The Decoupling That Wasn’t

2017 was the year of synchronized global growth, and, in its wake, optimists believed 2018 would follow suit. The reality was disappointing: China, the engine of global growth over the last ten years, turned down, and Europe weakened too.1 The optimistic case for 2019, in turn, was built on the conviction that such weakness was attributable to transitory factors. As soon as these transitory factors passed, the economic soft patch would dissipate, especially with China now easing policy again.

In further support of this argument, the US economic expansion was immune to economic weakness brewing offshore, and could therefore decouple from any malaise elsewhere. Specifically, the US labor market was seen to be going from strength to strength, with the robustness of the US consumer set to underpin continued expansion.2 The rest of the world could hitch its wagon to the US economic locomotive. Add a steady pouring of Chinese stimulus into the tank, and it would only be a matter of time before the ‘transitory factors’ that spoiled the party in 2018 would be replaced by ‘green shoots’. 2019 was going to be different. The downswing was to be replaced by a generalized upswing. But it was not; not yet at least. In 2019, if anything, the downswing looks to have deepened. Worse still, the US locomotive appears to be joining the global weakness.

Rarely, if at all, do predictions of economic decoupling age well. Decoupling has a tendency to become convergence, and almost never in a good way.

The warning signs were there for all to see in the fourth quarter of 2018. The deflationary forces that steadily intensified in the offshore (US-dollar) economy throughout the year finally overwhelmed the reflationary onshore forces. The financial-market volatility prompted the Federal Reserve (Fed) to revise its outlook for monetary policy. The central bank signaled no further rate hikes, and explained that the future direction of policy was now data-dependent.3 This data dependency prompted the Fed to cut its main policy rate twice in the third quarter of this year – by 0.25% in July, and by another 0.25% in September 4.

As we noted last quarter, the Fed has a less-than-stellar record when it comes to preventing recessions with interest-rate cuts. Nevertheless, this is what Chairman Powell has promised to do, with a couple of rate cuts being seen as sufficient to cure the ‘mid-cycle slowdown’. In fact, when the September rate cut was served up, the Fed was forecasting no more cuts before the end of 2020.5 In all likelihood, reality will make a mockery of the Fed’s forecasts again.

Cue the ISM (Institute for Supply Management) manufacturing survey for the month of September, which gave a reading of 47.8, the lowest level since 2009, and well below 50, which is the Rubicon between expansion and contraction. The devil is always in the detail, and the forward-looking sub-components were very weak. The new orders index came out at 47.3, while new export orders stood at a woeful level of 41.0. Together with the production component at 47.3, we have a picture of US manufacturing in or near its worst state since the global financial crisis.6  The evidence is not so much for a decoupling of the US economy, but for the US joining the global downturn.

Economic Limbo

The continued deterioration in the data has invited discussion around the prospects of recession.

A sober assessment of the state of the US economy, and indeed the global economy, is that, while the data does not ‘scream’ recession, it is certainly far from good. In reality, the global economy appears to have reached stall speed (a state of limbo between growth and recession). The global manufacturing sector is arguably in recession, along with countries more geared into manufacturing, such as Germany, while the services sector has held up (still slowing, but not yet contracting). When an economy slows to stall speed, it is arguably more susceptible to downside risks. What might be a minor inconvenience when an economy is growing rapidly with solid momentum can be the straw which breaks the camel’s back when it stalls.

A key pillar of the optimistic outlook is the previously interconnected resilience of labor markets and the service sector: if the labor market is holding up, consumption will hold up too, and solid consumption spending will keep the services sector ticking along. Given that services account for a much larger share of the total economy these days, their strength should underwrite the wellbeing of the economy as a whole.

This may appear to be seductive logic, and it is the logic that Fed Chair Powell is leaning on too: “We are not forecasting or expecting a recession… The consumer is in good shape, and really, our main expectation is not at all that there will be a recession.”7 However, while consumption does indeed account for the lion’s share of GDP in most countries (c. 70% in the case of the US), it is a decline in investment that accounts for the bulk of a downturn in economic activity during recessions.

The question then is what could prompt companies to begin making major adjustments by way of cutting back on investment and reducing headcount, and the answer is likely to lie in the deterioration in returns on capital. On this front, financial data for the companies that make up the MSCI All Country World index are cause for concern. The growth of corporate revenue and operating profit has stalled, while return on equity peaked at the start of 2019.10 At the aggregate level of the market, corporate financials are moving in the wrong direction, which adds to the risks facing a global economy at stall speed.

The Long Road To Fiscal Policy

The third quarter of 2019 saw yet more ‘stimulus’ by leading central banks – the sixth consecutive quarter of policy easing if we begin the clock in April 2018 when the People’s Bank of China (PBoC) began lopping 0.25% chunks off the required reserve ratio (the proportion of liabilities that commercial banks must retain rather than lend or invest).11  As noted above, the Fed took a total of 0.5% off the policy rate over the quarter. The European Central Bank (ECB) was also in on the action. Following his penultimate policy meeting, President Draghi announced that interest rates would be taken further into negative territory, and pledged to revive the ECB’s €2.6 trillion asset-purchase program for “as long as necessary”.12

This is not how it was meant to be. As recently as the end of 2018, Mr. Draghi was still forecasting that those ‘transitory factors’ behind the economic soft patch would dissipate, with a rate hike penciled in for 2019. This was to be a rate hike that would vindicate eight years of ‘whatever-it-takes’ monetary policy.

Unfortunately for Europe’s monetary policymakers, the eurozone economy has not responded to their ‘whatever it takes’ approach. The 5-year/5-year swap rate (a market measure of what five-year inflation expectations will be in five years’ time), the ECB’s favored measure of inflation and thus economic strength, remains near the all-time lows.13 With the European economy spending 2019 walking the line between growth and recession, Mr. Draghi did not get to take his victory lap. Instead, we have seen the relaunch of quantitative easing (QE), and negative interest rates being pushed even further into negative territory. This, of course, is despite the abject of failure of QE and a negative interest-rate policy to deliver what was originally intended – a durable improvement in the economy.

Indeed, there is a growing, and arguably overwhelming, body of evidence that monetary policy does not work as billed. To Mr. Draghi’s credit, he has long said that monetary policy cannot revive the European economy alone, and called for greater fiscal stimulus (notably an increase in government spending) to stimulate activity: “So now it’s high time I think for the fiscal policy to take charge.”14  Leaving aside the debate around whether fiscal stimulus is desirable, those calling Mr. Draghi’s swansong ‘genius’ are generally commenting on how the retiring ECB president has apparently engineered the scope for an increase in European fiscal largesse, with the central bank to pick up the tab.

So now it’s high time I think for the fiscal policy to take charge.14

Mr. Draghi, President of the European Central Bank (ECB)

Enter Christine Lagarde – the new keeper of the ECB’s purse strings. As part of her nomination process, Lagarde appeared in front of the European Parliament in September, and used the occasion to press for urgent fiscal stimulus. Faced with the prospects of another recession without a single interest-rate hike since the last easing cycle, the soon-to-be president of the ECB is visibly unnerved. Perhaps the clearest signal that monetary policy as we know it is dead is that Lagarde is neither a central banker nor economist. Her background is that of a lawyer and politician. Given the apparent future direction of economic policy, perhaps the traditional central banker’s skillset is redundant.

One central bank that is still using the old play book is the PBoC. The start of September saw the PBoC announce yet more reductions in the required reserve ratio (RRR). Once again, this is being billed by commentators as a flood-like stimulus – the latest move by the mandarins in Beijing to juice the Chinese economy. The theory goes that a lower RRR means that banks can put more of their monetary resources to work in the Chinese economy, with the most recent RRR cut widely reported as equating to unlocking RMB900bn of ‘liquidity’.16 While in theory this may be technically true, in practice those hoping that the latest round of RRR cuts revives China’s economy are likely to be disappointed. The 3.5% of RRR reductions over the preceding 16 months have so far failed to translate into an upturn. Will another 0.5% be any different?

In order to understand why these RRR reductions are not fueling the widely anticipated cyclical upswing in the Chinese economy, we need to appreciate the context in which they are taking place.

As we discussed last quarter, there have been mounting signs of stress in China’s financial system for over a year now. In August, Hengfeng Bank was taken over by China’s sovereign wealth fund, joining Baoshang Bank and Bank of Jinzhou on the casualty list.

It is clear that the liquidity ‘freed up’ through these RRR cuts is not being released to a stable banking system. The breadth of evidence indicates that China’s banking system is currently grappling with a funding shortfall. As such, we see these RRR cuts as an effort to plug that funding deficit rather than as a net increase in liquidity. This is why we believe Chinese monetary ‘stimulus’ is not working. From this perspective, continued RRR cuts should be read as a warning, not as stimulus. It tells us that there are still stresses in the Chinese banking system, despite the continuing efforts of the authorities to hold back the turning of the liquidity tide.

Problems with the Plumbing

Central banks around the world are easing monetary policy at a faster rate than at any point since 2009.17 However, to reiterate the point we made last quarter, the easy part is to identify changes in policy; the more difficult part is to ascertain the efficacy of those changes. There is often a gap between the intention of policy action and the response in the guts of the financial system. To this point, the widely reported developments in the ‘repo’ market warrant close attention. 18

Just when the Fed’s rate-setting committee (the FOMC) was about to serve up the second ‘insurance cut’ in September, the repo market blew up in its face. The way in which this is being reported is as if this was the first sign of stress in the US money markets, but this could not be further from the truth. As with the Chinese financial system, there have been growing signs of stress in the plumbing of the US financial system for months, arguably going back to 2018. And it is not just the repo market. Chairman Powell, along with the FOMC, has been grappling with the federal funds market, the very market which the Fed uses to set the policy rate, since he became chair of the Federal Reserve. The disorder in the US money markets points to a Federal Reserve that has demonstrably lost control in its own backyard. This is a potential problem for two reasons.

First, while the Fed is correct that what is happening in the repo market is not the end of the world, and does not constitute a repeat of 2008, it certainly is not good either. The spike in the repo rate and the effective federal funds rate indicates that the demand for liquidity is greater than supply. We have noted on numerous occasions before that the weight of evidence points to a steadily intensifying shortage of dollar liquidity at the global level. Asked about the stress in the federal funds and repo markets at his September press conference, Mr. Powell replied that “they have no implications for the economy or the stance of monetary policy”.19 It is not the Fed chair’s job to make a bad situation worse, but rising stress in the US money markets, the plumbing of the world’s financial system, is never a good thing.

The second reason why the Fed’s apparent loss of control is cause for concern relates to perceptions. The narrative central banks have cultivated for themselves is one of both omniscience and omnipotence, particularly over the last ten years. As a result, many market participants are wholly invested in the notion of the central-bank ‘put’ – the belief that no harm can come in the markets, with central banks ensuring a steady ascent into perpetuity. But what does the Fed’s loss of control of the very market it uses to set the policy rate do for confidence in the central-bank put?

No Change

To summarize, we are witnessing a global economy at stall speed, decelerating job creation, nascent service-sector weakness, and stagnant corporate revenue and profit growth. In our view, the downside for risk-asset prices is clear, but, until events cause that downside to be realized, it remains only potential. However, all of the above continue to be moving in the wrong direction, despite continued policy easing, and so the balance of risk continues to move in favor of the downside. The probability that risks catalyze into something more material for markets is only increasing with the continuing deterioration in the funding environment. The message from the bond markets remains loud and clear. We remain open to the possibility that policy is once again able to turn the ship around, but for now the course remains unchanged. We continue to believe that a safety-first approach is broadly appropriate in client portfolios.

10 Bloomberg
13 Bloomberg
18 A ‘repo’ or repurchase agreement is a form of short-term borrowing by which government securities are sold to investors, usually on an overnight basis, and bought back the following day. It enables central banks to implement policy efficiently.

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