Chief Economist & CIO
Summary: The theme for the coming quarters is 'policy panic' as the rising price and declining quantity of money, the reversal of globalisation, and the ramp-up in energy prices places policymakers' backs firmly against the wall.
Europe is sliding back into recession despite a negative European Central Bank policy rate and Germany and its marquee names suddenly look a far greater risk than Italy’s populist government. Australia is a mess, both politically and economically, as the Royal Commission leaves banks tightening lending standards in an economy that is at least 50% driven by housing.
The US credit market, meanwhile, is one standard deviation away from panic as the flows from corporate repatriation run dry and Federal Reserve policy normalisation kills the massive financial engineering game that drove so much of the last 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 in with its 2025 plan now pushed back to 2035. In India, the rupee is in free fall and the central bank of India has lost independence. Japan registered a negative nominal GDP growth number 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 reason for all this? The Four Horsemen we have identified over the last couple of quarters that are pressuring global markets, and the increasingly the economy as well:
• The rising price of global money from the Fed’s tightening.
• The declining quantity of money from not only the Fed’s tightening, but also a tapering of balance sheet growth from both the BoJ and ECB.
• The reversing of globalisation as the US and China face off over trade.
• The ramp-up in global oil prices before the recent decline, which was made especially painful by USD outperformance.
Since the global financial crisis, we suspended the business cycle and replaced it with 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.
That’s the second conclusion I take from my global travels: inequality, both economically but also in terms of access to education and equal rights for women, is an issue which will drive all elections. Election hopefuls better get those female voters and the millennial generation right, otherwise are they are headed for the dustbin of history.
The mood in Europe, Middle East, Africa and Asia is the worst I have seen – 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 on 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: there is perhaps a 25% chance the Fed doesn’t hike at this week's FOMC meeting. Tactically, I will play this meeting for a dovish surprise. A Fed hike in December will be a bridge too far and even if it does hike, it is still switching to a more neutral stance.
Besides, the price of money is the least important of the horsemen as the proximity of the zero-bound weakens the monetary transmission potential if the Fed was eventually to reverse course: aborting hikes will offer psychological support but nothing more.
The most important factor is the quantity of money, and even if all the major central banks opened their taps now it would still be late summer next year before economic activity levels would start improving. The lead of credit impulse into the economy is at least nine months, and is often longer depending on a country’s debt levels.
The price of energy in USD terms has moved back to where it was when we started this year, but not in the major emerging market importer countries like India, Indonesia and China; there, it remains elevated in local currency terms. This is a massive tax on consumption, so much so that I believe direct subsidies to energy and housing markets will prove key in the incoming policy response. Energy could go lower but Opec and non-Opec producers alike will try to keep the $50/barrel US price level in place. For the big oil importers, again, what’s needed is cheaper oil in local currency terms.
I believe a combination of the Fed pausing and China engineering the CNY up to 6.50/6.60 could help. China can pay the price of a 5% stronger currency as it reduces the burden on state-owned enterprises' US dollar 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, the S&P is down for the year, 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 need 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 the Chinese New Year, we will see a powerful support for the Chinese economy as it is needed, and it will come.
But where does all of the above leave us, tactically?
Beware of incoming air pockets as policy response is reactive rather than predictive and may come a bit too late. This means that Q1 is the biggest risk, and this is where the cyclical low in assets and the economic cycle will come. We still see February as the low.
The challenges of the Four Horsemen dictate that when you have a smaller cake (quantity of money), the pieces are more expensive (price of money), and its more expensive to bake (energy) and harder to sell (anti-globalisation), then all companies and countries with high exposure to debt are the most vulnerable.
• We are short AUD and GBP versus USD on this.
• We are short unprofitable NASDAQ companies versus global mining companies and long EM versus US.
• We are long two-year US T-notes at 2.80%.
• If the Fed hikes in December, we go overweight US 10-year T-Notes and 30-year T-Bonds.
• Long CNY via short USDCNH on improved ‘trade impasse’ - see policy change and 6.60 target.
• Short DAX versus FTSE (playing on a weaker GBP) and versus OMX-Sweden (like SEK long-term).
• Long gold.
I will write an extensive piece on China from my two visits in the last four weeks. China continues to fascinate me, and humble me by my ignorance, but one thing is for sure: get China right and the rest is easy.
For now, I am convinced that the big macro theme in 2019 will be: The Great Policy Panic.
Still, 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. It fits 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.