Welcome to trade ideas. I'm Jake Merle sitting down Kevin Caron senior portfolio manager at Washington Crossing advisors
Kevin it's great to have you on the show
We've had your partner Chad Morgan land on a couple times. So it's great to finally have you here nice to be here?
Thank you
So we'd love to get your thoughts of what's going on with China right now and the trade war
So what is your research saying right now about China?
Well China as one of the world's largest economies an hour trade with them, of course, the capital flows that go along with that are
First and foremost in investors mindset as we move into the latter part of the year here
We're coming up against some very tough choices for China and as a result, there are concerns that
As relationships begin to change between US and China and then secondarily also within Europe there are similar dynamics going on
Within Europe, these dynamics will have will play out in capital markets in an uncertain way
so you're having a little bit of concern about global growth and you're having some
Increase in volatility as these things play out
So in order to understand where we're going, I think it's important to understand how we got here in the first place
So, can you please walk through you know the trade imbalance and how we got here to begin with? Sure
So all of this goes back to a lot of subsidies that have been put in place within China to direct
savings
From the how from that Chinese household basically to the export sector and as a result of that
We've had a long period of a new and unusual situation where you have a developing economy
Running a tremendously robust investment program, but generating even greater domestic savings
normally, for example
If you look back at the 1800s when the United States was in a rapid development process
We were actually importing capital from the rest of the world to fund that
China is in a very weird position because they're not only producing a large matter
That's but even greater savings that they ultimately have to export abroad and that's a very strange place
For an emerging market Khanna me to be in
And as the recipient of all that capital the rest of the developing world including the United States
Have had some unusual dynamics here as well
So you're saying the trade deficit here in the United States is actually a reflection
Of the imbalances going on within the Chinese economy with the fact that they have
You know fifty percent of their GDP is investment with only 30 percent
consumption and the two should be flipped in order for more balanced economy and that excess production is being soaked up from demand here in
The United States leading to this trade deficit and then in turn the Chinese are buying US debt
Which is allowing the u.s. To consume their products, you know missus reflexive cycle. Is that right?
Yes
and it's that's not helpful for either China in the long run or the United States in the long run and from our perspective that
That has that
phenomenon of these very large sustained trade deficits from our point of view trade surpluses from China's point of view and
The opposite in terms of the capital account more capital coming in here than going out there
that's a really unusual situation and it's something that
Washington Crossing
We don't think that would happen in a market driven economy or if price signals were driving
What was what is happening with their currencies the reality is that?
For a long time we've had we've had this situation that has benefited the United States
Throughout the 1980s and 1990s as we were able to import cheaper goods from China
helped us bring down and tackle the inflation problem of the 70s for example, but we've now gotten to a point where
Well originally started out as a good thing from the US point of view has turned into an awful lot of debt
First it was the mortgage the build-up of debt in the mortgage
Crisis and the run-up to the financial crisis of oh seven. Oh nine and then the
significant doubling of US federal debt in the years following that so at this point, there are some
significant costs of this relationship and that's beginning to create some
Attention which has now finally manifest itself as this trade war that were involved in so it sounds like in order to fix the imbalances
Right now China needs to increase their consumption and decrease their investment
But what's stopping them from doing so well, it's turns out that with China. It's very easy to to command more investment
It's easy to it's easy to direct the investment side of the equation
China has proven to be very nimble at being able to do that
but that investment has to come from somewhere and
what where it has to come from ultimately is the Chinese household sector if you look at the average income of
A person in China. It's something like ten thousand dollars from that perspective
China is not a very wealthy economy and and when you think about
Where all of the where all of the subsidies have come from ultimately to fund the investment program
It's really been from
subsidies either direct or indirect subsidies
Borne on the backs of Chinese households at the private sector in China's like 200% of GDP and debt. Is that right?
Yes, in fact in the United States
we had a similar buildup of debt in the
2000 2007 period we got to about a hundred and seventy percent of GDP that's private debt relative to GDP
China has now far eclipsed that in the last few years and
Now we're at a point where it's over 200 percent as you said
so there is a there is a tipping point at some place and
We don't want to say that all debt is bad. Certainly. Some debt is very good because it creates growth. But if you're borrowing money
That is ultimately not
Serviceable because the underlying investments are not producing the cash flows necessary to service that debt
Then it becomes a big problem and ultimately leads either to a period of much slower growth or some kind of debt crisis
so this entire situation that we're talking about the
Savings glut has pushed down interest rates over the past 10 20 years or so. Do you see that dynamic changing at all?
Yeah, in fact again, that's a very weird thing. I want to just emphasize this usually when you're developing economy
You're in a net importer capital to fund the investment here. It's been exactly the that's a really unusual thing and not something that's sustainable
Unless there is some kind of intervention in markets to redirect capital away from where it would otherwise go
So ultimately that does that does become an issue and so Kevin?
What are your thoughts on Treasuries right here? Because I know you and Chad have absolutely crushed
this move
chad has been on real vision a couple different times over the past year and he was expecting the ten-year field less than 2% which
We've seen unfold over the past few months. So I'm just curious because it sounds like based on this
Savings glut that may be coming to an end in these emerging markets that may be bond yield to start rising globally
What do you think about that? Yeah, where we stand in our tactical asset allocation
Portfolios today at Washington Crossing is we're neutral on Treasuries. We've
looked at where yields are and what we see is a
Investment that has and on the one hands
Significant downsides if yields were to normalize to where they would be in isolation
So in other words in the absence of large capital flows around the world in
Absence of regimes that are repressing rates around the world
We would think that the that yields here wouldn't tend to migrate higher
That's the negative knock on Treasuries
The positive for Treasuries is that when you look around the world our yields are still relatively good compared to many places around the world
That are offering negative or very low yields so stuck between the push and the pull of those two forces
Leads us to a place where we're essentially neutral relative to our policy allocations
So how do you see the trade war unfolding in the weeks and months to come the long arc of this thing is?
towards some kind of liberalisation of China when you think about the
Best way for the global economy to grow and China is now a large percentage of it if you ask the Chinese
the best thing for them would be to be involved with a global economy that's growing in a peaceful and
sustainably strong way
What China has done?
moves beginning in
1980 in the early 1980s up through 2000 is move towards a more
Open in a very but in a very slow way
Recently in the last several years they seem to be backing away from that and that's a cause of concern
because ultimately the way that how a capital gets allocated most efficiently to create the most growth for the most people on planet earth is
to have markets dictate where that capital flows and to the extent that market signals are short-circuited we create
winners and loser classes
We create a lot of deadweight loss and ultimately the potential for more volatility and debt crisis and unserviceable debt
None of those things are in China's best interest. None of those things are in the United States best interests
so we would imagine that with a lot of
Wrangling still to be had eventually we'll get something in terms of a compromise on both sides
it would move China closer to the rest of the world and
Move ahead with the development of China and integration with the rest of the world, which would be a good thing
So given the current market dynamics and everything we're seeing right now
How do you suggest traders and investors play the current environment right now?
Well a couple things the the build-up of the buildup of debt in the global financial system has been significant
That's major point one. And if you look at the Standard and Poor's 500, for example the companies in that
Have far greater leverage in on the balance sheets of those companies then
That then 20 or 30 or 40 years ago
so if you're interested in generating returns
It's equally important to have some handle on the risk in the portfolio
One of the places that risk comes from is the way in which companies finance their businesses. So if you have a business that has
Leverage in our case. We like to see debt less than about 30 percent of capital net debt debt minus cash
We think that's a pretty conservative idea for a portfolio. And then otherwise you want to own businesses that are very consistent
so the consumer sector which would also benefit from a rise of potentially at some point of a
improved
Chinese consumer glass that might be also a very good longer-term sort of secular play. Well Kevin. That was great
Thanks so much for joining us. It was a pleasure having you on the show. Thank you for having me