A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

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Macro Letter – No 128 – 17-04-2020

A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

  • A European fiscal spending package worth Euro 540bln has been agreed
  • Eurozone bonds have crashed and recovered
  • Corona Bonds have been found unnecessary
  • The issue of Eurozone backed Eurobonds will not go away

On April 9th the Eurogroup of Finance Ministers eventually agreed upon a three-pronged package to avert some of the economic impact of the Covid-19 pandemic. For financial markets this was a relief, had the Eurogroup broken up, for the second time in a week, without a deal markets would have reacted badly. The three-pronged package included health expenditure funding from the European Stability Mechanism (ESM), loans for businesses from the European Investment Bank (EIB) and further funding from the European Commission’s unemployment fund. The total package is a modest Euro 540bln, the political ramifications are much less so.

What was not agreed, despite the unprecedented circumstances surrounding the pandemic, was a collective pooling of Eurozone (EZ) resources in the form of ‘Eurobonds,’ deftly renamed ‘Corona Bonds,’ by their advocates. For the fiscally responsible countries of Northern Europe, even the current crisis was insufficient for them to contemplate underwriting the prodigal South.

The compromise, agreed last week, included the use the ESM. The ESM itself, together with the outright monetary transactions (OMT) undertaken by the ECB, were forged in the 2010/2012 Eurozone crisis. At that time the convergence of Eurozone government bond yields, which had begun long before the advent of the Euro, was unravelling as investors realised that Europe would not collectively underwrite any individual state’s obligations. The North/South divide became a chasm, with Greek, Portuguese, Italian and Spanish bond yields rising sharply whilst German, Dutch and Finnish yields declined. The potential default of a Eurozone government was only averted by the actions of the then President of the ECB, Mario Draghi, when he stated that the central bank would do, ‘Whatever it takes.’

Once again, a motley deal has been forged, recriminations will follow. Whilst lower government financing costs remain a major attraction of EZ membership for newer members of the EU, the benefit is by no means guaranteed, as this 2017 paper – Eurozone Debt Crisis and Bond Yields Convergence: Evidence from the New EU Countries – by Minoas Koukouritakis, reveals: –

Based on the empirical results, there is some clear evidence of strong monetary policy convergence for each of the Czech Republic, Lithuania and Slovakia to Germany. Alternatively, under the UIP and ex-ante relative PPP conditions, the expected inflation rate of these three countries has converged to the expected inflation rate of Germany. This is an expected result not only because Lithuania and Slovakia are already Eurozone members, but also because Germany plays a very important role in the economies of these three countries. Furthermore, the empirical results provide evidence of weak monetary policy convergence for each of Croatia and Romania to Germany. In contrast, for the remaining seven new EU countries, namely Bulgaria, Cyprus, Hungary, Latvia, Malta, Poland and Slovenia, the empirical evidence suggests yields’ divergence for each of these countries in relation to Germany. For Cyprus, Latvia and Slovenia, which as Eurozone members they have common monetary policy with Germany, the empirical evidence could probably be attributed to the increased sovereign default risk of these countries, which in turn led to large and persistent risk premia.

In summary, the empirical evidence indicates that in the context of the Eurozone debt crisis, even though Germany has established its dominance and sets the macroeconomic policies in the Eurozone, several new EU countries are unable to follow these policies. And this conclusion addresses once more the issue of core-periphery in the Eurozone and, thus, the Eurozone’s future prospects.

The past six weeks has seen a global fiscal response to the pandemic. Stock markets have declined and credit spreads in corporate bond markets have widened. In European government bonds the pattern has been similar, the migratory flight to quality saw flocks of investors head north, especially into Switzerland and Germany. The simplified chart below shows three data points;

March 9th, when German Bund yields reached their recent nadir,

March 18th, the date investors became spooked by the sheer magnitude of the fiscal response required by EZ governments: and

April 14th, the day on which Italy and Spain announced the first relaxation their lockdown restrictions: –

European Bond Spread chart March April 2020

Source: Trading Economics, Investing.com

There are several observations; firstly, even as the lockdown comes towards its end, bond yields are higher, reflecting concerns about the impact of fiscal spending on government budgets as tax receipts collapse. Secondly, German Bund yields are now lower than Swiss Confederation bonds, despite expectations that Germany may end up footing the bill for the lion’s share of government borrowing across the EZ. This may be a reflection of the lower percentage fatality rate in Germany – 2.5% versus 4.4% in Switzerland – or simply a function of the greater liquidity available in the German bond market.

A third observation concerns the higher yielding countries of Greece, Italy, Portugal and Spain. Despite a larger number of Covid-19 infections, Spanish Bonos have maintained their lower yield relative to Italian BTPs, meanwhile, Greek bonds have converged towards Italy and Portuguese bonds trade within 4bp of Spain.

Convergence, divergence and political will

This is not the first macro letter on the topic of EZ bond convergence, the chart below is taken from Macro Letter – No 10 – 25-04-2014 – The Limits Of Convergence – Eurozone Bond Yield Compression Cracks the second of eight previous articles on subject: –

European Bond Yields - 2005 - 2014 - Bloomberg

Source: Bloomberg

At that time I suggested three scenarios: –

  1. Full Banking Union and further federalisation of Europe
  2. Full Banking Union but limitation of federalisation
  3. Eurozone break-up

The EZ crisis had finally disapated but the full impact of QE had not yet been appreciated, the table below shows the yield to maturity and spread over German Bunds of the 10 year bonds of Italy, Spain, Greece and Portugal traded on 24th April 2014 (roughly six years ago): –

Spreads in April 2014

Source: Bloomberg

In April 2014 I saw the second scenario as most likely. I anticipated limited ‘Eurobond’ issuance, this has not yet come to pass, but last week’s stimulus looks like a federal bail-out by any other name. Last month, as the Covid-19 pandemic took hold, the spread between German Bunds and Spanish Bonos touched 1.54%, whilst the spread against Greek bonds reached 4.22% and Portugal, 1.75%. Only Italy fared less well, the Bund/BTP spread reached 3.15; a marked deterioration since 2014.

Conclusions and Investment Opportunities

By the time I penned Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? it was becoming clear that Italy was the focus of concern among fixed income investors. I concluded (a little too late) that: –

Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero.

The spread never returned to parity.

When I last wrote about EZ bonds, I focussed once again on Italy in Macro Letter – No 98 – 08-06-2018 – Italy and the repricing of European government debt. BTP yields had risen to a spread of 1.22% over Spanish Bonos and I expected a retracement. As the chart below reveals, BTP yields rose further before than regained composure: –

Spanish BONO vs Italian BTP 10yr Yield Spread Chart - March 31st 2020

Source: Y-Charts

Eurobonds are still not on the agenda even in a time of pandemic, therefore, Italian indebtedness remains the single greatest risk to the stability of the EZ. The convergence trade is fraught with geopolitical risk as cracks in the European Project are patched and papered over. Now is not the time for revolution, but the ongoing fiscal strain of the pandemic means the policy of issuing Eurobonds backed by a European guarantor will not go away. I expect EZ government bond yield compression accompanied by occasional violent reversals to become the pattern during the next few years, together with increasing political tension between European countries north and south.

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

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Macro Letter – No 127 – 13-03-2020

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

  • As the COVID-19 pandemic gathers momentum, history offers too few data points
  • The Spanish Flu is the nearest comparison – similarities are matched by differences
  • Clinical trials have started, but the rise in new cases is slowing in China already
  • Global economic growth will suffer, but monetary and fiscal stimulus should support stocks

As I write this article I am conscious that the Coronavirus is a very real and global tragedy. In all that follows I do not wish to detract from the dreadful human cost of this disaster in any way.

Putting the current pandemic in perspective, according to a 2017 estimate from the US Center for Disease Control, in a normal year, seasonal flu kills 291,000 to 646,000 globally. By contrast, the fatality rate for coronavirus seems to have stabilised at around 3.6% of those diagnosed. Of course, a more heartening figure of 0.79% can be found in South Korea which has tested almost 10 times more of its population than other country:-

Testing for COVID-19 - 9-3-2020 - Worldometer.com

Source: Worldometer.com

Suffice to say the current statistics are still confusing at best, but they are all we have to work with.

In a recent interview Dr Soumaya Swaminathan of the World Health Organisation (WHO) provided some insights (emphasis is mine): –

Of 44,000 Wuhan patients 80% had very mild symptoms, 15% of cases are severe and 5% critical. In terms of transmission rates, the R0 is still just an estimate of between 2 and 3 – in other words for every carrier between two and three people are infected.

…Two drugs, an antiretroviral called Lopinavir-ritonavir and an experimental drug used in the treatment of Ebola – Remdesivir, manufactured by Gilead (GILD) – are being tested in China where more than 80 clinical trials are already underway. The development of an effective vaccine it several months away. 

It was reported today (11-3-2020) that Gilead has begun trails with US nationals and signed a deal with the US military.

Market Impact

Given the continued lack of clarity about COVID-19 in terms of numbers infected and numbers suffering, it may seem futile to attempt to gauge the potential economic impact of the current Coronavirus outbreak. History, however, may be able to provide some guidance to investors who might otherwise be tempted to liquidate and hibernate, especially after the dramatic decline this week in the wake of Saudi Arabia’s decision to turn its back on the OPEC cartel.

In order to begin this assessment, there are a vast array of factors which need to be considered. Here are just a few: –

  1. Speed of spread – higher in urban areas due to population density
  2. Urban versus rural population – generally a function of GDP per capita
  3. Likelihood of a cure or vaccine – the majority of estimates range from three months to a year (hopefully it was be sooner)
  4. Health of demographic cohorts by country – a function of average age and GDP per capita
  5. Average income – also a function of GDP per capita
  6. Extent of healthcare coverage – generally a function of GDP (although European welfare arrangements are more developed than those of the US)

Each of these factors are complex and warrant an essay to themselves. Suffice to say, the economic impact is already becoming evident. Schools, factories and offices are closing. Those workers that can are beginning to work remotely. At the extreme, entire cities, towns and countries are being subjected to lock-downs. In these conditions, economic activity inevitably suffers, this is a supply and demand shock combined. The price of crude oil has already responded, encouraged by the actions of Saudi Arabia, it has collapsed. Transportation activity has been substantially reduced. Economic indicators from China point to a pronounced contraction in 2020 GDP growth. Will the pattern seen in China be repeated elsewhere? Are the nascent indications of a resumption of economic activity now evident in China a reliable indication of the speed of recovery to be expected elsewhere? The jury is still out.

For G20 countries the effect of the 2008/2009 financial crisis still lingers. According to a BIS report more than 12% of developed nation firms generate too little income to cover their interest payments. Meanwhile, at the individual level, the Federal Reserve estimates that more than 10% of American adults would be unable to meet a $400 unexpected expense, equivalent to around two days’ work at average earnings. There is concern among governments that people may start to hoard cash if the crisis deepens.

Where the viral epidemic began, in China, the Purchasing Managers Index for February was the lowest since the series began in 2004. According to China Beige Book’s flash survey for February, 31% of companies were still closed and many of those that have reopened lacked staff or materials. Other estimates suggest that between 40% and 50% of the China’s truck fleet remains idle – those essential materials are unlikely to be delivered anytime soon. This supply-shock slowdown has inevitably fuelled expectations of an actual contraction in the size of the Chinese economy, the first shrinkage since the death of Mao Zedong in 1976: –

China PMI

Source: Trading Economics

Everywhere GDP forecasts are being revised lower: –

Economist GDP revisions from Q4 2019 to Q1 2020 OECD

Source: Economist

Policy Response

For the world’s governments there are essentially three policy responses: –

  1. Provision of credit via banks and money markets – central banks are doing what they can
  2. Aid to corporates to meet fixed costs, such as rent and tax bills
  3. Protection of workers by subsidising wage costs

Central banks are limited in their ability to lend directly to firms, meanwhile the banking system, petrified by the recent widening of credit spreads for sub-investment grade debt, is likely to become a bottleneck. It will take more than gentle persuasion to force banks to lend new funds and reschedule existing non-performing loans. Other aid to corporates and individuals requires varying degrees of fiscal stimulus. Governments need to act quickly (today’s UK budget is an indication of the largesse to follow) it would also help if there were a coordinated global policy response.

The Peterson Institute – Designing an effective US policy response to coronavirus make the following suggestions: –

A first step is to lock in adequate public funding. In 2014, emergency funding of about $5.4 billion was provided to fight the Ebola outbreak. Much more than that should be provided today, given the apparently greater transmissibility of COVID-19 and the fact that it has already appeared in many locations around the United States and more than 60 countries around the globe.

…A classic recession involves a shortfall of demand relative to supply. In that more ordinary situation, economic policymakers know how to help fill in the missing demand. But this case is more complicated because it involves negative hits to both supply and demand.

No one knows how serious the economic damage from COVID-19 will be, so a key challenge is to design a fiscal countermeasure that clicks on when it’s needed and clicks off when it’s not. One approach that would fit that description would be to move immediately to pre-position a temporary cut in the payroll taxes that fund the Social Security and Medicare programs…

The final suggestion is a US-centric proposal, it is different from the income tax cut alluded to by President Trump and will directly benefit lower-income families, since healthcare costs will be a larger proportion of their after tax income. The authors’ propose a similar mechanism to click in when the unemployment rates rises and click off when re-employment kicks back in.

The table below shows actions taken by 4th March: –

Government response to COVID-19

Source: Economist

It is worth mentioning that Hong Kong, still reeling from the civil unrest of last year, has pressed ahead with ‘helicopter money’ sending cheques to every tax payer. This approach may be more widely adopted elsewhere over the coming weeks.

The Spanish Flu

In an attempt to find an historical parallel for the current Corona outbreak, there are only two episodes which are broadly similar, the Black Death of 1347 to 1351 and the Spanish Flu of 1918 to 1919. Data from the middle ages is difficult to extrapolate but it is thought that the Plague wiped out between 20% and 40% of Europe’s population. The world population is estimated to have fallen from 475mnl to between 350mln and 375mln. The world economy shrank, but, if data for England is any guide, per capita economic activity increased and the economic wellbeing of the average individual improved. For more on this topic I would recommend a working paper from the Federal Trade Commission – The English Economy Following the Black Death by Judith R. Gelman -1982.

The Spanish Flu of 1918 was the next global pandemic. It began in August of 1918, three month prior to the end of the First World War, and, by the time it had ended, in March of 1919, it had infected 500mln out of a global population of 1.8bln. The fatality rate was high, 40mln people lost their lives. Following the war, which cost almost 20mln lives, the combined loss of life was similar in absolute terms to the Black Death although in percentage terms the fatality rate was only 2%.

An excellent assessment of the Spanish epidemic can be found in the Economic Effects of the 1918 Influenza Pandemic – Thomas A. Garrett – Federal Reserve Bank of St Louis – 2007 – here are some key findings: –

The possibility of a worldwide influenza pandemic… is of growing concern for many countries around the globe. The World Bank estimates that a global influenza pandemic would cost the world economy $800 billion and kill tens-of-millions of people. Researchers at the U.S. Centers for Disease Control and Prevention calculate that deaths in the United States could reach 207,000 and the initial cost to the economy could approach $166 billion, or roughly 1.5 percent of the GDP. Longrun costs are expected to be much greater. The U.S. Department of Health and Human Services paints a more dire picture—up to 1.9 million dead in the United States and initial economic costs near $200 billion.

Despite technological advances in medicine and greater health coverage throughout the 20th century, deaths from a modern-day influenza pandemic are also likely to be related to race, income and place of residence.

The Spanish-flu was different from COVID-19 in that the highest mortality was among those aged 18 to 40 years and was often found among those with the strongest immune systems.

Garrett goes on to assess the economic impact with the aid stories from newspapers and the limited amount of previously published (and some unpublished) research. National statistics on unemployment and economic activity had yet to be compiled, but the simultaneous supply and demand shocks were broadly similar to the patterns we are witnessing today.

…One research paper examines the immediate (short-run) effect of influenza mortalities on manufacturing wages in U.S. cities and states for the period 1914 to 1919. The testable hypothesis of the paper is that

influenza mortalities had a direct impact on wage rates in the manufacturing sector in U.S. cities and states during and immediately after the 1918 influenza. The hypothesis is based on a simple economic model of the labor market: A decrease in the supply of manufacturing workers that resulted from influenza mortalities would have had the initial effect of reducing manufacturing labor supply, increasing the marginal product of labor and capital per worker, and thus increasing real wages. In the short term, labor immobility across cities and states is likely to have prevented wage equalization across the states, and a substitution away from relatively more expensive labor to capital is unlikely to have occurred.

The empirical results support the hypothesis: Cities and states having greater influenza mortalities experienced a greater increase in manufacturing wage growth over the period 1914 to 1919.

Another study explored state income growth for the decade after the influenza pandemic using a similar methodology. In their unpublished manuscript, the authors argue that states that experienced larger numbers of influenza deaths per capita would have experienced higher rates of growth in per capita income after the pandemic. Essentially, states with higher influenza mortality rates would have had a greater increase in capital per worker, and thus output per worker and higher incomes after the pandemic. Using state-level personal income estimates for 1919-1921 and 1930, the authors do find a positive and statistically significant relationship between state-wide influenza mortality rates and subsequent state per capita income growth.

Aside from wages, however the author concludes: –

…Most of the evidence indicates that the economic effects of the 1918 influenza pandemic were short-term. Many businesses, especially those in the service and entertainment industries, suffered double-digit losses in revenue. Other businesses that specialized in health care products experienced an increase in revenues.

How did financial markets react? The chart below shows the Dow Jones Industrial Average over the period from 1918 to 1923. The shaded areas indicate recessions: –

dow-jones- 1918 to 1923 Macrotrends

Source: Macrotrends

When reinvested dividends are included, the total return of the Dow Jones Industrial Average in 1918 was 10.5%, despite influenza wiping out 0.4% of the US population. Fears about a slowdown in economic activity, resulting from the end of WWI, were the underlying cause of the brief recession which coincided with the pandemic, the stock market had already reacted, dipping around 10% earlier in the year. The subsequent recession of 1920 had other causes.

As is evident from the chart below, the newly created (1913) Federal Reserve felt no compunction to cut interest rates: –

fredgraph

Source: Federal Reserve Bank of St Louis

US 10 year Treasury Bonds simply reflected the actions of the Federal Reserve: –

US Bonds Jan 1918 to Dec 1919

Source: ECB

One is forced to concede, financial markets behaved in a very different manner 100 years ago, but they may yet have something to teach us about the global impact of a pandemic – that it is an economic interruption rather than a permanent impediment to progress.

Conclusions and investment opportunities

Whilst there are similarities between the Spanish Flu of 1918 and the COVID-19 pandemic of today, there are also profound differences. Urban areas, for example, are expected to suffer higher fatalities than rural areas today. In 1919 only 51% of the population of the US was urban, today it is above 80%. Population density has also increased three-fold over the last century, if 500mln were infected in 2018/2019 then the comparable figure today would be 1.5bln. Changes in the ease of transportation mean that the spread of a pandemic will be much more rapid today than in the first quarter of the 20th century. Tempering this gloom, for many people, communications have transformed the nature of work. Many aspect of business can now be transacted remotely. Unlike in 1918 self-isolation will not bring commerce to a standstill.

The economic impact will also be felt more rapidly. Supply chains have been optimised for efficiency, they lack resilience. Central banks have already begun to cut interest rates (where they can) and provide liquidity. Governments have picked up the gauntlet with a range of fiscal measures including tax cuts and benefit payments.

Many commentators are calling the COVID-19 pandemic a Black Swan event, yet SARS (2003), H1N1 (2009), and MERS (2012) preceded this outbreak. Predictions that just such an event would occur have been circulating for more than a decade.

Financial markets have behaved predictably. The oil price has collapsed as Saudi Arabia has broken with the OPEC cartel, stocks have fallen (especially those related to oil) and government bonds have rallied. Gold, which saw significant inflows during the last few years, has vacillated as holders have liquidated to meet commitments elsewhere even as new buyers have embraced the time-honoured ‘safe haven.’ Looking ahead, we do not know how long this pandemic will last nor how widespread it will become. The two prior pandemics of a similar stature provide little useful guidance, the Spanish Flu lasted seven months, the Black Death, by contrast, spread over more than four years and was still flaring up into the 17th century.

Expectations of a cure and a vaccine remain a matter of conjecture, but epidemiologists suggest that within a year we will have a viable solution. At the time of writing (Wednesday 11th March) the total number of infections has reached 120,588, there have been 4,365 deaths while 66,894 patients have recovered – a 55.47% recovery rate, although the Chinese recovery rate has been steadily rising and now stands at 76.22%. The global fatality rate is 3.62%, whilst individual country fatality rates range from Italy at 6.22% to South Korea (where 210,000 people have been tested – ten times the per capita global average) at a heartening 0.79%. The WHO still expect the fatality rate to stabilise at around 1% which implies that 99% should eventually recover.

Whilst a larger correction in stocks should not be ruled out, the relative lack of selling pressure suggests that investors are prepared to reappraise their estimates of what price to earnings they will accept – remember interest rates have been cut and will probably be cut again. Where rates can be lowered no further, quantitative easing (including the purchase of stocks) and fiscal stimulus will aim to preserve value.

The historical evidence of the Spanish Flu suggests this pandemic will be short-lived. The recent market correction may prove sufficient but, with only two data points in more than 600 years, it is unwise to assume that it will not be different this time. Defensive equity strategies which focus on long-term value have been out of favour for more than a decade. Good companies with strong balance sheets and low levels of debt are well placed to weather any protracted disruption. They may also benefit from rotation out of index funds. When markets stabilise, the reduced level of interest rates will see a renewed wave of capital pouring into stocks. The only question today is whether there will be another correction or whether now is the time to buy.

When the facts change

When the facts change

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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

US Bonds – 2030 Vision – A decade in the doldrums

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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.

Uncertainty and the countdown to the US presidential elections

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.

Interest Rates, Global Value Chains and Bank Reserve Requirements

Interest Rates, Global Value Chains and Bank Reserve Requirements

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Macro Letter – No 117 – 28-06-2019

Interest Rates, Global Value Chains and Bank Reserve Requirements

  • Global Value Chains have suffered since 2009
  • Despite low interest rates, financial costs remain too high
  • Bank profitability has not recovered, yet banks are still too big to fail

In a recent speech, Hyun Song Shin, Head of Research at the BIS, discussed – What is behind the recent slowdown? The speech focused on the weakening of global value chains (GVC’s) in manufactured goods. The manufacturing sector is critical, since it accounts for 70% of global merchandise trade: –

During the heyday of globalisation in the late 1980s and 1990s, trade grew at twice the pace of GDP. In turn, trade growth in manufactured goods was driven by the growing importance of multinational firms and the development of GVCs that knit together the production activity of firms around the world.

The chart below reveals the transformation of the world economy over the past 17 years: –

The Arrival Of China 2000-2017

Source: BIS, X Li, B Meng and Z Wang, “Recent patterns of global production and GVC participation”, in D Dollar (ed), Global Value Chain Development Report 2019, World Trade Organization et al.

Hyun’s next chart tracks the sharp reversal in the relationship between world trade and GDP growth as a result of the Great Financial Crisis (GFC): –

Ratio of World Goods to GDP 2000 - 2018

Sources: IMF, World Economic Outlook; World Trade Organization; Datastream; national data; BIS calculations

The important point, highlighted by Hyun, is that the retrenchment in trade occurred almost a decade before the trade war began. China, growing at 6% plus, has captured an increasing share of global trade at the expense of the developed nations, most notably the US. Europe went through a similar transition during the second half of the 19th century, as the US transformed from an agrarian to an industrial society.

Returning to the present, supporting GVCs is capital intensive. Historically low interest rates have allowed these chains to flourish, but the recent reversal of interest rate policy by the Federal Reserve has caused structural cracks to emerge in the edifice. The BIS describes the situation for multi-national manufacturing firms in this way (the emphasis is mine): –

…firms enmeshed in global value chains could be compared to jugglers with many balls in the air at the same time. Long and intricate GVCs have many balls in the air, necessitating greater financial resources to knit the production process together. More accommodative financial conditions then act like weaker gravity for the juggler, who can throw many more balls into the air, including large balls that represent intermediate goods with large embedded value. However, when the shadow price of credit rises, the juggler has a more difficult time keeping all the balls in the air at once.

When financial conditions tighten, very long and elaborate GVCs will no longer be viable economically. A rationalisation of supply chains through “on-shoring” and “re-shoring” of activity towards domestic suppliers, or to suppliers that are closer geographically, will help reduce the credit costs of supporting long GVCs. 

It is interesting to note the use of the phrase ‘shadow price of credit,’ this suggests that concern about the intermediation process by which changes in the ‘risk-free’ rate disseminate into the real-economy. In a 2014 study, the BIS Committee on the Global Financial System (CGFS) found that 65% of world trade is still financed through ‘open account financing’ or through the buyer paying in advance. For GVC’s, short-term US interest rates matter, especially when 80% of trade finance is still transacted in the US$. Even when rates reached their nadir, banks were reluctant to lend at such favourable terms as they had prior to the GFC. The recent rise in short-term interest rates has supported the US$, accelerating the reversal in the trade to GDP ratio.

A closer investigation of bank lending since the GFC reveals structural weakness in the intermediation process. Since 2009, at the same time as interest rates fell, bank capital requirements rose. The impact of this fiscal offsetting of monetary accommodation can be seen most clearly in the global collapse the velocity of circulation of money supply: –

Global Money Velocity - Tom Drake, BEA, FRED, ECB, BoJ, China NBS, UK ONS

Source: Tom Drake, National Data, Macrobond

The mechanism by which credit reaches the real economy has been choked. Banks have gradually repaired their balance sheets, but the absurd incentives, such as the inducement to purchase zero risk-weighted government debt rather than lending to corporates, have been given fresh impetus through a combination of structurally higher capital requirements and lower interest rates.

In their January 2018 publication – Structural changes in banking after the crisis – the BIS examines how credit intermediation has changed (the emphasis is mine): –

The crisis revealed substantial weaknesses in the banking system and the prudential framework, which had led to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers…

There is no clear evidence of systematic and long-lasting retrenchment of banks from credit intermediation. The severity of the crisis was not uniform across banks and systems. Weaker banks cut back credit more strongly, and riskier borrowers saw their access to credit more tightly curtailed. In the immediate aftermath of the crisis the response of policymakers and bank managers was also differentiated across systems, with some moving more decisively than others to address the problems revealed. Bank credit has since grown relative to GDP in most jurisdictions, but has not returned to pre-crisis highs in the most affected countries, reflecting necessary deleveraging and the unwinding of pre-crisis excesses. While disentangling demand and supply drivers remains a challenging exercise, the evidence gathered by the Working Group does not point to systematic change in the willingness of banks to lend locally. In line with the objectives of post-crisis reforms, lenders have become more sensitive to risk and more discriminating across borrowers

The last two sentences appear to contradict, but measuring of loan quality from without is always a challenge. The authors’ continue to perceive credit quality and intermediation, through a glass darkly (once again, the emphasis is mine): –

If anything, the shift towards commercial banking activities suggests that banks are putting more emphasis on lending than trading activities. Still, given the range of changes in the banking sector over the past decade, policymakers should remain attentive to potential unintended “gaps” in credit to the real economy. Legacy asset quality problems can be an obstacle to credit growth. Excessive pre-crisis credit growth left a legacy of problem assets, especially high levels of NPLs, which continue to distort the allocation of fresh credit in several countries…

Persistently high NPLs are likely to lead to greater ultimate losses, impede credit growth and distort credit reallocation, potentially incentivising banks to take on more risk….

Again, the evidence seems to be contradictory. What is different between the cyclical patterns of the past and the current state of affairs? The tried and tested central bank solution to previous crises, stretching all the way back to the 1930’s, if not before, is to cut short-term interest rates – regardless of the level of inflation. The yield curve steepens sharply and banks rapidly repair their balance sheets by borrowing short-term and lending long-term. In the wake of the GFC, however, rates declined yet the economy failed to respond to the stimulus, at least in part, because the central banks accommodative actions were being negated by the tightening of regulatory conditions. Collectively the central banks and the national regulators were robbing Peter to pay Paul. The result (please pardon my emphasis once more): –

Post-crisis bank profitability has remained subdued. This reflects many factors, including bank-specific drivers (eg business model choices), cyclical macroeconomic drivers (eg low growth and interest rates) and structural drivers that will have a more persistent impact. An example of this latter group includes regulatory reforms that have implied lower leverage and the curbing of certain higher risk activities, and a reduction of implicit subsidies for large or systemically important banks…

…all else constant, lower leverage and reduced risk-taking should reduce return on equity. Sluggish revenues have dampened profits and, combined with low interest rates, may have contributed to the slower progress made by some banks in dealing with legacy problem assets…

Sufficient levels of capital are needed for banks to deal with unexpected shocks, and low profitability can weaken banks’ ability to maintain sufficient buffers. Banks that lack a steady stream of earnings to repair their capital base after an unexpected loss will have to rely on fresh equity issuance. Yet, markets are usually an expensive source of capital for banks, when accessed under duress….

In this scenario banks have an incentive to extend and reschedule zombie loans in order to avoid right-downs. Companies which should have been forced into administration linger on, banks’ ability to make new loans is curtailed and new ventures are starved of cash.

The BIS go on to make a number of suggestions in order to deal with low bank profitability and the problem of non-performing legacy assets: –

If overcapacity is a key driver of low profitability, institutional barriers to mergers must be reviewed and exit regimes applied. If the problem lies with legacy assets (such as NPLs), these should be fully addressed, which might entail a dialogue between prudential authorities and other policymakers (eg those in charge of mechanisms dealing with insolvency)…

The exit of financial institutions might be politically costly in the short run, but may pay off in the longer term through more stable banking systems, sounder lending and better allocation of resources. The implicit subsidisation of non-viable business models might have lower short-term costs but could lead to resource misallocation. Similarly, any assessment of consolidation trends needs to take into account potential trade-offs between efficiency and stability, as well as examine the nature and impact of barriers to exit for less profitable banks.

These suggestions make abundant sense but that is no guarantee the BIS recommendations will be heeded.

I am also concerned that the authors’ may be overly optimistic about the resilience of the global banking system: –

Compared with the pre-crisis period, banks are better capitalised and have lower exposure to liquidity and funding risks. They have also reduced activities that contributed to the build-up of vulnerabilities, such as exposure to high-risk assets, and excessive counterparty risk through OTC derivatives and repo transactions, among others. That said, given that markets have not yet evolved through a full financial cycle, bank restructuring efforts remain under way. In addition, as many relevant reforms have not yet been fully implemented, it is too early to assess their full effect.

Thankfully the BIS outlook is not entirely rose-tinted, they do acknowledge: –

…some trends in banking systems that we have observed since the crisis, such as the decline in wholesale funding, might be affected by unconventional monetary policy and may not persist. Success in addressing prior problems does not guarantee that banks will be able to respond to future risks…

Problems of bank governance and risk management contributed to the crisis and have been a key focus of reform. Given that the sources of future vulnerabilities are hard to predict, banks need to have robust frameworks of risk governance and management to identify and understand emerging risks and their potential impacts for the firm.

The BIS choose to gloss over the fact that many banks are still far too big to fail. They avoid discussing whether artificially low interest rates and the excessive flatness of yield curves may be contributing to a different breed of systemic risk. Commercial banks are for-profit institutions, higher capital requirements curtail their ability to achieve acceptable returns on capital. The adoption of central counterparties for the largest fixed income market in the world, interest rate swaps, whilst it reduces the risk for individual banking institutions, increases systemic risk for the market as a whole. The default of a systemically important central counterparties could prove catastrophic.

Conclusions and investment opportunities

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.

Debasing the Baseless – Modern Monetary Theory

Debasing the Baseless – Modern Monetary Theory

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Macro Letter – No 114 – 10-05-2019

Debasing the Baseless – Modern Monetary Theory

  • Populist politicians are turning to Modern Monetary Theory
  • Fiscal stimulus has not led to significant inflation during the last decade
  • MMT is too radical to be adopted in full but the allure of fiscal expansion is great
  • Asset markets will benefit over the medium-term

A recent post from the Peterson Institute – Further Thinking on the Costs and Benefits of Deficits – follows on from the Presidential Lecture given by Olivier Blanchard at the annual gathering of the American Economic Association (AEA) Public Debt and Low Interest Rates . The article discusses a number of issues which are linked to Blanchard’s speech: –

  1. Is the political system so biased towards deficit increases that economists have a responsibility to overemphasize the cost of deficits?

  2. Do the changing economics of deficits mean that anything goes and we do not need to pay attention to fiscal constraints, as some have inferred from modern monetary theory (MMT)?

  3. You advocate doing no harm, but is that enough to stabilize the debt at a reasonable level?

  4. Isn’t action on the deficit urgent in order to reduce the risk of a fiscal crisis?

  5. Do you think anything about fiscal policy is urgent?

Their answers are 1. Sometimes, although they question whether it is the role of economists to lean against the political wind. 2. No, which is a relief to those of a more puritanical disposition towards debt. The authors’ argument, however, omits any discussion of the function of interest rates in an unfettered market, to act as a signal about the merit of an investment. When interest rates are manipulated, malinvestment flourishes. They propose: –

…that the political system should adopt a “do no harm” approach, paying for new proposals but not necessarily making it an urgent priority to do any more than that. Adopting this principle would have the benefit of requiring policymakers to think harder about whether to adopt the next seemingly popular tax credit or spending program. Many ideas that seem appealing judged against an unspecified future cost are less appealing when you make their costs explicit today.

  1. Yes. At this point the authors’ make the case for addressing the shortfalls in the social security and health budgets. They make the admirable suggestion that better provision is not only necessary but desirable, however, to achieve their goal they warn more will need to be contributed by individuals. Sadly, I expect politicians to cherry pick from the Modern Monetary Theory (MMT) menu, they will not champion the case for higher individual contributions. 4. No. Here I am in begrudging agreement with their conclusion, although I worry about their projections. Fiat currencies and artificially low interest rates underpin the current political system. It is hardly surprising that developed country government activity, as a share of GDP, has risen. 5. Yes. Again, I agree with the need to think about fiscal policy, though I anticipate that Peterson’s proposals are likely to exacerbate the current problems further.

A prelude to MMT

The reason for highlighting recent Peterson commentary is because it represents the acceptable face of a more dubious set of proposals, known collectively as MMT. These ideas are not particularly modern, beginning with the Chartalist tenet that countries which issue their own fiat currencies can never “run out of money.” For a measured introduction to this topic, Dylan Matthews has published a brilliant essay for Vox – Modern Monetary Theory, explained. Here are some of the highlights: –

[The starting point is]…endogenous money theory, that rejects the idea that there’s a supply of loanable funds out there that private businesses and governments compete over. Instead, they believe that loans by banks themselves create money in accordance with market demands for money, meaning there isn’t a firm trade-off between loaning to governments and loaning to businesses of a kind that forces interest rates to rise when governments borrow too much.

MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players.

A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends…

And why does the government issue bonds? According to MMT, government-issued bonds aren’t strictly necessary. The US government could, instead of issuing $1 in Treasury bonds for every $1 in deficit spending, just create the money directly without issuing bonds.

The Mitchell/Wray/Watts MMT textbook argues that the purpose of these bond issuances is to prevent interest rates in the private economy from falling too low. When the government spends, they argue, that adds more money to private bank accounts and increases the amount of “reserves” (cash the bank has stocked away, not lent out) in the banking system. The reserves earn a very low interest rate, pushing down interest rates overall. If the Fed wants higher interest rates, it will sell Treasury bonds to banks. Those Treasury bonds earn higher interest than the reserves, pushing overall interest rates higher…

“In the long term,” they conclude, “the only sustainable position is for the private domestic sector to be in surplus.” As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.

The second (and more profound) aspect of MMT is that it proposes to reverse the roles of fiscal and monetary policy. Taxation is used to control aggregate demand (and thus inflation) whilst government spending (printing money) is used to prevent deflation and to stimulate consumption and employment. Since MMT advocates believe there is no need for bond issuance and that interest rates should reside, permanently, at zero, monetary policy can be controlled entirely by the treasury, making central banks superfluous.

At the heart of MMT is an accounting tautology, that: –

G − T = S – I

Where G = Government spending, T = Taxation, S = Savings and I = Investment

In other words…

Government Budget Deficit = Net Private Saving

wraybook

You may be getting the feeling that something does not quite tally. Robert Murphy of the Mises Institute – The Upside-Down World of MMT explains it like this (the emphasis is mine): –

When I first encountered such a claim — that the government budget deficit was necessary to allow for even the mathematical possibility of net private-sector saving — I knew something was fishy. For example, in my introductory textbook I devote Chapter 4 to “Robinson Crusoe” economics.

To explain the importance of saving and investment in a barter economy, I walk through a simple numerical example where Crusoe can gather ten coconuts per day with his bare hands. This is his “real income.” But to get ahead in life, Crusoe needs to save — to live below his means. Thus, for 25 days in a row, Crusoe gathers his ten coconuts per day as usual, but only eats eight of them. This allows him to accumulate a stockpile of 50 coconuts, which can serve as a ten-day buffer (on half-rations) should Crusoe become sick or injured.

Crusoe can do even better. He takes two days off from climbing trees and gathering coconuts (with his bare hands), in order to collect sticks and vines. Then he uses these natural resources to create a long pole that will greatly augment his labor in the future in terms of coconuts gathered per hour. This investment in the capital good was only possible because of Crusoe’s prior saving; he wouldn’t have been able to last two days without eating had he not been able to draw down on his stockpile of 50 coconuts.

This is an admittedly simple story, but it gets across the basic concepts of income, consumption, saving, investment, and economic growth. Now in this tale, I never had to posit a government running a budget deficit to make the story “work.” Crusoe is able to truly live below his means — to consume less than his income — and thereby channel resources into the production of more capital goods. This augments his future productivity, leading to a higher income (and hence consumption) in the future. There is no trick here, and Crusoe’s saving is indeed “net” in the sense that it is not counterbalanced by a consumption loan taken out by his neighbor Friday…

When MMTers speak of “net saving,” they don’t mean that people collectively save more than people collectively borrow. No, they mean people collectively save more than people collectively invest.

MMT goes on to solve the problem of achieving full employment by introducing a job guarantee and wage controls.

If, by this stage, you feel the need for an antidote to MMT, look no further than, Forty Centuries of Wage and Price Controls: How Not to Fight Inflation by Dr Eamon Butler of the ASI. Published in 1978, it documents the success of these types of policy during the past four thousand years.

Conclusion and Investment Opportunities

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.

John Mauldin describes the end-game of the debt-explosion as the Great Reset, but if government borrowing costs are zero (or lower) the Great Reset can be postponed, but the economy will suffer from low productivity growth due to malinvestment.

Capital Flows – is a reckoning nigh?

Capital Flows – is a reckoning nigh?

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Macro Letter – No 111 – 15-03-2019

Capital Flows – is a reckoning nigh?

  • Borrowing in Euros continues to rise even as the rate of US borrowing slows
  • The BIS has identified an Expansionary Lower Bound for interest rates
  • Developed economies might not be immune to the ELB
  • Demographic deflation will thwart growth for decades to come

In Macro Letter – No 108 – 18-01-2019 – A world of debt – where are the risks? I looked at the increase in debt globally, however, there has been another trend, since 2009, which is worth investigating as we consider from whence the greatest risk to global growth may hail. The BIS global liquidity indicators at end-September 2018 – released at the end of January, provides an insight: –

The annual growth rate of US dollar credit to non-bank borrowers outside the United States slowed down to 3%, compared with its most recent peak of 7% at end-2017. The outstanding stock stood at $11.5 trillion.

In contrast, euro-denominated credit to non-bank borrowers outside the euro area rose by 9% year on year, taking the outstanding stock to €3.2 trillion (equivalent to $3.7 trillion). Euro-denominated credit to non-bank borrowers located in emerging market and developing economies (EMDEs) grew even more strongly, up by 13%.

The chart below shows the slowing rate of US$ credit growth, while euro credit accelerates: –

gli1901_graph1

Source: BIS global liquidity indicators

The rising demand for Euro denominated borrowing has been in train since the end of the Great Financial Recession in 2009. Lower interest rates in the Eurozone have been a part of this process; a tendency for the Japanese Yen to rise in times of economic and geopolitical concern has no doubt helped European lenders to gain market share. This trend, however, remains over-shadowed by the sheer size of the US credit markets. The US$ has remained preeminent due to structurally higher interest rates and bond yields than Europe or Japan: investors, rather than borrowers, dictate capital flows.

The EC – Analysis of developments in EU capital flows in the global context from November 2018 concurs: –

The euro area (excluding intra-euro area flows) has been since 2013 the world’s leading net exporter of capital. Capital from the euro area has been invested heavily abroad in debt securities, especially in the US, taking advantage of the interest differential between the two jurisdictions. At the same time, foreign holdings of euro-area bonds fell as a result of the European Central Bank’s Asset Purchase Programme.

This bring us to another issue; a country’s ability to service its debt is linked to its GDP growth rate. Since 2009 the US economy has expanded by 34%, over the same period, Europe has shrunk by 2%. Putting these rates of expansion into a global perspective, the last decade has seen China’s economy grow by 139%, whilst India has gained 96%. Recent analysis suggests that Chinese growth may have been overstated by 2% per annum over the past decade, but the pace is still far in excess of developed economy rates. Concern about Chinese debt is not unwarranted, but with GDP rising by 6% per annum, its economy will be 80% larger in a decade, whilst India’s, growing at 7%, will have doubled.

Another excellent research paper from the BIS – The expansionary lower bound: contractionary monetary easing and the trilemma – investigates the problem of monetary tightening of developed economies on emerging markets. Here is part of the introduction, the emphasis is mine: –

…policy makers in EMs are often reluctant to lower interest rates during an economic downturn because they fear that, by spurring capital outflows, monetary easing may end up weakening, rather than boosting, aggregate demand.

An empirical analysis of the determinants of policy rates in EMs provides suggestive evidence about the tensions faced by monetary authorities, even in countries with flexible exchange rates.

…The results reveal that, even after controlling for expected inflation and the output gap, monetary authorities in EMs tend to hike policy rates when the VIX or US policy rates increase. This is arguably driven by the desire to limit capital outflows and the depreciation of the exchange rate.

…our theory predicts the existence of an “Expansionary Lower Bound” (ELB) which is an interest rate threshold below which monetary easing becomes contractionary. The ELB constrains the ability of monetary policy to stimulate aggregate demand, placing an upper bound on the level of output achievable through monetary stimulus.

The ELB can occur at positive interest rates and is therefore a potentially tighter constraint for monetary policy than the Zero Lower Bound (ZLB). Furthermore, global monetary and financial conditions affect the ELB and thus the ability of central banks to support the economy through monetary accommodation. A tightening in global monetary and financial conditions leads to an increase in the ELB which in turn can force domestic monetary authorities to increase policy rates in line with the empirical evidence presented…

The BIS research is focussed on emerging economies, but aspects of the ELB are evident elsewhere. The limits of monetary policy are clearly observable in Japan: the Eurozone may be entering a similar twilight zone.

The difference between emerging and developed economies response to a tightening in global monetary conditions is seen in capital flows and exchange rates. Whilst emerging market currencies tend to fall, prompting their central banks to tighten monetary conditions in defence, in developed economies the flow of returning capital from emerging market investments may actually lead to a strengthening of the exchange rate. The persistent strength of the Japanese Yen, despite moribund economic growth over the past two decades, is an example of this phenomenon.

Part of the driving force behind developed market currency strength in response to a tightening of global monetary conditions is demographic, a younger working age population borrows more, an ageing populous borrows less.

At the risk of oversimplification, lower bond yields in developing (and even developed) economies accelerate the process of capital repatriation. Japanese pensioners can hardly rely on JGBs to deliver their retirement income when yields are at the zero bound, they must accept higher risk to achieve a living income, but this makes them more likely to drawdown on investments made elsewhere when uncertainty rises. A 2% rise in US interest rates only helps the eponymous Mrs Watanabe if the Yen appreciates by less than 2% in times of stress. Japan’s pensioners face a dilemma, a fall in US rates, in response to weaker global growth, also creates an income shortfall; capital is still repatriated, simply with less vehemence than during an emerging market crisis. As I said, this is an oversimplification of a vastly more complex system, but the importance of capital flows, in a more polarised ‘risk-on, risk-off’ world, is not to be underestimated.

Returning to the BIS working paper, the authors conclude: –

The models highlight a novel inter-temporal trade-off for monetary policy since the level of the ELB is affected by the past monetary stance. Tighter ex-ante monetary conditions tend to lower the ELB and thus create more monetary space to offset possible shocks. This observation has important normative implications since it calls for keeping a somewhat tighter monetary stance when global conditions are supportive to lower the ELB in the future.

Finally, the models have rich implications for the use of alternative policy tools that can be deployed to overcome the ELB and restore monetary transmission. In particular, the presence of the ELB calls for an active use of the central bank’s balance sheet, for example through quantitative easing and foreign exchange intervention. Furthermore, the ELB provides a new rationale for capital controls and macro-prudential policies, as they can be successfully used to relax the tensions between domestic collateral constraints and capital flows. Fiscal policy can also help to overcome the ELB, while forward guidance is ineffective since the ELB increases with the expectation of looser future monetary conditions.

Conclusions and investment opportunities

The concept of the ELB is new, the focus of the BIS working paper is on its impact on emerging markets. I believe the same forces are evident in developed economies too, but the capital flows are reversed. For investors, the greatest risk of emerging market investment is posed by currency, however, each devaluation by an emerging economy inexorably weakens the position of developed economies, since the devaluation makes that country’s exports immediately more competitive.

At present the demographic forces favour repatriation during times of crisis and repatriation, at a slower rate, during times of EM currency appreciation. This is because the ageing economies of the developed world continue to drawdown on their investments. At some point this demographic effect will reverse, however, for Japan and the Eurozone this will not be before 2100. For more on the demographic deficit the 2018 Ageing Report: Europe’s population is getting older – is worth reviewing. Until demographic trends reverse, international demand to borrow in US$, Euros and Yen will remain popular. Emerging market countries will pay the occasional price for borrowing cheaply, in the form of currency depreciations.

For Europe and Japan a reckoning may be nigh, but it seems more likely that their economic importance will gradually diminish as emerging economies, with a younger working age population and higher structural growth rates, eclipse them.

Sustainable government debt – an old idea refreshed

Sustainable government debt – an old idea refreshed

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Macro Letter – No 109 – 01-02-2019

Sustainable government debt – an old idea refreshed

  • New research from the Peterson Institute suggests bond yields may fall once more
  • Demographic forces and unfunded state liabilities point to an inevitable reckoning
  • The next financial crisis may be assuaged with a mix of fiscal expansion plus QQE
  • Pension fund return expectations for bonds and stocks need to be revised lower

The Peterson Institute has long been one of my favourite sources of original research in the field of economics. They generally support free-market ideas, although they are less than classically liberal in their approach. I was, nonetheless, surprised by the Presidential Lecture given at the annual gathering of the American Economic Association (AEA) by Olivier Blanchard, ex-IMF Chief Economist, now at the Peterson Institute – Public Debt and Low Interest Rates. The title is quite anodyne, the content may come to be regarded as incendiary. Here is part of his introduction: –

Since 1980, interest rates on U.S. government bonds have steadily decreased. They are now lower than the nominal growth rate, and according to current forecasts, this is expected to remain the case for the foreseeable future. 10-year U.S. nominal rates hover around 3%, while forecasts of nominal growth are around 4% (2% real growth, 2% inflation). The inequality holds even more strongly in the other major advanced economies: The 10-year UK nominal rate is 1.3%, compared to forecasts of 10-year nominal growth around 3.6% (1.6% real, 2% inflation). The 10-year Euro nominal rate is 1.2%, compared to forecasts of 10-year nominal growth around 3.2% (1.5% real, 2% inflation). The 10-year Japanese nominal rate is 0.1%, compared to forecasts of 10-year nominal growth around 1.4% (1.0% real, 0.4% inflation).

The question this paper asks is what the implications of such low rates should be for government debt policy. It is an important question for at least two reasons. From a policy viewpoint, whether or not countries should reduce their debt, and by how much, is a central policy issue. From a theory viewpoint, one of pillars of macroeconomics is the assumption that people, firms, and governments are subject to intertemporal budget constraints. If the interest rate paid by the government is less the growth rate, then the intertemporal budget constraint facing the government no longer binds. What the government can and should do in this case is definitely worth exploring.

The paper reaches strong, and, I expect, surprising, conclusions. Put (too) simply, the signal sent by low rates is that not only debt may not have a substantial fiscal cost, but also that it may have limited welfare costs.

Blanchard’s conclusions may appear radical, yet, in my title, I refer to this as an old idea, allow me to explain. In business it makes sense, all else equal, to borrow if the rate of interest paid on your loan is lower than the return from your project. At the national level, if the government can borrow at below the rate of GDP growth it should be sustainable, since, over time (assuming, of course, that it is not added to) the ratio of debt to GDP will naturally diminish.

There are plenty of reasons why such borrowing may have limitations, but what really interests me, in this thought provoking lecture, is the reason governments can borrow at such low rates in the first instance. One argument is that as GDP grows, so does the size of the tax base, in other words, future taxation should be capable of covering the on-going interest on today’s government borrowing: the market should do the rest. Put another way, if a government become overly profligate, yields will rise. If borrowing costs exceed the expected rate of GDP there may be a panicked liquidation by investors. A government’s ability to borrow will be severely curtailed in this scenario, hence the healthy obsession, of many finance ministers, with debt to GDP ratios.

There are three factors which distort the cosy relationship between the lower yield of ‘risk-free’ government bonds and the higher percentage levels of GDP growth seen in most developed countries; investment regulations, unfunded liabilities and fractional reserve bank lending.

Let us begin with investment regulations, specifically in relation to the constraints imposed on pension funds and insurance companies. These institutions are hampered by prudential measures intended to guarantee that they are capable of meeting payment obligations to their customers in a timely manner. Mandated investment in liquid assets are a key construct: government bonds form a large percentage of their investments. As if this was not sufficient incentive, institutions are also encouraged to purchase government bonds as a result of the zero capital requirements for holding these assets under Basel rules.

A second factor is the uncounted, unfunded, liabilities of state pension funds and public healthcare spending. I defer to John Mauldin on this subject. The 8th of his Train-Wreck series is entitled Unfunded Promises – the author begins his calculation of total US debt with the face amount of all outstanding Treasury paper, at $21.2trln it amounts to approximately 105% of GDP. This is where the calculations become disturbing: –

If you add in state and local debt, that adds another $3.1 trillion to bring total government debt in the US to $24.3 trillion or more than 120% of GDP.

Mauldin goes on to suggest that this still underestimates the true cost. He turns to the Congressional Budget Office 2018 Long-Term Budget Outlook – which assumes that federal spending will grow significantly faster than federal revenue. On the basis of their assumptions, all federal tax revenues will be consumed in meeting social security, health care and interest expenditures by 2041.

Extrapolate this logic to other developed economies, especially those with more generous welfare commitments than the US, and the outlook for rapidly aging, welfare addicted developed countries is bleak. In a 2017 white paper by Mercer for World Economic Forum – We Will Live to 100 – the author estimates that the unfunded liabilities of US, UK, Netherlands, Japan, Australia, Canada, China and India will rise from $70trln in 2015 to $400trln in 2050. These countries represent roughly 60% of global GDP. I extrapolate global unfunded liabilities of around $120trln today rising to nearer $650trln within 20 years: –

image_2_20180622_tftf

Source: Mercer analysis

For an in depth analysis of the global pension crisis this 2016 research paper from Citi GPS – The Coming Pensions Crisis – is a mine of information.

In case you are still wondering how, on earth, we got here? This chart from Money Week shows how a combination of increased fiscal spending (to offset the effect of the bursting of the tech bubble in 2000) combined with the dramatic fall in interest rates (since the great financial recession of 2008/2009) has damaged the US state pension system: –

pensionshortfallinussince1998-moneyweek

Source: Moneyweek

The yield on US Treasury bonds has remained structurally higher than most of the bonds of Europe and any of Japan, for at least a decade.

The third factor is the fractional reserve banking system. Banks serve a useful purpose intermediating between borrowers and lenders. They are the levers of the credit cycle, but their very existence is testament to their usefulness to their governments, by whom they are esteemed for their ability to purchase government debt. I discuss – A history of Fractional Reserve Banking – or why interest rates are the most important influence on stock market valuations? in a two part essay I wrote for the Cobden Centre in October 2016. In it I suggest that the UK banking system, led by the Bank of England, has enabled the UK government to borrow at around 3% below the ‘natural rate’ of interest for more than 300 years. The recent introduction of quantitative easing has only exaggerated the artificial suppression of government borrowing costs.

Before you conclude that I am on a mission to change the world financial system, I wish to point out that if this suppression of borrowing costs has been the case for more than 300 years, there is no reason why it should not continue.

Which brings us back to Blanchard’s lecture at the AEA. Given the magnitude of unfunded liabilities, the low yield on government bonds is, perhaps, even more remarkable. More alarmingly, it reinforces Blanchard’s observation about the greater scope for government borrowing: although the author is at pains to advocate fiscal rectitude. If economic growth in developed economies stalls, as it has for much of the past two decades in Japan, then a Japanese redux will occur in other developed countries. The ‘risk-free’ rate across all developed countries will gravitate towards the zero bound with a commensurate flattening in yield curves. Over the medium term (the next decade or two) an increasing burden of government debt can probably be managed. Some of the new borrowing may even be diverted to investments which support higher economic growth. The end-game, however, will be a monumental reckoning, involving wholesale debt forgiveness. The challenge, as always, will be to anticipate the inflection point.

Conclusion and Investment Opportunities

Since the early-1990’s analysts have been predicting the end of the bond bull market. Until quite recently it was assumed that negative government bond yields were a temporary aberration reflecting stressed market conditions. When German schuldscheine (the promissory notes of the German banking system) traded briefly below the yield of German Bunds, during the reunification in 1989, the ‘liquidity anomaly’ was soon rectified. There has been a sea-change, for a decade since 2008, US 30yr interest rate swaps traded at a yield discount to US Treasuries – for more on this subject please see – Macro Letter – No 74 – 07-04-2017 – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

With the collapse in interest rates and bond yields, the unfunded liabilities of governments in developed economies has ballooned. A solution to the ‘pension crisis,’ higher bond yields, would sow the seeds of a wider economic crisis. Whilst governments still control their fiat currencies and their central banks dictate the rate of interest, there is still time – though, I doubt, the political will – to make the gradual adjustments necessary to right the ship.

I have been waiting for US 10yr yields to reach 4.5%, I may be disappointed. For investors in fixed income securities, the bond bull market has yet to run its course. Negative inflation adjusted returns will become the norm for risk-free assets. Stock markets may be range-bound for a protracted period as return expectations adjust to a structurally weaker economic growth environment.

A world of debt – where are the risks?

A world of debt – where are the risks?

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Macro Letter – No 108 – 18-01-2019

A world of debt – where are the risks?

  • Private debt has been the main source of rising debt to GDP ratios since 2008
  • Advanced economies have led the trend
  • Emerging market debt increases have been dominated by China
  • Credit spreads are a key indicator to watch in 2019

Since the financial crisis of 2008/2009 global debt has increased to reach a new all-time high. This trend has been documented before in articles such as the 2014 paper from the International Center for Monetary and Banking Studies – Deleveraging? What deleveraging? The IMF have also been built a global picture of the combined impact of private and public debt. In a recent publication – New Data on Global Debt – IMF – the authors make some interesting observations: –

Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.

The most indebted economies in the world are also the richer ones. You can explore this more in the interactive chart below. The top three borrowers in the world—the United States, China, and Japan—account for more than half of global debt, exceeding their share of global output.

The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt. Another change since the global financial crisis has been the rise in private debt in emerging markets, led by China, overtaking advanced economies. At the other end of the spectrum, private debt has remained very low in low-income developing countries.

Global public debt, on the other hand, has experienced a reversal of sorts. After a steady decline up to the mid-1970s, public debt has gone up since, with advanced economies at the helm and, of late, followed by emerging and low-income developing countries.

The recent picture suggests that the old world order, dominated by advanced economies, may be changing. For investors, this is an important consideration. Total debt in 2017 had exceeded the previous all-time high by more than 11%, however, the global debt to GDP ratio fell by 1.5% between 2016 and 2017, led by developed nations.

Setting aside the absolute level of interest rates, which have finally begun to rise from multi-year lows, it makes sense for rapidly aging, developed economies, to begin reducing their absolute level of debt, unfortunately, given that unfunded pension liabilities and the escalating cost of government healthcare provision are not included in the data, the IMF are only be portraying a partial picture of the state of developed economy obligations.

For emerging markets, the trauma of the 1998 Asian Crisis has finally waned. In the decade since the great financial recession of 2008 emerging economies, led by China, have increased their borrowing. This is clearly indicated in the chart below: –

eng-december-26-global-debt-1

Source: IMF

The decline in the global debt to GDP ratio in 2017 is probably related to the change in Federal Reserve policy; the largest proportion of global debt is still raised in US$. Rather like the front-loaded US growth which transpired due the threat of tariff increases on US imports, I suspect, debt issuance spiked in expectation of a reversal of quantitative easing and an end to ultra-low US interest rates.

The IMF goes on to show the breakdown of debt by country, separating them into three groups; advanced economies, emerging markets and low income countries. The outlier is China, an emerging market with a debt to GDP ratio comparable to that of an advanced economy. The table below may be difficult to read (an interactive one is available on the IMF website): –

imf chart of debt by country december 2018

Source: IMF

At 81%, China’s private debt is much greater than its public debt, meanwhile its debt to GDP ratio is 254% – comparable with the US (256%). Fortunately, the majority of Chinese private debt is denominated in local currency. Advanced economies have higher debt to GDP ratios but their government debt ratios are relatively modest, excepting Japan. The Economist – Economists reconsider how much governments can borrow – provides food for thought on this subject.

Excluding China, emerging markets and low income countries have relatively similar levels of debt relative to GDP. In general, the preponderance of government debt in lower ratio countries reflects the lack of access to capital markets for private sector borrowers.

Conclusions and Investment Opportunities

Setting aside China, which, given its control on capital flows and foreign exchange reserves is hard to predict, the greatest risk to world financial markets appears to be from the private debt of advanced economies.

Following the financial crisis of 2008, corporate credit spreads narrowed, but not by as much as one might have anticipated, as interest rates tended towards the zero bound. The inexorable quest for yield appears to have been matched by equally enthusiastic issuance. The yield-quest also prompted the launch of a plethora of private debt investment products, offering enticing returns in exchange for illiquidity. An even more sinister trend has been the return of many of the products which exacerbated the financial crisis of 2008 – renamed, repackaged and repurposed. These investments lack liquidity and many are leveraged in order to achieve acceptable rates of return.

The chart below shows the 10yr maturity Corporate Baa spread versus US Treasuries since March 2007: –

baa 10yr spread 2007 to 2019

Source: Federal Reserve Bank of St Louis

The Baa spread has widened since its low of 1.58% in January 2018, but, at 2.46%, it is still only halfway between the low of 2018 and the high of February 2016 (3.6%).

The High Yield Bond spread experienced a more dramatic reaction into the close of 2018, but, since the beginning of January, appears to have regained its composure. The chart shows the period since September 2015: –

high yield spread 10yr 2016 to 2019

Source: Federal Reserve Bank of St Louis

Nonetheless, this looks more like a technical break-out. The spread may narrow to retest the break of 4% seen on November 15th, but the move looks impulsive. A return to the 3.25% – 3.75% range will be needed to quell market fears of an imminent full-blown credit-crunch.

If the next crisis does emanate from the private debt markets, governments will still be in a position to intervene; the last decade has taught us to accept negative government bond yields as a normal circumstance. Demographic trends have even led long dated interest rate swaps to trade even lower than risk-free assets.

A decade after the financial crisis, markets are fragile and, with an ever increasing percentage of capital market transactions dictated by non-bank liquidity providers, liquidity is ever more transitory. Credit spreads have often been the leading indicator of recessions, they may not provide the whole picture this time, but we should watch them closely during 2019.