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Deciphering the Rosetta Stone of world finance — it’s about to become a lot more disorderly

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Dr Michael Power recently retired from Ninety One where he was the Global Strategist for most of the past two decades. He remains a Consultant to Ninety One. Prior to Ninety One, he had worked in London, South Africa and Kenya for Anglo-American, Rothschild, HSBC Equator and Barings. He has a PhD from UCT, a master’s from the Fletcher School at Tufts and a bachelor’s from Oxford. His primary focus today is doing research into the emerging field of geo-economics focussing in particular on the global implications of the return of the economic centre of gravity to a China-centred Asia.

What will happen if the current-account-surplus runners of the world collectively lose faith in the US bond market? Worst case would be a grand dislocation of the world’s current financial order. And the order replacing it would — unfortunately — be disorderly.

Last week, I spoke to 35 chairpersons and CEOs at the Chairs’ Forum in London, organised by the Financial Times. My chosen topic was “The Changing World Economic Order”. I was able to bring together my various strands of thinking — some previously shared here in Daily Maverick — into a single overarching thesis.

I was fortunate enough to be able to do a “dry run” on the previous day at a British investment firm managing the wealth of high-net-worth individuals. I regard them as the sharpest knives in the London drawer. Afterwards one of them commented — and I detected relief in his voice — that at last someone had cracked the code of the Rosetta Stone of world finance today.

His only proviso was that far from unearthing insights into a bygone civilisation as was the case with Jean-François Champollion’s deciphering of Egyptian hieroglyphics, I was able to explain the status and “values” of an alternate civilisation to today’s reigning economic hegemon, a civilisation that is very much alive and whose time at the top may again lie ahead.

The essential summary of my thesis is as follows: We live in a world of finance where two broad atmospheres operate and interconnect. The first I call the “Ecosystem of Capital”; it is the incumbent Ecosystem and the one in which I suspect most of this article’s readers live and breathe. It is US-centric and its atmospheric pressure is measured by the US dollar at market rates.

The second I call the “Ecosystem of Trade”: it is increasingly Asia-centric and, within Asia, China-centric, and its atmospheric pressure is best (albeit much more loosely) measured by US dollar purchasing power parity (PPP).

Most of the West breathes the atmosphere of the Ecosystem of Capital. Much of the world’s Rest (but by no means all of it) is, at least in matters of trade flows as opposed to capital flows, increasingly oriented towards the Ecosystem of Trade.

The two Ecosystems are connected via their external accounts, their balances of payments. The US is overwhelmingly dominant in the capital account segment that records global capital flows. China and other mostly trade-surplus-running Asian countries relate to the outside world primarily via their trade flows.

My conviction is that the US’s hold on the Ecosystem of Capital is far larger and more precarious than China’s much smaller hold on the Ecosystem of Trade. Accordingly, it is important to grasp the defining characteristics of the anchor nation of the Ecosystem of Capital:

  • The US, with 4.2% of the world’s population, ran 62% of global current account deficits in 2023;
  • With the US dollar broadly stable in 2023 (the Dollar DXY Index fell 2%), this means the US must have sucked in some 60% of globally mobile capital — the world’s net international savings — last year;
  • Contrary to popular belief and on a net basis, the US Treasury tells us the lion’s share — 92% — of those foreign inflows did not go into US equity markets: $700-billion went into US government instruments and $250-billion into US private sector debt instruments. Only some $83-billion went into the US’s headline-grabbing equity markets. (To put this $83-billion into context, Nvidia’s market capitalisation rose $856-billion in 2023 and is up $1.6-trillion in 2024);
  • In 2023, the US ran an all-in budget deficit of 8.2% of GDP: $2.1-trillion. Again, with only 4.2% of the world’s population, last year the US generated 42% of all budget deficits worldwide;
  • Since 2008’s Global Financial Crisis, the out-sized quantum of US deficits has become so “normal” that many US-based but “global” economists ignore it. The collective detritus these deficits leave behind — the US’s Federal Debt — has soared more than four times in 16 years, from $8-trillion to $34.8-trillion today. Tying in with other ratios cited here, this means that in the leading global investable bond index, the FTSE World Government, US government bonds had a 42% weight at the end of April 2024;
  • If US interest rates do not fall by the end of this year — they may but only marginally — Bank of America estimates the US will pay $1.2-trillion of interest on its Federal Debt in 2024, up from $500-billion in 2021;
  • The US’s net domestic saving rate in 2023 was -0.3% of national income. The average since WW2 has been 6.4%. This deficit reflects the combined dissaving of individuals, businesses and government, adjusted for depreciation; and
  • The US’s net international financial position — what the world owns in the US less what the US owns in the world — has gone from broadly balanced in 1990 to a negative $19.8-trillion at the end of the fourth quarter of 2023.

Let me be blunt. Contrary to the prevailing near-populist narrative, the US economy is — all told — not in robust health.

In peacetime and at close to full employment, the US is running a budget deficit of more than 8% of GDP, a level that would make even the fiscally biased John Maynard Keynes turn in his grave! The Economist may laud “America’s pumped up economy”; Ruchir Sharma in the Financial Times rather sees it as the “Overstimulated Superpower”, pumped up on the steroids of debt.

A sizeable chunk of the US’s ongoing deficit is being financed by — to adapt a phrase from Tennessee Williams — “the kindness of foreign strangers”. There are multiple — and, for the US, ominous – signs that this kindness is facing exhaustion, at which point the current precarious equilibrium between the two Ecosystems would be destabilised. Then what?

I will answer this question further below. But first back to those two Ecosystems.

Ecosystems

As already noted, value in the Ecosystem of Capital is determined by market exchange rates. (And just to be crystal clear, for those breathing only this atmosphere — such as most of South Africa’s capital market fraternity — these values are very real and very tangible.) But for the Ecosystem of Trade, a less precise proxy of value is PPP. What is often overlooked is that demand-oriented PPP is umbilically linked to its supply-side sibling: production power parity. (And just to be equally crystal clear, the production costs, wages and so resultant prices that make up the lattice that determines production power parity are not theoretical: they too are very real and very tangible.)

And herein lies the most important and, for what remains of Western industry, the most devastating insight of this two-ecosystem approach. From a competitive perspective, for the exporters of China and its cohort of largely Asian countries (plus Mexico), the prices of the products they produce massively undercut the prices of Western corporations producing competing products.

In the aftermath of China joining the WTO in 2001, Chinese products flooded Western markets. Most of these exports were in categories that are today called “low value added”: toys, textiles, shoes, furniture. The success of China’s post-2001 tsunami was made possible by the so-called “China Price”: Chinese goods that were typically 80%-90% of the quality of Western equivalents were available at 40% — and less — of the prices of their Western competitors.

Back then, China was exploiting its low-cost labour advantage. And for much of the next 20 years, this advantage is what drove China’s manufacturing and so its export success: goods priced at values keyed off that lattice of costs and wages making up China’s productive power parity, product prices no Western-based company could hope to match.

Fast forward to 2024. The China Price 2.0 has arrived. In the world of production, China increasingly does not have the “cheap labour” required to compete in the world of very low value-added products: Chinese hourly wages for a worker on a typical assembly line are some 30% to 40% higher than that paid in Mexico’s maquiladoras.

China: ‘Quality productive forces’

Cue China’s 2024 focus: in Chinese Communist Party’s parlance, it is “new quality productive forces”. And what products do these new forces produce? Higher value items: electric and petrol vehicles, solar panels, wind turbines, lithium batteries, ships, trains, drones, port equipment.

Commercial aircraft will come next, spearheaded by CAC’s C919 which will soon take on Boeing’s 737 and Airbus’s A320, A330 and A350. And how will these Chinese products be — in some cases they are already being — produced? By AI-enabled, 24/7/365 automated factories powered by increasingly cheap renewable energy.

Many of these products will typically be priced at levels around 50% cheaper than their Western peer products. How is this possible? Western governments believe it is because of “Chinese subsidies”.

Initially, when industries were establishing themselves, subsidies may indeed have played a part… but let us not forget the infant industry argument was an American invention championed by Alexander Hamilton, the first United States Secretary of the Treasury (1791 Report on the Subject of Manufactures).

China’s current success has far less to do with subsidies; it is much more derived from the harnessing of their production cost curves to the massive Chinese market and, via volume gearing, driving down their average cost curves.

Result? The sales price is far below what is possible in the West. It helps that in 2023, 50% of all electric vehicles, wind turbines, solar panels and lithium batteries sold worldwide were sold by China Inc into its domestic market. (This echoes how Detroit’s Big Three auto companies conquered the world in the late 1950s and 1960s: America first, then the world.)

And now — with Western markets often only a secondary target — China Inc is exporting its higher value-added products worldwide. In particular, the Global South is a priority destination: China Inc’s top five export markets for wind turbines in 2023 were Uzbekistan, Egypt, South Africa, Laos and Chile, countries that have no local wind turbine manufacturers to compete with Chinese imports.

And what is the net effect of these newer export successes? Corporate giants like Goldwind can get even further down that wind turbine cost curve meaning 2024’s prices are again lower (and the product is more efficient) than was the case in 2023.

The net result is that Chinese turbines are 70% down in price since 2020 while those of their two leading Western competitors, Siemens Gamesa and Vestas, are up 50%! Except for semi-protected markets in Europe, these latter two producers now find it increasingly difficult to sell beyond Europe.

‘Overcapacity’ issue

The latest stick Western politicians are beating China with is that their new export industries are plagued by “overcapacity”: the result is, apparently, dumping. On a narrow definition of “the Chinese market”, there may indeed be overcapacity in some sectors of the Chinese manufacturing machine.

But the sad and very uncomfortable truth is that — if overcapacity rather depends on where a company is on the global supply cost curve — most of the high-cost producers and so surplus capacity is now in Europe (the US barely has any competitors left in these spaces, despite the subsidised intentions of the “let’s-rejuvenate-American-manufacturing-industry” Inflation Reduction Act. As the Wall Street Journal recently and wryly remarked: “Buy American, Build Nothing”. In 2023, three of the US’s top five export categories were rather oil related. Still, the US leads in global arms sales, exporting more than the next six countries combined.)

Production power parity

Back to PPP and its lesser-known but arguably more important sibling, production power parity. This year China’s PPP GDP is forecast by the IMF to be $35.3-trillion. almost twice its nominal dollar GDP of $18.5-trillion.

By contrast, the US’s GDP is forecast to be the same (by definition) for both nominal and PPP measures: $28.8-trillion. Very roughly, this suggests China’s production power parity gives it a real-world cost and so price advantage over the United States and most of the countries of Europe of somewhere between 40% and 50%. (Market chatter hints that China has offered to build four nuclear power plants in Saudi Arabia for the same price as one from France.)

Add to this the extra price edge annually being gained from getting its products further down their cost curves thus tapping into the “magic” of volume gearing.

This massive price advantage underlies the logic of the Daily Telegraph’s Ambrose Evans-Pritchard writing an opinion piece on 22 May 2024 titled: “China’s next shock is coming — and Britain and Europe are sitting ducks.” It was sub-headed: “The UK and EU must face reality and defend themselves against an export tsunami.”

The only consolation the US might take from this dire forecast for Europe is that their shock will likely be less… but only because they have so few export-oriented manufacturing industries left to be shocked by China!

As noted earlier, what has sustained the uneasy equilibrium between the two Ecosystems has been a willingness by the world’s current account surplus runners to park their excess savings principally in the US bond market. But there are growing cracks in this arrangement.

Most obviously, states that are pariah to the US — Russia, Iran, Venezuela for example — no longer do this as their assets have been seized by the US authorities. But it does not stop there: China’s US Treasury holdings are down from $1.200-million in 2017 to $764-million today. Even Saudi Arabia — historically the anchor tenant of the Dollar World since FDR met King Ibn Saud in 1945 — is a net seller of Treasuries. In fact, Asia’s central banks as a bloc are net sellers of US dollar assets.

Read more in Daily Maverick: As US rivalry with China intensifies, Africa must tread a neutral path and be aware of proxy wars

The US believes it can always rely on Europe and Japan to park their recurring surpluses in US paper. But even here there are warning signs. In a speech at the Sorbonne in April, France’s President Emmanuel Macron noted that “every year, our savings, amounting to around €300-billion a year, go to finance the Americans, whether we look at Treasury bills or capital risk. This is absurd.”

Shift from US to Asia  

On another level, we are seeing new trends that suggest a shift in the financial balances of the world. Leading sovereign wealth funds are increasingly moving assets from the US (and Europe) to Asia, the likes of Norway to India, with the Arabian Peninsula sovereigns to India, Malaysia and Indonesia. Asean is increasingly recycling its surplus savings within Asean. And almost all these redirected investments are being made into equity and not bond instruments.

But for now, the “balance” between the two Ecosystems is being maintained even if the underlying fundamentals are ever more built upon eggshells.

Two of the US’s most “loyal allies” are the fund management community — 17 out of 20 of the world’s largest asset managers are American — and the fabled “Mrs Watanabe” of Japan.

The latter enjoys a near 4% yield uplift from US Treasuries over their Japanese equivalents and further benefits from the currency gains of a weak yen. The former parks almost all proceeds from any international disinvestment in transit into reinvestment elsewhere in the world in US dollar instruments.

And besides, tracker funds will hold 42% of their global assets in US Bonds if following the FTSE World Government Bond Index; 70% in US Equities if following the MSCI World Index.

But longer term, these two “allies” will likely not be weighty enough to paper over the cracks appearing in the US’s external — and specifically its capital — account. What might drive those cracks wider?

The answer is the increasingly fractured state of US politics and the consequences for the ever-growing US budget deficit of a seemingly insoluble congressional stalemate. These factors are undermining the status of the world’s so-called “risk-free rate”, the yield on the US 10-year Treasury. The latter is the axiomatic linchpin of the Ecosystem of Capital.

Contrary to the rhetoric of the US’s liberal wing, Donald Trump is not the cause of the toxicity pervading American politics… but he is likely a symptom of it.

That toxicity long predates Trump’s 2016 election as president, even if this “cancer” has metastasised rapidly over the past eight years. The real source of this disease is Congress… which is why what happens in the November 2024 congressional elections may be even more important for the US’s long-term financial future than what happens at the presidential level.

Read more in Daily Maverick: Elections & Crises — political twists abound in a year of destiny for many nations

It is Congress that has the final say in the US’s national budget and thereby determines the size of the US’s budget deficit. And Congress has rarely been more divided in its near 250 years of history, especially when it comes to matters of money: the last time it passed an “Appropriations Bill” (as the US budget is called) on time was 1996.

Broadly Congress’s Democratic members want to spend more while their Republican counterparts want to tax less (though the latter are always keen for higher spending on defence). The result has been — especially in the post-Clinton era — ever mounting budget deficits.

Whoever wins in November, the result is likely to be yet higher budget deficits. If the Democrats win, expect more social spending. If the Republicans win, expect less taxes… or, at the very least, the so-called Trump tax cuts not to be repealed. If the latter were to happen, the Congressional Budget Office estimates it would add a further $4.6-trillion to US national debt. And if neither win outright, expect the worst of both worlds for the US deficit: more spending and less taxes!

American low-risk nightmare

Even were it not for the steadily worsening fiscal incontinence of the US, foreign investors are justifiably losing faith in what the US bond market has long offered them: the promise of low risk (mostly from low volatility and high liquidity) and above all positive returns.

One of the highest rated US bond benchmarks is Vanguard’s Total Bond Market Index Inv (VBMFX). Its year-end value in 2020 was $89.19; 2021: $84.75; 2022: $73.35; and 2023: $72.75. It is currently at $71.57. Total returns — so including dividend yields — have been 2021, -1.61%; 2022, -12.99%; 2023, +5.31%; and year to date 2024, -1.91%. The last four years have been a cumulative horror show; 2022’s annual returns alone were the worst ever. (For foreigners, there may still be currency moves to factor into their returns.)

Add to this, volatilities have now become high: negative returns and excessive volatility do not define “risk-free” nor “safe”. And at times of market stress, the bond market’s much-lauded liquidity has recently been known to evaporate… at least until the Fed has stepped in.

(Though few US-based analysts are so politically incorrect as to point this out, Chinese Government Bonds have, in US dollars and since the end of 2020, given positive returns, so outperforming US bonds by some 20%… and this with far less volatility!)

Many US-based investors either deny or are unwilling to face up to these facts: one senses some feel they must make the best of that which they are “stuck” with. Foreign bond managers are less forgiving! And herein lies the Achilles heel that could eventually deflate the US-centred Ecosystem of Capital: the US lives increasingly on borrowed money and borrowed time.

And foreigners who have recently lent money to the US have mostly lost money by doing so.

I am not alone in this conclusion that the US bond market is in trouble. Over 2024, several of the US’s leading financiers and businessmen — Jamie Dimon, Brian Moynihan, Paul Tudor Jones, Ray Dalio, Elon Musk — have all said unequivocally: “Washington DC, we have a problem.”

What will happen if the current-account-surplus runners of the world collectively lose faith in the US bond market? Jamie Dimon talks of a “rebellion” in the US bond market. Supply would overwhelm demand… although the Fed would likely step in to clear the market, but only with another massive round of quantitative easing. Since this would involve yet more Federal debt creation, it would be seen — especially by foreigners — as “drinking more to avoid the hangover”. Hardly a desired solution!

Worst case, interest rates in the US would rise sharply, so endangering the US economy: consumption would likely be curtailed, equity and property markets undermined, and corporate borrowings become much more expensive. The value — even the Reserve Currency status — of the US dollar could be compromised. And the dark side of the US economy — that it is, in JP Morgan’s phrase, “a boiling frog” — would be exposed.

What could then follow would be a grand dislocation of the world’s current financial order. And the order replacing it would — unfortunately — be disorderly.

All this may explain why gold is regularly hitting all-time highs. As the Daily Telegraph recently noted: “Gold is sniffing out monetary and geopolitical dystopia.” The Financial Times agreed: “Gold is back — and it has a message for us. The precious metal’s surge may herald a whole new world.” DM

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  • MUSHTAQ ANWARY says:

    An excellent article on international trade and finance scenario. It explains the change in the world’s economic axis that some of have been experiencing for a couple of years now. It also highlights the north south divide. We are gradually moving towards economic dominance of the South over Europe and the US. However the HiTech sector in these geographies will continue to do well.

    • MICHAEL POWER says:

      Kind words, Mushtaq. The question now is what dos this realignment mean for South Africa? We have elected to position ourselves on the fringes of the Ecosystem of Capital not Trade. One result – and arguably the most important result – is that we cannot grow our GDP (last quarter -0.1%) mostly because we cannot generate employment. We need to ask ourselves where are we in the Production Power Parity rankings, especially where PrPP is still heavily influenced by wage costs. The answer makes unpleasant reading. Our semi-skilled wages are still high when we look to at comparisons with much of the Indian Ocean basin: our hourly minimum wage is still nearly 3 times that of Kenya which is – according to one of President Ramaphosa’s economic advisors – ‘eating our lunch’. (We were 10x the size of Kenya’s economy a decade ago; last year that ratio had shrunk to 3.7x.) Yes the South is indeed rising. And politically, South Africa sees itself as part of that bloc…but not yet economically.

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