The US, China and the return of a two-bloc world

Technology, not military power, will be the basis for this new global split

Gideon Rachman

During the cold war, there was an “east” bloc and a “west” bloc and nations were defined by whether they were closer to Washington or Moscow.

Now, nearly 30 years after the fall of the Berlin Wall, rising tensions between the US and China are re-creating a geopolitical dividing line. And countries are increasingly expected to make clear whether they stand with Washington or Beijing.

The latest example of this came last week, with the news that Italy is close to becoming the first G7 country to sign a memorandum of understanding endorsing China’s giant infrastructure project, known as the Belt and Road Initiative. Within hours, a White House spokesman had criticised the BRI as “made by China, for China”, and suggested that it would bring no benefits to Italy. The Chinese foreign minister fired back, reminding the Americans that Italy is an independent nation. President Xi Jinping is planning to visit Italy later this month to seal the deal.

The tug of war over Italy underlines that the US-Chinese rivalry is now global. China’s economic and political pull reaches well beyond its Asian hinterland and stretches deep into Latin America and western Europe, areas that were once seen as naturally part of the American sphere of influence.

This Sino-American struggle is also increasingly overt. The Trump administration’s decision to launch a trade war on China ended the era when both sides could insist that trade and investment were neutral territory that could be kept separate from strategic rivalry. At the same time, the sheer ambition of the BRI has stoked fears in Washington that China is entering a new phase in its rise to great power status. If the BRI succeeds it will link the whole of the Eurasian landmass much more closely to China, potentially undermining the importance of transatlantic links.

In Washington, big Chinese investment projects are now routinely scanned for their strategic implications. The fact that Chinese firms are investing heavily in ports around the world is seen through the prism of an emerging naval rivalry with the US. And the international expansion of Huawei, the Chinese telecoms company, has become part of a broader struggle over technological supremacy and espionage. American officials have spent recent months imploring their allies not to allow Huawei to run 5G networks, arguing that this would be an intolerable security risk.

Several key US allies, including Japan and Australia, have already taken the American line on Huawei. But others, such as Britain, are still thinking about it. If the British allow Huawei in, they will be taking a security risk that could damage their precious intelligence-sharing arrangements with the US. But if they block Huawei, British hopes for a post-Brexit trade surge in trade and investment from China will be at risk.

Getting squeezed between Washington and Beijing can be very uncomfortable. After Canada obeyed an American extradition request and arrested Meng Wanzhou, the chief financial officer of Huawei, the Chinese response was fierce. Within days, Canadian citizens were arrested in China, and Canadian executives are now wary of travelling there. Similarly, when South Korea agreed to a US request to deploy an American anti-missile system called Thaad, Chinese tourists were directed away from South Korea and stores owned by Lotte, a South Korean retailer, were shut in mainland China after failing “safety inspections”.

The fact that China is increasingly willing to put direct pressure on US treaty allies is testament to the growing confidence of Beijing. That, in turn, reflects a shift in economic prowess. When countries along China’s Belt and Road consider whether to accept Beijing’s infrastructure packages, there is almost never a counter-offer from the US to consider. Nor is there yet an American firm that can offer an alternative to Huawei’s 5G technology.

In the battle for influence with China, the US’s trump card is often security rather than trade. Countries including Japan, South Korea, Germany and Australia now all do more trade with China than the US. But they all still look to America for military protection.

The US could undermine this security advantage if President Donald Trump goes through with his reported desire to charge allies for American protection. But China is not currently in the business of offering security guarantees. As a result, an emerging two-bloc world is unlikely to be based around rival military alliances as it was in the cold war, when the Warsaw Pact faced off against Nato.

Instead, it is technology that could become the basis of the new global split. China long ago banned Google and Facebook. Now the US is struggling to thwart Huawei. With concern mounting over the control and transfer of data across borders, countries may increasingly come under pressure to choose either the US tech-universe or the Chinese version — and they may find that the two are increasingly walled-off from each other. But a division that started with technology would not stay there. Data and communications are now fundamental to almost all forms of business and military activity.

The two-bloc world of the cold war was replaced by an era of globalisation. Now globalisation itself may be threatened by the re-emergence of a two-bloc world.

Wealth Matters

The Allure, and Burden, of Private Equity

By Paul Sullivan

Andrea Auerbach, global head of private investments at Cambridge Associates, said picking a good money manager was crucial for private equity investments. CreditAnastasiia Sapon for The New York Times

Private equity offers the promise of exclusive deals, outsize returns and enviable cocktail parties.

But as seductive as these investments are, they can trap investors with onerous restrictions like high capital requirements and longtime commitments.

Simply put, private equity is an investment in an asset that is not traded on a public stock market. It’s a catchall term that also includes debt, real estate and various esoteric forms of financing — all of which have different expectations and risks.

The high returns offered by these private equity funds, and the minimal regulatory oversight, draw investors with deep pockets, like pension funds and wealthy individuals, who can meet the minimum investment requirement. The downsides are that the fees are high and the money is typically locked in for at least four to seven years.

That has not stopped the industry from growing. Private market fund-raising rose nearly 4 percent globally in 2017 to $748 billion, according to a review by McKinsey & Company. That year, the private equity firm Apollo Global Management raised a record $24.6 billion for its ninth fund.

But investors must understand the risks. Private equity investments are less liquid than public market securities, for starters, which makes them harder to cash out in a market downturn. And investors may be required to put in money later, an agreement known as a capital call.

“You always have to think about the margin for safety,” regardless of the type of investment, said Tony Roth, chief investment officer at Wilmington Trust. “What happens if it doesn’t turn out the way you’re thinking?”

This is the fourth in a five-part series looking at highly desirable assets that can deliver great returns but can also become burdens when owners need to offload them quickly. Previous columns have looked at art, cars and collectibles.

Private equity is different from the other types in this series because it is a financial investment, not a tangible asset. You can’t hang it on your wall, park it in your garage or serve it with dinner. But it has a cachet from the past successes of other investors, and the high barrier to entry creates an air of intrigue.

The first step to making a private investment is understanding the pitch. After all, there are some 7,000 private investment managers across the globe.

Determining the skill of the manager is important, so do your homework. Andrea Auerbach, global head of private investments at Cambridge Associates, a consultant and an adviser, said picking an average manager could affect your bottom line.

The difference in returns between public equity managers who are in the middle of the pack and top performers was less than three percentage points, she said. But when it came to private equity, the difference in returns between mediocre and top managers was 21 points.

A second step is spreading money across funds raised in different years, not just with different strategies. For instance, funds raised in the years before the recession made most of their investments when the market was at a peak, so they consequently performed worse than those that raised money in the years right after the downturn, when asset values were lower.

A bigger problem for investors in 2008, though, was that private equity firms demanded money from investors in a capital call. The timing was bad because some investors had put their money in the stock market and had to sell their shares at steep discounts to avoid defaulting.

“Most investors oversimplified it, which increased their risk,” said Adam I. Taback, deputy chief investment officer for Wells Fargo Private Bank. “You have to figure in the growth of every other asset. What’s happened to the other 90 percent of your portfolio while you’re doing all this private equity planning?”

Patience is a necessity in private investments.

The marketing material for these funds suggest the investment will last about seven years, but in reality, with clauses in the documents about mandatory extensions, some of these funds can drag on for twice as long.

“Let’s say you make a commitment to a manager and they turn out to be not who you think they are,” Ms. Auerbach said. “You can try to sell your slightly used private equity stake on the secondary market, or you can do your homework and make sure you can stay with the manager for 12 to 15 years.”

“Everything,” she added, “takes longer than people think.”

In the current economic cycle, advisers are urging their clients to do more due diligence and be cautious. “With at least a five- to seven-year outlook, it’s almost certain there is going to be a recession during that time frame,” Mr. Roth said.

Investors should factor in periods of volatility. “When you know you’re going to have a recession, you need a much larger margin of safety than earlier in the cycle,” he said.

To this end, Mr. Roth said, Wilmington Trust has formed partnerships with various private equity firms on behalf of its clients to make niche investments. One involved investing in distressed loans in Europe.

In another recent deal, Wilmington Trust joined forces with a private equity firm that invested only in digital and personal security companies. Its $700 million fund, entering its second year, has already returned capital from successful deals.

Uneven allocation can be a problem. As a private investment matures, managers are both asking for capital and returning money from earlier investments.

“If you have $10 and want to go into small-cap equity, you write your check and you have your $10 of exposure,” said Katherine Rosa, global head of alternative investments at J. P. Morgan Private Bank. “With private equity, you commit capital and that’s drawn down over three-, four-, five-year periods and the distributions come back to you when the manager decides to sell that position.

“So at any time,” she added, “the most you’ll be out of pocket is between $6.50 and $7.50 out of that $10.”

That dynamic has tripped up some investors who pledged money to private equity funds that was allocated to another investment, hoping their returns would cover the call for more capital.

For investors new to private equity, buying a stakes on the secondary market may be a good entry point, Ms. Auerbach said, because the buyer will have a sense of the fund’s performance and get returns more quickly.

But the question remains: How much do you put into private equity to reap the benefits but avoid the downside? Unfortunately, there is no hard rule like the 60/40 split between stocks and bonds that serves as a baseline for investing in the public markets.

Ms. Auerbach wrote a paper analyzing the private investment strategies of top-performing institutional investors and what individuals could learn from them. She found that most big institutions had at least 15 percent of their portfolio in private investments, with some going more than 40 percent.

She said large, multigenerational families might be able to do the same, given their wealth and ability to remain comfortable with the illiquidity.

Of course, that percentage depends not just on the asset base but also on a family’s spending. Ms. Rosa said clients needed to think about whether they could get returns on their other investments that were high enough to cover their lifestyle while they waited for their private equity investments to mature.

That makes sense, but all those numbers need to be forecast out years, and by that time, the economy may have stalled.

Tick, Tick, Talk, 2019 Recession Coming

by: David Haggith

- I'm now predicting a 2019 recession as the major economic news for this year (both US and global).

- The Fed's plan is going to fail; it was always obvious it was going to fail; and it is now, in fact, failing in exactly the manner I've said it would.

- I think a big, fat recession in 2019 could be the best thing that ever happened, even though it would be the worst thing that ever happened.

The 2018 stock market crash is now a fait accompli, having taken a polar bear plunge that put ice in the veins of the Fed and electrified their collective spine with such a deep chill they ran like a fat walrus from the bear market to halt their long-nurtured plans of economic tightening.

With that event fulfilled, I'm now predicting a 2019 recession as the major economic news for this year (both US and global).
To confirm my bearish claim on the market's crash:
Several leading stock market indexes around the globe endured bear market declines in 2018. In the U.S. in December, the small cap Russell 2000 Index (RUT) bottomed out 27.2% below its prior high. The widely-followed U.S. large cap barometer, the S&P 500 Index (SPX), just missed entering bear market territory, halting its decline 19.8% below its high.
But the Dow fell completely into bear territory and the NASDAQ even further into the bear's territory. Even the S&P hit an intraday low that was 20% down, so its stop right at the edge by the end of the day is nothing but a rounding error.
In terms of real cost, anyone who scoffed at my 2018 warnings and held their stocks through 2018 is still recovering from his or her losses. That we have only just this week recovered those losses is quite easily proven with one simple graph of 2018 where the breakdown begins in January where I said it would and hits full crash velocity in the fall:

And, technically, we're still in the bear market, as we've recovered to the point where the market broke all to pieces in January 2018 but not to the point from which the bear market began.
If you like wild financial roller coaster rides that end right back where you started, stocks were the place to be in 2018. Obviously, it was an extremely bumpy ride to worse than nowhere for those who bought and held in the market thoughout 2018. The year was, however, a completely pleasant financial ride for those who were in cash all year, which was the only major asset that performed positive for the year! (And, of course, if you are the rare prodigy who can accurately time every peak and every trough, years of high volatility can make you more money than a steady climb; but then you are a very rare bird with a very high tolerance for risk - some would say a fantasy.)
I can attest to the calm because that is where I sat out the turbulence, being someone who doesn't prefer bumpy rides to worse than nowhere. Moreover, those who jumped out at January's peak, as I did, and remained out of stocks for the rest of the year, could also have experienced a joy ride of pure gains over the past three months in the stock market, instead of wasting the whole rally on mere loss recovery.
Now the losses are finally made up, and so reported here, but that doesn't diminish the risk of a 2019 recession. On the contrary, US stock market crashes usually correspond with a recession, but often happen before or after the recession:
In the US, most analysts agree that bear markets and domestic recessions have generally been fairly closely related, though the exact leads and lags between the two may differ considerably across cycles. Furthermore, there have been several bear markets, notably in 1987 and 1978, that have not been accompanied by recessions, and vice versa.

That is not to say the stock market will make it back up to its record summit ( or not go deeper into its polar region than in December; but, whether it does or not, a 2019 recession is in the making.
What will spark the next bear market? An economic recession, or the anticipation of one by investors, is a classic trigger, but not always. Another trigger has been a sharp slowdown in corporate profit growth, as we are seeing now…. Stock market pundits are widely divided about the nature of the next bear. For example, Stephen Suttmeier, the chief equity technical strategist at Bank of America Merrill Lynch, has said he sees a "garden-variety bear market" that will last only six months, and not go much beyond a 20% dip, per CNBC. At the other end of the spectrum, hedge fund manager and market analyst John Hussman has been calling for a cataclysmic 60% rout.
Whatever continues to play out in the stock market, the main economy now steps into the forefront of the picture for me. The stock market's 2018 trip on the Polar Bear Express already did its damage to investor confidence and pushed fleeing money into bonds, bringing long-term bond interest down, even as the Fed was dumping bonds, which should, otherwise, have pushed interest up. (After all, the Fed bought bonds in the first place to lower long-term interest.) That changed the bond market significantly enough to decisively align with recessionary sentiment in a historic bond inversion. And that makes 2018's bear market a game changer.
While bond-market inversion has never failed at predicting a recession in the last half century, that is not, by any means, the only reason I'm predicting a 2019 recession, which I did before the full inversion. I laid out in my first Premium Post the numerous headwinds that would likely assail the US and global economies in 2019, regardless of anything that happens in stocks. So, my attention this year moves along to those things and to the likelihood of a 2019 recession hitting around summertime (as noted before not to be officially declared until half a year after that because that is just a fact of how recessions are declared - always more than half a year after they start as we wait for the stats to come in).

We may well see a second crash in US stocks because of this year's recession, but whether we do or not is irrelevant now that we have already taken a trip with the bear. Another game-changing result of that excursion into the polar regions that happened because of the Federal Reserve's Great Rewind is that it proved to everyone the Fed cannot do what it has always said it could (and I always said it couldn't), which was to reduce its balance sheet and return to normal interest targets after building a fake (as in unsustainable) recovery. Therefore, confidence in the Fed is also badly shaken, leaving it weaker in its ability to lift us out of a 2019 recession than its bloated balance sheet and already-low interest rates leave it. At this time, the Fed's moves are just following the market's dictates. The Fed is now the market's bitch in nearly everyone's eyes.
Moreover, the Fed's damage to the economy is still coming in. I've noted before that there is typically a half-year lag between any major Fed action and where the economy goes; yet, the Fed is continuing to reduce its balance sheet by the same amount this month and next, cutting that by half in June but not stopping until the end of summer. That means there will be half a year of lagging results after this summer, even as the Fed's actions from this past winter are still playing out into this summer. With the Fed continuing to let more hot air out of the balloon until the end of summer, things certainly aren't going to get more buoyant. So, there is plenty of downdraft still to carry through the general economy all the way to the end of this year as a result of the Fed's recent and continuing actions.
My past statements about the next major economic downturn have always said the Great Recession will return like the undead because the Fed will go too far in sucking liquidity out of the economy. I believe the Fed has already done that, but the results of that withdrawal will take time to become fully realized. That's why President Trump and his two stooges of finance are begging the Fed to go back to QE "immediately" because, if they wait until it is obviously necessary, it will be WAY too late!
You see, any results from the Fed jumping back into full economic-stimulus mode - if the Fed does as the Trump administration demands and as most financial analysts and investors now appear to expect - will also take time to be realized … other than in stocks and bonds.

Moreover, any results they do get will have diminished returns at best. At worst, new Fed stimulus will now have an opposite effect if people are smart enough to realize it all means we are right back where we started and that Fed money-printing must now go on ad nauseam. So, the Fed has done its damage (which it really did by the recovery path it chose), and the bond market knows it. For stocks, as I laid out in that first Premium Post, this will be a year of turmoil whether stocks are generally up or down.
Now on to the talking points throughout the past week's news that show we are, as I've claimed, goose-stepping our way into a 2019 recession as metrically as the ticking of a coo coo clock:
Tick tock goes the clock, counting down to a 2019 recession
The U.S. private sector added 129,000 jobs in March, the weakest reading in 18 months and below consensus expectations of 165,000, according to an Econoday economists survey. The report is watched for clues to official labor data due Friday.
New hirings around 120k or less are usually recessionary.
Following last month's weak ADP print which front-ran the dismal "must be an outlier due to weather, shutdown, or anything else" payrolls data, expectations were for a slightly weaker ADP employment headline in March. However … ADP disappointed, adding just 129k jobs in March (well below the expected +175k…. This is the weakest growth in employment since Sept 2017.

On the other hand …
The BLS reported that the US added 196K payrolls in March, higher than the 177K.
Since the job reports are all over the place, it's hard to know who to believe - the ADP or the government's Bureau of Lying Statistics. You may recall that February's jobs came in at an extremely disappointing 20k, which the BLS just revised upward to an almost equally disappointing 33k. To sort out the messy disagreement in job statistics, consider the following for the BLS's more optimistic numbers: If you average all three months of the first quarter, 2019 is down from 2018's average for the first quarter by a fairly significant 40,000 jobs per month. Annualized, that would be the lowest level in almost five years! So, even the better BLS numbers are not the numbers you want to see if you believe the Trump Tax Cuts and government hyperspending - now in effect for more than a year - are taking the economy upward! Kocain Kudlow must have lasting damage from his old habit in order to call this a strong economy, even as he begs for more immediate Fed assistance. No wonder he's begging!
Meanwhile, 2019's rise in continuing jobless claims is the worst we've seen since the start of the Great Recession!

The overall unemployment rate just started trending back up as well:

Those little upticks at the end of each graph may seem insignificant, but they are actually highly significant because the first uptick in unemployment downtrends from a low bottom always immediately precedes a recession:
St. Louis Fed

That means two of the most accurate predictors of recession, according to the Fed - yield-curve inversions and unemployment trend changes - are now lined up on the same side for a 2019 recession.
On average, since 1969, the unemployment rate trough occurred nine months before the NBER-determined recession trough, while the yield curve inversion occurred 10 months before…. The minimum lead times were one month for the unemployment trough and five months for the yield curve inversion.
On the downside of the above jobs report, wages (which had been seeing a little better improvement, albeit briefly) fell off badly to just a 0.1% gain. Manufacturing jobs within this report also dropped significantly; so, on to manufacturing statistics of the week just passing …
Markit's March services purchasing managers index [PMI] came in at 55.3 above consensus expectations of 54.8, according to FactSet. A reading of at least 50 indicates improving conditions.

Pretty good except …
US Manufacturing PMI dropped to weakest since June 2017
So, services up but manufacturing well down … and …
The Institute for Supply Management's services sector gauge fell to 56.1% in March, down from 59.7% in February.

A broad slide in manufacturing - as verified in both the jobs report and the PMI - is more likely to bring a 2019 recession than the converse rise in health-care and education jobs is likely to bring economic salvation.
Moreover …
In a world where Caterpillar is considered a global industrial bellwether and a key indicator of economic inflection points … today's downgrade of Caterpillar (NYSE:CAT) by Deutsche Bank is a harbinger that the recent risk on euphoria may be coming to an end….. Dilllard says that "synchronized global growth has collapsed, the China Land Cycle is rolling over (and will continue to weaken despite the single positive data point this week), Europe is slowing more than expected and the US is oversaturated with construction equipment…. Together this synchronized slowdown will not only usher in a negative earnings revision cycle, but also make 2019 the cyclical peak.

Then again …
The Financial Times reported that the U.S. and China were nearing the final stages of trade talks (paywall) and had two issues left to resolve - the current tariffs on Chinese imports and details on an enforcement mechanism to keep China compliant with the deal.

US stocks jumped euphorically this week upon China's PMI (manufacturing index) getting a mild bump; but, in fact, a rise to 50.5 is not considered expansionary for China's economy, but merely flat; and that tiny bump came after a huge one-off bump in credit by the People's Bank of China, now mostly used up.
Meanwhile, other Asian countries are fully in a manufacturing contraction. PMI throughout European nations also continued to plummet.
Autos, retail and housing continue to sputter "2019 recession"
Auto sales in the U.S. wrapped up an ugly first quarter with dismal results for the month of March as the buying frenzy from last year's tax cuts wore off and the economy continues to decelerate…. General Motors saw deliveries drop 7% for the quarter, with all four brands falling…. Fiat Chrysler sales fell 7.3%…. Ford sales were down 5% in March….

All other major manufacturers with plants in the US were down, except Honda. Even pickup sales - a formerly hot performer - are sputtering.
Another area where the jobs report fell off was in retail. Only two periods in retail sales looked as bad as the present - the dot-com crash and the Great Recession crash:

And that is including online sales!
One more highly accurate indicator the Fed gives for timing a recession is a decline in housing:
Housing downturns have preceded every U.S. recession since World War II. For example, one measure of the momentum of residential investment turned negative before each of these episodes…. Recent movements in several housing indicators - mortgage rates, existing home sales, real house prices and the momentum of residential investment - resemble those seen in the late stages of past economic expansions. Could these storm clouds gathering over the housing market be signaling a broader economic downturn in 2019 or 2020….? Each of these indicators is in a range that, in previous cycles, preceded a recession by a year or two.
The hottest housing markets are still cooling, which doesn't bode well for jobs in construction either (where job growth remained moderate in the latest reports):
Listing prices are declining in what were some of the hottest housing markets in the country…. For instance, the median asking price in San Jose, California, was $1,100,050 in March - the highest of 500 metro areas, but down 11.6% from a year ago. Median asking prices in Denver and Boulder, Colorado, experienced similar declines. The median asking price declined the most year over year in Lynchburg, Virginia, plunging 37% to $145,000. Overall, 114 of the 500 markets surveyed saw a drop in the median listing price. On the other side, smaller markets in the middle of the county experienced the largest increases in asking prices.
This is all just this week's news!
Elsewhere, the Canadian housing market is falling hard (just a fun FYI, not that it has anything to do with a US recession … but certainly fits the picture of a simultaneous global recession:
The Real Estate Board of Greater Vancouver (REBGV) reported today … the lowest sales total for [March] since 1986 - down 31% from a year earlier and 46% below the 10-year March sales average.
And Australia's is looking precarious:
Australia's housing boom/bubble could unravel badly. Last week, Grant Williams highlighted a video by economist John Adams, Digital Finance Analytics founder Martin North, and Irish financial adviser Eddie Hobbs, who say Australia's economy looks increasingly like Ireland's just before the 2007 housing collapse.
Elsewhere on the global recessionary front, German industrial orders just took a slam to a level Germany hasn't seen since the Great Recession, and Germany can always be counted on as doing better than any other part of the EU:

Germany estimates that, if Brexit doesn't happen neatly, Germany's own numbers will get much worse.
On the other hand …
Global recession fears are exaggerated and … a recovery is most likely in store for both China and the Eurozone in the next several months.
Sure. And what was this bit of good news based on?
While the financial media continue to fret over the global slowdown, a salient piece of good news having positive economic implications was largely ignored…. The good news is that at the end of the first quarter last week, the S&P 500 Index registered its best start to a year since 1998…. In years when the SPX was up strongly and didn't suffer a significant decline in the first three months, it nearly always finished higher at the end of the year.
Yeah, that'll do it. We're safe from a recession in 2019 now. You can all go back to sleep. However, bear in mind, that assurance comes from a permabull who calls last year's stinging bear market "a 20% correction," making him, I think, the only person on earth who defines a 20% plunge that radically changes the course of the Fed and sets up a bond inversion as a "correction." That man is from mars.

Why we NEED a 2019 recession
I am reasonably confident the few people (if not the only person) who mocked my prediction of a stock market crash in 2018 and of a housing downturn, both of which hit on every beat throughout the year, aren't going to do any better betting against me on a 2019 recession.
I know that sounds smug, but here's why I don't care: I like to taunt them into trying to because, when this all proves out just as 2018 proved out, it all goes to demonstrate that the massive failure of the Fed's fake recovery was as predictable as I've always said. The Fed's plan is going to fail; it was always obvious it was going to fail; and it is now, in fact, failing in exactly the manner I've said it would.
What I really want to do is utterly destroy the Federal Reserve's unmerited credibility and, with that, its centralized planning and manipulation of the global economy as well as its rigging of stock and bond markets. I want to see Capitalism rise again from the Fed's ashes. To that more important goal, I think a big, fat recession in 2019 could be the best thing that ever happened, even though it would be the worst thing that ever happened.
So, bet on the Goliath Fed, or bet on this little David. The Federal Reserve went down hard last year even as each of my little stones hit their mark (stock-market crash, Carmageddon, Retail Apocalypse, and Housing downturn). So, the Fed bears some disgrace by lying flat on its face already. Now, it's time to cut off its head, which it will do for me when the 2019 recession starts to undo the whole well-Fed world, and Father Fed is helpless to prevent it.

The Challenge of Monetary Independence

By shadowing the US Federal Reserve so closely, Latin American countries are foregoing the policy flexibility that their floating exchange-rate regimes are intended to allow. They also risk relying too heavily on possible US interest-rate cuts to boost their economies, and not enough on deeper, long-term reforms.

Andrés Velasco

LONDON – The United States Federal Reserve has done it again. In 2018, the prospect of higher US interest rates sent emerging markets into a tailspin. But so far this year, indications of a more relaxed Fed stance have boosted emerging-market currencies and stock markets, despite concerns about a possible US-China trade war, economic slowdowns in most major economies, and rampant populism.
Around Latin America, currencies and central banks are enjoying a much-needed breather. Markets had been anticipating tighter monetary policy in a number of countries, including Chile, Peru, and Mexico. Now, the talk is of a wait-and-see approach before withdrawing monetary stimulus.

Even in Argentina, still battling the twin evils of high inflation and low investor confidence, the more benign external scenario allowed for a sharp, if short-lived, reduction in peso interest rates.

By shadowing the Fed so closely, Latin America’s central banks are foregoing the policy flexibility – or so-called monetary independence – that their countries’ floating exchange-rate regimes are intended to allow. What’s more, policymakers risk relying too heavily on possible US interest-rate cuts to boost the region’s economies, and not enough on tougher structural reforms and export-promotion measures.

In theory, a country with a floating currency can use local interest rates to smooth domestic inflation and output, while letting the exchange rate rise or fall as needed to achieve external balance. This is why most emerging markets have moved to floating exchange rates, and why the fixed-but-adjustable pegs once so common in Latin America are now mostly a thing of the past.

The change is broadly considered to have been a success. But practice is turning out to be quite different from what theory would predict.
When the US raised rates last year, Latin America was expected to follow. Now the Fed seems to be pausing, and so are the region’s central banks. What is going on? What happened to monetary independence? Weren’t local conditions supposed to determine local interest rates?

Not really. Although currency movements that absorb shocks are a good thing, central bankers seem to believe that too much of a good thing can become bad. To borrow the memorable title of a paper by Guillermo Calvo and Carmen Reinhart nearly two decades ago, they suffer from “fear of floating.”

So when US rates rise, putting downward pressure on local currencies, emerging-market central banks tend to follow the Fed’s lead. This is partly to limit inflationary pressures, because local-currency depreciation makes imported goods more expensive. Emerging-market central bankers also want to protect the balance sheets of local banks and companies, which tend to borrow in dollars and will face greater difficulty repaying if the local currency falls.

Now that the Fed has signaled a loosening of its stance, Latin American policymakers will probably follow the US lead again. For starters, most countries in the region are more worried about slow growth than inflation these days, and do not want their currencies to appreciate sharply. Possible Fed easing therefore gives policymakers the chance to inject some additional monetary vitamins into Latin American economies with little or no risk of higher inflation.

Argentina’s recent experience highlights another reason to cut interest rates as soon as the Fed does. Starting in the second quarter of 2018, local rates had increased sharply to contain rising inflation and prop up the plummeting peso. But the record rates (as high as 60%) were causing central-bank debt to snowball, a phenomenon economists call “unpleasant monetarist arithmetic.” So, as soon as the Fed began sounding dovish, Argentina’s central bank cut rates, hoping to prevent the debt snowball from getting even bigger.

The view that most countries’ monetary policies are really made in Washington, DC, has been around for a while. Hélène Rey of the London Business School has argued that local financial and credit conditions reflect what the Fed does, almost regardless of the exchange-rate regime. This idea of a “global financial cycle” is plausible, but remains controversial.

The good news is that most Latin American economies are better prepared nowadays to deal with US interest-rate changes. In the past, the region’s central banks had little choice but to follow Fed rate rises, because they needed to attract enough foreign funds to finance large current-account deficits. But nowadays, Latin America’s main economies run much smaller external deficits – usually 1-2% of GDP – and are therefore far less dependent on foreign finance.

The bad news is that these smaller Latin American deficits reflect relatively low investment rather than high levels of saving. Growth around the region has been lackluster since the commodity boom ended five years ago and seems likely to remain so for the foreseeable future.

Complacently relying on looser US monetary policy to manufacture the region’s next growth spurt will not help. The Fed’s magic punch may be tasty, but it is no substitute for the deeper, long-term economic reforms that Latin America urgently needs.

Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities.

Alliances Shift as the Syrian War Winds Down

The countries that aligned to help protect Assad may be reconsidering their allegiances.

By George Friedman


Last week, Israeli Prime Minister Benjamin Netanyahu announced that Israel and Russia had agreed to cooperate on withdrawing foreign forces from Syria. If confirmed, it would mean that Russia has agreed to force the Iranians out of Syria, a significant development for both Israel and the Syrian war itself. It’s even more critical given that another round of talks between Turkey, Iran and Russia to find a settlement to the war is looming.

Russia has yet to confirm or deny Netanyahu’s comments, but it seems unlikely the Israelis would put Russia on the spot this way if they weren’t true. Israel wants Iran out of Syria, but it also wants accommodation with Russia. And the two countries have already shown some degree of cooperation in their Syrian operations. Israel has likely provided Russia with advance notice of its airstrikes on Iranian targets in Syria, and so far, Russia has not blocked or, as far as we can tell, notified the Iranians about the strikes. In addition, Turkey, one of three countries negotiating an end to the conflict, appears relatively calm on the subject. Around the time Netanyahu made the announcement, Turkey’s pro-government Daily Sabah newspaper published an article dispassionately analyzing Russia’s relationship with both Israel and Iran in Syria. It seems clear Russia has indeed agreed to push foreign forces out of the country.

Before we can understand why Russia would do this, however, we need to understand why Russia went into Syria in the first place. The official explanation was that it wanted to protect Bashar Assad, a longtime Russian ally. But this explanation is hard to buy as Assad’s government is not strategically important to Moscow. Some have speculated that Russia was really trying to secure naval bases in Syria. The problem with that explanation is that supplies for a significant Russian naval squadron in the Mediterranean would have to flow through the Bosporus, which is controlled by Turkey. Turkey and Russia have an extraordinarily complex relationship, and the Russians simply could not rely on Turkish cooperation to supply the squadron in the event of war. Russian bases at Syrian ports would also be highly vulnerable to U.S. attack. So that reasoning never made much sense. Another possible explanation was that Russia wanted to gain control of energy pipelines, but given the price of energy and the cost of Russia’s military intervention, that explanation makes little economic sense.

It seems more likely that Russia intervened to demonstrate that it could undertake significant operations in the Middle East. It wanted to deliver this message to the Americans but more importantly to the Russian people. It was a low-risk operation that involved limited forces and an attainable goal. The Russians did save Assad, and that in itself had some strategic value.

Turkey, meanwhile, didn’t want Assad to survive the war, but in the wake of the 2016 coup attempt, Ankara wasn’t eager to involve itself in a foreign conflict. It needed to get its own house in order first. So although there was always some tension and distrust between them – in part because of Russia’s coveting of the Bosporus and in part because of Turkey’s desire to project influence in the Caucasus, a region located on Russia’s doorstep – Russia and Turkey found ways to manage their relationship. They were content to keep out of each other’s way.

Russia, however, was willing to provide only air support and a limited number of special forces to help Assad. It didn’t want to inject massive ground forces to protect the Syrian government, especially not against potential U.S. incursions or Turkish involvement, should Ankara change its mind. Inevitably, the amount of resources Moscow devoted to Syria climbed, but it was intent on avoiding the U.S. experience in the Middle East.

In particular, Russia had no desire and limited capability to extend its operations to southern Syria and areas along the Iraqi border – the territory in which the Islamic State was operating. It needed someone else to handle IS. Enter Iran. It was active in fighting IS in Iraq and was also a close ally of Assad. Assad was a member of the Alawites, a Shiite sect of Islam, and Shiite Iran wanted to ensure its ally remained in power. But the Iranians also had strategic reasons for protecting Assad.


Iran, with its anti-IS operations in Iraq, had managed to project power beyond the Zagros Mountains on its western border. It already dominated Lebanon, whose major faction, Hezbollah, was an Iranian proxy. The Iranians were thus one country away from having an empire stretching from the Persian Gulf to the Mediterranean – which would make them the dominant country in the region, more powerful than the fragmented Sunni nations.

The one country missing in the Iranian project was Syria. While Russia wanted to limit its exposure there and supported Assad for reasons having little to do with Syria itself, Iran had an overriding interest in destroying IS and saving Assad. This formed the basis for a logical alliance.

But the Russians were wary of cooperating with Iran because, like Turkey, Iran has interests in the Caucasus. The Caucasus guard southern Russia and are, after the buffer states in Eastern Europe, the most important region for Russian national security. Azerbaijan, Georgia and Armenia were part of the Soviet Union, but after its collapse, they became independent states. The North Caucasus remained part of Russia, but this included places like Chechnya and Dagestan that were occasionally difficult to manage and always capable of posing a challenge.

Azerbaijan, in particular, is a place that could present problems for Russia in the future. The Iranians have tried to project power in Azerbaijan through schools, propaganda and other sources of influence. A significant number of ethnic Azeris live in Iran today, mainly in the north, an area that was also occupied by the Soviets during World War II. Azerbaijan therefore is a complex place where Russia and Iran compete for power. If Russia dominated all of Azerbaijan, it would be an enormous threat to Iran. If Iran took control of Azerbaijan, it would be a dagger pointing at the North Caucasus.
Russia therefore doesn’t want Iran to build an empire stretching to the Mediterranean. In fact, it’s privately happy to see U.S. sanctions cripple Iran, though it won’t admit as much publicly. Russia needed Iran in Syria for a time, but as the saying goes, nations have no permanent friends or allies, only permanent interests. So, having saved Assad, it’s now time for the Russians to move the Iranians out of Syria and deny them their empire.

Israel would be content if Russia were to manage to push Iran out of Syria. The Turks don’t want to see Assad stay in power in the long term but will tolerate him in the short term. The United States has mostly let the conflict play out, showing for one of the first times since 9/11 that it can restrain itself in a major Middle Eastern issue. And Russia got the boost in prestige it was seeking, though it has myriad other problems to contend with at home. Assad, meanwhile, has survived the war thanks to the help of his closest allies. All things considered, he was the biggest winner of all.