From jittery 2015 into even more unsettling 2016
Monday January 4th 2016:
- We are all doomed but maybe just not yet
- Bear in a China shop
- Global growth: shop or drop
- Central banks: classic fail
We are all doomed but maybe just not yet
One thing that can be said about 2015 is that it was a year of abundant forecasts. Most of them wrong, of course, and often published by people talking their own book. Chart 1 from Dent Research nicely captures the increasing polarisation between the shrill doomsters (bottom right) and the determined optimists, who as the good news runs out, are having to shuffle from top left to top right. For the record, I am wobbling just below top right but still reluctant to go much lower. There certainly are big problems being carried over into 2016 as I highlighted in Economic Insights last month and also at our Private Client Forum on December 1st. My main concern dating back to 2014 and intensifying ever since remains the financial markets themselves. It is really rather scary to realise that most traders and investors have never experienced economic and market conditions such as those currently prevailing. Understanding and managing risk has never seemed more important. A cyclical downturn or even secular stagnation ought to be navigable but not if market participants panic. So, while there is as ever a need to ‘keep calm’ it would be wise not to ‘carry on’ as usual!
Chart 1 The Human Model of Forecasting
Bear in a China shop
While the arguments rage about the truthfulness of official China data it is worth remembering that the country has been fuelling global growth for much of the last 25 years, especially in the last seven when it ‘heroically’ sought to make up for recession in the decadent West. China has become the largest or second largest trading partner for most of Asia, North and South America and Africa but now both imports and exports are falling. As one might expect from a centralised one-party state, fear of losing power takes precedence over not just publishing inaccurate data but also prudently managing the economy itself. It could, of course, be argued that the task is almot impossible anyway with a population of almost 1.4bn spread unevenly over 3.7m square miles. For the last two years the government has been trumpeting a switch in emphasis from manufacturing, infrastructure investment and exports to consumption but more recently seems to have lost its nerve and reverted to type. The trouble is that so much of the new investment may well be unproductive as well as funded by debt and a rigged stock market. No doubt loss-making debt-laden state-owned enterprises will be propped up but the government is going to have to choose soon between continuing to open up the economy to market forces or battening down the hatches. Either choice will slow growth further for China and the rest of the world. Given the shamelessness of China’s leaders, we can expect throught 2016 a lot of pious waffle for international consumption and increased domestic control freakery (e.g. prominent financiers and business leaders ‘helping the authorities with their enquiries’).
Figure 2 China Matters
Shop or drop
So, while China is sorting itself out, where will global growth come from and in what form? A sudden revival in trade can be ruled out just because of China while government spending remains constrained indefinitely almost everywhere. More Business Investment would be most welcome but it depends on growth in profits and confidence and both seem at best flat in most major economies.
The spotlight has, therefore, to fall on consumption. We are doing our bit in the UK but apart from Spain retail sales in Europe are somewhat patchy and dire again in Japan. This means that US consumers have to step up and at first sight Chart 3 suggests they are. However, the headline numbers have been made ‘real’ by being adjusted for inflation (not much of that recently!) and further analysis suggests that 18% over ten years is not very exciting , even allowing for a 3% drop after the Great Financial Crisis. Over the last five years it works out at only about 2% per annum allowing for compounding and it has been wobbling a bit of late. No surprise, therefore that US GDP has been struggling to get much above 2% over the same period, including 2015.
Chart 3 can consumers continue to save the day?
The trouble is that if consumers are to spend more they will have to borrow more too, which they may well not feel either inclined (because of low inflation on the prices of stuff) to do or, indeed sufficiently confident of their future financial position. Moreover, the banks may spoil the party through reluctance to lend because of past excesses (notably in Europe) or lending too much imprudently (in China and the US) and then repenting suddenly (as Hyman Minsky warned in the 1970’s and 1980’s). I have mentioned before the work of Professor Steve Keen on the correlation between debt and economic growth and what consumers do next is the key economic question for 2016. There may be a big boost from lower oil prices but consumers in the richer economies are increasingly worrying over healthcare and age care, which are two of the areas where inflation is picking up. Investors should worry too!
Central Banks: Classic fail
Monetary policy is not really supposed to be understood by the likes of you dear readers, and me. It requires mysterious constructs such as Dynamic Stochastic General Equilibrium and mathematical models which are so logical that economic data often requires adjusting to make the models ‘work’. The great spanner in the works is something called the ‘Liquidity Trap’, which is when businesses become reluctant to invest and consumers to spend. The ‘classical’ avoidance solution is to make everyone feel good by slashing interest rates and printing money via Quantitative easing, which also should entice investors into taking bigger risks through switching out of cash, government bonds and mortgage-backed securities. All this extra money being splashed about is supposed to reduce its value vs. goods and services: i.e. it generates inflation, which in moderation, helps to stimulate growth. Less publicised motives for QE are to bail-out improvident banks and to devalue the national currency.
True-believers amongst central bankers argue that the lower official interest rates and the larger the QE programme the better. It is just a case of doing it for long enough and all will be well. Unfortunately, the models appear not be working any more, even if they may have at first:
- Many companies have taken advantage of lower interest rates not to borrow for investment but to fund share buy-backs.
- Most consumers, especially those with middle and lower incomes, have yet to be convinced that they should stop worrying about their jobs and their old age (see above)
- Investors have been as likely to invest in foreign equities and bonds, commodities and currencies as backing domestic companies, creating large hot money flows.
- Competitive currency devaluations have become more common.
It is proving very difficult to start tightening again either through ending new QE asset purchases or raising interest rates as financial markets have reacted unfavourably in each of 2013, 2014 and 2015. Traders and investors have become addicted to a powerful cocktail of low rates and large QE programmes. Somewhat theoretical studies at the Atlanta Fed have calculated ‘shadow’ Fed Funds rates to be as low as the equivalent of -3% (vs. the official target range of 0.00-0.25%) in May 2014 by which time the FOMC had taken fright and started the taper that it had delayed in the previous year.
Chart 4 Economic model not working, so change the facts?
Chart 4 (blue line) shows that after 7 years of zero interest rates and QE programmes totalling $4.5tn that the FOMC’s preferred measure of inflation remains close to zero after falling below the target 2% level in 2012. A quick tour of other major economies reveals headline CPI levels at similar levels, except (sigh) in China where it is currently at 1.5%, despite several years of Producer Price deflation. In my house this record wold be greeted with the lugubrious cry of ‘classic fail’.
Two points need to be made here. First, the headline PCE and CPI numbers include energy and food prices, which when stripped out leave so-called ‘core’ numbers that are considerably higher (green line on Chart 4). Naturally, the central banks now place greater emphasis on the latter even though the politicians have yet to take the hint and change the inflation mandates. Second, even the headline numbers are likely to increase sharply over the next few months as the first major slump in oil prices drop out of the calculation, which the central bankers are likely to gloss over while patting themselves on the bank. At this stage it seems almost churlish to mention Minsky’s theory that economies are inherently unstable and periods of apparent equilibrium are always temporary. So, I won’t!
What next from central bankers? The FOMC continues to have a credibility problem despite, or because of, months of hand-wringing over the first rate hike. Having at last proclaimed the return of economic normality, Dr Yellen et al would be damned if they faltered on the gradual tightening that they have themselves predicted. On the other hand, they will be damned if they do carry on hiking when there is no fundamental economic justification and markets are sending out alarm signals. There seems to be an unofficial truce that the FOMC will solemnly forecast three or four rate hikes in 2016 while markets will price in only one or two. Chart 5 from Bloomberg highlights how the damage inflicted by a 1% increase in interest rates has risen throughout the great bond bull market to $3tn on some $45tn investment grade issues (tracked by the BofA Merrill Global Broad Market Index). The doomsters are convinced that, faced with the threat of a market rout and a new recession. the FOMC will reverse last month’s hike and even launch QE4 this year. For now,however, it does appear that the market’s expectation of one or two hikes is about right. Speculation will resume as soon as this week in the build up to Friday’s release of the December Labor Market numbers but these are unlikely to be conclusive.
Chart 5 Don’t do it, Janet!
Here in the UK, the MPC is subject to gentle ridicule because despite its protests to the contrary its decisions on interest rates seem beholden to the FOMC’s. If there is any substance to this it is because the UK and US economies are experiencing similar rates of growth and inflation. It should be noted that the MPC stopped its QE programme as long ago as 2012 and has since been much more willing to debate its efficacy. Moreover, apart from some curious recent kite-flying by Chief Economist Andy Haldane, the Bank has resisted any moves towards zero or negative official rates. Having said that, the MPC will not not want to tighten faster than the FOMC and may not raise rates at all in 2016 or merely stop at one symbolic hike.
In Asia, the PBoC will have to do as it is told by the party leadership and further loosening can be expected. The bond market is growing rapidly but is not yet large enough to justify a QE programme similar to those elsewhere. There should, however, be large-scale direct bail-outs of state-owned banks and other enterprises and the private sector, especially in the shadow banking sector where retail savings are at risk, is also likely to benefit from PBoC largesse. The policy of a weaker exchange rate will continue but not so aggressively as to jeopardise its growing international status. Government pressure on the Bank of Japan is much subtler than in China but it seems its QE programme will carry on indefinitely while inflation remains minimal and the yen does not weaken. The hunt for assets that the BoJ can buy has been quaintly extended to include ETFs that do not yet exist. All in all, more classic fails ahead!
The Super Mario image took a major hit last month when Mr Draghi ran into some stiff opposition to further substantial easing from a hard core of ‘Nothern Europeans’ and bond yields and the euro surged higher as a result. He may yet get a reprieve if the FOMC really does hike aggressively and, of course, he has since been quick to put a new spin on his ‘whatever it takes’ line. As in the US, European businesses are reluctant to invest and consumers to spend but excessive private debt is not the main reason while even those who are looking to borrow are still finding many banks rationing their lending as they cover up their non-performing loans. QE in Europe is a bit like the proverbial pushing on a string. In the most recent Financial Times survey of European economists I was in both the minority camps on pessimistic economic prospects for 2016 (1.3% max GDP growth) and on further ECB loosening (more but limited rate cuts and an indefinite time extension of asset purchases).
The most active European borrowers are, of course, governments (mainly but not only Southern) who are relieved to benefit not only from extremely low rates but also a buyer of first and last resort in the ECB. Chart 6 shows just how much of EZ sovereign debt has negative yields and there is a knock-on effect on maturities all the way out to 30 years. It is likely that the Italian and French governments, both facing important elections in 2017, are already relying on ECB funding while all the Germans can do is try to cap it. This is a conveyor belt that nobody can afford to get off without wrecking the market for EZ sovereign bonds or, indeed, threatening the Monetary Union itself. Ironically, this could provide the glue for Europe at a time when everyone is quarrelling over everything else. Luciano Pavarotti once described his spectacular singing to me as ‘ I takk beeg reesks’ and the same can surely be said of Mr Draghi and his song for Europe.
Chart 6. Draghi the Great Redeemer?