Tag Archives: Interest Rates

The Assault on Capitalism is Complete

A few data points, brought together in an Financial Times article this last weekend (see At a record high, the US market is still shrinking), suggests our political and economic leaders are looking in the wrong direction for the real challenges undermining our economy. Let me summarize them for you:

  • The US stock market is at an all-time high
  • The US stock market is experiencing its longest bull run
  • The tally of listed companies in the US stock market has halved since 1996, from 8,090 to 4,336 last year
  • M&A, funded more by cheap money (via Quantitate Easing) rather than underplaying competitive weakness, has been rampant
  • Industry concentration is widely up leading to mega-firms more able to snap up smaller firms sooner in their life cycle
  • IPOs are happening at half their average rate compared to 1980 and 1990
  • The number of start-ups overall continues to be running at near historic lows

In essence, creative destruction, that natural process whereby death is the catalyst or preparatory step leading to new birth, has been put in hold and worse, twisted into an abomination. What is the cause? How did we get to a place where natural, independent, entrepreneurial spirit has near extinguished? A range of disconnected public policies and actions have conflated to nudge us to this place.

  • Increased regulation, followed up by yet more regulation, ever driven by powerful lobbies and ever more splintered interest groups
  • Reduced public funding of primary R&D
  • Poor alignment of vocational and educational services
  • Social policies that promoted the false idea that everyone should go to university (everyone should have the opportunity) and the resulting demise of things like professional apprenticeships

More insidiously is that money, more specifically the capital markets, are now so distorted that the behavior that acted as the foundations of creative destruction are not holding it back. With the volume of cheap money that flooded the market in recent years, so much money has been chasing ever more riskier bets. The M&A mentioned above was one result. Another is the funding models for how capital investment is prioritized. This has led to a huge growth in private equity and so many more private companies. Thus the cycle of creative destruction has been undermined from several fronts over a long period of time.

The current situation is that the economy is being managed by fewer and fewer public giants and larger and larger private investment and sovereign investment funds. What is left to the retail market, once thought of as a natural part of the cycle, is being shrunk and may soon count for little. The economic cycle firms used to follow, that operated naturally and yielded up profits and growth, is now a managed system by politicians and a small number of the very rich.

What do we do? The FT article suggests yet more regulation to try to rebalance some of the results. No one of note is willing to suggest we roll back the policies and actions that caused the problems in the first place. Shame.

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The Debt Chickens Are Coming Home to Roost

A story it today’s Us print edition of the financial times highlights a building ‘bubble’ of disquieting proportions. The article, ‘Britain’s Pizza Chain Boom Faces Debt Reckoning’, highlights how a large number of restaurant chains have been snapped up over recent years using debt. This might be by a private equity firm or a leveraged buy-out. In either and other cases, many acquisitions were executed using cheap debt which was facilitated by central bank policies such as near-zero interest rates and quantitative easing (QE), both of which massively distorted the price of corporate bonds and debt. Add to this public policy and pressure on banks to increase loans to help drive growth, you can see signs of a perfect storm.

The UK example is specific, but the problem is wide and applicable to most developed economies. The US has just come off a long-run marathon of high and record levels of corporate acquisitions, again much funded by cheap debt. There must be many organizations hanging by a thread, just waiting for interest rates to nudge up resulting in unsustainable debt burdens and interest payments. Unless growth drives the top-line of these businesses at a faster rate, the chances are many such firms will go to the wall.

This situation was created as an unintended consequence of near-zero interest rates for such a long time and massively price-distorting quantitative easing. Though most governments have ceased buying sovereign and corporate debt, the damage is done. Massive, trillion dollar, balance sheets at central banks need to be unwound in such a way as again, not upset the market. The act of creating the balance sheet did upset the market. In reducing their balance sheets, central banks will do it again.

And the sad part about all this, as it will play out? Smart investors with lots of money and a high risk-tolerance will hedge against such business failures and reap huge rewards. The rich investor-class will get richer, and the poor will just lose their jobs or otherwise miss out. Politicians will have a field day, calling out the failure of capitalism. Of course, it’s not a failure of capitalism since central banks and their policies are not part of any capitalist model: central bank operations are closer to a socialist model where the few take decisions to ‘help’ the many, as if they know better and how to help us.

Oh well, such is life. Just buckle down and wait the storm. The debt chickens will soon be home to roost. Maybe not by this Easter but expect them home by next year.

New Cracks in the Euro

News today suggests that the central European economies are beginning to surge ahead with growth while at the same time the periphery continues to struggle terribly.

In today’s US print edition of the Wall Street Journal there is news that German GDP in December continues to grow. We only just read that house prices are surging too. As Germany starts to surge ahead, it will need to push interest rates up to help control growth and prevent overheating.  

See German Economy Accelerated Last Year and Eurozone Output Data Suggests Strong Upturn.  
But Greece, Spain, and even Italy, really don’t want and may not even be able to sustain an increase in interest rates. The Greek economy has not yet recovered. It needs persistent low rates and in fact additional help (or changes in policy) to help repair the damage.

As such the pressure-cooker-politics of the Euro is about to get a dose of heat. It won’t be another six months before the pressure becomes clear to all.
 

The Home Owners/Renters Market is Upside Down

Two articles today suggest that two of the world’s largest economies are swapping roles and focus for home ownership and renting. Germany has been a nation of renters; home ownership has run at relatively low levels compared to the UK or US. The US has operated under the assumption that home ownership is central to the American Dream.

As we all now know, policies adopted by the US government in the 1980s led to a relaxation of requirements for those seeking a mortgage and low income, even zero-income families, obtained mortgages they could never afford. The result, when combined with human greed both by home buyers and the investment community, led to the financial crisis that is the cause of the situation we are in today: near zero interest rates and massive influx of quantitive easing that has filled the coffers of the investor class.

But what is happening now? It seems that the near zero interest rates in Germany are driving record levels of home ownership and low interest rates in the US is driving up demand for rental property with record low-levels of home ownership. The world is turning upside down!

In the US print edition of the Financial Times, the article, “German’s switch to home ownership fuels bubble fears“, reports that house prices are rising as demand for mortgages continues to rise. The good news is that many of these new mortgages are fixed rate plans- which protects home owners as interest rates increase.  Germany has been a relative laggard when it comes to home ownership. See Most Germans don’t buy their homes: Theey rent.  Here’s why.  

In the US print edition of the Wall Street Journal, in an article, “Millennials Fuel House Rental Boom“, we hear of the later boom afflicting the US market. It turns out that US home ownership is at record lows, yet house prices around the country are recovering and in some regions, back to pre-crisis levels. How can this be?   Turns out that firms flush with cash and low cost loans have been buying up property in the cheap and renting them. The article above goes even further and explains how firms are now increasing investing in entirely new property developments specifically for the rental market.  

This all might alarm you. The American Dream, perhaps western democracy, was assumed to be predicated on home ownership. But this is not the case. The German economy has done very well with relatively low home ownership rates. The US might have to learn from the Germans how to run such an economy; likewise the Germans need to take a leaf out of the US’ books to avoid bubble blow-out.  

But in all practical terms we should be alarmed. Germany is an export-based economy. Other counties want (or need) to buy Germany’s products. Exports from the US is vastly less of a proportion of it’s GDP than it is for Germany. So there is little room for the US to behave more like Germany. Additionally Germany cannot set its own interest rates; even now the stresses between the EU center and periphery are growing again. Greece, Spain and Italy continue to need low interest rates to help nurture their local economies to recovery. Germany, never near a recession, is showing signs of too rapid growth (and growing inflation) and may approach overheating before the periphery is even back to positive growth.  

Bottom line: zero interest rates and quantitive easing (and resulting central bank balance sheet ballooning) is changing our economic foundations. This will impact our societies in ways it is hard to predict. Hang on guys, it’s gonna be a bumpy ride!

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?

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.

A US Recession Would Require Fed to Raise, not Reduce, Interest Rates

I read with alarm this morning, as I tucked into my poached eggs and sausage at the China World Hotel, Beijing, a CNBC article where a previous Fed economist (Marvin Goodfriend) was quoted as saying the Fed would have to target negative 2 per cent interest rates if the US entered a recession.  See “Why the Fed might need to cut rates to minus 2 percent: Former Fed economist.” 

At this point there are few signs the US will hit a recession any time soon though the US economy is certainly in what might be considered the down-slope from the last growth ‘peak’. Private firms operating margins are being cut which is about the only non-maladjusted metric (as in no government intervention) we can relay on as a sign.  

But Mr Goodfriend’s point is logical: in some of the past recessions the Fed has had to push interest rates 2 per cent below long term rates. As it currently stands the 10 year interest rate is at around 1.5 per cent. So logically we should expect a record breaking negative 2 percent interest rate. But this is not going to work.

At near zero interest rates many ofthe economic and behavioral assumptions related to how the market works are distorted and are not working. If negative or near interest rates were a solution to growth and recovery, why hasn’t the US, UK, Europe or Japan bounced out of the current stagnation? With near zero or negative interest rates there are numerous distortions that suggest more of the same medicine would be, to say the least, daft and ineffective:

  • Private industry does not open up their strategy play-books due to changes in interest rates. Business strategy precedes interest rates. A change in interest rates simply signals to the CFO or Treasurer that there might be alternative funding models for those strategies that need funding. In other words, if there are no strategies for growth, lowering interest rates does not seem to create them. Thus capital investment seems impervious to interest rates at such low levels.
  • Cheap loans fund bad business habits. Where private firms have exploited near zero interest rates is to take out loans to fund both stock buy-backs and fund what I might call non-productive M&A. Stock buy-backs improve earnings per share (EPS) and thus reward executives according to their bonus scheme. But there is no change in the productivity of those firms led by those executives. As such the EPS metric is creating a drug that executives are finding hard to resist but it will rot their, and our, teeth. Second, so much M&A (which is running at record levels), is not actually tied to business strategy developed over time to drive improved performance. So much M&A is short-term or even knee-jerk planning from firms as opportunities to take out a competitor, muddy the market, or upset someone else’s strategy. Thus the companies being acquired are not necessarily sick or struggling. The cheap cash is being used ineffectively and not in accordance with creative destruction.

If you throw on top of this quantitive easing (QE) you can see that the vast majority of the free and cheap money goes to the well-off and investor class and this goes to explain the worsening inequality we see in the US.  And top this lot off with anti-business political policies designed to:

  • Slow growth of start-ups
  • Favor the hegemony of very large, atrophied private business
  • Force direct reallocation of funds to the less well-off versus policy to encourage expansion of employment of the same resources at a more productive and therefore higher paying level

One can see that the current medicine was only good insofar as it stalled the collapse of the financial system some 5 or more years ago. The medicine has gone off; it is now as much a poison to the economy.

Should the US fall into recession the Fed should urgently raise interest rates 2 percent. This will cause the following to happen:

  • Private industry will look at the data and start to behave more logically. Funding choices will start to resemble normal conditions. To grow a business normal business strategy will return to the fore. Capital investment over cheap M&A should start to look more desirous.
  • Stock buy-backs will slow thus forcing a more useful employment of the relatively cheap money. The stock market rally will peak and the economy will start to right itself. Not immediately but over a business cycle money will again flow to firms that grow through innovation and productivity, not intervention and policy.
  • Other sovereign nations will have to respond with similar interest rate increases since the dollar will appreciate rapidly and so the Fed could lead the gradual return to normality around the world.

The challenge will be with government for it will and does today, get in the way. Polices, outlined above, are actually preventing growth. If we don’t remove them, the success of the Fed path, to raise rates to head-off a recession, will be at risk. But this risk is smaller than what will happen if the Fed cuts rates as Mr. Goodfriend suggests.