Why further financial crises are inevitable

As time passes, regulation degrades and risks rise

Martin Wolf

We learnt this month that the US Federal Reserve had decided not to raise the countercyclical capital buffer required of banks above its current level of zero, even though the US economy is at a cyclical peak. It also removed “qualitative” grades from its stress tests for American banks, though not for foreign ones. Finally, the Financial Stability Oversight Council, led by Steven Mnuchin, US Treasury secretary, removed the last insurer from its list of “too big to fail” institutions.

These decisions may not endanger the stability of the financial system. But they show that financial regulation is procyclical: it is loosened when it should be tightened and tightened when it should be loosened. We do, in fact, learn from history — and then we forget.

Regulation of banks has tightened since the financial crises of 2007-12. Capital and liquidity requirements are stricter, the “stress test” regime is quite demanding, and efforts have been made to end “too big to fail” by developing the idea of orderly “resolution” of large and complex financial institutions. Daniel Tarullo, the Fed governor in charge of financial regulation until early 2017, recently noted that “the aggregate risk-weighted common equity ratio of the largest US banks increased from about 7 per cent in the years preceding the financial crisis to about 13 per cent as of the end of 2017”.

Yet complacency is unjustified. Banks remain highly leveraged institutions. The public expects them to be safe. But, with average ratios of assets to core capital of around 17 to one, their loss-bearing capacity remains limited. The argument for this is that these institutions promote growth. As Stanford’s Anat Admati insists, this is a doubtful argument. But, politically, it works.

Furthermore, as Jihad Dagher of the International Monetary Fund, shows in a recent paper, history demonstrates the procyclicality of regulation. Again and again, regulation is relaxed during a boom: indeed, the deregulation often fuels that boom. Then, when the damage has been done and disillusionment sets in, it is tightened again. This cycle can be seen in the UK’s South Sea Bubble of the early 18th century and, three centuries later, in the run-up to — and aftermath of — recent financial crises. Plenty of examples can be seen in between.

We can see four reasons why this tends to happen: economic, ideological, political and merely human.

The big economic reason is that over time the financial system evolves. There is a tendency for risk to migrate out of the best regulated parts of the system to less well regulated parts. Even if regulators have the power and will to keep up, the financial innovation that so often accompanies this makes it hard to do so. The global financial system is complex and adaptable. It is also run by highly motivated people. It is hard for regulators to catch up with the evolution of what we now call “shadow banking”?

The ideological reason is the tendency to view this complex system through a simplistic lens. The more powerful the ideology of free markets, the more the authority and power of regulators will tend to erode. Naturally, public confidence in this ideology tends to be strong in booms and weak in busts.

Politics are also important. One reason is that the financial system has control of vast resources and can exert huge influence. In the 2018 US electoral cycle, according to the Center for Responsive Politics, finance, insurance and real estate (three intertwined sectors) were the largest contributors, covering one-seventh of the total cost. This is a superb example of Mancur Olson’s Logic of Collective Action: concentrated interests override the general one. This is much less true in times of crisis, when the public is enraged and wants to punish bankers. But it is true, again, in normal times.

Borderline or even blatant corruption also emerges: politicians may even demand a share in the wealth created in booms. Since politicians ultimately control regulators, the consequences for the latter, even if they are honest and diligent, are evident. If necessary, they can be removed. JK Galbraith invented the “bezzle” — the wealth people think they have, before theft is revealed. Bubbles create vast legal bezzles. Everybody hates officials who try to stop them getting a share of these spoils.

A significant aspect of the politics is closely linked to regulatory arbitrage: international competition. One jurisdiction tries to attract financial business via “light-touch” regulation; others then follow. This is frequently because their own financiers and financial centres complain bitterly. It is hard to resist the argument that foreigners are cheating.

Then there is the human tendency to dismiss long-ago events as irrelevant, to believe This Time is Different and ignore what is not under one’s nose. Much of this can be summarised as “disaster myopia”. The public gives irresponsible policymakers the benefit of the doubt and enjoys the boom. Over time, regulation degrades, as the forces against it strengthen and those in its favour corrode. The bigger the disaster, the longer stiff regulation is likely to last. But it will go in the end. The very fact that the policy response to the last crisis successfully prevented another depression increases the chances of an earlier repetition. That the private sector remains heavily indebted makes this outcome more likely.

The advent of Donald Trump’s administration should be viewed as a part of this cycle. It is possible that parts of the regulations and tough supervision it dislikes are unnecessary, or even damaging. But the cumulative effect of its efforts is quite clear: regulation will erode and that erosion will be exported. This has happened before and will do so again. This time, too, is not different.


How to be a rock-star bond investor

Bill Gross, Rolling Stone

ONE NIGHT in 1965, Keith Richards woke up with a riff going around inside his head. He reached for his guitar, played the bare bones of a song into a cassette recorder and promptly fell asleep. Mick Jagger was soon scribbling lyrics by the swimming pool. Four days later, the Rolling Stones recorded “(I Can’t Get No) Satisfaction”.

Hit records are not made like that any more, according to John Seabrook’s book, “The Song Machine”. Instead they are assembled from sounds honed on computers. It can take months. A specialist in electronic percussion does the beats. Another comes up with hooks, the short catchy bits. A third writes the melody. Everything is calibrated against what worked well on previous hits.

This brings us to Bill Gross, who founded PIMCO, the world’s biggest bond firm, and ran its market-beating Total Returns fund from 1987 until 2014. Mr Gross, who retired last month, is often called a rock-star fund manager. A new paper by Aaron Brown of New York University and Richard Dewey of Royal Bridge Capital, a hedge fund, gives him the “Song Machine” treatment, breaking his performance into constituent parts. It finds that even if you could simulate his strategy, a human factor would remain that algorithms cannot match. A Stones fan might call it inspiration. In finance, it is known as alpha.

What were Mr Gross’s trademark beats and hooks? He spoke of three. He took on more credit risk, buying bonds from issuers who might default, than would a bond manager tracking a benchmark index. He similarly loaded his portfolio with mortgage-backed bonds. His third signature trade relied on the shape of the yield curve. A five-year bond will usually have a higher yield (and lower price) than a four-year bond. Bonds therefore become more valuable as time passes. As a five-year bond yielding, say, 6% becomes a four-year bond yielding 5%, its price goes up. Mr Gross’s trick was to isolate the sweet spot where this “roll-down” is strongest—around the five-year mark—and hold more of those bonds. He offset this by holding fewer 30-year bonds, where roll-down is weak.

Messrs Brown and Dewey compiled simple trading rules to mimic these elements. They then undertook a statistical exercise to gauge how far they explain Mr Gross’s excess return. Even when you allow for these factors, they find he still beats the index. He had the magic alpha.

The template for this kind of analysis is “Buffett’s Alpha”, a paper in 2013 by Andrea Frazzini, David Kabiller and Lasse Pederson. It found that the market-beating performance of Warren Buffett, the Beatles to Mr Gross’s Stones, could have been matched by an investor following a well-defined strategy, a core part of which was buying “value” stocks (ie, those with low prices relative to the worth of a firm’s assets). Their conclusion is a tad reductive for some tastes—like saying anyone with an Apple Mac could come up with “Satisfaction”. Mr Buffett was able to identify a winning strategy and to stick with it, which is not easy. But the main goal of these exercises is to show that systematic investing can work well.

It appears, though, that Mr Gross did something that could not easily be replicated. Whatever his edge, it was just as well he had it, argue Messrs Brown and Dewey. When you think you have a market-beating strategy, it is wise to ask, “If I am to win, who loses?” A value investor of the Buffett stamp wins because of other investors’ tendency to extrapolate the initial success of “growth” stocks and overpay for them. Similarly, Mr Gross’s roll-down trade may work because excess demand for long-dated bonds from certain kinds of investors with long-term liabilities leaves that end of the yield curve rather flat.

Profiting from the errors of others is what skilful investors do. But two of Mr Gross’s strategies involved taking on extra risks that a lot of bond investors would prefer not to bear. Credit securities and mortgage bonds give a little extra return compared to safe government bonds. But from time to time they inflict big losses. An investor who makes better returns by taking on such risks is not demonstrating skill, say the authors.

Even the most talented rock stars take risks. Keith Richards took enough illicit drugs to fell a herd of bison. He lived to tell the tale. Mr Gross’s riskier bets also paid off. But as Messrs Brown and Dewey argue, the risk of catastrophic loss that comes with these strategies is hard to gauge upfront. Things might have gone differently. As Mr Richards has noted, a lot of rock stars don’t survive.

Package deal

China’s current-account surplus has vanished

A deficit could remake the financial system, if the government lets it

IN A CONTROL room at the headquarters of Ctrip, China’s largest online travel agency, dozens of fluorescent lines flash every second across a big digital map of the world. Each line represents an international flight sold on Ctrip’s platform. The top destinations on the morning of March 11th, when your correspondent visited, were Seoul, Bangkok and Manila. A live ranking for hotel reservations put Liverpool in first place among European cities, Merseyside’s rough-hewn charms briefly trumping Venice and Barcelona (and apparently benefiting from a special offer).

In this century’s first decade Chinese citizens averaged fewer than 30m trips abroad annually. Last year they made 150m, roughly one-quarter of which were booked via Ctrip. That is not just a boon for hotels and gift shops the world over. It is a factor behind a profound shift in the global financial system: the disappearance of China’s current-account surplus.

As recently as 2007 that surplus equalled 10% of China’s GDP, far above what economists normally regard as healthy. It epitomised what Ben Bernanke, then chairman of the Federal Reserve, called a “global saving glut”, in which export powerhouses such as China earned cash from other countries and then did not spend it. China’s giant surplus was the mirror image of America’s deficit. It was the symbol of a world economy out of kilter.

No longer. Last year China’s current-account surplus was just 0.4% of GDP. Analysts at Morgan Stanley predict that China could be in deficit in 2019—which would be the first annual gap since 1993—and for years to come. Others, such as the International Monetary Fund, forecast that China will maintain a surplus, though only by the slimmest of margins. Either way, it would be a sign that the global economy is better balanced than a decade ago. It could also be an impetus for China to modernise its financial system.

The basic explanation for the change is that China is buying much more from abroad just as its exporters run into resistance (see chart). Its share of global exports peaked at 14% in 2015 and has since inched down. The trade war with America adds to the headwinds. At the same time, imports have soared. China’s surplus in goods trade in 2018 was the lowest for five years.

The tale of trade in services, especially tourism, is even more striking. When Beijing hosted the Olympic games in 2008, foreign visitors splashed out a little more in China than Chinese did abroad. Since then the number of foreign arrivals in China has stagnated, while Chinese outbound trips have surged. Not only that: Chinese travellers have proved to be big spenders, as anyone who has queued for a VAT refund at London’s Heathrow airport knows only too well. In 2018 China ran a $240bn deficit in tourism, its biggest yet.

Some of the current-account fluctuations are cyclical. Chen Long of Gavekal Dragonomics, a research firm, notes that the price of oil and semiconductors, two of China’s biggest imports, was high last year. If they come down, a current-account surplus could swell up again.

Yet deeper forces are also at work. At bottom, a country’s current-account balance is simply the gap between its savings and its investment. China’s investment rate has stayed at a lofty 40% or so of GDP. But its savings rate has fallen to about the same, from 50% of GDP a decade ago, as its people have learned to love opening their wallets (or rather, tapping their mobile payment apps). An ageing population should lead to a further drawdown of savings, because fewer workers will be supporting more retirees. The disappearance of the surplus is, in this sense, a reflection of China growing richer and older.

There is, nevertheless, some concern about the implications. In emerging markets big current-account deficits can be a warning sign of financial instability, indicating that countries are living beyond their means and relying on fickle foreign investors to fund their spending. But China is in no such danger. Any deficit is expected to be small, as a fraction of GDP, in the coming years. What is more, the government still has a fat buffer of $3trn in foreign-exchange reserves. That should buy it time.

The crucial question is how China uses this time. By definition any country that runs a current-account deficit needs to finance it with cash from abroad. In an economy with a wide-open capital account and a freely floating currency, inflows and outflows balance without the central bank giving it much thought. But in China the government keeps a tight grip on both its capital account and its exchange rate.

So now that it is facing the prospect of current-account deficits, it has little choice but to relax its grip, in order to bring in more foreign funding. It is moving in that direction. China has long controlled access to its capital markets by issuing strict quotas to foreign investors, with a preference for institutions such as pension funds. But in recent years it has opened more channels, notably through carefully managed links to the Hong Kong stock exchange.

These moves, though incremental, have been enough in aggregate to persuade compilers of leading stock and bond indices, important benchmarks for global investors, to bring Chinese assets into their fold. Last month MSCI said it would more than quadruple the weight of mainland-listed shares in its emerging-markets stocks index to 3.3%. Next month China will enter the Bloomberg Barclays bond index, which could fuel roughly $100bn of inflows into Chinese bonds within two years.

In a new book on China’s bond market, the IMF argues that this could foster a virtuous cycle. More active investing in bonds would support the government’s goal of using interest rates as a bigger weapon in its monetary-policy arsenal (instead of old-fashioned administrative guidance). With a more flexible exchange rate to boot, China would end up with a more modern, efficient financial system—proof that a current-account deficit can, handled well, be a welcome development.

But there are clear limits to how far China is willing to go. Efforts to lure in foreign investors have not been matched by moves to make it easier for its citizens to invest abroad. Yi Gang, the newish governor of the central bank, has repeatedly vowed to maintain the “basic stability” of the yuan. Louis Kuijs of Oxford Economics thinks the constraint is ultimately philosophical. The Chinese government is wary about ceding too much control to the market. “It implies a relatively slow opening up,” he says.

Another element of China’s approach to managing a deficit is therefore to stop it from getting too big in the first place. Guan Tao, a former central-bank official, says that China has to improve its competitiveness in services. With a better tourism industry, better universities and better hospitals, China would, he believes, attract more foreigners and keep more of its own spending at home.

Think of it as the second act for the Great Wall. It never much worked as a fortification for China: over the course of its two-plus millennia in existence, barbarian invaders repeatedly breached it. But now its role is to lure in tourist hordes. In this battle it has a better chance of success.

How the Trade War Won’t End

Washington wants to cut a deal now, but Beijing is playing the long game.

By Phillip Orchard


The U.S. and China are circling ever closer to a trade deal. They just need to agree on how to make it mean something a year or two from now. In the weeks since U.S. President Donald Trump agreed to postpone the March 1 spike in tariffs on $200 billion in Chinese goods, enough progress has apparently been made that both sides are eyeing a “signing summit” between Trump and Chinese President Xi Jinping by June. This cautious optimism is fueled by several factors, from Beijing’s offer to nudge down the trade deficit by binging on U.S. energy and agriculture products, to new laws set to be approved this week that include expanded protections for foreign investors. Trump’s barely concealed urgency to give markets a boost by calling off the dogs is probably furthering hopes in Beijing.
But “ending” the trade war still appears to mean something quite different to each side. China, naturally, wants to put this whole unpleasantness behind it and to turn its full focus to its staggering domestic headaches, and is reportedly demanding that all tariffs be lifted immediately. The U.S., naturally, is wary of China’s history of backsliding on rigorously negotiated deals, and presumably aware that it would take Beijing years to implement some of the structural reforms Washington is demanding. Washington needs to hold on to at least some leverage to ensure that the Chinese follow through. As a result, the U.S. is reportedly offering only to lift tariffs incrementally (while Chinese counter-tariffs would be lifted immediately). What’s more, the U.S also wants snapback mechanisms in place to further discourage Beijing from backsliding.
In other words, the focus of the talks has evidently moved to the thorny issues of implementation and enforcement. This speaks to a core problem bedeviling U.S. aims in the matter: Given that U.S. tariffs are only one of many problems weighing on Beijing, can the U.S.-China trade dispute really be negotiated away?
Keeping to a Deal
Whether the U.S. has any real urgency beyond political interests to wrap up a deal depends on whether it believes its broader strategic aims merit the costs of the trade war. The U.S. economy is at the peak of the business cycle and will eventually come back to earth. And the diminishing returns of a tool as blunt as tariffs for forcing China to make systemic changes are starting to become clear. Already, according to the Institute of International Finance, Chinese counter-tariffs are costing U.S. exporters more than $3 billion per month. The higher cost of imports is falling primarily on U.S. consumers, with losses expected to approach $70 billion this year, according to two new authoritative studies. None of this is devastating to the U.S., but Washington can’t ignore the ghost of the Smoot-Hawley Tariff – which raised duties on 20,000 imported items and contributed to the severe economic deterioration of the Great Depression. Meanwhile, there’s no evidence suggesting Beijing is preparing to make the sweeping structural changes demanded by the U.S. To get everything it wants from Beijing, the U.S. would have to keep up the pressure for years – likely well into an economic downturn, and certainly during a key election year. Moreover, even if annual Chinese growth plummets to 3-4 percent, it will still be adding hundreds of billions of dollars in new consumption. The opportunity cost to U.S. exporters is steep.
If the U.S. deems the costs necessary to stunt China’s rise, then no deal is imminent. Otherwise, the U.S. has an interest in settling for quite a bit less up front. By agreeing to a limited deal, pairing relief from specific tariffs with implementation of select concessions by Beijing, Washington can gradually ease the burden on the U.S. entities hurting most – exporters, firms with supply chains routed through China, firms dependent on lower-cost Chinese inputs, and consumers. And it will still have other tools like export controls, investment restrictions and the embattled but still potent World Trade Organization dispute settlement courts with which to protect U.S. firms and target Chinese practices that pose the biggest long-term threat, particularly in the race for technological supremacy. Whether or not the current negotiations produce a substantive deal, U.S. pressure in these areas isn’t going away.
But to trade hawks in the Trump administration, the sense of urgency to get a deal risks undermining efforts to address the very real problem of post-deal implementation – and giving Beijing incentive to try to run out the clock on what it sees as an impatient president. (Beijing would be foolish to think the next U.S. administration will be fundamentally more dovish, but it’s reasonable to think political and economic complications in the coming years will weaken U.S. appetite for a sustained offensive.) China has a mixed history, at best, of implementing deals. If it had fulfilled all of its WTO obligations, after all, it wouldn’t be in this position in the first place.
Beijing is trapped between oft-conflicting imperatives: economic dynamism and social stability. Under Xi, it has routinely prioritized the latter, deepening state domination of the economy in ways that have provoked the U.S., but that also helped maintain steady employment and manage China’s immense internal financial risks. Tariffs are a far smaller problem for China than internal dysfunction. But the duties are making Beijing’s tightrope walk of internal reform ever more precarious. In all likelihood, China will agree to whatever it deems necessary to make the tariffs go away. But if keeping order necessitates cheating on its commitments and risking a backlash, Beijing won’t hesitate.
What the U.S. Can Do
U.S. Trade Representative Robert Lighthizer is trying to make it harder for Beijing to backslide in a couple ways. The U.S. is insisting that concessions from Beijing be as explicit and quantifiable as possible. (Lighthizer says the agreement will exceed 110 pages.) The easier it is to identify cheating, the greater the reputational costs for Beijing and the easier it will be for Washington to make the case to the U.S. public and allies that pressure be revived. There are two main problems here: One, the Chinese system is exceedingly opaque, especially given the dominance of state-owned enterprises. Two, implementation progress on the biggest issues – forced technological transfers and cyber theft, for example – can’t easily be quantified or monitored. Thus, the U.S. is also demanding the right to independently assess whether China is living up to what it considers the spirit of the deal – and to unilaterally reimpose tariffs, without retaliation, if it concludes Beijing is falling short.
Still, these sorts of measures can do only so much. Trade deals, like most international agreements, last only as long as each side is willing to comply, which is why they tend to work only when they are truly in both sides’ interests. Either way, it’s really hard to make them binding. There won’t be any trade cops to make arrests when there’s a violation. The U.S. isn’t going to threaten war to enforce this sort of deal. Nor can the U.S. really take too much reassurance from measures like China’s new foreign ownership law, which would ostensibly help address the issue of forced technology transfersThe new law is vague, and Beijing has only so much ability and interest to enforce it at a granular level. (Trade lawyers say tech transfer typically happens willingly, often by foreign firms that are desperate for funding or that simply failed to adequately protect themselves under existing Chinese laws.) And when it comes to core technologies Beijing deems critical for initiatives like next-generation military applications, all bets are off. Law in China is applied only to the extent that it serves the Communist Party’s interests.
This isn’t to say China won’t have reasons beyond the lure of tariff relief to continue to comply. A lot of what Beijing will likely concede is fairly low-hanging fruit. For example, it’s expected to pledge to refrain from artificially weakening its currency (currently, it’s trying to keep the yuan from collapsing) and to buy more U.S. goods (items it needs to import anyway). Its measures to improve intellectual property protections, meanwhile, are needed to reassure spooked foreign investors, ease discontent among domestic private firms fed up with their state-owned counterparts, and further erode the U.S. business community’s support for the trade war. Countries often use trade agreements to bring recalcitrant domestic players obstructing needed reforms into line. And Beijing has a real need to repair its image abroad. The trade war has triggered a slow-motion stampede to the exits by foreign firms in the country, while also intensifying the spotlight on internal practices, deterring new investment. It’ll be dealing with the fallout of this for years and has ample reason to let the U.S. lose interest.
But structural reforms like ending industrial subsidies and scaling back the state’s role in the economy would be an order of magnitude trickier for Beijing to implement. These issues also happen to be at the heart of U.S. grievances. Even if the U.S. can pressure China into including concessions in these areas in the deal, it will be an exceedingly wobbly deal, however many pages it runs.

Alan García, Ex-President of Peru, Is Dead After Shooting Himself During Arrest

Former President Alan García of Peru in Lima last year.

By Andrea Zarate and Nicholas Casey

Former President Alan García of Peru in Lima last year.CreditCreditErnesto Arias/EPA, via Shutterstock

LIMA, Peru — A former president of Peru died on Wednesday after shooting himself in the head when the authorities tried to arrest him in connection with one of the biggest corruption scandals in Latin American history.

When the authorities arrived at the home of the former president, Alan García, with an arrest warrant, he locked himself into his bedroom, shot himself and was rushed to a hospital, his personal secretary told reporters.

The charges relate to Odebrecht, a Brazilian construction giant, which last year admitted to $800 million in payoffs in exchange for lucrative contracts for projects including roads, dams and bridges. The company was a main builder across Latin America, where it profited from a commodities boom that led to a huge spike in infrastructure construction.

The revelation that Odebrecht had secured contracts through graft set off a flurry of investigations by prosecutors and lawmakers, principally in Latin America, as they sought to learn who was on the receiving end of the payments.

Mr. García, 69, a rare two-term president who had become a larger-than-life figure in Peru, and whose legacy straddled periods of both growth and economic collapse, knew that he was under investigation. Last year, he fled to the Uruguayan Embassy in Lima, the capital, where he asked for asylum. The request was denied, and Mr. García returned home.

On Wednesday morning, the Peruvian authorities ordered an initial 10-day detention of Mr. García on accusations of money laundering, influence peddling and collusion. The measure allows officials to hold suspects before charges are formally presented.

That afternoon, mourners from his political party gathered outside the hospital as news came that the former president was dead.

Writing on Twitter, Peru’s current president, Martín Vizcarra, said that he was “dismayed” by the death of Mr. García, who served one term from 1985 to 1990 and another from 2006 to 2011. Mr. Vizcarra joined many Latin American leaders in expressing their condolences to Mr. García’s family.

The kickback scandals in which Mr. García had been implicated have touched off a surge of arrests throughout the region.

In Brazil, former President Luiz Inácio Lula da Silva was sentenced to 12 years in prison last year for corruption and money laundering, and is accused of taking bribes from Odebrecht.

In Ecuador, a former vice president was given a six-year sentence for pocketing millions from the company.

Police officers outside the hospital where Mr. García was treated on Wednesday.CreditGuadalupe Pardo/Reuters

And in Colombia, protesters have called for the resignation of the attorney general, who is investigating Odebrecht despite having worked as an adviser to one of its partners.

But of all the countries affected by the prosecutions, none has been more shaken than Peru, where the scandals reached a number of ex-presidents.

Last week, prosecutors detained Pedro Pablo Kuczynski, Mr. Vizcarra’s predecessor, in an investigation related to the case. They have asked that he be held up to three years as they gather evidence.

Alejandro Toledo, who was president in the early 2000s, is wanted for extradition from the United States and has refused to return to Peru; Ollanta Humala, president from 2011 to 2016, was detained as well, but eventually released. 
Odebrecht, which began work in Peru in 1979, had risen to be one of the country’s chief constructors of roads, bridges, dams and highways.

The company built a $4.5 billion road that connected the Pacific to the Amazon basin and an electric train in Lima. It was behind a $1.9 billion irrigation project called Chavimochic that irrigated a section of desert on Peru’s northern coast and paved the way for the export of asparagus and strawberries.

But it also left Peru in the lurch of one of its most toxic political crises in years.

In late 2017, after Mr. Kuczynski, then the president, was linked to a $782,000 payment from Odebrecht, and his rivals in Congress moved to impeach him. He avoided being ousted at the time, but resigned last March, and was detained this month. He has maintained his innocence, and chosen to fight in court.

The authorities appeared to have been closing in on Mr. García as well, bringing a corruption case that could have ended his decades-long career in Peruvian politics.

At the time he took office in 1985, he was Latin America’s youngest president, at 36. But the country soon entered a disastrous economic collapse in which hyperinflation reached an estimated 2 million percent. The period was also marred by deadly conflict with the Peruvian rebel group Shining Path, which Mr. García seemed unable to control.

Mr. García was succeeded by Alberto Fujimori, a populist who suspended the Constitution and ran the country as a dictator for a decade, citing the unrest.

Peru’s democracy was eventually restored, and Mr. García returned to power in an election in 2006. With the Shining Path largely defeated, Mr. García turned his attention to foreign investment, particularly in mining, and the country’s economy grew at rates well above 5 percent.

But Mr. García’s popularity, even after his second term, never recovered. He was known by many critics in Peru as “crazy horse,” for what they called his tendency to make rash decisions and behave in an unstable way.

His second term became a point of investigation for prosecutors, who examined whether campaign contributions for Mr. García’s party were tied to the Odebrecht scandal.

A class apart

Private education is booming in new markets and new forms

Governments should support, not suppress it, says Emma Duncan

HOUSED in a jumble of ancient buildings in the shadow of Westminster Abbey, Westminster School has been educating boys since it was founded in 1560 by Queen Elizabeth I to provide lessons for 40 poor scholars. It has evolved since then—its 750 pupils now include some girls, and with fees of £39,252 a year for boarders and £27,174 for day pupils, poor scholars are thin on the ground—but for nearly half a millennium, these historical premises defined its geographical limits.

That is about to change. A ground-breaking ceremony on April 9th marked the start of the construction of Westminster Chengdu, the first stage in a venture with a local partner, Hong Kong Melodious Education Technology Group. The school is due to open in September 2020 and will have 2,500 pupils from the ages of 3 to 18. It will be followed by a further five establishments of a similar size in other Chinese cities over the next ten years, by the end of which Westminster will be educating 20 times as many children in China as in the heart of London.

A slice of the Chinese operation’s income will flow back to the mother ship, enabling Westminster to increase the share of pupils on bursaries in Britain from around 5% to 20%. “It will give us a revenue stream that will allow us to go back to our roots,” says Rodney Harris, deputy headmaster in London, who is moving to Chengdu in September to take the top job there. By extending its model to China, the school thus hopes to mitigate the inequality to which it contributes in Britain.

Education used to be provided by entrepreneurs and religious organisations, but starting in Prussia in the 18th century, governments began to take over. In more recent years the state has dominated education in the rich world, with the private sector restricted to the elite and the pious. In the developing world, too, new states created from crumbling empires were keen to provide (and control) education, both to respond to their people’s ambitions and to shape the minds of the next generation.

But now the private sector is enjoying a resurgence. Enrolment in private schools has risen globally over the past 15 years, from 10-17% at primary level and from 19-27% at secondary level; the increases are happening not so much in the rich world as in low- and middle-income countries. People are pouring money into schooling, tuition and higher education (see chart).

Four factors are driving the increase. First, incomes are rising, especially among the better-off. Since birth rates are falling, the amount of money available for each child is rising even faster than incomes. In China the one-child policy has meant that in many families six people (four grandparents and two parents) are prepared to invest in the education of a single child.

Second, thanks to the relative decline and increasing capital intensity of manufacturing, job opportunities for the less well-educated are shrinking. Even good factory jobs require qualifications. The returns to education have risen despite the rise in the supply of well-educated people. In developing countries, which have fewer of them, the returns are higher than in the rich world, making it even more important for young people there to go to school.

Third, the output of education also provides some of the input: the more children that are educated, the more teachers will be available to bring on the next lot. This is especially true in countries in which job opportunities for women are limited: lots of educated women translate into a ready supply of cheap teachers.

Fourth, technology is creating a demand for new skills which the private sector seems better at providing. It is also opening up new markets as the internet enables people to get educated in different ways and at different times in their lives.

The dividing line between private and public is often unclear—many countries have government schools that are partly privately financed, for instance, and private schools that are publicly financed—and the size and growth of the private sector varies from country to country. Broadly, the more developed the country, the smaller the private sector’s role tends to be. In Haiti about 80% of primary-school pupils are being educated privately; in Germany, just 5%. In mainland Europe, the quality of state education is generally high, so the private sector tends to play a smallish role—though there are wrinkles. For example, a history of religious divisions in the Netherlands has meant that three-quarters of pupils go to private schools, the great majority of them publicly financed; in Sweden, 10% do. In America and Britain the quality of government schools is variable, which explains sizeable elite private sectors and a growing number of privately managed, publicly funded schools—“charters” in America, “academies” in Britain. In the tertiary sector, private institutions have a big role in America, both at the top and the bottom of the market; in Britain, the tertiary sector is now largely privately financed.

In Latin America the Catholic church’s big role in schooling, the low quality of state provision and the rapid growth in demand for tertiary education have all contributed to a big role for the private sector. In much of South Asia and Africa, poverty, migration and population growth make it hard for governments to provide schooling in many cities, so the private sector is big, and growing fast. The elites have already left the public systems, and many middle-class and poorer people are following.

Like Europe, East Asia has generous and mostly good state provision, but unlike Europe it also has a fast-growing private sector. Vietnam has both the best state-school system in a low-income country and probably the world’s fastest-growing private-school sector. The market capitalisation of Chinese education companies, bigger than those of any other country, suggests that investors see it as a golden opportunity.

The Chinese state is clamping down on the private sector’s role between the ages of 6 and 16, but there is still room for growth. If the child goes to a private nursery and a private university, and receives two hours of private tuition on each school day and eight at the weekends, with a summer maths camp thrown in—a fairly standard routine for a child of Chinese professionals—he or she will spend as much time in the private as in the state sector.

All of this makes education attractive to investors, says Ashwin Assomull of L.E.K. Consulting. Demand is growing faster than incomes and holds up well in economic downturns. Technology is creating new markets. Schooling is fragmented, but there are large and growing chains, such as GEMS Education, a Dubai-based company with 47 schools mostly in the Middle East; Cognita, a British company with 73 schools in eight countries; and Beaconhouse School Systems, a Pakistani company with 200 schools in seven countries.

The main downside is the sector’s political sensitivity. Private investment in education makes governments uncomfortable because it pits a private good against a social one. Governments, like parents, want children to learn, but they also want to maximise social mobility and minimise inequality, whereas parents simply want to ensure that their children do better than anyone else’s.

These objectives inevitably conflict, so governments regulate and restrict the private sector, controlling what is taught, banning profits, outlawing selection, cutting fees and generally making the business unattractive to investors. Yet they need it, too, so they work with it, channelling its skills, inventiveness and capital and pouring taxpayers’ money into it.

This special report will consider what the private sector is providing that the state is not, and look at the costs and benefits of its growth. It will examine how well it is performing, and conclude by asking how the private sector and the state can work together to best effect.

Is the equity bull market too big to fail?

Private sector’s growing reliance on stocks means a crash could substantially damage the economy

Joseph Carson

The US equity market is on another streak, posting a double-digit gain since the start of the year and extending a bull run that has lasted 10 years. In terms of pure numbers, equities occupy a position far above any other asset, and in everyday life stocks have jumped ahead of real estate as a store of wealth for Americans.

From a risk management perspective, policymakers should consider broadening the definition of “too big to fail” to include market segments and not just financial groups since, at various times, the main risks to the economy and financial system have been the high value of assets on the private sector’s balance sheets.

The power and influence of equities should not only be assessed by the numbers, but also by how the market has become part of daily public and political conversation as well as a driver and verification of policy.

At today’s prices, the market value of publicly traded equities is estimated to be about $33tn, not far off the record high of $36tn recorded in the third quarter of 2018. Measured in relation to nominal GDP, the market value of equities stands at about 1.6 times. The record high of 1.7 times was reached twice before, in Q3 2018 and Q1 2000.

Household holdings of equities, both directly and indirectly held, stand at almost $30tn, and represent the highest valued asset on household balance sheets. Equities account for 33 per cent of total household financial assets, topped only by the 37 per cent share recorded in 2000.

Equities have exceeded the market value of real estate on household’s balance sheets for six consecutive years. The only other time equities exceeded real estate was in 1998-1999, which came on the heels of five consecutive years of 20 per cent to 30 per cent gains in the equity market.

News on the equity market dominates the airwaves. Today there are several financial markets shows dedicated to stocks, and even news TV broadcasts post an equity ticker showing how the market is faring. Updates on the equity markets are as frequent and as common as weather reports.

The equity market has become an important driver of consumer and business confidence and is often viewed as the single most important “real time” barometer of current and future economic conditions.

Monetary policymakers often look at the equity market for a validation of their views on the economy and policy stance. Many analysts think the recent pivot by the US Federal Reserve to pause from further rates hikes was directly linked to the near 20 per cent sell-off in equities in the fourth quarter of 2018. And political leaders such as President Donald Trump have been pointing to the stock market as a barometer of the success or failure of their policies and even their leadership.

None of this suggests a correction in the equity market any time soon, but it does illustrate how it has risen to a level of financial, economic, public and political importance never seen before.

That raises the natural question: “Is the equity market too big to fail?” That clearly was a valid issue back in the late 2000s when the housing market — a key driver of growth and liquidity — crashed, triggering widespread damage to the economy and financial market.

When it comes to the equity market, that question can only be answered in hindsight, but after 10 years of gains risks are rising, especially since recent gains appear to be linked to the promise of easy money and not stronger corporate earnings.

Policymakers have consistently argued that it is impossible to identify asset bubbles and the best defence against them is robust supervisory and regulatory oversight. That policy does not work in practice when the risks sit on the balance sheets of the private sector and easy money is part of the problem.

At today’s levels, the equity market is too big to fail without causing substantial damage to the economy that would be far greater than what happened after the tech bubble burst in 2000, since policymakers have far less capacity to reduce interest rates and real estate is unlikely to provide the same buffer for investors or the economy.

The writer is former chief economist at AllianceBernstein

Market Outlook: Is The Stock Market Making A Head And Shoulders?

by: Fundamental Capital

- As the stock market approaches all-time highs, some traders and investors are wondering if the stock market is making a head and shoulders pattern.
- The problem with these patterns is that they are only obvious with 20/20 hindsight. These patterns have too many false signs.
- In this article we examine the medium term bullish and short term bearish case for stocks.

The stock market’s relentless rally continues. The S&P 500 (excluding dividends) is just 1% from a new all-time high, while the S&P 500 Total Return Index (including dividends) is already at an all-time high. While the chart may “look like” a bearish head-and-shoulders pattern, these patterns are only clear with the benefit of 20/20 hindsight. Too many potential head-and-shoulders patterns don’t work out in real-time (i.e. false bearish signals). And by the time you wait for a “bearish confirmation” break of the neckline, the S&P is already down -20%.
Source: Investing.com
The economy’s fundamentals determine the stock market’s medium-long term outlook. Technicals determine the stock market’s short-medium term outlook. Here’s why:
  1. The stock market’s long term risk:reward is no longer bullish.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. The stock market’s short term leans bearish
We focus on the long term and the medium term.
Long Term
While the bull market could keep going on, the long term risk:reward no longer favors bulls.
Towards the end of a bull market, risk:reward is more important than the stock market’s most probable direction over the next 12+ months
A few leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. This has occurred already
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. The labor markets have not deteriorated significantly yet.
  3. Other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A U.S. recession is not imminent right now
*All economic data charts are from FRED
Labor market
Initial Claims is trending sideways/downwards while Continued Claims is trending sideways.
In the past, these 2 figures trended higher before bear markets and recessions began.
You don’t need to be worried about the most recent drop in Job Openings.
Month-to-month changes in economic data are notoriously noisy, which is why we focus on the trend.
Here’s what happens next to the S&P when Job Openings falls more than -7% in a single month.
The labor markets could deteriorate in the coming months, so pay close attention to the data as it is released. For example, the KC Fed Labor Market Conditions Index is trending downwards. (This is not yet a long term bearish sign for stocks. In the past, this index fell to zero when bear markets and economic recessions began.)
Heavy Truck Sales
Heavy Truck Sales is mostly trending sideways right now. The key point is that Heavy Truck Sales has not trended downwards. In the past, Heavy Truck Sales trended downwards before bear markets and recessions began.
New Orders
Inflation-adjusted New Orders for Consumer Goods is still trending sideways/upwards. In the past, inflation-adjusted New Orders trended downwards before bear markets and economic recessions began.
Financial conditions

Financial conditions are still very loose. Here’s the Chicago Fed’s National Financial Conditions Index
The Financial Conditions Index is broken down into 3 subindices:
  1. Credit
  2. Risk
  3. Leverage
In a credit-driven economy, the Credit Subindex is most important. You can see that the Credit Subindex is still very low.
This is not a long term bearish factor for the stock market right now because historically, financial conditions tightened significantly before bear markets and recessions started.
Retail Sales
Inflation-adjusted Retail Sales are no longer trending upwards. This is a necessary-but-not-sufficient condition for bear markets and economic recessions.
The stock market’s valuations are still extremely high, no matter what valuation indicator you use.
Valuations are not timing indicators. Shiller P/E consistently peaked at approximately 22 from 1900 – 1994. But from 1994 – present, valuations have been consistently higher. Here’s what happens when you sell the S&P when Shiller P/E reaches to 22. As you can see, a strategy that worked pre-1994 no longer works post-1994.
Conclusion: The stock market’s biggest long term problem right now is that as the economy reaches “as good as it gets” and stops improving, the long term risk is to the downside.
The end of a bull market is always very tricky to trade. The stock market can go up a lot in its final year, even if the macro economy is deteriorating (e.g. 2006-2007). That’s why it’s better to focus on long term risk:reward instead of trying to time exact tops and bottoms. Even when you think the top is in, the stock market could very well surge for 1 more year. (Just ask the people who thought that the dot-com bubble would end in 1998. It lasted another 1.5 years).
Medium Term
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
The stock market’s price action demonstrates a bullish lean over the next 6-12 months.
New highs
The S&P 500 is within 1% of new all-time highs while the S&P 500 Total Return Index is already at new all time highs. This is a very fast reversal, since the stock market was crashing less than 4 months ago.
Source: StockCharts
Historically, such quick reversals were more bullish than bearish 3-12 months later.
VIX fell below 12 on Friday for the first time since October 2018
Source: StockCharts
This is mostly bullish for the S&P 6-12 months later. It is also short term bullish for VIX
Trend Following + Breadth
The Zahorchak Method is an interesting indicator that combines trend following techniques with breadth/participation indicators. The general idea is that you sell when the Zahorchak indicator is breaking down (e.g. falls below -6), and buy when the indicator is breaking up (e.g. rallies above 0)
Source: StockCharts
Here’s what happens next to the S&P 500 when the Zahorchak Method goes from -10 to +6 within the past 6 months.
Breadth continues to improve as the stock market relentlessly pushes higher. Here’s the S&P 500 Bullish Percent Index, which saw weaker breadth in the 2000-2002 and 2007-2009 bear market rallies.
Source: StockCharts
Here’s what happens next to the S&P when the Bullish Percent Index reaches 79 for the first time in 3 months.
Meanwhile, 73% of the S&P 500’s stocks are above their 200 dma.
Source: StockCharts
You can see that this didn’t happen during 2008’s bear market rallies.
*Be careful when using indicators with limited history. They tend to be misleading. E.g. you have no idea how this indicator performed in the 2000-2002 bear market, 1973-1974 bear market, 1969-1970 bear market.
The S&P’s 14 weekly RSI (momentum indicator) is now at 62. Historical bear market rallies usually did not see such strong momentum.
Source: Investing.com
Other Indices
Small caps continue to significantly lag large caps and tech.
Source: StockCharts
Small caps’ underperformance occurred at the top of the 2000 dot-com bubble, but also occurred in other less ominous historical cases.
Bond Spreads
While the stock market has rallied significantly over the past 3.5 months, corporate bond spreads have not narrowed significantly.
This divergence is not as long term bearish as you think.
Short Term
The stock market’s short term outlook leans bearish. However, the short term is extremely hard to predict, no matter how much conviction you think you have. That’s why we focus on the medium-long term.
Small caps
As of Wednesday, the Russell 2000 fluctuated above and below its 200 dma 7 times in the past 50 days. This reflects some indecision in the stock market.
Source: Investing.com
Historically, this was a short term bearish factor for the stock market 1 month later.
SKEW is often viewed as a black swan indicator. As it rises, the potential risk in financial markets rises. It tends to move mostly inline with the S&P.
You can see that SKEW has diverged from the S&P 500 since January 2019. This is a short term bearish factor for stocks.
Junk Bonds
Junk bonds are on fire, recording one of the highest daily and weekly RSI readings in JNK’s short history.
Source: StockCharts
Here’s what happen next when JNK’s 14 weekly RSI exceeds 72 (i.e. overbought).
As you can see, this is a short term bearish factor for stocks and junk bonds.
*Don’t take the “up 94% of the time 1 year later” too seriously. The historical data is limited to only a bull market, so of course the 1 year forward returns would be ridiculously bullish.
Here is our discretionary market outlook:
  1. The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. We don’t predict the short term because the short term is always extremely random. At the moment, the short term does seem to have a slight bearish lean.
  4. In summary, 12-24 months = bearish, 12 months = neutral, 6-9 months = slightly bullish.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk: reward does favor long term bears.