Economic Growth

In the decades prior to 2008, rising credit allowed most economies, even inefficient or unstable ones, to grow and prosper. 2008 marked a turning point in the long term credit cycle. With global deleveraging, weak and strong economies have been revealed for what they are.

Countries hardened by previous crises which have learnt from their past mistakes have emerged stronger. Most of the emerging markets fall into this category. North America, in particular the US with its flexible economy has recovered with renewed vigor. The innovativeness and entrepreneurial nature of the American people, coupled with a free and open market, have allowed prices to adjust and resources to be reallocated more quickly than elsewhere. The result is a self sustaining and stable recovery, even if a modest one. Europe‘s experiment with a common currency has been less successful. The rising tide pre 2008 hid the serious inefficiencies introduced by the common currency, the EUR. With sticky wages and over-regulated labour markets, the Eurozone structural unemployment is currently acutely high. Witness the Swiss and UK economies which unfettered by a common currency have been relatively robust compared with the Eurozone. Asia like Latin America, has had the benefit of severe crises in the 1990s which taught hard lessons about fiscal prudence and balance sheet management both in the private and public sectors. The relative strengths and weaknesses of the North American, European and Asian economies are now revealed by the withdrawal or reduction of credit on a global scale.

Inflation and Interest Rates

Inflation expectations can be similarly extrapolated from the different underlying efficiencies of each country. Massive money printing by the world’s central banks have surprised by not producing the expected levels of inflation. Globalization is an important factor. Open capital accounts allow capital to flow to where it is most welcome or where it obtains the best returns. As a result, capital has flowed to relatively robust emerging markets, creating inflation there, while in the developed markets, capital has gone into asset markets most notably into the equity stock of global companies. If long term interest rates reflect inflation expectations, steeper yield curves are likely to follow. In the meantime, while vast QE irrevocably implies rising interest rates, developed markets long term rates can be expected to rise relatively more slowly compared with inflationary emerging markets. Globally, rising interest rates are almost inevitable. The question is which countries will outperform and which will underperform. The factors driving relative performance will include inflation expectations, public finances, and the current account. With lower inflation expectations and improving terms of trade and trade balances, it is likely that developed markets will outperform, this despite much worse public finances. Fiscal austerity has been deployed to address this issue and is likely to bear fruit down the road. The UK is a case in point where the early application or austerity is currently paying off.

Equities

What are the prospects for equity returns? As companies become more global, national aspects become less important. Is GE a US company or a Chinese one? Is Caterpillar a US company or a Central / Latin American one? Esprit sells more in Europe than it does in Asia. Santander has more balance sheet deployed in Latin America than it does in continental Europe. From 2007-2008 equity markets were correlated as they fell sharply, driven by fear. From 2009-2012 equities remained highly correlated as they recovered, driven by liquidity and relief. Correlations have fallen sharply since late 2012 as equities began to price in the relative and idiosyncratic fortunes of companies. This has created a stock picker market. This is likely to persist. The potential alpha, and it is potential since ex post alpha can be negative as well as positive, is high. The analysis of a company is complicated by their global reach and exposure, by their disparate geographical as well as priority of funding. Interest rates not only represent a cost of business, they are important in valuations as well. The coming rise of interest rates will create different winners and losers.

Besides fundamentals, equity investing requires an understanding of the demand and supply of equities. The supply side is impacted by IPOs, secondary offerings and even share buy backs. The demand side is driven by the nature of the investor base, by psychology, by cultural and historical behavior and by taxation.

For these and other reasons, self directed investment portfolios will be disadvantaged versus the professional investor. Investors are well advised to rely on professional fund managers to invest on their behalf.

Credit and Fixed Income

Interest rates have spent the last 30 years falling. This is unlikely to continue; in fact rates are very likely to rise. In some countries the rise of interest rates will be precipitated by improving economic growth and moderate inflation. In others, rates may rise on inflation expectations. In yet others, rates may need to rise to defend a weak currency. The US is most likely to see rates rise as growth consolidates and QE is gently withdrawn. Initially rate volatility will be high, as when any sort of analgesic is withdrawn. The outlook for the Eurozone is complicated. Emerging markets with high inflation are likely to see higher rates in a less benign light.

Higher interest rates will impact equity risk premia in the respective markets. Where higher rates are the consequence of higher growth and profits, the equity risk premium and thus valuations can be preserved. The US is most likely in this camp. Europe is not only complicated but interesting. European companies are very much global. If disinflation or deflation takes hold in the Eurozone, companies may find their cost of debt remaining low while profits improve. Of course this would require and might imply some sort of mismatch in funding currency. The prospects for emerging markets are similarly complicated. The reader is invited to extrapolate the above line of argument.

Corporate bonds are mostly fixed rate securities and will find it hard to escape the effects of rising interest rates. Even high yield, where the yield is a composite of duration and spread will be affected to some extent. If we think of the spread as being correlated to the equity risk premium, interesting inferences can be made as to the relative fortunes of different issuers’ bonds depending on their currency and country of issue. Where rates rise due to a stronger economy, the spread is likely to compensate for the duration. Again the US is likely to be in this camp. Where rates rise due to inflation the impact of duration may be exacerbated. Readers are left to make their own inferences regarding the regional relative prospects for corporate credit.

The thirst for yield has compressed spreads across high grade to high yield bonds, and bid up the prices of sovereigns and loans and just about any security that threatens to pay an income stream. Yield junkies a.k.a investors have even bought unrated, first loss securities, paying an uncertain coupon and with infinite duration, a.k.a equities, in their quest for yield. The usual intermediaries have of course been quick to meet this demand by offering all manner of income funds.

Given the state of the global economy, weak but for some pockets of strength such as the US, credit has become overpriced, particularly in investment grade but now including high yield as well. Even, or some would argue especially, emerging market bonds, are overvalued. Almost globally, credit is overvalued and the risk of the bubble bursting grows day by day. The market consensus, not bereft of moral hazard, believes that central banks will be able to sustain the credit bubble for longer if not indefinitely. What might confound this thesis?

Short term rates are mostly determined unilaterally and arbitrarily by central banks. It is hard to see the developed markets’ central banks raising rates any time soon given their desperate efforts to suppress their respective term structures. Some emerging markets may already find themselves at the foot of stagflation as global growth slows while inflation rises. Control over the longer term interest rates is not so simple, generally involving intervening in otherwise free and open sovereign bond markets. The Bank of Japan’s latest QE efforts are illuminating. Their stated objective of 2% inflation has had the unintended consequence of causing a selloff in JGBs.

Inflation has thus far been absent from the weak, developed markets, where demand is deficient. Instead it has manifested in emerging markets where growth has been robust. Now even emerging markets seem to be slowing. Yet inflation may be persistent, if sufficient money is printed globally. Witness Brazil‘s predicament of slowing growth and rising inflation. The situation that the major central banks have put us in is one perched between inflation and deflation, an unstable equilibrium.

If inflation should prevail, the ability of central banks to maintain flat term structures will be challenged. Given the low levels of interest rates, debt service is highly nonlinear in rates and could prove problematic. Also, the dependence on almost all asset markets on the level of interest rates in their derivation of value makes them vulnerable to a treasury selloff. Fixed income would be most sensitive, but so would highly geared investments such as real estate and REITs.

Deflation would allow rates to be held low but this would be a Phyrric victory since real rates would have risen.

It is academically appealing to seek causation in market moves but experience has shown that while causation matters, underlying fundamentals can be held back for long periods of time, all the while building unhealthy pressure. Catalysts are more difficult to identify. Often the catalysts lie in the same inscrutable animal spirits that policy has strived to revive. Pressures build in fundamental imbalances and in the collective psychology of the markets as well. Sometimes the catalyst for unwinding a fundamental imbalance or mispricing is purely a turn in the balance of sentiment. Aided by accumulations of gamma at key market levels, such reversals can be quite violent and mark the establishment of a protracted new trend.

The policies that Japan has embraced in an effort to revive its flagging economy are indeed desperate measures. To be clear, I believe that they will work in at least boosting asset prices and reviving the economy for a period of time. The long run prognosis is not so good.

Abenomics is like a swimmer trapped under water who must get to air quickly enough before he passes out. Unfortunately, to do that, he has to swim faster and burn more oxygen thus quickening his drowning. His fate rests on reaching the surface before his lungs give out.

Much of Japan’s fortunes and ills have come from its demographics. Given its current aging and shrinking population, economic growth will be hard to sustain and government budgets will be difficult if not impossible to finance.

The current spurt of asset purchasing by the BoJ coupled with fiscal expansion will only hasten the process of cash flow insolvency. The BoJ’s policy has already become hostage to game theoretic paradox, a curious manifestation of the Lucas Critique. If successful, the BOJ’s 2% inflation goal must make JGBs less attractive and so investors must shed JGBs wholesale. To be successful, therefore, the BOJ must become the sole bidder of JGBs, accelerating a demographical eventuality.

This is a vast acceleration of a dynamic that I had described in my last comment about Japan and it has surprised me. Be that as it may, I expect the BOJ to be able to control the term structure at least for the near future, and thus for the equity market rally to continue at least for about a year as animal spirits are revived. We can already see some optimism among domestic investors and corporates which is a very good sign in an economy which has this far been skeptical about all previous efforts to resuscitate the economy.

The longer term prospects are poor as savings dwindles with the population. Japan needs to reach oxygen before its lungs burst.

10 Year JGB Yields. Source Bloomberg.

The credit infused growth of the last twenty years has allowed many an inefficiency to persist undetected or un-addressed. The EUR is one such inefficiency. Unless national factor prices are flexible or factor productivities converge between countries in the Eurozone, a single currency must impede market clearing leading to inefficient allocation of resources leading to underemployment or unemployment. Only the acute dearth of credit has exposed this systemic weakness, at least to some. Many economists and central bankers continue to focus on the financial markets effects of the EUR without addressing its impact on the real economy. A point will be reached when the real economy issues will demand resolution.

The area most likely to demand attention is the labour market. As long as national level wages do not adjust to reflect differing levels of labour productivity, and without national currencies to effect that adjustment, unemployment must result in some markets, and shortages in others. Productive capacity may be shifted to reflect total factor productivity. This may hollow out manufacturing in some parts of the Eurozone to the advantage of others.

How does this micro structural inefficiency impact he UK and Switzerland? The answer is not simple. It is not clear if the EUR is over valued or under valued and thus if the Eurozone is beggaring its non EUR neighbours. Strictly, any distortion to relative prices is suboptimal for market clearing, so the region as a whole suffers. That said, there can be localized winners and losers. Many companies in Europe, both within the Eurozone and without, are global companies. Europe has a very open economy and so a weak currency helps Europe’s terms of trade and improves its balance of trade. Unfortunately, the weak currency strategy is not unique to Europe, Japan has recently begun to depreciate the JPY in an effort to get its exports going, and trade partners and competitors may not countenance more currency weakness as they too try to boost exports. Also, the common currency impedes price adjustments within the region creating intra European trade imbalances. Were intra European trade less significant the problem might be less troublesome but Europe does considerable trade with itself.

Even if The Eurozone does manage to boost exports, the distribution of profits will be unbalanced, precisely because of the internal misallocation of resources. Based on current observations, the owners and generators of intellectual property and brands will continue to thrive and the rest of the region will continue to struggle. For a more precise analysis of the fortunes of the Eurozone’s economies one would have to ask more specifically what each part of the world wants that The Eurozone can supply.

What must be apparent to observers who are not too close to sovereign bond and currency markets is that the cost of the EUR is not just financial sector stress and banking crises but more importantly a failure of the market in goods and services as well as factor markets. Yet it is the financial markets which have drawn the most attention and policy response. The recent actions of the ECB have removed much of the default risk from the banking system. Calls for closer banking union are misguided because they treat a tangential symptom. At he heart of Europe’s problems is that a common currency cannot serve a region with inflexible labour markets. The realization and the call to action will likely come from a chronic inability of the labour markets to clear.