simplification, but robots and their associated machinery have been somewhere in the neighborhood of four times more important in the loss of manufacturing jobs than off-shoring of jobs has been. But it is hard to protest against increased automation and easier to point a finger at China or Mexico.
The real challenge the US and the rest of the developed world face is how to create new jobs in the face of this automation challenge. The problem is not one we can walk away from. The best estimates that I have read suggest that Korea may be 15–20% more productive than we are in terms of costs, because they are pushing further and faster into the automation process. That trend will leave US manufacturers and exporters – or those in Germany or Italy or any other developed country – behind in the global business contest. Think Japan is not seeing the same thing?
If we don’t automate faster, we lose jobs by being uncompetitive. If we do automate, then we see jobs go away. What we have to do is figure out how to make sure that new jobs are created, and that these jobs are simply not make-work but are rather meaningful and fulfilling. Tall order. For whatever it’s worth, we are programmed in our evolutionary DNA to value what we contribute to the community through our work. Simply getting welfare without a way to eventually make it on your own does not help personal self-esteem or your community.
Incidentally, in the process of writing a book on how the world will change in the next 20 years, with over two dozen chapters on all aspects of the transformation before us, the single biggest and most difficult challenge has been this very topic. One of the reasons the book isn’t finished yet is that I’m still trying to get my head around this very problematic issue. It is at the core of how our society will evolve … or devolve. Not all the paths forward are good ones, and it is critical that we make the right choices.
I gained a new appreciation for the social and political crossroads we are at when I wrote last year about the “Unprotected” voters (to use Peggy Noonan’s term) who flocked to Donald Trump and (to a lesser extent) Bernie Sanders. Both of those men understand that unemployment and underemployment don’t simply reduce people’s incomes, though that’s bad enough. People want to be real contributors to the economy, but the economy increasingly tells them they aren’t necessary.
I’ve been told by people in the transition team that Trump and those around him are laser-focused on restoring jobs and creating new ones, particularly in the Rust Belt states. I have been having more than a few off-the-record conversations with members of the team, and they leave me at least somewhat optimistic that they are thinking about the right problems. It is also clear that they are looking hard for solutions. This is only part of the reason why Trump is pressuring companies to keep jobs in the US. He knows the numbers are small. He’s trying to force a wider change. And the staff around him get this focus.
If Trump succeeds at boosting US jobs, the problem may just be offloaded elsewhere if unemployment rises in Mexico and other places where US companies once operated. We need solutions that bring in the tide and lift all boats at once. Otherwise, conflict will continue and worsen in many different ways and places.
As an economic matter, lower costs and higher productivity are deflationary. Excess supply in the absence of higher demand pushes prices downward. This is why we’ve seen such sluggish growth in the last decade. At some point, faltering growth may turn into outright contraction on a global scale. Then the real problems will begin.
For those of you with some classical economics training, it is as simple as the supply-demand lines that we drew in Economics 101. If you push the supply curve to the right, you are going to find that you are in a new price equilibrium. I am really coming to believe that it is this process that has been (at least partially…) responsible for the lack of inflation that we have seen in the past 15 years. I suspect it has a bigger role to play even than interest rates, though I have no real justification other than personal, anecdotal observation to make that point.
At some point this year, we will be talking about why the whole theoretical construct that nearly all economics is founded upon, that of a dynamic equilibrium, is a false premise. The base case for the economy is not equilibrium, no matter how you define it, but rather constant change and near chaos. Part of the reason that dynamic equilibrium models work so well in theory is that we actually have the mathematics to create them. The fact that these models are perpetually wrong should give us a clue that something else is going on for which we don’t have the math or even sufficient fundamental insight.
This discussion will not only bring us back to Hayek but forward to complexity mathematics and information theory, and I believe all three in combination hold a better way to explain the workings of the economy.
Mainstream economics keeps using the same models and theories, or variations on those theories, but some of the underlying premises of Keynes are simply wrong (not everything of course; he was a brilliant man for his times); and nothing built on a foundation of faulty premises is going to allow you to model the economy in any really useful manner. There’s a lot to tackle with this topic, but it will be fun to try to gain some insight together.
Let me warn you, there are no simple solutions or silver bullets. I’m reminded of the old Blackadder skit where the hero is handed a blank sheet of paper and told that it’s the map to where he is going. When he points out that there is nothing on the page, the man says, “Of course, you have to fill it in. Nobody’s been there” (paraphrasing of course).
2017 will certainly allow us to fill in a lot more of our map. But none of us have ever been there. It is my hope that 2017 will be the year when we start to recognize our true potential for abundance and begin adapting to it, in a way that everyone benefits.
