Category Archives: Exchange Rates

What Will Go Wrong in 2018?

James Mackintosh of the Wall Street Journal posts in today’s US print edition on “The 3 Things That Can Go Awry in 2018“. The article details three dynamics that, if played out as he suggests, could cause the global economy to trip in 2018. His summaries are good and compelling and, given our amazingly positive outlook today as 2017 comes to a close with all major nations growing at roughly the same time (an odd occurrence in its own right), they come at a good time to consider conservative actions against possible shifts next year.

The three are:

  1. Monetary Tightening. The story here looks at Fed and central bank interest rate hikes. We all know that interest rate raises have started, at least in the UK and US, even though the EU remains firmly stuck taking that drug. Japan is taking it slow, even as its economy shows much signs of improved life – Japan will have to continue pushing rates up in 2018, just as the EU will have to follow the US’s lead. The problem with this item is that there are us a lot of debt out there – corporate debt, public debt and yes, some consumer debt. It is not the same kind of debt that was part of the run-up to the crash that put us where we are today, but for some firms and some governments its big risky debt. As an example, and tangentially related, another article in the WSJ reports on a few firms that are high in debt that will be financial impacted by Trump’s tax reform – see Tax Plan Downside for Dell, Others in Debt. A lot firms have issues debt in the last few years in response to QE and near zero interest rates. As rates increase, debt load and repayments will increase. If inflation were to join the party, it could be a messy time for a number of firms and governments.
  2. China. This story has been used before since China has been the source of two recent periods where the US stock market (in fact the global stock market) fell by about 10%. As such, China’s management of its economy – shifting from a producer-based to consumer-based economy – is a major challenge. Debt remains a problem, and capital controls and currency exchange rates just add more menu items for Chinese leadership to wrestle with. Should China sneeze, so the saying goes, we would all fall could of a cold or something worse. Worse, there is no coordination between east and west – so we are somewhat at the behest of the Fed and People’s Bank of China – and we all hope they do the right thing. Of course, they will both do the right thing for their own constituents – or try to. Hence the lack of cooperation.
  3. A Correlation Correction. This for me is the more interesting and most likely issue to blow up in 2018, and it is the least talked about in the press since it is not as well understood. Mr. Mackintosh states, “one reason investors hold bonds is to cushion losses in a stock-market downturn.” This approach has worked for quite a while, as prices have diverged short-term all the while converging over the long-term. The risk is that should inflation appear in 2018 the relationship between stocks and bonds may revert to how it was in the 1980s and early 1990s, with rising bond yields being bad for share prices. The problem for me is that I think inflation will rise in 2018 to just levels that this will be the catalyst for change in the markers. If you read the tea leaves, there is ample evidence of a change underway. Many commodity prices are doing very well. Copper prices are, as an example, reportedly at recent high’s due to increased production. If you look at producer prices in the US, they are inching up now over 3%. Even though wage pressures remain subdued, the pressure is building. Though participating rates for males in the US aged 25-54 are at near all-time lows, yes the employment rates seems low and may go lower, but there remains some slack to take up the growth we will see. But that pressure is there. I think that by the second half of the year, certainly by Q3, US inflation forecasts will show that 3.5-4% are on the horizon. This won’t cause a panic, but it will lead the change and correction that will come. On top of this the author suggests that the Fed may just “give in” to the needs to cap the bloated asset prices we see all around us, to nip the bubble before it becomes unsustainable. Trump’s tax deal will push this peak out a year or two, but the dynamics are in play.

Reading between the lines you can see that all three of the authors ideas overlap and intersect. Inflation is mentioned directly in 2 of the 3; growth is everywhere; public policy too. As such he has hedged his bets and tried to call out the category of challenge. I will try to break the triggers into more simplistic sections.

As such, I give the following percentage probability for each driving a correction by the end of 2018:

  1. Monetary Tightening, most likely US led, due to over heating: 15%
  2. China growth, debt to currency issues: 28%
  3. EU or euro-zone debt or banking crisis: 15%
  4. Inflation-driven policy changes: 22%
  5. Japan public debt or growth challenges: 10%
  6. Emerging Market currency or debt issues: 5% (this one won’t trigger in isolation but might follow from one of the others, namely 1, causing a currency drain)
  7. Significant War triggering financial panic: 5%
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My Top 5 Biggest New Year Risks to the Global Economy

In order or scale, priority and impact, here are my picks for the five most critical trigger-points that may impact, negatively, a return to ‘old normal’. Currently we stand at the edifice of a new normal, the great stagflation, but the anti-establishment and populist changes taking place seem to suggest a knew-jerk reaction by nations fed up with socialist dressed-up-as-market politics that have led the West for 20 years.

  1. China’s economy stagnates or crashes. Debt levels are above EM levels and are now among the largest, approaching the incredulous Japanese levels. This dynamic is not sustainable for a nation whose currency is not a reserve currency. However the economy is the world second largest even without the development and emergence of whole swathes of other sectors such as healthcare and leisure, which may offset contracting first world growth over the next year or two. So the risk is there and there is no clear leaning one way or the other, yet. But debt is growing faster than these new sectors; exchange reserves at $3bn are limited (though huge), and currency value management is not market-bases. So greater risk is with the downside. China’s growth flags, currency sinks, counterbalancing US growth and confidence, creating a massive imbalance in the global economy. Europe watches on as global GDP sinks under its own debt weight. KPI’s to avoid/watch out for: China GDP falls to or below 4.5%; China’s debt load surpasses 300% of GDP.
  2. Trump quits after 18 months due to intractable political limitations that prevent policy changes he seeks related to healthcare, regulatory complexity, tax reform and trade. Trump’s political rhetoric is being replaced with solid business-based policy. However not all such policies have ever been tested at a national level and scale. Some efforts will fall foul to physical, social and political limitations. This may prove frustrating for Trump. As growth will return short term, such medium term frustration will lead Trump to claim, “My policies worked, see? But now the system has reached its limit and there is nothing I can do until the country agrees with me to shut down the whole government system! Since they are not ready, yet, I am ‘outa here’ until they are!” Markets crash, interest rates balloon, inflation rages all within a year. World economy sinks into the abyss. KPI’s to avoid/watch out for: US GDP 1H 2017 reaches 4.5% but Congressional conflict leads to policy deadlock ; vacancy in position at Whitehouse. 
  3. Emerging Marker currency crisis as massed capital investment is siphoned away towards a resurgent US economy and dominant dollar, as well as a stable and even growing China economy. This situation is already underway. The risk is that what is currently a reasonably ordered trend becomes a financial route. This is possible since the financial markets are starved of yield due to the collective policies of central banks to keep interest rates very low for too long and for the build up in their massive balance sheets. If the trend becomes a torrent, EM’s will have to yank up interest rates far beyond what their local economics can support and economic disaster will follow. This will ferment more political instability and drive increased destabilizing ebonies to ruin. Though the US may be growing well, compared to its peers, it’s the imbalance they tips the ship over. KPI’s to avoid/watch out for: dollar index, the weighted value against basket of currencies, surpasses 115. It is currently at 103.33, which is a 14 year high; EM interest rate differential balloons.
  4. Hard Brexit forced through by intransigent Europeans who think the EU experiment is more about political union than economic liberalism. A new trade deal, legal framework and social contract can be negotiated within a two year window. But only if politicians and civil servants want it too. Continental politicians however, under the strain from populist pressures, will equate intransigence over Brexit negotiations with an improved politicos standing with their electorates. Fool for them as this will actually create the opposite response for such behavior will simply worsen the economic climate. The lack of any sign of return to old normal will lead to political paralysis and the clock will time-out. Hard Brexit will be forced upon a supplicant Britian. Europe and UK economies will tank; currency wars will wage; global trade will collapse further. This will not sunk the global economy short term but will act as a dead weight slowing its resurgence down. KPI’s to avoid/watch out for: no agreement at end of two year period lost triggering of Article 50. 
  5. Latin or Indian debt or economic crisis. Much like with other EM’s, growing sectors of significant size around the world may blow up- India being the best example. India’s growth is different to China. It is more integrated socially and politically with the west, but it’s corruption levels are far greater than what one can see or observe in China. It is possible that local economic difficulties, hard to observe today, may trigger a collapse in confidence that leads to a destabilizing debt or currency crisis. Brazil’s economy is certainly in the dock currently; Argentina is struggling. India’s economy looks like paradise right now but the growth across the country is extremely uneven- you only have to look at public sector infrastructure investment. So should two such countries suffer local difficulties, the combination may result in significant risk to the global financial system. KPI’s to avoid/watch out for: two simultaneous financial/debt crisis afflicting EM or India.

These are my top 5 risks the global economy faces in 2017. I hope I am wide of the mark, in a positive way. I left Japan off the top 5 list yet their economy remains anathema to growth. The Japanese market invented the whole new normal cycle with a anaemic growth, massive debt, low inflation, and demographic contraction. And Japan has an amazing debt load that refuses to spook investors. Things may yet have a Japanese tinge before the year end. Does Japan, along with the US, lead the global economy back to the old normal!
What potential risks do you see?

China’s currency to be added to IMF’s SDR basket as of October 1. About two years too early.

Transcript of an IMF Conference Call on the SDR Basket.

This is a big risk for the IMF and suggests a confidence challenge as they could not resist the pressure from China. The RMB is not yet freely or fully convertible. China has a close-hand on how the currency moves. The IMF is thus handcuffing its own possible monetary policy instrument (it keeps talking about the SDR playing a legitimate role in currency trade settlements). Worse, when firms claim against their own SDR, their fees will be partly held hostage to China’s own rate setting for its currency.

This move by the IMF is too early and mostly as a result of pandering to the growth of China and its [IMF] effort to try to help work with/control how China evolves in the wider world. The RMB should be planned for and accommodated in the SDR, but not until full and free convertibility.

Near or below zero interest rates do not encourage investment

Central Banks around the world have got it wrong.  During near-normal economic cycles, lowering interest rates altered (through signaling) how businesses funded planned investments.  But those investments are driven by business strategy, not market economics.  Firms are not sitting there saying, “Well, with near zero interest rates- what innovations shall we come up with today?”  Just ask business leaders!

Lowering interest rates just signals a different potential pattern of sourcing of funds, if investments are ready to be funded.  But in this high-regulatory and low-inflation economy, with cheap money funding easy stock buy-backs and a stock market rally, there is no need to innovate as much or make the big or medium size bets that such capital investments need.  Firms are achieving their EPS goals without them.  Just look at the data.
The central bank’s have got it wrong.  Just look at the data.  Capital investment is flat when, according to central bank thinking, it should be ballooning.  Has any central banker actually spoken to any number of business leaders?  Or if so, are they confusing political sycophants for real leaders?

The only way to encourage investment in capital programs for innovation is to return the market dynamics to near-normal settings.  That means that counter intuitively central banks now need to raise rates and curtail quantitative easing.  And quickly.

Why can’t central banks see the obvious?

The problem now is that central banks are looking for even more fuel for the fire.  The Bank of Japan is now reportedly looking at even more extreme measures of the same medicine.  The bond market is about to go the same way as the stock market as in massively distorted.  If we are not careful we will enter the twilight zone and no one will be able to control a thing.

Biting the Hand that Fed Us

Mr. Kevin Warsh, a former member of the Federal Reserve board, now a distinguished visiting fellow in economics at Stanford University’s Hoover Institution, pens a damning Commentary of the Federal Reserve in today’s US print edition of the Wall Street Journal.   

In “The Federal Reserve Needs New Thinking“, he slams the Fed for “….[T]he economics guild push[ing] ill-considered dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. It’s medium term policy objectives are at odds with its compulsion to keep asset prices elevated. It’s inflation objectives are are far more precise than the residual measurement error. It’s output-gap economic models are troublingly unreliable.”

If that were not enough he adds: “And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.”

Wow- this is a damning perspective from a ex-member of the Fed. I have to say that I tend to agree with his perspective. However the Comment falls short of the title: there is little new policy offering or suggestion to warrant any ‘new thinking.’ The challenge is to query what could or should the Fed and other central banks do differently.
One odd idea I toyed with a few months ago (see The ghost of Keynes haunts our global leaders and economic conditions today) is to globally reset interest rates as if a new normal had been established. What I mean to say is that central banks around the world should all raise their interest rates at the same time by an agreed amount in order to:

  • Preserve current interest rate differential between central bank authorities
  • Establish a more natural rate in order to reestablish normal market and investment operations

If we had nearer-normal interest rates the following would happen:

  • Private capital investment decisions might once again take on a normal demand curve and pattern, thus contributing and steering toward increased productivity
  • The cost of money will rise and so private firms will stop issuing bonds or taking out cheap loans only to increase share buy-backs, thus decreasing the inequality in invest class assets
  • M&A levels would fall to more normal competitive levels
  • Consumers will start to save again
  • Pension funds will have their unfunded portion of their liability reduced

All in all that would be a good day at the office. But it only works if the Fed and central banks in UK, Canada, Europe, Japan, and China agree and collaborate closely.  Additionally the IMF probably needs to leed this effort.

The other problem is the large overhang of debt that central banks now have on their balance sheets. These acquisitions represent government (and some private) debt. These enlarged balance sheets also distort the market. The problem is that central banks have no idea how to jettison these debts without completely upsetting the market again.  

So I guess the only option might be to collaborate with other central banks and agree some kind of normalized write-off. If all central banks agreed to write-off 75% of the government debt they hold, it would free up government spending (since they can start up again, hopefully on the right things this time like education and infrastructure) and the market prices will be balanced. This is of course a silly idea. But how else can we make progress with this challenge?

Yes, new thinking is needed. And a lot more collaboration. The solution will not be found in one central bank. We are too connected. We need a new Bretton Woods 2.0 agreement.

The Next Emerging Bubble (and crisis?) Is Underway

Both the US weekend print editions of the Financial Times and Wall Street Journal reported on what I consider to be the nextfinancial bubble and potential global financial crisis. Let’s ask ourselves – what would the source of the next financial crisis be?

  •  Japan, with its massive public debt that might, should the market ever give up on Japan, swallow up government spending with unyielding interest payments (should interest rates need to be hiked to defend the loss of confidencet in the economy)?
  • Europe, with its weakened and twisted euro, now bereft of the stability of Britain, at the hands of the profligate consumer south of Europe stretching away from the conservative and producer norther states? It maybe the bailed-out Italian banks fall?
  • US, with its “exorbitant privilege” of reserve currency status but with huge watches of government debt held by China, decides to dump it in order to drive the dollar to he floor as a step to push the yuan to reserve status?

No, none of these three challenges are going to blow-up any time soon though they are clear risks. They are all slow burners.  But what might just snap enough to cause a global financial crisis that can overwhelm the monetary policy and reserves of the world? I think it’s emerging markets. 
You see, there is a finely balanced investment model that is ticking and it slips and slides every day – trillions of dollars – and right now the shift is back toward investing in emerging markets.

This is how it works: Yield is globally very low. This is due to (mainly) low and near- or negative interest rates. As such, the trillions of dollars in the world that represents currency exchange combined with hedge fund investments move around the globe daily in search of yield. When the US Fed suggests that interest rates will rise in the US, it is clearly a vote of confidence in the US economy and so funds are attracted toward the dollar. This then puts pressure on the dollar (since everyone wants dollars) and so the value increases with respect to other currencies. This then leads to increased export prices thus depressing US exports. 

But where does that money come from that would move toward the US? The answer is from everywhere around the world and specifically wherever the money is most liquid. Guess what, that means emerging markets. Right now the US is signaling to the market that interest rates are not going to rise immediately, so yield is slightly more attractive in emerging markets. Thus, as the reports in the two newspapers show, funds are flowing freely towards them. This puts pressure on those economies much as the same funds would do to the US. They stoke currency valuation, inflation and weaker exports (over time).  But short term they hep fund construction and keep the recycling of dollars and funds around the world.

As you probably noted in the last two years, as the Fed sneezes with respect to changes in interest rates, even hints of changes to interest rates, trillions of dollars move back and forth between the US and EM in the search for the greater yield.  US interest rates will raise and when they do, the yield will shift to the US.  And we are talking of razor thin margins hence the nervousness of the market.
From the FT article:

  • Equity funds saw inflows of $5.1bn during week ending August 17, the seventh straight week of inflows, according to data from EPFR
  • Over the same seven weeks, a record $20bn was invested in emerging market bonds, with investors taking money out of US and European bonds in favor of the riskier assets

From the WSJ article:

  • The Bank for International Settlements warned Thursday that a corporate-debt binge for emerging-market countries that starts in 2010 is starting to come due now. Between this year and 2018, repayments will total $340bn, it’s estimates show, which is 40% more than during the past three years

Thus the global system of equity and currency trade and investments are finely balanced. Should the dollar suddenly look more attractive, and funds then flow towards the US, at the exact same time as emerging markets need to recycle their debt, there will be a big problem. Emerging markets will have to jack rates up in an attempt to strengthen their currencies which could choke their own growth, thus reducing the markets confidence in them, and so a spiral takes shape – downward. If EM have to jack up interest rates, the US may have to reciprocate. Either way the balance is finely tuned and the great weight of funds will flip-flop between EM and the world supremely quickly. That will create huge complexity and volatility.

Hang on, everyone!

China Shock: The Untold Story

Front one of the US print edition of the Wall Street Journal last Fridy: Deep, Swift China Shock Drove Trump’s Support. A fascinating article that suggest, despite its title, that the impacts of China as it joined the global trade game led to swift and irreparable damage to America’s workforce and so led to the swell of support for Trump and Saunders. It so happens that I am half way through reading China Shock, by  David Autor, David Dorn, and Gordon Hanson. The story in the paper and the WSJ article is referring to in its title.

There are are several things to note about this so called, “China Shock”. They are not all good news and hindsight helps (where doesn’t it?)

Firstly global trade is taking a bashing. This is unfortunate. It is unfortunate because economically global trade has been shown to balance out and help everyone, even if one nation is better than all others at everything. What the economists models thus far did not show, nor were they meant to, is what happens under extreme changes in the dynamics of global trade. That is the fact: China shock is not a weakness of global trade, it’s a lack of understanding of the dynamics underpinning it.

The WSJ journal and the paper demonstrate with examples where massive displacement of jobs took place, in a very quick period, over and over in related industries. The two factors that made the shock such a shock are:

  • Original employers (US, per WSJ article and including Europe per the paper) national institutions, job training, educational practices and industrial policy were focused on the wrong thing. Instead of being focused on rapid migration and support for global trade dynamics, they were more focused on slow and limited protection for targeted and said to be critical industries
  • Exporting nation (China) was exporting so much cheap Labour and products across a broad and often related swathe of markets and industries that had a multiplier effect I terms of displacement and elimination of ‘landing places’ for those initially displaced.

These two factors explain how it was that worker after worker listed in the article lost a job, gained a job, then lost it again. Then finally were not able to get a job.

Our economists did misunderstand some of the dynamics of global trade given the entrance of such a large supplier as China. But governments should have spent more time focused on policies related to growth and industrial migration, rather than pandering to selfish efforts protecting themselves.  

Now that China Shock has shocked, what do we do about it? Well, media and press are now gunning for global trade. This hype will damage global growth and crimp efforts to get past current anemic conditions. Capitalism is again under attack not due to a failure of the system but a failure of our own misunderstanding of the dynamics of the world around us.

Governments need to focus on building a resilient trade and industrial policy that responds to changing global dynamics. Industry and government need to work more closely together so that as global trade pressures alter the competing advantage of nations and firms, action can be taken to provide alternative safety nets.

Another article in the Business and Technology section of the WSJ demonstrates this: Coding Camps Attract Tech Firms. A small private educator runs 12 week courses for $15,000 that leads to no degree. But almost every attendee gets a job within 6 weeks of graduating with an average salary of over $74K. What is impressive is that the curriculum changes within weeks of any new demands from industry. Try doing this at more established educational establishments.

Governments also need to work on exchange rate policy and collaborative monetary policy. One aspect, not explored in detail here, relates to how currency value can have a big impact on comparative advantage. As such this policy effort needs to be reconciled to industrial policy.

If global trade gets bashed, and government policy targets protection of industries that are no longer competitive, we will just avoid paying the piper at the right time. The piper will be back but his tune will be louder and more deafening.