FOR too many years, global monetary policy has been ultra-easy. It has resulted in a debt trap of its own making. With the goldilocks global economy we now have, continuing on the current monetary path is imprudent – adding to demand even as the economy is running hot.
Indeed, rather dangerous. It brings with it, the serious threat of inflation. But any sharp reversal also involves great risks. Indeed, the odds of another crisis coming through continue to rise. At this time, inflation is not the only danger. Debt ratios have been allowed to rise for too long; it has now grown global.
Moreover, tolerance of risk-taking is beginning to threaten future financial stability, as does the narrowing of profit margins since interest rates have begun to rise. Worse, the misallocation of resources, including by banks, is being encouraged by the easy money environment.
When markets are unable to allocate resources properly as a result of super-low interest rates, bad investments have been made. Indeed, the likelihood that rising debt servicing will not be honoured has risen rapidly. So, normalising monetary policies is long overdue.
Unfortunately, doing so also carries significant risks in the face of potential inflationary pressures since any monetary tightening could have destabilising effects. As sovereign bond yields start to rise from historically low levels, this could have important implications for the over-extended prices of many other assets, including equities.
In recent weeks, there has been a sharp correction, and subsequent recovery in the value of US and European equities. Volatility has come and gone. It will come again. There has been much prognoses of what the returning volatility means for the future.
Indeed, investors are warned often enough of how markets are fraught with pitfalls. Sure, price volatility is something to worry about. Yet, I well remember at Harvard Business School reading Ben Graham (the famed father of value investing), who remains worth repeating: “Price fluctuations have only one significant meaning for the true investor,” he wrote in the 1940s: “They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market.”
A simple practise is to remain cool headed and stay focused when the market is flailing its arms in panic: “If the market persists in behaving foolishly, all that’s needed is common sense to exploit its foolishness.”
The Bank of International Settlements – BIS (often described as the central banks’ central bank) reported recently: “Volatility is back,” suggesting that “some volatility can be (the regulator’s) friend.”
True, financial markets are sailing in uncharted waters. It would be unrealistic to expect no further market ructions. The market wobble we now see may well not be the last. Central banks currently face the delicate task of winding down – seeking to strike a balance between normalising policy (if nothing else, to add room for manoeuvre to deal with the next downturn) and avoiding unnecessarily derailing economic growth.
It’s not going to be easy since Trump’s protectionist rhetoric will further complicate matters. The road ahead calls for a great deal of skill, judgement and yes, even a good measure of luck.
Line in the sand
Recent turbulence in the equity markets has been accompanied by rising real interest rates (i.e. yields adjusted for inflation). The US 10-year real yield loiters around 0.8% towards end-February 2018, up from 0.44% at the start of the year and within sight of September 2013’s peak of 0.92% seen at the height of the bond market taper tantrum.
Rates have been moving up since. I think real interest rates still look too low, given fast rising fiscal deficits (and the prospect of twin deficits), Fed balance sheet reductions, a booming global economy and a US unemployment rate heading below 4%.
And then there are the Trump protectionist measures – new tariffs on steel and aluminium. They may look like a repetition of President George W. Bush’s mistakes (Bush’s tariffs eventually backfired and withdrawn in late 2003; they also drew retaliatory tariffs against US exports). Trump tariffs are far more ominous. This has serious implications for equities since recent correlation evidence shows that bond yields vary inversely with equity prices.
And, as workers finally appear to have some wage bargaining power, real yields certainly have scope to move higher. The line in the sand appears to be 2% for the 10-year real yield – not seen since 2009 when the current equity bull run began – and a level for now appears to loiter beyond the horizon.
The Fed is committed to shrink its bloated US$4.5 trillion balance sheet, although it’s still unclear what the endpoint should be. It will now start by letting some of its Treasury and mortgage-backed bonds expire without replacement (at a rate of US$10bil a month, rising to US$50bil later in the year). It should approach a new normal balance sheet of US$2.5 trillion-US$3 trillion within four years.
With this a reality, “taper tantrum” (a term used by panicky traders) has become as boring as watching paint dry. Why no more panic? Investor psychology has since changed – they now have other more urgent matters to focus on:
(i) a faster-than-expected pace of interest rate increases in the face of Trump’s tax and infrastructure spending plans, and its impact on budget and trade deficits; there’s also the repatriation of US companies’ huge overseas cash piles;
(ii) the Fed’s quantitative easing (QE) policies were not such a big deal after all – of late, they did not seem to have affected rates much;
(iii) engineering the taper “roll-off” was smooth and rather inconspicuous despite the complex technical details involved; and
(iv) much is still work in progress – further, the Bank of Japan and the European Central Bank could start tapers of their own. One thing is for sure. No one should underestimate how much QE has distorted the global financial system. No market tantrum so far. But the jury is still out.
President Trump tweets that: “Trade wars are good, and easy to win.” I think he is wrong. History says he is wrong. Tariffs raise prices and dull competition; they spark retaliation that restricts markets for exports. They give rise to undue risks. In essence, they poison world trade.
There have been at least six US-inspired “trade wars” since the “Tariff Act of 1890” – the latest being Bush’s December 2003 tariffs. The US since paid a high price and “lost” all of them, including the infamous “chicken wars” of the early 1960s. The winners? I think are those nations that didn’t take part. But make no mistake; there is almost universal agreement among historians that no one “won” in any trade war.
The biggest losers are consumers, who are the vast majority. History shows that a few industries may benefit. But, there are way more losers than winners. And the poor are the biggest losers of all. For Trump, I think it’s a sure shot-in-the-foot.
It has to be pointed out that there’s a big difference in context between Trump’s tariffs and Bush’s. Bush’s action reflects a bipartisan US tradition that begun after the Great Depression. US Presidents often sought to liberalise trade overall, but buys support from a usually more reluctant Congress (which tends to seek protection for local business, while the White House protects the national interest in open trade).
Bush continued in this tradition and imposed steel protective tariffs in 2003. However, Trump isn’t trying to placate Congress; in fact, Congress is wary of his tariffs – a role reversal from the post-war norm. Neither is Trump pursuing a broader agenda of freer trade. He is disdainful of post-war US trade policies and seeks to renegotiate or dismantle them – in defiance of the lessons of history.
That’s why, for those of us who recognise that post-war liberal trade has been enormously beneficial for the US and world economy, Trump’s latest tariffs moves (including those on solar panels and washing machines in January 2018, together with his belief in widening protectionism to cover services as well) are much more ominous than their predecessors.
US history on protectionism has been a disaster that led to higher consumer prices and inflation, and provoked a voter backlash. Trump may not care about the costs; but lots of people don’t have that luxury. For sure, tit-for-tat trade barriers in response to Trump’s moves threaten to undermine a strengthening world economy. Eventually, everyone will suffer as global growth gets distorted and slowed.
What then are we to do
As I see it, global finance faces three key issues, reflecting echoes of the past: leverage has risen because of cheap money; low rates have fostered much financial engineering; and regulators are having a tough time keeping track of the rising diversity of risks.
> Debt – BIS calculates that global debt-to-GDP ratio is now 40% higher than a decade ago, reflecting higher government borrowing, exploding China debt, and rising US corporate debt (now 96% GDP, as against 32% in ’07). Rising interest rates has become a serious worry.
> Engineering – the low-rate era has created higher returns products (for example, CDOs, ETNs), many being built assuming rates would stay low. Fortunately, these exotic products total far less than US$10bil, and only affect mainly equity markets, not credit channels. Then, there is the impact of the digital revolution that’s changing the structure of markets and the risks it brings.
> Regulators – cyber-issues and rising protectionist policies are creating new problems for regulators. Fortunately, the core financial system is much healthier than a decade ago and regulators, perhaps, are now wiser (a little); the global economy is expanding and investors remain flushed with cash in the face of growing volatility and ever-changing complexities. As the Organisation for Economic Co-operation and Development (OECD) rightly warned: “Trade protectionism remains a key risk that would negatively affect confidence, investment and jobs.”
What’s clear is that rising rates and uncertainties can lead to more future shocks. The world of cheap money will soon be gone, but rising debt will remain worrisome. So does protectionism. Ignore at your peril.
It is prudent that measures are taken now to limit the likelihood of disorder and instability in markets in the next downturn. Early action to help resolve the debt overhang might even serve to reduce the likelihood of the downturn happening. And, measures to ensure that adequate levels of liquidity can be available to stabilise markets and the financial system are critical.
This need for preparatory action is amplified, given the regulators scope for reacting with counter-cyclical policies is now more limited. Indeed, these policies could even spark the disorder we wish to avoid. It is far better to prepare for the worse, even as we hope for the best.
Former banker, Harvard educated economist and British Chartered Scientist, Dr Lin is the author of “The Global Economy in Turbulent Times” (Wiley, 2015) & “Turbulence in Trying Times” (Pearson, 2017). Feedback is most welcome.