1. Resilience Challenged
2. Low Volatility
3. Changing of the Guard
4. Key Events in Q2
The political consequences of the Great Depression on the 1930s were extreme, and in many ways that experience helped shape the modern institutional framework of the global economy and various national political arrangements. If the 2009 Great Financial Crisis has been the most acute economic and credit cycle since then, the consequences have thus far remained considerably milder.
Populism has been checked. The center-right party of the two-party systems in the UK and US embraced the populist agenda (Brexit and Trump), but populists were mostly turned back in Europe. In Austria, the populists will serve in government, though not for the first time. In Italy, the Five Star Movement won a plurality of votes but has walked back some of it populist planks, including to ditch the euro and exit the European Union.
The greatest threat to the liberal global order that emerged after WWII and has evolved ever since comes from its key architect: the United States. With nearly all countries having joined the World Trade Organization (WTO) and International Monetary Fund (IMF), US President Trump and many of his key economic advisors come from a faction of America’s political and economic elite that does not accept the basic premise of the world order.
They do not accept that an international community has been erected out of the ashes of past wars. Instead, they view international relations as dominated by competing nation-states seeking short-term transactional advantage. For them, there is no fundamental difference between China and Japan, for example, in that both have accumulated a little more than $1 trillion of US Treasuries. The accumulation of Treasuries, they argue, was done primarily to resist the upward pressure on their currencies. In effect, Treasuries were bought instead of US goods.
This means that the US experiences a substantial and chronic trade deficit. Trump Administration officials believe that in a world of floating exchange rates and free trade, sustained trade imbalances are only possible if some are cheating. Either the cheating is preventing the exchange rates from reaching a clearing price for trade, or is found in illegal subsidies or other state assistance. Several of the officials shaping Trump’s trade policy earned their stripes in the Reagan government when Japan was the rising Asian power and resisted US commercial advances.
The US did not take much trade action in Trump’s first year, though there were signs of things to come. The US opened an investigation into steel and aluminum trade not on the usual dumping claims, like the 30% steel tariffs imposed by George W. Bush. Instead, in a highly unusual fashion, the US claimed national security grounds. Tariffs on steel and aluminum were announced in Q1 ’18, and although they are ostensibly aimed at China, many US allies were caught in the sweeping action.
Investors and policymakers around the world fear a tit-for-tat trade war--shades of Smoot-Hawley. While this is indeed a possible scenario, we do not think it is the most likely. There is precedent for another, more measured response. Trump is not the first US president to take protectionist action. The usual response has been some symbolic retaliation, but ultimately reliance on the conflict-resolution mechanisms of the WTO.
This reliance is a practical solution. The most powerful response to an attack on the multilateral system is to defend and strengthen the system. Tit-for-tat retaliation weakens the system and the rule of law. A successful challenge to US actions will be a testimony to the resilience of the system. It offers China a chance to project an alternative leadership, ironically by endorsing the very system that has been associated with America’s version of globalization.
Moreover, other countries are going forward with trade agreements even though the US now eschews multilateral arrangements. At the same time as the US was announcing the tariffs on steel and aluminum, a Trans-Pacific Partnership (without the US) was struck. The EU has successfully negotiated new free-trade deals (e.g., Canada and Japan).
Unlike Chinese President Xi, US President Trump is not the “core leader.” The US system of checks and balances curbs Trump’s ability to act unilaterally. For example, the judiciary has blocked or modified his immigration policy and several attempts to unwind environmental protection.
The American Constitution gives Congress the power to regulate commerce. However, the legislative branch has delegated some of its authority to the executive branch, but it may begin clawing some back. Former President Obama was given “Trade Promotion Authority,” which allows a president to negotiate a trade agreement and Congress to approve it with only a yes or no vote. That authority carried over into this year but will expire in Q2. Congress does not seem inclined to renew it.
In Trump’s first year, Congress acted to prevent the president from unilaterally lifting sanctions on Russia and Iran. There is a bill in Congress that seeks to claw back more of the president’s power to take unilateral trade action.
Another check on the president’s power comes from the electorate itself. The US holds mid-term elections in November. Several special elections, voter interest polls, and early voter registration drives warn that the Republican majority in the legislative branch is in jeopardy. A Democratic victory in one or both houses will likely curtail executive initiatives, though a wing of the Democrat Party shares some of the Trump administration’s trade views.
Many foreign officials recognize that Trump is a break from American tradition and are not convinced the change is permanent. They seem prepared to make small concessions, take measures to strengthen the multilateral trading system, bide their time, and avoid a large-scale confrontation.
That said, there does seem to be consensus within the US, and also in Europe and Japan, that Chinese trade practices are not acceptable. China is unlikely to be recognized as a market economy by the WTO, which would make anti-dumping actions more difficult. There are some concessions China appears willing to make, such as greater protection of intellectual property rights going forward, which serve not only China’s interest but are consistent with WTO rules.
At the heart of the problem is that China has over-invested in many important industries. This excess capacity is used to export and, in effect, China exports goods deflation. The US, Europe, and Japan also wrestle with excess capacity in some sectors, but the surplus capital is siphoned out of production and shifted to financial assets. We argue that surplus capital is one of the most important factors lifting asset markets and depressing the return on financial capital (interest rates). There is a substantial risk that the confrontation with China intensifies in the coming months.
Since the Great Financial Crisis and the unprecedented expansion of the balance sheets of central banks, many investors think that officials are responsible for various distortions that they detect in the capital markets. The compressed nature of equity market volatility is one of those distortions.
However, the decline in the S&P 500 volatility index (VIX) became most pronounced last year, when it frequently slipped below 10% and did not get above 20% even once. After raising interest rates once in 2015 and once in 2016, the Fed's normalization accelerated last year with three rate hikes and the beginning of the unwinding of its balance sheet.
While accepting this logic, another force seems to be at work, and it cannot be simply reduced to the Fed's QE: corporate share buybacks. From 2009 through 2017, the Federal Reserve's flow of funds shows corporates bought back $3.3 trillion of shares. They are the most significant buyer of US shares.
Households sold roughly $670 bln of US equities, and insurers and pension funds have sold about $1.2 trillion of US shares. Mutual funds and ETFs bought about $1.6 trillion worth of US shares, offsetting most of the selling. The IMF noted last year that "large US corporations have experienced a negative net equity issuance of $3 trillion since 2009 through share buybacks."
Why do corporations buy back their stock? The first and simplest answer is because they can. Before 1980, the SEC prohibited such activity on the grounds of potential manipulation of share prices. The second answer is that they can in the sense that they have the means: strong earnings growth and share buybacks, like dividends, return unwanted/unneeded capital to shareholders.
There is a role for low interest rates, which may be a function of the Fed's buying (which stopped in 2014). That is partly because some large companies, especially with retained earnings offshore to avoid (minimize) taxes borrowed to buy back shares. In 2013, S&P dubbed this "synthetic repatriation." However, with the new tax cuts and changes on how global earnings of US MNCs are treated, there will likely be less of a need to borrow (i.e., real repatriation can replace the "synthetic" approach).
Indeed, early estimates quoted in the media suggest that through the middle of February, US companies have announced $177 bln in share buybacks this year. That is more than twice the amount from a year ago and contrasts with a 10-year average for this period of about $77 bln.
Share buybacks may be an important part of the equity market story and the low volatility. Since 2009, the large equity pullbacks have coincided with the blackout period around earnings releases, for which share buybacks are still prohibited. Corporate buyers seem largely price insensitive but always appear ready to buy into weakness in what is perceived to be a bull market. Share buybacks create a virtuous cycle. The low volatility and low liquidity that result encourage additional corporate purchases.
Volatility experienced a Minsky moment in Q1, by which we mean the low and stable volatility led it its opposite. The sustained low volatility environment bred a financial eco-system designed to profit from it, and then served as an accelerant and echo chamber. The VIX jumped from around 10% to 50% if a few days.
This also underscores that fact that while there may be some structural factors depressing volatility, market forces can counter it. After last year’s strong advance, and extension into January 2018, it ought not be surprising if the correction that began in Q1 carries into Q2. This will underpin the VIX, and maybe 15% is the new 10% (base).
The US was the first. Powell replaced Yellen at the top of the Federal Reserve. At the first meeting he chaired, the FOMC hiked interest rates. This stands in sharp contrast with BOJ’s Kuroda who announced QQE at his first meeting and ECB’s Draghi who cut interest rates at his first two meetings. If Trump wanted to put his mark on the Fed, there were few candidates that demonstrated greater continuity with Bernanke and Yellen than Powell.
The seven-member Board of Governors has only three governors presently. Until more vacancies are filled, it would be difficult for Powell to deviate much from the current framework if he wanted to, which we doubt. Still, there are some modest changes that can be implemented, such as a press conference after every meeting, which we have been encouraging since the rate hike cycle began in 2015.
Japan was second. BOJ Governor Kuroda will serve a rare second term. As Yellen was the first Fed chair in more than 30 years not to serve a second term, Kuroda is the first BOJ Governor in 50 years to have a second term. Kuroda's (meaning black) reappointment, and the new deputies, solidify the change in Japan's central bank from the Shirakawa (meaning white) tradition to a more activist stance. As Powell appears to offer great continuity with Bernanke and Yellen, Kuroda's reappointment signals a steady hand in Japan.
Kuroda has been clear. Given the current inflation readings, it is premature to even begin talking about an exit from the two-prong monetary course of Qualitative and Quantitative Easing and Yield Curve Control. The BOJ projects that in FY19, which begins April 2019, inflation will be sufficiently close to its target that a change of policy can be contemplated then. However, the BOJ’s track record in forecasting inflation is not particularly robust. Moreover, we suspect the strong likelihood that the retail sales tax will be hiked as planned in October 2019, also deterring a reversal of BOJ policy.
China was third. PBOC Governor Zhou Xiaochuan retired as widely expected in late Q1 ’18. Yi Gang replaced him. As with the Fed and BOJ, there is a sense of great continuity in China. Following the March Fed hike, the new PBOC Governor raised the rate on an open market operation by five basis points, exactly like Zhou did in December 2017 when the Fed last hiked.
The PBOC can be expected to continue what appears to be a three-prong mission: prudent monetary policy, financial reforms, and opening up of the financial sector. The PBOC will continue to be a voice of financial liberalization, within a strong regulatory framework. Governor Yi will have a powerful advocate in the form of Liu He, the new vice premier and close friend of President Xi, who is also is understood to support such an agenda.
Next year, Bank of England Governor Carney is expected to step down in June, while ECB's Draghi sees his term end in October. In the UK, Broadbent is seen as a likely successor to Carney. The changes at the ECB are part of a larger transition in Europe that will culminate with a new European Commission and a European parliamentary election next year. That transition is already underway. Portugal's Centeno is the head of the Eurogroup of eurozone finance ministers. Portugal though is losing the vice presidency of the ECB. Spain's de Guindos will likely be formally named at ECB vice president at the European Council toward the end of next month.
Five of the top seven posts at the ECB will be changed by the end of next year. Also, the heads of the European Stabilization Mechanism (Regling), the Single Resolution Board (Konig), and the European Investment Bank (Hoyer) will be replaced. This number of positions allows for greater horse trading and may help facilitate the kind of balances that European often seeks.
Many observers see De Guindos at the vice presidency boosting the chances that Bundesbank's Weidmann succeeds Draghi. On the one hand, Germany has not held that office before, and on the other hand, if the ECB is going to be exiting from its extraordinary policies, it may be desirable to have a hawk lead the way. Nevertheless, in his role at the ECB, Weidmann has not demonstrated the kind of consensus-building that the top position seems to require.
One of the balances that Europe seems more sensitive to in addition to big/small and creditor/debtor is gender. If Weidmann gets the nod, the only woman on the executive board, Germany's Lautenschlaeger, would have to step down. There is an unwritten rule that no county should have two members on the executive board. Bini Smaghi stepped down, for example, when Draghi was named as ECB president. However, there are at least three women deputy governors of national central banks (Germany, France, and Ireland) that could be promoted if their governors get new jobs (Weidmann and Lane), or their terms end (Coeure at the end of next year). It is reasonable to expect that going forward the ECB will have more women on the board.
Our preliminary analysis suggests German Chancellor Merkel may not push very hard for Weidmann (or another German) to replace Draghi. Germany’s main interest is not in the nationality of the next ECB president but the policies it pursues. Taking away the proverbial punch bowl will not win friends, and it is fraught with technical risks. Rather, we suspect more important for Merkel and Germany is the future of the European project as it contemplates its prospects post-crisis and post-Brexit. Merkel, arguably one of the savviest politicians of our generation, may have her eyes on a different prize than ECB president, such as the presidency of the EU. Her strategy may be clearer in Q3 ’18, if not earlier.
If we are right and the heightened trade tensions do not turn into an eye-for-an-eye, tooth-for-a-tooth path of mutual destruction that leaves a blind and hungry village behind, the prospect of a trade war will subside as a source of anxiety and uncertainty for investors and businesses. This may allow macroeconomic considerations to reassert themselves.
The Bank of England and the Federal Reserve are the most likely among the major central banks to raises rates in Q2. Canada is a possible candidate, but July may be more likely than May. The evolution of the ECB’s forward guidance is evolving slowly, and it may be stymied by the sharp loss of economic momentum seen in a range of survey data. We think the base case should be that the ECB tapers its purchases further in Q4, but that will not have to be decided/announced for several months. The BOJ seems to be the least likely of the major central banks to change policy in Q2.
Brexit negotiations are proceeding. Stage three of the negotiations will begin in Q2. This is the final stage and involves negotiating the new relationship and tying up some loose ends, and there are several substantial ones (e.g., the Irish border). Progress was deemed sufficient on the terms of the separation (e.g., UK’s financial obligations) and on the transition to push negotiations along.
Despite the apparent progress on Brexit, the UK may still be headed toward a political crisis. It could come as early as next quarter. Significant Tory losses in the local elections in May could spur a leadership challenge. The strategy of most of the potential alternative candidates would seem likely to result in a hard Brexit.
Political risk also stems from Italy, which is trying to form a government following an inconclusive election that dealt a blow to the centrists. Investors have thus far taken it in stride. While the Five Star Movement would seem to be the key to practically any majority government, it needs an ally. Investors would likely prefer an alliance with the PD (center-left), but that is anathema to some fundos in both parties. The alternative is a coalition with the nationalist-right Northern League, which has not abandoned its anti-EU and anti-euro rhetoric as has the Five Star Movement.
There has been a dramatic LIBOR increase in Q1, and this has seen spreads widen considerably. These include some credit-quality indicators like LIBOR-OIS and TED (T-bills-Eurodollar). US dollar rates widened dramatically, but it was not evident in the cross-currency basis swap space as we had anticipated. We accept that there are technical factors behind the increase rather than a signal of rising stress in the financial sector.
It appears that some of the dollar funding that was accessed offshore is coming onshore (there may be some interesting parallels with CNH and CNY). This may be due to US tax changes. Not only is this about repatriation, but also about non-US banks being forced to substitute FX swaps with unsecured funding. It may also be due to the flood of bills the Treasury has issued, and the Fed raising interest rates. Some currencies, especially those that are pegged to the US dollar, including the Hong Kong dollar, may come under pressure.
We suspect that the so-called “Greenspan Put” is still operative but that the strike price is lower. The idea is that in the past, the US Federal Reserve seemed prepared to alter its monetary stance if the stock market fell too far, too fast. The broad principle still seems valid: officials understand that a major disruption of the financial markets could have a feedback loop and undermine the real economy. Yet because of the elevated valuations and a desire to minimize moral hazard post-crisis, the official pain threshold and the pain threshold for any set of investors may not be aligned.
Perhaps one of the most important developments for investors in the coming months is whether the globally synchronized upturn is intact. The US and the eurozone appeared to lose some economic momentum in Q1. Was this the breath that refreshes or does it mark the turning of the global expansion? While we would locate the US in the late part of the business cycle, the large-scale fiscal stimulus could extend it. Japan also seems somewhat immune to a slowing of the global economy. The country appears to be in an investment cycle in China, and Asia more generally, such as building semiconductor fabrications facilities.
Europe seems more vulnerable. A downturn in the eurozone business cycle may be slowed by the continued asset purchases and the ECB’s broadly accommodative monetary stance. However, it would come at an inopportune time for the ECB, which is trying to edge toward ending its asset purchases. The downside of the business cycle would limit the pace and extent of the normalization of ECB monetary policy.
This gets us a bit beyond the second quarter, but it is a weight on investors. Many will not be convinced that the Great Financial Crisis is truly over until the downside of the business and credit cycle is managed. Traditional monetary tools may be of limited use. Many in the US expect the Fed’s balance sheet to be used again in the next downturn. What if the easier monetary policy is judged necessary and the ECB has not managed to raise its deposit rate above zero?
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