Readers of this blog will be aware that I have been bearish about global economic and political conditions for some time now. Yet I find things to buy. I leave for my vacation and will return in 2 weeks and will endeavor to monitor news and markets as little as possible. But befor e I go, a few thoughts.

I do think that the global situation is far from ideal. We are in a synchronized slow down, yet it is one that isn’t dangerously sharp. The risks are that central banks are not prepared to deal with it having never come out of emergency mode since the last crisis. Growth is slowing, but it should. In fact, what I object to is our continuing efforts to avert a slowdown at all costs, even a mild one.

The problems I see are deeply fundamental and will manifest over time with durable effects. The immediate impact will be difficult to distinguish from normal market volatility.

Finally I give you this. Investors are so focused on the global slowdown that they are unprepared for an adjustment in the business cycle. We saw the same in 2017 when a 5 year slowdown in trade and manufacturing reversed, primarily as a result of lag effects in capex and restructuring, and caught many bears off guard. Today, European PMIs are dismal, India’s growth is slipping, China’s economic data is awful, even the US is slowing down. Everything looks bad. But the nature of cycles is recovery and the current data are so bad that they are ripe for recovery. It is likely that the deterioration in manufacturing has peaked and that manufacturing and trade data will improve from here, and this is with or without a US trade deal. It is likely that a new capex cycle has begun, in part driven by the restructuring in global supply chains.

I don’t think it will all reverse in the 2 weeks I am off the grid, but it will happen gradually over the next few weeks and months, and it will catch the bears unawares. The longer term problems remain and that means the longer term prospects remain poor, but for traders (as opposed to investors) who are willing to gamble on a little decompression in the pessimism trade, there is some upside.

A hedge fund manager friend of mine sold me the doom and gloom scenario back in 2015, and I told him he was right but that central banks had rigged the market, and he’d better not short it too aggressively. Well he did and paid handsomely for it. The markets are still rigged and the central banks still have some funny money to print and if you couple that with some improvement in conditions, it could be a bit of a relief.

Populists may be wrong in their prescriptions, but they are not wrong in their prognoses.

Inequality

If it feels like inequality, it probably is.

1% of the world’s population hold 47% of its wealth. To qualify, they must have at least 700,000 USD in assets. The share of wealth of the top 1% has been growing since the early 2000s. The share of wealth of the bottom 90% has been shrinking monotonically since the 1960s.

Emmanuel Saez and Gabriel Zucman of the University of Berkeley estimate that in the US, the share of wealth of the top 0.1% has been rising steadily since the mid-1980s and has reached some 20% whereas the bottom 90% has seen a corresponding decline to some 25% of total wealth.

The progression of widening inequality has been steady, but it has only recently been noticed due to the rise of social media and transparency. Social media allow rich and poor to live in close cyber proximity exacerbating the perception of inequality.

Senator Elizabeth Warren would like to tax the rich to feed the poor. The self-interest of incumbent elites is aligned against her and anyone who would threaten the status quo. Years of entrenchment have established a mass of orthodoxy to preserve the lie that the current organization of economic activity works for all.

Capitalism doesn’t work for all. All work for a few capitalists.  And this isn’t even real capitalism.

What do populists want, and will it solve the problem?

Raise taxes on the rich. This sounds easy but apart from the US where taxes are on global income and wealth, other countries may struggle. People will shift assets offshore to other countries depriving the local economy of funding and depressing growth, which usually hurts the poor even more than the rich. For taxes to work, they would have to be worldwide and comprehensive.

Expropriation of assets. This will trigger a mass exodus of capital and people denuding the economy of human and financial capital. Foreign investors would flee. Expropriation of assets is a disastrous policy and again hits the poor harder than the rich who probably already have assets offshore. And since incumbent elite are unlikely to want to expropriate their own assets, it suggests some kind of regime change, which would again likely be messy, noisy and dangerous.

Universal basic income. Capitalists would regard this as a market distorting policy, raising the cost of labour and creating more unemployment which in turn slows the economy and again impacts all, and yet again hurting the poor disproportionately more. However, if automation and technology will already create the unemployment, then perhaps a universal basic income to cover the lost employment income would be justified. The arguments against: inflation from increased demand, no change in standard of living since inflation would rise to compensate, disincentivising work, falling labour participation, seem to be mitigated by the future to which we appear to be headed. We seem not to be able to hit inflation targets and automata are taking our jobs anyway. A universal basic income would need to be funded of course and could lead to ballooning national debt. However, we seem to have found an innovative way of dealing with the national debt, which is to have our central bank fund it, directly if need be, and indirectly if regulatory propriety needs to be observed.

Rigged economy

The pre crisis (2008) years were defined by high salaries and bonuses for high finance. House prices were rising, but so were leverage levels and debt burdens. When the bubble burst, we were almost thankful that governments rode to the rescue and attempted to bailout the financial system. The policy they engaged was quantitative easing. Under QE, central banks cut rates and bought government bonds in an effort to provide liquidity to the market and depress lending costs across the whole yield curve. My making funds cheap, it was hoped, investment and consumption would rise to drive the economy. What happened was a little bit different. QE depressed interest rates which led to a surge in assets prices. When assets are valued using discounted cash flow models, their value rises as the discount factor, which are interest rates, fall. So QE basically distributed wealth to the people pro rata to their assets. This was excellent for those with lots of assets and less good for anyone who had no assets except their ability to work or cash on deposit.

People were told that a burgeoning economy would lift all boats, that if rich people got richer, they would spend more, invest more, employ more, and the wealth would trickle down to poorer people. Since the crisis, unemployment has fallen but the labour participation rate has been stubbornly low. Wage growth has increased from the lows in 2012, but still struggles to break into the target range of 3.5% – 4.0%, a disappointing outcome considering that the Fed’s balance sheet went from below 1 trillion USD to 1.2 trillion USD during the initial stages of the crisis, then grew steadily over the next 5 years to 4.5 trillion USD where it has hovered since 2015.

QE was a de facto relative transfer of wealth from the poor to the rich. And didn’t work.

The QE Trap.

When QE was tapered in 2015, the result was a gentle but steady flattening of the yield curve. When balance sheet reduction was undertaken, flattening pressures managed to invert the USD yield curve as excess reserves were depleted and primary dealers struggled to fund the short term money market. Basically, QE works by making money cheap so people invest and consume. But, attempting to operate the economy beyond its natural growth rate is unsustainable since the unwinding of QE induces recessionary pressures on the economy via the credit market.

The latest thinking is to engage fiscal policy to boost economic activity. This is in part an admission that QE has been ineffective. Fiscal policy can be highly redistributive. This is an opportunity and a risk. It can either try to alleviate some of the inequality or it can be used to exacerbate it.

When all you have is a hammer, every problem is a nail. QE didn’t work. It was meant to raise inflation and growth but what it did instead was channel liquidity into assets while demand and output remained weak. The recovery from the recession of 2007 – 2009 was a weak recovery and any growth since then would have happened with or without QE. Instead of seeking alternatives to improve long term productivity and sustainability, additional rounds of QE were undertaken to boost growth. The bulk of the impact went into financial markets, with only a minority of the impact affecting the real economy. As the European economy has turned back towards recession, China’s growth slows as it stabilizes its credit markets, and the US slows as well, central banks have turned again to QE. This is an exercise in futility. Not only did it not work, it had adverse side effects such as increasing inequality, blunting emergency financial crisis fighting tools, distorting market prices and disrupting efficient capital allocation. Moreover, it creates a long-term dependence that cannot be exited safely, as the US Fed has now discovered. As every central bank engages in QE, it leads down a path of ever increasing debt levels, often not even to finance anything, ever declining inflation, moribund growth, lengthening a runway of ever decreasing albeit positive returns, but with ever increasing risk of disruption and an accumulated scale of imbalance to be corrected.

Trade war and more.

The inability of the global economy to return to pre-crisis levels of growth has led to a more selfish and uncooperative world. This has manifested in multiple ways. Discontent is an opportunity for populists. Apparently irrational behaviour can be explained by a general state of tension. Surprising political choices are driven not by positive choice but by the rejection of the status quo. Within this general air of discontent, protectionism is a natural symptom.

When the pie is not growing, or shrinking, nobody is willing to share.

A low level, cold, trade war has been in progress for about a decade. US President Trump has only brought it out into the open and converted it into a hot war with tariffs and embargoes. In an already highly globally integrated economic system, such policies have significant collateral damage and unintended consequences. Where once outsourcing to China was a deliberate economic and commercial policy intended to reduce costs and mute inflation, US economic policy has become protectionist. Technology transfer once regarded as a necessary evil in bringing China up to speed to supply America with cheap goods, is now seen as intellectual property theft.

More than a trade war.

A battle can become a war if it brings to the surface more fundamental differences. This is the case between China and the US. There is a history of enmity between the two nations dating back to the early 1900s, further if you consider the Chinese Exclusion Act of 1882.

More recently, when communism died some 3 decades ago, capitalism lost its nemesis which it so required for balance and for essence. Without communism, capitalism loses its raison d’etre. The rise of China with its own economic and political organization, a state directed form of capitalism presented American capitalism with the nemesis it sought. The success of China represented a threat to the legitimacy of American capitalism. The result is a clash, not of economies but of ideology. This type of conflict is highly durable. The Soviet communism American capitalism conflict was different in that both sides were diametrically opposed. The Sino American conflict is more complex.

China has adopted free markets where the central government deems a free market is the best organization. It maintains central control where it deems a free market would fail. China’s primary objective appears to be stability at all costs, as opposed to growth at all costs. It appears to be pursuing a diversified external policy, reaching out and building bridges in all directions. It considers American insularity a pity. China wants to grow, not just to improve the welfare of the people, but because growth implies stability. China will probably have to find its own balance between stability and efficiency, for the product of the two is often stationary.

America and China are not diametrically opposed, and this complicates the engagement strategy, for both, but particularly for the US. It wants to say its capitalism is superior, yet it fails its own standards at home where inequality is high, there is poverty and growth is probably slower than it should be given the pace of innovation. America points to China’s environmental credentials, China is the largest emitter of carbon today, but has historically been the largest polluter in terms of current climate conditions, but China has probably peaked and is taking the most action to improve its climate impact. America points to China’s human rights record, harsh treatment of criminals, racial discrimination and oppression of ethnic minorities, surveillance and privacy issues, and lack of freedom of expression and dissent. However, America’s own record is far from exemplary including areas like harsh criminal sentencing, racial disparity (black people are 13% of the population but 40% of the prison population), rising hate crime, national security procedural issues (read torture and detention without trial), surveillance and data protection issues, and efforts to limit freedom of expression and assembly.

If anything, the American complaint against the Chinese seems like envious competition.

This type of competition does not end easily. It tends to fester and escalate. It tends to be fought by proxy, in the shadows, in unexpected places and along unexpected lines. We can only hope that it does not escalate into an all-out shooting war. This is unlikely given the geographical realities of both countries but logic and rationality rarely direct warring nations. It is more likely that each side will first try to disengage their interests. The world had become more globalized up until recently and supply chains and financial and commercial infrastructure are very much internationally integrated. Combatants will seek to disengage their assets and interests before engaging in more open conflict. It is already underway. Each side will want distinct systems, networks, physical and non-physical infrastructure, so that they are not mutually dependent. The first battles will be in particular industries, or territories, HK, Taiwan, TPP, 5G, IoT standards, cyberwarfare. How it may escalate is hard to predict, but it is unlikely to find resolution soon. The countries are too alike to resolve their differences easily.

In recent times equity and credit markets have reacted to bad news with optimism, reasoning that weaker economic data would encourage the central banks to cut rates which would in turn boost the economy and support higher asset valuations. This is a perverse logic but one that supports trillions of dollars in investments. This year, the US Federal Reserve, the ECB, and the Peoples Bank of China have accommodated investors’ calls for easier monetary policy. Economic data have indicated a general weakening of growth, so providing justification for the central banks’ acquiescence. This is the bad news is good news scenario, and it relies on investor acceptance of the logic above.

An equally valid argument is that slowing economic growth would impact companies’ earnings growth leading to weaker equity and credit markets. The market has not followed this script. It may do so in future. This is the bad news is bad news scenario. Both the bad news is good and the bad news is bad scenarios are valid. Why would investors accept one and not the other is fairly arbitrary and depends a lot on sentiment.

The switch can be triggered by a catalyst or it can happen for no reason at all. One potential catalyst is higher interest rates. Given that central banks are in full accommodation mode, this is unlikely. Longer term rates may start to climb if fiscal support is accelerated which would lead to steepening term structures unless QE bond buying is restarted in earnest. This would leave central bank balance sheets permanently inflated with rates close to or below zero, and the economy decelerating.

Then we shall see how bad the news can be to make it good.

Fiscal policy will join monetary policy in the fight against stagnation.

10 years of loose monetary policy has inflated assets while failing to raise growth or inflation. Orthodoxy is slowly pivoting towards fiscal policy.

The textbook dangers of unlimited monetary and fiscal support are, excessive and rising national debt and the eventual loss of confidence in policy and currency leading to runaway inflation or a currency crisis. This has not happened in Japan where nearly 3 decades of constant support have failed to either provide results or induce a crisis. Whether such policies can be operated elsewhere with such benign and ineffective results remains to be seen. Japan might be a special case.

A more fundamental question is, what is the right level of growth that policy should aim for? Is it that level that maintains low unemployment? And what if inflation resurfaces? (Unemployment and inflation are important catalysts for social change.)

Since the 1980s most policy responses to recessions have been monetary which exerts downward pressure on interest rates. The engagement of fiscal policy exerts upward pressure on interest rates and will have unfamiliar implications for markets and the economy. Additionally, fiscal policy is not only an economic decision but involves many political ones and can raise lines of division.

Inequality

In a knowledge economy, the ability for institutions to accumulate generations of intellectual capital versus a human being’s ability to store but one lifetime of IP encourages a chronic decline in labour’s share of output. Owners of capital benefit from passive accumulation of IP and hence wealth whereas labour must constantly  acquire knowledge to maintain relevance. This increases inequality, potentially without bound.

In many countries, electoral success correlates with the ability to raise campaign finance. Political outcomes are therefore influenced by wealth. Political lobbying further biases outcomes towards the interests of the wealthy.

Inequality in moderation encourages progress. However, excessive inequality lowers the informational efficiency of an economy and lowers growth. It is also a risk to social order. The awareness of inequality has risen in recent years. When inequality begins to feel like injustice, social stability is threatened. Dissatisfaction can manifest in many ways which may be appear only tangential to the real issue.

Climate change and its social implications.

The adverse effects of climate change impact disproportionately upon poor and low-income communities . The poor also have less access to mitigants such as climate control, medical resources and disaster insurance for example. Rising sea levels, drought and famine encourage mass migrations which can catalyse anti-immigration tendencies. The UN has highlighted the risk of a climate apartheid where the wealthy pay to escape heat, hunger and conflict while the rest of the world suffers. The resultant deprivation and discontent could stimulate xenophobic, nationalist and racist sentiment. It could also precipitate anger and anti-establishment sentiment. Today, climate change is in the centre of media and public attention.

There are many ways to avert a climate crisis. Fundamental among them is the need to grow more trees and to stop releasing carbon (by burning fossil fuels which hold carbon sequestered over millennia.) Only plants can effectively sequester carbon. Sustainable consumption can help the cycle by consuming less resources and less energy.

For general sustainability, parsimony is an important concept. The world consumes more than it needs to leading to acute levels of waste. By consuming only what humans need and changing desires regarding what they want, it is possible to hasten the advent of a post scarcity economy. The transition may be difficult. 

Post scarcity

Is the world capable of sustaining a population of 10 billion people? According to the Brookings Institution, the answer is yes. The question, however, is complex. Humans may exhaust land, minerals and fossil fuels, air, water, habitable areas, and other scarce resources. The carrying capacity of the earth is not constant but affected by many factors. The impact of humans is not only characterized by their number but depends also on their per capita consumption and the impact of technology. In addition, projections of population are subject to many assumptions. If the developed world’s demographics are an example, developing world populations will, after a period of high growth, slow and decline as well. Linear or exponential growth models should be tempered. Non monotonic growth is more likely in the long run. The path to a post scarcity future is therefore a possibility. The problem is how we get there. The transition may be difficult.

Money must lose relevance and value. Labour must become irrelevant. The former must follow from the latter, possibly after a period of difficult adjustment. The latter may already be in progress as automata replace humans. Universal basic income may be one policy to help the transition. Ownership of capital is a question that may be raised along the way. These are questions with risky implications for society.

For a while now, the Fed funds effective rate has pushed up against the upper bound of the Fed funds target rate. If not for the Fed, short term rates would have risen above the target range. We see this pressure in repo rates, not just this week but for some months now, where repo is pushing above IOER. This week, just before the FOMC met to cut rates (by 25 bps), overnight repo traded up to 10% prompting remedial action by the Fed to provide liquidity. An initial injection of 53 billion USD was followed by 75 billion USD and is going to be increased to 80 billion USD tonight. Repo is settling down, the markets have been calmed, pundits assure us that this is not a prelude to a 2008 type credit crisis. And they are probably right. 2008 was a credit squeeze in the mortgage market, transmitted by the banking system into full blown panic endemic to fractional reserve systems. This time is different. Slightly. 

Corporate credit has increased significantly in the last decade. The corporate bond market has increased 3 fold, the leveraged loan market doubled. But generally, corporate balance sheet leverage is manageable because earnings have grown. Household balance sheets are the least stretched as banks rationed credit to meet new regulatory standards. The increase in leverage has occurred on sovereign balance sheets. Aggressive tax cuts have increased the national debt and resulted in increased treasury issuance. 

At the same time, the Fed has, since early 2018, begun to shrink its balance sheet gradually. But just as the implications of QE were not well understood as it was being phased in, the consequences as it was being phased back, are also not well understood. We are seeing some of its effects now. 

The market experts are probably right that the repo surge is probably nothing to worry about, but they are illuminating. A number of factors contributed to the repo surge. The FOMC was to meet on Wednesday and announce a rate cut on Thursday. This was widely expected but the concern was that the Fed would send a signal that was insufficiently dovish and could cause a back up in rates. We saw this earlier in the month with the ECB when its 0.1% rate cut and resumption of bond purchases at 20 billion EUR a month was deemed insufficient, or ineffective, and rates backed up aggressively. The reduction in the Fed’s balance sheet over the past year, coupled with increased capital requirements for the banks, led to a shortage of reserves to deploy in the repo market. September 15 is the quarterly deadline for payment of taxes. The treasury issuance calendar has also been full, financing the increasing national debt. 

We now have a hypothesis for why the yield curve had inverted earlier this year. The shortage of reserves led to a liquidity squeeze in the money market resulting in rising short term rates. The Fed owns just under a third of the mid section of the yield curve and under two thirds of the long end. The roll back of balance sheet led to a demand and supply imbalance that lifted the short end and the long end, leaving the belly fairly balanced. The result was a curve inversion up to 10 years, and a normal curve out to 30. 

So we have a theory for how the curve got this way and it has nothing to do with growth expectations. But an inverted curve induces recession as banks borrow at the short end to lend at longer maturities. Maintaining positive margins means that the bank credit market fails to clear. The result is a shortage of credit for SMEs. Large caps have access to the bond market and continue to fund more or less as usual. Quality bank credit assets that can be securitized are also taken out of the equation. That means that the causality between curve inversion and recession is diluted but not completely mitigated. Curve inversion causes credit rationing. 

The Fed needs to cut rates or restore some QE. From an economic perspective, data do not support further rate cuts or bond purchases. Further accommodation may exacerbate valuations and prolong a credit expansion cycle that is in need of decompression. However, the financial system may not be robust against balance sheet reduction. 

I don’t know if this is the justification for President Trump’s encouragement of deeper rate cuts, but the Fed needs to resume QE if it wants to cut rates. This raises a couple of questions. Is QE trap? Is it a policy which once embarked upon cannot be exited without inducing recessionary conditions?