China: Trade War and Treasuries
Featuring Kevin Caron
Published on: August 23rd, 2019 • Duration: 12 minutesKevin Caron, CFA, senior portfolio manager at Washington Crossing Advisors, makes his Real Vision debut by breaking down the imbalances in China’s economy. He examines the relationship between trade and debt, discusses the origins of the trade war, and reviews his outlook for 10-year Treasury notes, in this interview with Jake Merl. Filmed on August 22, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl sitting down with 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 Morganlander, on a couple of times, so it's great to finally have you here.
KEVIN CARON: Nice to be here. Thank you.
JAKE MERL: 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?
KEVIN CARON: Well, China, as one of the world's largest economies and our trade with them-- and, 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 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.
JAKE MERL: 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 the trade imbalance and how we got here to begin with?
KEVIN CARON: 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 Chinese household, basically, to the export sector. And as a result of that, we've had a long period of an 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 are not only producing a large amount of investment, but even greater savings that they ultimately have to export abroad. And that's a very strange place for an emerging market economy 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.
JAKE MERL: 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-- 50% of their GDP is investment, with only 30% consumption, and the two should be flipped in order for a more balanced economy. And that excess production is being stoked 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 us to consume their products in almost this reflexive cycle. Is that right?
KEVIN CARON: Yes, and that's not helpful for either China in the long run or the United States in the long run. And from our perspective, 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 at Washington Crossing, we don't think that would happen in a market-driven economy or if price signals were driving what is happening with the currencies.
The reality is that for a long time, 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. It helped us bring down and tackle the inflation problem of the '70s, for example. But we've now gotten to a point where what 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 buildup of debt in the mortgage crisis in the run-up to the financial crisis of '07 to '09, 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 tension which has now finally manifested itself as this trade war that we're involved in.
JAKE MERL: 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?
KEVIN CARON: Well, it turns out that with China, it's very easy to command more investment. It's easy to direct the investment side of the equation. China's proven to be very nimble at being able to do that. But that investment has to come from somewhere, and 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 $10,000. From that perspective, China is not a very wealthy economy, and when you think about 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.
JAKE MERL: And the private sector in China is, like, 200% of GDP in debt. Is that right?
KEVIN CARON: Yes. In fact, in the United States, we had a similar build up of debt in 2000-2007 period. We got to about 170% 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%, as you said. So 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.
JAKE MERL: 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?
KEVIN CARON: Yeah. In fact, again, that's a very weird thing. I want to just emphasize this. Usually, when you're developing an economy, you're a net importer of capital to fund the investment. Here, it's been exactly the opposite. 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 become an issue.
JAKE MERL: 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 of different times over the past year, and he's expecting the 10-year to yield 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 maybe bond yields just start rising globally. What do you think about that?
KEVIN CARON: 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, on the one hand, 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 the absence of regimes that are repressing rates around the world, we would think that yields here would 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.
JAKE MERL: So how do you see the trade war unfolding in the weeks and months to come?
KEVIN CARON: The long arc of this thing is towards some kind of liberalization 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 to be involved with a global economy that's growing in a peaceful and sustainably strong way. What China has done, beginning in 1980, in the early 1980s, up through 2000, is move towards a more open economy, 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 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 interests. None of those things are in the United States's 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 that 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.
JAKE MERL: 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?
KEVIN CARON: Well, a couple things. The build-up of debt in the global financial system has been significant. That's major point one. And if you look at the Standard & Poor's 500, for example, the companies in that have far greater leverage on the balance sheets of those companies than 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'd like to see debt less than about 30% 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, potentially, at some point, of a improved Chinese consumer class, that might be, also, a very good longer-term sort of secular play.
JAKE MERL: Well, Kevin, that was great. Thanks so much for joining us. It is a pleasure having you on the show.
KEVIN CARON: Thank you for having me.