It's Bolton's World Now

by: Martin Lowy

In this post I explore U.S. international and trade policy and discuss its potential impact on medium-term equity investment.

Some things American policy can change; many things it cannot. We should try to tell the difference.

The U.S. economy is in good shape, if we ignore that the progress is built on debt. And booms based on debt turn to busts eventually.

But I do not see the bust coming soon. Therefore the U.S. is the place to invest, while still worrying about geopolitical events--and therefore keeping some powder dry just in case.

On March 23, I wrote here on Seeking Alpha that “The equity markets are in imminent danger because President Trump’s paranoia has seized the levers of power. The appointment of John Bolton as National Security Adviser signals this ascendance.” Since that date, actions by the Trump Administration have roiled world markets through an unprecedented series of policy lurches and adjustments. Many of these have to do with the complex U.S.-China relationship, but others have to do with Iran, other Middle Eastern nations, NAFTA, and even trade relations with Europe. The only thing that seems sure at this point is that there are many balls in the air - and others may sail forth from the White House at any time.

There still is room to hope that an accommodation will be made between the U.S. and North Korea. There also still is room to hope that the nascent trade war between the U.S. and China will peter out with mutual expressions of good intentions and room for both sides to claim victory. Indeed, I think it possible that something will have been gained for both sides by the U.S.-China trade exercise. But the Administration’s repeated zigzags on major issues must leave the world scratching its collective head.

There still is room for the U.S. and its [former?] allies in Europe to back off from another trade-war theater of operations. But from where I sit, trust in any stated U.S. policy is disappearing, and thus it is becoming harder to reach less than the most formal understandings with other nations.

This article is going to be a somewhat rambling account of my take on the global politico-demographic situation, so if you wanted a hard-hitting brief encounter with the simple truth, this ain’t it. (Hint: I don’t think there is a simple truth.) But if you want to understand the big picture, I hope I can help. I read a lot of stuff on all sides, and I try to make sense of it. I am not favorably impressed with the Trump Administration’s approach to trade relations and foreign relations in general. But I was not impressed with the Obama Administration’s approach, either. A longer view is needed, but a long view is difficult to maintain when successive American administrations have worldviews so at odds with each other. I wish politicians, like doctors, had to pledge first to do no harm! My father, who was a physician, taught me that in many situations, the best one can do is “benign neglect.”

China’s Roles

The North Korea situation has to be a four-way discussion among the two Koreas, China, and the U.S. How that will play out remains to be seen, but one might foresee some kind of Chinese guarantee for North Korea, during a transition phase at least.

It is in China’s best interests to resolve the Korean mess. And therefore if Trump can use China’s self-interest to create a solution, then a solution may be found. Chinese President Xi must be able to claim some credit. I am guardedly optimistic that Trump’s unorthodox approach will work in this case.

Cancelling Chinese participation in naval exercises was an act of pique that pokes China in the nose to no good purpose. Yes, China is militarizing the Spratly Islands in violation of previous pledges and probably in violation of international law. But cancelling their participation in naval exercises will do nothing about that.

The Spratly Islands, Syria, and Crimea all are trains that have left the station. They no longer are in play. The West has to accept that. They are not worth going to war over.

The West also has to accept that China will not permit the U.S. or any other western power to have hegemony over its natural territories. (The West can draw the line at Japan and India.) The Chinese leadership knows very well some history that Americans do not learn in school - that is, that British, German and American gunboats held China (and some of Japan) hostage for over a century because China lacked the military technology to defend itself. Then Japan attacked China in 1894-95 and again in 1937-44, each time inflicting heavy losses on the Chinese, enabled by superior Japanese technology. The Chinese are not going to let those things happen again if they can help it. (And you wouldn’t, either.)

From some early date until 17-something, Chinese technology was about equal to the West’s. The Industrial Revolution changed that dramatically, as it permitted western incomes to soar and western military strength to prevail throughout the world. It was not until after WWII that China had an opportunity to begin to catch up, and then Mao’s mistakes in The Great Leap Forward etc. held China back from making progress, even while the Asian Tigers and Japan, China’s neighbors, were bounding forward. Deng changed all that, beginning in the 1970s and accelerating in the 1990s. Now that China has made such progress over the last four decades, its leadership is not going to give up its long game of global (perhaps shared) leadership and regional military superiority. China will attain sufficient power that neither Japan nor the west will attack China. And that means that China will have to have equal technological prowess - and it will not give up that goal, either. The Trump Administration might possibly gain some short-term relief from Chinese competition - though I doubt it - but over even the medium term, China will acquire technology roughly equal to America’s, simply because it has to do so and because it can do so. (Over half a million Chinese students study abroad, mostly in the West, each year. They are learning the same technologies as western students, and often they are excelling. China does not need theft to achieve its technology goals. Indeed, one might forecast that urban China fairly soon will have the world’s most qualified technological workforce.)

The U.S. has to accept that these are medium-term realities, and that short-term gains, if any, therefore will be apparent, not real.

The Middle East

Iran and the Middle East are another story entirely. There, no one outside Iran has a long game, except for the implicit population bomb that is built into Sunni fertility rates in countries like Afghanistan, Syria, the Palestinian territories, and Egypt. Probably it is notable that the high Sunni birth rates are only in countries where there is civil unrest or economic deprivation. Populations have stabilized in Turkey, Indonesia, and in the rest of North Africa. The birth rate is below replacement in Shiite Iran, but is about 4 per woman in war-torn Iraq. (Demographics is destiny, it often is said, though who coined the phrase seems not known. The phrase is suggestive. It tells us to pay attention to demographic trends but not how to interpret them.)

Syria is over as a major hotspot for the moment. The Shiites have won, with the help of Russia. Russia has won because it has demonstrated its ability to project its power and because it has cemented its rights to two important military bases. One could say that the U.S. has not lost because the U.S. never really was there, except half-heartedly. Russia and Iran showed how much easier it is to support an existing government that is ruthless than it is to bring together various bands of competing rebels.

I also would aver that, other than inciting mayhem in France and elsewhere, ISIS, despite global rhetoric, was never more than an ugly and expensive distraction because its goals were territorial but it did not have the power to hold territory - only to destroy it. Blowing people up will not end just because ISIS has lost its territories.

Sunni extremism will rise in another guise, perhaps soon. And Syria will have a civil war again some day. Oh, yes, people still are dying and cities still are getting obliterated in Syria, and the Kurds will be curbed, which they do not deserve. It is not over for the peoples of Syria, but temporarily it is over for the rest of the world.

Afghanistan is not over. It never is, and for the foreseeable future, it never will be over, regardless of U.S. policy.

Iraq, as anyone should have known in 2003, has a Shiite majority, and therefore it is and will be allied with Iran because Iran is the majority’s only natural protector. Thus to declare war on Iran, as the U.S. has just done (no shooting, just attempted strangulation) is to declare war on Iraq as well. The strangulation war proposed to be conducted by the U.S. will punish European nations as much as Iran, and Iran, logically, will turn its trade more toward nations that will not join in U.S. sanctions, whether they be Russia, China or some Europeans. If the Iran imbroglio goes on long enough, the dollar’s position will be damaged because those who trade with Iran will have to trade in some other currency. Most Europeans want to do business with Iran and do not feel threatened by Iran the way they feel threatened by the Sunni and African population bombs.

Strangling Iran will not likely cause regime change. There is no precedent for that - only for attempted strangulation strengthening the existing regime, as it did in Russia. South Africa is not a case to the contrary because the issue there was moral, not a question of power.

(Will Bolton or Netanyahu bomb Iran? Either might, though what either could gain long-term I am at a loss to see. If you bomb a nation but are not prepared to take it over and run it, what have you accomplished, except to assure the nation’s continued enmity?)

Our “friends” in Saudi, who will be friends with anyone not Iran, play every side against the other. They are friends to no one. Nor is Turkey. With Sunni friends like these, the idea that the U.S. bashes the Iranian Shiites is a bit weird. But what would a long-term Middle East policy look like? We have not had one in a long time. And I have no recommendation.

In the Middle East, Israel alone is the friend of the U.S. - and that because without the U.S., Israel would not exist. But Israel has no other friends. It therefore is a poor friend, and the U.S. is a poor friend to Israel when it encourages Israel’s worst tendencies. A peace between Israel and the Palestinians and their backers seems as elusive as ever. The premises do not seem to have changed.

Long-term, there can be no plan for the Middle East. It is all tactics - with no strategic goals other than to gain greater acceptance for Israel - a situation that may suit the Trump team quite well.

The immigration dilemma

Before the inventions of gunpowder and effective means to use it, hordes of people from outside the urban cores (urban cores both in Europe and in China) that had high birth rates invaded from central Asia again and again, for a thousand years or so, and took over the more sophisticated urban nations of China and Europe. Guns put a stop to those invasions because the urban cores had the guns and the hordes did not. Thus the urban cores were able to defend themselves, and both Europe and China stabilized around the 17th century (some places earlier than others, of course). See Ian Morris, Why The West Rules - For Now, one of the great books of the last few decades. I keep going back to it.

Europe cannot use the gun against the immigrants invading their shores and borders, and thus they are at risk of being overrun by a population that reproduces at multiples of the rates that they do. Whereas the U.S. is protected by oceans on two sides, Europe has no such protection, the Mediterranean not proving much of a barrier at all. (Indeed, the Mediterranean historically has been a pathway, not a barrier.) And whereas in the U.S., immigrants have tended to assimilate within a couple of generations, that seems not to be happening in Europe, where populations tend to be more homogeneous to begin with. And thus emigration from the south to Europe is changing the Continent. Viz. recent political events in Italy, Hungary and Poland, as well, perhaps, as Brexit.

The only useful and humane protection against the invading hordes would be to stop them from invading by making the places they come from more livable. But U.S. policy does the reverse. For example, the best way to stop Mexicans and Central Americans from crossing the U.S. border would be to make life better in Mexico and in the Central American nations. None of them has a very high birth rate, so the emigration pressure is coming from violence and underdevelopment. But the Administration, through its renegotiation of NAFTA and otherwise, is seeking to take jobs away from Mexicans. Very shortsighted.

Indeed, the benefits of trade are generally underappreciated. In addition to the usual theoretical arguments in favor of trade, trade tends to make the lives of people in less developed nations better, and that benefits not only themselves, but also Americans and Europeans because poverty causes civil wars, political unrest, and massive emigration. Poverty anywhere is in no one’s best interests. Yet speaking an international conference on May 30, 2018, Commerce Secretary Wilbur Ross summarized the U.S. policy as follows: “Every country’s primary obligation is to protect its own citizens and their livelihood. Maybe that’s a populist saying, but it’s one we feel very strongly about.” See here. Although international trade rules could be improved - it is over 20 years since the WTO was formed - zero sum thinking is a mistake in a world where trade usually increases the size of the overall economic pie and where the U.S. benefits from economic development all over the world. Yes, trade means that some people lose jobs in developed nations with higher wage rates, but America could (and should) protect those workers by helping them to make a transition without making life worse for everyone else. See my discussion of income supplements here.

Immigration’s benefits and dangers

This outline of the historical dangers of large-scale immigration is not meant to suggest that immigration is bad. It has been the backbone of American growth almost since the founding of the Republic. But when the numbers become too large and the immigrants are too different from the local population (Nigerians in Italy, for example), serious problems arise. Assimilation becomes difficult, discrimination lasts longer, and political backlash threatens the former liberal consensus, leading in the direction of illiberal democracy - which long was thought an oxymoron.

Yet the U.S. disengages from Syria and from Africa, where high birth rates and low development rates make it inevitable that young people will leave for wherever they can get to. The rest of the world either can shoot them or can try to manage them in some other, more civilized manner. But they will remain a serious threat, so long as the places they come from are so economically backward. The local problems are not merely local. They will continue to spill over into the developed world until birth rates moderate and economies and education improve. U.S. policy should recognize those realities, but neither Republican nor Democratic dogmas take them into account. (For example, the U.S., Europe and China could tell African nations they will not give foreign aid or invest unless the nation commits to an effective population control regime.)

Italy already has gone the way of repression with the election of anti-European, anti-immigrant parties. The uncertainty that the Italian situation causes is not good for trade or for economic growth in general. Italy, with its long Mediterranean coastline and low birthrate, is a sitting duck for the Sunni and African population bomb. And Nigeria likely will be the epicenter of the explosion. See, for example, Gideon Rachman in the FT here. Nigeria already has a population of close to 200 million, but its birth rate continues to be over 5 per woman. (Replacement is about 2.1.) See Wikipedia on birth rates here. Global warming, moreover, likely will make the immigration problem worse, as many of the high-birth-rate areas are the places that are likely to become less inhabitable.

I will be pilloried by my friends as racist for singling out Nigeria and for inveighing against the apparent liberal thesis that emigration always is harmless. But the plain fact is that the combination of very different looks and large physical presences make Nigerians feel threatening to native Italians. (I have witnessed this contrast myself in Italy.) The Italians are going to react defensively regardless of western liberal sentiment. To think otherwise is to whistle past the graveyard.

And one should not blame anyone else for Nigeria’s problems, even though perhaps the British-created Igbo-Yoruba-Hausa/Fulani combination was never destined to work. Nigeria has failed to govern itself well for the over 50 years since independence, and its continuing explosive population growth is irresponsible. (Numerous other African nations have birth rates above 5, so Nigeria is not in that sense an outlier, but it is alone in its absolute size.) Nigeria has natural resources and intelligent people, many of whom have great artistic talent as well, but it nevertheless will be a thorn in the side of the rest of the world because of its corruption and uncontrolled population growth. As a sad irony, a Nigerian writer recently called his country “the world’s greatest sperm donor”. See here.

Looking at Nigeria, I am reminded of a conversation I had with a savvy friend from Argentina about 50 years ago. We discussed Argentina’s natural advantages, contrasted with its persistent financial difficulties (not much has changed in the intervening fifty years), and I asked what was the problem? “Argentineans,” he replied. Demographics may be destiny, but culture, I conclude, tends to create success and failure, regardless of race or geographic location. Neither Argentina nor Nigeria appears to have made much cultural progress in the last half century. I weep for the peoples of both nations.

Thus global demographic problems are likely to continue for a very long time, and they may worsen. They also may cause voters to empower additional defensive, illiberal democratic rulers.

Is there an investment thesis lurking here?

For the long term, current American economic and international policies are detrimental. Increased debt, reduced trade, and increasing differences between rich and poor nations in an interconnected world will lead to less economic activity than even benign neglect would engender. And it likely will lead to increased political repression. Denying global warming effects will exacerbate the long-term problems.

But what about investment over the next medium term?

Amidst my forecast of longer-term demographic gloom, the basic fact remains that the U.S. economy - and the global economy to a lesser extent - are in good shape - if one forgets that it all grows on the back of unprecedented debt. The two biggest questions are (1) when the debt bomb will explode (as it must some day) and (2) whether a geopolitical bomb will explode before then - and when that will happen?

U.S. corporate profits are robust and are likely to remain robust for the foreseeable future. The stimuli of lower corporate taxes and deficit spending are almost bound to make profits continue to go up and returns to shareholders in the form of dividends and buybacks continue to grow. Employment continues to improve, as it has done for nine years, and so long as economic growth continues, employment should benefit as well.

Nevertheless, markets, over the long term, are expected to reflect long-term estimates of cash flow. And such long-term estimates should reflect the likelihood of recessions, global events that reduce profits, and the possibility that debt repayment becomes sufficiently burdensome that a financial crunch ensues and reduces economic activity. If the dangers are real (and I believe they are), those factors are likely to hold the market back. A featured WSJ story online on June 3, 2018, says some signs of global slowdown already are apparent - though whether they are temporary blips or canaries, I think, is hard to know.

I am optimistic about U.S. equity markets because I do not yet see the near-term catalyst that will derail the profit machine.

I have been pessimistic about European finance for the last decade and I have been pessimistic about emerging markets (China is not in that category any more, IMO) for the same time period. I continue to be pessimistic about both Europe and emerging markets. The potential instability of the euro, the weakness of many European banks, and the German opposition to the logical remedies make me reluctant to invest in Europe. Substantially all less developed economies are indebted in ways that are vulnerable to rising interest rates and a rising dollar. I do not invest in Chinese companies because I do not trust their accounting or that the state will not at some point seize a part of their profits. (I do not trade. Therefore most short-term opportunities are not of interest to me, though I recognize that many people are adept at it and make money.)

But U.S. companies, including regulated banks, generally are in good shape.

What will eventually derail the U.S. corporate profit juggernaut?

Debt will derail it. Booms end because the debt that has fuelled them no longer can be repaid. That causes the triple whammy of less consumer spending, more consumer defaults, and tighter credit conditions.

When will that happen? Some, including writers at Seeking Alpha, pointing to rising delinquencies, say it is happening already, asserting that we are in the Ponzi stage of the Minsky process. I am a fan of Minsky, but I do not think the U.S. is yet in the Ponzi stage. My reason is that the debt that recently has become delinquent in larger percentages (auto and credit card) is a small part of the overall U.S. debt picture - and a part that does not necessarily lead to contagion. That delinquencies on any debt are rising at a time when employment is at new highs says the underwriting was very bad - and that steeply rising delinquencies of that type of credit are likely if and when the employment picture reverses. The largest part of U.S. consumer debt, however, is long-term mortgage debt at fixed rates. And, except for FHA-sponsored debt, most of it has been underwritten pretty well. Thus it is less likely to cause the kind of cascade that we saw in the Great Recession. (The FHA delinquencies that I think will come when the employment picture reverses will simply make the federal debt picture even worse, but not by a huge margin, comparatively.)

Corporate debt also is, on the whole, fairly solid. High yield and leveraged loan debt likely will be in danger, if business does not remain robust. But most of the debt issued in the last ten years has been issued by stronger credits that can withstand a normal business contraction. My guess is that most of the high-yield and leveraged loan debt is held by people who have used equity, not debt, to buy it, and that large banks holding it have taken reasonable loan loss reserves for it. If that set of guesses is correct, then the forecasted higher delinquencies are not likely to have a cascade effect, although they likely will have a contagion effect across the whole spectrum of lower-rated credits.

Government debt is the big outlier. Cities and states are strapped by their pension debt, and that is likely to become an even bigger burden if the equity market turns negative, since the pension funds have bet so heavily on equities in order to recover from their deficit positions. The federal debt, which should be stable-to-decreasing in buoyant economic times like the present, is growing. And that is without funding the vast sums that the nation will need to prepare its infrastructure for the mid-21st century. Eventually, that combination has to become a more immediate problem. But I doubt that it is immediate yet.

(Perhaps you recall the line from Hemingway’s The Sun Also Rises where the character Mike Campbell, when asked how he became bankrupt, responds, “Two ways. Gradually and then suddenly.” That is the case with a majority of severe financial events of all kinds. You know they are coming, but it is hard to predict when they will become sudden.)

Thus, although American society continues to build long-term imbalances, it does not appear that those imbalances will derail the buoyant economy any time soon. The wild card is geopolitical risk, including the risk of trade wars that throw sand in the wheels of all economies. Whether and when such risks will be realized, I do not know, but it could be fairly soon.

Because of those geopolitical risks, I remain conservative about the medium-term for U.S. equities, not constructive for European and developing economy equities, and I own no long-term bonds of any kind, except for TIPs. My equity allocation is a bit under 50%. Call me chicken or call me prudent - I prefer the latter, if you are on the fence.

Regardless of your political or investment orientation, I hope you have enjoyed this idiosyncratic world tour.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.