Druk!

Winter it seems, across much of Europe, has come early. Two instincts that grow as the evenings darken are the inclination to have a tipple in the evening and to watch a good film. One Danish work that captures both sentiments is ‘Druk’ or ‘Another Round’, which won the Oscar for best international film in 2021. I recommend it.

In the film a group of four school teacher friends decide to test the hypothesis of a Norwegian psychologist that humans have a deficiency of alcohol in their blood, and the protagonists undertake an experiment to maintain a ‘warm’ level of alcohol in their blood. It is an experiment I attempt often, but the real lesson today is with central banking.

It seems that central bankers have decided that in the spirit of ‘Druk’, the liquidity in the world financial system is not sufficient and have set out to administer near daily injections of cheap money. The number of central banks changing policy (i.e. to negative) is the greatest it has been, apart from the global financial crisis and the COVID period. In September alone there have been 24 rate cuts from central banks around the world.

Chief amongst these has been the 50-basis point cut from the Federal Reserve and the very dramatic, multiple policy moves by China. In short China has cut rates, infused the banking system, made mortgages cheaper and generally tried to spread liquidity over the emerging cracks in China’s economy. In the spirit of ‘Druk’ it is the equivalent of going on a five day bender in order to cure a serious disease.

Nonetheless, the easing in policy from the Fed and China, together with what will likely be a couple of more rate cuts this year from the European Central Bank mean that the world financial system is flush with liquidity. Chinese markets – hitherto the worst performing markets of a major economy – show the impact and importance of liquidity. The market cap of the Hang Seng index has grown by a quarter in less than two weeks. China has overtaken the US in terms of equity market performance to date.

There is no change to fundamentals – I don’t see this policy move having a decisive impact on the downward trend in Chinese earnings, but that doesn’t matter in the near term – liquidity is coursing through the pipes of the Chinese financial system, and in turn might bring a temporary easing to conditions in the property market.

For all the analysts who devote time to measuring earnings and calibrating valuations, the reality is that in this era of ‘quick to please’ monetary policy, liquidity matters a lot for asset prices. My rule of thumb in constructing a measure of liquidity would encompass money supply, the state of central bank balance sheets, the key role of the dollar and net issuance of debt by treasuries.

The arcane notion of financial liquidity has attracted enough attention that the Financial Times recently ran an article breaking down its component parts. A couple of top-flight economics consultancies run their own measures of liquidity – such as LongView Economics and Michael Howell at CrossBorder Capital. The latter holds that we are on the cusp of a significant upswing in global liquidity.

If that is true, the implication for markets is ‘Druk’- a persistent giddyiness whilst central banks keep rates low and liquidity flush, amidst an acceptable level of GDP and profit growth. Friday’s job market figures in the US were very strong, suggesting that in fact there was no need for a large rate cut. This is the kind of macro climate we have seen in the mid and late 1990’s, and one that tends to dampen the market implications of turbulent geopolitics.

From the point of view of asset prices, there are a couple of possible trajectories. Historically, the Fed has started to cut interest rates when the price to earnings ratio on the S&P 500 has been close to 10 times (1960’s to 1990’s). Now, like in 2000, it is in the mid 20’s which suggests that extra liquidity now could run asset prices in bubble territory proper, and cultivate the next bout of inflation, something the central banks’ bank, the BIS, has warned about (helpfully the BIS has taken a counter view to that of its members ahead of a number of crisis).

For the time being, the upturn in liquidity may be most meaningful for capital markets activity and assets in the private economy. They have been in the doldrums. If the ‘Druk’ hypothesis is working we should see a rise in IPO activity into 2025, and intensification in private equity deals and a rise in funding activity (beyond AI firms) in venture.

Then, later in 2025, the hangover will arrive.

Have a great week ahead,

Mike

Building Sovereign Debt Funds

One of the attractions of elections is that they throw up new ideas and policy proposals – and it is not unkind to say that one increasingly gets the impression of politicians throwing suggestions at the ‘policy wall’ to see what sticks. Aggressive tariffs on China and taxes on unrealised capital gains are two examples from the US.

One idea that Democrats and Republicans share is the proposed establishment of a sovereign wealth fund in the US. In the case of Donald Trump, his aim is to fund it with tariff revenues, whilst the Democrats conceive a sovereign wealth fund that might take stakes in firms in strategic industries, which is a very French idea (recalling the ‘strategic yogurt policy’ of 2005). The flaw in this particular idea, is that there is in fact no money to capitalise such a fund.

In stark contrast, I recall the last time Washington pondered a sovereign wealth fund was at the end of the Clinton presidency, when Treasury Secretary Bob Rubin had in a financial ‘end of history’ moment engineered a fiscal surplus (government earning more than it is spending). At the time, the sense was that surpluses would feed a ‘social security’ sovereign wealth fund, which would allow Americans to enjoy a prosperous retirement.

What is striking is that if you look at the history of America’s financial health, the Rubin/Clinton surplus is an anomalous blip. Since then, the US has registered nearly a quarter of a century of deficits, which irregardless of the level of growth of the economy, seem to get bigger (relative to the economy) every year. These burgeoning deficits are starting to take their toll on the US (and I should mention that many other large developed economies – Britain and France prominently so), as its debt level rises beyond 100% to GDP (expected to hit 122% in 2035). It is a very odd situation. In textbook economics, large deficits tend to exist in times of war, recession or crisis. As such, if any of these occurs, there will be scant room for governments to help the economy (and rescue plans may become a trial of strength of central banks).

That’s not all. Readers will sense that I am writing more and more about indebtedness, and it is indeed becoming a preoccupation of mine. The idea of the ‘Age of Debt’ is that debt is becoming pervasive, and as a factor will weigh on geopolitics, the tenor of political debates and the shaping of the financial markets of the future.

In that context, once we get beyond the rise of election campaigns and into 2025, governments will have to jettison dreams of sovereign wealth funds and instead subject themselves to debt sustainability analysis. It is akin to a household giving up a dream of buying a second home as their bank manager demands that the mortgage and credit card balance are paid off first.

Debt sustainability analysis is one of those arcane activities in economics, and I can count at least three friends who can run their own debt sustainability models, which is not something I should readily admit. The essence of debt sustainability analysis is that the future debt load (and its precariousness) of a country are driven by a set of factors – the rate at which a government spends, the inflation adjusted interest rate it pays, growth and demographics. These factors are inter-related – borrowing that is deployed to productive investment can produce growth and thus reduce the risks associated with debt for instance. Today, the rapid acceleration in the indebtedness of many countries, low growth and ebbing demographics are some of the factors that make debt increasingly unsustainable.

If that was a reasonably technical explanation, the best parallel I can think of to communicate debt sustainability is climate sustainability – or at least both sets of analysis point to a world that is heating up, and where there is relatively little reaction to this. Debt and climate sustainability analyses are long-term processes, and my sense is that governments gladly ignore them, until they become immediately problematic.

That is beginning to happen. France’s bond spread (over Germany) is elevated, and British bond yields are close to 4%. Neither country can afford to increase debt levels. The same is true for Canada. In the US, next February will see the installation of the new Treasury Secretary, and he or she will have the difficult task of telling the next President that there is no money in the kitty.

As such, the establishment of sovereign wealth funds is a distant, fluffy dream for most governments. A violent lesson here is that Ireland had a sovereign wealth fund in the early 2000’s, but it was swallowed up in the consequences of the euro-zone financial crisis, and is only now being re-established.

For those sovereign wealth funds that exist – in Norway or Saudi Arabia – the next trade may not be to buy quoted equities and private equity, but to either buy the discounted debt of developed countries when they have their sustainability crisis, or to engage in private lending to them. When that happens, a new shift in geoeconomic power will be under way.

Have a great week ahead,

Mike

Samuelson vs. Sahm

Next week the Federal Reserve will very likely cut interest rates, for the first time since the COVID related rate cutting cycle. Recall of course that at the end of this speedy sets of cuts, most of the leading central banks had declared inflation to be ‘transitory’. The Fed cut will come on the back of a series of rate cuts from ‘elder’ central banks – the Bank of England, Riksbank and the Swiss National Bank, as well as the European Central Bank from whom we had another rate cut last week.

The anticipated move by the Federal Reserve is instructive in several respects. Market based interest rates are lower than Fed rates and many investors expect (or rather crave) the Fed to make a 50 basis point cut, as opposed to a ‘standard’ one of 25 basis points. At the weekend, the lead headline in the Financial Times read ‘Investors raise bets on bumper half-point Fed rate cut’.

This is yet another sign of monetary addiction – the result of the conditioning of investors to financial liquidity. In mid-August, following a dip in the stock market, I wrote that the idea of the ‘Fed put’ – the notion that the Fed would react to a fall in asset prices by cutting rates – is very much alive in markets.

The market dip led several seasoned and apparently credible investors to call for an emergency cut in rates. However, the Fed has only ever taken such dramatic action in the thick of deep crises (LTCM/Russian economic collapse, the dot.com collapse, 9/11, the global financial crisis and the COVID crisis). Similarly, it has not begun a rate cutting cycle with a 50 basis point cut, outside of financial crises. There is no financial crisis today (though plenty of mounting financial risks such as very high debt levels), but a crisis of expectations.

That crisis of expectations is at play as investors position for the Fed meeting next week. In my experience, the Fed is, in normal economic conditions, a cautious and slow-moving beast, and it would be untypical for them to begin a rate cutting phase with an outsized rate cut. To do so would suggest that they are in a hurry to correct a mistake of their own making.

To the extent that investor behaviour demands a 50-basis point cut, this recalls the quip from Paul Samuelson, the first winner of the Nobel Prize in Economics, that the market has predicted nine out of the last five recessions.

Set against this apparent concern by investors (do they fear a recession or desire lower rates?) is a debate around a relatively new economic rule of thumb called the Sahm Rule, named after research by economist Claudia Sahm at the Federal Reserve. Her rule states that when the medium-term unemployment rate rises an impending recession is signalled (the three month average of unemployment needs to rise by 50 basis points). It is a surprisingly simple rule that appears to have prefigured eleven US downturns going back to 1953. Sahm’s aim in establishing a reliable rule was that stimulus checks can be sent out at the outset of recessions (as opposed to waiting for GDP data to indicate a recession).

I am tempted to trump the Sahm Rule with two observations.

The first is Goodhart’s Law, named after Bank of England and LSE economist Charles Goodhart which states that ‘when a measure becomes a target, it ceases to be a good measure’, or more colloquially that fame kills a good model.

More seriously, most of the last ten business cycles were conventional ones, whereas this business cycle bears the scars of reversing demographics, the lingering effects of COVID fiscal policy and labour market distortions (work from home) not to mention the contortions of strategic industrial policy (i.e. the CHIP’s Act, Inflation Reduction Act) and the political ramifications of high inflation and immigration. It is anything but a typical business cycle, and very hard to read.

Somewhat unusually at this stage in the cycle government finances are weak (from France to the US) whilst the large corporates of the Western world are in a generally healthy financial state. Of the major economies, China poses the greatest risk to the downside in the near-term.

With different components of the US economy moving in different directions, my expectation is for a slowdown than a deeper recession (this may eventually come at the end of 2025 if inflation rises again). Equally, I expect the Fed to make a series of rate cuts rather than deep cutting cycle. If that view is correct, the interest rates market will be very volatile, as investors periodically over react to data points and price in ‘booms’ and busts’.

Expect a market tantrum next week with investors complaining that the Fed is behind the curve. Samuelson would tell us that the curve has got it wrong.

Have a great week ahead,

Mike

The End of Globalization

In last week’s note(s) I focused a lot on France, to the exclusion of mentioning other debates that are live around the world. One that preoccupies me is that of globalization – which for most readers will seem so esoteric and distant, that they may rightly care little about it. It is in my view worth stopping to think about the direction of globalization – given the way it has shaped the past thirty years. I sense that as globalization crumbles, we are already starting to miss its notable characteristics – peace, low inflation and international prosperity.

Three things happened last week that have globalization, or its demise, back on my mind.

First at the Rencontres Economiques, I had a row with a former German economic minister who claimed that a new wave of globalization was about to start. This claim seemed fanciful, not least that the German economy is cleaven between a reliance on China, a need to be better aligned with the US, a disastrous energy policy and a fascination with Russia that has still not been broken by the war in Ukraine.

Granted that globalization refers to a world that is interdependent and interconnected, it is wrong to hold that we live in a globalised world when dependencies are shifting (the US and Europe want to be much less dependent on China for instance) while the US and China barely have any political and policy connections, and are, in the minds of many, about to embark on war.

The second encounter that set me thinking about globalization was that I ran into Prof Barry Eichengreen, the international authority on foreign exchange, financial flows and who was passing through Europe on his way back to the US from India, where he had delivered a paper entitled ‘Globalization and Growth in a bi-polar world’. Whilst I believe it impossible to enjoy globalization in the context of a world that is severely divided, I was much more careful to pick an argument this time, given Barry’s great mind.

In the paper he charts how trade (relative to GDP) – one of the tenets of globalization – has faced severe headwinds but remains at high levels and has changed course somewhat (trade and investment flows have pushed out to countries like Mexico and Vietnam). Capital and financial flows have retraced even more, and the Eichengreen paper details China’s efforts to deepen its financial markets and boost the use of its currency (though its political economy is a major obstacle to this).

The Eichengreen paper, based largely on what we see in trade and capital flows, paints a picture of the contours of globalization as we have come to know it, as remaining in place. However, I would add to the argument other metrics of globalization – the flow of people, the flow of tourism and overseas education, the flow of ideas and of political and diplomatic discourse between nations. On many of these criteria, walls are going up, and it is impossible to speak of there being a consensus on one global system or way of doing things. Markedly, most of the institutions of the globalised world order (IMF, WHO, World Bank to name a few) are defunct.

My argument is that globalization is not to be confused with the ongoing growth of trade, or the business cycle, it is a very specific form of interconnectedness of nations and regions that is breaking down. It started with the fall of communism, and mostly likely died with the snuffing out of Hong Kong’s democracy in 2020.

This idea was part of a great discussion I had with Chris Watling of LongView Economics as part of their podcast series. LongView is perhaps the best independent markets and economics research firm, and one of the elements they tend to capture very well is the idea of (short and long-term) cycles of risk appetite in markets and economies. In that context, the idea that we are passing from one long-running economic ‘regime’ (globalization, to something else, was apt.

The Interregnum will be a period of breaking (down the imbalances that have built up with globalisation such as climate damage and debt) and making (new world institutions and the integration of technology into economies and societies). It will be a noisy, chaotic process and its success is not yet a given.

For the moment, the very least we should do is accept that globalization has passed and start to think about the future.

Have a great week ahead.

Mike

Re-emerging Risks

I started the week chatting with one of the leading experts on globalisation, or deglobalization’ as it is now. He is a little older than me (he won’t mind me saying) but we share much the same formative experiences, notably an internalising of the way the world worked in the 1990’s and 2000’s.

Back then, the big project was the construction of the euro, to the chorus of debates on global imbalances, fiscal strength (Hans Tietmeyer the former Bundesbank chief would be horrified by Western economic policy today). Elsewhere in the late 1990’s forward guidance of monetary policy consisted of analysing the size of Alan Greenspan’s briefcase and there was a healthy debate on whether central banks should act to burst asset bubbles (today central banks seem to trade those bubbles).

The point of this reminiscence is twofold.

The first is to demonstrate that compared to previous decades (and indeed the long-run of economic history) today’s economic landscape is an aberration, out of kilter with most long-term expectations of how economies behave.

The second point is to illustrate that for very long periods, economies follow regimes of behaviour where very different norms can endure for some time. It is often the correction of these norms that triggers large scale shifts in asset allocation, and volatility. One marked echo of market behaviour today, with the early 2000’s is that the equity risk premium (the benefit of owning equities over bonds) has fallen to its lowest level since 2000, and the performance of smaller companies (to very large ones) is the weakest it has been since 2001.

In general, the 1990’s and 2000’s were periods of rising expectations, whereas today that is not generally the case across countries. A notable feature of the sense that ‘things were on the up’ in the 1990’s was the growth of emerging markets.

Indeed, that period has given us at least two economic miracles – the rise of China as an economic and geostrategic power, and the rise of small, emerging states (Singapore and the Emirates). Neither of these ‘miracles’ is given enough credit by the West for what they have done in such a short space of time.

Specifically, last week was highly instructive in the case of emerging economies – three elections registered high market volatility. Mexico has elected a new president amidst fears that the institutions of the state, and its democracy will be further undermined, combined with a leftward tack on economic policy. The peso reacted badly.

India surprised most commentators (the consensus view on Modi has been far too bullish) by failing to ‘ordain’ Modi’s third term in office with a wholesome majority. While this may be positive from the point of view of India’s democracy, it means that the Modi economic steamroller has less momentum.

Then, the failure of the ANC to regain their majority in South Africa should not be a surprise given the failure of that economy to grow much in the last fifteen years (GDP per capita is at the same level as it was in 2010).

In the cases of India and Mexico, markets appear to be pricing democracy very differently – less of it in Mexico is bad, but the checking of Modi’s near absolute power is also bad (at least for the notion that he could have forced through another round of government spending).

Similar to governments across many emerging countries, investors appear to be torn between the strong man model and the Western oriented rule of law one. This is just one parameter where emerging economy governments will be forced to choose – another is between the US and China, and a further one is how to build an economy (and cities) around new technologies and in a more efficient way.

Of the three countries, South Africa is a depressing warning to others, and I see very little hope that it can put in place a coherent developmental model. What is more reassuring is that there are plenty of examples of countries that have made the journey from emerging markets to stable economies – Poland, the Czech Republic and the Baltic states are good examples, and the cohort of Vietnam, Indonesia, Thailand and Malaysia is on its way. Other emerging economies like Nigeria and Argentina are ‘experimental’.

What is also interesting is that emerging markets show that investors are becoming more sensitive to political and institutional risks (institutional investors in Turkey have all but given up). In this respect the important question is whether they start to more severely price in the macro risks associated with some of the developed economies.

If my notional 1990/2000’s investor was to return to the marketplace today, he/she would be confounded by valuations, low volatility and miniscule credit risk, and might start to believe that markets should treat the developed world economies with the same mercilessness it has shown to emerging markets this week.

Have a great week ahead,

Mike