The West looks East

Having conducted a significant number of client meetings over recent weeks, one feature that has struck is that amongst this, albeit probably rather biased, sample group, there would seem to be a distinct desire to sell risks – although few people have actually done so yet.

Monday, September 5th 2016, 10:31AM

by Andrew Hunt

Certainly, it does seem that many people now recognise or ‘know’ that current economic policy regimes are neither sustainable nor likely to create the types of economic recoveries that people would like; it certainly seems that more people are prepared to acknowledge that all is not well within the current global system. For example, a year ago, it was borderline heretical and certainly unpopular to suggest that negative rates would hurt banks and drive up household savings rates but today these points are readily accepted.

People are increasingly coming to understand that the effectiveness or otherwise of any country’s quantitative easing (QE) depends on the structural nature of the economy concerned and we suspect that over time people will also come to accept that QE only stands any chance of working if it is accompanied by large fiscal deficits or if the population is already ‘overweight’ risk assets and therefore in a position in which it can realise holding gains during any QE-inspired asset price bubble.

Rising equity prices have provided a benefit to that particular subset of the US population that was already overweight equities, and therefore could ‘afford’ to realise its profits, but for the majority of the world that does not own excess equity holdings that can be sold, all that this particular aspect of QE has done is to make it more expensive to save at a time in which, for demographic and other reasons, many simply must save more.

Perhaps the best thing that we have seen in the press over recent days was Ed Chancellor’s Breaking Views commentary, in which he noted that when he first suggested the use of zero coupon perpetual bonds as policy option for governments on the 1st April 2006 in a WSJ article, it was meant only as an April Fools’ joke but a decade later such a policy is being touted as a ‘serious option’ (Breaking Views, No Longer Laughing) by such luminaries as Bernanke (who of course brought us much of the madness in the first place) and Rogoff (the sponsor of European austerity).

That Rogoff and the other theoretical believers in negative rates also believe that cash should be abolished so as to force savers either to give up saving or to march up the risk curve as they approach their retirement years is certainly no joke either – but fortunately we know of no politician that would dare enact such monetary and electoral madness. Over the next generation, physical cash may die out of its own accord but to abolish by diktat would be political and economic insanity.

As a result of all of these factors and many more besides, we suspect that most professional investors, in their hearts at least, now accept that the current monetary policy regimes are not going to deliver sustained economic recoveries and that one day asset markets may fall sharply but at the same time it is difficult for them to sell markets because there is simply nothing cheap to buy instead.

Hence, markets are developing some form of counter-intuitive upward bias. Moreover, given that there is still ‘liquidity’ flowing into the financial systems from the Chinese, European, Japanese and UK central banks, there may therefore be further positive ‘quarterly returns’ that have to be captured so as to avoid any ‘business risk’.

Perhaps the only consolation for money managers is that it is probably not easy being a central banker either these days. The old days of simply raising or reducing interest rates, giving an occasional (ineffectual?) nod to financial stability, and then meeting a few times a year in the very pleasant surroundings of Davos & Jackson Hole are behind us.

Conventional and unconventional policy tools now seem ineffectual in the short term and increasingly damaging in the longer term to both sustainable economic growth rates and society as a whole. Those central banks that may want to raise rates to control corporate zaitech (the US) or rampant house price inflation (e.g. New Zealand) are thwarted either by the behaviour of their currencies or by soft data within parts of their own economies, while the primary sources of the dangerous externalities that global capital flows can bring are understandably too pre-occupied with their own problems to care what impact their capital flight might have on the recipient countries. Indeed, there are after all two ways of achieving a real exchange rate depreciation – you can either depreciate your nominal exchange rate or export so much money to your competitors that you ‘inflate’ their costs bases.

In terms of near term ‘policy actions’ by the major central banks, we suspect that Fed Chairperson Yellen will try to talk up ‘animal spirits’ and try to pave the way for an opportunistic but operationally insignificant rate hike if economic conditions allow, if only so that the Fed can provide some respite to the banking system and some cooling influence on the booming corporate zaitech cycle that is still very much in existence.

China, we suspect, will endeavour to remain below the radar in terms of its commentary but to continue pumping in large amounts of money in order to support its troubled banking system – and we further suspect that a great deal of this money will continue to flow abroad and to inflate overseas markets as a result. Meanwhile, BoJ Chairman Kuroda will probably be looking to create two-way optionality in policymaking given that Japan is perhaps the only major country with an overheating economy but at the same time the Japanese authorities will not want to create more weakness in the TOPIX / strength in the JPY by appearing too hawkish.

We also suspect that many central bankers, and particularly those from Europe, will want to keep attention focused on BREXIT, if only because it is probably a subject that doesn’t matter that much in the grand scheme of things – it is important to the UK and to European politics over the longer run but not to global growth in the near term. What the ECB certainly will not want to do is admit that political relations within Europe look fragile, that the ‘off-balance sheet’ ECB credit system known as TARGET2 system is once again being used to paper over some massive fault lines in the system and that the ECB’s latest efforts to stimulate the economy have actually been counter-productive.

Clearly, the ECB will not want to signal that it is ‘considering other options’ to QE at this time for fear of creating a ‘bond market crash of epic proportions’.

In terms of policies that could in theory be announced - but almost certainly won’t be announced – that could solve the global malaise, we would suggest a wholesale reform of the North Asian Economic model so that the region started to export its wares at economically efficient (i.e. higher profit-maximising prices that would allow the global trade and price imbalances to be addressed); a planned and controlled disaggregation of the EUR back into an ERM-style arrangement that included an implicit revaluation of the DEM in the process; an unwinding of negative policy rates; and large scale investment in education and infrastructure.

Aside from the simple practical and political impossibility of doing these things in the near term, the problem with doing them is that they would likely be inflationary and therefore destructive to bond markets. Indeed, we would argue that bond, equity, currency and property markets – are simply not priced for such things. In practice, the world has travelled so far over the last 20 years from where it should be that to get ‘back’ to equilibrium would be too painful at this juncture for bondholders, creditors and other vested interests.

Therefore, since the world cannot it seems return to a free-market equilibrium in the near term, we suspect that it will attempt to achieve more of a planned economy type of equilibrium.

From this, we can envisage more state spending and wider budget deficits; monetary policy morphing into a funding policy for government deficits; more quasi capital controls (that are disguised as financial stability measures); more financial repression’; and we suspect more attempted suppression of democracy in Europe. In the near term, wider budget deficits could boost corporate profits in the way that they did in 2009-10 (providing of course that the private sectors don’t respond to more state borrowing by saving more...) and yet more QE will imply more liquidity for asset markets in the near term.

In reality, while the West’s plan back in the 1990s may have been to make North Asia more like ‘the West’ by allowing these heavily planned, non-profit-maximising economies into the world trading system despite their incompatible economic models, we would argue that the reality has been that the West is moving towards more state intervention and more financial repression.

This brings us to our final point. When we first began covering Asia back in the mid 1980s, the biggest holders of Japanese equities were Japanese companies and the new issue markets were insignificant. The Taiwanese equity market was defying gravity despite apparently serving little or no economic function and the week that the Hong Kong equity market was closed by the 1987 Crash, the Jockey Club betting organisation witnessed its largest ever takings during the Wednesday night horse racing.

By way of a personal example, during the 1980s and 1990s, it seemed that the most effective ‘asset manager’ in the relatively large AUM company in which the author worked was notionally the Head of IT, his instinctive trading and liquidity-chasing abilities apparently performing much better than any of the CFA-trained analysts.

Unfortunately, when the markets finally did turn, our part time asset manager was unable to extricate himself and the company then had to pay his family’s groceries bill for a while but while the system appeared to work and there was liquidity, the North Asian model produced significant asset price gains despite the fact that earnings growth was often minimal and the economies were in fact performing quite sub-optimally from a longer term perspective – as subsequent events in Japan and of course the events of 1997 were to reveal.

If nothing else, the North Asian model can produce financial market trends that can remain divorced from adverse real economic trends for some considerable time – although when they do finally crack the results can be equally extreme.

Arguably, Japan’s economic model started to fail in the early 1980s, just before its most aggressive bull market began. Of course, there subsequently followed a number of lost generations but we would argue that while the Western authorities are prepared to adopt ever more state intervention and to allow the system to continue to rely on ever larger injections of credit (policies which we suspect that the Jackson Hole crowd endorsed last week), asset markets will likely remain divorced from reality, at least until the democratic processes that operate in the West finally prove more powerful than current policymakers.

Indeed, we suspect that it will be politics that will one day prove to be the limiting factor on just how far the West can move towards the North Asian Economic Model.

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Andrew Hunt International Economist London

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