This year has been a banner year for asset prices. Risk assets have outperformed. Growth has beat value. We argue that it is not simply the fact that central bank balance sheets are bloated or that they (collectively) are still expanding. Slow growth and slow inflation may justify low yields, which in turn may favor risk assets in general, and depress volatility.
The 1987 stock market crash that saw the S&P 500 fall nearly 25% in a single day was a minor disruption of the secular bull market (and is hardly noticeable on a long-term chart that is not on a log scale). The US business cycle is longer and flatter than cycles before the early 1980s.The Great Financial Crisis was on a different magnitude of order, but the Great Moderation that preceded it appears to remain intact.
For reasons, like demographics, that we think we understand, and other reasons, like the decline in productivity, that we are still grappling with, trend growth has slowed. There seem to be technological and competitive forces keeping the price of goods contained, as well as eating into some services prices. The generational shift from the Baby Boomers may be contributing to the weak median wage growth in most high-income countries with tight labor markets. The weak state of organized labor arguably also has been a factor keeping wage costs constrained.
We suggest another factor is at work. It is consistent with — but different than — Lawrence Summer's revival of the secular stagnation thesis. It has roots going back to the 19th century understanding of the market economy. The factor was articulated first in the United States by an employee of Brown Brothers, Charles Conant: surplus capital. Corporate strategies for competing in such an environment formed the cover story of the March-April Harvard Business Review issue. Written by analysts at Bain & Co, the article discusses how what it calls the “superabundance of capital" requires a profound re-think of business investments, internal hurdle rates, and broader corporate strategies.
We suspect that infatuation with the so-called cyber currencies, which have little in common with what we know as money, and even fiat money at that, is partly driven by the same underlying factor as other financial assets. There is too much capital relative to the demand by industry and much of the surplus capital that is not simply wasted gets circulated in financial assets.
Moreover, companies used to be the net borrower of capital, and now they are net suppliers. US, Japanese, and European corporates are sitting with an estimated $7-$8 trillion of cash and cash equivalents on their balance sheets.
Research by William Lazonick, a professor at the University of Massachusetts Lowell, found that the 449 companies in the S&P 500 (publicly listed 2003-2012) used over half of their earnings (54%) to buy back their own stock (~$2.4 trillion). More than a third of their earnings (37%) were used to pay dividends.
One of the developments this year has been the stepped-up corporate buybacks of their debt. According to Bloomberg data, S&P 500 companies have already bought back nearly $180 bln of their bonds in 2017 (through the end of September) while they only bought back a little more than $87 bln during all of 2016.
Leave aside the lessons that Minsky taught, and many of us had to re-learn during the Great Financial Crisis, that financial stability itself leads to its opposite, through financial engineering, leverage, and mispricing of risk. Leave aside that the spread between the Russell 1000 Value Index and the Russell 1000 Growth Index is the widest since the end of the tech bubble in 2000. The immediate problem is that the rewards of the market economy and appreciating asset prices benefit the few, and, in various forms and numerous ways, the response has become a potent political force.
One of the biggest fears at the start of this year, and a weight on the euro at the end of 2016, was that the wave of populism-nationalism that led the UK to vote to leave the European Union and the unlikely election of Donald Trump as President of the United States was going to sweep across Europe in series of elections.
The euro bottomed in early January, but at the start of the second quarter, it was still bouncing along its trough. It wasn't until it became clear that Macron was going to beat the National Front that the euro's five-month rally began. Indeed, the euro gapped higher on April 24 and did not look back until peaking in early September just shy of $1.21.
Several crosscurrents in European politics, as well as state-level idiosyncrasies, make it difficult to draw hard conclusions. While the neoliberal agenda remains intact, there has been a shift against immigration, and to different extents, religious minorities, including but not limited to Muslims. There also appears to be a generational shift as well. France and Austria have joined Greece with young senior officials (president, chancellor, and prime minister respectively). If Italy's Renzi has his way, it will be a quartet early next year.
The shift in European politics may make it more difficult to find common ground to continue to build “Europe” after Brexit and the financial crisis. Instead of enacting a new vision, the coming years may be rearguard action, where integration that has been achieved is defended from attempts to roll it back. It may also provide an opportunity to get the individual states' fiscal and banking houses to provide a better case for integration later.
There are four key political issues Europe will face in the remainder of the year. The first is Brexit. The EU judged the UK as not having met the threshold to shift negotiations from what has been compared to a divorce settlement to the new relationship. The UK Prime Minister's negotiating hand was weakened when she lost her parliamentary majority in a snap election bid in June. Her position seems precarious, especially if the Brexit talks remain deadlocked. Even though economists may debate who stands to lose the most, perceptions of increased risk that negotiations may end without an agreement tends to weigh on sterling.
The second political development is the formation of the new German government. The Social Democrats have moved into opposition. Merkel will negotiate with the center-right Free Democrats and the Greens, for a so-called Jamaica Coalition as the color of the parties are the colors of the Jamaican flag. A new government is expected to be in place by the end of the year. Among the first casualties of the election was German Finance Minister Schäuble, who will now be the president of the Bundestag, the lower parliamentary chamber. His successor is keenly awaited and who is chosen to replace him may be revealing of political dynamics in Germany, as well as the country's stance toward Europe.
The third is the resolution of Catalonia's ill-conceived plan for independence. It appears, from the outside, that Catalonian officials were driven by passion more than reason and had not developed a coherent strategy. Though they had fanned the flames of independence, they were ill-prepared to deal with the inevitable resistance from Madrid. They, like the Umbrella Movement in Hong Kong, did not reach out to other sectors and interest groups. Some press reports suggest over 1500 companies have moved their headquarters out of Catalonia. A new regional election may help ease the immediate crisis.
Fourth, Italy’s parliament has approved a new electoral law. It makes possible an election next year. It must be held by the end of May 2018, and early March is a likely time frame. The new electoral rules will raise the bar of representation for small parties, and encourage coalitions, for which the populist Five Star Movement shows disdain. The polls suggest that the center-left, the center-right, and the Five Star Movement are each supported by a third of the voters.
In the US, President Trump is proud of his disrupter status. This is a complicated enough task, but it is also compounded by numerous dramatic distractions, such as US tax reform, which probably affects more investors than other policies. As with health care reform, the debate within the Republican Party is key. Its failure to find common ground undermines its strategy of using its majority in the reconciliation process, allowing Congress to legislate with the minority Democrats.
At the same time, US demands in the NAFTA negotiations have lost the support of the US Chamber of Commerce. The hard work is typically left until the last rounds, and last-minute deals are common in trade negotiations. There is a sense that US demands are meant to end the multilateral trade deal (which Trump campaigned against), seemingly without the US ending it as the President initially advocated.
In addition to tax reform and NAFTA, the third key issue for investors is the debt ceiling and spending authorization, which expires in December. A reinstatement of the debt ceiling will force the Treasury to again do some maneuvering to extend it as far as possible. If it were to run out of “tricks” before the legislative solution is found, the US would have to selectively service is debt. We continue to believe that there is an extremely low risk of this, but recognize the incredible disruption that it could cause. If spending authorization is not granted, some parts of the federal government would be closed. There is a greater chance of this second scenario than the first.
President Trump's nomination of the next Chair of the Federal Reserve is awaited. We suspect that outside of a crisis, there are not substantive differences between the leading candidates. The betting markets have been fickle. They seem to prefer Jerome Powell (currently a governor on the Federal Reserve Board) and John Taylor (professor of economics at Stanford University), while economists favor Kevin Warsh (formerly a governor of the Federal Reserve Board), according to a recent Wall Street Journal survey. Many asset managers seem to be most interested in whether the outlook for Fed policy will change. One way to quantify this is whether the median forecast for Fed funds changes. Currently, the Fed anticipates that three rate hikes will be appropriate next year.
We understand that the Fed moves are data dependent. We do not mean that in a crass way, but the Fed currently is anticipating that core inflation will soon accelerate, that the transitory forces holding it back are passing. If it does not materialize, or if inflation resumes the decline seen earlier this year, the current Fed leadership is likely to lose its consensus. The median dot plot will likely take back one or two of the hikes it expects to deliver in 2018 and could reduce the number of hikes anticipated in 2019 as well.
For this year and this leadership, confidence in the underlying strength of the US economy (relative to trend growth) is the key to their willingness to gradually normalize policy, while leaving conditions extremely accommodative by nearly any historical measure, in the face of less than expected price pressures. This may change. The confidence and the conditions that facilitate it may wane next year, depending as much on the data as the idiosyncrasies of the person who has the Chair. At the extremes in personality types, and economic conditions that must be confronted, there may be an important difference, but most of the time and in most of the decisions, it is a technocrat, not an ideological function.
We expect the Federal Reserve to deliver its third rate hike of the year in December. That hike would bring the new target range for Fed funds to 1.25%-1.50%. The interest the Fed pays on reserves (all reserves, not just excess reserves) is set at the upper end of the Fed funds target range. The market is barely discounting a single rate hike next year. We suspect the risk is that the Fed hikes more rather than less.
The decline for most of the second and third quarters helped give rise to a narrative that suggested that divergence was over. New convergence was celebrated. We demur. Peak divergence lies ahead, and all indications point to it extending into 2019.
There are two elements of the divergence of monetary policy that we consider here: policy rates and central bank balance sheets. The Federal Reserve expects to raise rates three times in 2018. The European Central Bank recently underscored the fact that, like the Federal Reserve, it will not raise rates until after its asset purchases are complete. The ECB intends on purchasing assets through at least September next year.
The Bank of Japan (BOJ) has not even given a hint about its exit strategy. The recent election increases the likelihood that the current monetary course is continued, even if Governor Kuroda steps down after his term ends next year, as is customary in Japan. That said, there is much speculation that he will be the first governor in half a century to have the second term. The point is that the BOJ is not expected to raise rates in 2018. Its balance sheet is expanding at a somewhat slower pace than the JPY80 trillion targeted, but it turns out that keeping the 10-year bond yield in a ten-basis point band around zero does not require as many purchases.
The Fed's balance sheet has begun shrinking, even without the central bank selling a single security. Its balance sheet has begun to gradually fall as it stops reinvesting the entire amount freed up as the assets it bought mature. The balance sheet is projected to shrink by $30 bln in Q4, which seems largely inconsequential given the size of the Treasury and Mortgage Backed Securities (MBS) market, and the Fed's $4 trillion balance sheet. In contrast, the ECB's balance sheet is projected to increase by 180 bln euros in Q4, and the BOJ's balance sheet may expand by JPY15 trillion.
Gradually, the Fed's balance sheet operation will accelerate. In H1 of 2018, the Fed's balance sheet is projected to shrink by $150 bln. The Fed intends to allow its balance sheet to shrink by $120 bln in Q3 of 2018, for a total reduction in the first three quarters of next year of $270 bln. The ECB's balance sheet, however, will likely expand by another 270bln euros in the first nine months of next year.
The Fed waited nearly two years between its first rate hike (December 2015) and when it began to allow its balance sheet to shrink (October 2017). It is not clear if the Fed's example in these uncharted waters will be followed. The divergence between the Fed and the ECB’s balance sheet has been a function of the ECB's actions. However, now the divergence is because both central banks are moving their balance sheets in opposite directions. Even after the ECB completes its asset purchases, the divergence will continue, provided that the Federal Reserve continues to allow its balance sheet to shrink.
The divergence with the BOJ is broadly similar. For the past several quarters, it has been driven by the Japanese side. Now the central banks are moving in opposite directions, and we expect they will continue to do so next year and in the years beyond. The Japanese retail sales tax is scheduled to be hiked from 8% to 10% in 2019, and given the recent experience (when it was raised from 5% to 8%), the BOJ will likely seek to cushion the blow.
It is true that not all major central banks are easing policy. The Bank of Canada hiked rates twice in the third quarter. However, rather than signal the start of a sustained monetary tightening cycle as the Fed has, the Bank of Canada essentially took back the precautionary easing provided in 2015 in the wake of the terms of trade shock when oil prices cratered. Similarly, there are widespread expectations that the Bank of England may hike rates this year. If it does, the hike probably would be more similar to the one in Canada than the one in the US.
The Bank of England eased monetary policy around the time of last year's referendum. Many members of the Monetary Policy Committee want to unwind that accommodation. With price pressures thought to be near a peak, the economy slowing, and the strong pass-through of higher interest rates to households, it could very well prove to be one and done.
We conclude with two points. First, contrary to the consensus narrative, we see monetary policy continuing to diverge. If the US does pass tax reform, this will add to the divergence. Indeed, the mix of less accommodative monetary policy and looser fiscal policy is the best policy mix for a currency.
Second, we think that this divergence broadly understood is the main driver of the dollar's underlying trend. The dollar's decline in the late April through early September period seems best explained by the unwinding of tactical positioning and the extreme pessimism of Q4 2016 over the political challenges presented by the numerous European elections in 2017. The dollar's pullback was within the magnitudes that technical analysis suggests is consistent with corrections rather than trend reversals.
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