Markets reflect too much confidence in US-China trade deal

Investors learn not to rely unduly on central banks, but still show undue optimism

Mohamed El-Erian

© FT montage; Getty Images; Bloomberg

The more it changes, the more it remains the same.

Markets and central banks have been stuck in an unhealthy co-dependence since the global financial crisis. Spoiled by too many years of timely and significant liquidity support from central banks, investors have long transitioned away from their traditional role of pressing for favourable policy changes — their longstanding role of “vigilantes” — to happily backing policies that have narrow chances of delivering durable economic improvements.

While the market is evolving away from a sole reliance on monetary policy, the relationship that is replacing it calls for greater longer-term caution than many investors seem willing to embrace.

It is increasingly evident that investors are, at last, becoming less confident about the ability of central banks to stimulate growth, repress financial volatility and boost asset prices to ever higher levels — especially in risky asset classes such as stocks and high-yield bonds.

But, looking at market developments over the past month, overly optimistic policy expectations continue to have a material impact on asset price movements, raising interesting questions for both market and economic prospects.

While abandoning unquestioned faith in the ability of both the Federal Reserve and European Central Bank to support asset prices, investors have found a new way to profit. That is to anticipate good news on trade, in the form of an early and durable China-US truce that rolls back the tariffs imposed by both countries and lifts uncertainties in a decisive manner.

Yet the chance of this holding is slim. If it does, it would not be sufficient to compensate for a host of other cyclical and structural impediments inhibiting high and inclusive growth. With that, the risk is rising that economic and corporate fundamentals will fail to improve to the extent needed to validate already-elevated asset prices and avoid global financial instability.

While consensus expectations continue to look for a significant loosening of monetary policy by the Fed, the ECB, the People’s Bank of China and many other central banks — starting in September and playing over the subsequent months — fewer market participants and economists expect this to materially alter the darkening prospects for the global economy.

European growth continues to weaken, with this week’s manufacturing data out of Germany suggesting a deepening economic contraction. China struggles to come up with stimulus measures that are both effective in the short run and consistent with needed reforms over the longer term. Emerging market currencies continue to weaken, opening the door to destabilising debt dynamics. Even the US, the consistent economic bright spot among advanced countries, is showing pockets of weakness.

Yet stocks in the advanced world have mounted an impressive recovery from the lows of August. Some, like the major US indices, have climbed back to within striking distance of their all-time highs.

The driver of this widening decoupling between asset prices and underlying fundamentals has shifted from overconfidence in central banks to hopes of a durable resolution of trade tensions between China and the US, the world’s two largest national economies.

Two types of dynamics are driving such behaviour. The first is the growing influence of algorithms coded to look for favourable trade comments from American and Chinese officials. Once they move the markets — as they inevitably do — there is a tendency for retail investors in particular to be pulled in.

Yet more than the occasional partial and ad hoc signal is required to sustain the upward moves in prices. You need both durable tension resolution and greater adoption of pro-growth policy packages at the national, regional and global levels.

Whether viewed from the Chinese or US perspective, the baseline on trade continues to point to a further escalation in tensions notwithstanding the occasional ceasefire. Meanwhile, the headwinds to growth coming from elsewhere only grow stronger. And do not look for global policy co-ordination to act as a counter. The last G7, with its distinct lack of a collective statement, let alone collective action, highlighted the poor state of multilateralism.

Economic concerns are particularly relevant for Europe where uncertain politics in the largest five economies continue to hinder the implementation of impactful pro-growth policies, be they structural or cyclical.

The more these countries slow — and they will soon be collectively at stall speed or in outright recession — the bigger the challenges for other countries and the greater the pressure on the dollar to appreciate. That increases the prospects of two other risks also under-appreciated by markets: a currency war on top of the trade tensions, and financial instability undermining economic activity.

Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge

Gold Will Break Its All-Time High… and It Won’t Stop There

By E.B. Tucker, editor, Strategic Trader

I sat down for half a dozen media interviews this year where I called for $1,500 per ounce of gold in 2019.

In several cases, the hosts nagged me about my prediction, asking if I would stick with it. I did.

Last month, it hit my target.

What I’m telling you today and what I told those same media outlets last week is $1,500 is only the beginning for gold.

Because I expect gold to take out its previous high of $1,900.


In fact, as I told Kitco News last week, from there I see it hitting $2,200 – about a 50% rise from its current price of $1,508 per ounce.

The question reporters ask is, “When?”

“When” doesn’t matter to me. I’ll explain why.

All of the serious money I’ve made investing came through positioning for a big move and sitting tight. Trading is tough. In and out all the time can work over a short period. But the big gains come from sitting tight.

After hitting an all-time high in 2011, the price of gold fell 45% to a low of $1,052 in late 2015.
While the Obama administration and the Federal Reserve experimented with radical money policies, gold stayed stuck. Notice in the chart above it didn’t do much after hitting its 2015 low.

What’s bad for gold is unbearable for gold miners. They commit to projects assuming they’ll sell produced gold for $1,500. Then it falls to less than $1,100. That means the project is bankrupt before it pours the first gold ounce.

That period is over.

I can give you a list of anecdotal evidence as proof. Several large mining firms combined this year in order to survive. These were not bidding war takeovers. CEOs got over their egos and merged to avoid losing their companies entirely.

But we need more than strong anecdotes to risk money on the gold sector.

From our view, that’s why the chart of gold is so important. It’s how I determined $1,500 was an important target for gold this year. If it hit that target, which it did, I felt it was a green light to invest more aggressively for higher prices.

The gold chart below goes back to 2014. Notice that after gold hit its low in late 2015 (circled in red), each rally that followed registered a higher low. The pullbacks of 2016 and 2018 (also circled in red) each hit low points higher than the last. To us, this meant it was a matter of time before gold exploded higher.


Breaking $1,500 was the first test. Now, I expect it to correct, which is market speak for rest and get ready for the next leg higher.

That next move for gold will catch mainstream asset managers off guard. As I said above, I expect it to eventually take out its 2011 high. That’s why the current pullback in gold is the perfect time to position for what may come next.

Now’s the time to take advantage. You don’t want to be sitting on the sidelines during this gold bull market.

Inequality Is Holding Back the U.S. Economy

Rising inequality isn’t a problem just for those at the bottom of the distribution

By Justin Lahart

Shoppers at Miami’s Dolphin Mall. Data shows a growing divide between the haves and have-nots. Photo: Lynne Sladky/Associated Press

When it comes to money, America has always had winners and losers, but the widening gulf between the rich and the bulk of U.S. households may be making almost everybody worse off.

That includes investors.

Income data released by the Census Bureau on Tuesday showed that the median U.S. household—the one in the statistical middle—had income of $63,200 last year. That was a bit more than the $62,600, adjusted for inflation, that the median household made in 2017. And it is well above the $56,750 that new data, adjusted for methodology changes, show the median household made in 2014, when many Americans were still smarting from the aftermath of the financial crisis.

But the 2018 figure was basically even with what the adjusted data show for 1999. Considering that the U.S. economy grew by an inflation-adjusted 48% over the same period, that is more than striking. It reflects shifts in the economy by which upper-income tiers are capturing more of the economy’s gains. The top 20% accounted for 52% of household income last year, compared with 49.4% in 1999. A similar dynamic is going on with wealth; Federal Reserve data show a growing share of U.S. net worth accruing to the rich.

There is a heated debate over where income and wealth inequality stem from, with factors including globalization, the collapse of unions, changes in tax policy and rising demand for high-skilled over lower-skilled workers all seen as potential drivers. But the effects of inequality are just as important.

For starters, there are political considerations. The populism that President Trumpt apped into in the 2016 election was driven in part by a feeling among Americans that the economy was passing them by. Leading Democratic presidential candidates have embraced a smorgasbord of positions aimed at combating inequality that could pinch investors, including higher taxes on capital gains, raising the corporate income tax and treating carried interest as ordinary income.

Indeed, the Business Roundtable’s decision last month to change its mission to take into account “all stakeholders”—a group that includes employees, customers and society, as opposed to just shareholders—can be seen as a response to political environment in which attempts to undo inequality could put companies at risk.

But inequality may also change the way the economy works, points out Karen Petrou, who runs policy-analysis firm Federal Financial Analytics Inc. Rich people are less likely than others to spend additional income, for example, leading to reduced growth and inflation. And because the rich tend to invest that extra money instead, it can lead to increased asset prices.

Inequality might therefore have helped create the bind the Federal Reserve finds itself in, in which its easy-money policies have failed to ignite growth and inflation the way it expected them to. And for investors it may be creating an environment in which returns are increasingly hard to come by.

Did Dudley Do Right?

The New York Federal Reserve's immediate past president recently caused controversy by calling on the Fed to make it “abundantly clear" that President Donald Trump will bear "the consequences" of his fiscal and trade policies. But what does "abundantly clear" entail?

Barry Eichengreen

eichengreen132_Ramin TalaieCorbis via Getty Images_william c dudley

HANALEI, HAWAII – William Dudley, the immediate past president of the Federal Reserve Bank of New York, recently stirred up a hornet’s nest when he called for the Fed to consider the impact of its policies on the 2020 presidential election. In fact, Dudley performed a valuable public service by observing that Fed policy can influence politics, sometimes with profound implications for the course of the United States. But that doesn’t mean his recommendations were on target.

Dudley’s logic was straightforward. If the Fed cuts interest rates in response to Donald Trump’s disruptive trade-policy actions, the president may be encouraged to resort to more of the same. Trump believes that the US and China are locked in a trade war to the death. But he also has acknowledged that the stock market reacts negatively to his tariff threats, that trade-related uncertainty weakens growth, and that this damages his reelection prospects.

The worry is that if the Fed loosens policy, thereby minimizing an uncertainty-induced slowdown in investment and growth, Trump will feel free to escalate his China-focused trade attacks. As Dudley put it, the Fed should make “abundantly clear that Trump will own the consequences of his actions.”

The question is what exactly making it “abundantly clear” entails. Federal Reserve officials can explain that the president’s actions are forcing them to lower interest rates in order to fulfill their dual mandate of stable inflation and maximum employment. They can warn of the collateral damage of low interest rates, which harm Americans living on fixed incomes and raise financial stability risks by encouraging investors to stretch for yield. The Fed should flag these undesirable consequences without hesitation.

Fed officials should also emphasize that monetary loosening cannot fully neutralize the effects of trade-policy uncertainty. Many investments, once undertaken, are reversible only with difficulty, to the extent that they’re reversible at all. Investments predicated on the existence of global supply chains will be rendered worthless by a full-blown trade war. Equally, investments in local production, predicated on ongoing trade conflict, can turn out to be costly mistakes if commercial peace unexpectedly breaks out.

When trade policy is uncertain, miscalculations like these are unavoidable. Companies therefore have an incentive to delay investing until that uncertainty is resolved – whatever the level of interest rates. The central bank needs to remind Trump that it can’t entirely offset the macroeconomic impact of his trade war, no matter how much he wishes this to be so.

Dudley’s most provocative remark was that “there’s even an argument that the election itself falls within the Fed’s purview.” Seeming to suggest that the Fed should seek to influence electoral outcomes, this comment ignited ferocious criticism, and Dudley subsequently walked it back. Fed officials “should never be motivated by political considerations or deliberately set monetary policy with the goal of influencing an election,” he clarified.

But Fed policies do influence elections, and this indisputable fact has consequences for the central bank. Policy-rate reductions that head off an impending recession make Trump’s reelection more likely. In turn, his reelection implies slower growth in the medium term, insofar as it means continued erratic policies, commercial conflict, and uncertainty. How should a Federal Reserve, whose mandate extends to ensuring “maximum employment,” trade off short-term employment gains against longer-term employment losses?

This is a difficult question, not least because the Humphrey-Hawkins Act, which gives the Fed its mandate, specifies no timeframe for achieving it or a discount rate at which current gains can be weighed against future losses. But that conversation is unavoidable. Or at least it should be.

Much of this discussion can take place in private. But imagine now that the Democrats nominate a 2020 candidate with very different trade-policy predilections. Fed staff and governors will then have to formulate economic forecasts that describe two different paths for the economy depending on the outcome of the election. The Fed, as an agency accountable to the Congress, will face pressure to make these forecasts public. Once can well imagine the resulting tweetstorm of opprobrium accusing the central bank of partisanship and worse.

Should the Fed suppress or fudge its forecasts in order to appear apolitical? Doing so would be a dereliction of duty, which is to forecast economic scenarios and formulate policy accordingly.

The Bank of England faced an analogous dilemma when opining on the implications of Brexit for the British economy, and it was subjected to withering political attacks. Political flak and discomfort are part of the job description – and unavoidable when making public forecasts under such circumstances. Politicians will impugn central bankers’ impartiality. Unavoidably, controversy and reputational damage will follow.

In speaking out, Dudley conveyed another important message: the brickbats are worth bearing.

Were the Fed to pull its punches about the obvious risks US fiscal and trade policies now pose to the US economy, the reputational damage it would suffer would be infinitely worse.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era.

The Global Debt Bubble Enters It’s Blow-Off Stage

by John Rubino

People have been talking about a “debt bubble” for some years now. They’ve been right, of course, based on the combination of surging borrowing and plunging rates. But the bubble hasn’t stopped inflating, and recently it entered what sure looks like a terminal blow-off stage. Some highlights:

Though July, China’s total debt rose by $2 trillion, a year-over-year increase of 26%. And this month the Chinese government cut bank reserve requirements in an attempt to further rev up lending.

In Japan, the junk bond market is being constrained by banks so desperate for yield that they’re lending directly to companies previously considered too risky. See Japan Junk Bond Market Hopes Crushed by Banks Hungry to Lend.

A recent week of corporate bond issuance was “the biggest weekly volume to hit global markets on record,” according to Dealogic. US investment-grade companies raised $72 billion across 45 deals, equaling the total issued in all of August.

Numerous companies issued 30-year bonds with yields below 3%, which used to be the province of safe haven governments. Even Apple, which is sitting on an epic pile of cash, borrowed money.

At the other end of the spectrum, junk bond issuer Restaurant Brands, which owns the Popeyes and Burger King chains, sold 8.5-year bonds with a coupon under 4%, a record low yield for a US junk issuer.

In Europe sales of new bonds hit $1 trillion earlier than in any previous year. Fully a third of European investment-grade bonds (and some junk bonds) now trade with negative yields. And the ECB is expected to cut rates further at its upcoming meeting.

Why is all this happening? Three reasons:

1) Virtually all the world’s central banks are now easing, sending interest rates to record lows in most major markets. The lure of this ultra-cheap money is proving irresistible even to borrowers who don’t immediately need cash.

2) The world is looking increasingly scary, what with trade wars, military brinkmanship in Asia and the Middle East, and the hint of an incipient global recession. So a massive cash hoard is increasingly seen as a good thing to have.

3) Bubbles generally end this way, with everyone just giving up on self control and grabbing for one last piece of easy money.

All three of these rationales will probably turn out to be mistaken. But that’s just how it goes in financial manias. As Credit Bubble Bulletin’s Doug Noland notes, “It’s difficult to envisage a more manic bond market environment – at home or abroad.”