Why did nobody notice it?

During a visit to the London School of Economics in November 2008 Queen Elizabeth II demanded about the debt bubble, “Why did nobody notice it?”. She might ask the same about the onset of the coronavirus crisis, particularly of her prime minister and her eldest son. The defining characteristic of the coronavirus crisis has been its speed. For example, markets have fallen by the same magnitude as during the dot.com crisis, but this time the fall took 16 days not 16 months.

The speed is explained by the sudden restriction placed on human movement by the crisis, and the fact that in general we are used to dealing with single set piece economic or financial crises (market bubble, classic recession, regional – EM or EU – crisis) and not five overlapping crises at the same time. The speed and drama of the crisis is heightened by the fact that it is breaking things – diplomatic relations, investment funds, political careers and economies.

The policy response has not, as I have outlined in previous mails – been well coordinated between fiscal and monetary policy, nor between nations. That so many policy makers repeat Mario Draghi’s mantra of ‘do whatever it takes’, betrays the fact that the magic of those words is vested in Draghi himself.

Still monetary and fiscal support has come thick and fast and will help stem market pain. My worry is that given we are at the late stage in a very long expansion, it will be harder for policy to significantly boost trend economic growth. Of the other policy measures – the quest for vaccines and treatments is the most exciting, whilst Russia and Saudi Arabia’s adherence to their oil price war is the most disappointing.

From here, I see three scenarios.

Easter: Under this optimistic case (25% likely) the fruits of isolation in Europe begin to show, the race for treatments and vaccines is promising, while central bank liquidity dampens market distress. As such, workers, companies and governments begin to get a sense as to the parameters around the crisis and some visibility as to when and how it can be managed. A slow return to ‘normal’ then begins in Europe and the US in late April. Stock markets hit new highs in October and Donald Trump stays in the White House.

Summer: ‘Isolation’ is increasingly debated on ethical, economic and political grounds. It proves hard to enforce across America and harder still to prosecute in emerging economies. Under this ‘main’ scenario (55%) the second derivative in infections and macroeconomic indicators only begins to significantly improve in mid-summer. As a result, many businesses close or are near to ‘broken’, despite fiscal support. At the same time, investment in ‘newer’ industries – data (5G, AI, Cloud), healthtech and digital finance is accelerated. Still, high unemployment and low trend growth are significant policy issues into 2021.

Winter: Under this ‘pessimistic’ (20%) scenario, much of the world’s workforce is disrupted by the virus, and second waves become the norm. Social unrest, political disunity and a breakdown in diplomacy between nations (US and China for instance) are some of the resulting side-effects. Monetary and fiscal policies cannot contain the full effects of bankruptcies and unemployment, to the extent that central banking ‘accidents’ crop up. The 1930’s is the nasty template to follow here. Property markets and alternative asset classes like private equity are hard hit.

While broad scenarios are useful for framing problems, they are often overly simplistic. One distinction to draw here is between the short to medium term return to normal in terms of end of isolation and return to work, and the enduring long-term imbalances that result from, and are exacerbated by this crisis.

Ideally, following a two-month period of isolation in the US (taking us to mid-May) a return to normal might be in sight.

However, under the surface of the world economy the following trends will have been deepened by the crisis – the end of globalization and the resulting multipolar world, the biggest debt load since the Napoleonic Wars and central banks who are running out of effective policy measures. In the alphabet soup of U, V,L and W shaped recoveries that forecasters talk about, we might well have a cyclical V, followed by a structural L.

With three of the G7 leaders now in quarantine, world political leadership is under strain. It has two battles to fight – beating the virus, and then resolving the end of globalization in as constructive and imaginative a way possible.

With best wishes

Mike

Quid Pro Quo

Otto von Bismarck, 19^th century Germany’s Iron Chancellor, is reputed to have said ‘laws are like sausages, it is better not to see them being made’. With the benefit of very recent experience, the same is true of economic and monetary policy. The lightning speed with which a public health crisis has morphed into a deep, financial crisis has resulted in chaotic policy brawl where bouts of market volatility are met with new initiatives.

There is little sign yet of coordination across nations and regions, and between monetary and fiscal policy authorities. The US, Europe and China are all guilty here. In the short-run, the flow of policy moves will likely eventually swamp market volatility. Policy makers, be it in the Treasury, White House or the Fed may sigh with relief when volatility dies down, but they will do well to focus on the potential of their actions.

While the speed with which the coronavirus has morphed into a deep financial crisis has humbled policy makers, it has also revealed the faultlines in a deglobalizing world.

For instance, world debt to GDP is the highest since the second world war, labour markets have been hollowing out, and instead of investing in capital spending many American companies have deployed cashflow to buyback shares (Boeing, which has spent tens of billions of dollars on stock buybacks and is now seeking a bailout of sorts is an example).

The relevance of share buybacks here is that they have pushed up earnings per share, the choice benchmark for CEO pay. So, with two-thirds of CEO’s being paid according to rising earnings per share, playing a ‘financial’ trade rather than say making better products (e.g. Boeing) has been attractive for executives.

Yet, having debated ‘stakeholder capitalism’ at Davos in January, the corporate world is now entrenched in ‘survivor capitalism’. The risk now is that in treating the fallout from these faultlines, that has been catalyzed by the coronavirus crisis, policy makers paper over bad economic behavior that has contributed to unimpressive productivity over the past decade, and growing wealth inequality.

In this context, policy action needs to have a ‘quid pro quo’. The phrase entered the lexicon of American politics through George H Bush, and more recently in the President’s impeachment case. The notion of a quid pro quo should reign over policy interventions, in potentially, a range of ways that will produce a more sustainable and resilient economic model.

A first suggestion is that though the USA has no corporate governance framework in the same way that the UK does, a ‘quid pro quo’ skeleton framework can be introduced in return for policy support. For instance, it should tie executive pay more closely to underlying profitability and an array of measurable goals, rather than earnings per share. Tax and securities laws can make overly enthusiastic share buybacks and excessive debt loading less attractive.

Second, many businesses that will require assistance – such as airlines and energy companies – are vital cogs of the economy but also contribute to climate damage. One brief upshot of the now worldwide coronavirus quarantine is that the skies over China have cleared of pollution and the waters of Venice have a healthier hue.

Here, financial assistance to companies should come with the rider that as a quid pro quo they change business models to become more environmentally friendly – that can entail more investment in green sources of power and raw material, less investment in extractive industries and an acceleration in the adoption of a ‘green’ approach to urban develop.

Then, while medical studies suggest that the human cost of the coronavirus can be severe – one scenario in an Imperial College London study points to over 2 million coronavirus related deaths in the US – the coronavirus crisis, like the global financial crisis, has laid bare the vulnerabilities of American society.

At a time when life expectancy in the US has been falling and where healthcare is a locus of inequality, and when tens of millions of workers are vulnerable to layoffs, this crisis presents an opportunity to rethink the US healthcare model and to fashion a more resilient labour market. If this is not done now, there will be a severe political backlash.

The idea of a ‘quid pro quo’ is to encourage policy makers to stop and think about the faultlines that the coronavirus has exposed, to mend them and to steer industries and society towards a more sustainable path.

Otto von Bismarck also said that ‘politics is the art of the possible’, now is the time for policy makers to grasp this by matching urgency with foresight.

Have a great week ahead,

Mike

Friday 13

In the current panicked environment, it will not have escaped the attention of most people that last Friday fell on the 13^th of the month. Friday 13th is typically seen as an omen of dark things to come, though its origin is more interesting than many will suspect.

Friday 13^th October (1307) was the day that King Philip (le Bel) IV of France launched a lightening raid against the Knights Templar, imprisoning their Grand Master Jacques de Molay and many others. Philip was in debt to the Templars, whom he also feared for their military power and the clout of their pan-European financial network (they in many respects, invented banking as we know it).

The Templars were subjected to years of torture, the techniques of which prefigure the worst of the Inquisition and recent wars (i.e. water boarding). At the end of some seven years in captivity, Jacques de Molay was arraigned, and upon declaring that his only mistake was to renounce the Templars, he was carted off to be burnt at the stake (there is a memorial to him at the end of Ile de la Cité in Paris). Before dying, he cursed Philip and the Pope, both of whom died within the year.

While this tale is a good diversion from the ups and downs of the Dow, and to scare you the death of de Molay was followed thirty years later by the bubonic plague, it has made me think of the the link between torture/pain and one’s view of the world.

In de Molay’s day, torture quickly made the Templars recant their views, and in markets the same is true today. My first thought is of ECB President Christine Lagarde, who having been born in Paris should be familiar with the plight of the Templars.

On Thursday she stepped into the fire of markets by declaring that it was not the job of the ECB to close bond spreads. It was a brave statement, delivered at exactly the wrong time. Regular readers will know that I often rail against the ‘morphine’ that central banks have provided to economies and markets, and of the need to curb the oversized role of central banks. Lagarde, wisely I think, agrees and she has also expressed the view that European governments (especially Germany) need to be much more fiscally active.

By choosing to express this near heretical view, Lagarde risked monetary martyrdom, and disarray on the periphery of the European bond markets. I suspect that the pronounced and prolonged market volatility will produce a more generous and less thoughtful policy response from the ECB. We should expect a rate cut, more QE and liquidity intervention and I suspect more joint communiques with the Federal Reserve.

Lagarde is not alone in having her feet held to the fire of the market’s ire, Angela Merkel may be next. If there is a time for Germany to engage its borrowing power and fiscal surplus, it is now. Berlin needs to quickly communicate a plan to stimulate the German and by extension the European economy. This must also include ambitious structural objectives such as the need to a unified pan-European capital market, banking consolidation and a common approach to business start-ups across the EU.

If Merkel doesn’t act now, her career will be marked by banking collapses and rising unemployment. Like the network of the Templars, the future of the Union is at stake.

In the same way, the future of Donald Trump and the American approach to capitalism is also at stake. His administration is not the exemplar of the kind of big, responsive and diligent government that is necessary to defeat this crisis. Neither is big, responsive and diligent government something that can be conjured up in the short-run.

As market pain persists, I suspect that the Trump administration will increasingly turn ‘socialist’, and ask the private sector to take the strain of the coronavirus crisis (i.e. organizing testing, work from home and a less aggressive approach to layoffs), and will push for new monetary measures such as ‘helicopter money’ from the Federal Reserve. As the unfortunate Jacques de Molay found, pain can motivate great inventiveness.

Have a great week ahead,

Mike

Recession Rehearsal

The last week has seen many different expressions of adaptive behaviour. First, the Democratic Party establishment and organisation have rallied around Joe Biden, and helped to push him to stunning turnaround in the Party’s campaign for President.

Then there has been widespread adaptation to the coronavirus – people have stopped shaking hands, travel only when necessary and it seems, lead incrementally more healthy lives (though a half-marathon I had entered was cancelled). In some cases however, stoicism wins out – the London Tube is as packed as ever.

In markets, investors – a great deal of whom are unsentimental robots – are adapting to extreme volatility. It has been one of the most extraordinary weeks in markets as investors try to position around the uncertainties introduced by the coronavirus. If and when we get it, a mid-twenties reading on the Vix volatility index would suggest that what might be described as ‘normal’ trading is getting underway.

Then, policy makers have also been adapting, slowly. My sense is that to a large extent the policy reaction to the coronavirus is a rehearsal for how the next recession is met. So far, it has been a shambles.

Jerome Powell, in making a 50 basis point cut in interest rates revealed that he is beholden to both equity and bond markets, and it seems, to politics. His action underlined the existence of the Fed ‘put’ – that the central bank will ride to the market’s rescue in times of turbulence.

The delivery of the rate cut was poor. It focused insufficiently on the sense that this move would provide ‘insurance’ and on the ways it might combat the economic panic (e.g. risk of bankruptcies) associated with the coronavirus.

With the idea of a ‘rehearsal’ in mind, Powell’s move contributed to a feeling that when the ‘real’ recession comes, the Fed will have relatively little monetary ammunition and may, like the ECB and Bank of Japan (BoJ), have to resort to extraordinary measures like negative interest rates.

If that is where the Fed is headed to, then the lesson for them from the likes of the BoJ, ECB and Riksbank in Sweden is not a happy one. The rush towards very low to negative rates in those monetary jurisdictions undercut banking sectors – a key reason why Europe and Japan have had weak recoveries, and also why to date US banks have outcompeted their international rivals. Sharply cutting rates, in tandem with a compressing yield curve, undercuts the balance sheets of banks, and in some cases can deepen a downturn. The Fed needs to study this carefully.

The second issue with the political response to the economic side-effects of the coronavirus crisis so far, is that despite G7 conference call and very general statement of intent, there is little apparent leadership and coordination.

The fracturing of international politics has made sincere collaboration difficult in practice (America might for example have announced a moratorium on sanctions on China). Moreover, the absence of a serious fiscal response in countries like Italy (the support measures announced come to only 0.3% of GDP), and the notable lack of open thinking on how deregulation might serve to boost business, is worrying.

I may be a little too critical here, but the sum of the week’s policy activity highlights depleted economic arsenals. Debt is too high and few countries have a decent fiscal surplus. Those that do, like Germany, don’t have the will to spend it.

It also points to a depleted international policy community – where the goodwill, leadership and force of mind that existed in the 1980’s or 1990’s (I am thinking of the likes of James Baker or Robert Rubin) is no longer visible. In Europe, Christine Lagarde has been strangely quiet.

There is now a need, an opportunity and hopefully time for someone like Kristalina Georgieva, or even departing Bank of England boss Mark Carney, to so a postmortem on the economic policy response to the coronavirus crisis. With world debt to GDP at its highest level since the Second World War, the next recession will be for real.

Month: March 2020

Why did nobody notice it?

Quid Pro Quo

Friday 13

Recession Rehearsal

Recession rehearsal