How to Think About Hedging Against Inflation

One of the topics that seems to be on the minds of investors right now is the idea of rising inflation. The recent global economic upturn, combined with a stimulative tax package, is causing some to believe that we’re about to see the whites of inflation’s eyes.

If that truly is the case, how should we handle this as investors? Should we move our portfolios into asset classes that have been deemed good “hedges” against inflation?

What I’d like to get across to you today is the idea that hedging for inflation cannot be looked at as an isolated investment factor, or objective. Inflation plays a very real role in how we should manage our portfolios, but it does not trump factors such as economic growth, monetary policy, or which portion of the business cycle we’re in. Hedging for inflation must be considered within the context of these and other factors.

In other words, it’s not as easy as just “buying gold.”

There are many ways to slice this topic but I want to begin by talking about correlations. Using historical returns for various asset classes, and data from the Consumer Price Index (CPI) or a similar inflation index, we can identify the basic correlations between different types of investments and inflation.

Vanguard was kind enough to compile the data for us, and created the informative chart below. This chart shows us – by asset class – what the expected return impact is of a 1% rise in inflation. Please note that in the chart, “cash” does not mean actual cash, but rather short term T-bills.

Okay, so what does this chart tell us? Based on historical data from 1970 - 2010, we can see that the two asset classes most positively correlated with inflation (look at the red bars) are commodity futures - #1 and gold - #2. Hence the widespread notion to own commodities and gold during periods of unexpected inflation.

Based on this, you might be tempted to shift your portfolio towards commodities and gold as inflation moves higher. But not so fast …

First, consider this. While these two asset classes have positive correlations with inflation over the long-run, those correlations break down in epic fashion during shorter time frames. For example, the price of gold in January of 1980 was $850. By early 2002, it had fallen to $293. During this 20+ year period, the average inflation rate was 3.9%.

So not only did gold investors experience a 65% drop in the nominal value of their investment during that period, but in terms of purchasing power, they lost about 85%. During that 20-year period, gold was an absolutely terrible hedge against inflation.

But, to be fair, there have been other periods during which gold has not only provided adequate inflation protection, but has provided exceptional positive real returns. So this is not to say that gold is a poor hedge against inflation (we can see in the chart above, it’s clearly not) only that other factors are often much more important determinants of investment returns.

What are some of these other factors? I mentioned a few of them above, and we’ll go into more detail in a moment, but first – let’s talk about stocks.

Many investment strategists will tell you that stocks are an excellent hedge against inflation. In fact, I’m actually one of those folks …

But wait, doesn’t that fly in the face of what the chart above tells us? Well, yes and no.

Just like there are multiple ways to skin a cat, there are multiple ways to analyze any given effect. Gold was a perfect example of this – over the 40 year period of data incorporated into the chart above (1970 – 2010), gold returns were positively correlated with inflation. But from 1980 – 2002? Absolutely not …

The same effect can be seen in stocks. According to Jeremy Siegel, professor at the Wharton School of Business, “Over 30-year periods, the return on stocks after inflation is virtually unaffected by the inflation rate.”

In other words, the real return that stocks have historically provided is relatively constant – you receive it regardless of what the inflation level is. As proof, Siegel points out that the real return on stocks during the inflationary postwar period is “almost exactly the same as it was in the 19th and 20th centuries when inflation was virtually nonexistent.”

The reason stocks act as a good hedge against inflation is because they are effectively claims on real assets, such as plant, property and equipment, which rise in value as general price levels rise. In addition, companies are often able to pass along cost increases to their customers, provided those increases are reasonable.

Keep in mind that the key word here is “reasonable.” With inflation levels around 2-3%, there’s a good chance stocks will continue to perform extremely well. But in the short-run, this dynamic shifts when inflation begins to hit 3-4% and beyond.

Stocks tend to lose their inflation hedging ability at these levels because high inflation expectations translate into higher interest rates in the economy. These higher interest rates, in turn, effectively reduce the present value of future profits, as well as result in increased competition from bonds in the eyes of investors.

Exceedingly high inflation also triggers monetary tightening behavior from the Federal Reserve, which acts to constrain economic growth, and therefore the total size of corporate profits.

Hopefully at this point you’re beginning to realize that historical correlations between various asset classes and inflation do NOT provide a complete (or even clear) picture of how one should navigate rising inflation. This is because inflation is but one of MANY factors that determine the performance of these asset classes.

It is the context in which rising inflation occurs that will ultimately determine how one’s portfolio should be positioned. Are we seeing strong economic growth? Is that growth accelerating or decelerating? What’s the Federal Reserve doing with monetary policy? What’s the outlook for corporate profits? Can margins be maintained? What’s happening to the dollar? Do consumers and businesses have the financial resilience to absorb higher prices? How are our trading partners doing? Where are their interest rates at? What are their central banks up to? What geopolitical risks exist?

These types of considerations will play a larger role in the ultimate performance of various asset classes than what happens with inflation. This is not to say that we should ignore inflation (that would be ludicrous), only that we need to react to inflation in the context of many other variables.

I’ll leave you with a couple of suggestions regarding how to do this. The first is to rely much more heavily on current price action than on historical data and correlations. Do you care if gold is supposedly a “good inflation hedge” if it’s in a primary bear market losing value every year? Or do you care if stocks supposedly “aren’t” a good inflation hedge (as suggested by the chart above) if they’re still delivering double-digit returns?

Looking at investing solely through the eyes of “how do I hedge against inflation?” makes the assumption that all other variables remain constant, which is perhaps one of the biggest mistakes an investor can make. Instead, we need to recognize that every situation is fluid, and that many factors are much more important than how a particular investment has stood up to inflation in the past.

That being said, there are some general takeaways that can help guide us in the event that we do see higher inflation ahead:

1. Stay away from longer dated bonds. These will almost always lose value as a result of rising interest rates when inflation picks up. T-bills are fine (shorter the better), as these mature so quickly you can take advantage of rising rates.

2. Treasury Inflation Protected Securities (TIPS) can provide good inflation protection as their payments change with the general level of prices. TIPS offer similar security to bonds if held to maturity, and have much lower volatility than gold or commodities.

3. Commodities can be a good inflation hedge, but recognize that they are often more volatile than both stocks and gold.

4. Gold has preserved purchasing power over the very long-term, but there have been multi-decade periods when it has not. Gold also tends to be volatile and reacts to much more than just inflation expectations.

In summation, it helps to have an idea of how various asset classes typically behave with respect to inflation, but there are many other factors we will need to consider if inflation begins to rise substantially. I don’t see that happening anytime soon, but it doesn’t hurt to begin laying the groundwork in the event that it does

What Would Happen If China Stopped Buying U.S. Treasury Bonds?

A January 2018 Bloomberg article suggests that Chinese officials may reduce their purchases of U.S. government bonds. It is very unlikely that China can do so in any meaningful way because doing so would almost certainly be costly for Beijing. And even if China took this step, it would have either no impact or a positive impact on the U.S. economy.

The furor over recent comments by Chinese officials that they may reduce their purchases of U.S. Treasury bonds show just how poorly the world understands the balance of payments. Here is what Bloomberg had to say:

Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.

China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly. China’s State Administration of Foreign Exchange didn’t immediately reply to a fax seeking comment on the matter.

Why would China reduce its purchases of U.S. government bonds? In a January 2018 Financial Times article, ING’s Asia chief economist and head of research, Rob Carnell, was quoted as saying that the Chinese decision may be in reaction to U.S. President Donald Trump’s trade rhetoric:

The most likely explanation, aside from a mistake, in this author’s opinion, is to demonstrate that China is unlikely to passively accept tariffs on steel, aluminum, and solar panels—industries the U.S. Trade authorities are looking to penalise shortly for unfair trade practices.

If China is indeed threatening to retaliate against any U.S. trade action by reducing its purchases of U.S. government bonds, not only would this be a pretty hollow threat, but in fact it would be exactly what Washington wants. To see why, let’s consider all the ways in which Beijing can reduce its purchases of U.S. government bonds.

1. Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.
2. Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.
3. Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.
4. Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.
5. Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.

These five paths cover every possible way Beijing can reduce official purchases of U.S. government bonds. As I will explain, the first two ways would change nothing for either China or the United States. The second two ways would change nothing for China but would cause the U.S. trade deficit to decline, either in ways that would reduce U.S. unemployment or that would reduce U.S. debt. Finally, the fifth way would cause the U.S. trade deficit to decline in ways that would likely either reduce U.S. unemployment or reduce U.S. debt; this fifth way would also cause the Chinese trade surplus to decline in ways that would likely either increase Chinese unemployment or increase Chinese debt.

By purchasing fewer U.S. government bonds, in other words, Beijing would leave the United States either unchanged or better off, while doing so would also leave China either unchanged or worse off. This doesn’t strike me as a policy Beijing is likely to pursue hotly, and Washington would certainly not be opposed to it. Let’s consider each possibility in turn.

1) Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.

This would be a non-event. Basically, it means that Beijing would redirect its purchases from U.S. government bonds to other U.S. assets. Of course, the seller of those other assets would now be forced to deploy the proceeds of the sales elsewhere, so that directly or eventually the proceeds would be used to buy U.S. government bonds. The only thing that would change, in this case, is that Beijing would have swapped its ownership of U.S. assets from one form to another.

U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Because this outcome represents nothing more than a swap by Beijing out of lower-risk assets into higher-risk assets, with no net change in demand for U.S. assets, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.

U.S. investment: There would be no change in overall U.S. investment except to the extent that tightening credit spreads would cause a small rise in risky U.S. investments.

U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have an impact on the U.S. current account or trade deficits.

Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have an impact on the Chinese current account or trade surpluses.

2) Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.

Again, this would largely be a non-event. The volume of Chinese capital flows to the United States would be unaffected, but there would be minor changes in the composition of assets to which the flows are directed.

U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Again, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.

U.S. investment: There would be no change in overall U.S. investment, except to the extent that tightening credit spreads cause a small rise in risky U.S. investments.

U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have any impact on the U.S. current account or trade deficits.

Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have any impact on the Chinese current account or trade surpluses.

3) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.

In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States, and an increase in its capital account deficits and current account surpluses with the rest of the developed world. The reduction in the U.S. current account deficit would mean a reduction in the excess of U.S. investment over U.S. savings. If U.S. investment were constrained by an inability to access savings, this reduction would occur in the form of lower U.S. investment. Because that is not the case, it would occur in the form of higher U.S. savings.

Savings can be forced up in many different ways, almost always involving either less debt or lower unemployment. For example, a reduction in capital inflows can deflate asset bubbles and so discourage consumption through wealth effects, or such a reduction can lower consumption by raising interest rates on consumer credit, or even by encouraging stronger consumer lending standards. A reduction in capital inflows can also increase savings by reducing unemployment. One way or another, in economies like the United States that do not suffer from weak access to capital, a reduction in foreign capital inflows automatically increases domestic savings.

It may be harder than we think for China to redirect capital flows from the United States to other developed economies. Continental Europe, Japan, and the UK are the only developed economies large enough to absorb a significant change in the volume of capital inflows, but none of them are eager to absorb the current account implications. Some economists, misunderstanding the nature of the account identity that ties net capital inflows to the gap between investment and savings, will undoubtedly argue that these inflows would cause investment in Europe, Japan, and the UK to rise, but this is wrong. That would only be true if investment in these economies had previously been constrained by scarce savings, but because this is clearly not the case in today’s environment, the impact of higher capital inflows into developed economies could only be to reduce domestic savings.

For developed economies, in other words, significantly higher capital inflows from abroad would either cause savings to decline as the inflows strengthen their currencies and reduce exports—causing either unemployment or consumption to rise—or, if their central banks act to sterilize the inflows, to increase imports by increasing consumer debt. If continental Europe, Japan, and the UK are unwilling to accept higher unemployment or higher debt, they would be unwilling to allow unlimited Chinese access to domestic investment and may quickly take steps to retaliate.

U.S. interest rates: Contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up. Because the reduction of the U.S. capital account surplus would result in an increase in U.S. savings, this would fully match the reduction in Chinese savings that had previously been imported by the United States.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.

4) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.

In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States and an increase in its capital account deficits and current account surpluses with the developing world. As explained above, the reduction in the U.S. current account deficit would occur through an increase in U.S. savings.

Because investment in developing countries is often constrained by difficulty accessing global savings, a redirection of Chinese capital from the United States to developing countries would boost investment in those countries. The problem is that China has had a very bad experience with its investments in developing countries and may not be eager to raise them significantly more than it has already planned.

U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.

5) Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.

Finally, China could reduce its overall capital account deficit by reducing the amount of capital directed to the United States and not replacing it with capital directed elsewhere. This would mean that China must either reduce domestic savings or increase domestic investment. This would also mean, of course, that it must run lower current account and trade surpluses.

One way savings can decline quickly is if a drop in exports causes unemployment to rise. The only other way is if there is a surge in consumer debt. For investment to rise quickly, there almost certainly has to be either a rise in unsold inventory as exports drop or a rise in nonproductive investment into infrastructure. In either case, this would mean a rising debt burden.

U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would reduce the Chinese capital account deficit, it would necessarily also result in a reduction in the Chinese current account or trade surpluses.

CONCLUSION

Even if Beijing forced institutions like the People’s Bank of China to purchase fewer U.S. government bonds, such a step cannot credibly be seen as meaningful retaliation against rising trade protectionism in the United States. As I have tried to show, Beijing’s decision would either have no impact at all on the U.S. balance of payments, or it would have a positive impact. It would have almost no impact on U.S. interest rates, except to the extent perhaps of a slight narrowing of credit spreads to balance a slight increase in riskless rates.

It would also have no impact on the Chinese balance of payments in the case that it leaves the U.S. balance of payments unaffected. To the extent that it would result in a narrower U.S. deficit, there are only three possible ways this might affect the Chinese balance.

First, China could export more capital to developed countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of angering its trade partners and inviting retaliation. Second, China could export more capital to developing countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of increasing its investment losses abroad. And third, China could simply reduce its capital exports abroad, in which case it would be forced into a lower trade surplus, which could only be countered, in China’s case, with higher unemployment or a much faster increase in debt.

Robots, Robots Everywhere

Robots in Food Service

With the Consumer Electronics Show (CES) just past, it might be a good time to mention two developments in robotics that we’ve recently noted. Sage analyst Larry Jeddeloh at The Institutional Strategist noted that this year’s CES was the occasion for Pizza Hut [NYSE: YUM] to unveil a driverless delivery service, partnering with Toyota [NYSE: TM] in the development of autonomous electric vehicles.

Autonomous food delivery systems will represent a major savings in labor and insurance costs for the companies that adopt them. Automation in fast food businesses will not be restricted to delivery services, however. Fast food, of course, represents a major portion of low-skill employment in the United States — a portion of the workforce that is the focus of the recent push for greater minimum wage requirements in many states. In 2018, 18 states are pushing to raise their minimum wage, with California leading the charge — aiming at $15 before the end of the first quarter.

The impulse behind minimum-wage hikes is often noble — the socioeconomic betterment of the lowest-income strata of the working class. Unfortunately, the law of unintended consequences is very pertinent here. Faced with a sudden hike in labor costs, companies with the ability to do so — including fast-food stalwarts McDonald’s [NYSE: MCD] and Wendy’s [NASDAQ: WEN] — will ramp up automation. Both of the companies mentioned are planning to replace significant numbers of cashiers in 2018.

As we have noted frequently, we do not hold with the doomsayers who believe that automation will render large swathes of the population permanently unemployed. In every historical epoch of accelerating automation, the economy has adjusted and created new demand to absorb the labor of displaced workers. This time will not be fundamentally different. Therefore, we cannot regard companies using automation to boost their financial performance as evil or underhanded. In fact, the rollout of such technology always ultimately serves to push an economy towards the creation of more fulfilling and rewarding employment, and less menial labor — the whole economic history of the developed world since 1800 serving to illustrate this truth.

With that said, we would not shy away from investment in companies whose bottom lines stand to benefit from the increased automation of menial and routine tasks — and it looks like fast food and all types of delivery businesses are likely to be strong beneficiaries of this trend over the medium term.

Robots in Agriculture

We last wrote about agricultural technology back in 2015, when we commented on the rising trends of “precision agriculture” and “smart farming.” Back then, we commented on the new capacity to acquire and analyze extremely granular data about soil and moisture conditions — and how those data could be deployed to automatically deliver targeted irrigation and fertilizer inputs to precise areas of specific fields.

Humans Are Still Driving... For Now

That was big data penetrating the world of agriculture. We read recently about how another set of fourth-industrial-revolution technologies is coming to agriculture: this time, it’s robotics and artificial intelligence.

We read in Bloomberg Businessweek about a new agricultural startup, Blue River Technology, which was recently acquired by Deere & Co. [NYSE: DE]. Blue River develops robots which can view plants, distinguish weeds from crops, and deliver targeted herbicides to the weeds and targeted fertilizer and water to the crops. The company was founded by a Peruvian, Jorge Heraud, who grew up weeding his grandparents’ farm north of Lima — and says he realized at age 7 that “this was a job for robots.”

Eventually, Blue River’s robots will also be able to weed fields — and the same processing technology being developed by innovators such as Nvidia [NASDAQ: NVDA] will drive the trend. Both the granular, targeted application of herbicides and the potential for mechanical weeding could reduce herbicide application significantly. With the advent of glyphosate-resistant “superweeds,” the apparent peak of yield-boosting from GMO crops, and political pressure from environmentalists, companies such as Syngenta (soon to be acquired by ChemChina) and Monsanto (soon to be acquired by Bayer) must be watching carefully.

Some analysts estimate that 40% of California’s agricultural workforce is comprised of undocumented immigrants. Therefore, political pressures for immigration reform will likely also contribute to an acceleration of agricultural robot adoption.

Investment implications: Pressures from new minimum-wage laws will accelerate the adoption of automation in food service and delivery, and the companies that capitalize on it will benefit. They will ultimately be doing a service to both the workforce and the economy, which will adapt to the changes and create new demand for human labor as they have in the past. The same trend will accelerate in agriculture, particularly if immigration reform proceeds. On a fundamental basis, we like tech innovators in food, food service, and agriculture. Many of them have moved ahead very strongly in the past year and have gotten ahead of themselves — but we would be buyers on a significant correction.

Donald Trump’s difficult decision on steel imports

Being the world’s trade policeman is tough work

EVERY Tuesday, senior members of the administration gather in the White House to discuss trade. They are divided between hawks, who argue that America needs to be tougher in its defence against what they see as economic warfare waged by China, and doves, who worry about the costs of conflict. So far, against all expectations when President Donald Trump entered the White House, the doves have prevailed. The first of a series of legal deadlines could soon unleash the hawks.

Last April Wilbur Ross, the commerce secretary, initiated a probe into whether steel imports were a threat to America’s national security. His department pointed to a “dramatic” increase in steel imports over the previous year and to the idling of nearly 30% of America’s steel-production capacity, as imports feed a quarter of its consumption. If the report, due by January 15th, finds imports are a threat, Mr Trump, under Section 232 of the Trade Expansion Act of 1962, will have 90 days to respond.

The report’s conclusion is not in much doubt. The government is likely to argue that steel is important for the defence industry. It is used to make navy ships and submarines; “exotic” high-strength, low-weight alloys are used for fighter jets. The armed forces use only a tiny fraction of domestic steel output, but some producers claim that to make the requisite high-end specialised steel, they rely on selling lower-quality stuff in volume to cover their fixed costs. The government can also consider the importance of steel to America’s “critical infrastructure”, including chemical production, communications and dams.

In fact, a hefty chunk of America’s steel imports come from long-standing allies, like Canada and the EU, rather than China, the hawks’ real target. And an investigation into iron ore and semi-finished steel in 2001 found that on a broad definition, an upper limit for the fraction of domestic production required by critical industries was only 31%. It is unlikely to be very much higher now. But the law is so vague that the government can decide as it wants.

The national-security case may be specious. But the Trump administration is right that the world has too much steelmaking capacity. The industry has long been prone to bloating, because of state support that blunts price signals. This time, China is the main culprit. Its production bulged from 15% of the global total by volume in 2000 to 50% in 2016. When its domestic demand declined, exports rather than plant closures took the strain, and mills elsewhere were left idle. Excluding China, global capacity use fell from 86% in 2004 to 69% in 2016 (see left-hand chart).

Even so, it is hard to blame China for all the world’s steel woes. A document seen by The Economist, produced in August by Mr Trump’s Council of Economic Advisers, suggested that the surge of steel imports in the first half of 2017 was consistent with changing domestic demand, not dumping by foreigners (nor did it seem, as some suggested later, to have been fed by importers stockpiling steel in anticipation of tariffs).

The steel market’s struggles may be abating. Analysts at the OECD, a think-tank, reckon global capacity stopped growing in 2017. Research from Bank of America Merrill Lynch (BAML) suggests that hefty cuts in China mean it is on track to use a full 88% of its capacity in 2018. Steel prices have rallied (see right-hand chart). There is further to go. Global capacity-utilisation rates need to be five to ten percentage points higher to give steel mills sustained pricing power, says Michael Widmer, a metals strategist at BAML. And, unlike cutting subsidies, paring capacity by decree, as China has, will not stop the problem recurring.

Some in the Trump administration see steel as part of a much bigger problem of Chinese mercantilism. They worry that China plans to build enough capacity in strategic industries to weaken, and ultimately destroy, America’s. Even if this is alarmist, influencing China is extremely difficult. A multilateral initiative last year to curb excess capacity yielded some recommendations, such as limiting subsidies and sharing information. But action is voluntary, and the data self-reported. China’s recent cuts have been driven less by pressure from the West than by domestic imperatives such as cutting pollution.

The Trump administration may now lash out unilaterally. According to one person familiar with its internal debates, some argue for the hammer of a broad tariff, while others prefer the chisel of a narrower mix of tariffs and quotas directed at particular products. Others still favour doing nothing, arguing that trade measures would complicate the handling of delicate international issues, such as North Korea’s nuclear programme.

The costs of severe trade restrictions would indeed be great. As a result of 48 existing defensive duties on steel imports from China, they represent a mere 3% of America’s total. Broad trade barriers would upset America’s allies, invite retaliation and raise costs for American steel consumers. A legal challenge would give the World Trade Organisation the dangerous task of arbitrating over America’s perceived national-security interests.

Narrower restrictions would hurt less, but raise the chances of imports leaking into America anyway. Using the report as a threat to trigger negotiations could be the least damaging option. But others might question whether the threat of tariffs is credible, given the self-harm they entail.

For a year Mr Trump has refrained from a big trade confrontation. This is the most serious test yet of the doves’ ability to keep him from scratching his tariff itch. Document on desk and pen in hand, he may feel he has to do something. When it comes to steel, there are no good options.

Why the oil price is so high

…and why it might not fall by very much soon

PERHAPS the most vexing thing for those watching the oil industry is not the whipsawing price of a barrel. It is the constant updating of theories to explain what lies behind it. In March 2014, when the price of a barrel of Brent crude was in three figures, the then boss of Chevron, an oil giant, observed that the scarcity of cheap oil meant “$100 per barrel is becoming the new $20”. Two years later, when the oil price slumped below $28, the talk was of a global oil glut caused by the furious efforts of the OPEC cartel to regain market share. Now that oil prices have tested $70, analysts are again scratching their heads.

In “1984”, George Orwell coined the term “doublethink”, the ability to believe two contradictory things. Oil analysis seems to require similar cognitive gymnastics. Three big questions arise. First, why has the oil price more than doubled in the space of two years, against all expectation? Second, why has this surge been met with cheers from global stockmarkets and not concern for the world economy? Lastly, where might the oil price eventually settle?

tart with the journey to $70. The slump in prices two years ago was in part a response to weak demand—with the fragility of China’s economy a big concern—and in part to abundant supply. Few believed then that OPEC would, or even could, cut output. Saudi Arabia, the world’s largest oil exporter, appeared to have every reason not to. Plentiful oil supply would check the growth of the shale-oil industry in North America. It would also stymie Iran, its bitter rival, which was back in the market following the lifting of sanctions.

Yet demand recovered quickly. China pepped up its economy with faster credit growth and other fillips to spending. Commodity prices surged. Within months clear signs of a broad-based global economic upswing were palpable. And OPEC proved better able to curb production than anyone had imagined. A deal reached in November 2016 to restrict output had little immediate effect but by late last year started to pay off. Oil stocks fell, notably in America (see left-hand chart). Demand was outstripping supply. Prices duly rose.

It is still surprising they have risen so far. Higher prices are often blamed in part on the messy politics of the Middle East. The usual worries are there but “there has been no impact on physical supply,” says Martijn Rats of Morgan Stanley. Shale was also seen as the oil industry’s flexible response to price signals. Too high, and the wildcatters in Texas would drill for fresh supply. But small producers are showing a new restraint, because their financiers want greater focus on profits and less on output. And it takes several months from drilling wells for oil to come on-stream.

The financial markets show little sign of anxiety about the oil-price surge. Stockmarkets remain buoyant, which is itself another puzzle. Since the oil shocks of the 1970s, markets have associated a sudden run-up in oil prices with economic calamity. The world is both producer and consumer of oil, so in principle the overall effect of oil-price increases is neutral. But in practice, the net impact had been to reduce global demand, because oil exporters in the Middle East tended to save a big chunk of the windfall income they gained at the expense of oil consumers in the West.

Over time, however, the rich world has become less reliant on oil. Demand in America peaked in 2005, for instance. Meanwhile, oil exporters became ever more dependent on high oil prices to pay for lavish government budgets and imported consumer goods. Most of the big oil producers in the Middle East need an oil price above $40 to cover their import bill (see right-hand chart on previous page).

In this new arrangement, dearer oil is both far less damaging to rich-world consumers and soothes the strained finances of the big oil exporters, not just in the Middle East but in Africa, too. For all the other trouble-spots, investors seem to find the world economy a safer place. And they have other reasons to feel cheery. The shale industry means that dearer oil is a shot in the arm for investment in America, which adds to GDP growth. And a rising oil price is taken as a sign of healthy growth in China, the world’s biggest oil importer.

Beneath the dramatic ups and downs in the oil price and its changing influence on the world economy are some big themes: the rise of the shale-oil industry and how OPEC responds; the dependence of the big oil exporters in the Middle East on high oil prices; the peak in oil demand in America and eventually elsewhere. These forces will have a big say in where oil prices eventually settle.

How they will play out is the subject of a new paper by Spencer Dale, chief economist of BP, another oil giant. The critical change in the oil market, he argues, is from perceived scarcity to abundance. When oil was considered scarce and expensive to find, it seemed wise to ration it. It was more like an asset than a consumer good: oil in the ground was like money in the bank. But new sources of supply, such as shale oil, and improved recovery rates of existing reserves, along with the emergence of mass-market electric vehicles, have changed the reckoning. There is a fair chance that much of the world’s recoverable oil will never be extracted, because it will not be needed. It thus makes sense for the five big producers in the Middle East (Saudi Arabia, UAE, Iran, Iraq and Kuwait), which can extract oil for less than $10 a barrel, to undercut high-cost producers and capture market share while the demand is there. The financial logic has changed to “better to have money in the bank than oil in the ground,” notes Mr Dale.

Does that mean oil prices are poised to plummet? Probably not, unless shale producers ramp up output again. The peak in global oil demand might be decades away, argues Mr Dale, and it will not tail off sharply. And for now, the big oil exporters cannot sustain very low oil prices for long. Their “social cost” of production, taking in government spending reliant on oil revenue, is about $60 a barrel on average. Sustaining an oil price close to the cost of extraction will require reforms, which do not usually happen quickly. Translated into doublespeak: oil prices are too high; but they may not fall, in large part because big oil producers have got used to them.

(This article appeared in the  print edition of a known magazine and is copied directly from the same.It is not a view or an advice given by RSAdvisories. We are not responsible for any trades taken on the bases of this article. Kindly do your due diligence before trading in the market.)

India’s tea industry is going through tepid times

Outdated government regulations and millennials’ impatience bode ill for plantations

BULK tea sales at the offices of J Thomas in Kolkata, which first started auctioning the stuff in 1861, lack the boisterousness of years past. Gone is the noisy trading pit, replaced by a handful of buyers sitting behind their laptops in a silent auditorium. Armed with tasting notes, they bid electronically on hundreds of lots drawn from the city’s hilly hinterlands in Assam and West Bengal. To passing visitors, it appears as if everyone in the room could do with a little caffeination. Yet within only three hours or so, enough tea changes hands to brew 24 Olympic-sized swimming pools.

If Indian tea delights those who get to drink the country’s finest blends, it frustrates all those who plant, pluck and peddle it. Archaic government regulations have in recent years pushed up production costs to around 175 rupees ($2.70) per kilogram, well above average auction prices of 140 rupees, which makes large cultivators grumble. Pickers complain about working conditions. Marketers fret over whether young people around the world thirst for tea as their parents do.

For now, tea remains the most popular drink in the world after water. Around 40% of global production of black tea comes from India (China also grows the stuff but specialises in green tea, which uses the same species of plant but processes it differently). Many of the firms in the business can trace their heritage to well before Indian independence in 1947.

Back then four out of five lots used to end up abroad; now the same proportion is drunk locally. That is due as much to sluggish exports as to rising domestic demand. Tea drinking in India has grown by less than 3% a year since 2012, and foreign sales have barely risen in 70 years; in some rich export markets they are shrinking. On the world scene India is behind Sri Lanka and Kenya, both relative newcomers.

Government meddling, in the form of onerous, outdated rules, is mostly to blame for the industry’s worsening fortunes (although producers do also benefit from protection from imports). Regulations from the 1950s have heaped paternalistic obligations onto owners of large tea plantations. These mandate the number of workers and provide their families with schools, health care, subsidised food, electricity and so on. Labour now accounts for around half of production costs, a figure which has grown by 12% a year over the past three years. Despite that, few workers make more than $2 a day on top of their housing cost and other benefits, and child labour is rife—hence widespread discontent with conditions.

Over time, new processing techniques have raised output, to 1.25m tons last year, but at the expense of quality. Tea leaves are now shredded into tiny bits, which generate lots of flavour but less of the subtlety for which Indian tea has been prized abroad (Indians boil rather than brew their tea and so tend to make do with lower-quality leaves). Improvised small-time growers, some of them with barely a few plants, have sprouted, further denting quality. With much lower costs, given they carry none of the social obligations of large plantations, these small producers now make up nearly half the market, from barely nothing at the turn of the century.

Traditional producers have tried to find ways to adapt. Giants like Hindustan Unilever or Tata have focused on marketing and selling the stuff to tea-drinkers rather than just growing it and selling it wholesale. Others have invested heavily abroad; McLeod Russel, the world’s biggest producer, last year made enough profits in Uganda, Vietnam and Rwanda to offset losses in India. Another large producer, Rossell India, has diversified into kebab shops and making military kit.

Many would like to use their tea land for other purposes, but this is forbidden by government regulation. The resulting overproduction of lower-quality tea has depressed prices and profits (though a bad harvest in Kenya has recently nudged up prices). It also bodes ill for future exports. According to ICRA, a credit-rating agency, the country’s nine biggest planters combined made no profit in the most recent financial year, ending in March 2017. Few producers are making the investments that are needed to raise productivity by uprooting old bushes and planting new ones.

Tea marketers’ hope is to nudge consumers both in India and abroad to slurp pricier brews, moving them from loose tea to tea bags, canned iced tea or premium blends. Their plan is in its early stages, and a short-term setback came this summer when a three-month agitation by local separatists in the Darjeeling area of West Bengal, which grows what is considered the country’s finest tea, resulted in perhaps 40% of the year’s revenue being lost.

Yet the biggest gripe in the industry is not to do with prices, quality or even heavy-handed regulation. Customers, especially millennials, increasingly lack the patience to make a proper cup of tea, laments Krishan Katyal, the boss of J Thomas. The leaves need at least three minutes to release their complex aromas, beyond an eternity for youngsters these days. Like a master distiller told of a single malt being mixed with Coca-Cola, he winces at the thought of drinkers squeezing their tea bag after merely a few seconds. “That poor thing,” he says. “It never got a chance.”

Japan Is The Center Of The Crypto-Revolution

It has been nearly 4 years since the fall of Japan-based Mt. Gox, arguably the most devastating incident to hit the bitcoin world, resulting in the loss of 650,000 bitcoin. It took almost two years for the bitcoin market to recover, but the episode may have just paved the way for the regulation of cryptocurrencies in Japan.

It seems fear has faded. Bitcoin is thriving, and Japan has taken huge steps to set up infrastructure and regulation surrounding cryptocurrencies. Now, even large corporations are offering to pay employees in bitcoin.

GMO Internet Group, an operator of a number of online businesses including a bitcoin mining operation and a crypto-exchange, announced that in February, the company will be rolling out a bitcoin payment program. Up to 100,000-yen monthly in bitcoin will be offered to its 4,000 employees. Though GMO is not the first company to offer payments in bitcoin, it may be the biggest.

“We hope to improve our own literacy of virtual currency by actually using it,” Harumi Ishii, a spokeswoman for GMO explained.

While it is especially noteworthy when a corporate giant such as GMO begins down the path of bitcoin adoption, Japan’s patience and long-standing crypto-friendly attitude finally came to fruition in April 2017.

When Japan officially recognized bitcoin as a legal payment method through its Virtual Currency Act, over 4,500 stores began accepting BTC and others for goods and services. The country’s acknowledgement of the potential of cryptocurrencies, and the focus on the protection of its citizens has since made Japan the epicenter of crypto-commerce, boasting over 50 percent of the world’s crypto-exchange volume.

In addition to the Virtual Currency Act, the Japan Financial Service Authority gained the ability to license and regulate bitcoin exchanges, while a new piece tax plan was pushed through which made trading cryptocurrencies more appealing to both domestic and foreign investors. With fresh tax incentives, and China’s regulatory confusion, Chinese Huobi, in partnership with Tokyo-based SBI announced an exchange and platform to develop “digital assets and financial services in Asia.”

It seems like it Japan’s efforts are paying off…

Analysts from Nomura, a financial holdings company based in Japan, are suggesting that proceeds from cryptocurrency trading could net the country an increase of up to $854-million in consumer spending. Nomura’s suggests that, due to the huge returns on bitcoin investments in Q4 2017, the country could see “a potential boost to real GDP growth on an annualized quarter-on-quarter basis of up to about 0.3 percentage points.”

Japan’s tremendous success in crypto-endeavors has also sparked the interest of its neighbors.

On January 8th, a South Korean news agency, Yonhap News reported that a top South Korean financial regulator is looking to cooperate with Japan and China with the goal to curb the speculative transactions of cryptocurrencies and provide market oversight. This comes following a statement from the Korean Financial Services Commission’s chairman suggesting that investment in cryptocurrencies is “irrational.”

China and South Korea have assumed a notoriously fickle stance on cryptocurrencies, with rumors of bans, criminal action, crackdowns, and shutdowns swirling around for years. However, official correspondence from the South Korean government issued today quashes rumors on a trading ban, stating that nothing is finalized. that Whatever the end goal may be, Japan’s success in the sector has certainly made its mark, and while China and South Korea struggle to find their regulatory foothold, Japan’s future is promising, painting an ideal portrait for countries looking to follow the same path.

On top of everything else, Japan even has its own crypto-crazy, all-girl J-pop group, the Virtual Currency Girls, whose “Moon and Virtual Currencies and Me” advocates for cryptocurrencies and raises awareness about online security.

Rara Naruse, the group’s leader, noted: “We want to promote the idea through entertainment that virtual currencies are not just a tool for speculation but are a wonderful technology that will shape the future.”

Who knows? Maybe someone will take note.