History in the Making
According to the National Bureau of Economic Research – the official arbiter of whether the US economy is expanding or in recession – the current expansion entered its 121st month in July.1 It has now outlived the golden era enjoyed by the US economy from March 1991 to March 2001, and is more than twice as long as the average expansion since the Second World War. In fact, the US economy is enjoying its longest expansion since at least 1854.2
With milestones passed and new records set, the age-old tradition of high-profile commentators making the case that ‘this time it’s different’ is in full swing. Take Chamath Palihapitiya, a venture capitalist and early investor in Facebook. Palihapitiya announced in an interview with CNBC that the economic cycle is a thing of the past:
I don’t see a world in which we have any form of meaningful contraction nor any form of meaningful expansion. We have completely taken away the toolkit of how normal economies should work when we started with QE (quantitative easing). I mean, the odds that there’s a recession any more in any Western country of the world is almost next to impossible now, save a complete financial externality that we can’t forecast.3Chamath Palihapitiya
It should perhaps come as no surprise that such confidence about a new paradigm should come from someone who has prospered so handsomely from the latest bull market. The new ‘masters of the universe’ are typically those who have accumulated wealth in the recent bull market. However, as the economist JK Galbraith observed, the possession of great wealth is not indicative of superior intelligence or insight. While Palihapitiya is correct in noting that central banks are far more interventionist these days, something we have discussed at length, we would argue that his confidence that they have the power to postpone a recession indefinitely is misplaced. Perhaps he leaves open this possibility in referring to the prospect of a ‘complete financial externality’.
Still Waiting for Godot
The kind of confidence in policymakers espoused by Palihapitiya has been central to the market outlook of many commentators this year. After it became clear that policymakers (central banks in general and China in particular) would respond to the synchronized global slowdown of 2018, many began forecasting that the slowdown would in due course be arrested, and that an acceleration would occur in the second half of this year. Some better economic data early in the second quarter lent weight to the idea that stimulus was beginning to take effect; ‘green shoots’ had sprung in the global economy. However, the optimism engendered by those green shoots was undone by economic data of a decidedly less positive tone over the rest of the quarter.
Take the global manufacturing purchasing managers’ index – a well-watched barometer of global manufacturing activity – as a case in point. After showing tentative signs of stabilization in April, the index resumed its decline in May, falling below 50, the threshold that separates expansion from contraction, and declining further still in June. With global manufacturing activity moving deeper into the doldrums, it is difficult to argue that efforts at stimulus have fed through into the real economy. For now, investors appear unperturbed, at least as indicated by market price action. While the global slowdown has led to growing concerns about recession in some quarters, the majority of investors appear willing to back policymakers to keep the show on the road.
Red Herring or Scapegoat?
One reason put forward for optimism about the economic outlook is the strong likelihood of a trade deal being struck between the US and China (which, it is hoped, will clear the air hanging over the global economy). The logic goes that it is in nobody’s interest for a complete breakdown in trade to occur as it would amount to mutually assured economic destruction. The slowdown in the global economy since the middle of 2018, in particular in global trade, is held up as evidence of the damage already wrought by the ongoing tiff between China and the US. At some point, reason goes, level heads will prevail, and both sides will walk back from the edge.
The only problem with this logic is that it does not square with reality. First, the slowdown in the global economy predates the first shots being fired in the trade war. Secondly, given the breadth and magnitude of the deterioration in the economic data, it is hard to argue that the experience of the last 12 to 18 months is anything less than a global downturn. The slowdown is completely out of proportion with a relatively small increase in costs. The slowdown goes much further than could reasonably be expected from a few hundred billion dollars in penalties on a $21-trillion-dollar economy. It just does not add up. Even economists are having a hard time making the numbers work in their models. Nonetheless, trade wars make a convenient scapegoat for a profession that was collectively forecasting a continuation of 2017’s synchronized global growth. Better perhaps to blame unforecastable trade wars than admit that forecasting efforts have been wide of the mark once again.
For now, a de-escalation of hostilities at the G20 summit in Osaka brought an optimistic end to the quarter, at least compared with the near total breakdown of negotiations earlier in the quarter when China made some last-minute amendments to a draft deal. The US retaliated by sanctioning Huawei, the Chinese telecommunications company, and threatening to cut the company off from access to US technology.4 At the G20 summit, presidents Trump and Xi agreed to what amounts to a ceasefire.5 The US held off putting further tariffs on Chinese goods, while China agreed to buy more US agricultural goods. Negotiations have been rekindled, apparently in good faith, but optimism should be tempered by what appear to be incompatible ‘red lines’. While Trump receives much of the media’s focus, it is clear that there has been a major shift in US geopolitical strategy. It appears to us that no longer is the US willing to accommodate China’s expansion. Instead, it now appears focused on containment.
Much has been made of the pressure President Trump has publicly placed on Federal Reserve (Fed) Chairman Jerome Powell to cut interest rates, and it appeared the pressure had paid off. In the run-up to June’s rate-setting meeting, a number of Fed members adopted a more dovish tone, preparing the ground for Mr Powell to officially open the door to rate cuts should economic data continue to deteriorate; the reason cited for the deterioration to date was of course the aforementioned trade wars. Powell committed to act as necessary to prolong the expansion, and his comment that “an ounce of prevention is worth a pound of cure” has widely been interpreted as meaning that, when the Fed does cut, it will be by more than 0.25%.6
If there was any doubt before the June meeting, it now seems clear that the ‘Powell put’ is firmly in place. But the more important question is not whether the Fed will cut interest rates, but whether it will have the intended effect. Leaving aside discussions about the state of the US economy for a moment, the Fed has a less-than-stellar record when it comes to preventing recessions with interest-rate cuts.
Not So Stimulating Stimulus
As we have noted on previous occasions, stimulus in China is one of the two pillars used to support the case for a second-half of 2019 rebound. Since market participants have been conditioned to accept that whatever a central bank wants it gets, each of the five cuts to the required reserve ratio (the proportion of liabilities that commercial banks must retain rather than lend or invest) administered by the People’s Bank of China (PBoC) over the last 13 months have been accepted as stimulus; the PBoC referred to it as such after all.7 But with data in hand for the first five months of 2019, hopes have been dimmed by a very different reality. Powerful stimulus is just not making a positive difference to the real economy. Anywhere.
According to most accounts, China has been revving up its internal economic engine to offset the economic weakness caused by the slings and arrows thrown in the trade war with the US. But if the PBoC’s reserve-ratio cuts were translating into stimulus, internal demand would be rising substantially, regardless of exports or global trade. Instead, imports are now contracting – a clear sign of weak domestic demand. In May, the total US-dollar value of China’s imports fell by a sharp 8.5% when compared with the same month in 2018, a very clear and apparent downturn in the domestic Chinese economy.8
The weakness in China’s imports is corroborated by other data points, whether it is the ongoing weakness in vehicle, smartphone and white goods sales, or the collapse of global semiconductor demand, or indeed the continued weakness in commodity prices.
Pushing on a String
Quite simply, monetary easing has not translated into an increase in demand. In central-bank parlance, the monetary transmission mechanism (the process through which monetary policy decisions affect the economy) appears to be broken. This does not come as a surprise to those who have been monitoring the mounting signs of stress at the heart of China’s bloated financial system – stress which has been present and rising for at least 12 months.
The stress percolating within China’s financial system has garnered much more attention since Chinese regulators announced the first bank restructuring in modern China’s history on 24 May9 Baoshang Bank was seized because of what the PBoC and the Banking and Insurance Regulatory Commission said was “serious credit risk”.10
On Sunday, June 16, China’s securities regulator convened a meeting to ask big brokerages and funds to support their smaller peers, as reported in a Wall Street Journal article.11 The briefing cited rising risk aversion in money markets after defaults in the bond repurchase market. The same article reported that the one-month repo rate (the rate at which borrowers can access liquidity by pledging collateral as security) had nearly doubled from 2.9% to 5.2% since the takeover of Baoshang Bank. But while it took the takeover of Baoshang Bank to draw the attention of investors to the stress in China’s money markets, it was evident before the bank was taken over. Baoshang Bank was not the cause of stress in the money markets, but one of its victims. Creditors in the funding markets – the heart of the financial system – were no longer willing or able to extend Baoshang the liquidity needed to fund its impaired balance sheet.
China’s Lehman Moment?
The takeover of Baoshang, and the stress in China’s money markets, is drawing comparisons with the failure of Lehman Brothers. The catalyst for the global financial crisis in 2008 was arguably the closure of two BNP Paribas money-market funds in 2007 which led to a funding crunch for leveraged holders of mortgage-backed securities, but the comparisons are misleading. Baoshang will not be China’s Lehman moment because it is not systemically important. What Baoshang tells us, however, is that it is increasingly probable that the liquidity tide has turned in China.
Warren Buffett famously said that one only finds out who is swimming naked when the tide goes out. In assessing the near-term outlook for markets and economies, it is far less important whether swimmers are wearing bathing suits or otherwise than to understand the direction of the water itself. Only when one sees the first naked swimmer is it usually possible to figure out that the tide is really receding. The takeover of Baoshang Bank suggests that China’s liquidity has deteriorated to such a degree that the weakest hands are being exposed.
Although much of the world had never heard of Baoshang before its takeover, the government’s appropriation was a long time coming. The bank had first reported a capital shortfall almost two years ago. The question then is why now? The difference between now and two years ago is the liquidity environment. Creditors in the funding markets – the heart of the financial system – were no longer willing or able to extend Baoshang the liquidity needed to fund its impaired balance sheet.
So far, the efforts of the PBoC to arrest a deterioration in the liquidity environment have failed. No doubt further efforts will follow, but just as efforts thus far have been unsuccessful, we cannot assume they will be successful in future. The situation is fluid and necessitates close monitoring because the way in which the situation is resolved is likely to hold the key for financial markets. The probability that China’s financial system delivers one of those ‘unforecastable financial externalities’ to which Mr Palihapitiya referred is rising.
Gold or Goldilocks?
While not betting on a significant acceleration of the global economy, investors appear willing to back policymakers to ensure material downside is off the table. Global equity prices rose further over the second quarter, driven by earnings multiple expansion.12 At the index level, earnings estimates were largely unchanged, suggesting that little improvement in the earnings outlook is expected. In sympathy with dampened growth and inflation expectations, global bond yields declined and markets priced in central-bank rate cuts.
Many commentators have argued that the collapse in bond yields and inversion of the yield curve contradict the continued advance of the equity market – and that only one of these can be correct. But there is a scenario in which these apparently contrasting signals can be reconciled. It is that in which the central banks successfully inflate credit, and with it nominal incomes, as first identified by Richard Cantillion when he observed how the Scottish economist John Law used the Banque Royale (the first central bank of France) to engineer a sustained inflation of the French monetary system in the early part of the 18th century. Perhaps investors are taking the recent comments from central bankers as an indication that another round of QE is not too far away, should the economic slowdown continue.
Indeed, the corporate-bond markets appear to be pricing in this outcome. While high-yield credit spreads were largely flat over the quarter – slightly wider in the US, but tighter in Europe – credit investors have favored those companies with balance-sheet leverage over operational leverage, indicating a preference for companies that have funding risk over those with greater sensitivity to the economic cycle.
The fly in the ointment is the price action in the commodity markets. The behavior of commodity prices, along with US yield curves, continues to suggest a more durable downtrend in global growth. If the liquidity tide has turned, the synchronized global slowdown which has stalled economic growth nearly everywhere is very likely to be in its early stages.
An economic recovery was central to the bullish outlook that prevailed at the start of the year because it would bring with it an improvement in corporate earnings. According to data compiled by Bloomberg, more than 80% of S&P 500 companies that have revised their profit estimates in the lead up to second-quarter reporting have slashed them.13
Analysts are in on the action too, reducing company projections at the fastest pace in nearly three years. The question is when this begins to matter for growth assets. Perhaps it does not matter if the central banks return to money printing and asset inflation as the solution to the current economic slowdown. To this point, it is notable that gold (a traditional safe-haven asset) had its best quarter in some time, outperforming all other major asset classes. Whether or not central banks are successful in levitating growth assets, we continue to believe that a safety-first approach to the composition of clients’ portfolios remains appropriate while renewed monetary easing is on the horizon.
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