The Great Malaise Continues

Joseph E. Stiglitz
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The Big Mac index

After the dips

Big currency devaluations are not boosting exports as much as they used to
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MIGHT “Made in Russia” labels become common? If currency depreciation alone could boost exports, then yes. According to our latest Big Mac index, the Russian rouble is one of the cheapest currencies around, 69% undervalued against the dollar. The index compares the cost of the famous burger at McDonalds outlets in different countries by converting local prices into dollars using market exchange rates (as of January 6th, see chart 1). It is based on the idea that in the long-run, exchange rates ought to adjust so that one dollar buys the same amount everywhere. If a burger looks like a bargain in one currency, that currency could be undervalued.

Americans hunting for cut-price burgers abroad are spoilt for choice: the index shows most currencies to be cheap relative to the greenback. This is partly owing to the Federal Reserve’s decision to raise interest rates when the central banks of the euro zone and Japan are loosening monetary policy. The euro is 19% undervalued against the dollar, according to the index, and the yen 37%. Another force weakening many currencies, including the rouble, has been the ongoing slump in commodity prices since mid-2014. Shrinking demand from China and a glut of supply have sapped the value of exports from Australia, Brazil and Canada, among other places, causing their currencies to wilt, too. By the index, they are respectively 24%, 32% and 16% undervalued. If commodity prices continue to fall, they could slide even further.  

These large currency devaluations can hurt, by raising the price of imports and spurring inflation. But although devaluations may not be pleasant, they are meant to be nutritious.

Pricier imports should encourage consumers to switch towards domestic products and stimulate local production. A cheaper currency should also boost growth by spurring exports.

Between 1980 and 2014, according to an analysis of 60 economies by the IMF, a 10% depreciation relative to the currencies of trading partners boosted net exports by 1.5% of GDP over the long term, on average. Most of the improvement came within the first year.

But devaluations do not seem to have provided quite the same boost recently. Japan is the best example. The yen has been depreciating rapidly. A Big Mac was 20% cheaper in Japan than in America in 2013; now it is 37% cheaper. Yet export volumes have barely budged (see chart 2).

This is a surprise: the IMF calculates that Japanese exports are around 20% lower than it would have expected, given how the yen has weakened. Devaluations in other countries, including South Africa and Turkey, have also disappointed.

A global contraction of trade in dollar terms may be obscuring devaluation’s benefits. Although exports from countries with weakening currencies may look limp, many of them are still securing a bigger slice of the shrinking pie. The collapse in commodity prices is also masking some signs of life.

Take Brazil, where the volume of exports rose by 10% in 2015 even as their value plunged by 22%.

Some of that is caused by commodity exporters compensating for falling revenue by selling ever more minerals and oil. But not all of it. In Australia, for instance, exports of goods other than raw materials jumped by around 6% in mid-2015, according to the Commonwealth Bank of Australia.
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Track global exchange rates over time with The Economist's Big Mac currency index

But there are also signs that “Dutch disease” has taken a toll on the capacity of commodity-producing countries to ramp up other exports. When prices were high, capital flowed in, pushing up their currencies and thus making their other exports less competitive. Labour and investment flowed mainly to commodity firms. That has left other industries too weak to pick up the slack now that these once-soaring currencies have fallen back to earth.

Russia is a good example. Non-energy exporters appear to be struggling despite the rouble’s plunge. Over the first half of 2015, as the volume of energy exports surged, non-energy exports fell, according to Birgit Hansl of the World Bank. She points out that it is not enough to have a price change: “First you have to produce something that someone wants to buy.” The rouble’s weakness is an opportunity for industries that already export, such as chemicals and fertiliser.

But boosting other exports requires investment in new production, which takes time.

Both the IMF and the World Bank have highlighted another possible explanation for the weak performance of exports in countries with falling currencies: the prevalence of global supply chains. Globalisation has turned lots of countries into way-stations in the manufacture of individual products.

Components are imported, augmented and re-exported. This means that much of what a country gains through a devaluation in terms of the competitiveness of its exports, it loses through pricier imports.

The IMF thinks this accounts for much of the sluggishness of Japan’s exports; the World Bank argues that it explains about 40% of the diminished impact of devaluations globally. That leaves many manufacturing economies in a pickle.

$590 Billion…Gone in a Day

Justin Spittler


Oil just hit a fresh 11-year low.

The price of oil dropped 6% today. It’s now down 68% since peaking in June 2014. Oil hasn’t been this cheap since February 2004.

Dispatch readers know the world has too much oil right now. “Fracking” and other new technologies have unlocked tens of billions of barrels of oil that used to be impossible to extract.

U.S. oil production is at a 30-year high, and the U.S. is now the world’s largest oil producer.

According to the International Energy Agency (IEA), oil reserves of developed nations reached a record high of almost 3 billion barrels in September.

• OPEC is also pumping record amounts of oil…

The Organization of the Petroleum Exporting Countries (OPEC), a cartel of Middle Eastern countries, produces 40% of the world’s oil. Until recently, OPEC limited its oil production to keep prices high.

But last month, OPEC abandoned its production limit of 30 million barrels per day (bpd). According to Bloomberg Business, investment bank Goldman Sachs (GS) expects OPEC to pump 32 million bpd this year. That would be a new record.

The economies of OPEC nations depend on oil. For example, crude oil accounts for 83% of Saudi Arabia’s exports. And it makes up 68% of Iran’s exports. These countries must keep pumping oil…even with prices at 11-year lows.

• Shares of major oil companies dropped…

ExxonMobil (XOM), the largest U.S. oil company, fell 0.8%. Chevron (CVX), the second biggest U.S. oil company, dropped 4%.

Oil services companies, which sell “picks and shovels” to the industry, also tanked. The Market Vectors Services ETF (OIH), the largest U.S. oil services ETF, fell nearly 4.5%.

Eventually, this cycle will end with absurdly low prices for oil stocks. We’ll get an amazing opportunity to buy oil stocks at fire sale prices. But, for now, the world is simply pumping too much oil. We’re staying away.

• Energy is just one sector that’s struggling…

If you’ve been reading the Dispatch this week, you know U.S. stocks have had a horrible start to the year. The S&P 500 fell 1.5% on Monday, its biggest year-opening drop since 2001.

Today, U.S. stocks slid again. The S&P fell 1.3% to its lowest level in nearly three months.

Foreign stocks have sold off too. The Japanese Nikkei 225 fell 1% today…and the Euro STOXX 600, which tracks 600 of Europe’s largest stocks, fell 1.3%.

• Emerging market stocks are hitting new lows…

The iShares MSCI Emerging Markets Index (EEM) plunged 1.9% today, and is down 4.4% this year.

That follows a 16% decline last year, its third losing year in a row. Emerging market stocks are now at their lowest level since 2009, when the world was in a financial crisis.

• And Chinese stocks are off to their worst start ever…

The Shanghai Composite Index tanked 6.9% on Monday. The crash erased $590 billion in value from Chinese stocks. China’s stock market is the second largest in the world, behind only the U.S.’s.

The selloff triggered China’s new “circuit breaker” rules, which automatically suspend trading for the rest of the day. The Chinese government put these rules in place to prevent panic when stocks crash. But, like most government rules, they do more harm than good.

Here’s Bloomberg:

While the maneuvers may stabilize the market temporarily, they’re unnecessary because intervention creates price distortions and fosters moral hazard as traders come to view the government as a backstop for shares, according to UBS Wealth Management, Henderson Global Investors and Wells Fargo Funds Management.

Many investors also expect Chinese officials to extend the ban on short selling (betting that a stock will fall). Chinese regulators banned short selling over the summer, and the ban is set to end on Friday.

Chinese stocks are extremely volatile. They have huge booms and huge busts. If you prefer safe, steady investments, don’t buy Chinese stocks.

If you do invest in Chinese stocks, use stop-losses. A stop-loss is a predetermined point at which you’ll sell a stock if it declines. Using a stop-loss will allow you to make money while a stock is rising…then automatically sell when the uptrend ends. It allows you to speculate in volatile stocks without risking huge losses.

• With stocks around the world falling…

We recommend owning a significant amount of physical cash and physical gold. And to avoid major losses, we suggest selling any stocks that are expensive or vulnerable to an economic downturn.

Holding a significant amount of cash will ensure you can buy stocks next time they’re cheap. And physical gold is wealth insurance. It has protected wealth through stock market collapses, economic depressions, and full-blown currency crises.

If you’re interested in other proven strategies to protect your money from a bear market, watch this free video we put together.

Chart of the Day

Emerging market stocks just hit a six-year low.

Today’s chart shows the performance of the iShares MSCI Emerging Markets ETF (EEM), the second-biggest emerging market ETF. As we mentioned earlier, EEM has dropped to lows not seen since the global financial crisis of 2008-9.

Yesterday, Financial Times explained why emerging markets stocks could drop even further…

The emerging markets-focused investment bank [Renaissance Capital] predicts that 17 of the 36 EM countries it covers are likely to be downgraded by at least one of Moody’s, Standard & Poor’s and Fitch in the next 12 months.

Such a tally would comfortably exceed the joint record of 11 sovereign downgrades in 2008, 2012 and 2013.

Credit agencies like Moody’s (MCO) and Fitch downgrade countries whose financial health is worsening. If Renaissance Capital is right about the record amount of defaults coming this year, emerging market stocks will likely take another big leg down.

Up and Down Wall Street

The Trouble With China

Stock-market bulls’ hope that the big emerging nation will save the global economy by encouraging spending by its consumers. But that seems to be more pipe dream than reality.

By Jonathan R. Laing

Brazil’s crisis

Irredeemable?

A former star of the emerging world faces a lost decade
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THE longest recession in a century; the biggest bribery scandal in history; the most unpopular leader in living memory. These are not the sort of records Brazil was hoping to set in 2016, the year in which Rio de Janeiro hosts South America’s first-ever Olympic games. When the games were awarded to Brazil in 2009 Luiz Inácio Lula da Silva, then president and in his pomp, pointed proudly to the ease with which a booming Brazil had weathered the global financial crisis. Now Lula’s handpicked successor, Dilma Rousseff, who began her second term in January 2015, presides over an unprecedented roster of calamities.

By the end of 2016 Brazil’s economy may be 8% smaller than it was in the first quarter of 2014, when it last saw growth; GDP per person could be down by a fifth since its peak in 2010, which is not as bad as the situation in Greece, but not far off. Two ratings agencies have demoted Brazilian debt to junk status. Joaquim Levy, who was appointed as finance minister last January with a mandate to cut the deficit, quit in December. Any country where it is hard to tell the difference between the inflation rate—which has edged into double digits—and the president’s approval rating—currently 12%, having dipped into single figures—has serious problems.

Ms Rousseff’s political woes are as crippling as her economic ones. Thirty-two sitting members of Congress, mostly from the coalition led by her left-wing Workers’ Party (PT), are under investigation for accepting billions of dollars in bribes in exchange for padded contracts with the state-controlled oil-and-gas company, Petrobras. On December 15th the police raided several offices of the Party of the Brazilian Democratic Movement (PMDB), a partner in Ms Rousseff’s coalition led by the vice-president, Michel Temer.

Brazil’s electoral tribunal is investigating whether to annul Ms Rousseff’s re-election in 2014 over dodgy campaign donations. In December members of Congress began debating her impeachment. The proceedings were launched by the speaker of the lower house, Eduardo Cunha (who though part of the PMDB considers himself in opposition) on the grounds that Ms Rousseff tampered with public accounts to hide the true size of the budgetary hole. Some see the impeachment as a way to divert attention from Mr Cunha’s own problems; Brazil’s chief prosecutor wants him stripped of his privileged position so that his role in the Petrobras affair can be investigated more freely. Mr Cunha denies any wrongdoing.
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Brazil is no stranger to crises. Following the end of two decades of military rule in 1985, the first directly elected president, Fernando Collor, was impeached in 1992. After a “lost decade” of stagnation and hyperinflation ended in the mid-1990s the economy was knocked sideways by the emerging-markets turmoil of 1997-98. In the mid-2000s politics was beset by the scandal of a bribes-for-votes scheme known as the mensalão (“big monthly”, for the size and schedule of the payments), which eventually saw Lula’s chief of staff jailed in 2013. 

Yet rarely, if ever, have shocks both external and domestic, political and economic, conspired as they do today. During the original lost decade global conditions were relatively benign; in the crisis of the late 1990s the tough measures to quell inflation and revive growth taken after Mr Collor’s departure stood Brazil in moderately good stead; when scandal rocked the 2000s commodity markets were booming.

A sad convergence

 

Now prices of Brazilian commodities such as oil, iron ore and soya have slumped: a Brazilian commodities index compiled by Credit Suisse, a bank, has fallen by 41% since its peak in 2011. The commodities bust has hit economies around the world, but Brazil has fared particularly badly, with its structural weaknesses—poor productivity and unaffordable, misdirected public
spending—exacerbating the damage. Regardless of what she may or may not have done with respect to the impeachment charge, Ms Rousseff’s cardinal sin is her failure to have confronted these problems in her previous term, when she had some political room for manoeuvre. Instead, that term was marked by loose fiscal and monetary policies, incessant microeconomic meddling and fickle policymaking that bloated the budget, stoked inflation and sapped confidence.

Poor though her record has been, some of these problems have deeper roots in what is in some ways a great achievement: the federal constitution of 1988, which enshrined the transition from military to democratic rule. This 70,000-word doorstop of a document crams in as many social, political and economic rights as its drafters could dream up, some of them highly specific: a 44-hour working week; a retirement age of 65 for men and 60 for women. The “purchasing power” of benefits “shall be preserved”, it proclaims, creating a powerful ratchet on public spending.
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Since the constitution’s enactment, federal outlays have nearly doubled to 18% of GDP; total public spending is over 40%. Some 90% of the federal budget is ring-fenced either by the constitution or by legislation. Constitutionally protected pensions alone now swallow 11.6% of GDP, a higher proportion than in Japan, whose citizens are a great deal older. By 2014 the government was running a primary deficit (ie, before interest payments) of 32.5 billion reais ($13.9 billion) (see chart).

Mr Levy tried to live up to the nickname he had earned during an earlier stint as a treasury official—“Scissorhands”—with record-breaking cuts of 70 billion reais from discretionary spending. But Mansueto Almeida, a public-finance expert, points out that this work was more than countered by constitutionally mandated spending increases; government expenditure as a share of output rose in 2015. On top of that, a new scrupulousness in government accounting surely not unrelated to the impeachment proceedings has seen 57 billion reais in unpaid bills from years past newly recognised by the treasury.

Nor could Mr Levy easily fill the fiscal hole by raising taxes. Taxes already consume 36% of GDP, up from a quarter in 1991. And the recession has hit tax receipts hard. On December 18th, days after Fitch, a rating agency, followed the lead of Standard & Poor’s in downgrading Brazilian debt, Mr Levy threw in the towel. His job went to Nelson Barbosa, previously the planning minister, who insists he is committed to following the same policies. But before his elevation Mr Barbosa made no secret of favouring a more gradual fiscal adjustment—for example, a primary surplus of 0.5% of GDP in 2016, against Mr Levy’s preferred 0.7% (and an original promise of 2% a year ago). The real and the São Paulo stockmarket tumbled on news of his appointment.

Analysts at Barclays, a bank, expect debt to reach 93% of GDP by 2019; among big emerging markets only Ukraine and Hungary are more indebted. The figure may still seem on the safe side compared with 197% in Greece or 246% in Japan. But those are rich countries; Brazil is not. As a proportion of its wealth Brazil’s public debt is higher than that of Japan and nearly twice that of Greece.

Unable to increase taxes, Ms Rousseff’s government may prefer something even more troubling to investors and consumers alike: inflation. Faced with the inflationary pressure that has come with the devalued real, the Central Bank has held its nerve, increasing its benchmark rate by three percentage points since October 2014 and keeping it at 14.25% since July in the face of the recession. But despite this juicy rate the real continues to depreciate.

There is a worry that the bank may be unable to raise rates further for fear of making public debt unmanageable—what is known as “fiscal dominance”. This year the treasury spent around 7% of GDP servicing public debt. What is more, raising rates may have the perverse effect of stoking inflation rather than quenching it; an increasing risk of default as borrowing costs grow is likely to see investors dumping government bonds, provoking further currency depreciation.

A handful of economists, including Monica de Bolle of the Peterson Institute for International Economics, believe that Brazil is on the verge of fiscal dominance. And once interest rates no longer have a hold on inflation, she says, it can quickly spiral out of control. Forecasts by Credit Suisse warn that prices could be rising by 17% in 2017. Three-quarters of government spending remains linked to the price level, embedding past inflation in future prices. That said, the economy as a whole is much less indexed than it was in the hyperinflationary early 1990s.

That leaves the government a bit more time, thinks Marcos Lisboa of Insper, a university in São Paulo. But not much more: perhaps a year or two.

Despite this pressing economic need for speed there seems to be no political capacity for it. Members of Congress are consumed by Ms Rousseff’s impeachment. By February they must decide whether to send her case to the Senate, which would require the votes of three-fifths of the 513 deputies in the lower house. To fend off such a decision Ms Rousseff is rallying her left-wing, anti-austerity base.

Gently doesn’t always do it

 

These efforts are meeting with some success: in December pro-government rallies drew more people than anti-government ones for the first time all year. It looks unlikely that the impeachment will indeed move to the Senate (which would trigger a further six months of turmoil). But this hardly provides a political climate conducive to belt-tightening, let alone to the amendment of the constitution which Mr Barbosa has said is needed to deal with the ratchet effect on benefits. Fiscal adjustment is anathema to the government workers and union members who are Ms Rousseff’s core supporters.

Like the country’s economic problems, its political ones, while specific to today’s particular scandals and manoeuvring, can be traced to the transition of the 1980s. History reveals a consistent tendency towards negotiated consensus at Brazil’s political watersheds; it can be seen in the war- and regicide-free independence declared in 1822, the military coup of 1964, which was mild compared with the blood-soaked affairs in Chile and Argentina, and the transition that created the new constitution. One aspect of this often admirable trait is a resistance to purging. The mid-1980s saw a lot of institutions—the federal police, the public prosecutor’s office, the judiciary, assorted regulators—overhauled or created afresh. But many of the old regime kept their jobs in the civil service and elsewhere. The transition was thus bound to be a generational affair.
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So it is now proving, with a retiring old guard being replaced by fresh blood often educated abroad.

In 2013 the average judge was 45 years old, meaning he entered university in a democratic Brazil.

Civil servants are getting younger and better qualified, says Gleisson Rubin, who heads the National School of Public Administration. More than a quarter now boast a postgraduate degree, up from a tenth in 2002. Sérgio Moro, the crusading 43-year-old federal judge who oversees the Petrobras investigations, and Deltan Dallagnol, the case’s 35-year-old lead prosecutor, are the most famous faces of this new generation.

Unfortunately, this rejuvenation does not extend to the institution most in need of it: Congress.

Its younger faces typically have family ties to the old guard. “Party politics is a market for lemons,” says Fernando Haddad, the fresh-faced PT mayor of São Paulo and a rare exception to the dynastic rule, nodding to George Akerlof’s classic analysis of adverse selection in the market for used cars: it attracts the venal and repels the honest. Consultants who have advised consecutive Congresses agree that each one is feebler than the last.

Brazilians have noticed the decline, and are transferring their hopes accordingly. “Judges and prosecutors are becoming more legitimate representatives of the Brazilian people than politicians,” says Norman Gall of the Braudel Institute, a think-tank in São Paulo. Everyone wants a selfie with Mr Moro and, disturbingly, nearly half of Brazilians think that military intervention is justified to combat corruption, according to a recent poll. Barely one in five trusts legislators; just 29% identify with a political party.

Monthly, oily, deeply

 

That last fact is perhaps particularly impressive given that they have so many parties to choose from.

Keen to promote pluralism the constitution’s framers set no national cut-off below which a party’s votes would not count. It is possible to get into Congress with less than 1% of the vote: in principle, it could be done with 0.02%. As a result the number of parties has grown from a dozen in 1990 to 28 today. The three biggest—the PT, the PMDB and the opposition centre-right Party of Brazilian Social Democracy (PSDB)—together account for just 182 of 513 seats in the lower house and 42 out of 81 senators.

One of the causes of the mensalão scandal was corruption that provided Lula’s government with a way to get the votes it needed from the disparate small parties. The petrolão (“big oily”, as the Petrobras affair is widely known) apparently shared a similar aim. Such ruses may have helped PT governments pass some good laws, such as an extension of the successful Bolsa Família (family fund) cash-transfer programme. But the party was not able to do all that it had said it would; potentially helpful reforms in which it was less invested fell by the wayside.

Raphael Di Cunto of Pinheiro Neto, a big law firm in São Paulo, points to many antiquated statutes in need of an update, such as the Mussolini-inspired labour code (from 1943) and laws governing foreign investments (1962) and capital markets (1974).
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A Congress in which dysfunction feeds corruption which feeds further dysfunction is not one likely to take the hard decisions that the economy needs. But this is the Congress Brazil has: though there will be local elections in October 2016, congressional elections, like the next presidential poll, are not due until 2018. Can Brazil’s public finances hold out that long?

Many prominent economists think they just about can. They forecast a “muddling-through” in which Ms Rousseff holds on to her job, Congress passes a few modest spending cuts and tax rises, including a financial-transactions levy, the Central Bank continues to fight inflation, the cheap real boosts exports and investors don’t panic. After three years of this, the theory goes, an electorate fed up with stagnation and sleaze will give the PSDB a clear mandate for change. Ms Rousseff narrowly defeated the party’s candidate in 2014 by deriding his calls for prudence as heartless “neoliberalism”, only to propose a similar agenda (through gritted teeth) immediately after winning. If proposed by a PSDB in power that actually believed in them, such measures might receive cross-party support—though given the PSDB’s spiteful unwillingness to support Mr Levy’s measures in 2015 this would not be without irony.

Such a scenario is possible. Figures for the third quarter of 2015 show exports picking up. Price rises could slow down as steep increases in government-controlled prices for petrol and electricity put in place in 2015 run their course. Politicians and policymakers are keenly aware that Brazilians are less tolerant of inflation than in the 1980s and 1990s, when rates of 10% would have seemed mild.

Investors are staying put, at least in aggregate. Yield-hungry asset managers are taking the place of pension and mutual funds that left in anticipation of Brazil’s inevitable demotion to junk status. The real has fallen 31% since the start of 2015 and the stockmarket is down by 12.4%; but though battered they are not knocked flat. The banking system is well capitalised and, observers agree, diligently monitored by the Central Bank. The $250 billion in foreign-denominated debt racked up by Brazilian companies during the commodity-price-fuelled binge has ballooned in local-currency terms and remains a worry. But much of it is hedged through the firms’ own dollar revenues or with swaps—though settling some of those swaps has cost the government, which sold them, some 2% of GDP this year.
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Waxing and waning: Brazil's economic woes, in charts

The sardonic Mr Lisboa observes with uncharacteristic optimism that “at last people are talking seriously about Brazil’s structural problems”. Fiscal dominance has left arcane discussions among economic theorists and burst onto newspaper columns. Mr Barbosa is openly discussing pension reform and the constitutional change that would have to go with it.

In October the PMDB, which tends to lag behind public opinion more than to lead it, published a manifestothat talked about privatising state businesses and raising the retirement age. Even the famously stubborn Ms Rousseff has begun to listen rather than to hector, says a foreign economic dignitary who met her recently.

But the fact that muddling through may be possible does not mean it is assured. It hinges on the hope that politicians come to their senses more quickly than they have done in the past (witness the lost decade begun in the 1980s). It also assumes that Brazil’s penchant for consensus will hold its people back from social unrest on the sort of scale that topples regimes in other countries. The anti-government protests of 2015 were large, drawing up to a million people in a single day. But they were middle-class affairs which took place on sporadic Sundays, causing Ms Rousseff more annoyance than grief. As wages sag and unemployment rises, though, tempers could flare. If they do there will be every chance of a facile populist response that does even deeper economic damage.

Should Ms Rousseff be booted out—through impeachment, annulment of the election or coerced resignation (none of which looks likely just now)—chaos would surely ensue. Her core supporters may be less numerous than they once were, but she has many more than Mr Collor had in 1992. They would close ranks against the “coup-mongers”.

The strength of Brazil’s institutions suggests something shy of the failed populist experiments of some South American neighbours. And the fact that voters in Argentina and Venezuela rebuffed that populism in the past few months has not escaped the notice of Brazil’s politicians.

But every month of dithering and every new petrolão revelation chips away at Brazil’s prospects. The 2010s are already certain to be another lost decade; GDP per person won’t rebound for years to come.

It will be a long time before a president can match the pride with which Lula showed off his Olympic trophy. But if Brazil’s politicians get their act together, the 2020s could be cheerier.

Alas, if they do not, things will get a great deal worse.

Global Slowdown Steepening

By: Gordon Long

The Credit Cycle Is Reacting!

QE: Supply Outstripped Wealth Effect Demand

In March 2015 in "QE: A Failed Experiment" we began reporting on how Quantitative Easing was becoming more about creating over supply than about its intended purpose of creating economic demand.

Cheap money may help consumers' ability to consume via the wealth effect and the cheap financing driving it, but we found globally it was having a much more profound impact on producers and their suppliers. Specifically, it turns out that the expected wealth effect for consumers, paled in comparison to the incentive to producers to dramatically ramp up production, and in turn for their raw material commodity suppliers to explode production output.

 

An Artificial Equilibrium

From our college economics courses we all remember that at some point it can be expected Demand and Supply will come into balance. However, that balance can be preceded by a massive overshoot of supply if money is made too cheap for too long a period of time.

Which is one of the unintended consequences of the failed QE Monetary Policy.

The overshoot of supply and then a slowing of demand has resulted in most global suppliers now chasing slowing demand growth which has critically lead to lost pricing power. Margin and profit problems can be disguised while the easy credit for zombie companies keeps them temporarily alive. These players in their desperation to stay alive and meet loan obligation payments, bring further pricing power pressures to the global markets.

This is the stage we are in presently as we have documented on numerous occasions and most recently in the "The Coming Auto Abyss".

 

Credit Cycle Has Turned

What this paper highlights is how we have now entered another stage in this re-balancing. Specifically, we have a turn in the Credit Cycle as cash flows are shrinking and the requisite credit ratings for new loans is increasingly under pressure.

Credit Cycles can be expected to turn when Cash Flow and EBITDA growth goes negative or slows relative to growth in Debt. This is what in now occurring. Those in the equity market don't yet realize why the HY and IG Bond Market are now feeling significant pain. They soon will!


  Credit Cycles Always Lead

Read Full Report: Download PDF
22 Pages

Watch 20 Minute YouTube Video (With 37 Slides)

 

Has The Power Of Low Interest Rates Been Played Out?

Alternative assets loom as best bet

Gentle shift towards cheap stocks in emerging markets has better chance of working in 2016

 

©iStock

 

 

At last, 2016 is here. It is now incumbent on this column to suggest what investors should do to position themselves for the next 12 months.

 

There are two problems with this task. First, and foremost, I do not know what will happen in the next 12 months. Neither does anyone else. The best I can manage is some scenario analysis.

Second, a 12-month calendar year is arbitrary. Unless you are planning for some unusual splurge of expenditure on New Year’s eve, you should almost certainly be planning very much longer term, certainly with any money that you cannot afford to lose. Positioning for the next five or 10 years would make sense.

A final caveat is that we are coming off a year when, very unusually, the main asset classes of stocks, bonds and cash were almost identical to each other, and all almost exactly flat. We need not have worried about allocating between these assets — and the way to make money was to try to profit from the rise of the dollar and the fall of commodity prices, or to play with real assets such as property.

 

Sum these factors and the advice will echo that of previous years, which is to have a balanced asset allocation, rebalance so that at the margin you sell securities that are high and buy those that are low, and restrict shorter term bets to tweaks within this structure.

For those who must look to the short term, what are the likeliest scenarios for 2016?

 

Let us look at stocks, the strongest performing asset class in the long term, which should most of the time make up most of an investment portfolio. A stock is worth its future stream of earnings, discounted by a suitable long-term interest rate. So let us break this down to the two issues of earnings and rates.

Earnings for the US S&P 500 fell slightly last year. Brokers’ analysts, as polled by Thomson Reuters, expect 8 per cent growth next year — although most top-down analysts expect the outcome to be lower than this. European earnings, coming off a very bad year, are expected to rebound somewhat more.

 

So that is the base case — a “blah” but positive recovery for US earnings, thanks largely to the low base of comparison for energy companies, with a more robust recovery in Europe. As US valuations are steep, this would not pull share prices up very much.

An alternative scenario is that US earnings continue to tank — because higher wages and higher interest rates eat into margins, while commodity prices stay low, messing up corporate pricing power.

China, in this scenario, probably drags into further difficulties, which means that European earnings — rather more dependent on exports to China — also suffer, and the European economy fails to achieve any lift-off.

For profits to recover more strongly, we require a more genuine, full-blooded economic recovery. That is probably because the US consumer starts buying more, using the savings that cheaper oil has generated, and so revenues increase. Despite the obvious angst in the US, reflected in the presidential campaign so far, higher wages, higher house prices and cleaner household balance sheets all suggest that this is not far-fetched, albeit unlikely.

Now, for rates. The market thinks that the Federal Reserve will raise rates twice next year. The Fed itself has forecast that it is more likely to do so four times. From two to four rate rises is the base case — reflecting an economy where unemployment remains under control, but recovery does not accelerate significantly from where we are now.

 

To undershoot this, we need commodity prices to fall further, and for the Fed to be scared by another wave of deflationary pressure — most likely felt through another rise in the dollar. To overshoot, we need true evidence of inflation, presumably driven by a resurgent US consumer.

 

In the former case, the positive effect of low rates for stocks is cancelled out by poor earnings. In the latter, the positive effect of higher earnings is cancelled out by higher rates.

So the base case is for a “blah” year, with risks skewed towards something worse. The most positive version of the “base case” — in which the Fed stays at the easy end of expectations, while profits enjoy an unspectacular rebound — would make for a decent year for stocks, however. It is hard to find any scenario in which bonds are exciting, given the price at which they start.

2016 could look like 2015, when alternative assets proved the best option. The best chance of good money within stocks and bonds, as this column argued a year ago, might be a gentle shift towards the stocks that look cheapest — in emerging markets. That did not work last year. It has a better chance of working next year, as emerging assets are even cheaper and European assets are cheap, while US assets are no less expensive than they were a year ago.

 

If, as is quite possible, buying cheap stocks does not work this year, the chances are that it will work in the longer term. As ever in 2016, it will pay to take the Long View.

 

The world's political and economic order is stronger than it looks

Stefan Zweig tells us in The World of Yesterday what it feels like when the wheels really do come off the global system

By Ambrose Evans-Pritchard

Even during the slaughter of the First World War, Europe still had a moral conscience

 

He could travel anywhere without a passport, received with open arms in Paris, Milan or Stockholm by a fraternity of writers and artists. It was a cheerful, peaceful world that seemed almost untainted by tribal animosities.

It was not an illusion, but it was only half the story. A handful of staff officers at the apex of the German high command under Helmuth von Moltke were already looking for their chance to crush France and Russia, waiting for a spark in the Balkans - it could only be the Balkans - that would lock the Austro-Hungarian empire into the fight as an ally.

What is striking in Zweig's account is that even during the slaughter of the First World War, Europe still had a moral conscience. All sides still bridled at any accusation that they were violating humanitarian principles.

Two decades later, even that had disappeared. Zweig lived to see his country amputated, cut off from its economic lifelines, and reduced to a half-starved rump. He saw Hitler take power and burn his books in Berlin's Bebelplatz in 1933, then in stages extend the ban to France and Italy.

Stefan Zweig

He saw what remained of Austria extinguished in 1938, and his friends sent to concentration camps.

As a Jewish refugee in England he slipped from stateless alien to enemy alien. He committed suicide with his wife in February 1942 in Brazil, too heart-broken to keep going after his spiritual homeland - Europe - had "destroyed itself".

Erasmus was also the best-selling author of his day, attaining a dominance that has probably never been challenged by any other author in history, except perhaps Karl Marx posthumously.

More than 1m copies of his works had been printed by the early 16th century, devoured by a Latin intelligentsia in the free-thinking heyday of the Renaissance, chortling at his satires on clerical pedantry and the rent-farming of holy relics.

But after lighting the fire of evangelical reform, he watched in horror as the ideologues took over and swept aside his plea that the New Testament message of love and forgiveness is the heart of Christianity.

They charged headlong into the Augustinian cul-de-sac of original sin and predestination, led by Martin Luther, a rough, volcanic force of nature, or the "Goth" as Erasmus called him.



Christian Europe split into armed camps rather than yield an inch on abstruse points of doctrine


Luther preferred to see the whole world burn and Christian Europe split into armed camps rather than yield an inch on abstruse points of doctrine. And burn they did. The killing did not end until the Treaty of Westphalia in 1648. By then the Thirty Years War had left a fifth of Germany dead.
 
So perspective is in order as we look at the world in late 2015. The fateful rupture between the US and China that many feared has not in fact happened. Washington has so far managed the rise of a rival superpower more or less benignly.

China has just been admitted into the governing elite of the Bretton Woods financial system with the backing of the US Treasury. To wide consternation, Barack Obama and Xi Jinping steered through a sweeping climate change accord in Paris, the template for a new G2 condominium.

This is not to deny that the Pacific Rim remains the world's most dangerous fault-line. The South China Sea is on a hair trigger. The US Navy faces the unenviable task of defending the global commons of open shipping lanes without crossing an invisible strategic line.

The South China Sea is on a hair trigger


Yet the Chinese hubris that seemed so alarming four years ago has faded with the dawning realisation that they are not magicians after all - and America is not in decline after all - and that they risk the middle income trap soon enough if they make any further mistakes.

Russia's Vladimir Putin has gained little by overthrowing Europe's post-war order, and seizing a piece of recognized Ukrainian territory by armed force. He has kept Crimea but his attempt to foster revolt in the Donbass through agitators and proxies has fizzled, and in the process he has transformed what was previously a neutral Ukraine into a hostile rampart of the West.

His hopes of dividing the Atlantic alliance have come to nothing. Europe has just renewed sanctions. They are biting deep. The country is shut out of Western capital markets. Unless oil recovers, the Kremlin will have exhausted its reserve fund by 2016, and will face a fiscal crisis by mid-2017.

There are grounds for hoping that the world economy is at last starting to free itself from a low-growth trap. The global savings rate has peaked at 25pc of GDP and seems to be trending down very slowly as China switches to a consumption-led growth model. Or put another way, the underlying imbalance of capital over spending that has bedevilled us for so long is finally correcting.

China is switching to a consumption-led growth model

Icing the cake, we have the net global stimulus of the oil slump. It is a windfall gain in spending power for importers in Asia and the West. Yet the petro-powers are not cutting their spending pari passu: they are running down their wealth funds to prop up their welfare states.

So why is there such populist ferment in the West, and so much political angst? Joschka Fischer, the former German foreign minister, calls it - a little carelessly - the fascism of the affluent.

"It is a fear based on the instinctive realisation that the White Man’s World is in terminal decline, both globally and in the societies of the West," he said. "It has become increasingly clear that globalisation is a two-way street, with the West losing much of its power and wealth to the East."

Perhaps, but his evidence for this chauvinist lurch in America is that Donald Trump is scoring well in the polls. Whether the Republicans will really vote for him in the primaries is questionable, and US elections are prone to wild moments. We forget too easily that Texan billionaire Ross Perot won 19pc of the presidential vote in 1992 with a third-party bid on a protectionist platform.

As Washington correspondent in the early 1990s I covered the Oklahoma bombing - America's worst act of home-grown terrorism - and the sudden eruption of state militia movements, mostly blue collar workers from states like Texas, Oklahoma or Montana, who had fallen through the bottom of the globalised economy and spent their weekends training with assault rifles for a showdown with the "Feds". This weird revolt spread like wildfire and then disappeared again as the labour market tightened.


US elections are prone to wild moments


Mr Fischer is closer to the mark on Europe but there is a glaring omission in his diagnosis. He never mentions monetary union, which has, for very complex reasons, ensnared the eurozone in a seven-year depression.

Output has yet to match its earlier peak in 2008. The overall damage has been worse than the equivalent period from 1929 to 1936. There are still 17.2m unemployed in the eurozone, and the youth jobless rate is still 47.9pc in Greece, 47.7pc in Spain, 39.4pc in Italy, 31.8pc in Portugal and 24.7pc in France.

The underlying deformities of the eurozone have not been corrected. There is still no fiscal union. The tensions will return in the next global downturn. But for now the quadruple stimulus of a cheap euro, cheap oil, quantitative easing and the end of fiscal austerity are all combining in a "perfect positive storm", enough to give the eurozone another cyclical lease of life.



The one great disorder we have in the world right now is the collapse of the century-old Sykes-Picot dispensation in the Middle East, made more combustible by the Sunni-Shia battle for regional mastery.

It is certainly a humanitarian tragedy, but in hard-headed geostrategic terms it is a regional problem, a particular struggle within Islam to come to terms with modernity. It is sui generis and of no universal relevance.

Nor should we overestimate the staying power of the Wahhabi caliphate as it attempts to hold fixed ground against a world now seriously roused in wrath, and without fixed ground, constant infusions of money and the allure of rising momentum, Isis does not add up to much.

Yes, the world is a mess, but it has always been a mess, forever climbing the proverbial wall of political worry even in its halcyon days. So let us drink a new year's toast with a glass at least half full.