We began 2018 with expectations of synchronized expansion and then things slowed down almost everywhere. How do you see the economy progressing?

Trade is an interesting area since the American President decided to turn a Cold War into a shooting one. Global trade, as a percentage of GDP, had peaked in 2008 and has steadily declined until 2016, when it stabilized and rebounded. Unfortunately that rebound had run out of steam by early 2018, well before trade protectionist rhetoric was translated into tariffs and quotas. The slowdown has affected Europe the most but is apparent in the US and China as well. The openness of the European economy is a factor, trade is over 80% of GDP. This deterioration in trade is an important and long term phenomenon. The economic crisis was a turning point as it made countries pursue a less collaborative and more rivalrous policy. China’s reduction on trade dependency was less reactive and more an effort to create a more balanced economy less reliant on any one engine of growth. The US, had a pragmatic issue of growing an economy where the banking system was damaged, government debt levels had climbed to fund bail outs, and household demand and balance sheets had been dented by the mortgage crisis. Trade was an avenue of growth, but it had to reverse a large and chronic deficit with China and the rest of the world. The rebound in trade in 2017 was not a fundamental reversal of this trend but a respite, and the reversion to trend is now being exacerbated by a belligerent US President. I don’t think the primary trajectory has changed. Specialisation and trade is good and we’ve reaped the benefit for decades, but recently the incremental benefits  had come with some adverse side effects, such as inequality, unemployment, less robust albeit more efficient supply chains. The US reshoring phenomenon began in 2010, and I don’t see it stopping. As automation and robotics become more ubiquitous, the tendency is for production to be located closer to end markets. As US or Western companies are the most global, there will be some net retrenchment in globalization of supply chains. One implication is potential inflation from loss of efficiency, but this will probably be compensated for by more efficient localized production. Involuntary reshoring, the type driven by policy shocks, is another matter and tends to be a lot more inflationary with efficiency losses not compensated by robustness gains. Generally, trade will be a drag on global growth in the coming years. Given that global trade represents a third or more of global GDP, this drag will be substantial. And given the nature of trade, the drag will be synchronized.

Technology is an important factor. Cold Wars are good for technology. They are when the public purses are made available to private enterprise to further innovation and technology. The US leads in many areas in technology, although the tech sector is possibly one of the most globalized of sectors with a single chip being designed in Europe, arranged in the Netherlands, and fabricated and completed in China by a Taiwanese company, before finding its way into an American device. The Cold Trade War will disrupt this ecosystem, resulting in more expensive devices, but will encourage domestic innovation. The near term effects are most likely to be negative as global supply chains are disengaged and reorganized domestically. Capex will rise but it will be wasteful resulting in more robust but less efficient production. Greater automation will have impact on employment. I don’t think AI will live up to its promise in the short or medium term, but simple automation can already have significant impact. Given tight labour markets and a rise in xenophobia and anti-immigration, technology will be a more important aspect of localized supply chains.

There are some risks to the tech industry from regulation. In the past decade, technology has run ahead of regulation as the regulatory spotlight was turned to banks. This needs to change and I think it will. It has already begun in Europe and could spread to the US. Regulation is another step in shifting the balance from efficiency to robustness but which will also slow the meteoric growth of the tech industry.

Policy has been a driver of markets and the economy. A decade on from the financial crisis it is only right that we come off monetary accommodation. The Fed is well on its way, the ECB will stop net purchases of assets, the PBOC has been regulating the nature and quantum of credit growth for a couple of years now. Even the BoJ may ease off the accelerator if not tap the brakes.

In the short term, the Fed needs to reset interest rates to a level from which it can cut them to deal with a slowdown. The problem here is that time and time again, it never fully normalizes before the next crisis or slowdown. The analogy here is anti-biotic resistance. The Fed has to be careful also how far it goes, given that government and corporate debt levels have surged in the last decade. Household leverage, thankfully, has not risen as quickly. The short term, slightly myopic view is that the Fed will continue to raise rates as far as it can without triggering a recession. If as I expect the economy slows over 2019, the Fed may lengthen the intervals between hikes, but generally, the Fed will keep going, past neutral, perhaps well past neutral, to get to a level from which it can credibly cut rates. The question here is whether the economy gives the Fed this latitude, or if it falters before the Fed is done. Prior to the tax cuts in the US, I would have said that the answer was yes, that a slowdown would occur, but that it would be sufficiently shallow that the Fed could maintain course even through the slowdown. However, the tax cuts have now increased inflation, and the national debt, placing the Fed in a difficult position; deal with the inflation or the national debt service. Either way, fiscal policy has lengthened and deepened the economic cycle. My revised expectations are that the Fed will cave not to Donald Trump, but to the stock of debt that needs to be financed and refinanced. Even so, with a neutral rate of 3% Fed Funds, say, an overshoot to 3.5% or 4% is still manageable. Unless the curve steepens too much. The management of balance sheet normalization will be of great importance. On top of this, market funding costs, basically the yields in the corporate bond market, will be important. With companies buying back shares in the last few years, basically depleting their capital, and often times funding this with debt, corporate leverage has risen significantly. Higher rates and wider spreads would place corporate balance sheets under some stress. For households, higher rates would mean a slower housing market and retail sales, both acting as brakes on the economy. In the longer term, the accumulation of debt makes higher rates simply impractical for the US. That QE has been demonstrated to work also means that it will be deployed in future to deal with less serious crises as well. The long term trajectory of rates is therefore one of short periods of rising rates, perhaps rising more quickly, and long periods of falling rates, perhaps falling more gradually.

The ECB’s problems are more complicated both in the short and long term. As it is Eurozone growth is slowing and inflationary pressures are ebbing before the ECB has had a chance to raise rates, or normalize its balance sheet. We know that net purchases under its Asset Purchase Program cease in Dec 2018. What we don’t know is how it will reinvest cash flows. I expect them to lengthen the duration of their portfolio and to supplement this de facto accommodation with LTROs at the back end of 2019. With time, a shallow slowdown will be turned around into growth once more. That’s the short term view. The longer term view is complicated. Politics could lead to the loss of a member of the Eurozone, and size matters. If an economy the size of Italy quits the Euro, it might actually break it. It is difficult to envisage Euro rates significantly above zero for any length of time. The most likely scenario is that the ECB emulates the BoJ’s policy in the last 20 years and maintains zero rates to accommodate the weakest members of the Eurozone. At some point the threat to the Euro will come from societal and political pressures and not commercial or economic ones.

Japan is in the midst of economic reform which might lift rates out of negative territory at some stage but not far from zero. This already would be regime change and have implications for the economy and the savings industry. The economy would likely transform itself gradually to a more balanced, in terms of gender and foreigner participation, economy and would regain some vitality from doing so.

As for India which is also of interest, the real change has been the political one and the country is on the reform track. The risk is that the Prime Minister loses his majority or mandate and the reform agenda is stalled or rolled back. The hard work of demonetization and tax alignment (GST) has been done, the recapitalization of the financial system is underway with the regulator wielding a newly inked bankruptcy code, and it seems that India will be one of the more vibrant economies in the short to medium term, and extend this into the long term. The main threat to growth is energy prices, and it is a real threat as supply is likely to become more of an issue. Another threat is the independence of the RBI, already compromised this year. If, oil doesn’t rise too quickly, inflation should not be acute

The PBOC has the most policy tools at its disposal, but also has a complex economy whose financial system, shadow and formal, has grown more quickly than regulators’ ability to monitor, measure and regulate. The PBOC is still in risk management mode 10 years after a massive fiscal and monetary expansion that it has only begun to moderate and manage since 2015. Since then, efforts to reduce leverage have precipitated slowdowns and capital markets volatility. The recent slowdown in the Chinese economy can mostly be attributed to tighter monetary policy than the trade war as the PBOC seeks to deleverage and regulate the shadow banking sector while channelling credit through the regulated banks. That the PBOC has only reacted moderately to recent market volatility is a positive sign that it will tolerate free markets even if unruly ones and signals confidence that China can tolerate slower growth in the 6.0% – 6.5% region. Growth is unlikely to rebound given the size and heft of the Chinese economy but a slower decay to 4.0% – 4.5% over a longer time frame would not be a disaster. There is a more important lesson to be learnt in China. China operated QE in 2008, then started to normalize policy in 2015. The Chinese experience of normalization may be extrapolated to the US. When the effects of normalization became too acute, China paused. When markets improved, they resumed. The US will likely go through the same phases as they manage their system leverage down to more reasonable levels.

These are very long term considerations. What about 2019? What are your expectations for 2019?

The world ex US has likely reached the crest of the economic cycle. Europe and China are slowing, in part due to a slowdown in trade which they do a lot of with one another. The US cycle has been prolonged, I don’t know for how long, possibly into late 2019. The US will eventually slow, probably in early 2020, and given the tax cuts and the leverage in corporates due to the increased leverage, might be deeper than I initially envisaged before the tax cuts but it will still likely be a shallow recession.

Europe is a worry. 2019 will see new management in Brussels which will distract from policy. If the ECB actually tapers QE without compensation, expect the European economy to slow down markedly. Any compensation will help financial markets but likely have less impact on the real economy. Politics are a recurring issue in Europe and with EU elections in late 2019, the risk of disruption is high. The far left and right have not gone away and a slowdown in Europe will certainly ignite their cause.

China will continue to slow. The GDP prints are quite clearly ‘massaged’ and a 6.2% print somewhere in 2019 would be expected, if nothing else to test the market. The restructuring of manufacturing is mostly complete and the impact of trade wars, if they haven’t been somewhat settled, will have less of an impact. Policy will remain tight on balance but the marginal impact of policy will have been blunted. China is closer to completing normalization of policy than either the US, Europe or Japan.

What ailed the markets in 2018 and how do you see markets in 2019?

Strong economies, slowing moderately. I don’t think we have weak economies. Growth has been robust, relative to new normal equilibria. The problem we had in 2018 was that markets had priced in continued synchronized economic acceleration in growth at the peak of that growth. The slightest disappointment would have triggered a sell off.

US stocks are expensive relative to rest of the world. China stocks are cheap. Even with the weakness in 2018, equities are still expensive. The skew is therefore to the downside. Given the significant valuation premium in US equities relative to the rest of the world, I expect convergence and US underperformance. China, India and Japan hold considerable value relative to the US and I expect them to outperform. That said, it is still possible that they all give a negative absolute return.

USD duration is still a short. As long as the economy remains stable, even if there is a shallow deceleration, I expect the Fed will continue hiking rates. The pace may slow, but it will be not only dependent on macroeconomic data, the Fed will also watch market credit spreads, lest they widen too much. I expect 3 to 4 hikes in 2019 and possibly 2 more in 2020, as long as the economy and market can digest it. There is less certainty around the balance sheet normalization. Here, the Fed has latitude to manage the duration of its portfolio. However, given that as a percentage of total outstanding bonds, the Fed was a third of shorter maturities and three fifths of the long bond, I expect the curve to steepen along the 2 to 30. Now, it may be that the curve flattens to the belly but the 30 year has lost a significant buyer. Another theme is that sharp declines in risk assets create demand for shorter maturity treasuries.

There is value in Asian credit but the soft links to USD import Fed policy when more accommodative policy may be more appropriate. As a result, Asian high yield is preferred to investment grade. Spreads are sufficiently wide to dominate duration. In Europe 5 year credit duration is valuable as is 15+ year rate duration. The ECB will have to advertise hawkishness while practising dovishness, quite the opposite of the Fed. Expect an LTRO at the back end of 2019 to roll over a wall of maturities. There is even an outside chance of an early LTRO program to sterilize the QE taper. A more likely scenario is a dovish operation twist even as net purchases under the asset purchase programs are terminated. Either way, euro duration is probably the only duration to own.

Corporate IG is a difficult trade. Current spreads offer near fair value but the risk reward is not attractive. Corporates are over leveraged, the economy is rolling over, and rates are rising. High yield is an even more difficult trade. While HY spreads have risen lately (from 290 in Jan to 420 in November) and are possibly at fair value, the risk of overshoot is high. Momentum in HY could see spreads over 650. IG spreads (155 in Jan and currently 234) could see 320. Similarly, loan spreads which went from 250 in March to 315 in November could easily head to 550. Certainly 420 is an easy target.

Opportunities lie in CLOs but even here, spreads have only just begun to widen. The default characteristics and the dynamics between tranches offer some positioning opportunities. At some stage in 2019, equity is likely to look attractive. In the meantime, the IG bonds are likely trade down in price but probably still give a small positive total return. Compared with cash, it will be a hard call.

One area which has sold off well past fair value is European bank subordinated capital. Returns in the low to mid teens is not impossible. This asset class has been profitable before but is somewhat correlated to equities. For those who believe the story, given how much bank equities have sold off, it may be more sensible to just buy the stock. In any case, European banks look like good value. And on the subject of banks, US banks are also good value having lagged the market in the last legs of the bull market.

Finally, there is energy. The oil market is a minefield of technicality, fundamentals and politics. That said, oil tends to be supply driven and future capacity is seriously constrained. US shale can only grow so much and is dependent on cheap credit. With the HY market in a bit of trouble, OPEC has turned on the taps. I think the disagreement over quotas is a bit of a show and that the Saudis are intentionally oversupplying the market to depress the price. Not for long but certainly while the credit markets are stressed, in an effort to sweat the US producers. These are short term strategems. In the longer term, failure to invest in long cycle oil will create the supply imbalance. Buy oil and/or oil companies.

How would you invest for 2019? And how about the longer term?

If you want to invest in 2019 to make money in 2019 you’ll be in a hurry and make a lot of mistakes. If you haven’t de-risked your portfolios by now, especially in credit, you should. Volatility is quite stationary and high vol begets high vol. There are fragilities in the market, more than there are in the economy, and there will be opportunities to deploy cash in 2019. To deploy cash, you need to have cash. To find bargains, you have to be patient. 2.5% for 3 month cash means you can be very patient. This is not to be underestimated. With short rates rising, the price for waiting is low, and this will apply to all USD based investors. If everyone faces this, you will have to be more patient than most.

You can be less patient to deploy in Chinese equities. Valuations are cheap and China is further along QE normalization than any other country.

You can be less patient to buy banks. US banks are good value, European banks even more so, although the subordinated capital securities are probably better risk reward in Europe.

Energy is a tricky one. OPEC will sweat US shale but at some point the realities of capacity constraints will bite and OPEC will not be able to hike production any further. Everybody knows how energy markets turn on a dime.

You should be patient in credit. It is sufficiently low vol that you can try to time it. Lets talk about leveraged loans. This is a very attractive asset class given its structural seniority and floating rate coupon. However, it suffers from fickle liquidity. It can be as liquid as the IG bond market one day and liquidity can evaporate the next. To get a jump on the loan market, monitor the discounts in the closed end loan funds. You can afford to be a bit early if you can buy at discount to NAV.

The HY market will be impacted by the oil market. The HY market is slower moving than the oil market so you might want to time the HY entry when you have some confirmation in the oil market. Be patient with HY. It is very late in the day and you will be investing before the downturn. Give it a miss and wait for the next cycle if you have to.

The IG market will be driven by duration, unless you can lever your portfolio or hedge the duration. Be very patient with IG. The budget deficit, QE normalization, rising inflation, are not ideal for duration. As for spreads, there is still further potential widening even from current levels.

Economic growth is slowing in 2019. Even if it mild, only buy assets which are pricing in a slowdown. Be less patient with assets pricing in a sharp slowdown. Be patient with assets pricing in a shallow slowdown. Avoid assets pricing in business as usual.

What are the risks that we get a recession and even beaten down sectors fall further?

This is the most important question of all.

The rivalry between China and the US is a very significant risk. Today we see it manifesting in trade and technology. The US President has been very aggressive and sometimes counterproductive, dispensing friendly fire. Hopefully, private commercial interests prevail and deter politicians from populist antagonisms. If the trade war escalates and supply chains have to be duplicated locally, embargoes and quotas are established, tariffs and taxes are raised, output would fall while prices were rising. Fiscal and monetary policy would be severely constrained. In this scenario, gold becomes a good substitute for short term treasuries as a reserve asset.

Another risk is our understanding of the economy particular as it relates to how inflation and interest rates interact. If higher rates somehow stoke inflation, say for example by causing substitution away from fixed capital to labour, or because real rates are more stationary than nominal rates, then the central bank’s reaction function would exacerbate any inflationary situation. This also would lead to a stagflationary scenario.

Societal currents are a significant risk and difficult to quantify financially. Inequality is rising to acute levels leading to people rejecting the current social contract. Capitalism has been perverted, since the fall of Communism, a hypothesis validated by the solutions to the financial crisis of 2008. So far it has led to unexpected results which should be classified simplistically as the rejection of the status quo, and thus may not be rationally explained. Brexit, the election of Donald Trump, the composition of the Italian government, the democratic representation of the Alternative fur Deutschland in the Bundestag, and the gilet jaunes in France and Belgium.

Markets were badly shaken again this week. The trading was interrupted by a US holiday as the nation paid its respects to the late President George HW Bush. The stock rally that was triggered by an apparent change of pace of the Fed, and a temporary ceasefire on the trade front at the G20 meeting, gave way to concerns that the truce would be short lived and inconclusive. Daily market volatility has been elevated. Index moves under-represent the degree of uncertainty at the stock level. Credit spreads have re-widened to year highs.

What is going on? The global economy is undoubtedly slowing, perhaps excepting the US which is still growing robustly. NAPM manufacturing and non-manufacturing PMIs remain well north of 50 and are not decelerating. The trade balance is worsening, surely a sign of strength in the domestic economy. Outside the US, in Europe for example, the economy is quite evidently slowing. Weakened consumer sentiment and trade are to blame. The trade woes predate the trade war and are part of a longer term trend. In China, the economy is also slowing quite apparently and the PBOC appears bent on deleveraging rather than arresting the deceleration. And yet, growth in Europe is still positive, 1.7%, and growth in China is 6.5%, perhaps slowing to 6.2% next year, hardly slow, and hardly a recession.

The economic recovery is nearly 9 years old, with some interruptions in Europe and China. Its been a long time. A diet of QE has stabilized the economy and prolonged the cycle. A prescription of financial system regulation, the recapitalization of banks and the deleveraging of the shadow banks, has stabilized and strengthened the financial infrastructure. The cycle was due to turn, but it would be a shallow cycle.

The problem was that asset prices ran ahead of themselves. Reality is not bad, but markets priced in a reality that was great and forever. With such expectations, all it takes is a few disappointments for sentiment to get ugly.

Let’s look at the reality in China.

Growth is slowing, no doubt, but the quality of that growth is improving. China is becoming less unbalanced, relying more on consumption and internal technological innovation; it has become the largest patent filer in the world, overtaking the US, Japan and Germany. Technology and innovation are supported by government, this is one area of contention with America, but ask who funded US technological innovation during the post war years and the Cold War (with Russia.) The middle class is growing with more urbanization and higher incomes; one of the reasons for rising costs is rising wages. Private consumption is now 39% of GDP, low by international standards, but high when adjusted for the high savings rate.

The primary driver of stock market returns, and the economy, is policy. China is deleveraging in reaction to an earlier infusion of leverage which it used to stabilize the economy post the financial crisis. Yes, China was doing QE. You could say that since 2015, China was normalizing policy. One could draw examples of what could happen as the US normalization ages and how it could impact markets. On the fiscal front, China is cutting taxes and introducing deductibles for the first time (Jan 2019) which should give consumption a boost. Corporate tax cuts have been signaled for later 2019. As China deleverages, it does so mostly in the shadow banking system while compensating by capitalizing and providing liquidity to the regulated banking system. It’s just good risk management.

The trade war is hurting China, yes, but China’s dependency on trade has fallen in the last decade as part of an intentional effort to balance the economy. While the US remains its largest trading partner gross exports to the US constituted just 4% of total China GDP in 2017, down from 8% in 2008. The trouble with this trade war is that its not just about trade but about hegemony and supremacy.

Were equity valuations as high as in the US, one might worry, but the S&P trades on 16X earnings while Chinese stocks trade around 11X earnings. US earnings growth is likely to lag China’s by 9% vs 12% according to the consensus on Bloomberg. China has been normalizing QE for over 3 years whereas the US is only in its first year. One country is building walls, while the other builds bridges.

ESG is gaining awareness among investors. To date there are some 120 ESG ETFs with 11 billion USD of assets under management. SRI investing is expanding and currently totals 12 trillion USD in assets. Why might ESG investing be important and useful from an investment perspective, that is apart from doing good? Asset managers responsible for some 60 trillion USD of assets, roughly 50% of the global institutional asset base, have signed up to the UN Principles of Responsible Investing. While they may not explicitly manage assets to stated ESG criteria, they are at least aware of the PRI standards and incorporate the practices in some form.

Sustainability is an all-encompassing concept which takes into account factors economic, environmental and social. Economic sustainability is self-evident. Business has to be profitable and a going concern. It cannot act in ways that threaten its long term status as a going concern. Robust corporate governance is necessary to align the interests of all stakeholders and manage conflicts of interests. Efficiency and robustness needs to be balanced. The balance of power between the executive and the board has been an area of recent focus. The separation of duties has value in providing checks and balances. Employee relations are equally important as a factor in attracting talent, retaining it and enabling it.

On the environmental front, climate change awareness is important, if nothing else as a factor in risk management. Companies which ignore this aspect are at risk of being unprepared for the implications of climate change. Seasonality changes impact agriculture, transport and consumer behaviour. Increased unpredictability places physical assets and infrastructure at risk. Insurance costs rise and fall with the occurrence of natural disasters. Failure to at least be aware and apprised of climate risk is a weakness in risk management within a business.

On the social front, human rights are not only a moral factor, they are an important risk factor. The health and welfare of local communities, developed or developing, can have important implications for supply chains, and the commercial ecosystem of consumers, employees, and shareholders. Consumer protection and welfare is important. Firms may be tempted to optimize shareholder value at the exclusion of all other stakeholders, but the detriment of the customer is surely self-defeating and a significant risk while the detriment of employees is failure to manage an important input factor.

More than all these rather pragmatic and self-serving considerations, businesses clearly do not operate in a vacuum. Their actions and decisions have implications which reach beyond their narrow industries, supply chains and markets. Society and the global economy is an ecosystem which thrives on balance. Imbalances are corrected over time, gradually or suddenly and the greater the imbalance the greater, and often the more sudden the adjustment.

One of the more difficult hurdles that ESG will have to surmount is the misalignment between individual and collective objectives, commonly referred to as the tragedy of the commons, solutions to which are hard to find.

It is important to realize that ESG is not philanthropy, not does it involve sacrificing returns in return for altruistic objectives. In fact, ESG investing is an extension of risk management above and beyond the traditional quantitative metrics such as VaR and volatility, or default and recovery. The adoption or integration of ESG principles of investing should therefore yield better results, not worse. The simplistic view that ESG compliance results in poorer corporate performance is outmoded. Externalities are priced in over time and businesses which neglect including these factors in their production functions are assuming additional risk. As for investors, the pricing of these externalities simply results in a more complete characterization of a business which surely leads to better decision making, which in turn yields better investment results.

The consensus amongst investors is the following:

The US is still a good place to invest because the economy is strong, inflation is under control, and policy is accommodative despite the Democrats winning the House and potentially stopping further shots of performance enhancing substances, the Fed is raising rates reassuringly and gradually, and finally, there are few alternatives as attractive once the risks are accounted for.

China is a risky investment because growth is slowing, there is a credit bubble, policy is hawkish as the government tries to deflate the credit bubble, and there is a trade war with America which China will lose.

Europe is a basket case where growth is already slowing, policy is behind the curve and hasn’t normalized when the going was good, Brexit is a distraction and a material loss of an important partner, Italy is misbehaving fiscally, and populism threatens from the extreme right and left.

Here’s what I think.

With Democrats in the House the political and regulatory risk has risen. It’s going to be difficult to analyse policies on their merits and along conventional lines because even tangential matters can be used as bargaining chips or hostages.

Expect a standstill in tax cuts. The negatives are of course that the equity and credit markets have been counting on further tax cuts and deregulation. In the short to medium term, this will reduce the momentum in earnings. Deregulation is also likely to be set back.

In some areas, Democrats and Republicans agree, such as infrastructure investment and containing China. Even here, there is uncertainty as each piece of legislation becomes a potential pawn in a larger conflict between the two parties. Anything is possible.

The US has prolonged its prosperity by cutting taxes, which essentially borrows from its future. Were these borrowings spent on investment in future growth and capacity it might be positive for risky assets but instead a significant portion has been spent on share buybacks, thus inflating asset prices. Eventually this debt needs to be refinanced or repaid. Rates are rising and spreads have been kept artificially low by QE and policy. The future cycle could be deeper than previously thought.

China is slowing down and directly as a result of the campaign to deleverage the economy. The effort has been turbulent as the speed of deleveraging has surprised the regulators as they shifted leverage from the shadow banks to the regulated banking system. This type of contraction is the price for a worthwhile cause, a safer credit system.

Trade has already had some impact on the economy but mostly through sentiment. China’s export reliance has fallen steadily over the last 10 years as part of a deliberate policy to balance the economy. China has the domestic demand to support its economic growth. Exports account for 10% of economic growth of which a third is to the US. Europe is China’s largest trading partner, which brings with it its own set of problems as Europe reverts to moribund trend growth. But tariffs on goods headed to the US penalize Americans as much as they do China.

Between a market trading at 19X (S&P500) and yet to slow down, and a market trading at 11X (Shanghai Comp) which is already in a slowdown, it really depends on whether you prefer the game of chicken to being too early into a trade. China slowing from 7% to 6% growth still generates a comparable incremental nominal output as the US growing at 3.5%.

Europe is a trading bloc, which explains much of its attitude towards trade policy. Europe has an ageing population, is most lately averse to immigration, and has relied most heavily on international trade for growth. Without miscreants weakening its currency (2008 – 2016, and most recently 2018), the EUR would have been too strong for the Eurozone’s business model. Trade has been good to the Eurozone and exports to GDP have risen steadily from 40% of GDP in 2008 to 46%, almost monotonically. China, has been an avid buyer of European brands and intellectual property. Some would say, thief, not buyer, but this is an exaggeration from extrapolation in certain sectors. The Chinese have been heavy buyers of high tech and industrial products to supply its growing economy.

Europe’s problems would fill volumes, but the complicated mess that is Europe provides a lot of stock picking opportunities. At 12X – 13X earnings, Europe is not expensive, and contains pockets of opportunity. European luxury brands demand by an increasingly rich populace in China is a durable theme. The broad brush approach of macro investors to Europe create opportunities even in the European banking sector where healthy banks have to pay over 7% for tier 1 capital. The simple refinancing of bank liabilities would improve margins even if the ECB maintains negative interest rates.

The consensus view on Europe is, however, accurate, and a broad exposure based approach to invest in Europe is inadvisable. The ECB is in a corner, not entirely of its own doing. Growth rose sharply in 2017 but did not last long enough for the ECB to raise rates. Its compromise of backing away from QE is not really viable without replacing it with some other accommodation. The ECB will almost certainly have to resume its LTROs, if nothing than to refinance the old ones. Any dreams of ECB rate hikes will have to be preceded by large scale LTROs.

The political landscape in Europe is highly uncertain. 13% of the Bundestag is with the AfD. Italy is run by a coalition of two populist parties bent on challenging the fiscal discipline of Brussels. Brexit will at the very least distract and would remove the most pro-business lobby within the EU.

And, Europe is slowing down again, off its 2017 trade infused high. Manufacturing PMIs are flagging, declining in 8 of the last 10 monthly readings. Service PMIs are a little bit better but the overall picture is down. Other economic indicators corroborate the slowdown. Some of this is the slowdown in China, and some of it is the trade war between China and the US which introduces some very complicated problems. The European auto industry, as an example, produces in the US to serve Asia and Europe, Asia to serve America and Europe, and Europe to serve America and Asia, often within the same car company. (Generally, SUVs are made in America, compacts are made in Asia and America, and flagships are made in Europe.)

How does one make money under these conditions?

US earnings growth is still strong and theoretically, one could just invest in US companies. Market prices are, however, driven by more than just earnings. They are impacted by valuations and by expectations of future earnings. If investors think that future earnings growth may not live up to expectations, they may value companies less and prices would fall even if current earnings were robust. Expectations about future earnings are impacted by fiscal and monetary policy, domestic and foreign demand, costs of credit and input costs, among other things.

Companies in China are cheap but the economy is slowing and while earnings are still growing, they too will slow with the general economy. India is growing strongly and earnings are highly correlated to growth but the risk of higher oil prices and a strong USD threaten inflation and diminished returns in USD. Japan is a bright spot with growth just accelerating and disinflation reversing. But global sentiment on equity risk typically drives equities of all nations in the same direction with dispersion mostly in magnitude.

Credit markets also struggle. The Fed raising rates makes duration unattractive. Credit risks correlate with equity risks, so as a bundle, the outlook for traditional bonds is not great. There are pockets of value and returns in the more esoteric corners of the bond market but they tend to be accessed by institutional investors and unavailable to private investors.

Trading FX is an adventure fraught with risks as currencies can decouple from fundamentals for a long time. In the meantime, short term variation is explained more by capital flows, sentiment and news.

For the next year at least, a couple of possible investments suggest themselves.

• Italy’s bond yields are some 3% higher than German bund yields. If one believes that Italy will not exit the Euro currency mechanism then odds are the difference between BTP and bund yields will fall. (Buy the Italian bond and sell short the German one.) An additional catalyst is that the ECB revives the LTROs. It almost has to just to refinance the expiring LTROs to avoid a liquidity crisis (not a solvency one) for Europe’s banks. And given the latterly soft economic data from Europe, it may have to expand its LTRO sizes to replace the expiring QE program. The risks to this trade are that Italy’s two co-ruling parties decide to amplify their defiance of EU rules thus widening the budget deficit and further growing the national debt. Even so, it may make sense to stick two fingers at the Italian government and make the trade. If Italy tries to exit the Eurozone it will wind a 480 billion EUR (25% of GDP) debt obligation from the conversion of its TARGET2 net balance, into a bona fide debt. A similar trade with less risk can be attempted between Spanish and German bonds that doesn’t involve staring down sovereign governments.

• The US treasury curve had been flattening for the past seven years and has reached an extreme level of flatness. It has only been this flat in 2005/2006, 2000, 1989/1990, mostly leading up to recession years. The US is unlikely to sink into recession. The current flatness was born from technical issues to do with QE, notably the extension of the Fed’s SOMA holdings. At peak, the Fed owned some 30%-40% of the market in short and intermediate maturities. It owned 56% of the 30 year treasury market. Just as QE in its latter stages was meant to flatten the curve, to cap long term borrowing costs, so the withdrawal of QE is bound to reverse it. On a duration neutral basis, the trade has generous carry, precisely because the curve is so flat. That the curve is steep at shorter maturities provides a positive roll down for the trade. The risks to the trade are that inflation falls or that the US enters into a recession and the Fed resumes QE.

• European bank capital is attractive because it is mispriced. European banks have seen two years of improved earnings and beating forecasts. More recently bank capital buffers continue to improve and banks are meeting ECB stress tests under the most stressful conditions. Despite these improvements, the bank capital market has sold off in sympathy with bank equities, which had in turn sold off in sympathy with increasing sovereign default risk.

• European banks may not be in the best of shape even after all the recapitalization exercises, but, if the ECB does go ahead with LTROs, it presents European banks with a capital free (or at least very low capital consumption) way to make money. We know also that the ECB cannot raise rates before embarking on large scale LTROs as they would be punishing the banks whom they needed to do their dirty work for them. The first ECB rate hike would lift the banks as it would aid their profitability.

• 2 vs 10 year bund flattener. This is a more risky trade. The economics are sound. The ECB will unlikely revert to QE for fear of signalling that Europe was back in intensive care. LTROs are less glitzy steroids. However, it is likely to lift the benchmark deposit facility rate from -0.4% towards zero to take pressure off European banks and insurers. Raising the short rates and operating 3 year repos will put flattening pressure on the EUR sovereign curve. Being long the 10 year pays 0.4 and being short the 2 year pays (yes, pays, not costs) -0.6 X 5 (duration hedged) for an all in carry of 0.7% in EUR. This is a risky trade because if the moderate slowdown in Europe becomes a recession, and the stock market crashes, the risk aversion trade will likely steepen the curve from 1% to 2% for a 5% loss on an unlevered basis, and you’re not going to do this without leverage are you?

Trump seeks glory and believes that it can be achieved by making America great again. He wants to do it his way.

He found it unacceptable that a black man was President. He has never accepted the legitimacy of the Obama Presidency holding that Barack Obama was not born in America (he was, in Hawaii). His response to this apparent aberration in American history is to undo all that President Obama did during his term in office, to rewrite American history. That means rolling back Obamacare, rolling back Dodd-Frank and Consumer Protection Act, cancelling the Iran Nuclear deal, among other things.

Trump wants to make America great again if it means making everyone worse of, in fact, in his constant sum calculus, this might be preferable.

He wants to be a hero, a saviour of America. He sees America as having been taken advantage of by friends and enemies. He sees America as the injured party, always at the losing end of the bargain, and he intends to correct that.

He wants America to be first and best and sees China as a threat. He will not only maintain America’s lead by advancing America but by confronting and containing China. There are some important implications of this. One is that he will not deal with China in good faith regardless of whether China deals in good faith or not. It is entirely possible that neither side will deal in good faith. The risk of escalation is therefore high. No deal will be good enough.

He is aggrieved that Europe and his other allies are not helping America with the fight against China and other perceived and real enemies. He considers them pacifists and it irritates him no end that he has pacifist allies. He has no qualms punishing allies who are uncooperative or whom he considers guilty of treachery. It is a fine line between regarding an ally as weak and pacifist and regarding them as colluding with the enemy. We may be past that point.

He sees trade as a zero sum game and he wants to reverse America’s trade deficit with everyone. He cannot understand why America has so many great companies making so many great products yet manages to run a deficit with China and Europe. It is unlikely that Trump does not understand the logic of comparative advantage but that he does not accept its conclusions. Trump only accepts his own perspective and conclusions and will only accept a zero balance of trade as evidence that the playing field is level. At worst he ignores the globally integrated nature of corporate American supply chains, at best he expects corporate America to restructure them along national lines.

Trump regards a non-negative trade balance as evidence of free and fair trade. Even if all supply chains were fully domestically re-shored, this is a difficult task. It would require America to save more and Europe and Asia to save less, tendencies which are in part culturally influenced.

He sees Canada and Mexico as irresponsible neighbours who are not with America in the global competition. He regards them as porous borders through which European and Asian exports find their way, unfairly, into the US. Again, a fine line separates regarding them as naïve victims of America’s economic rivals and outright profiteering colluders.

He sees all American opposition to his rule as a personal slight and betrayal. He regards his American detractors as pacifist allies at best and at worst, traitors to the American cause. This applies to the Democrats, the media and a good proportion of moderate Republicans. Any American who does not support him is betraying America and himself personally. The law and the constitution are not principles to be upheld but constraints to his modus operandi and where they can be circumvented, will be.

He believes that the ends justifies the means. He cannot understand why this is a problem. In his business career, this has been his guiding principle. The US is currently the most powerful country in the world, economically and militarily. Trump has no qualms about using that economic might to achieve his objectives. He will comply with the letter of the law but will continue to interpret it to his convenience to further his agenda.

Trump will make policy that most advantages himself and his peers. This is unremarkable as it is a natural tendency of any government. However, Trump’s lack of empathy may lead to more extreme outcomes. This is already evidenced in a more regressive tax code which could become even more regressive going forward. Regulation has also been relaxed to make conditions more business friendly. All this while the US economy is in late stage expansion and at full employment. These policies will likely prolong the cycle but also increase the amplitude of mean reversion at the end of the cycle. Fortunately, the two term limitation on the Presidency will ensure a new president deal with the consequence of the current profligacy.