Recession Rehearsal

Powell troubled by low rates

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.

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