2019 Summer Roundtable Insights

 

Trade and the Heartland:
From Agriculture to Manufacturing

 
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INTRODUCTION

The Pacific Pension & Investment Institute (PPI) held its Summer Roundtable in Chicago, Illinois from July 10-12, 2019. PPI’s first program in the U.S. Midwest centered around the main theme of “Trade and the Heartland – From Agriculture to Manufacturing,” and dove deeply into this vibrant economy. The program offered our members new perspectives on the profound impacts of global trends such as trade and tech disruptions. Participants also discussed topical issues such as monetary policy, strategic partnerships, government-sponsored retirement savings programs, derivatives and risk management, entitlement spending, and a debate on whether the liberal international order can prevail without a dominant superpower.

 
 
 

KEY TAKEAWAYS

  • The trade war between the U.S. and China has undermined the rules-based international trade system. As a result, the world economy may become more fragmented, more competitive, less cooperative, and less productive and efficient overall.

  • While most industries are demand-driven, opportunities in agriculture tend to come from dislocations on the supply side.

  • Managing soil carbon is the key to soil health, which in turn affects unit crop yield and productivity, and ultimately the value of farmland.

  • The auto industry has been bracing for its own demise. But in the meantime, there is still decent money to be made.

  • U.S. imports from Vietnam increased by 40 percent in the first quarter of 2019, compared to 2018. It is the fastest-growing exporting nation to the U.S. in Asia.

  • The American Heartland is working hard to be part of the innovation economy by leveraging its strengths in traditional industries and by improving business environments.

  • The current U.S. administration's trade war with China has spilled over to almost all aspects of U.S.-China relations. Even Chinese students and researchers in the U.S., as well as the Chinese-American community are being affected.

  • One of the main reasons for keeping interest rates relatively low is subdued levels of inflation in the U.S.

  • The single biggest predictor of whether someone is saving for retirement is whether their job has a retirement program.

  • In addition to risk management, derivatives also allow investors with specific views on specific parts of the market to gain cheap factor risk exposure.

  • Nationalism has become one of the world’s most powerful ideologies, more so than the values that have traditionally undergirded the liberal international order.

 
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THEME DISCUSSIONS

The New Normal in International Trade Relations

The trade war between the United States and the People’s Republic of China has profoundly affected the rest of the world by undermining the rules-based international trading system. The rise of tensions between these two great powers underscores the erosion of third-party arbitration. As the authority of the World Trade Organization (WTO) weakens, countries are rushing to sign bilateral and/or regional free-trade arrangements. In the long run, the world economy is becoming more fragmented and as a result less productive and efficient. It is the possible beginning of a competitive, rather than cooperative, global economy.

The U.S. seems to have three conflicting objectives in this trade war. First, the White House wants to eliminate or significantly reduce the trade deficit with China, which is practically impossible, given the structure of the U.S. economy. Second, the U.S. Congress wants to confront and to change China’s approach to issues such as intellectual property, market access, and government subsidies. Third, many in the U.S. foreign policy and intelligence communities regard China as a long-term threat and they want to stem China’s rise now before it becomes too powerful. Politically, hostile attitudes toward China are not exclusive to the president or the Republican Party. They are well-entrenched in the left wing of the Democratic Party as well.

China appears to be suffering more from this trade war at the moment. However, in the long run, the U.S. economy will probably end up hurting more, as the U.S. has a higher proportion of its economy in high-value services that rely on global trade. While the U.S. remains politically divided, China is likely going to be able to absorb some the short-term losses by inciting nationalism, creating domestic demand, and by issuing debt stimuli.

The Global Agricultural Economy: Short-Term Disruptions and Long-Term Shifts

Agriculture can be seen as a growth industry because of the global population expansion. Furthermore, while most industries are demand-driven, supply plays a larger role in agriculture. Intuitively, the demand for food is steady and increasing. However, the supply of food is affected by frequent dislocations due to factors such as trade barriers, infestation, and changes in weather patterns, especially rainfall patterns, which can result in the narrowing of seeding and harvesting seasons. There is a constant need to manage these short-term supply-demand imbalances by transporting agricultural products from surplus areas to deficit areas.

In the 1980s, the U.S. produced 50 percent of the world’s grains and seed oils. But now that percentage is reduced to only 20 percent. U.S. policymakers need to pay attention to what is happening in the global agricultural system. Brazil and Argentina are stepping up in building storage facilities and developing new production technologies. Eastern Europe and Russia are also expanding their production capacities. Even though China currently relies heavily on U.S. agricultural products, particularly soy beans, the trade war has pushed Chinese importers to explore alternatives. China is also ramping up its own production capacity through agricultural technology and land reform. American farmers need to prepare themselves for potentially losing China as a major export market, permanently.

Consumption trends are changing. The growing middle class around the world wants more choices, especially healthier ones. Food companies need innovative customer solutions such as plant-based protein. A new category of food that sits between food and medicine, or food with medicinal value, may become the next big thing for middle-class consumers. On the other end of the demand spectrum, large parts of the developing world still struggle to feed their populations with basic food. It is an unfortunate reality that nearly one third of total food production is not consumed - food waste happens at every stage of the value chain. Regulation and education are keys to reshaping behavior. Coding and packaging technologies can help extend the shelf-life of products. There are also ways to turn food excess into valuable commodities, such as ethanol and other bio-fuel made from corn in North America and from palm oil in Southeast Asia. Corn-based plastic and other biodegradable packaging materials made from crops may replace fossil fuel derived plastics.

Technology has always played a major role in revolutionizing the agricultural industry. A modern example was the adoption of heavy farming equipment, which largely came from converted tanks after the end of the First World War. Other technological breakthroughs include the use of chemical fertilizers and the spread of genetically modified organisms (GMOs). Today, farmers are utilizing sensors, drones, satellites, and big data to improve the efficiency and precision of their yield. In the near future, crops modified by the genome editing technology CRISPR and artificial intelligence (AI) enabled farming equipment will once again change the industry. Thanks to technological advancement in agriculture, it is unlikely that the earth will run out of food by as far out as 2050.

Business models in agriculture are rapidly changing. Small family-owned farms are being replaced by larger operations with better infrastructure and distribution networks. This trend will bring changes to agricultural employment, which is a positive development as farmers’ earnings are very low around the world and may attract young people back to this sector. Another significant change in the business model is the declining ownership of land by farmers. Food companies and institutional investors are increasingly buying up farmland and renting them out to farmers.

Farmland Investing: Dirt vs. Soil

Even though farmland investing currently only represents a sliver in most institutional investors’ allocations, persistent low yield in public markets may force them to look harder in private assets. And after being constantly outbid in real estate and infrastructure deals, smaller asset owners may find stronger appeal in farmland investing. However, serious investors need to dig a little deeper and learn more about soil and soil health, which is the real value driver of farmland.

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At the most basic level, soil needs the right amount of moisture to grow crops. The moisture cultivates the micro-organisms that improve the carbon content, the basis of soil fertility. Soil profiles can also be affected by the landscape and climate, as well as by farming methods such as plowing and the use of synthetic fertilizers.

As farmland ownership gradually gets transferred from small families to large institutions, there is an opportunity for farmland investors to lead the way in mass-adopting advanced farming methods, such as regenerative agriculture. Regenerative agriculture is a holistic land management practice that focuses on improving soil health by increasing soil organic matter. Currently, there is a financing gap in this area, as cash-strapped farmers cannot afford the three-year transition period or risk window to go regenerative, which is not covered by conventional farm insurance.

Automotive Manufacturing Amid Trade and Tech Disruptions

The automobile industry is indeed a global one, as its supply chains are built all around the world. Outsourcing has improved productivity and profitability for car makers. However, the margins in the industry are quite thin and may not be able to bear much of an additional cost increase. Most car manufacturers see trade negotiations as short-term policy disruptions that likely do not warrant long-term actions in response. Moving manufacturing plants to another country is very costly and may take several years to complete. By the time the new plant is operational, new administrations and new trade or tax policies might invalidate their relocation decision. The industry seems willing to wait out this period of extreme policy uncertainty, before making decisions to shift supply chains and assembly plants.

Tech disruption is a hot topic in the auto industry. Every car company is talking about its roadmap for new technology and expanding its tech team and tech fund. But spending too heavily in new technology (with unproven profit potential) will quickly hit stock prices. The key is to differentiate the company from other car makers, as any single company cannot make cutting-edge bets on every new frontier.

Most car companies now focus on electric vehicles. Some of them also see opportunities in ownership models. There are essentially two ownership models for vehicles, dedicated and shared. Although the shared model is the emerging one, it is unlikely to replace the dedicated model. In the foreseeable future, 75 percent of cars will still remain dedicated. The shared model will do well only in highly concentrated urban areas. Connectivity is another differentiator. Traditionally, vehicle hardware constitutes 90 percent of the revenue. In the future, it may be only about 50 percent, while 30 percent will be represented by software and 20 percent by content. It is widely believed that vehicles will be a major platform for the Internet of Things (IoT). Instead of selling a car as a piece of hardware, there will be ways for car makers to charge for exclusive content and services delivered through their vehicles. Google’s interest in the auto industry, for example, is driven by the need to capture driver and passenger data. No one is certain about which technology will be the big winner.

Operating in the auto industry is tough and not many companies are making money. Even if there is a profit, the cash will be quickly recycled back into the business. There is a high barrier to entry in the form of scale, as it requires at least two million cars to allow the business model to be potentially profitable. For established car makers, profits are expected to decline and will probably eventually disappear. In the process, there will be significant consolidation in the industry. In a way, the auto industry has been bracing for its own demise. But in the meantime, there are still decent business opportunities. Car companies can still make money with internal combustion engine products for at least another decade.

Winners of Supply Chain Redistributions

Despite the White House’s threat to impose tariffs on Vietnam, the Southeast Asian country has already benefited hugely from the escalation of U.S.-China trade tensions in the past few years. U.S. imports from Vietnam increased by 40 percent in the first quarter of 2019, compared to 2018. In Asia, it is the fastest-growing exporting nation to the U.S. Vietnam is primarily benefiting from international companies relocating their production facilities and other parts of their supply chains out of China. Additionally, the current Vietnamese government is putting in place market liberalization policies, including privatizing some of its state-owned enterprises. The improvement of the business environment did not go unnoticed by the European Union, which signed its own new trade deal with Vietnam in late June 2019. Other Southeast Asian economies also saw varying degrees of inbound supply chain shifts during the same period.

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South Asian economies, by contrast, remain less globally integrated in terms of supply chains. While India and Bangladesh are making efforts to integrate their economies regionally, their current initiatives may become obstacles to taking advantage of the U.S.-China trade war. While business opportunities may arise from strategically partnering with the U.S. in the Indo-Pacific region, the future of international trade for India is still unclear. India is somewhat reluctant to sign bilateral free trade agreements with the U.S., even though it rejected China’s Belt and Road Initiative. For most South Asian and Southeast Asian economies, the best scenario would be to trade freely with both the U.S. and China. However, the economic rivalry between these two countries are forcing them to take sides.

The Heartland Economy

As the economic center of the U.S. Midwest, Illinois is home to not only traditional industries such as agriculture and manufacturing, but increasingly to service-oriented industries and tech start-ups. Compared to U.S. coastal states, it is much less costly for entrepreneurs to start a new business in Illinois, where they can still gain access to world-class freight transportation, high-quality talent pools educated by renowned universities, and a labor force that is proud of its culture of strong work ethics.

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However, there are many challenges facing the state: a large fiscal deficit and outstanding debt, a politically divided legislature, special interest groups, dated public infrastructure, income inequality, and a looming public pension crisis. The state government is working hard to solve or improve these issues, with the ultimate goal of creating the right environment for the private sector to flourish, which will in turn generate more jobs. Such measures include new tax cuts for businesses, giving tax credits to research and development, increasing broadband internet access, improving college affordability, and modernizing transportation infrastructure. The government is also taking serious steps toward balancing the state budget through bipartisan efforts, which will improve the credit ratings of Illinois’ government bonds and thereby reduce borrowing costs. New sources of tax revenue are being explored too, including legalized sports betting and cannabis. Finally, many possible solutions to the public pension crisis have been proposed and discussed, including pension buyout, pension ramp, and pension obligation bonds. The problem may call for using a combination of them rather than just one.

Such heightened awareness of government fiscal discipline is perhaps in part a lesson learned from the financial misfortune of a close neighbor just across Lake Michigan. Before the City of Detroit filed for Chapter 9 bankruptcy in 2013, it was spending 60 percent of its budget on debt servicing. Though controversial in the press and disliked by bondholders and rating agencies alike, declaring bankruptcy was the last resort that helped save the Motor City from complete financial ruin. It was the clean slate that the city needed to stay afloat. Just four years later, the state budget remains balanced and Detroit’s economy has rebounded. Michiganders are hopeful that Detroit’s revival will help eventually reverse decades of net population outflow.

40 Years of U.S.-China Relations: A Review and Reassessment

In the early 1970s, the U.S. faced a growing threat from the Soviet Union. President Richard Nixon saw the need to normalize relations with China, which had recently fallen out with the USSR. The U.S. and China therefore found a common enemy. Ping-pong diplomacy in 1971 paved the way for Nixon's historic visit to Beijing in 1972. The seven-day official visit to three Chinese cities became the week that changed 20th-century world history by significantly tilting the balance of the Cold War. In 1979, President Jimmy Carter granted the People's Republic of China full diplomatic recognition and severed all but commercial and cultural ties with Taiwan. Between 1979 and 1989, the U.S. continued its efforts to normalize relations with mainland China, which included signing of the third Joint Communiqué in 1982, reaffirming the U.S. commitment to the One China policy. This period was also marked by intelligence cooperation and military equipment sales between the two countries. President Reagan visited China in 1984.

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The first inflection point in the relationship since normalization came after the Tiananmen protests in 1989. The U.S. suspended military sales and froze relations, but it held back from sanctions against China. From 1994 to 2011, the U.S. largely made efforts to integrate China into the liberal international order, despite isolated incidents in 1996, 1999, and 2001. In 2000, President Bill Clinton granted China Permanent Normal Trade Relations status with the U.S., laying the groundwork for China's accession to the World Trade Organization (WTO) in 2001. Five years later, China surpassed Mexico to become the United States' second largest trade partner. By 2010, China's GDP rose to 5.8 trillion USD, overtaking Japan as the world's second largest economy. China's meteoric rise took both sides by surprise. The Obama Administration’s pivot to Asia signaled a change in attitudes toward China. In 2018 and 2019, under Donald Trump’s presidency, trade tensions between the two countries eventually escalated into a trade war.

The current administration's trade war with China has spilled over to almost all aspects of U.S.-China relations. Different departments and agencies of the U.S. Government are taking their own (uncoordinated) actions against China. Even Chinese students and researchers in the U.S. as well as the Chinese-American community are being affected. On the receiving end, China sees them as comprehensive attacks that seek to decouple the two economies, to limit China's roles in regional affairs and global governance, cripple its best companies, and block its technological advancement. China’s response to this hostility has been to incite nationalism, which could drive Chinese society further away from the West. Both countries are on dangerous path that could lead to much greater conflict. An immediate de-escalation of bilateral tensions would benefit them and the rest of the world.

 
 
 
 

DIVERSIFIERS

Monetary Policy Update

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The U.S. Federal Reserve (Fed) remains committed to its dual mandate, balancing both concerns about the U.S. labor market and inflation. It explicitly aims for a two percent target inflation. However, 2-2.5 percent would be an acceptable range. Some developed economies have failed to generate adequate inflation for extended periods. The Fed hopes to avoid that kind of situation in the U.S. One of the main reasons for keeping interest rates relatively low is subdued levels of inflation in the U.S., despite strong consumer spending, robust labor market growth and job creation, and exceptional stock market performance. The Fed prefers to be running in the background with its monetary policy tools. It tries to avoid heavy intervention unless it is necessary. However, when fiscal policy becomes too tight, the Fed will intervene. Monetary policy cannot permanently improve economic growth. It needs to work with compatible fiscal policy to yield the best economic outcome.

Strategic Partnerships in Higher Education

American universities are facing many long-term structural challenges. The base of high school graduates is flatlining if not declining. After decades of price increases for higher education, consumers have become more price sensitive about tuition. International enrollment Is declining. Universities, therefore, must learn how to live within their means and find creative ways to work with businesses to stretch the value of their dollar without sacrificing quality.

DePaul University in Chicago created a joint-venture educational advancement fund to share costs, combining multiple colleges and universities to own and operate a dormitory in Chicago. Eventually, the facility was sold to an independent operator for a large sum. The university also opened the Wintrust Arena at McCormick Square. While its business partners profited from parking revenue, concerts and events, and conventions, DePaul was given naming rights, premium seating revenue, gate receipts, and National Basketball Association-quality locker room and training facilities. Both of these projects benefitted local communities as well, by increasing commerce for local businesses. Overall, these unconventional partnerships greatly strengthened the financial position of the university. However, in the long run and for the rest of the higher education system, more funding and financing models need to be devised and experimented with to help offset the structural challenges ahead.

Government-Sponsored Retirement Savings Programs in the U.S.

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 There is an under-reported retirement crisis in the U.S. Less than half of Americans have more than 5,000 USD saved for retirement. The single largest predictor of whether someone is saving for retirement lies not in their race, gender, or education level, but whether their job has a retirement program. Those who do not save are less likely to save in the future. Those who save are likely to save more.

Illinois's Secure Choice program is a government-sponsored retirement savings program that automatically enrolls workers of companies who have more than 25 employees to contribute a default but adjustable rate of five percent of their pay. The default percentage was set at a moderate level so that it would not be too noticeable to workers from paycheck to paycheck. The proposal of the program was initially controversial in the state legislature. Republicans opposed on the grounds that government would be interfering too much into individuals’ lives by forcing employers and employees to pay for their retirement. Employers feared that it would increase costs. However, none of these consequences materialized. The Secure Choice program on its own is certainly not enough to solve the retirement crisis. There are hopes to expand the program further, possibly cooperating with other states to lower the fees as much as possible. Oregon and California have also launched programs that have similar characteristics.

Derivatives: New Trends Post-2008

Derivatives have two major functions: risk management and leverage. However, there is a gap in understanding or even misunderstanding about their usage, even among large institutional investors, often between the board and the investment staff. The 2008 global financial crisis drew a dividing line in financial market practices. Some investors since shunned assets that had any structural complexity. Indeed, there was a reduction in derivatives transaction volume in the first couple of years after the financial crisis, due to the risk-off environment. In 2010, dollar derivatives were only 40 percent of the cash market. But by 2016, it had jumped to 150 percent, gold futures went to 160 percent of the physical gold market, while U.S. equity derivatives rebounded to nine times the S&P500.

The rapid recovery was partly attributable to the role of clearing houses, which manage counter-party risk. New regulations also helped institute good practice around safeguards. Ultimately, however, it was investors' migration from over-the-counter (OTC) derivatives to listed derivatives that turned the tides. Investors have cast their votes between "standardized but very liquid" versus "perfect hedge but highly illiquid." In addition to risk management, derivatives also allow investors with specific views on specific parts of the market to gain cheap factor risk exposure.

For institutional investors that are thinking about building in-house derivatives execution capacities, there are four decision factors that they may wish to consider: 1. Need: determine the true reason for having this capability, be it for hedging, managing exposure, or adding liquidity during transition or rebalancing. 2. Selection: choose the right instrument, such as OTC vs. listed; and understand the trade-offs between liquidity, execution cost, and compliance, etc. 3. Readiness: build readiness at the people, process and platform levels. 4. Experience: hire people with experience in related technologies, regulations, and governance.

Will the Liberal International Order Survive Without a Dominant Superpower?

The liberal international order is defined as a world in which liberal nations, specifically the U.S. and its allies, enforce a rules-based system that encourages democracy, open markets, and international institutions. The question at hand is whether this liberal international order can survive if the U.S. is no longer overwhelmingly dominant, economically and militarily, on the world stage. Whether there is an intent or not, China already poses a threat to this U.S.-led order.

Many believe that the liberal international order has secured a period of relative peace and prosperity, ushering in trade and democracy. However, the liberal international order has also created burdens on countries in its crusading effort to spread democracy. For example, despite the image of peace and prosperity, the U.S. has been at war in two-thirds of the years since the fall of the Soviet Union. America’s deeply flawed efforts at regime change in the Middle East, in particular, has negatively impacted millions of lives.

Since their rise in the 19th century, nation states are still thriving around the world. By extension, nationalism has become one of the world’s most powerful ideologies. National identity has been a more powerful force than liberalism. Tenets of liberal democracy such as freedom of speech and the press, democratic elections, etc. have always had less appeal compared to upholding the collective identity of a people. In recent years especially, the liberal values have fallen further behind nationalistic thinking around the world, even in the United States and the United Kingdom. If the liberal international order is unpopular both at home and abroad, what does the future hold for it? If the liberal international order is to survive, it will have to change and to adapt to circumstances. Member states of this order, such as the UK, Canada, Australia, and Western Europe, must be willing to contribute more of its resources to the security of the liberal international order. The U.S. is no longer in a position to maintain this order unilaterally.