After traveling extensively in the fourth quarter of 2018, I am convinced that the world is one or at most two quarters away from a global policy panic, signs of which have already emerged in the first days of 2019. What would this look like? Policymakers throwing everything they can at an economy that is sinking fast and still reeling from the mistakes of the last decade, exactly six months after those same policymakers said the crisis was over.
As 2019 gets under way, Europe is sliding back into recession despite a negative European Central Bank policy rate, and Germany and its marquee names suddenly look like far greater risks than Italy’s populist government. Australia is a mess, both politically and economically, as the royal commission has left banks tightening their lending standards in an economy that is at least 50% driven by housing.
Strains in the US credit market reached a crescendo in the first trading days of 2019, as Bloomberg Barclay’s high-yield spread index climbed more than 500 basis points above US Treasuries. This combined with a bear-market run in equities from the September highs saw US Federal Reserve chief Jerome Powell trotting out the latest version of the Fed in an interview where he shared the stage with his two bubble-blowing predecessors. There was plenty of egg on Powell’s face as his promise to “listen to the market” came barely two weeks after he put on a hawkish show at the December 20 Federal Open Market Committee meeting.
So the Fed is already slamming on the brakes as the flows from corporate repatriation run dry and high-risk issuers have not been able to auction debt. Clearly, the Fed has already gone too far as its policy normalisation, including the blistering $50 billion/month of quantitative tightening and not just the rate hikes, kills the massive financial engineering game that drove so much of the past decade’s unsustainable US corporate profitability growth.
China is still contemplating its next stimulus – tax cuts, mortgage subsidies, a stronger renminbi – and is wondering how to proceed towards its 100-year anniversary in 2049 with its 2025 plan now pushed back to 2035. In India, the rupee still looks shaky after a freefall in the third quarter, and the central bank of India has lost independence. Japan registered negative nominal GDP growth in Q3 – nominal growth – despite the ramping up of spending for the 2020 Olympics in Tokyo.
The UK, meanwhile, has suffered the biggest credit impulse contraction of any country, leaving the first half of next year a major risk for UK assets.
The worst December for global equity markets in more than a generation has set up a risk that policymakers overcorrect and scramble to bring back the policy punch bowl that they tried to remove in 2018. Indeed, a policy panic could see a major market low as soon as the first quarter of this year.
The chief drivers of the above were the Four Horsemen we identified over the previous couple of quarters that pressured global markets and increasingly dented the economy as well:
The rising price of global money from the Fed’s tightening and contagion into higher risk spreads.
• The declining quantity of money due not only to the Fed’s tightening, but also due to the tapering of balance sheet growth from the Bank of Japan and European Central Bank.
• Reversal of globalisation as the US and China face off over trade.
• Ramp-up in global oil prices before the recent decline, which was made especially painful by USD outperformance.
Since the global financial crisis, the business cycle has been suspended, and replaced by only a credit cycle. Credit, credit and more credit crowded out productivity and inflated asset prices while doing little for the real economy and driving the worst inequality in generations. The mis-pricing of money and credit has also driven a terrible misallocation of capital and kept unproductive zombie debtors alive for too long.
The mood in Europe, Middle East, Africa and Asia is the worst I have seen in recent memory – including the conditions leading into 2008. There is, however, a new sense of urgency everywhere, and the classic response of “it could be worse” is now being replaced by frank questions about what to do next and how bad the trade war and populism can get. A status check tells us that the situation is bad and will get worse if nothing changes. Looking ahead of the curve, however, we need to ask what might change the dynamic?
The price of money is the easy fix: the market has already largely reversed the Fed’s anticipated tightening, and the entire US yield curve – so important as the Fed controls the price of global money – has dropped BEWARE THE GLOBAL POLICY PANIC sharply. This offers little more than psychological support; the price of money is the least potent of the Horsemen as the proximity of the zero-bound weakens the monetary transmission potential of lower rates. Outside the US, there is even less interest-rate policy room to work with in most cases.
The most important factor is the quantity of money, and even if all the major central banks opened their taps now, the boost to economic activity wouldn’t really be felt until around Q3 of this year. The transmission of the credit impulse into the economy, in other words, takes at least nine months and often longer depending on a country’s debt levels. But for renewed growth in the quantity of money, the Fed will need to reverse QT, a shift that would bring a fresh bout of market distress akin to what we saw in December.
One bright spot for the new year is that the price of energy in USD terms plummeted back to 2017 levels in Q4, though it remains very volatile. Still, it will take some time for this fresh stimulus to be felt after the highest prices since 2014 were registered a mere three months ago – particularly for emerging market currencies, which were likewise very weak at the time. Energy could remain lower, but Opec and non-Opec producers alike will try to keep the $50/barrel price floor in place for Brent.
In Q1, a combination of the Fed pausing and signalling a climb-down from QT with China continuing to drive the CNY stronger toward 6.50 or better versus the USD could help. China can pay the price of a 5% stronger currency as it reduces the burden on state-owned enterprises’ USD-denominated debt and could power a massive boost in resolving the trade impasse. At the same time, a strong policy move like this from China with a weaker USD backdrop could drive a considerable relative revival in EM assets.
Finally, on the reversal of globalisation: there is no clear long-term solution here, but the global economy is suffering, global markets are shaken after a terrible 2018, and China will do all it can for stability. The hunt for a solution is fully engaged, and the odds of one appearing are rising fast. In our view, a solution needs to show itself before February 5, the Chinese New Year – this is a top priority for both sides in the US-China trade dispute. The alternative is simply too dire.
After Chinese New Year, we will see powerful support for the Chinese economy – it is needed, and it will come. Nonetheless, beware of incoming turbulence as the policy response everywhere is reactive rather than predictive and may come a bit too late. This means that Q1 is the riskiest period, and this is where the cyclical low in assets and the economic cycle will come. Q1 may see a significant market low for this part of the cycle.
That being said, early 2019 could merely mark the start of the cycle or the early innings of the next cycle of intervention. 2020 is more likely to prove the real year of change. That would fit the political cycle, and it might take an even bigger scare for central banks and politicians to get their acts together – unfortunately.
Welcome to the Grand Finale of extend-and-pretend, the worst monetary experiment in history.
