USA

First In, First Out – China as a Leading Indicator
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First In, First Out – China as a Leading Indicator

Macro Letter – No 138 – 21-05-2021

First In, First Out – China as a Leading Indicator

  • China was the first country to recover from the Covid-19 pandemic
  • The PBoC began tightening monetary conditions in May 2020
  • Chinese housing and stocks remain strong despite official policy
  • Chinese contagion remains a risk to the global recovery

Whilst there are many aspects of the Chinese command economy which differ radically from that of the US, it is worth examining the performance of China’s economy, fiscal and monetary policy, and its financial markets. They may afford some insight into the future direction of other developed and developing markets as we gradually emerge from the Covid crisis: –

Source: Trading Economics

As can be seen from the chart above, whilst China was the first country to be struck by the Covid-19 pandemic it was also the first country to recover, however, a comparison of the Chinese and US bond markets provides a rather different picture: –

Source: Trading Economics

Chinese bond yields reached their lows at roughly the same time as those of the US, since when they have returned more rapidly to their pre-pandemic levels. If the US follows a similar trajectory the yield on US Treasuries is set to rise further.

It can be argued, however, that the plight of the Chinese bond market is a function of the monetary stance of the People’s Bank of China (PBoC). When the crisis first erupted the PBoC cut its interest rate corridor by 0.3% and also drove down Chinese interbank rates by around 1.2% through its open market operations. By May 2020 that policy had changed, accommodation was replaced by a steady drain of liquidity.

The chart below shows the, rather volatile, 3 month Shibor rate, this is in marked contrast to the ‘lower for longer’ approach taken after the 2008 crisis. The Covid accommodation has been remarkably short-lived: –

Source: Trading Economics, PBoC

This PBoC tightening, which began in May 2020 and has been accompanied by official talk of the need for stability and the desire to avoid creating asset bubbles, is finally becoming evident in the money supply data: –

Source: Trading Economics

This contrasts with the continued expansion of US monetary aggregates: –

Source: Trading Economics

One of the challenges facing all central bankers is that interest rates are a blunt tool. Not all China’s asset markets have heeded the PBoC advice. The residential property market, for example, remains red hot despite the introduction of the three red lines policy – which aims to limit their liability-to-asset ratio (excluding advance receipts) to less than 70%, or their net gearing ratio to less than 100%, or their cash-to-short-term debt ratio to less than 1x, or a combination of all three. New home prices surged on regardless, gaining 4.8% in April, led by luxury real estate in Shenzhen, Shanghai and Guangzhou which is up 16% to 19% over the last year – a further tightening of regulation seems inevitable.

The PBoC has had greater influence elsewhere, Total Social Financing, their favoured measure of lending across the entire domestic financial system, rose by 12% in March, its slowest pace since April 2020:-

Source: Financial Times, CEIC

Another sign that official policy measures may be biting was seen in April’s retail sales which, whilst they rose by 17.7%, were down from a 34.2% in March, and came in well below the consensus forecast of 24.9%. Here again, China appears to be a leading indicator of the direction that the US economy might take: –

Source: Trading Economics

Interestingly, unlike 2015, the Chinese stock market has, thus far, reacted in a more measured way to the general tightening of monetary conditions. The next chart shows the relative performance of the Shanghai Composite versus the S&P 500 Index: –

Source: Trading Economics

As mentioned above, money supply data points to a slowing of the Chinese economy but, like so many other countries, China saw a sharp rise in its, already high, household saving rate. The Paulson Institute estimates that Chinese households saved 3% more of their income than prior to Covid; Pantheon Macroeconomics equate this pool of savings to roughly 3% of GDP. While many commentators suggest that in China’s case this is a pool of precautionary saving, consumption will likely resume its long-term growth, now that employment prospects have begun to improve. The chart below shows the lagged trajectory of unemployment in US compared to China: –

Source: Trading Economics

US unemployment remains elevated relative to its pre-Covid rate but the economic recovery continues to gather momentum.

In China, as elsewhere, that portion of excess savings not consumed will either be left on deposit, used to reduce debt or invested. Even though interest rates have risen, the liquidity of Chinese capital markets should remain plentiful for the next six months to a year, sufficient to cushion any sudden downturns in the post-Covid recovery.

Conclusions and Investment Opportunities

In the analysis above, I have produced a strew of charts suggesting that the US may follow the trajectory of China as the post-Covid recovery unfolds. This is almost certainly too simplistic. Above all else Beijing craves stability, it knows its pace of economic growth is slowing, this is structural. The investment-led growth model which has transformed the economy over the last four decades, requires the methadone of more credit to sustain even these lower rates of return. The policy of rebalancing towards domestic consumption offers longer-term hope, but China’s recovery from the Covid crisis was driven principally by investment and, to a much lesser extent, exports. The chart below, from George Friedman of Geopolitical Futures, shows the damage done to Chinese consumption by the pandemic and the subsequent rebound: –

Source: Geopolitical Futures, IMF, CEIC

The new(ish) US administration is also different from any we have seen for several decades. Markets believe in the arrival of a New New Deal fuelled by a gargantuan monetary and fiscal tonic which will heal-all. Asset prices continue to rise as The Everything Bubble inflates further.

We are still in the early stages of the economic recovery. Supply-chain constraints and labour shortages, even whilst under-employment remains elevated, have driven inflation expectations higher in the near-term, yet asset markets look beyond these shorter-term factors to the productivity gains, which have, in many cases, been a long overdue response to the crisis itself.

A few brave central bankers are seeking to temper the speculative frenzy. The majority, however, will place their emphasis on outcomes rather than the outlookas Federal Reserve Governor Lael Brainard recently stated. This politically expedient approach means fiat currencies will continue their race to the bottom, bond markets will remain neutered by the policy of QE; that leaves assets as the solitary safety-valve, somewhere between a store of wealth and thar she blows. They afford some protection against debasement and, with the advent of Decentralised Finance, there is a non-zero possibility that some of these assets might even become a means of exchange.

In the near-term we have seen the Norges Bank indicate that it may raise rates in H2 2021. The Bank of Canada has announced a tapering of government bond purchases, inking in a potential rate increase for late 2022, meanwhile the Bank of Japan, whilst it has made no bald statements, has moderated its ETF purchases and stands accused of taper by stealth because the scale of its bond-buying has actually slowed since it adopted yield curve control in 2016. These isolated actions are but clouds in a blue sky of endless liquidity but financial markets prefer to travel rather than to arrive. Choppier markets are likely over the next few months, there may be some excellent asset buying opportunities on sharp corrections.

Relax, Rotate, Reflate
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Relax, Rotate, Reflate

Macro Letter – No 134 – 27-11-2020

Relax, Rotate, Reflate

  • With US elections over and a vaccine in sight, financial market uncertainty has declined
  • Rotation has seen a resurgence in those stocks battered by the onset of the pandemic
  • Monetary and fiscal spending will continue until inflation returns

November has been an interesting month for financial markets around the world. The US Presidential election came and went and with its passing financial market uncertainty diminished. This change of administration is undeniably important, but its effect was overshadowed by the arrival of three vaccines for Covid-19. As I write (Thursday 26th) the S&P 500 Index is within 30 points of its all-time high, amid a chemical haze of pharmaceutical hope, whilst the VIX Index has tested its lowest level since February (20.8%). The Nasdaq Composite is also near to its peak and the Russell 2000 Index (an index of smaller capitalisation stocks) burst through its highs from February 2020 taking out its previous record set in September 2018. The chart below shows the one year performance of the Russell 2000 versus the S&P500 Index: –

Source: Yahoo Finance, S&P, Russell

It is worth remembering that over the very long term Small Caps have outperformed Large Caps, however, during the last decade the rapid growth of index tracking investments such as ETFs has undermined this dynamic, investment flows are a powerful force. I wrote about this topic in June in – A Brave New World for Value Investing – in which I concluded: –

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

To date, evidence of a return to Value Investing seems premature, Growth still dominates and the structural acceleration of technology trends seems set to continue – one might say, ‘there is Value in that.’

The vaccine news led to a rotation out of technology stocks but this was more to do with profit taking, new ‘Tech’ buyers quickly emerged. The rotation into Small Caps was also echoed among a number of out of favour sectors such as Airlines and Energy. It was enough to prompt the creation of a new acronym – BEACHs – Booking, Entertainment, Airlines, Cruises and Hotels.

Source: Barchart.com, S&P

Above is the one year performance of the 11 S&P 500 industry sectors. Information Technology remains the leader (+38%) with Energy bringing up the rear (-32%) however the level of dispersion of returns is unusually which has presented an abundance of trading opportunities. The table below shows the one, three and six month performance for an expanded selection of these sectors: –

Source: Tradingview

Beyond the US, news of the vaccines encouraged both European and emerging markets, but the latter (EEM), helped by the strong performance of Chinese stocks, have tracked the US quite closely throughout the year, it is Europe (IEUR) which has staged the stronger recovery of late, although it has yet to retest its February highs: –

Source: Yahoo Finance, S&P, MSCI

In the aftermath of the US election, US bond yields have inched higher. From an all-time low of 32bp in March, 10yr yields tripled, testing 97bp in the wake of the Democrat win. Putting this in perspective, the pre-Covid low was seen at 1.32% in July 2016. The current concern is partly about the ‘socialist’ credentials of President-elect, Biden, but the vaccine announcement, together with the prospect of a return to some semblance of normality, has also raised the spectre of a less accommodative stance from the Fed. There was initial fear they might ‘take away the punch-bowl’ before the global economy gets back on its knees, let alone its feet. Governor Powell, quickly dispelled bond market fears and yields have since stabilised.

Longer-term, these bond market concerns may be justified, as this infographic from the McKinsey Institute reveals, combined central bank and government fiscal stimulus in 2020 has utterly eclipsed the largesse witnessed in the wake of the 2008 crisis: –

Source: McKinsey

Bond watchers can probably rest easy, however, should the global economy stage the much vaunted ‘V’ shaped recovery economists predicted back in the spring, only a fraction of the fiscal stimulus will actually materialise. Nonetheless, prospects for mass-vaccination, even in developed countries, remains some months away, both monetary and fiscal spigots will continue to spew for the present.

On the topic of monetary policy it is worth noting that the Federal Reserve previously employed ‘yield curve control,’ though it was not called by that name, back in April 1942, five months after the attack on Pearl Harbor. Under this arrangement the Fed committed to peg T-Bills at 3/8th and implicitly cap long-dated T-Bonds at 2.5%. The aim was to stabilize the securities market and allow the government to engage in cheaper debt financing during the course of WWII. This arrangement only ended with the Treasury – Fed Accord of 1951 in response to a sharp peace-time resurgence in inflation. This chart shows the period from 1941 (when the US entered WWII) up to the middle of the Korean War: –

Source: US BLS

I believe we will need to see several years of above target inflation before the Fed to feel confident in raising rates aggressively. The experience of Japan, where deflation has been lurking in the wings for decades, will inform Fed decision making for the foreseeable future.

Returning to the present environment; away from the stock and bond markets, oil prices also basked in the reflected light shining from the end of the pandemic tunnel. West Texas Intermediate, which tested $33.64/bbl on 2nd, reached $46.26/bbl on 25th. The energy sector remains cautious, nonetheless, even the recent resurgence leaves oil prices more than $15/bbl lower than they were at the start of the year.

Looking ahead, the stock market may take a breather over the next few weeks. A vaccine is coming, but not immediately. US politics also remains in the spotlight, the Republicans currently hold 50 Senate seats to the Democrats 48. If Democrats secure the two seats in Georgia, in the runoff election on 5th January, VP Elect, Harris, will be able to use her ‘tie-break’ vote to carry motions, lending the Biden Presidency teeth and hastening the expansion of US fiscal policy.

The stock market has yet to make up its mind about whether Biden’s ‘New New Dealers’ are a positive or a negative. Unemployment and under-employment numbers remain elevated as a result of the pandemic: and, whilst bankruptcies are lower than at this time last year, the ending of the myriad schemes to prolong the existence of businesses will inevitably see those numbers rise sharply. Does the stock market benefit more from the fiscal spigot than the tax increase? This is a question which will be mulled, chewed and worried until long after Biden’s inauguration on January 20th.  

Meanwhile the trend accelerations in technology which I discussed in – The prospects for Emerging and Frontier Markets in the post-Covid environment – earlier this month, continue. The chart below shows how information industries have been transforming the makeup of global trade ever since the great financial crisis: –

Source: ECIPE, OECD, TiVA, van der Marel

Manufacturing trade is in retreat, trade in digital services is accelerating. The chart above stops at 2015, when we have the data to incorporate the period of the current pandemic, I expect the pace of growth in information industries to have gain even greater momentum.

Back in 1987, MIT economist and Nobel Laureate, Robert Solow, observed that the computer age was everywhere except for the productivity statistics. During the 1990’s technology productivity growth was finally observed, but the past decade has seen a string of disappointing productivity growth statistics, yet they have coincided with digitisation transforming vast swathes of the global economy, perhaps the next decade will see the fruit of these labours. I believe we can look forward to significant productivity improvements in the coming years. Stock prices, however, are forward looking, their valuations may seem extended but this may be entirely justified if technology ushers in a new golden age.

Step-change at the Fed – Reaching for the stars
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Step-change at the Fed – Reaching for the stars

Macro Letter No 132 – 04-09-2020

Step-change at the Fed – Reaching for the stars

  • The Federal Reserve has changed the emphasis of their dual mandate
  • Inflation targeting will become more flexible in the long-run
  • Full employment has become the Bank’s priority
  • Asset markets will be the immediate beneficiaries

In a speech entitled – New Economic Challenges and the Fed’s Monetary Policy Review – given on August 27th, at the Jackson Hole, Kansas City Federal Reserve Economic Policy Symposium, Federal Reserve Chairman, Jerome Powell, announced a change in the emphasis of the dual mandate. The new focus is on promoting full-employment even at the expense of price stability.

The policy review was, of course, more nuanced. Past policy decisions were analysed and found wanting – especially the rate increases witnessed between 2015 and 2018. The extraordinary flatness of the Phillips Curve was noted; the lower trend rate of economic growth, contemplated; the stickiness of inflation expectations, contextualised: and the ever rising, pre-pandemic participation rate, considered. What the speech omitted was any discussion of forward guidance or expectations of the change in size, composition or direction of the Fed’s, already historically large, balance sheet.

For financial markets the key change is contained in this paragraph: –

Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

The initial market response saw stocks rally whilst 10yr T-bond yields rose – testing 0.79%. During the week which followed, 10yr yields slipped back to 0.62%. Equity markets subsequently switched focus and moved on, returning to their obsession with the ever rising tide of technology stock earnings expectations. Even the Dow Jones Industrials Average Index has been effected by the tech boom, as reported by S&P – Dow Jones Industrial Average: 124 Years and It Keeps Changing – the index changes, announced on August 31st included, Salesforce.com (CRM) replacing Exxon Mobil (XOM), Amgen (AMGN) replacing Pfizer (PFE), and a tech switch with Honeywell International (HON) replacing Raytheon Technologies (RTX).

Returning to monetary policy, the Fed announcement was hardly a surprise, the August 10th, FRBSF Economic Letter – Average-Inflation Targeting and the Effective Lower Bound had already set the tone. The chart below reveals the Fed’s inflation targeting dilemma: –

Source: FRBSF

If the average for Total PCE over the last decade has been less than 1.5%, allowing it to rise above 3% for a few years is just what is needed for the Fed to get back on track.

Setting aside the vexed questions of whether an Inflation Target is appropriate or, deflation, a good or bad phenomenon, we need to investigate the structural cause of the decline in inflation. Here I will resort to the monetary equation of exchange: –

MV = PQ

Where: –

M            is the total nominal amount of money supply in circulation on average in an economy.

V             is the velocity of money, or the average frequency with which a unit of money is spent.

P             is the price level.

Q             is an index of real expenditures for newly produced goods and services.

The basic problem for the Fed is that, despite their success in expanding money supply (see below): –

Source: Federal Reserve Bank of St Louis

The velocity of circulation has continued to plummet: –

Source: Federal Reserve Bank of St Louis

I discussed the rapid expansion of money supply in more detail in a June article for AIER – Global Money Supply Growth and the Great Inflation Getaway: –

I suspect, fearful of repeating the mistakes made by the Bank of Japan, that once the inflation genie is finally out of the bottle, central bankers will forsake the hard-learned lessons of the 1970’s and 1980’s and allow inflation to conjure away the fiscal deficits of their governments at the expense of pensioners and other long-term investors.

Of course, consumer price inflation may not return, even with such egregious debasement as we have seen thus far, as Michel Santi suggests in Japan: a sleeping beauty: –

A global battle has thus been raging on pretty much since the deflationary episodes of the 2010s in an attempt to relaunch economies by dint of inflation. In this respect, the Japanese experiment, or rather multiple experiments, remains a case study to show that inflation is still proving a difficult spectre to revive.

Santi, points to demographic decline, a trend in which Japan is a world leader, together with, what he considers to be, an irrational fear of debt and deficits, which renders people unwilling to spend. In this scenario, government, corporate and consumer debt cannot be inflated away and sits like a giant toad atop all the animal spirits that might reignite economic growth. He also alludes to the profound changes in the nature of work – from permanent to temporary, from employed to self-employed, from office based to remote. These changes have rendered the Phillips Curve redundant.

The dual mandate of full employment and price stability has never been so easy for the Federal Reserve to achieve. That, at least, was the case until the global pandemic unknit the fabric of the global market economy. Now, the Federal Reserve – and central bankers in general – are faced with the prospect that printed money, whether it be sterilised or not, will either be invested or hoarded. In this scenario, the greater the debt the less likely prices are to rise as a result of demand-pull inflation. On the opposite side of the inflation equation, the shortening of global supply chains and the need for dual-redundancy, agin another unwelcome and unexpected lockdown, has created the classic bottlenecks which lead to product scarcity, personified in cost-push inflation.

Interest Rates, Global Value Chains and Bank Reserve Requirements– published in June of last year, notes that Global Value Chains have suffered and shortened since 2009; that, despite low interest rates, financing costs remain too high and yet, at the same time, bank profitability has not recovered from the damage caused by the great financial recession. Nonetheless, those same banks, which were supposed to have been broken up or dramatically deleveraged, remain still too big to fail. My conclusion looks dismally prescient: –

The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.

US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.

Conclusion and Investment Opportunities

According to data from S&P, US share buybacks were lower for the second quarter in a row in Q2, 2020. They amounted to $166bln, versus $205bln in Q1 and $190bln in Q2, 2019 – this is still the seventh highest quarterly amount ever recorded. The chart below shows the evolution of buybacks over the last two decades: –

Source: S&P, FT

The consolidation of the US equity market continues – from a high of 7,562 on July 31, 1998, the Wilshire 5000 Index list of constituents has shrunk to just 3,473 names. This is a side effect of the fact that debt finance remains cheaper than equity finance. According to a recent article published by the Financial Times – US corporate bond issuance hits $1.919tn in 2020, beating full-year record corporate issuers have raised more capital in the first eight months of 2020 than in any previous full year. Low rates going to no rates, thanks to the actions of the Fed, is said to have driven this step-change in activity. The reticence of commercial banks to extend finance, despite the favourable interest rate and liquidity environment, is a contributing factor: –

Source: Refinitiv, FT

The Covid pandemic has accelerated many of the economic and financial market trends which have been in train since the end of the 2008/2009 financial crisis. Lower interest rates, more quantitative easing, further share buy-backs and greater debt issuance – by borrowers’ individual, corporate and national – look set to continue.

A global economic depression is looming, yet the price of many assets continues to rise. In a similar manner to the Tech bubble of the late 1990’s, today’s valuations rely more on the willing suspension of disbelief than on any sober assessment of earnings potential. The US stock market has outperformed partly due to the high proportion of technology stocks, as the chart below (from May) shows: –

Source: FactSet, Goldman Sachs

The magnitude of this fiscal and monetary response has already reached far beyond the United States. The table below shows those national stock markets with a positive year to date performance exceeding 5%: –

Source: Trading Economics, Local Stock Exchanges

I have deliberately excluded the Nasdaq 100 which is currently up more than 57%. Other countries will catch up. The US$ has weakened, since February, on a trade weighted basis: –

Source: BIS, Federal Reserve Bank of St Louis

In a competitive race to the bottom, other central banks (and their governments) will expand monetary (and fiscal) policy to stop their currencies appreciating too fast.

Global bond yield convergence will continue, stock market strength will endure. Inflation will creep into consumer prices gradually and the central banks will turn a blind eye until it is too late. The world economy may be on its knees but, in general, asset prices will continue to reach for the stars.

When the facts change
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When the facts change

In the Long Run - small colour logo

Macro Letter – No 126 – 14-02-2020

When the facts change

  • The coronavirus is a human tragedy, but the markets remain sanguine
  • A slowing of global growth is already factored into market expectations
  • Further central bank easing is expected to calm any market fears
  • A pick up in import price inflation has been discounted before it arrives

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Is the impact of Covid-19 going to be seen in economic data? Absolutely. Will economic growth slow? Yes, though it will be felt most in Wuhan and the Hubei region, a region estimated to account for 4.5% in Chinese GDP and 7% of autopart manufacture. The impact will be less pronounced in other parts of the world, although Korea’s Hyundai has already ceased vehicle production at its factories due to a lack of Chinese car parts.

Will there be a longer-term impact on the global supply chain and will this affect stock and bond prices? These are more difficult questions to answer. Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs. The longer-term impact remains unclear. Why? Because the performance of the stock market over the last decade has been driven almost entirely by the direction of interest rates, whilst economic growth, since the financial crisis, has been anaemic at best. As rates have fallen and central banks have purchased bonds, so bond yields have declined making stocks look relatively more attractive. Some central banks have even bought stocks to add to their cache of bonds, but I digress.

Returning to my title, from an investment perspective, have the facts changed? Global economic growth will undoubtedly take a hit, estimates of 0.1% to 0.2% fall in 2020 already abound. In order to mitigate this downturn, central banks will cut rates – where they can – and buy progressively longer-dated and less desirable bonds as they work their way along the maturity spectrum and down the credit-structure. Eventually they will emulate the policy of the Japanese and the Swiss, by purchasing common stocks. In China, where the purse strings have been kept tight during the past year, the PBoC has already ridden to the rescue, flooding the domestic banking system with $173bln of additional liquidity; it seems, the process of saving the stock market from the dismal vicissitudes of a global economic slow-down has already begun.

Growth down, profits down, stocks up? It sounds absurd but that is the gerrymandered nature of the current marketplace. It is comforting to know, the central banks will not have to face the music alone, they can rely upon the usual allies, as they endeavour to keep the everything bubble aloft. Which allies? The corporate executives of publically listed companies. Faced with the dilemma of expanding capital expenditure in the teeth of an economic slowdown – which might turn into a recession – the leaders of publically listed corporations can be relied upon to do the honourable thing, pay themselves in stock options and buyback more stock.

At some point this global Ponzi scheme will inflect, exhaust, implode, but until that moment arrives, it would be unwise to step off the gravy-train. The difficulty of staying aboard, of course, is the same one as always, the markets climb a wall of fear. If there is any good news amid the tragic Covid-19 pandemic, it is that the January correction has prompted some of the weaker hands in the stock market to fold. When markets consolidate on a high plateau, should they then turn down, the patient investor may be afforded time to exit. This price action is vastly preferable to the hyperbolic rise, followed by the sharp decline, an altogether more cathartic and less agreeable dénouement.

Other Themes and Menes

As those of you who have been reading my letters for a while will know, I have been bullish on the US equity market for several years. That has worked well. I have also been bullish on emerging markets in general – and Asia in particular – over a similar number of years. A less rewarding investment. With the benefit of hindsight, I should have been more tactical.

Looking ahead, Asian economies will continue to grow, but their stock markets may disappoint due to the uncertainty of the US administrations trade agenda. The US will continue to benefit from low interest rates and technological investment, together with buy-backs, mergers and privatisations. Elsewhere, I see opportunity within Europe, as governments spend on green infrastructure and other climate conscious projects. ESG investing gains more advocates daily. Socially responsible institutions will garner assets from socially responsible investors, while socially responsible governments will award contracts to those companies whose behaviour is ethically sound. It is a virtuous circle of morally commendable, albeit not necessarily economically logical, behaviour.

The UK lags behind Europe on environmental issues, but support for business and three years of deferred capital investment makes it an appealing destination for investment, as I explained last December in The Beginning of the End of Uncertainty for the UK.

Conclusions

Returning once more to my title, the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy. The chart below shows the diminishing power of the credit multiplier effect – Japan began their monetary experiment roughly a decade earlier than the rest of the developed world: –

Credit Multiplier

Source: Allianz/Refinitiv

Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

US Bonds – 2030 Vision – A decade in the doldrums
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US Bonds – 2030 Vision – A decade in the doldrums

In the Long Run - small colour logo

Macro Letter – No 125 – 17-01-2020

US Bonds – 2030 Vision – A decade in the doldrums

  • US bond yields have been in secular decline since 1981
  • Predictions of a bond bear-market have been premature for three decades
  • High indebtedness will see any inflationary yield surges quickly subdued

Having reached their yield low at 1.32% in July 2016, US 10yr bond yields have been locked in, just shy of, a 2% range for the last two and half years (subsequent high 3.25% and low 1.43%). For yields to fall again, supply must fall, demand rise or central banks, recommence their experimental monetary policies of negative interest rates and quantitative easing. For yields to rise, supply must rise, demand fall or central banks, reverse their multi-year largesse. Besides supply, demand and monetary policy there are, however, other factors to consider.

Demographics

One justification for a rise in US bond yields would be an uptick in inflationary pressure. Aging demographic have been the principal driver of the downward trajectory of secular inflation. During the next decade, however, Generation Y borrowing will accelerate whilst Generation X has yet to begin their aggressive saving spree. The table below looks at the borrowing and saving patterns of the demographic cohorts in the US: –

Demographics

Source: US Census Bureau

Excepting the obesity and opioid epidemics, life expectancy will, nonetheless, continue to extend. The Gen Y borrowing binge will not override the aging demographic effect. It’s influence on the inflation of the next decade is likely to be modest (on these grounds alone we will not see the return of double-digit inflation) and the longer term aging trend, bolstered by improvements in healthcare, will return with a vengeance during the 2030’s, undermining the last vestiges of current welfare provisions. Much more saving will be required to pay for the increasing cost of healthcare and pensions. With bond yields of less than 4%, an aging (and hopefully healthier) population will need to continue working well beyond current retirement age in order to cover the shortfall in income.

Technology

Another secular factor which has traditionally kept a lid on inflation has been technology. As Robert Solo famously observed back in 1987, ‘You can see the computer age everywhere but in the productivity statistics.’ Part of the issue is that productivity is measured in currency terms. If the price of a computer remains unchanged for a decade but its capacity to compute increases 10-fold over the same period, absent new buyers of computers, new sales are replacements. In this scenario, the improvement in productivity does not lead to an uptick in economic growth, but it does demonstrably improve our standard of living.

Looking ahead the impact of machine learning and artificial intelligence is just beginning to be felt. Meanwhile, advances in robotics, always a target of the Luddite fringe, have been significant during the last decade, spurred on by the truncation of global supply chains in the wake of the great financial crisis. This may be to the detriment of frontier economies but the developed world will reap the benefit of cheaper goods.

Central Bank Omnipotence

When Paul Volcker assumed the helm of the Federal Reserve in the late 1970’s, inflation was eroding any gains from investment in government bonds. Armed with Friedman’s monetary theories, the man who really did remove the punch-bowl, raised short-term rates to above the level of CPI and gradually forced the inflation genie back into its bottle.

After monetary aggregate targets were abandoned, inflation targeting was widely adopted by many central banks, but, as China joined the WTO (2001) and exported their comparative advantage in labour costs to the rest of the world, those same central bankers’, with Chairman Bernanke in the vanguard, became increasingly petrified by the prospect of price deflation. Memories of the great depression and the monetary constraints of the gold exchange standard were still fresh in their minds. For an economy to expand, it was argued, the supply of money must expand in order to maintain the smooth functioning of markets: a lack of cash would stifle economic growth. Inflation targets of around 2% were deemed appropriate, even as technological and productivity related improvements insured that the prices of many consumer goods actually declined in price.

Inflation and deflation can be benign or malign. Who does not favour a stock market rally? Yet, who cares to witness their grocery bill spiral into the stratosphere? Who cheers when the latest mobile device is discounted again? But does not panic when the value of their property (on which the loan-to-value is already a consumption-sapping 90%) falls, wiping out all their equity? Blunt inflation targeting is frankly obtuse, but it remains the mandate of, perhaps, the most powerful unelected institutions on the planet.

When economic historians look back on the period since the collapse of the Bretton Woods agreement, they will almost certainly conclude that the greatest policy mistake, made by central banks, was to disregard asset price inflation in their attempts to stabilise prices. Meanwhile, in the decade ahead, upside breaches of inflation targets will be largely ignored, especially if growth remains anaemic. Central bankers’, it seems, are determined to get behind the curve, they fear the severity of a recession triggered by their own actions. In the new era of open communications and forward guidance they are reticent to increase interest rates, too quickly or by too great a degree, in such a heavily indebted environment. I wrote more about this in November 2018 in The Self-righting Ship – Debt, Inflation and the Credit Cycle: –

The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.

Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying ‘this time it’s different,’ the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.

Conclusions and Investment Opportunities

There have been several drivers of disinflation over the past decade including a tightening of bank regulation, increases in capital requirements and relative fiscal austerity. With short-term interest rates near to zero in many countries, governments will find themselves compelled to relax regulatory impediments to credit creation and open the fiscal spigot, at any sign of a recession, after all, central bank QE appears to have reached the limits of its effectiveness. The table below shows the diminishing returns of QE over time: –

QE effect

Source: M&G, Deutsche Bank, World Bank

Of course the central banks are not out of ammunition just yet, the Bank of Japan experiment with qualitative easing (they currently purchase ETFs, common stock may be next on their agenda) has yet to be adopted elsewhere and the Federal Reserve has so far resisted the temptation to follow the ECB into corporate bond acquisition.

For the US bond market the next decade may well see yields range within a relatively narrow band. There is the possibility of new record lows, but the upside is likely to be constrained by the overall indebtedness of both the private and public sector.

Fragility – what the US money-market squeeze means for the future
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Fragility – what the US money-market squeeze means for the future

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Macro Letter – No 122 – 18-10-2019

Fragility – what the US money-market squeeze means for the future

  • Last month’s squeeze in overnight domestic US$ funding rattled markets
  • The Fed responded rapidly but the problem has been growing for some time
  • Market fragility stems from problems in the transmission mechanism

At the end of October the Federal Reserve are expected to announce the details of their latest balance sheet expansion, this will follow the FOMC meeting. Fed watchers estimate the central bank will buy between $250bln and $330bln of Treasury bills in their effort to provide sufficient reserves to keep the benchmark Effective Federal Funds Rate (EFFR) within its target range. The allocation of liquidity is unlikely to be even, but the Fed has indicated that it will purchase $60bln/month and that they will continue until at least Q2 2020. They are making an unequivocal statement. Let us not forget that it is the traditional function of a central bank, to lend freely against good collateral. The fact that estimates do not exceed $330bln is due to perception that the Fed will not wish the markets to regard these money-market operations as tantamount to QE.

The markets are feverish with speculation, some commentators calling it a further round of QE, despite official statements to the contrary. The money-markets have been unsettled ever since the cash-crunch which occurred in mid-September. For once I concur with the Fed, that this is the management of liquidity via market operations, it is entirely different from the structural effect of longer-term asset purchases. George Selgin of the Cato Institute has coined the acronym SOAP – Supplementary Organic Asset Purchases – nonetheless, this additional liquidity has the effect of expanding the Fed balance sheet and expanding the monetary base. Perception will be all.

Spikes in overnight lending rates are not unusual, especially around tax payment dates, what is unsettling is the challenge the Fed has encountered trying to keep the EFFR within the Fed Funds target range for several days after the initial squeeze. The implementation of SOAP (or whatever they choose to call it) undoubtedly amounts to a further easing of conditions. The Fed may manage expectations by slowly the pace of easing in official rates, after all, what is the point in lowering official rates only to have your good intentions high-jacked by the money-market?

The chart below shows the Fed Fund Effective Rate over the last year (you will note the spike during September): –

Fed Effective Rate - 1yr

Source: Federal Reserve Bank of New York

At the same time the Secured Overnight Funding Rate (SOFR) spiked more wildly: –

SOFR YTD

Source: Federal Reserve Bank of New York

It is important to note that, while the EFFR squeezed higher, SOFR actually spiked more than the chart above indicates, rising from 2.19% to 9% on September 17th. The following day the Fed increased its holdings of Repos from $20bln to $53bln, it also officially cut the Fed Funds target rate by 25bp to 1.75%. On Wednesday 18th the Fed Repo balance rose again to $75bln, by Monday 23rd those balances had reached $105bln.

There are numerous theories about the stubbornness of money-market rates to moderate. Daniel Lacalle writing for Mises – The Repo Crisis Shows the Damage Done by Central Bank Policies – observes: –

What the Repo Market Crisis shows us is that liquidity is substantially lower than what the Federal Reserve believes, that fear of contagion and rising risk are evident in the weakest link of the financial repression machine (the overnight market) and, more importantly, that liquidity providers probably have significantly more leverage than many expected.

In summary, the ongoing — and likely to return — burst in the repo market is telling us that risk and debt accumulation are much higher than estimated. Central banks believed they could create a Tsunami of liquidity and manage the waves. However, like those children’s toys where you press one block and another one rises, the repo market is showing us a symptom of debt saturation and massive risk accumulation.

…what financial institutions and investors have hoarded in recent years, high-risk, low-return assets, is more dangerous than many of us believed.

A different opinion about the root of the Repo problem is provided by Alasdair Macleod, also writing for Mises – The Ghosts of Failed Banks Have Returned: –

The reason for its failure has little to do with, as some commentators have suggested, a general liquidity shortage. That argument is challenged by the increase in the Fed’s reverse repos from $230bn in October 2018 to $325bn on 18 September, which would not have been implemented if there was a general shortage of liquidity. Rather, it appears to be a systemic problem; another Northern Rock, but far larger. Today we call such an event a black swan.

The author goes on to suggest that a large non-US bank may be the cause of the issue. Inevitably Deutsche Bank’s name is mentioned.

I believe the issue stems from a number of different factors. Firstly, the Fed is far more central to the banking system today, especially since they elected to pay interest on bank deposits. Secondly, the banks have been wary of lending to corporates, or to one another, they are therefore more beholden to the Fed. Finally, the void created by the banks refusing, or being unable, to lend to the real economy has been filled by private capital, provided by hedge funds, money market funds and synthetic ETFs – these latter instruments have balances in excess of $4trln.

These new sources of funding cannot access the SOFR market directly, they must intermediate with the 24 broker-dealers with whom the Fed transact open market operations. Any hint of a bank being in difficulty will see these shadow-bankers move assets from that institution rapidly, causing the institution concerned (if it can) to make a dash for the Repo market and the succour of the Fed.

Macleod suggests other factors which might have contributed to the SOFR squeeze, including: –

…Chinese groups are shedding $40bn in global assets… domestic funding requirements faced by Saudi Arabia in the wake of the attack on her oil refining facilities, almost certainly being covered by the sale of dollar balances in New York.

…with $307.9bn withdrawn in the year to July, foreign withdrawals appear to be a more widespread problem than exposed by current events.

Enough of speculation, the official explanation is contained in this article from the Chicago Fed – Understanding recent fluctuations in short-term interest rates: –

Two developments in mid-September put stress on overnight funding markets. First, quarterly tax payments for corporations and some individuals were due on September 16. Over a period of a few days, these taxpayers took more than $100 billion out of bank and money market mutual fund accounts and sent the money to the U.S. Treasury. Second, the Treasury increased its long-term debt by $54 billion by paying off maturing securities and issuing a larger quantity of new ones. (A reduction in short-term Treasury bills outstanding partly offset the increase in long-term debt.) Buyers of the new debt paid for it by withdrawing money from bank and money market accounts. Combined with the tax payments, the debt issuance reduced the amount of cash in the financial system.

At the same time as liquidity was diminishing, the Treasury debt issuance caused financial institutions to need more liquidity. A substantial share of newly issued Treasury debt is typically purchased by securities dealers, who then gradually sell the bonds to their customers. Dealers finance their bond inventories by using the bonds as collateral for overnight loans in the repo market. The major lenders of cash in that market include banks and money market funds—the very institutions that had less cash on hand as a result of taxpayers’ and bond buyers’ payments to the Treasury.

With more borrowers chasing a reduced supply of funding in the repo market, repo interest rates began to rise on September 16 and then soared on the morning of September 17, reaching as high as 9% in some transactions—on a day when the FOMC was targeting a range of 2% to 2.25% for the fed funds rate.

Pressures in the repo market then spilled over to other markets, such as fed funds, as lenders in those markets now had the option to chase the high returns available in the repo market. In addition, when banks experience large outflows as a result of tax payments or Treasury issuance, they may seek to make up the money by borrowing overnight in the fed funds and other markets, putting additional pressure on rates there. The fed funds rate reached 2.25%, the top of the FOMC’s target range, on September 16 and 2.30% on September 17.

Here, is a chart showing the change in SOFR and EFFR over the last five years (you will notice that on none of these charts does the transaction struck at 9% ever appear – perhaps they do not want to frighten the horses): –

SOFR and EFFR

Source: Chicago Federal Reserve Bank

In their discussion of how the Fed responded (on September 17th) to the squeeze the authors point out: –

…the (Fed) Desk offered $75 billion in repos, primary dealers bid for only $53 billion. On the margin, this meant that primary dealers were forgoing the opportunity to borrow at the operation’s minimum bid rate of 2.1% and lend money into repo markets that were still trading at much higher rates. This outcome suggests that there could be some limits to primary dealers’ willingness to redistribute funding to the broader market.

They suggest that this may be a function of the level of leverage already in the banking system. By September 19th the Fed were compelled to lower the interest rate on excess reserves – IOER. Finally the relationship between EFFR and SOFR returned to its normal range.

According to the authors the Fed have learnt from their hysteresis that adjustments to the IOER are also critical to control of money-markets, repo operations may not be sufficient in isolation. The chart below shows the spread between SOFR and IOER: –

IOER - SOFR

Source: Chicago Federal Reserve Bank

This is how the Fed describes the evolution of the relationship (the emphasis is mine): –

When the repo rate is below the interest rate on reserves, as it generally was from 2015 through March 2018, the supply of liquidity is so great that Treasury securities are very easy to finance and have a lower effective overnight yield than reserves. From March 2018 through March 2019, repo rates were generally very close to the interest rate on reserves. Then, beginning in the second quarter of 2019, repo rates ticked above the interest rate on reserves. Around the same time, money market rates started to exhibit slightly more upward pressure near tax payment deadlines. Most recently, just before the volatility in mid-September, the spread between SOFR and IOER on September 13 was the highest yet on the business day before a tax date in the period since the FOMC began normalizing monetary policy in late 2015.

This confirms my suspicion that since the financial crisis the Fed (and central banks in general) have become far more central to the smooth functioning of the financial markets. Actions such as QE are clear, the function of the lender of last resort is less so. Professor Perry Mehrling’s – The New Lombard Street (published in 2010 the wake of the financial crisis) discusses the changed role of the Fed in detail, it is well worth re-reading.

Conclusions

I normally end my newsletters with an investment proposal. This time my advice is of a different nature. During the financial crisis central banks saved the global financial system, but, as last month’s’ SOFR Squeeze makes clear, the patient is still on life support. The solution to too much debt has been the reduction of interest rates, but, because lower rates make debt financing easier, this has led to an even greater system-wide burden of debt. In the process the role of the central bank has become far more pivotal. They have reaped what they sowed, the financial markets still function, but they remain inherently fragile. If the Fed analysis of the reasons for the price spike are correct, a relatively small imbalance may, on another occasion, derail the entire market.

The advice? Batten down the hatches, maintain excess liquidity and prepare for the next stress-test of the overnight lending market.

Uncertainty and the countdown to the US presidential elections
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Uncertainty and the countdown to the US presidential elections

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Macro Letter – No 120 – 13-09-2019

Uncertainty and the countdown to the US presidential elections

  • JP Morgan analyse the impact of 14,000 presidential Tweets
  • Gold breaks out to the upside despite US$ strength
  • China backs down slightly over Hong Kong
  • Trump berates Fed Chair and China

These are just a few of the news stories which drove financial markets during the summer: –

VOX – The Volfefe Index, Wall Street’s new way to measure the effects of Trump tweets, explained

DailyFX – Gold Prices Continue to Exhibit Strength Despite the US Dollar Breakout

BBC – Carrie Lam: Hong Kong extradition bill withdrawal backed by China

FT – Trump lashes out at China and US Federal Reserve — as it happened.

For financial markets it is a time of heightened uncertainty. The first two articles are provide a commentary on the way markets are evolving. The impact of social media is rising, with Trump in the vanguard. Geopolitical uncertainty and the prospect of fiscal debasement are, meanwhile, upsetting the normally inverse relationship between the price of gold and the US$.

The next two items are more market specific. The stand-off between the Chinese administration and the people of the semi-autonomous enclave of Hong Kong, prompts concern about the political stability of China, meanwhile the US Commander in Chief persists in undermining the credibility of the notionally independent Federal Reserve and seems unable to resist antagonising the Chinese administration as he raises the stakes in the Sino-US trade war. Financial markets have been understandably unsettled.

Ironically, despite the developments high-lighted above, during August, US bonds witnessed sharp reversals lower, suggesting that geopolitical tensions might have moderated. Since the beginning of September prices have rebounded, perhaps there were simply more sellers than buyers last month. In Europe, by contrast, German bunds reached new all-time highs, only to suffer sharp reversal in the past week. Equity markets responded to the political uncertainty in a more consistent manner, plunging and then recovering during the past month. As the chart below illustrates, there has been increasing debate about the challenge of increased volatility since the end of July: –

VIX Index Daily

Source: Investing.com

Yet, as always, it is not the volatility or even risk which presents a challenge to financial market operators, it is uncertainty. Volatility is a measure derived from the mean and variance of a price. It is a cornerstone of the measurement of financial risk: the key point is that it is measurable. Risk is something we can measure, uncertainty is that which we cannot. This is not a new observation, it was first made in 1921 by Frank Knight – Risk, Uncertainty and Profit.

Returning to the current state of the financial markets, we are witnessing a gradual erosion of belief in the omnipotence of central banks. See Macro Letter’s 48, 79 and 94 for some of my previous views. What has changed? As Keynes might have put it, ‘The facts.’ Central Banks, most notably the Bank of Japan, Swiss National Bank and European Central Bank, have been using zero or negative interest rate policy, in conjunction with balance sheet expansion, in a valiant attempt to stimulate aggregate demand. The experiment has been moderately successful, but the economy, rather like a chronic drug addict, requires an ever increasing fix to reach the same high.

In Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory – I discussed the latest scientific justification for debasement. My conclusion: –

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

As this recent article from the Federal Reserve Bank of San Francisco – Negative Interest Rates and Inflation Expectations in Japan – indicates, even central bankers are beginning to doubt the efficacy of zero or negative interest rates, albeit, these comments emanate from the FRBSF research department rather than the president’s office. If the official narrative, about the efficacy of zero/negative interest rate policy, is beginning to change, state sponsored fiscal stimulus will have to increase dramatically to fill the vacuum. The methadone of zero rates and almost infinite credit will be difficult to quickly replace, I anticipate widespread financial market dislocation on the road to fiscal nirvana.

In the short run, we are entering a period of transition. Trump may continue to berate the chairman of the Federal Reserve and China, but his room for manoeuvre is limited. He needs Mr Market on his side to win the next election. For Europe and Japan the options are even more constrained. Come the next crisis, I anticipate widespread central bank buying of stocks (in addition to government and corporate bonds) in order to provide liquidity and insure economic stability. The rest of the task will fall to the governments. Non-inflationary fiscal profligacy will be de rigueur – I can see the politicians smiling all the way to the hustings, safe in the knowledge that deflationary forces have awarded them a free-lunch. Someone, someday, will have to pay, of course, but they will be long since retired from public office.

Conclusions and Investment Opportunities

During the next year, markets will continue to gyrate erratically, driven by the politics of European budgets, Brexit and the Sino-US trade war. These issues will be eclipsed by the twittering of Donald Trump as he seeks to win a second term in office. Looked at cynically, one might argue that Trump’s foreign policy has been deliberately engineered to slow the US economy and hold back the stock market. During the next 14 months, a new nuclear weapons agreement could be forged with Iran, relations with North Korea improved and a trade deal negotiated with China. Whether this geopolitical largesse is truly in the President’s gift remains unclear, but for a maker of deals such as Mr Trump, the prospect must be tantalising.

For the US$, the countdown to the US election remains positive, for stocks, likewise. For the bond market, the next year may be broadly neutral, but given the signs of faltering growth across the globe, it seems unlikely that yields will rise significantly. Economies will see growth slow, leading to an accelerated pace of debt issuance. Bouts of volatility, similar to August or Q4 2018, will become more commonplace. I remain bullish for asset markets, nonetheless.

AIER -U.S. Dollar Supremacy Could Quickly Fade
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AIER -U.S. Dollar Supremacy Could Quickly Fade

American Institute for Economic Research

U.S. Dollar Supremacy Could Quickly Fade

As you may have seen elsewhere I have recently been invited to contribute to AIER. This article was first published in June.

https://www.aier.org/article/us-dollar-supremacy-could-quickly-fade

dollarfade

AIER also operate the Bastiat Society, a global network of business professionals committed to advancing free trade, individual freedom, and responsible governance. To find a chapter near you please click on the link below: –

https://www.aier.org/bastiatsociety/chapters

 

 

Chinese currency manipulation – Trump’s petard
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Chinese currency manipulation – Trump’s petard

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Macro Letter – No 119 – 23-08-2019

Chinese currency manipulation – Trump’s petard

  • The risk that the Sino-US trade war morphs into an international currency war has risen
  • The US$ Index is up since 2010 but its only back to the middle of it range since 2000
  • The Chinese Yuan will weaken if the Trump administration pushes for higher tariffs
  • Escalation of domestic unrest in Hong Kong will see a flight to safety in the greenback

According to the US President, the Chinese are an official currency manipulator. Given that they have never relaxed their exchange controls, one must regard Trump’s statement as rhetoric or ignorance. One hopes it is the former.

Sino-US relations have now moved into a new phase, however, on August 5th, after another round of abortive trade discussions, the US Treasury officially designated China a currency manipulator too. This was the first such outburst from the US Treasury in 25 years. One has to question their motivation, as recently as last year the PBoC was intervening to stem the fall in their currency against the US$, hardly an uncharitable act towards the American people. As the Economist – The Trump administration labels China a currency manipulator – described the situation earlier this month (the emphasis is mine): –

After the Trump administration’s announcement of tariffs on August 1st added extra pressure towards devaluation, it seems that the PBOC chose to let market forces work. The policymaker most obviously intervening to push the yuan down against the dollar is Mr Trump himself.

China does not meet the IMF definition of a ‘currency manipulator’ but the US Treasury position is more nuanced. CFR – Is China Manipulating Its Currency? Explains, although they do not see much advantage to the US: –

Legally speaking, the issue of whether China meets the standard for manipulation set out in U.S. law is complex. The 2015 Trade Enforcement Act sets out three criteria a country must meet to be tagged a manipulator: a bilateral surplus with the United States, an overall current account surplus, and one-sided intervention in the foreign-exchange market to suppress the value of its currency. The Treasury Department’s most recent report [PDF] concluded that China only met the bilateral surplus criterion.

But the 1988 Omnibus Foreign Trade and Competiveness Act [PDF] has a different definition of manipulation, saying it can emerge either from action to “[impede] effective balance of payments adjustments” or action to “[gain an] unfair competitive advantage in international trade.” The United States is likely to argue that the recent depreciation was intended to give Chinese exports an edge. China would counter that it has no obligation to resist market pressures pushing the yuan down when the United States implements tariffs that hurt China’s exports.

In the past (2003-2013) China has intervened aggressively to stem the rise of its currency, since then it has intervened in the opposite direction, to the benefit of the US. Earlier this month it briefly appeared to withdrawn from the foreign exchange market, allowing the markets to set their own level based on perceptions of risk. As the Peterson Institute – Trump’s Attack on China’s Currency Policy – puts it: –

This depreciation is due to market forces: Trump’s tariffs push the dollar up against all currencies, the Chinese currency weakens as a result of the trade hit, and China will undoubtedly lower its interest rates to counter that slowdown. There is no evidence that China has sold renminbi for dollars to overtly push its exchange rate down.

Since the inflammatory pop above 7 Yuan to the US$, China has sought to calm frayed nerves, indicating that it wishes to maintain the US$ exchange rate at around current levels: nonetheless, a pre-US election sabre has been rattled.

Speculation about the next move by the Trump administration is, as always, rife, but the consensus suggests the ‘currency manipulator’ label may be used to justify an escalation of US tariffs on Chinese goods. In this new scenario, every tariff increase by the US, will precipitate a decline in the Yuan; it will be a zero-sum game, except for the US importer who will have to foot the bill for the tariffs or pass them on to the consumer. Either a weaker Yuan will mitigate their effect or the tariffs will bite, leading to either a slowdown in consumption or higher prices, or possibly both.

Barring a weaker Yuan, this sequence of events could also threaten the independence of the Federal Reserve. The central bank will be torn between the opposing policies required to meet the dual mandate of price stability and full employment. In the worst case, prices will be rise as employment falls.

Current estimates of the increased cost of tariffs to the US economy are in the region of 10%, yet during the past year the Yuan has already declined from 6.3 to 7 (11%). As the chart below shows, a move back towards 8 Yuan to the US$ cannot be ruled out, enough to significantly eclipse the impact of US tariffs to date: –

china-currency 1993-2019

Source: Trading Economics

Conclusions and investment opportunities

In the run-up to the November 2020 presidential election, US foreign policy towards China is likely to remain confrontational. China, as always, has the ability to play the long game, although the political tensions evident in Hong Kong may highjack even their gradualist agenda. Either way, the Yuan is liable to weaken, pressurising other Asian currencies to follow suit. The US$ may appear relatively strong of late but, as the chart below shows, it is more than 50% below its 1980’s peak: –

united-states-currency

Source: Trading Economics

A move above the 2016 highs at 103 would see the US$ Index push towards the early 2000’s highs at 120.

The US bond yield curve has been steadily inverting, a harbinger, some say, of a recession. The other interpretation is that US official rates are much too high. Relative to other developed nations US Treasury yields certainly offer value. I expect the Fed to cut rates and, if inflation rises above the 2% level, expect them to point to tariff increases as a one-off inflation effect. They will choose to target full-employment over price stability.

Barring a catastrophe in Hong Kong, followed a US military response (neither of which can be entirely ruled out) any risk-off weakening of stocks, offers a buying opportunity. Further down the road, when US 10yr bond yields turn negative, stocks will trade on significantly higher multiples.

A global slowdown in 2019 – is it already in the price?
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A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.