Capitalism leads to inequality of wealth.

• Capitalism is based on competition. Capitalism incentivises competition and the maximization of inequality at the micro and macro levels.
• To maximize profits companies have to maximize revenues and minimize costs. Minimizing costs implies indirectly minimizing payments to resources, labour included.
•  Labour’s share of GDP has shrunk consistently for at least the last 60 years. The relentless accumulation of intellectual capital and innovation results in greater efficiency and productivity of resources and capital. To the detriment of labour.
• Individuals supply labour. Individuals can only store a small and finite amount of knowledge in their lifetimes.
• Business entities like corporates are able to accumulate intellectual capital. As the share of returns to innovation increase, enterprises’ share of GDP will increase.
• Capital is scalable whereas labour is not. Intellectual property is an inexhaustible resource whereas labour is not. Individuals do not generally licence their intellectual property, they sell it as an integral part of their labour, rendering the intellectual property of the individual an exhaustible resource.
• Ownership of businesses allows the individual to accumulate more wealth than supplying labour.

· Inequality of wealth leads to slowing economic growth and carries political risks.

• The potential for inequality promotes greater effort, enterprise and innovation.
• Past a certain point, inequality impairs growth. The rich save a greater proportion of their income than the poor and thus greater inequality translates to more saving and a slower rate of circulation of money leading to slower growth.
• When the perceived probability of advancement from the lower strata to the higher strata becomes sufficiently small under the current economic and social system the lower strata will find it unacceptable.

· Slow economic growth has wide ranging risks.

• Humans have evolved social behaviour as an economic expedient. Sufficiently weak economic growth can threaten faith in the social compact.
• Slow growth can therefore encourage less cooperation, more competition, trade protectionism and other anti-trade practices, disintegration of economic and political unions, civil and martial conflict.

· Slow economic growth coupled with high levels of inequality imply that the majority of households experience negative growth.

· Central bank policy has limits and limitations.

• Central banks make policy while having imperfect information about and imperfect understanding of the economy. This leads to oscillations in later time periods. The probability that policy is suitable and adequate is extremely low.
• The more activity, the more potential imbalances are accumulated. The cost of policy is cumulative.
• The engagement of fiscal policy introduces the same theoretical instabilities as monetary policy but adds complexity and the political dimension.

· Low interest rates have multiple effects.

• Low interest rates make it cheaper to borrow and therefore boost consumption and investment.
• When lower interest rates stimulate growth they are inflationary.
• Low interest rates can encourage over-investment and over-capacity which in an economy suffering from weak demand can be deflationary.

· Firms versus Individuals:

• A highly knowledge based economy encourages labour specialization which can lead to loss of flexibility and diversification in the labour force.
• Firms are able to accumulate a diversified portfolio of intellectual capital and even trade in intellectual property. Individuals find it more difficult to do so.

· Globalization and open factor and goods markets increase competition in specific segments of the labour market.

• Segments facing the most immigration face unemployment and wage pressures.
• Segments which face outsourcing also face unemployment and wage pressures.
• For the other sectors, the increased efficiency and productivity is a positive development.

· Technology and Human Ingenuity

• Technology can either augment or substitute human ability. So far the ability for technology to substitute human ability has been limited.
• When labour is abundant the need for and the return on investment in human replacement is low. Efforts turn to augmentation instead of replacement. When labour is limited or inadequate, the reverse is true.
• Low unemployment, rising wages, tight labour markets and low participation rates indicate a mismatch between supply and demand for labour, namely, a labour shortage, an environment which might drive investment in human substitution.
• If human substitution increases in incidence social questions about the ownership of automatons may arise. Apart from technological and practical questions, the advent of human substitution technologies will generate many questions in the legal and ethical domain.

· Time and technology blunt the memory of the cost of war.

On September 21st there were two central bank meetings, the Fed and the Bank of Japan, both closely watched but both garnering very little expectations.

The Fed was expected to do nothing and to signal a December rate hike, which it did. The market reaction was positive, not because this was unexpectedly good news but because investors had taken risk off the table, despite having no big expectations for this FOMC. Some of these investors put capital back to work in the anti-climax. The buying, although relatively muted was indiscriminate as investors bought equities, credit, duration, oil and gold.

The BoJ was perhaps even more closely watched and with similarly low expectations. Investors had expected the review to justify current efforts and recommend more negative interest rates. They also expected a targeted effort to steepen the long end of the JPY yield curve. What the BoJ delivered was a promise to raise inflation expectations, perhaps beyond 2%, to be flexible about its bond buying, to maintain a cap on the 10 year JGB yield and an effort to steepen the yield curve. It was a lacklustre package, maybe even a disappointing one. The initial reaction was a rise in equities and a fall in JPY. It is too early to tell where they go from here but if the market was unimpressed by the BoJ’s negative rate debut in January it is hardly going to be impressed this time.

One view is that the BoJ’s lack of determination is a sign that the government should shoulder some of the burden. The Prime Minister has publicly welcomed the “new policy” and will “coordinate closely with the BoJ to accelerate Abenomics.” Quite how new the policy is and how Abenomics is to be accelerated remains to be seen. As long as rates and JPY do not rise too quickly or far, the economy appears to have a chance to muddle on, and there are some signs of material progress in Abenomics’ Third Arrow. Economic immigration, for example, has been growing as regulations have been relaxed and businesses begun to hire foreigners.

On current demographics and reasonable growth forecasts, Japan will not be able to repay its national debt in the foreseeable future. It has already amended its 2016 debt issuance by  3.7% or +60 billion USD, paltry, but a start.

It needs to keep issuing debt. The debt must be bought by private investors, such as the private commercial banks. The BoJ will then buy the seasoned bonds from these private investors. It could buy the bonds directly from the government but this would merely finance the fiscal deficits, which would be direct debt monetization or helicopter money, which is apparently frightening and illegal. Passing through private hands has an advantage. It is Chinook helicopter money, two rotors. First, it still monetizes the national debt, indirectly but effectively. But second, it generates a profit for the initial buyers, and thus puts money in their pockets. Now, if bond yields decline continuously, this generates a capital gain for the investor, but is not sustainable since eventually you get to negative rates at long maturities and undermine the entire savings, banking and insurance industry. A more sustainable strategy is to steepen the yield curve, particularly at long maturities. In February 2016, investors who held on to 20 year JGBs for 5 years say, would have made 1.5% p.a., on top of a 0.5% – 1% coupon just from the rolldown. This ROA is quite substantial given current interest rates. For a bank which can leverage the position, and since JGBs consumer zero capital, the impact on ROE is significant. This works best at long maturities as duration multiplies the roll down which is otherwise too small at shorter maturities. By September the yield curve has flattened so that the same trade would earn 0.95% p.a. This strategy only works with a steep yield curve.

There are a couple of loose ends to this strategy. At some point the national debt will simply get too big. One way of addressing this issue is for a selective debt forgiveness whereby the BoJ converts its holdings of JGBs to zero coupon perpetuals. Or cancels them altogether.

This just leaves the persistent strength of JPY. This is troublesome for an export economy like Japan. When the BoJ cut rates into negative space in January, JPY weakened for less than 24 hours before appreciating some 16% to September. One way would be for the government or the BoJ to buy USD and USD assets such as US treasuries.

This strategy supports the following measures: 

BoJ keeps buying JGBs in secondary market. Check

BoJ keeps the yield curve steep. Check.

BoJ keeps short rates low, perhaps further into negative space. Maybe.

BoJ converts debt to perpetual zeros or cancels its JGBs. Maybe.

Japan government increases issue of JGBs. Check.

One day in the future, the world has nearly depleted its resources. Natural resources have been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth in the developing world has led to over-population and overcrowding in cities, while some areas face neglect and become under-populated. Parts of the world become dumping grounds for industrial and energy (read nuclear) waste. These areas become permanently uninhabitable.

The rise of robotics and artificial intelligence is a significant factor in exacerbating inequality through mass unemployment and a rising share of output accruing to owners of capital. Inequality of wealth within countries gives way to social tensions and domestic secular terrorism and limited civil war. Countries turn inwards and escalate an existing economic and trade war. In some cases, these turn into full martial conflict.

The complete depletion of resources forces some countries to surrender to others in order to survive. Eventually there is peace, but the scarcity problem persists. A united Earth begins to search a new home, a new planet on which to settle. One is found some 200 light years away. Analysis indicates a resource rich world with an atmosphere and gravity similar to Earth’s, not only capable of supporting, but on current evidence, actually supporting life. Unfortunately, this includes intelligent, humanoid life.

An analysis of animal behaviour suggests that the optimal approach is invasion. Spacecraft are built to not only transport the human population of Earth to the new planet but provisions are made for combat and conquest. Fortunately, the evidence is that the population of the new planet, dubbed, KoHo, is relatively technologically primitive and easy prey.

50 years of preparation later, Earth is evacuated and the first transports are launched, destination KoHo. A 400 year journey begins. The period begins in peaceful cooperation but soon, civil strife ensues, on account of inequality and segregation by wealth and social status. A revolutionary, left wing faction develops commanding some 20% of the fleet and population. War erupts lasting 100 years. The war ends in the destruction of the revolutionaries and some 50% of the fleet and population.

The surviving population rebuilds and continues their journey to KoHo. Upon entering the KoHo system, there are initially difficulties in locating the planet KoHo. When the planet is finally identified, landing parties find an abandoned planet devoid of life or resources.

Archaeological studies indicate that a humanoid species lived on KoHo and, similar to humans, ruled the planet at the top of the food chain, using its intelligence and technology to dominate the planet.

One day, this world had nearly depleted its resources. Natural resources had been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth had led to over-population and overcrowding in cities, while some areas faced neglect and became under-populated. Parts of the planet became dumping grounds for toxic industrial and energy waste. These areas became permanently uninhabitable…

A solution had to be found. Fortunately, a living, breathing planet was found, a blue planet some 200 light years away…

Inflection:

From the rhetoric it is apparent that the Fed wants to raise rates, the question is not if, but when. The ECB’s recent inaction and signals point to a pause and a possible rethink about QE. The BoJ is currently assessing the efficacy of current QE and has already surprised the market by its hawkish inaction in the face of weak data.

PMI data have been consistently strong globally with the exception of Japan and recently in the US. Japan is slowing but less severely and the US data is a single data point in a robust trend.

Recent musing by the financial elite have been leaning towards fiscal policy.

1. Are the world’s central banks near or at the point of inflection in super low rates?

The Fed is clearly at the inflection point. The question for the Fed is not if, but how quickly rates will be raised. The options are between slow and super slow. The UST market is unlikely to be complacent.

The BoJ is likely to be at an inflection but is it between holding and handing the responsibility to fiscal policy, or is it to accelerate monetary easing towards further unconventional measures such as debt forgiveness? Economic data while indicating continued deterioration are slowing in their descent presenting the risk that the BoJ may maintain status quo or even cut back stimulus. Or, if fiscal policy is expanded, the BoJ may deem it unnecessary to increase its efforts. Interest rates can be cu
t further or QE expanded but current efforts have not been effective and more of the same is unlikely to be helpful. The only shock and awe policy left is to cancel some of its holdings of JGBs effectively monetizing legacy debt. Politically and culturally, this is unlikely.

The ECB is reviewing the effectiveness of its QE program. On recent cyclical data, the ECB may conclude it has done enough. The Eurozone does not have fiscal union and fiscal policy will be decided at the national level although Brussels will have influence though the Maastricht conditions. Politically, Europe has less scope for fiscal policy, and even less for a concerted effort.

2. Has monetary policy reached its limits?

The question is moot in the US for now, although a prudent Fed would at least academically consider its options should the economy slip back into recession.

The BOJ is likely at its limits. It already owns a third of the national debt and is struggling to find assets to buy. It’s NIRP has resulted in a rise in deposits. Economic data remains weak although the pace of decline has slowed. More data are required to be certain but the current evidence is that monetary policy has had limited impact.

The ECB is likely close to limits. Negative interest rates have led to limited cash hoarding, including by corporates. The asset allocation of the QE has been politically constrained resulting in the capital flowing to where it is needed less, Germany and France, instead of the periphery. The ECB is unlike to be able to increase the scale of QE although it could make further progress by moving asset allocation away from the capital key.

3. Will fiscal policy be deployed and to what extent?

In the US this is academic. Politically also, it will depend on the future composition of Congress, the Senate  and who occupies the White House.

In Japan, fiscal policy engaged now will only be another salvo in a series which has seen the national debt swell to 2.5X of GDP. However, given the BoJ’s recent demeanour and Abe’s control of Upper and Lower Houses, fiscal policy cannot be ruled out.

Politics will make fiscal policy difficult to approve in Europe. Germany can afford it but doesn’t need it. France might but probably can’t and peripheral Europe almost certainly cannot afford it but might need it most. The political uncertainty in Europe makes this a difficult call.

4. Asset prices are very sensitive to the base curves. Equities are cheap relative to binds but otherwise expensive. IG spreads are reasonable to cheap and HY spreads are reasonable. The problem reduces to developing a view around base curves.  

USD.

Short end is very sensitive to Fed funds. Long end is more sensitive to inflation. Long end will find less upward pressure from risk of fiscal policy.

JPY.

Japan is already engaged in fiscal policy albeit not in a determined way. This would normally exert upward pressure on yields.  Much will depend on the BoJ’s review of QE due 21 September. The results could be a) mission accomplished, b) QE didn’t work, more needs to be done, and c) QE didn’t work, a new approach is needed. I’d a) then JGB yields will likely rise as will JPY, if b) JGB yields will likely fall as will JPY. The last scenario is the most interesting but unpredictable. A debt cancellation is the most likely strategy left and is one which allows Japan to raise more debt and spend more. On its own, c) should drive yields lower with JPY, however, c) is also an enabler of an acceleration in fiscal policy which would drive JGB yields higher.

EUR.

The system wide PMIs indicate a cyclical recovery in the Eurozone which should signal a success of policy to the ECB. The recovery, however, is not evenly distributed. The recovery in Spain is threatened by politics, the recovery in Italy by politics and specific issues in its banking system. France is in a very slow recovery with high political risk. Germany could do without any monetary or fiscal support. A tailored monetary solution is difficult given the single currency and the adherence to the capital key in QE allocation. A targeted solution would be to get off the capital key or engage national level fiscal policy.

The above would likely be neutral to positive for the EUR. Yields would react at national levels. If the ECB gets off the capital key, peripheral bonds will outperform. If national level fiscal policy is implemented, peripheral and core bonds will likely sell off. If both policies are implemented bunds suffer most.

Bank capital.

Bank capital spreads are mostly impacted by regulation and credit quality. They are, however, not immune to volatility in the base curves.

Rising rates will improve bank profitability. However, banks have significant exposure to sovereign bonds and could face losses if bonds sell off. The first order consequence is an improvement in the profit outlook for banks. Banks are generally more profitable in a higher yield and steeper yield curve environment. This is well highlighted by the relatively high short term correlation between government bond curves, yields and bank stocks

Rising rates may provide some volatility and a buying opportunity.

Loans.

Loans carry very little duration, particularly as LIBOR rises above the LIBOR floor, typically 1%.  Higher rates may put pressure generally on corporate balance sheets through higher debt service and refinancing costs. The inflection point may introduce volatility to the loan market which could be a good buying opportunity.

IG.

IG spreads have compressed considerably in the short term and while in the longer term they may be cheap, in the short term the momentum from a duration sell off will likely carry IG with it. Buying opportunity if duration hedged.

HY.

Same technicals as IG. HY could be more resilient as duration element is smaller and credit fundamentals remain robust.