Dear BrickStreet Folks:

 

Take a look at the chart above. It is a weekly chart of the 10 year US Treasury bond going back three years from this week. 

 

Notice we have placed a marker on October 5, 2018. This is the day after Vice President Mike Pence spoke to the Hudson Institute located in Washington , D.C.  The Hudson Institute is a consultant/research/think tank group whose mission is this: “Promoting American leadership and global engagement for a secure, free and prosperous future.”  

 

We have attached the link to this speech, which is a 14 page document that describes the current Administration’s thoughts, historical context and policy intentions toward China.

 

https://www.whitehouse.gov/briefings-statements/remarks-vice-president-pence-administrations-policy-toward-china/

 

The yield on the 10 year Treasury was 3.48% on the day VP Pence made his speech. As you can see by the chart, in the weeks following through this week the yield of the 10 year US Treasury has fallen almost without a pause. The yield today is 1.66% … a 50% decline.

 

Why was this speech so important to the bond market? Was it simply a coincidence? Did the Federal Reserve immediately change course? Did the European Central Bank make a policy announcement?

 

First for some context… The size of the global bond market is approximately $100 Trillion, with the global equity (stock) markets at about $64 Trillion. In the U.S., the bond market is about $40 Trillion and the U.S. stock market is about $20 Trillion in size. On average, the U.S. bond market has approximately $700 Billion in transactions each day compared with the U.S. equity markets trading about  $200 Billion per day.

 

The debt markets are much larger, but more importantly they are typically much more stable than the day to day changes in share prices of individual companies trading on the equity exchanges like the New York Stock Exchange or the NASDAQ. The stability is a result of the nature of a bond… it is a fixed rate security. Bonds have maturity dates where the security is cancelled at a specific date in the future and the investor typically gets their original investment back.

 

So looking at the chart above, after two years of ignoring bonds and not buying them, investors allowed the yields on bonds to rise. Then like a coordinated U turn, investors began buying the U.S. Treasury bonds and have not stopped.

 

This is a big deal.

 

The stock and bond markets are almost totally focused on the future. Sure, we hear about earnings from last quarter and such, but the real concern is what is about to happen? This chart is making the case that the markets are definitely anticipating a low interest rate environment where capital seeks safety. We still don’t have a good estimate of how much money has been transferred into bonds from cash and shares of stock to make the 10 year Treasury yield drop by 50% in ten months. Several things are sure though.

1.       A lot of foreign investment has come from the Asian and European markets into the US Treasury markets

2.       The Federal Reserve made a U turn from their December 2018 rate hike to lowering interest rates last month

3.       Folks who rely on income from their investments are facing another long stretch of increased portfolio risk in order to get paid from those investments

 

The Mike Pence speech seems to have been the cow bell signaling that the herd is headed back to the barn.

 

This Administration is attacking China face to face, accusing the Chinese government of using political, economic and military means to advance its influence over the United States. The Administration also believes China is contesting America’s geopolitical advantages in an attempt to change international order in their favor by implementing the “Made in China 2025” plan which is an ambitious effort to controlling 90% of the world’s advanced industries. Vice President Pence’s speech goes on to say that the Chinese Communist Party is rewarding American businesses, movie studios, universities, think tanks, scholars, journalists and state and local officials to interfere in domestic policies and politics in this country.

 

For the last twenty five years, US businesses have been sending people to China by the planeload to set up factories there seeking very cheap labor. Here in North Carolina, we lost most of our furniture and textile factories in a matter of a decade. Electronic manufacturers sprinted to China… plastics, paper goods, steel, glass, you name it, it went to China.

 

On July 15, 1991, the Shanghai stock market was officially opened. This was supposed to be the dawn of capitalism in China. A one billion homogenous person marketplace where prosperity was soon to be available for everyone was now open for business and it would seemingly take years to fulfill the demand. Twenty eight years later, the per capita GDP in China is $10,000. This is well below South Korea at $32,000, Japan at $41,000 and the US at $62,000. We have no data, but we are fairly certain that even though this is a low number for China, it’s a heck of a lot bigger than it was 30 years ago.

 

So the notion of America improving the financial strength of China is undeniable. Many other nations seized on the cheap labor costs of China’s greatest natural resource…people. The Chinese factories filled with 10 cent per day labor pushing out millions of items worth billions of dollars did not get evenly distributed across the Chinese population. A few families got very, very wealthy… very, very quickly… especially in organic Chinese timeframes of hundreds of years.

 

China being in the crosshairs of the Trump Administration is therefore globally significant. Any trade deal struck by the Americans will be pounced upon by Brussels, representing the European Union, the Canadians, the Mexicans, and the Japanese all seeking similar terms. And China knows it. Reorganizing, educating and shifting a massive economy with over one billion people will take years and years.

 

This Administration’s attention to China was at first a compliment to President Xi. It placed the Chinese paramount leader in the global spotlight like never before making his name synonymous with Chinese success. The notion that he would personally take credit for his nation’s economic and political success is coming back to clobber him as the sole contributor for China’s current economic hemorrhage.

 

The Pence speech is very significant. It triggered a global head spin for investors signaling that this Administration is not just talking. Americans typically have a very short attention span and very short time horizon in most things, especially political. But this topic seems to have a long horizon… it’s an attempt to reverse a couple of decades of economic leakage from a Republic democracy to a Communist country by blowing a hole in China’s economic water tank using low interest rates, tariffs, and regulation that squeezes the Chinese hierarchy into better practices enjoyed by the constituents of civil societies.

 

Low interest rates because of defensive investment profiles are in store for a while.

 

Providing advice to build and maintain wealth,

 

Matthew C. Burril

 

                 

                             Matthew Burril           

                  www.BrickStreetEquity.com

  Two Town Square Blvd., Suite 200 Asheville, NC 28803

                                 828-232-2223