Inflationary Angst

By John Mauldin 



According to the dictionary, the word angst refers to “a feeling of deep anxiety or dread, typically an unfocused one about the human condition or the state of the world in general.” It comes from a German word for “fear.”


Two weeks ago I referred back to my 2017 Angst in America series. “Deep anxiety or dread” is exactly what I described then, and it hasn’t improved for most people. For some, yes, life is good and getting better, at least financially. Not so for every American… or even most of us.


Yes, life could be even harder. “Poverty” living standards in the US are better than much of the world knows. But that doesn’t reduce the angst because we compare our conditions to what we see around us, or in the media we consume.


Today I want to bring some focus to this unfocused anxiety. We will see that much of it (though certainly not all) traces back to specific policies of a specific institution that has a specific mission it is failing to achieve.


Furthermore, that angst is going to rise up and bite us in our political derrière at some point in the future. And that gives me a great deal of personal angst, because I don’t think the results will be pleasant for anyone.


Before we begin, I want to call your attention to an opportunity to get six free months of a newsletter I read every day: Jared Dillian’s The Daily Dirtnap. Jared’s market analysis is almost supernaturally sharp. I’m genuinely not sure how he manages to keep it consistently top quality every single day he publishes, but he does.


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Stable Prices, Sometimes

Contrary to popular opinion, the Federal Reserve System is not independent. Nor does it have to follow the president’s orders, as much as Donald Trump wishes it would. The Fed operates under a legal mandate from Congress. Its monetary policy role is “to promote maximum employment, stable prices and moderate long-term interest rates.”

So how is it doing?

Long-term rates are certainly moderate. Employment is historically high, though wages and job quality aren’t always great.

As for that “stable prices” part… it depends on what you are buying. As you see below, for many goods the price is nowhere near “stable.”

Unfortunately, if you are in the bottom 60–70% of the income brackets, these are some of the things you buy the most.



The Fed believes that 2% annual inflation equals “stable prices.” Yet that small amount adds up over time—to almost 50% in 20 years. Which is about where CPI lands in this 20-year chart, so the Fed is succeeding by that yardstick.

Think about that for a second. The Fed defines “stable prices” as a 2% average. And then another government agency tries to measure those prices, often using “Hedonic Quality Adjustment” to account for changes due to innovation or completely new products. So because the car you are buying has new features, they conclude it’s not more expensive. Does that match your experience? Thought so…

CPI doesn’t reflect real-life spending for most people. Prices have risen dramatically more than average for some of life’s basic necessities. So if you wonder why people are anxious, this might be a clue.

The Fed either doesn’t see this, or doesn’t think it is a problem. Officials have been wringing their hands for years at their inability to make inflation reach that 2% level. The Financial Times reported last week that they may soon change their rules.

The Federal Reserve is considering introducing a rule that would let inflation run above its 2 percent target, a potentially significant shift in its interest rate policy.

The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation.

The idea would be to avoid entrenching low US price growth which has consistently undershot its goal.


The key here is that 2% average inflation isn’t the same as 2% all the time

Having run below 2% for years, Fed leaders now want to go above it, potentially far above it and for long periods. In other words, give themselves permission not to worry about the inflation a low-rate policy might otherwise cause.


As my friend Samuel Rines noted yesterday:

Bottom Line: Inflation is not going to be an issue for the Fed—too high or too low—for a while. Whether looking at CPI or the Fed favorite PCE, it is difficult to see an impending surge in underlying inflation. This should help keep longer-term yields in check with a pick-up in activity in 2020. Tariffs are already showing up in the data, but do not matter (much) for the indexes.


While Fed officials may think they have tamed inflation, their ZIRP and QE actually drove real-world prices considerably higher than CPI or PCE show. 

It showed up mainly in asset valuations, like stocks and real estate. These, in turn, drove up other prices like housing. Aggregate inflation isn’t higher because technology and globalization reduced manufactured goods costs and the shale revolution kept energy costs low.

Try to look at this like an average worker. Your rent keeps rising, your kids can’t go to college without racking up debt, your health insurance is astronomical, and your wages, while up a bit, aren’t keeping up with your living costs.

Meanwhile, the people who are supposed to be looking out for you keep talking about how the economy is improving thanks to their brilliant policies. Of course you’re angst-ridden. How could you not be?


Deaths of Despair

In Part 2 of Angst in America, I talked about the “deaths of despair” among middle-aged white men. This alarming and uniquely American trend is getting worse.

Last month an American Medical Association study found US average life expectancy, which had been steadily increasing for decades, has now dropped for three consecutive years. It actually goes back a little further; all-cause mortality rates began rising in 2010. For some groups it went back to the 1990s.

AMA zeroes in on the driver:

A major contributor has been an increase in mortality from specific causes (e.g., drug overdoses, suicides, organ system diseases) among young and middle-aged adults of all racial groups, with an onset as early as the 1990s and with the largest relative increases occurring in the Ohio Valley and New England.


The opioid crisis apparently has a lot to do with this, as do the globalization-driven factory closures in the Midwest and New England. Economic changes are literally killing us.

But again, think about this from ground level. Under-employed factory workers don’t read a lot of economic analysis. They just know they can’t pay the bills, they’re in physical pain from a life of hard labor, and no one in power seems to care. 

Many go on disability, which is not even close to minimum wage, and massively discouraging for somebody who wants to work. For some it leads to depression and, tragically, overdoses or suicide. And it’s common enough to bend the curve in national life expectancy stats that had been rising for decades.

Worse, it’s not like we are powerless to treat these conditions. Medical science knows what to do, and does it pretty well for those with the means to pay. For Americans, that means people who (a) are over 65 and on Medicare, or (b) are poor enough to get Medicaid, or (c) get health insurance through their employers.

Everyone else, like self-employed people or “gig” workers? Not so much. 

Here’s a tweet from my friend Luke Gromen.



Source: Luke Gromen



Those prices are pretty typical if you’re trying to buy insurance on the Obamacare exchanges and you’re middle-aged and not subsidy-eligible.

For illustration, let’s apply Luke’s prices to a hypothetical self-employed person making $100,000 a year. The $1,286/month premiums add up to $15,432 annually. But you get no benefits (except a basic wellness exam) until you’ve spent another $12,500. That totals $27,932, or 27.9% of your gross income that will go to healthcare if anyone in your family gets even a minor illness. A lot of angst.

Let’s take that a little further. This self-employed person is paying $12,000+ in Social Security plus another $3,000 in Medicare, plus federal income tax, in addition to state and local taxes. Which means that if someone in that hypothetical family gets sick, the family has to figure out how to make all of their payments on maybe as little as $45,000 net, after taxes and healthcare.

And in that scenario, then what? Spending that much of your income on healthcare means something else must go. Or, it will turn into medical debt and possible bankruptcy, even if you have insurance.

The irony is that much of the country thinks you are rolling in cash, and might be inclined to vote for someone who would raise your taxes.



Source: DQYDJ


The angst isn’t just severe, it is creeping up the income ladder. Double that example worker’s income to $200,000 and they’re still spending 7.7% of it on insurance premiums and potentially another 6.3% to meet the deductible.

Imagine the outcry if we imposed extra income taxes at those rates. That’s effectively what is happening. Remember the “yellow vest” protests in France? They were about a new gasoline tax. Small potatoes really. But at the risk of a really bad pun, it just threw gasoline onto a stretched- too-thin public fire. At some point we may see the same kind of unrest here, and healthcare costs could easily trigger it.

Yes, yes, I know, the US has the best healthcare in the world. That’s debatable, given these latest mortality numbers, but we certainly have the most expensive healthcare.



Source: Forbes



(By the way, this cost difference is roughly the same if you look at it in percent-of-GDP terms. OECD has the data here.)

How do we spend so much and still have people dying from despair? That’s another topic. My point today is that the way we distribute that spending is having seriously negative economic effects. We can and should debate reform ideas, but this can’t go on indefinitely.

Radical Solutions

Healthcare is just one source of angst. 

Here’s another look at inflation which, according to the Fed, is not high enough.



The education part deserves some comment. The narrative goes that today’s young people need more education because work is so much more complicated now. So, we push them to attend college. Higher demand and slow-growing supply raise the cost of college, so they (and/or their families) go into debt to pay for it.

Does it pay off? Sometimes, but far from always. The chart below breaks down the change in college graduate wages since 2000 by percentile. In most cases, after that 2% average inflation the Fed thinks is too low, real wages actually dropped over this period. And note this only looks at those who actually earn degrees. Millions drop out before getting that far (but not before racking up debt).



So not only is college more expensive, the economic benefit you get from it may well be negative. This is inflation on steroids.

Let’s think about that for a moment. You graduated in 2000 at age 22, got married, had kids, and right about now you’re facing college costs. What’s happened to the price of college? Up over 130% in 20 years. A tad more than 2% inflation.

Look, this isn’t complicated for most people. They need housing somewhere in proximity to their jobs. They want their kids to be safe and have opportunities. And they need to take care of their health. None of those are optional and their costs have risen far more than overall inflation.

To be clear, I’m not predicting higher CPI/PCE inflation, even if the Fed gets more dovish. Its present course will more likely produce more of the same: an asset bubble, lower prices for certain goods, and stable/rising prices for others. It won’t solve the problems regular people face.

And in fairness, the Fed is not alone in thinking inflation is no problem.



Trump is correct if he means the broad inflation measures like CPI though, as we have seen, even 2% is not “almost no inflation” over long periods. He’s seriously wrong about the things middle-class Americans—including the millions who voted for him—must buy just to keep their heads above water. Those goods are expensive and getting more so.

What we really need are policies that make middle class life affordable again. Lower interest rates won’t likely do that. Not when, as my friend Peter Boockvar reported last week, the average price of a new car is $34,000 and median household income is $64,000, and it’s that high only because millions need those cars to commute to underpaid jobs far, far away from the distant suburbs where they can afford to live.

In my normal peripatetic research mode, I found a fascinating Time article by Emily Guendelsberger, who wrote a book called On the Clock: What Low-Wage Work Did to Me and How It Drives America Insane. She describes her experiences working in warehouses, call centers, and fast food. I have family members who have worked at the places she names and their stories match. Conditions are more than a little stressful.  

I wasn’t prepared for how exhausting working at Amazon would be. It took my body two weeks to adjust to the agony of walking 15 miles a day and doing hundreds of squats. But as the physical stress got more manageable, the mental stress of being held to the productivity standards of a robot became an even bigger problem.

Technology has enabled employers to enforce a work pace with no room for inefficiency, squeezing every ounce of downtime out of workers’ days. The scan gun I used to do my job was also my own personal digital manager. Every single thing I did was monitored and timed. After I completed a task, the scan gun not only immediately gave me a new one but also started counting down the seconds I had left to do it.

It also alerted a manager if I had too many minutes of “Time Off Task.” At my warehouse, you were expected to be off task for only 18 minutes per shift—mine was 6:30 a.m. to 6 p.m.—which included using the bathroom, getting a drink of water or just walking slower than the algorithm dictated, though we did have a 30-minute unpaid lunch. It created a constant buzz of low-grade panic, and the isolation and monotony of the work left me feeling as if I were losing my mind. Imagine experiencing that month after month.


Vice is starting a series on what it’s like to work at low-paying jobs. The first installment from a young lady describing her experience working at McDonald’s for $9.30 an hour is deeply troubling. You can’t read it and not be emotionally moved.

It’s All Relative…

I mentioned above that even though the poverty level in the US is well above international average incomes, people compare their situation to what they see. 

My friend Philippa Dunne at The Liscio Report showed two charts demonstrating older generations (read Boomers) are doing much better than Gen-Xers and especially Millennials.





I understand the economic theories that GDP growth will eventually spread widely enough to ease the angst. But I am not sure we can wait that long. 

People are hurting now and they are increasingly willing to embrace radical solutions. “Just wait for better times” is not cutting it as technology eats into higher-paying jobs and aggravates the stress of lower-income jobs.


That’s doubly true if the economy weakens. Some of the data improved a bit in recent weeks. The November jobs report showed much stronger growth than we’ve seen in a while. That’s good to see and suggests we might postpone recession past 2020. But merely avoiding recession isn’t enough. 

Another year of sub-2% growth (which is my base case) will be another year of suffering for the millions whom this weak recovery hasn’t helped.


And it’s not clear that we can avoid a recession. One-third of economists surveyed by The Wall Street Journal think we will see a recession next year and almost 2/3s see a recession by 2021.




Source: John Mauldin



Danielle DiMartino Booth, whose Daily Feather is a must-read for me, showed this yesterday:



Source: Quill Intelligence



Danielle explains the above chart:


Non-manufacturing hours worked have slowed appreciably with growth falling below 2% in the seven months ended October; the ADP report confirmed the weakness in hours worked and exhibited broad-based job declines and slowing across the full spectrum of sectors.


Trade deal headlines and Fed liquidity continue to dictate market trading; the widening breadth of economic weakness suggests fundamentals will eventually prevail though it will take a weak nonfarm payrolls print to truly get the market’s attention.





No one should be surprised the lower 80% of the income pyramid is anxious and depressed. You would be, too, in their situation. And there’s a good chance you will be in their situation in a few years, because angst-ridden people can still vote. 

Economic theories aren’t relevant to them. They look at their own situations and want change.


History suggests that President Trump should win reelection unless recession strikes by next November. But even if we avoid a recession in 2020, what happens if there is one in 2021 or 2022? Democrats could gain power by 2024, if not sooner.


The already-growing annual budget deficit will soar to over $2 trillion. How do we finance that without creating more angst? I can easily imagine a populist Democrat winning the White House, followed by higher taxes and an echo recession. Then even higher deficits and the national debt spinning out of control. 

The Fed will give us massive quantitative easing and zero rates, but they may be in fact pushing on a string…


We don’t have much time to get our house in order, either in the US or globally. Everything I’ve said today applies, to various degrees, throughout the developed world. Thinking that 2% inflation or zero interest rates coupled with massive deficits will somehow help is beyond wishful thinking.


We can and should take steps to protect our individual families and lives, but that’s not enough. At the national level,  I’m beginning to fear only an enormously stressful Great Reset will deliver the deep but necessary sacrifices. The partisan divide inhibits compromise, so nothing happens and the problems grow.


Think about the late 1930s… Hopefully with just economic turmoil, not kinetic war. It will be hard but without the kind of motivation, I really question whether we will do what it takes.


Sigh.


Normally I end these letters talking about my travels and some personal story, but this one has me in a far too reflective mood. So I will just hit the send button and wish you a good week.


Your personally angst-ridden analyst,



John Mauldin
Co-Founder, Mauldin Economics

Beware the dawn of the corporate dead

Companies kept alive by low borrowing costs could make a downturn more gruesome

Galia Velimukhametova

'Zombie' savings accounts highlighted...EMBARGOED TO 0001 THURSDAY JANUARY 16 EDITORIAL USE ONLY Actors dressed as zombies exit Bank Station in London as peer-to-peer lender RateSetter highlights the issue of 'zombie' savings accounts with ‘lifeless returns’. PRESS ASSOCIATION Photo. Picture date: Wednesday January 15, 2014. The independent study commissioned by RateSetter found that 79% of Britons do not check their savings returns against inflation, with some falling as low as 0.1% earning just £1 a year on savings of £1,000. Photo credit should read: Matt Alexander/PA Wire
In most movies about the undead, zombies can still be killed. More companies may also meet a grisly end if profit margins come under further pressure © PA


Zombies continue to stalk the corporate landscape, and the horde is growing.

The number of businesses in industrialised countries whose interest costs are in excess of their annual earnings — “zombie companies”, as they are sometimes known — has reached a level not seen since the global financial crisis. Bank of America Merrill Lynch estimates that there are 548 of these zombies in the OECD club of mostly rich nations, against a peak of 626 during the crash.

These zombies have been kept alive by years of cheap borrowing costs, created by investors chasing whatever yield they can find in a long bull market for government bonds. This helps to explain why there are five times more zombies today than during the late 1990s, when interest rates were significantly higher worldwide.

Property group WeWork, which continues to suck in ever more capital merely to stay afloat, must be the poster-zombie. But, as recent research from Morgan Stanley highlights, there are plenty of other large companies with heavy debt loads that do not have enough earnings to cover their interest payments, such as Telecom Italia and Greece-based lottery company Intralot.

Numbers have been rising especially among US small and midsized companies, in Europe and particularly the UK. Staples of the British high street, swamped by debt, have been foundering with ever greater frequency and the economic consequences of Brexit are likely to ensure that more will follow the likes of travel group Thomas Cook into trouble.

Rising corporate debt loads are a natural consequence of central banks’ easy money policies, which have kept interest rates rooted at low levels. It is easy to see the cause of growing leverage in the real cost of debt.

Companies’ borrowing costs, viewed through the inflation-adjusted yield on eurozone investment grade corporate bonds, are about minus 1 per cent. And the story is similar in other parts of the world.

Companies have responded to this environment by rebalancing their sources of financing.

Nowhere is this more apparent than in the US, where since 2009 companies have borrowed more than $3.1tn through debt securities and loans while buying back $4tn of equities, according to US Federal Reserve data.

In most movies about the undead, zombies can still be killed. More companies may also meet a grisly end if profit margins come under further pressure because of trade conflict and a general global economic slowdown.

Corporate credit quality has been steadily deteriorating for decades now. In the 1990s, the median corporate debt rating from S&P Global, a rating agency, was solidly investment grade. Now it is just one notch above junk.

That is a big concern for the health of the wider stock market. An economic slump raises the prospect of a sudden, dramatic cascade of downgrades. Many large investors are restricted to holding investment grade debt, which means having to sell holdings that drop to junk rating.

This would cause serious indigestion in the relatively illiquid high-yield bond market, as remaining buyers struggle to absorb the additional supply.

A watering-down of traditional investor protections makes a sudden crisis more likely still. As recently as 2011, virtually all European corporate loans were issued with solid covenants — the minimum financial thresholds that help ensure a company will be able to meet its obligations.

Now, more than 80 per cent of debt sold by the largest companies is classed as “covenant lite”, offering negligible protection to creditors.

Those of us who invest in distressed assets and special situations are paying close attention to the fact that 6 per cent of European junk bonds are trading at “distressed” levels, or more than 10 percentage points above government bonds, according to Deutsche Bank. That distressed proportion is up from only 3 per cent a year ago. It is a similar story in the US where 9.3 per cent of the benchmark high yield index is trading at distressed levels, from a low of 3.5 per cent in September 2018.

By contrast, the majority of bond investors seem complacent. The average yield for a junk bond in Europe is just 3.1 per cent, down 1.2 percentage points from a year ago. The 20-year average is much higher, at 8.5 per cent.

Central bank intervention has propped the corporate sector up for much of the past decade and can continue to do so until inflation starts to rise. Meanwhile, a loosening of fiscal policy and a relaxation of trade tensions could spur profits.

But when a business cycle becomes as long in the tooth as this one, the odds start to tilt towards a downturn. The signs are that the slump could start in the corporate debt market.


The writer is senior investment manager at Pictet Asset Management

Can Hong Kong Avoid Tragedy?

To protect their own futures, the people of Hong Kong must reflect carefully on the need to end violent protests and work together to address genuine grievances. The alternative is not some fantasy of an independent and thriving Hong Kong. It is a devastated economy, a divided society, and a lost generation.

Andrew Sheng , Xiao Geng

sheng94_PHILIP FONGAFP via Getty Images_hongkongprotestpolice


HONG KONG – Nearly six months after they began, the protests in our city have reached fever pitch. On one particularly devastating day earlier this month, police fired more than 1,500 rounds of tear gas, a police officer shot a demonstrator at point-blank range while being attacked, and protesters immolated a man who disagreed with them. More than 4,000 people have been arrested, infrastructure has been destroyed, and the economy has sunk into recession. And for what?

Hong Kong’s government withdrew the extradition bill that triggered the protests. Yet the protesters rage on, lacking any coherent strategy or demands. They claim that they are fighting for democracy, but it is hard to reconcile that lofty goal with medieval-style catapults launching bricks and firebombs. In truth, the protesters’ scorched-earth strategy can lead only to more chaos, destruction, and death.

It does not have to be this way. To help find a solution, we have conducted a PEST (political, economic, sociocultural, and technological) analysis of Hong Kong’s current situation and future prospects.

On the political front, the main lesson is that it is up to the government to ensure order and security. Within the “one country, two systems” framework, Hong Kong’s own government has powers to address internal security matters. But where its actions are inadequate, it is the right and responsibility of China’s central government to intervene. By allowing peaceful demonstrations to escalate into large-scale riots, Hong Kong’s protesters have made such intervention unavoidable.

Economically, Hong Kong is paying a high price for the protracted protests. In July-September, the city’s GDP shrank by 3.2% quarter on quarter – the worst economic performance since the 2008 global financial crisis.

Yet all is not lost, as the city’s stock market continues to function. Alibaba – China’s largest e-commerce company, which holds the world record for the largest initial public offering – has followed through on its plan for a secondary listing in Hong Kong, where it is on track to raise nearly $13 billion.

For most of the last two decades, IPOs in Hong Kong have raised more than those in the United States or mainland China. The market capitalization of all listed companies in Hong Kong amounts to about half that of the mainland. Hong Kong is also an essential platform for China’s management of offshore financial assets, and a critical link to global supply chains, with about 60% of China’s inflows of foreign direct investment channeled through the city.

Yet these economic advantages have had unintended social consequences, driving the city’s highest level of inequality in 45 years. As in many Western economies, while property owners, developers, and elite professionals amass wealth, Hong Kong’s lower-middle-class workers have faced stagnating incomes and surging housing prices. The resulting frustration is at the root of the current upheaval.

Persistent governance failures aggravated public sentiment further. In the face of massive social, geopolitical, and technological disruptions, Hong Kong’s government needed to adopt proactive policies that could both respond to new developments and anticipate future challenges – beginning with the lack of affordable housing. But it remained committed to the outdated colonial-era principle of “positive non-interventionism,” so the problems festered, and popular anger grew.

That anger found a home on social media.

Technology shook the foundations of the “one country, two systems” arrangement by facilitating “information disorder”: the spread of overwhelming volumes of biased, misleading, and outright false information, often designed to stoke anti-China sentiment in Hong Kong. The formation of filter bubbles and echo chambers compounded the problem, inundating young people with the message that mainland China was to blame for their every woe.

When these ideas began to be translated into action, protesters used social media to organize, document, and spread awareness of their activities, often anonymously. For both the demonstrators and their opponents, social media have been a crucial means of shaping the narrative, enabling them to share images of, say, police brutality or protester violence.

But social media are a weapon as well as a battleground. In August alone, more than 1,600 police officers and their family members were victimized by “doxxing” – the publication of private information online, in order to invite harassment or worse. In some cases, even the addresses of children’s schools were shared. (Some journalists and opposition figures have also been doxxed.)

Despite these provocations, Hong Kong’s police have shown considerable restraint. Yes, two people have died in the chaos. But compare that to the 22 protesters who were killed in just two weeks of demonstrations in Santiago, Chile, or the more than 100 who were killed during recent protests in Iran.

If protesters in the US or France were rioting for six months, the government would send in the national guard to quell the unrest. Yet China has exercised strategic patience, recognizing that direct intervention could help those who seek to paint the conflict as a “clash of civilizations,” especially at a time when China is locked in a complex trade and strategic rivalry with the US.

But the longer the violence persists, the fewer options for all. Indeed, the latest district council election, with a turnout rate of 71.2%, showed that people voted peacefully for change. If the protesters had avoided violence and opted to wait patiently to express their preferences at the ballot box, the same message could have been sent.

The election result is an opportunity for all to reflect carefully on the need to end violent protests and work together to address genuine grievances. All sides must show empathy, humility, and a willingness to compromise as they design and implement governance reforms that are consistent with Hong Kong’s Basic Law and China’s constitution.

The alternative is not some fantasy of an independent and thriving Hong Kong. It is a devastated economy, a divided society, and a lost generation. Pretending otherwise will only make that outcome more difficult to avoid.


Andrew Sheng, Distinguished Fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance, is a former chairman of the Hong Kong Securities and Futures Commission. His latest book is From Asian to Global Financial Crisis.

Xiao Geng, President of the Hong Kong Institution for International Finance, is a professor and Director of the Research Institute of Maritime Silk-Road at Peking University HSBC Business School.

China Is an Emerging Market Now, for Better and Worse

By Mike Bird




The opening up of China’s stock market to the global financial system is a mixed blessing for Chinese companies—and the international investors now giving them more money than ever.

On Wednesday, index giant MSCI Inc. MSCI -0.65% completed a planned increase in the weight of the country’s domestic stocks—A-shares—in the flagship MSCI Emerging Markets Index.

The change raises the weighting of A-shares to 20% of a full market share, meaning they now make up 4% of the EM Index, up from 0.7% in February.

The Hong Kong Stock Connect, which allows foreign investors to buy select mainland shares, saw its busiest day on record on Tuesday as money managers aligned their funds with the new benchmark.

The Chinese government has wanted to be better represented in global benchmarks for years, but may find its status comes with unwanted baggage.

One of the valuable things about Chinese markets—even amid the chronic speculative activity, lack of transparency and tangled debt dynamics—is the relative autonomy the country enjoys to steer its own financial cycle.

Its ability to tweak financial conditions independently means its government bonds, for example, offer returns that are less correlated to those from other major markets.

The Chinese economy’s sheer heft is part of what allows it to exercise some control over its business cycle, but so is its relatively closed financial system.

The walled garden of capital controls, which constrains the ebb and flow of investment into and out of China, allows the government to maintain something of an economic microclimate.

Other emerging markets are less fortunate. Instead of setting their own monetary conditions, they are tugged along by global risk appetite among investors and the U.S. Federal Reserve’s policy decisions.


One of the valuable things about Chinese markets is the relative autonomy the country enjoys to steer its own financial cycle. PHOTO: ALY SONG/REUTERS


The mere designation of a country as an emerging market in benchmark indexes can make disparate bourses—tagged with the label because they meet some investability standards, but fewer than those of their developed-market peers—behave more like one another, with foreign capital flooding and fleeing them at the same time.

If China were more open to foreign capital flows, it would find itself more exposed to financial forces beyond its control. Indeed, the parts of the economy perhaps most open to outside investment—listed equities available for purchase through the Stock Connect platforms—have begun to respond more to decisions on economic policy made in Washington.

According to a paper by Chang Ma, assistant professor of finance at Fudan University, and two co-authors, Chinese companies accessible through the Connect enjoy lower financing costs and higher returns. Their investment spending was found to be sensitive to an unexpected tightening of American monetary policy, compared with both their competitors, and themselves prior to the existence of the Connect.

MSCI’s decision to include China is broadly a victory for the country’s stock market. But flows through the Connect have already become more volatile this year, with brief drawdowns recorded. More access and attention from the rest of the world could come with negative consequences, too.

After years of lobbying to become an emerging market, China may find it gets a little more than it wished for.

Why the dollar doomsayers have it wrong

The structure of the international financial system makes regime change difficult

Joshua Zoffer

Sheets of five dollar notes sit on a pallet before being printed with a serial number at the Bureau of Engraving and Printing in Washington, D.C., U.S., on Tuesday, April 23, 2013. Stocks rallied amid growth in U.S. home sales, better-than-forecast earnings and speculation the European Central Bank will cut interest rates. U.S. equities recovered after briefly erasing gains following a false report of explosions at the White House. Photographer: Andrew Harrer/Bloomberg
The dollar’s outsized role in international trade, payments and banking means governments alone cannot decide its fate © Bloomberg


Criticism of dollar dominance has arrived back at its ancestral home in Europe. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, first decried the dollar’s “exorbitant privilege”: the ability of the US to finance large balance-of-payments deficits due to its currency’s dominant status in global finance.

Over the past decade, calls to reduce the dollar’s role have come mostly from Russia, China and Iran. The past two years, however, have seen German foreign minister Heiko Maas and Bank of England governor Mark Carney add their voices.

There are signs that central banks are voting with their feet. IMF data show that central banks’ holdings of dollar reserves have fallen slightly, despite the dollar’s high yield relative to other major currencies.

But those who see these developments as cracks that could bring down the edifice of dollar hegemony overstate their point.

The structure of the international financial system makes regime changes in the global currency system exceptionally difficult. The dollar is going nowhere fast.

In that sense, little has changed. In the late 1960s, France led a push to replace the dollar with IMF Special Drawing Rights, a synthetic foreign reserve asset. But SDRs could be used only by official entities, not in private transactions, and never really caught on. Meanwhile, the dollar’s role expanded as financial globalisation took off.

This precedent is particularly telling because confidence in the dollar was then at its historical nadir. Even after President Nixon unilaterally severed the dollar’s link to gold in 1971 — collapsing the Bretton Woods agreement — weaning off the dollar proved impossible.

Half a decade later at the height of the financial crisis, China’s then central bank governor Zhou Xiaochuan made a similar argument for SDRs to replace the dollar. Needless to say, despite the US’s role as “patient zero” in the crisis, little changed.

There are a few reasons why the dollar’s role has proven so durable.

First, the market in dollar-denominated assets, especially government debt, is far deeper than any other. Foreign exchange reserve managers typically hold high-grade securities, not cash. As a result, they often have nowhere else to turn but dollar assets, especially ultra-liquid Treasuries.

Second, a consequence of the imperative of holding dollar assets is that many central banks have a lot of them. China and Japan each hold more than $1.1tn in US Treasuries, let alone other dollar assets.

A dramatic shift away from the dollar would imperil the value of these holdings, putting large holders in a Catch-22. Historically, this barrier has been overcome only when conditions are so dire — such as the shift from pound to dollar during the wars of the 20th century — that adding on the cost of a currency regime change will not make things much worse.

Third, the dollar’s outsized role in international trade, payments and banking means governments alone cannot decide its fate.

Roughly half of world trade is invoiced and settled in dollars, and the proportion is especially high for crucial commodities such as oil.

That dominance reflects, in part, the efficiency associated with using a single dominant currency.

But it also reflects the centrality of American consumers in the global economy.  

Finally, the benefits of a global currency can be provided only by strong institutions trusted by governments and private market participants alike. At the depths of the financial crisis, the US government and Federal Reserve used measures like emergency dollar swap lines to provide desperately needed liquidity to foreign banking markets.

There are two reasons to think things are different today. The US has weaponised the dollar to a greater extent than ever before. It has used its ability to kick banks and countries out of the global dollar system to conscript them into its foreign policy. Other countries have chafed at this, contributing to the dollar’s unpopularity. Cracks are starting to form, with Russia proving to be a particularly notable voice in shifting away from the dollar.

At the same time, digital currency has come into its own. In theory, it is now possible to build a digital finance and payments network with the scale to rival the dollar far more rapidly than at any prior point in history. But digital currencies have their own drawbacks, such as the trustworthiness of the provider. It is difficult to imagine a deep market in financial assets denominated in such a currency, or a world where governments issue debt denominated in Facebook’s Libra.

Moreover, a crucial element of the greenback’s appeal is that dollars represent claims on American goods and services. Fiat currencies are backed not just by governments but by the strength of the economies in which they are used. Today’s digital currencies cannot lay claim to anything remotely comparable.

If a digital currency is to rival the dollar, it will be one managed by a national government or international institution.

That seems a long way off yet.

Although the US would be wise to answer concerns about the dollar, the currency’s role is safe for now.


The writer is a student at Yale Law School


Crazy Extremis

Doug Nolan


Dr. Bernanke has referred to the understanding of the forces behind the Great Depression as the “Holy Grail of Economics.” But was the Great Depression chiefly the consequence of post-crash policy mistakes, as conventional thinking has come profess? Was it really a case of the Federal Reserve having grossly failed in its responsibility to expand the money supply? Or did the previous “Roaring Twenties” Bubble sow the seeds of a major down-cycle and collapse?

Having in the past carefully read through Bernanke’s writings on the twenties and subsequent depression, it was clear his analysis had a fundamental flaw: it disregarded momentous market dynamics that unfolded following the creation of the Federal Reserve system and recovery following the first world war.

The unprecedented buildup of speculative leverage throughout the twenties boom played an instrumental role in systemic liquidity abundance that fueled both financial distortions and economic maladjustment. Confidence in the Federal Reserve’s capacity to sustain marketplace liquidity was instrumental in bolstering a progressively speculative market environment that culminated in the 1927 to 1929 speculative blow-off.

There are those who believe the Federal Reserve should have acted even more aggressively when subprime cracked in mid-2007. More aggressive stimulus measures (why not QE in 2007?) and a Lehman bailout would have averted the “worst financial crisis since the Great Depression.”

As the late Dr. Kurt Richebacher would often repeat, “the only cure for a Bubble is to not let it inflate.” Certainly, the longer Bubbles expand the greater the underlying fragilities – ensuring timid central bankers unwilling to risk reining in excess. 

This was the problem in the late-twenties and in 2006/2007. I would argue this has been a fundamental dilemma for central bankers persistently now for going on a decade. Especially after the Bernanke Fed targeted risk assets as the key reflationary mechanism, central banks have been loath to do anything that might risk upsetting the markets. Remember the 2011 “exit strategy” – promptly scrapped in favor of another doubling of the Fed’s balance sheet to $4.5 TN (by 2014).

From my analytical perspective, things have followed the worst-case scenario now for over three decades. 

Alan Greenspan’s assurances and loose monetary policy after the 1987 crash spurred “decade of greed” excesses that culminated with Bubbles in junk bonds, M&A and coastal real estate. 

The response to severe early-nineties bank impairment and recession was aggressive monetary stimulus and the active promotion of Wall Street finance (GSEs, MBS, ABS, derivatives, hedge funds, proprietary trading, etc.).

Once the boom in highly speculative market-based Credit took hold, there was no turning back. 

The 1994 bond bust ensured the Fed was done with the type of rate increases that might actually impinge speculation and tighten financial conditions. The Mexican bailout guaranteed fledgling Bubbles would run wild in Southeast Asia and elsewhere. The LTCM/Russia market “bailout” ensured Bubble Dynamics turned absolutely crazy in technology stocks and U.S. corporate Credit. Things took a turn for the worse following the “tech” Bubble collapse. 

With Wall Street cheering on, the Federal Reserve fatefully targeted mortgage Credit as the key mechanism for system reflation. A doubling of mortgage debt in just over six years was one of history’s more reckless monetary inflations. The panicked response to the collapsing mortgage finance Bubble fomented by far the greatest monetary inflation the world has ever experienced: China; EM; Japan; Treasury debt; central bank Credit; speculative leverage everywhere…

The “global government finance Bubble” saw egregious excess break out at the foundation of finance – central bank Credit and sovereign debt. It was a “slippery slope”; no turning back. 

The sordid history of inflationism has been replayed: once monetary inflation commences it becomes virtually impossible to stop. 

There was barely a pause in the ECB’s $2.6 TN QE program before the electronic “printing presses” were fired up again. 

The Fed’s balance sheet inflated from less than $1.0 TN pre-crisis to $4.5 TN. After contracting to $3.7 TN this past August, it’s now quickly back above $4.0 TN. 

The Bank of Japan hasn’t even attempted to rein in QE, with assets at a record $5.3 TN – up from the pre-crisis $1.0 TN.

Believing “THE” Bubble had burst in 2000, the Fed saw no basis for not aggressively “reflating.” 

The Fed and global central bankers were convinced “THE” Bubble collapsed in 2008. 

It would be reckless not to proceed with history’s greatest concerted monetary inflation. “Whatever it takes” was necessary to save the euro and European integration. 

Globally, the scourge of deflation has apparently been lurking around every corner – for a decade. It was imperative for the Bank of Japan to demonstrate absolute resolve.

Things got completely away from Beijing. 

Having studied the Japanese experience, they failed to grasp the necessity of quashing Bubble excess early. Over time, GDP targets, global power dynamics and the fear of bursting Bubbles took precedence. 

As it turned out, the greater their Bubble inflated the more heated the U.S./China rivalry. 

In theory, it seemed reasonable to let air out of the Bubble gently. In reality, powerful Bubbles only scoff. As conspicuous as debt excesses and economic maladjustment became, “structural reform” took a backseat to negotiations with Donald Trump. A key Credit Bubble adage comes to mind: There’s never a convenient time to deflate a Bubble.

My view is that Chinese financial and economic fragilities were a major contributor to this past year’s historic global yield collapse. Present a highly speculative marketplace a high probability of aggressive monetary stimulus and you’re asking for a destabilizing “blow-off.” And in this strange world in which we live, wild speculative Credit market excess (i.e. collapsing yields) is viewed by nervous central bankers as a signal to employ aggressive monetary stimulus.

November non-farm payrolls jumped 266,000, much stronger-than-expected and the largest job growth since January (41.3k returning GM workers). The jobless rate declined to 3.5% (matching low since 1969), as average hourly earnings gained 3.1% from November ’18. For a fourth consecutive month of gains, preliminary December University of Michigan Consumer Confidence jumped to (an above estimates) 99.2, the strongest reading since May (and only 2 pts from the strongest reading going back to 2004). At 115.2, the reading on Current Conditions (up 10 points since August) jumped to a one-year-high.

The Fed erred in cutting rates three times this year. 

It was arguably a crucial policy blunder, though in all likelihood the exact opposite will be argued in the future: The Fed should have stimulated more aggressively. We can anticipate the assertion the Fed flubbed last year in raising rates. 

Heck, the Federal Reserve should have gone full Japanese: zero rates and QE indefinitely. 

The S&P500 ended the week with a year-to-date gain of 25.5%, lagging Nasdaq’s 30.5%. 

The Nasdaq Computer Index has jumped 43.8%, with the Semiconductors (SOX) surging 49.3%. 

The Banks (BKX) have enjoyed 2019 gains of 29.3%.

Markets have virtually no concern the Fed might reassess its policy course and reverse rate cuts (what happened to “mid-cycle adjustment”?). 

Markets see only a 1.7% probability of a rate increase by the June 2020 FOMC meeting, while the probability of another cut sits at 42.9%. 

Curiously, the bond market took Friday’s robust economic data calmly. 

Ten-year Treasury yields rose only three bps Friday to 1.84% (up 6bps for the week). 

A delayed reaction wouldn’t be surprising. 

Perhaps bonds are holding out hope for negative trade headlines. 

But an asymmetrical Fed policy bias (no rate increase at least through next November’s elections) seems for now to work for both stocks and bonds.

It’s difficult to define “crazy”. 

I suppose you know it when you see it. 

It’s a central facet of Bubble Analysis that things get crazy at the end of cycles. Arguing that we’re in the throes of the history’s greatest global Bubble, we shouldn’t underestimate Craziness Extremis. 

Bear markets and recessions have been rescinded. 

Stocks always to up. Debt and deficits don’t matter. 

The Beijing meritocracy is up to any challenge. 

Global central bankers have things well under control.

I’ve been thinking a lot lately about a key unheeded lesson from the mortgage finance Bubble experience: prolonged market distortions come with grave consequences. 

The belief that the Fed and Treasury wouldn’t tolerate a housing crisis was instrumental in the mispricing of finance that saw yields drop (prices rise) in the face of a doubling of total mortgage debt. 

The perception of government-imposed safety abrogated the market pricing mechanism. 

Supply and demand no longer dictated the price of mortgage Credit. 

The market became unhinged.

Over the years, I’ve described how a Bubble in high-risk junk bonds would pose limited systemic risk. 

If things heated up – if issuance got out of hand, the market would howl, “No More Junk!” 

Market discipline would essentially bring the boom to a conclusion prior to prolonged excess and the onset of deep structural maladjustment.

A Bubble financed by “money” is perilous. 

There is, after all, essentially unlimited demand for instruments perceived as safe and liquid stores of (nominal) value. 

Implied federal guarantees of GSE debt and assurance of aggressive Federal Reserve reflationary measures in the event of instability bestowed the precious attribute of moneyness (“Moneyness of Credit”) to mortgage-related debt during that fateful Bubble period.

More than a decade ago I warned of the “Moneyness of Risk Assets” – with Bernanke’s reflationary measures having lavished the perception of safety and liquidity upon equities, corporate Credit and derivatives.

November 30 – Financial Times (Chris Flood): “Global assets held by exchange traded funds have climbed to a record $6tn, doubling in less than four years… The sector’s explosive growth has attracted heightened scrutiny by regulators who are concerned about the influence of ETFs as they spread deeper and wider into financial markets worldwide. ‘Passing the $6tn milestone is a historic moment but we are still in a relatively early stage of the industry’s development as ETF adoption rates across Europe and Asia are well below those seen in the US,’ said Deborah Fuhr, co-founder of ETFGI…”

And if the incredible flows into perceived safe and liquid ETF shares weren’t enough… Is this the time to run to – or away from – the bond market?

December 1 – Financial Times (Chris Flood): “Exchange traded funds linked to bond markets have attracted higher investor inflows than equivalent equity products this year in a highly unusual development in the history of the ETF industry. Bond ETFs have traditionally accounted for a fraction of the new cash entering the $5.9tn segment of the asset management world… But this pattern has reversed in 2019 for the first time. Investors have ploughed $191bn into fixed income ETFs in the first 10 months, compared with less than $158bn in new cash gathered by equity ETFs, according to ETFGI… ‘Adoption rates have accelerated noticeably as more investors have realised that fixed income ETFs can provide efficient solutions to some of the liquidity challenges of cash bond markets,’ said Deborah Fuhr, co-founder of ETFGI.”

The mortgage finance Bubble finally got into serious trouble when the “blow-off” subprime mania had driven home prices to unsustainable levels. Speculators turned cautious, financial conditions tightened, the marginal subprime buyer lost access to Credit, home prices reversed, the Bubble faltered, and the fringe of mortgage Credit lost its “moneyness.” 

Those highly levered in mortgage securities lost access to funding and crisis erupted. Market and economic structures having become addicted to Credit and liquidity excess were suddenly starved of both.

In a replay of the previous Bubble, government distortions have ensured a complete breakdown in market pricing mechanisms. 

Yields have declined (securities prices inflated) in the face of a tripling of Federal debt. And with central bank Credit and government debt fueling the Bubble, markets breathe easily. 

What could go wrong? 

There’s no subprime and home price dynamic that could bring the party to a bitter end. And as the Italian debt market has demonstrated, market concern for the quantity, quality and liquidity of sovereign debt can be alleviated through the expansion of central bank Credit (“money”).

So how might this all come to an end? Where is the current Bubble’s soft underbelly – the area of potentially acute fragility?

December 2 – Bloomberg (Yalman Onaran): “Flare-ups in the repo market could still cause worries across the global banking system, more than two months after chaos subsided in this vital corner of finance. Of particular concern: U.S. Treasuries, the world’s biggest bond market and the place where the federal government funds its escalating deficit. If repo rates become jumpy again -- and many are girding for that to happen in the middle and end of this month -- some of those leveraged investors may have to unwind Treasury holdings, potentially increasing the U.S. government’s interest costs at a time of record borrowing. ‘If repos were much harder to get at reasonable rates, Treasury prices would drop,’ said Darrell Duffie, a Stanford University finance professor who’s co-authored research on repo with Federal Reserve staffers. ‘The cost to taxpayers for funding the national debt would therefore rise.’”

Global securities funding markets could well prove a critical weak link. Over recent months, instability has erupted in China’s money markets. There have been indications of vulnerability in global dollar funding markets. And, of course, there were September’s “repo” market convulsions here at home.

The Bloomberg article noted above included the following: “As U.S. government debt rose by $1 trillion in the 12 months through March, more than 80% of it was absorbed by ‘other investors,’ a category in the U.S. Treasury Department’s latest available database that includes broker-dealers and hedge funds. 

In the same period, holdings by primary dealers… increased by only about $100 billion.” Another Bloomberg article (see “China Watch”) discussed China’s $4.7 TN market in local government financing vehicles (LGFV), much of this market offering relatively high interest rates. 

A third Bloomberg article (see “Leveraged Speculation Watch”) noted “China’s crowded market of close to 9,000 hedge funds.” These are serious problems.

Evidence and anecdotes continue to support the thesis of unprecedented global leverage having accumulated throughout this most protracted boom cycle. 

People’s Bank of China liquidity injections stabilized China’s money market. 

Federal Reserve Credit expanded $293 billion in 12 weeks, pacifying U.S. overnight “repo” funding markets. 

But there’s a major problem: distorted markets and central bank backstops have afforded blank checkbooks to governments around the world. 

The U.S. Treasury is poised to run Trillion dollar deficits for as far as the eye can see. 

And so long as markets are fearing trade wars, recession and deflation, downward pressure on bond yields keeps the game chugging along.

Yet the possibility of a trade agreement, economic expansion and some inflationary pressures could prove problematic. 

Rising bond yields would put pressure on highly leveraged and vulnerable markets. 

In all the discussion of “repo” market issues and challenges, the key point is somehow missed: Accommodating and promoting a market that finances speculative leveraging virtually guarantees problematic Bubbles. 

How could this lesson not have been learned in 2008? 

Now it’s a global Bubble, with all the issues of financial fragility, economic maladjustment, and wealth redistribution on an unprecedented scale.