Roof

Courthouses are fascinating places, and often help to shine a light on the deeper, darker layers of society. One example which sticks in my mind is the hosting some years ago by the London High Court of disputes between Russian oligarchs. The proceedings provided insights into the workings of Russian ‘capitalism’ and in particular uncovered the term ‘krysha’, or ‘roof’. Its essence is that individuals are given protection (roof) or cover from interference, in return for money or other obligations.

Whilst I know little about the darker corners of the Russian economy the phrase ‘roof’ struck me as a useful one in the light of recent central bank interventions. Regular readers of this note and those who have read The Levelling will know that I consider that in recent years central banks have encroached too far into financial markets, to the extent that they ‘own’ them, economically and psychologically. Amongst the many risks that this can lead to, is for investors to believe that risks in markets are uneven (i.e. the Fed will cover downside risks) and this may help to explain why it took markets so long to react to the outbreak of the coronavirus crisis in January.

The latest moves by the Federal Reserve, in particular that to support the high yield bond market, are redolent of ‘roof’, though ‘floor’ might be a better term. In doing so the Fed distorts market prices, offers one sided ‘bets’ to speculators and helps out reckless investors. Apart from curbing market disorder, some of the Fed’s actions will have very limited economic impact at a time when small businesses and many households in the US are struggling.  

For some, this will create the impression that the Fed is beholden to Washington and more Wall Street than it is responsive to the broader American economy. What is more troubling is that the Fed’s activism will allow a stock market centric president (see my January 19 note ‘Peak Stocks, Peak Trump’) to claim a sense of ‘mission accomplished’, whilst ignoring the deeper economic and public health carnage of the crisis.

In markets, what is noticeable is that assets that do not have ‘roof’ appear to be underperforming those that do. Emerging market debt and fx have been weak, as have energy prices and copper, whilst small cap American stocks (Main Street) have underperformed the Nasdaq (Wall Street).

In this climate, the non-protected (non-roof) assets, or rather those that are not under the spell of big central banks, will likely continue to offer the best steer as to where the global economy is going – in that respect these assets (copper, oil and EM currencies) point to ongoing stress in the global economy. If this continues to be the case it will create a two-tier investment world where investors trade baskets of ‘roof’ (Fed sensitive assets) and ‘non-roof’ assets (economy sensitive assets) against each other.

In Europe, the propensity of the ECB to offer ‘roof’ is constrained by the political-economic divide between northern and southern economies. While the ECB has nonetheless been relatively speedy and generous in its actions, there has been something of a market backlash against periphery bonds (Italy in particular, and also Spain and Portugal). To one end, this strikes me as investors indulging in a habitual trade in that they expect every market crisis to become a euro-zone crisis.

One interesting rebuttal to this is that the US is beginning to look more like Europe. Note that US state governors (like EU state prime ministers) are enjoying a level of prominence they have rarely had and are beginning to form inter-state ‘pacts’ in the same way that countries within the EU are forming coalitions (i.e. France/Germany, the Hanseatic League 2.0). Financially, there will be greater market focus on municipal debt, the variability of real estate prices and mortgage debt across the US (a la Europe). So, Eurosceptics might well look to the US for their next trade.

As a final point Europe to reiterate the sense of recent comments of the French President, needs to give itself ‘roof’. Endless squabbling about debt mutualization is not the way forward here. The best approach is bottom up harmonization of processes – such as setting up a business, corporate governance and capital markets, not to mention harmonization of ‘emergency’ protocols for crises like the coronavirus crisis.

A more profound solution is to do what Europe has not done in a sincere way since its foundation – a strategy to grow its economies together, that goes beyond wordy plans and empty unenforceable commitments. That is the great challenge for Emmanuel Macron and those (myself included) who want the EU to thrive in a post coronavirus world.

Have a great week ahead,

Mike