Faultlines in a fracturing world

Cracks appear in the world order Source: Esquire

The front cover of ‘The Levelling’ – clearly the best part – shows a deflated globe. Another way of getting this message across might have been a crystal globe, with cracks appearing.

This came to mind last week as I was summing up some of the important geopolitical and economic catalysts for my first column as a contributor to Forbes, where the aim is that I write on events outside the USA for a largely USA centric audience (https://www.forbes.com/sites/mikeosullivan/2019/08/29/faultlines-in-a-fracturing-world/#3f9c31415890))

My sense, which is now reinforced daily by events such as the trade war, is that there is a fracturing of the old world order that is exposing a range of faultlines. The established world is cracking, the question is whether it will shatter, or whether it can be repaired.

There are at least two varieties of faultline. The first set is where we have the intersection of a disruptive macro development with an existing or incumbent industrial structure – think of the impact of negative interest rates on the European banking system, or the effect of the trade war on corporate supply chains or increasingly, the collision of ethics and technology (for instance opioid drugs or big data).

The second element in the fracturing of the world order relates to geographic areas and/or nation states. A number of them are increasingly making the news and are beginning to cause market ripples.  Strikingly, in each case the fracturing is picking up speed at an alarming rate such that we now go into September beset by three full crises.  

The one that preoccupies me most is the situation in Hong Kong, partly because I love the city and mostly because the ongoing demonstrations there are a microcosm of grander political battles to come – between a state of the world where people sacrifice their liberty for order and economic growth or one that we could call an open society/open economy model.

Should the situation deteriorate further, the onus will be on the US, EU and especially the UK to speak out more volubly, to China’s chagrin. Police violence and the recent arrest of some of the prominent demonstrators is an escalation in this conflict – I am not sure whether this is simply an error or a provocation to the protestors.

I have underlined in past notes that the Hong Kong protests are primarily an issue of liberty and identity, but market and investors are now also been drawn towards it with some focusing on the Hong Kong dollar peg as a source of volatility. I am not so sure – only a major political event such as a Chinese takeover of Hong Kong could push the peg to the top of its range. A more obvious Hong Kong contagion play might be the Chinese currency itself, with a long yen trade as an additional way of expressing risk aversion in Asia.

The situation in Hong Kong would be more alarming if we did not have Brexit as a benchmark, which was the first big rupture in the ‘end of globalization’ thesis. In a sense, nothing has happened with Brexit in that the UK has not yet left the EU, but at the same time the road to Brexit has taken a mind-boggling series of twists and turns.

A difficult, messy ‘hard-Brexit’ looks likely in late October, largely because Boris Johnson has caused so many people to lose faith in him and has whittled away any goodwill he had with Brussels. The step to prorogue Parliament took Brexit into a new realm, a very disturbing one for those who hold the view that what makes Britain are its laws, democracy and institutions. The move will possibly make a hard Brexit more likely, and certainly means that the post Brexit political climate will take on the bitterness of a civil war.

Finally, I am keeping an eye on the two biggest economies in Latin America – Argentina and Brazil. Both represent last chance experiments for populist politics, with the possible electoral overthrow of Mauricio Macri by Alberto Fernandez in Argentina and the increasingly troubled tenure of Jair Bolsonaro.

I recently wrote that the steep fall in the Argentine peso and in its government debt means that it is one of the few countries where sovereign risk is now beginning to be correctly priced, though the implications of Argentina’s attempt at yet another debt restructuring could lead to further downside for the currency and stock market. This would spill over to Brazil, whose stock market is vulnerable to an increasing lack of clarity in policy making and an increasingly contentious foreign policy. In each case, the strong dollar is an unwelcome financial headwind.

A potential formal default by Argentina may well also further damage the credibility of the IMF and by extension Christine Lagarde. The only good news is that Argentina’s woes will mean that austerity is no longer the knee-jerk response of bodies like the IMF to financial crises.

September promises to be lively.

With best wishes,

Mike

Death of the bond market

Now time for the death of bonds?

This week a very wise friend alerted me to the fact that exactly forty years ago, BusinessWeek magazine decorated their frontpage with the proclamation of  ‘The Death of Equities’. As with many bold magazine covers, they got it horribly wrong. At the time the S&P 500 index stood at 107, and it has recently touched over 3,000.  

Part of the reason that equities have done well is that inflation has been brought under control (largely by Paul Volker and to a degree by Alan Greenspan) and as a result interest rates have fallen structurally. Indeed, if one were to craft a magazine cover today, it might carry the title ‘Death of the Bond Market’ such has been the rally in bonds (half of bonds internationally have a yield below 2% and 20% are in negative yield territory. Perhaps the ‘Death of the Central Bank’ might be an even more provocative headline.

The historically odd phenomenon of negative yields signals lower trend economic growth, the end of globalization, the fracturing of the world order and the failure of policy makers to address these issues. The bottomless ‘central banking toolbox’ has as they say become the only game in town, but it increasingly produces market distortions rather than economic solutions.

With many other writers scribbling away on negative rates, the development that struck me last week came in the tiny sliver of the bond market where yields trade above 10%, and specifically with Argentina, which a year before the BusinessWeek headline, won the World Cup. Argentina has been a constant source of volatility in markets – it has defaulted on its debt eight times since its independence, seen many restructurings and economic crises.

Last week, a primary election vote suggested that Mauricio Macri is unlikely to gain re-election and this prompted an over 30% collapse in the peso (to 55 to the dollar compared to 18 when Macri came to power), and a similar downshift in its stock (Argentina was admitted to the MSCI Emerging Market index in May) and bond markets. With broader bond markets now beginning to price in a recession, there are several lessons from Argentina.

The first relates to country strength – which I define as the ability of a country to withstand economic and financial shocks. The robustness of its economy and the quality of its institutions are two of the factors that make up country strength. That markets can move so dramatically on the likelihood that Macri may not win a second term, shows that Argentina is low on ‘country strength’.

Conversely, as David Skilling of Landfall Strategy shows in his excellent, annual ‘State of Small Advanced Economies’ Report, the likes of Singapore, Norway and Switzerland rank amongst the highest in the world on factors like productivity and human development that help to generate ‘country strength’ or ‘resilience’ (https://twitter.com/dskilling/status/1162232440468824069). As the trade war deepens, this factor or quality will become increasingly prized by markets.

In emerging markets, this will be doubly the case, not least as globalization gives way to a multipolar world. Here, the example of  Argentina in the 1920/30’s is worth studying. At the time, the world was coming to the end of the first wave of globalization, and Argentina was an economic and financial powerhouse. However its economy was heavily dependent on agriculture and as a result was not resilient enough to deal with the collapse of globalization. The rest as they say, is history.

Argentina and the predicament of Mr Macri also hold lessons for international policy makers. Should Macri be replaced with the Alberto Fernandez government that markets fear, this will further damage the reputation of the IMF, and its austerity first policy recipe-book. Macri had pursued financial reforms but the effect of austerity has been politically costly. Much the same is true across the euro-zone. In future, if there are to remain relevant, bodies like the IMF will need to work around the political consequences of reform programs, and the time inconsistency implications of them for politicians.

Reform minded governments usually do not last to see the fruits of their labour, and as such reform programs may well need to be tilted away from fiscal consolidation and more towards supply side and institutional measures that will improve a country’s ‘strength’, and that will give serious political reformers a chance of staying in power to enact their policies. To this end, it may make more sense for bodies like the OECD to be more involved in economic rescues than the IMF.

For the time being, Argentina’s debt is an outlier in that it is perhaps one of the few fixed income assets that correctly reflects a country’s fundamentals, rather than the mirage of ‘QE’ (quantitative easing) driven pricing. In this way it is ‘normal’ and the rest of the bond world is increasingly absurd.

Have a great week ahead,

Mike