Slow Ride II, Michael Porter Returns
Change brings opportunities. On the other hand, change can be confusing – Michael Porter
Asset inflation to protect the banking system and to create a wealth-effect has been the de facto government economic policy since 2009. It worked beautifully but ultimately took our economy and our people to an ugly place that is divided and directionless. The new Administration was voted in to restore balance in our economy but that takes time.
In the meantime, the wealth-effect policy must remain in place until the new policies can show signs of success. It’s why I have been strongly against attempts to short this market – or even use hedges. Automated trading systems have morphed into the sentinels to ensure the wealth-effect policy remains in place. In the short run, you can’t beat them – not yet.
As a proponent of free markets, I ultimately want capital markets unchained from this yoke of control, but as a pragmatist, I accept the necessity for a smooth transition. Such a smooth transition requires confidence and positive markets are integral to maintaining economic confidence. Change is coming but it’s going to be a Slow Ride getting there.
Barriers to Exit II
The essence of strategy is knowing what not to do – Michael Porter
The US has not had a coherent industrial policy for decades, other than the vagaries of the Green New Deal which was long on platitudes but short on details. Instead, the best way I can explain our economic policies is that they have been geared to enrich insiders and well-heeled lobbyists.
The unspoken but ever-present policy was to maintain the US dollar as global reserve currency. It had to remain unspoken because it worked against our domestic industries. As I’ve written before, maintaining the dollar as reserve currency was the driving force behind moving much of the global supply chain to China. We needed to export dollars to expand the global economy.
The elevation of Donald Trump for a second term has partly been driven by the chart below which shows labor’s share of GDP. To be fair, organized labor deserves much of the blame for this decline because they were too greedy and inflexible in the 1970’s and 1980’s. I can remember the days when union work rules made it impossible for domestic industries to compete in global markets.
The pendulum swings both ways and today, the suppliers of capital have gone too far in crushing the bargaining power of labor in our economy. If it’s not clear by now, the whole reason for a flood of illegal immigrants into the US is to dilute the bargaining power of domestic labor.
The problem for the new Administration is to bridge the time between the old, wealth-effect driven economy and the new domestic production economy and that means doing their best to keep the capital markets elevated. This is what I mean by “barriers to exit.” Yes, the fundamentals indicate a stock market that is dramatically overvalued, as well as an oncoming negative global credit cycle. Working against the fundamentals is an existential imperative to keep the markets elevated until the first signs of success.
International Risk
Innovation is the central issue in economic prosperity – Michael Porter
The biggest risk in the world is China. If people would pay as much attention to the little clues coming from China as their favorite sports teams, we would have a more realistic policy towards them. Today, China is an economic, social, financial, and political basket case. The can-do attitude that made it successful in the 1990’s and early 2000’s is gone, replaced by communist inefficiency and waste.
I don’t expect the Chinese economy to hold together much longer because I believe the tariffs will prove to be the catalyst for financial destruction. When spokesmen claim that they are ready to fight to the end, it means they are close to the end; confident diplomats don’t need to boast. Xi Jinping is barely hanging onto power within the CCP.
The only avenues left for the CCP are to print money and extort the international community by threatening Taiwan. Longer term, I expect China to fracture once again into autonomous regions as the CCP loses its grip.
The other risk is Europe where competition is a dirty word. Europe will no longer have tariffs to hide its lack of competitive advantage. The socialist model, or failed liberal democracy, is designed to maintain those at the top of the system while redistributing wealth to keep the bottom of the system satisfied. That game is over.
Not only does Europe have a demographic problem due to a low birth rate, they have a social problem because they forced people from the Middle East and Africa into Europe to compensate for the low birth rate. Now they have a massive integration problem which will grow worse as the Continent’s economy contracts and the demand for marginal workers declines.
The technocrats in Brussels look at the European economy as an equation to be solved but economics isn’t about statistics, it’s about people. Adding people from the Middle East and Africa with different social mores is like mixing oil and water unless the immigrants are willing to adopt local customs. They’re not and therein lies the problem. The frictional costs of social harmonization are skyrocketing.
China and Europe employ different forms of socialism; innovation requires freedom to embrace risk and the necessity to embrace change. Both China and Europe are too centralized to compete with the US, especially a US that is forcing a level playing field with tariffs.
The tariffs are the catalyst that will break both economies. Our problem is that in breaking, both could turn to military adventurism and spark a global conflagration. China’s threat to Taiwan is well-known but Europe’s banging the war drums is less obvious yet more dangerous.
The Europeans don’t want peace in Ukraine, they want regime change in Russia to exploit Russia’s natural resources. They also want to distract voters who are increasingly turning against the EU establishment.
We face economic risk as the Chinese and EU economies contract but we face existential risk if a global kinetic war breaks out. It appears the Trump Administration knows this which is why my base case is a global economic decline later this year, not global war.
Conclusion
You can’t have a healthy society unless you have healthy companies that are making a profit, that are employing people and that are growing – Michael Porter
The world is being led by a cadre of technocrats who have been enriched by their own technical innovation and capital markets that only move up. The result has been an anti-humanistic movement that treats people like chattel. AI represents the swan song of this movement. By Porter’s definition, western economies are anything but healthy.
The good news is that we are at the end of this destructive cycle; the technocrats have been unmasked. The bad news is that we face global kinetic war as the worst-case scenario. Fortunately, I believe the probabilities of such a scenario are very low. Global war is impossible without US involvement.
No longer able to dump exports on the global market, China is going to break within months. Signing a trade deal with the US could be the start of the market sell-off.
With Europe, watch the popularity of conservative political groups. Brussels will be forced to outlaw this political movement or step aside. Either way, dramatic political change is coming to Europe. Friedrich Merz’s inability to be ratified by the German parliament as chancellor is proof of this.
Don’t look for the equity markets to lead this time. At best, they will be coincident but more likely lagging. Watch for strength in the dollar and weakness in copper. We already have strength in the Swiss franc and weakness in oil, signs that the deflation scenario is on-track, but the big moves will come when there is dollar scarcity in the international system.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and ask for Paul Hurley
Philip M. Byrne, CFA