Beware negative interest rates. The intention of central banks imposing negative rates upon an economy is to stimulate growth. But if 10 years of falling rates have done little to stimulate demand, 7 of those at close to zero interest rates, why would negative rates encourage more demand? Taken in the extreme, negative interest rates will encourage owners of money to change the relationship with their depository institutions from one of debtor to custodian. The result would be a withdrawal of money from the money market into a custodian network. There will of course be custody expenses but these are limited and such expenses are, at least for now, beyond the influence of central banks. Negative interest rates could therefore trigger a contraction of the money supply which would maintain the zero bound in market rates of interest while liquidity would overflow out of the money markets. The provision of liquidity to the system will have become waterboarding.

The FOMC meets March 16, the ECB March 10, the BoJ March 15. Confidence in central banks is waning resulting in more volatility surrounding signals they send whether hawkish or dovish. It certainly appears that central banks have reached the limits of policy and that efforts to boost growth will have to be even more innovative, if in fact growth needs boosting. Given the dogmatic pursuit of growth apparently beyond the natural metabolic rate of the global economy, it would not be surprising if fiscal policy were engaged.

In some ways, fiscal policy will be more effective than monetary policy. For all the magnitude of QE, it only supplies credit to the economy, it does not directly increase demand. QE policies assume that there is always demand for credit, but this is clearly not the case. If governments insist on pushing the economy towards a higher target growth rate, in the absence of private demand, it may have to spend. It cannot finance this spending out of taxes as that would sterilize the fiscal expansion. Instead, government would need to run a deficit and monetize it. When economists speak about ‘helicopter cash’, this is what they mean.

There is another way, which is to tax and spend, but to do it in a tax neutral and redistributive way. Imagine a wealth tax of 100% for all wealth over 100m USD. Put aside the practicalities and politics of such a tax for a moment and see what can be done with this. By one estimate (by Boston Consulting Group), this wealth totals 10 trillion USD, basically equal to the current nominal annual output of China. The marginal propensity to consume of these ultra-high net worth people is presumably quite low. Imagine if this, expropriation, to put it candidly, were ‘spent’ by distributing it to the bottom tenth of the global population, a group of households who could not save their income because they might be living below the poverty line, the boost to global output would be substantial. This is an absurd limiting case of course, but it illustrates the cost of inequality.

Economic orthodoxy will not easily relax the need for fiscal rectitude and austerity. Monetary policy has clearly hit a wall. Fiscal policy will eventually need to be engaged, and again, I qualify that this is if we target growth at a level beyond the natural metabolic rate of the real economy. Then countries will begin to tax and spend. Around the world, the people have already signaled their political choices, and it leans that way. Perhaps the masses know something the economists don’t.

2016 began with very weak equity and credit markets. Markets reacted strangely and counterintuitively to data and central bank policy. So, how does one invest in times like this? Ideally, one invests in precisely the same way one invests in calm markets. When the herd is panicking, calm is the scarce resource and therefore valuable. A few principles are worth remembering.

Find the exit before the entry. This is true whether one is investing or indeed doing anything. It is a most general concept. It is fine if the exit is expected to be a tricky one. Recognizing it as such prepares one for the eventuality and advises the enthusiasm of the entry. Sometimes, the exit requires that the market comes to its senses, and sometimes the exit is structurally established. Relying on the rationality of other investors is a risky endeavor, judging by one’s own rationality or lack of it. Relying on a structural or contractual exit is better, but the returns are usually commensurately smaller.

There is no return without risk. If there appears to be such an opportunity, then one has failed to identify the source of risk. Risks are not limited to market risk. General conditions can change altering the fortunes of companies and countries. Laws and regulations can change or be open to interpretation. Contracts are not always honored or enforceable.

Compounding is powerful. It is difficult to compound a volatile investment. An investor should realize that losses are inevitable. The nature of compounding is such that you want your profits to compound, that is to grow exponentially, and your losses to be linear. The only way to do that is to limit your losses. The downside to this strategy is that you will leave a lot of profits on the table, which is still preferable to sustaining losses which take too much time to recoup.

Managing losses comes with experience. Investors who have never lost money are either economical with the truth, or have yet to make a loss and are therefore inexperienced in dealing with it and at risk of sustaining a bigger loss than one practiced in the art of losing. Lose often, not big. But not too often for that is when embarrassment takes over.

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, said the great Warren Buffet. This needs some qualification. The market isn’t always greedy or fearful, most of the time its just mildly manic depressive. In these in-between states, it pays to be with the herd. How can you tell when there is fear? It’s when you yourself are fearful and selling. You will feel awful and feel like selling everything. Until you get there, it’s not fear. You must be acutely opposed to buying when you buy.

Managing one’s own emotions is at least as important as the cold rational decisions one is supposed to make. Completely removing emotions from investment decisions is almost impossible to do unless one delegates the decisions to a trading algorithm. The patchy performance of such algorithms implies that there are elements of our emotions which are useful in investment decisions, or that algorithms are inherently incomplete. A few rules might be necessary to mitigate emotional biases, such as having stop losses, independent risk managers, diversification rules and time outs.

Don’t overdo it. When a great investment idea comes along, do it, but don’t overdo it. Wall Street is great at coming up with great ideas but overdoing them, that’s why they almost always end in tears. CDOs, CLOs, SIVs, CDS, portfolio insurance, risk parity. At the more practical level, this applies to sizing your investments. You will never have enough of a winning position so make sure you don’t for if you do, you might have too much of a losing position. Best to always go away slightly hungry.

Leverage is not a bad thing, it makes good things better and bad things worse. Most importantly, far more important than the multiplier effect, leverage transfers control over an investment strategy away from the sponsor or equity to the senior lender. Structure leverage and use it with care.

We are not smarter than everyone else. It is natural to believe in our own intellectual superiority, but in fact we are the average. To avoid turning investing into a game of pure chance we need a sensible process and discipline. Genius is rare and cannot be confirmed.

China’s growth is evidently slowing and investors are concerned. China is the second largest economy in the world, and it is a manufacturing hub importing commodities and intermediate goods and exporting finished goods. More recently, China has extended its connectivity beyond trade in material goods but has sought participation in and sometimes led the establishment of significant clubs in the international arena. The establishment of the Asian Infrastructure Investment Bank, and the inclusion of the RMB in the IMF Special Drawing Rights are examples of how China seeks to engage and be part of the world. However, it is feared that its current and future position makes it a nexus for economic and financial contagion. To understand the potential for this it is useful to understand why China is slowing and if that rate of deceleration is a cause of concern or not.

Since 2008, the world has been in a Cold War in trade. As countries exhausted domestic consumption, their financial markets stopped funding business investment and their governments exhausted reserves in rescuing their banking and financial systems, trade became the only viable source of growth. A currency war was fought under the cover of financial system desperation’ it continues in fits and starts today. Weak economic data has become a relief as it justifies more monetary analgesic and currency debasement. New battlefronts have opened in the form of re-shoring in the case of Western economies previously happy to outsource manufacturing to foreign shores. The evidence lies in the stagnation of global trade since 2012. For an economy designed to export like China, a trade war is damaging. Exports as a share of GDP have fallen from 36% in 2006 to 22.6% at the end of 2014.

A related theme is the balance between manufacturing and services in the economy. Globally, services are growing whereas manufacturing is in decline. This is another consequence of the Cold War in trade. Manufacturing is more export sensitive than services so as global trade slows more than global growth, manufacturing must slow relative to services. This is a phenomenon measured from Asia to Europe to the US. As manufacturing capacity is re-shored, countries like China must experience a surge in excess capacity, even if GDP does not actually shrink. In the case of China, because manufacturing was the larger contributor to output, its relative weakness translates into weakness in aggregate growth.

It is illuminating of the culture that the shift from investment and exports to consumption and services is portrayed as an intentional strategy when fact it is a phenomenon which China cannot avoid.

Then there is the matter of simple mathematics. Economies are expected to grow exponentially even though this is not realistic. Economists expect constant growth rates or use this as the basis of their calculations even when they don’t expect constant growth rates. When growth rates are high, the path of nominal GDP levels, not growth, is exponential. When growth rates are lower, constant growth rates approximate linear growth in the level of nominal GDP. Technically, the higher powers of the polynomial can be ignored when the growth rate is small, and the linear component is sufficient to capture the growth. When China’s GDP was 3.5 trillion USD, it was easy to grow at 10% per annum. China’s GDP is some 11 trillion USD in nominal terms. If China adds 700 billion USD of nominal output every year, that is it grows linearly, growth this year, 2016, would be 6.4% and growth in 2017 would be 6.0%.

While China’s slowdown is understandable, it cannot and will not simply passively accept its fate. China recognizes that as the world evolves it too needs to keep up with it. It has to address a number of issues.

As China opens up as it evolves it has to adopt international standards and norms consistent with a free and enlightened society. The complexity of managing an economy without arbitrary control over the populace is risky both economically as well as socially. To diversify its risk, the Chinese Communist Party recognizes that rule of party poses to itself an existential risk, a risk which can be mitigated by embracing rule of law. This is already well underway as evidenced by the focus on the constitution and the anti-corruption campaign.

China is engaging the world by joining and creating economic and political coalitions such as the AIIB. It continues to engage in trade as buyer even if its export competitiveness has been eroded. China’s adventures in the South China Sea are most probably a device to appease the nationalists at home who tend to have a bit of a persecution complex and see China’s engagement in the context of weakness.

China is spending more on R&D than ever before and has overtaken the US, Japan and Germany in terms of patents filed. Not all of this frantic patent filing will be productive but China is reacting to the charge that it has a poor record of generating intellectual property and is more adept at stealing it or buying it.

Change has direct monetary as well as opportunity cost. Rebalancing an investment and industrial heavy economy to consumption and services is costs in growth. China has stated that it wishes to maintain growth near current levels, impossible without central bank largesse. The PBOC has been busy providing liquidity to the economy to compensate for the slowdown associated with restructuring costs. We have seen the debt accumulation post 2008 as China first reacted to the new reality in international trade. This will continue. The PBOC, however, knows it can only deal with one problem at a time and it has chosen to allow debt to pile up, as it must, but tackle the more immediate issue of debt service. Enter targeted open market operations and debt restructurings, particularly of local government debt, to reduce the debt burden on the more indebted corners of the economy, the local governments and SOEs. At the same time it is directing credit towards SMEs and households. Unlike developed world central banks who pull 2, maybe 3 levers, interest rates, size of balance sheet and maturity schedule of balance sheet assets, the PBOC has many more levers and behaves like a creditor committee working to maintain the going concern of its massive economy.

China is full of opportunity but it has never rewarded the macro investor who buys equity index exposure, not for long anyway. Investing in China requires an understanding of businesses, their prospects, the behavior of management and of the government who continues to direct capital where it is needed and siphon it away from where it isn’t. China is a stock pickers market but fundamentals are but one small part of the analysis. Policy, frustratingly opaque and seemingly arbitrary, play an important part also, in determining price discovery in this fascinating market.

Global trade has stagnated since 2011.

Why has trade stagnated?

In the wake of the global financial crisis of 2008/9 countries realized that their consumers were weakened, their businesses were discouraged, and their governments had used much financial reserves to bailout their banking systems. The only feasible driver of output was trade. All countries therefore attempted to increase net exports.

A state of Cold Trade War has persisted since then. Initial battles were fought in foreign exchange where each country in turn attempted competitive devaluation. Subsequent gambits included reshoring of manufacturing and protection of intellectual property to protect domestic businesses. It is impossible that all trading nations are net exporters. Currencies are quoted one in terms of the other. There is no successful resolution to trade wards, cold or hot.

 

What are the consequences of a Trade Depression?

In a trade war, exporters suffer, as currency volatility, protectionism and mercantilism weigh on business conditions.

Manufacturing is more export exposed than services. Manufacturing suffers relative to non-manufacturing. This has been supported by empirical data.

A general favoring of non-manufacturing over manufacturing explains the weakness in the Chinese economy as the larger part of its economy slows and the smaller services part of the economy takes over. It means, however, that the rebalancing is not a voluntary action by the Chinese but a reality imposed by circumstances.

A reduction in trade negatively impacts productive efficiency and lowers global productivity growth. Post 2008/9, productivity has been volatile and weak and this is set to continue.

Slower productivity growth implies lower efficiency and a smaller output gap. So far it has been assumed that central banks have much latitude to operate expansionary policy, however, a tighter output gap could challenge this assumption and introduce more uncertainty around interest rate assumptions across term structures via inflation expectations.

The uncertainty created around central bank policy and around the trajectory of rates and the shape of term structures will have significant impact on asset valuations.

IMF World Trade, Exports:

 

The Euro Stoxx is down 12% year to date as I write this, Nikkei down 15.85% and China down 16-20% depending on the exchange and S&P500 down 9%. A barrel of oil (-20% YTD) is now cheaper than a barrel of fried chicken at a fast food restaurant.

I read in the newspapers that the collapsing oil price, WTI now trading below 29, is one of the factors for the rout in global equity markets, and I find this a bit strange. I understand that weak oil prices are not so good if you are in the middle or the periphery of the oil industry but for consumers, this is not such a bad thing. One argument goes that weak oil demand is an indication of a weak global economy yet we are increasingly seeing data favoring services over manufacturing almost across the globe, which could weaken that particular argument.

I also read that the slowing economy in China is responsible for the weakness in global equity markets. Yet China and the US have simultaneously turned away from one another, the US reshoring manufacturing and China turning to domestic consumption. I understand that this bodes ill for economies and industries supplying old economy China, heavy industry and somnambulistic state owned enterprises. But China world trade stagnated in 2011 and has not recovered. The world is less global from a trade perspective than it used to be. China’s ability to export deflation is contained.

Emerging markets have been cited as a source of risk. Capital flows on the back of QE(N) supported unsustainable business models and propped up currencies and assets which are now retreating as capital flows reverse. Some emerging markets have again funded themselves in USD, but where credit creation has been greatest, China, debt has been raised mostly in local currency, and the Chinese government still has sufficient capacity to support its markets and economy, if it is smart about it. Even the biggest cache of ammunition is quickly depleted by a loss of confidence.

If there is a real problem that threatens to plunge us into the next crisis, it’s unlikely to be one of these. The oil price has been declining for 18 months and China has been slowing since 2012. Emerging markets do not suffer from a balance sheet problem but a business model and cash flow problem, not insignificant, but known and therefore unlikely to be a blindsiding impact. For that we have to look elsewhere.

But since the markets are looking a bit seasick, perhaps we should try to find some positives to sooth ourselves.

One, regulators have not been complacent. The banking sector is safer now than it was before. Banks have been forced to raise more capital, to deleverage and to be more prudent in lending practices. Not all regulators have been as successful and not all banks as cooperative, but by and large the system has been fortified.

Two, central banks have not been complacent, but they may have been one dimensional. Efforts to boost output through QE have been widespread and determined. The US has ended its QE activities but they have not reversed them. Plans to reverse them have, in fact, been placed on the back burner. Whether this is a good thing is another matter. The ECB has been slower to act and then less robust, but circumstances will likely pressure them to do more. The BoJ is already at the limits of credulity in its efforts and is attempting more subtle adjustments instead of outright increasing the expansion. The PBOC has the most complex problem and the most complex policies, but is supplying liquidity wherever and whenever it is required.

In the absence of cataclysmic risks it would seem rational to seek investments which offered good value. Chinese equities listed in Hong Kong are pretty cheap, so is Korea, Taiwan, Vietnam, the US auto, transportation and tech sectors, Brazil, Argentina, Russia, Turkey and just about any MENA stock market. Some of those markets are cheap for overwhelmingly compelling reasons, recession, stagflation, sovereign insolvency, broken business models, but not all of them are and value can be found. The same variation of valuations can be found in credit markets, with the same variation of credit and legal jurisdiction quality and economic strength. Generally, credit is cheap compared with benchmark sovereign and swap curves.

So, should we all go out and buy emerging, frontier and submerging market equities, leveraged loans, junk bonds, and structured credit junior tranches? It depends on your time frame. Too short, and you have volatility, too long and an unpalatable truth might emerge.

Since 2008 we have been playing a game of chicken with the central banks. The system broke, the central banks and governments stepped in to prop things up and reassure us that everything was alright, and we in turn knew that this was not the case but that the governments would have to keep the pretense up until everything was in fact alright. We always knew that one day, either everything was alright and our initially artificially elevated asset values were justified, or that things were not alright and the game was estimating when the wheels would come off the government QE machine and asset values would head lower in pretty short order.

When central banks are the determinants of asset prices, volatility is not a reflection of the risk in an asset but the risk of execution of central bank policy. A significant part of the volatility is likely due to the recent uncertainty in central bank policy. The Fed increased uncertainty when it failed to raise interest rates in September as it said it would resulting in speculation that the economy was in worse shape than suspected. At the same time, the BoJ failed to increase its asset purchases, as weak Japanese data suggested it would have to do, disappointing the market and leading to the unwinding of large consensus shorts in JPY. The ECB failed to increase its QE efforts enough, announcing a halfhearted extension to the asset purchase program from September 2016 to March 2017. The PBOC’s and CSRC’s multiple miscommunications and missteps led to a severe loss of confidence in the Chinese equity markets. So used have the markets become that they cannot make up their own minds about economic and commercial prospects they need central banks to show them the way. And when central banks themselves falter, investors understandably panic. This is unhealthy, but some change is coming, at least from the US.

The US Federal Reserve has a useful modus operandi. When it wants to do something, it telegraphs it well in advance, gets the market to price it in and then moves to align policy to the new market reality which it created, thus avoiding nasty surprises. This was not always the case, especially under Greenspan whose deliberate obfuscation may have hid bona fide confusion. From Bernanke onwards we are being fed information to manage us, to co-opt us into the deployment of policy. The Fed will now wean us off scrutinizing its actions as determinants of market behavior by itself becoming more data dependent in policy. With time, it is hoped, the market will try to gain an edge over the Fed by looking at the data.

We are in a period of adjustment, whether central banks still command markets or not, away from watching and front running central banks. It has been an easy 7 years, although many investors made it hard for themselves, relying on fundamentals instead of central banks in those early years after the crisis. Investors are as always slow to adjust. But the central banks are either losing their way, in part because there is no longer a clear and present danger, which is good, in part because policy has reached its limits, or recognizing that it is unhealthy to forever lead the market with a helping hand. Their messages are less clear and they seem less certain, even in Europe and Japan. The adjustment from policy focus to fundamental focus is a turbulent one with elevated volatility through the process.

The question then is, what will the fundamentals tell us? What valuations will we accept, under the assumption that central banks no longer drive asset prices. History is a guide but adjustments will need to be made to account for a loss of efficacy and certainty of central bank policy, a weaker credit transmission mechanism due to greater bank regulation, slower trend growth, slower global trade as countries seek greater self-sufficiency, the evolution of economies under innovation – the dominance o
f services over manufacturing, et al. Estimates for uncertainty around growth estimates will also need to be updated to take into account greater financial stability within the banking sector, the gradual withdrawal of central bank influence, income inequality and the risks of social unrest, increased geopolitical risk as countries become more insular, et al.

In the long run, growth will likely be lower, the loss of specialization by trade is an important factor as is credit creation which has run well ahead of itself and needs to be allowed or encouraged to mean revert, and asset markets will need to reflect this, likely with lower long run equilibrium valuations both in equities and credit. From the early 1980s we rerated in volatile fashion with booms and busts until we peaked in 2000. From there, valuations have fallen, again in volatile fashion. This long cycle derating is likely to continue, and again in volatile fashion.

In the medium term, an investor working with long term valuation assumptions will need patience and loss tolerance. The market will continue to adapt to the slowly changing reality of policy’s role in asset pricing, and in so doing will regularly overshoot in both directions providing good entry points and exit points to the lucky or smart investor. I’m happy to be either, I’m not fussy.