Competition Takes Many Forms

Saturday, May 7th 2016, 1:20PM

by Andrew Hunt

It may surprise some readers to know that we recently compiled an overtly positive review of the Irish economy. In the course of this review, we noted that despite the severe problems that the country had encountered a few years ago, the Irish economy was now facing what we described as a chronic balance of payments surplus.

This has been, in part, the result of a stronger trade balance but primarily the result of some extremely strong inflows that are notionally termed as being ‘direct investment flows’. In theory, direct investment flows are investments made by foreign companies in real assets such as plant and equipment but also included in this category are intra-company transfers. Almost amusingly, some of the recent direct investment flows into Ireland have rather implausibly been larger than Ireland’s entire GDP and this has of course occurred as a result of the significant number of (prominent) multi-nationals that are using Irish domiciled subsidiaries as tax efficient vehicles. 

There is of course something of a furore developing over these types of corporate tax avoidance strategies but for now, at least, the situation has resulted in a great deal of money residing in the Irish banking system. Initially, these inflows into the local financial system were simply recycled by the Irish banks into the repayment of many of their crisis-era international debts. Now that many of these historical liabilities have been discharged, the continuing inflows of funds are, it seems, increasingly being channelled into Irish assets and even into new credit growth. Hence, we are anticipating a rather unique boom in Irish assets over the next year or so despite the ongoing travails of much of the rest of the Euro Zone. We might be envisaging a (further) and quite possibly imminent calamity in Portugal and Greece before too long but Ireland seems to be ploughing its own rather unique and positive furrow for now.

Another rather unique theme that comes to mind at present centres on Australia.

Although the economy is clearly suffering from the weakness in its terms of trade brought on by events overseas, the still strong level of capital inflows into the AUD and the Australian asset markets at present (particularly flight capital from China) has resulted in a surprisingly impressive rebound in domestic credit growth, further increases in property prices and a remarkably resilient domestic service sector.

We might of course quibble that many of the jobs that Australia has been creating during this latest expansion phase have been quite low value-added / low productivity / low wage but nevertheless the employment and service sector activity data has held up and hence the RBA has not needed to reduce interest rates and the long-awaited credit bust / recession has not materialised.

Another factor that has been on Australia’s side of late, and which is an even more significant factor in the case of New Zealand, has been the countries’ rapid rates of population growth. In a world in which productivity growth is either weak or simply absent, the only reliable way in which a country can produce sustained growth would seem to be via an expansion in its labour force / level of employment. We suspect that the high levels of net migration into Australasia at present are providing these countries with a relative advantage when it comes to their absolute rates of economic growth. 

Of course, in per capita terms we find that growth rates within these economies are generally no better than those elsewhere but for companies seeking top line growth, or investors seeking countries in which interest rates may not need to go to zero or even lower, the Australasian countries offer some opportunity. Specifically, given that it is unlikely that nominal GDP growth will turn negative in these economies, as it has elsewhere, there is much less chance that interest rates will have to follow suit. 
The conclusion that we draw from these examples that countries are now competing not just in terms of their conventional export or investment destination competiveness as they used to do, they are now competing with regard to tax policies as Ireland does and even perceived quality of life as well. In order to beat the global trend, countries and companies may have to be smarter....

We mention these potential opportunities because we suspect that in aggregate world growth is likely to remain essentially subdued. According to the latest data from the Dutch CPD group’s World Trade Monitor, global trade volume growth remains essentially absent at this time (as confirmed by Taiwan’s and several other trade-depend economies’ recent poor GDP data points) and this will likely continue to act as a drag on overall growth in some prominent OECD economies, such as Germany, and of course many of the Emerging Markets. At the same time, we have just witnessed the Federal Reserve opt to ‘hold fire’ on its planned rate hike and the release of some extremely disappointing growth figures from the US. Unfortunately, the detail of the latest US data also suggested that there will be more weakness to come for domestic reasons as a well as external influences. 

Elsewhere, we have seen the Japanese authorities appear to ‘throw in the towel’ on generating growth and instead start to come to terms with the act that with the population declining and productivity growth exceptionally weak, Japan’s overall economy is likely to shrink over the next 10 – 20 years. In this overwhelmingly weak global growth environment, we believe that investors will likely have to search somewhat harder to find positive rates of earnings growth amongst companies.

We also suspect that investors will soon not be able to count on a rising tide of liquidity lifting all of the (investment vehicle) boats. The ECB is of course continuing with its Quantitative Easing Policies but the latest data suggests that even fewer of these funds are making it out into the real economies.

In Japan, the BoJ will soon have to announce some form of a tapering of its bond buying activities, if only because it is running out of bonds to buy. The Federal Reserve is we suspect unlikely to go back towards a QE even if the economy is weak, although we are increasingly coming to suspect that a QE-style policy may be imminent in China given the credit crunch within the private sector that seems to be forming. 

Initially, we suspect that any QE-with-Chinese-characteristics will exert a further positive impact on global liquidity (indeed we estimate that it could lift global broad money growth by two percentage points!) but ultimately we believe that a Chinese QE will result in a weaker RMB that will both create another deflationary bias within the global economy and make China’s capital outflows worth less than they were previously.

In short, it seems to us that by the end of this year the investment world may face something of a paradigm shift. With global growth likely to remain soft in aggregate due to weak productivity and poor predominantly Northern Hemisphere demographics, and the eight year tide of QE-sourced liquidity at last beginning to ebb, investors will need once again to look at individual countries, companies and instruments as the correlations between assets and asset classes begin to diminish.

If anything, we would argue that this will mark a transition to a more rational world but we must also remember Mr Buffet’s oft quoted line that “when the tide goes out, you find out who is swimming naked”.

The next six to nine months may well start to see the tide turning.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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