International Equities

Geopolitical skirmishes dominating the headlines

At the time of writing geopolitical skirmishes dominate the headlines. It’s probably easier to list those where calm reigns.
July 2019

President Trump has tweeted that he loves collecting “BIG TARIFFS”. In a telephone interview he defended the use of tariffs as a “beautiful thing” and vowed China would “never catch” the US economy in terms of size. At least he can’t be accused of equivocating.

Let’s take his last statement first. The US economy (nominal GDP) currently amounts to around US$21 trillion whilst China’s is around US$13.5 trillion. It’s a big gap but the key is the rate of China’s catch-up. If China maintains a growth advantage of 3% or more over the US it will match it in terms of the size of GDP in around 15-16 years. Even if it takes 20 or more years it is an inevitability. China is not without serious issues – rapidly increasing levels of debt and its static to declining workforce to name but two – but is benefiting from classic emerging market productivity gains applied to a massive population base whilst the US is a mature economy with modest rates of productivity growth (in keeping with the rest of the advanced world).

The chart below examines the share of world GDP taken by the “big 3” since 1960 – the US, China and Japan. The Chinese spurt commenced around the time it joined the World Trade Organisation (2001) whilst Japan and the US have experienced rapid relative decline over the same period (albeit more pronounced in the case of Japan).

The US, China (ex-HK and Macau) & Japan in the world economy

Share of global GDP at market exchange rates

Source: Thomson Reuters Datastream

Tariffs are a blunt and imprecise economic implement being utilized, in this case, to fight a political battle. They result in a subsidy from the efficient to the inefficient and distort the allocation of capital. They raise costs and lower growth – everywhere. All of this is known. The world has experienced tariffs in one form or another for centuries, so the consequences are not a matter of wild conjecture. The expansion in the global protectionist mood is a throwback to the economic dark ages.

The OECD recently endeavoured to put some numbers on the potential impact of the China-US trade spat. The first round of tariffs in 2018 were estimated to cut the level of output in the US and China by around 0.2% – 0.3% with world trade reduced by around 0.4%. US consumer prices were forecast to rise by around 0.2% in 2020 and 2021 (above the baseline forecast).The second round of tariffs in May this year potentially reduce GDP in the US and China by an additional 0.2% – 0.3% on average by 2021 and 2022 with US consumer prices pushed up by an additional 0.3% in 2020.

If the US proceeds with its threat to impose a 25% tariff on all imports from China the OECD estimates that global trade would be close to 1% below baseline by 2021 with import volumes in the US and China down by around 2%. Output would decline by around 0.6% relative to baseline in the US and 0.8% in China. “Close trading partners would also start to be adversely affected, as demand contracts in two major export markets…further uncertainty about trade policies, and a growing concern that new restrictions might be applied on a much wider range of items affecting many economies, is likely to check business investment plans around the world.”

This sounds to us like a lose-lose scenario. It comes on top of data indicating that world GDP is already on a slowing trend as evidenced by new orders, industrial production, retail sales and trade. The World Bank recently joined the chorus by lowering its global growth forecast for 2019 to 2.6% – 0.3% lower than its estimate just six months ago. It has also reduced its forecast for global trade growth by a full percentage point in 2019 to the weakest rate of growth since the global financial crisis.

The US economy is now at the tail-end of the one-off Trump stimulus initiatives and is heading towards its potential trend growth rate of 2% or less. An IMF update report released in late June forecasts that US real GDP will average growth of around 1.7% between 2020 and 2024. We tend to be slightly more optimistic with a forecast of 2% trend growth but either way it is a long way short of general market expectations.

During June around 640 US companies and groups sent a letter to Mr Trump headed “Tariffs hurt the Heartland”. It said, among other things: “We remain concerned about the escalation of tit-for-tat tariffs… we know first-hand that the additional tariffs will have a significant, negative and long-term impact on American businesses, farmers, families and the US economy.”

The US imports far more from China than it exports to China. Trade flows between the two will never be balanced no matter what Mr Trump may wish for. China simply makes a lot of “stuff” that the rest of the world demands – including products made by US companies with a manufacturing or outsourcing base in China. Global supply chains are now very complex. Disruption at one point of the chain can have a raft of unintended consequences.

The official newspaper of the Chinese communist party, the People’s Daily, included a rare warning in a recent editorial: “Don’t say we didn’t warn you” it said whilst hinting China may place an embargo on rare earth exports to the US. China dominates the global supply of rare earths and the US imports around 80% of its needs from China. This move would probably hurt China as much (or even more) than the US, but it demonstrates how foolish this spate of trade bullying has become.

History suggests that tariffs are easy to impose but never that easy to remove. We can only hope, therefore, that this “war” ends quickly before changes become entrenched.



For all the publicity received by renewables they still only make up a small percentage of global energy output. The latest BP Statistical Review of World Energy, 2019 calculates that renewables made up 4.1% of global primary energy consumption in 2018. Oil still dominates at 33.6%, followed by coal and then natural gas.

Primary Energy Consumption by Fuel Type - World

Percentage shares – 2018

Source: BP Statistical Review of World Energy, 2019

It will take many years for renewables to be globally significant. Both the International Energy Agency and the US Energy Information Administration estimate that by 2040 oil, coal and natural gas will still dominate although by that stage renewables should be approaching 20% of global energy supply.

On the contentious topic of carbon dioxide emissions, it is noteworthy that in much of the developed world CO2 emissions per capita have been declining for many years and in several countries have declined in an absolute sense as well. Since 2000 both Europe and North America have managed to achieve this admirable feat (see below). The problem is that the developing world has been increasing its emissions at a robust rate. In aggregate, over the last 50 years, global CO2 emissions have grown at an average compound rate of 2%. In China, despite the rapid growth in emissions, the per capita level is still less than half that of the US.

Carbon Dioxide Emissions

Growth Rate – % per annum (based on million tons of carbon dioxide)

Source: BP Statistical Review of World Energy, 2019

The elephants in the world of CO2 emissions are China and the US – together accounting for over 40% of global emissions – but in the last 10 years India has increased its emissions at a compound annual rate of over 5% and it is now also approaching elephant dimensions. This is nothing for India to be proud of but is difficult to control as this country of over 1 billion people steadily climbs the greasy pole of economic development.

Global Share of Carbon Dioxide Emissions

Source: BP Statistical Review of World Energy, 2019

One of the great ironies in the renewables debate is that 200 or so years ago virtually all energy came from renewables as it was the product of the burning of wood. It is still widely used of course and, yes, it does produce CO2 emissions but then in a tree’s lifetime it absorbs a great deal of carbon dioxide so that the debit/credit ledger for wood is extremely complex and well beyond our remit.

We are not climate scientists so feel somewhat enfeebled when it comes to the great carbon dioxide debate. To the non-scientist it seems extraordinary that something that accounts for approximately 0.04% of the earth’s atmosphere can have such a profound impact upon climate.

The contribution of the human race to annual CO2 emissions is said to be around 3-4% but the scientists advise that this is sufficient to alter the natural balance of the carbon cycle as it cannot all be absorbed. As a consequence, the amount of carbon in the atmosphere has been steadily increasing for many years. It is sensible to endeavor to limit or reduce this contribution as we must trust the science but at the same time recognize the significant economy-altering impact the various measures are having.

Rarely, if ever, have we come across an issue that has provoked such emotional debate and polarized so many sections of society. The irony is that it may not be known for many generations how this particular ledger balances.



Productivity growth throughout the world continues to disappoint. The chart below compares the experience since 2014 with various prior periods. In every case it is significantly inferior to the “glory years” of 1995-2005 – and this despite the trillions of dollars thrown at the world economy by central banks since 2009 and the record low level of interest rates. Clearly something “ain’t right”. If productivity growth in most advanced economies continues at an annual rate averaging around 0.5% the overall level of real output growth (GDP) will struggle to average more than 1% on an annual basis.

Productivity growth in selected advanced economies since 1995

GDP per hour worked, percentage change at annual rate

Source: OECD Compendium of Productivity Indicators, April 2019

Italian productivity growth is particularly disappointing. Even between 1995 and 2000 it averaged only 1%. Between 2005 and 2010 it was negative and since 2014 has settled at zero. Little wonder that Italian politics is in turmoil (although, to be fair, that applies to most countries) and there remain serious initiatives to emulate the UK and extract the country from the European Union (and thence the eurozone).

Growth in productivity requires steady growth in efficiently employed capital investment – something that has been in short supply since the financial crisis. Cheap and plentiful money hasn’t worked. Confidence to make long-term investment decisions is absent. Setting an official interest rate at zero – or even less – hardly sends a positive and confident message to the key decision makers in the private sector. What these low or non-existent interest rates have done is entrench vast numbers of “zombie firms” – diverting vital resources from more efficient companies. The Bank for International Settlements has calculated that zombie firms make up 12% of listed companies in the advanced economies – a staggering figure and an indictment of the economic policies that have brought it about. Ultimately the system only works at close to its efficient best if capital is effectively allocated. We are clearly a long way from that ideal.

Poor productivity growth leads to poor (or no) real wage growth and social unrest. The chart below looks at real compensation per hour since 2010 in a range of countries.

Growth in real average compensation per hour (employees)

Percentage change at annual rate


Source: OECD Compendium of Productivity Indicators, April 2019

The dismal performance of Greece, Spain, Portugal, Ireland and Italy is no surprise. All boosted wages to uncompetitive levels prior to the financial crisis whilst bathed in the warm glow of the early years of the eurozone but they are now paying the price. The UK has also been dismal although there have been some signs of life in real wages in recent times. Australia is suffering from the end of the China-induced mining boom and the associated collapse in capital investment. Japan has had poor productivity growth for years and our research indicates real wages have been declining since the mid-1990s.

The Central and Eastern European countries with relatively attractive rates of productivity growth are playing catch-up. The OECD recently commented: “…countries that have been able to increase their export-to-GDP ratio over time have also improved their labour productivity over the same period…participation in global value chains (GVCs) has contributed to the catch-up process.”

The OECD made an interesting comment in relation to the US, Canada and the UK: “…the decline [in productivity growth] since the end of the 1990s marked a reversal of growth that coincided with the IT revolution.”

In our judgement there is no near-term catalyst likely to encourage long-term capital investment and thence an improvement in productivity growth. The world appears locked into low or negative interest rates and probably further bouts of quantitative easing. It may stimulate financial assets but do little for the so-called real economy. This leads to ever-growing levels of wealth inequality – and even more social unrest.


Inflation and Bonds

If bond yields were the litmus test it would be easy to believe that inflation in most countries is at zero or below. Bonds should provide investors with a real return from the income yield, but this is not the case. The graph highlights the steady downward trend in benchmark 10-year yields over the last 25 years.

Benchmark 10-year government bond yields

Source: Thomson Reuters Datastream

Of the six countries in the graph only the US and Canada have a positive gap between the 10-year bond yield and the most recent annual rate of inflation – but it is a tiny one and well below historic norms. In Germany the latest annual inflation rate is a positive 2.1% yet the 10-year bond yield is negative!

In the UK the real bond yield has been negative for a significant chunk of the last decade. The last time this occurred was when inflation was rocketing in the 1970s through to the early 1980s. In that era 10-year bond yields reached as high as 16% whilst inflation was even higher.The cont rast with today couldn’t be greater.

UK Real Bond Yields

(10 year bond yields minus the RPI)

Source: Thomson Reuters Datastream

So, what is going on? Either inflation is expected to collapse, or a new order has been established – one in which investors no longer expect to generate a real rate of return from the income component of bond investing. We somehow doubt the latter based upon our contacts with investors around the world but, equally, a total collapse of inflation suggests a dramatic slump in the already feeble rates of economic growth.

The problem is that central banks have manipulated interest rates to these crazily low figures and investors have followed them down. Now they have a problem. From this level returns are going to be tiny or negative but that is not the basis on which the investment world operates. Insurance companies, pension funds, bond funds, investment managers, savers and all the rest are operating on the expectation of real returns. Budgets are prepared on the basis of real returns. Actuarial forecasts are based on the premise of real returns.

Could inflation collapse? For many years central banks and others employed the concept of the Phillips Curve to assist in inflation forecasting. In simple terms this drew a link between levels of employment and wage growth and, by implication, inflation. If this was applicable today wage growth and inflation in the advanced world should be robust as average unemployment levels are generally low.

It seems, therefore, that the link, if indeed there ever was one, has broken down. Our view is that the economic “recovery” since the global financial crisis has been tenuous – based on lashings of artificially cheap money and the forced improvement in financial markets – not the genuine private-sector return to confidence that has typified the years following recessions over the last 50 or 60 years. We have previously reported that this “recovery” has been the weakest based on all the traditional measures – GDP growth, consumption, employment, labor productivity and investment.

The last time inflation in much of the world fell below zero was during the financial crisis. Demand collapsed along with trade, employment and the financial markets. In the US the annual rate of inflation fell as low as -2.1% in 2009 before recovering as quantitative easing began to bite. The previous dip below zero was in 1955.

The relatively anemic shape of world demand and growth and, to use our term again, the tenuous nature of the recovery, suggests to us that inflation could again slip below zero. The other factor is debt. Once again, the world has far too much of it and a classic form of debt deflation could occur. Central banks will fight it tooth and nail, but they don’t have the firepower of a decade ago. Their balance sheets are now bloated, and official interest rates are already very low (negative in several countries and falling in others).

Conclusion – a bond yield of zero doesn’t look so bad if inflation is -2%, although putting your money under the mattress would yield the same return. If we were betting people, we would give this scenario a 50:50 chance over the next few years. But, by definition, that means we believe there is a 50% chance of inflation rising from current levels. Either prospect is not particularly inviting.



You may have noticed the price of gold creeping up. It is now at its highest level since 2013 (in US dollars). Gold does well in uncertain times and these times clearly qualify. We’ve always liked the fact that gold has been a constant throughout all of human history. It has been a store of value for thousands of years whilst alternatives have fallen away. Since 1800, and expressed in US dollars, gold has provided an average compound annualized real return of around 0.6% (source: The Golden Constant by Roy W. Jastram with updated data by Pyrford International). Anything that maintains its real purchasing power for more than 200 years gets a tick from us. Anecdotal evidence suggests it has probably maintained its real purchasing power since the era of the pyramids.

Modern paper currencies – fiat money – are a tiny blip in gold’s history. A recent web posting by made the following comment: “According to a study of 775 fiat currencies … there is no historical precedence for a fiat currency that has succeeded in holding its value. Twenty percent failed through hyperinflation, 21% were destroyed by war, 12% destroyed by independence, 24% were monetarily reformed, and 23% are still in circulation approaching one of the other outcomes…the average life expectancy for a fiat currency is 27 years.”

It is interesting that several central banks have been adding to their gold reserves in recent years – but none so prominent as the Russian central bank.

Russian Gold Reserves

Source: World Gold Council

It would appear that Russia is diversifying its reserves away from US dollars. On the other side of the ledger we see regular selling of US treasuries. China is also steadily adding to gold reserves although the actual amount is difficult to ascertain. It is believed that the official position understates the actual gold-holding status.

World Official Gold Holdings - Top 10

June 2019

Source: World Gold Council

According to the World Gold Council purchases by central banks in the first quarter of this year were the strongest since 2013. Turkey has been a constant in terms of central bank buying whilst other purchasers include Qatar, Columbia, India and Kazakhstan.

Exploration success has been lacking among gold mining companies in recent years and according to a recent study by McKinsey and Co stated reserves have fallen by around 26% since 2012. Exploration spending is down around 70%. The World Gold Council tells us that annual mine production is currently around 3500 tonnes, insufficient to meet annual demand for jewelry, investors, central banks and technology. The supply gap is made up by recycled gold.

Gold cannot be manufactured by central banks and, perhaps most importantly, gold is money. It always has been, and we’re not about to deride those who choose it over alternative investments. Besides, it looks far more attractive around the neck than a string of paper currency.



The US under its expansionist and big-spending President has been running counter-trend in terms of budget deficits relative to its peers. In 2018 and again in the current year the annual deficit has blown out to more than 4% of GDP. One of the serious issues confronting the US is that the share of “mandatory” programs in Federal government spending is steadily rising – these include Social Security, Medicaid and Medicare. Calculations by the US Office of Management and Budget indicate that these and other programs made up 27% of Federal Government spending back in 1965 but now make up 62%. On the flip side “discretionary” programs have fallen from a share of 66% to 30% over the same period. What this means is that there is diminishing wiggle room in the annual budgets.

General Government fiscal balance as a % of nominal GDP

Eurozone & major advanced economies

Source: IMF, April 2019

Ironically, Germany, one of the few countries able to afford deficit spending has continued to run surpluses. Even Japan, one of the most indebted nations (at the government level) has been modestly shrinking its budget deficit.

Deficits have to be financed and they steadily build aggregate debt. In terms of the former the IMF calculates that in the current year the US will have gross financing needs equivalent to 25% of GDP (the aggregate of maturing debt and the budget deficit relative to GDP). In the world of advanced countries only Japan has a greater financing requirement. In terms of general government debt relative to GDP the IMF forecasts the US will end this year around 107%. In the advanced world only Italy and Japan are higher.

We are perhaps old-fashioned in that we believe deficits and debt matter. The problem besetting the US is that it is building debt at the same time as global growth slows. This is never a good combination.


The Final Word

At the time of writing geopolitical skirmishes dominate the headlines – the US and China, the US and Iran, the US and Russia, the US and Mexico, the US and North Korea. Note the common denominator. And then there is the domestic political turmoil in the UK, Spain, Italy, Germany, France, Hong Kong, Venezuela, Indonesia, Turkey et al. It’s probably easier to list those where calm reigns. Despite all that is going on the financial markets remain relatively untouched – providing you can describe the steep fall in bond yields as being “untouched”.

Nevertheless, it is important to retain perspective as there are few moments in history when all sorts of troubling “stuff” isn’t happening. If we ignore all of this and look purely at market valuations, there is little to induce excitement. Fixed interest provides next to nothing whilst equities continue to look expensive – relative to history and our expectations for forward-looking growth.

Sometimes this investment management lark is a tough gig. We are expected to entice with all sorts of exciting propositions but about all we can offer at this time is more advice about staying defensive. We have noted, nevertheless, a revival in the price of bitcoin and general increased interest in blockchain technology. Even Facebook is planning to introduce its own digital currency.

We have admired blockchain technology from the start, and have stated so in these pages, but separated that admiration from any particular digital currency offering. We see no reason to alter that stance. Blockchain is clever and it is here to stay and must furrow the brows of central bankers around the world but there will be plenty to choose from in this field. Perhaps in 20 or fewer years it will dominate the global payments system and reduce the influence of the US dollar. But these are early days – be careful.


This material was provided by Pyrford Internation Ltd a wholly-owned subsidiary of BMO Financial Group. The value of investments can fall as well as rise and an investor may receive less than the amount invested. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment adviser. Performance data shown in the document may not be in the base currency of the country where an investor is based. Actual returns may increase or decrease as a result of currency fluctuations. Although the information contained herein is believed to be reliable, Pyrford does not warrant its completeness or accuracy. Pyrford does not guarantee that the views expressed will be valid beyond the date of the document.

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