Year of the Octopus, Part 1

Photo: Getty Images
John Mauldin
Year of the Octopus, Part 1
Inequality is a threat to our democracies
One possible development is the rise of ‘plutocratic populism’
Martin Wolf
Complacency Will Be Tested in 2018
Stephen S. Roach
NEW HAVEN – After years of post-crisis despair, the broad consensus of forecasters is now quite upbeat about prospects for the global economy in 2018. World GDP growth is viewed as increasingly strong, synchronous, and inflation-free. Exuberant financial markets could hardly ask for more.
While I have great respect for the forecasting community and the collective wisdom of financial markets, I suspect that today’s consensus of complacency will be seriously tested in 2018. The test might come from a shock – especially in view of the rising risk of a hot war (with North Korea) or a trade war (between the US and China) or a collapsing asset bubble (think Bitcoin). But I have a hunch it will turn out to be something far more systemic.
The world is set up for the unwinding of three mega-trends: unconventional monetary policy, the real economy’s dependence on assets, and a potentially destabilizing global saving arbitrage. At risk are the very fundamentals that underpin current optimism. One or more of these pillars of complacency will, I suspect, crumble in 2018.
Unfortunately, the die has long been cast for this moment of reckoning. Afflicted by a profound sense of amnesia, central banks have repeated the same mistake they made in the pre-crisis froth of 2003-2007 – maintaining excessively accommodative monetary policies for too long.
Misguided by inflation targeting in an inflationless world, monetary authorities have deferred policy normalization for far too long.
That now appears to be changing, but only grudgingly. If anything, central bankers are signaling that the coming normalization may even be more glacial than that of the mid-2000s.
After all, with inflation still undershooting, goes the argument, what’s the rush?
Alas, there is an important twist today that wasn’t in play back then –central banks’ swollen balance sheets. From 2008 to 2017, the combined asset holdings of central banks in the major advanced economies (the United States, the eurozone, and Japan) expanded by $8.3 trillion, according to the Bank for International Settlements. With nominal GDP in these same economies increasing by just $2.1 trillion over the same period, the remaining $6.2 trillion of excess liquidity has distorted asset prices around the world.
Therein lies the crux of the problem. Real economies have been artificially propped up by these distorted asset prices, and glacial normalization will only prolong this dependency. Yet when central banks’ balance sheets finally start to shrink, asset-dependent economies will once again be in peril. And the risks are likely to be far more serious today than a decade ago, owing not only to the overhang of swollen central bank balance sheets, but also to the overvaluation of assets.
That is particularly true in the United States. According to Nobel laureate economist Robert J. Shiller, the cyclically adjusted price-earnings (CAPE) ratio of 31.3 is currently about 15% higher than it was in mid-2007, on the brink of the subprime crisis. In fact, the CAPE ratio has been higher than it is today only twice in its 135-plus year history – in 1929 and in 2000. Those are not comforting precedents.
As was evident in both 2000 and 2008, it doesn’t take much for overvalued asset markets to fall sharply. That’s where the third mega-trend could come into play – a wrenching adjustment in the global saving mix. In this case, it’s all about China and the US – the polar extremes of the world’s saving distribution.
China is now in a mode of saving absorption; its domestic saving rate has declined from a peak of 52% in 2010 to 46% in 2016, and appears headed to 42%, or lower, over the next five years. Chinese surplus saving is increasingly being directed inward to support emerging middle-class consumers – making less available to fund needy deficit savers elsewhere in the world.
By contrast, the US, the world’s neediest deficit country, with a domestic saving rate of just 17%, is opting for a fiscal stimulus. That will push total national saving even lower – notwithstanding the vacuous self-funding assurances of supply-siders. As shock absorbers, overvalued financial markets are likely to be squeezed by the arbitrage between the world’s largest surplus and deficit savers. And asset-dependent real economies won’t be too far behind.
In this context, it’s important to stress that the world economy may not be nearly as resilient as the consensus seems to believe – raising questions about whether it can withstand the challenges coming in 2018. IMF forecasts are typically a good proxy for the global consensus. The latest IMF projection looks encouraging on the surface – anticipating 3.7% global GDP growth over the 2017-18 period, an acceleration of 0.4 percentage points from the anemic 3.3% pace of the past two years.
However, it is a stretch to call this a vigorous global growth outcome. Not only is it little different from the post-1965 trend of 3.8% growth, but the expected gains over 2017-2018 follow an exceptionally weak recovery in the aftermath of the Great Recession. This takes on added significance for a global economy that slowed to just 1.4% average growth in 2008-2009 – an unprecedented shortfall from its longer-term trend.
The absence of a classic vigorous rebound means the global economy never recouped the growth lost in the worst downturn of modern times. Historically, such V-shaped recoveries have served the useful purpose of absorbing excess slack and providing a cushion to withstand the inevitable shocks that always seem to buffet the global economy. The absence of such a cushion highlights lingering vulnerability, rather than signaling newfound resilience – not exactly the rosy scenario embraced by today’s smug consensus.
A quote often attributed to the Nobel laureate physicist Niels Bohr says it best: “Prediction is very difficult, especially if it’s about the future.” The outlook for 2018 is far from certain. But with tectonic shifts looming in the global macroeconomic landscape, this is no time for complacency.
Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.
Watch the bond market, not equities
Governments and leveraged borrowers would suffer if interest rates rise quickly
Gillian Tett
Traders in New York: this week the yield on 10-year Treasuries jumped to nearly 2.6 per cent, its highest level for almost a year, before falling back © Reuters
A few years ago, the head of a leading western central bank predicted that his job would soon be akin to flying a plane. The reason? Eventually, central banks in Europe, US and Japan would tighten monetary policy. After all, the supposedly emergency stimulus that central banks provided after the 2008 crisis could not remain in place forever.
But what central banks desperately needed to do, he explained, was withdraw that stimulus at a controlled pace, like a pilot landing a plane. The goal was to deliver such a smooth glide path for this “landing”, meaning a return to more normal interest rates, that investors would barely notice, let alone panic.
Can this glide path ever be achieved without tipping markets into a tailspin? That is the question investors must contemplate. In recent months, the issue that has grabbed most market headlines has been the sky-high level of equity prices, particularly in the US.
But it is the behaviour of bond prices that is more remarkable. A decade ago, popular investing wisdom posited that bond prices should fall when equities rise, especially if central banks were raising rates. But although the US Federal Reserve under the tenure of Janet Yellen has raised rates five times, and is likely to do so three times this year, bond prices have stayed sky-high, keeping long-term yields ultra low (prices and yields move inversely).
That means that the US yield curve (or the gap between long and short rates) has flattened. It also means that financial conditions in the markets “are extremely accommodative”, as Jan Hatzius of Goldman Sachs says.
But now bond prices are wobbling. This week the 10-year US yield jumped to nearly 2.6 per cent, its highest level for almost a year, after speculation that the central banks of China and Japan might be scaling back their Treasury purchases. Yields later fell back. But the swing was sharp enough to prompt Bill Gross and his rival and fellow guru Jeffrey Gundlach to warn that the three-decade-old bull market for bonds might be coming to an end (although they differ on the precise timing).
If so, this shift might not necessarily be a bad thing. After all, the current low level of rates looks peculiar and has fuelled all manner of asset price bubbles. An adjustment is inevitable at some point, and desired by the Fed. “The bond market is waking up to what the Fed is doing,” says Stephen Macklow Smith, an analyst at JPMorgan.
But the crucial issue now is the slope of the glide path. If rates start rising steadily there is every chance that the financial system can absorb this. But if they climb quickly, that could create a snowball effect of a kind last seen in 1994 (when the Fed unexpectedly raised rates).
The reason is that the long era of ultra-low interest rates has lulled many institutions into complacency. Investors have been reaching for yield, that is taking additional credit risks, on the presumption that rates will stay low, and using derivatives to magnify their bets. Nobody really knows how much exposure this has created, since the $400tn over-the-counter swaps market is so opaque.
But there will almost certainly be big losses in the system if rates did jump higher. Leveraged corporate borrowers, and even governments, would also suffer shocks. The Congressional Budget Office calculated that costs on US federal debt will rise from $270bn to $712bn over the next decade if 10-year yields rise from 1.8 per cent to 3.6 per cent (excluding the Trump tax cuts). If that happened in just one year, it would be deeply painful.
Thankfully, there is no sign of this type of shock yet. And there are plenty of factors that could prevent a sudden surge in rates. Inflation is subdued, the economy seems to have plenty of spare capacity and investors still appear keen to buy bonds. When the US Treasury held an auction of 10-year bonds this week it was more over-subscribed than at any point for a year.
But the essential lesson is that the longer investors, governments, companies and financial institutions think that rates will stay low, the greater the risk that any sudden decline in bond prices will lead to a repeat of what happened in 1994.
Conversely, the more that investors worry about a “bondmageddon”, the greater the chance that they will start positioning their portfolios in a manner that enables central bankers to deliver a smooth glide path. So central bankers should say a hearty “thank you” to Messrs Gross and Gundlach. Sometimes a whiff of drama is just what is needed to produce a calmer world.
Foreign Debt: The Price of Turkey’s Rise to Power
Summary
A country’s finances, studied in isolation, can’t tell us much about that country’s motivations or flexibility. Yet finances play a critical role in how a state funds things like social services and defense, pillars of the state’s geopolitical power. Finances can also help or hurt economic growth, which affects domestic politics. A geopolitical assessment of a country is therefore incomplete without an investigation of its finances.
When looking at a state’s finances, however, it’s easy to get bogged down in technical complexity or to be led astray by ultimately trivial aspects. This analysis will zoom in on one aspect of Turkey’s financial system: its external debt position. It will discuss the risks inherent in Turkey’s debt position, but with the purpose of describing how those risks will influence Turkey’s actions in the international arena. We chose to focus on external debt because it can, under certain circumstances, diminish the control that a sovereign government has over its own economy.
GPF anticipates that Turkey will become a more powerful regional actor, asserting itself farther abroad – including into the chaotic Middle East – both to protect its borders from groups it considers terrorists and to prevent Iran from gaining and holding territory that it can use to threaten Turkey’s interests. We do not, however, expect a smooth ascent. As with most events that unfold in the tides of history, trends emerge not in linear progressions but in fits and starts. Turkey’s external debt poses a real, albeit not a catastrophic, threat to that progress.
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