Nose Blind to Inflation

By John Mauldin


The human brain excels at taking shortcuts. Processing all the information our senses collect takes a lot of energy, so repetitive data gets lower priority. Things we see often fade into the background so we can notice new stuff.

This is where we get phenomena like “nose blindness.” We stop perceiving familiar smells like our pets, perfume, cigarettes, and even our own body odors. But others do smell them, which can get awkward.

I think something like that may explain why the Federal Reserve doesn’t see the inflation others notice. Their data says inflation isn’t a problem, so they ignore indications otherwise. We see this in their policy decisions. And it’s not just the Fed; other central banks, Wall Street analysts, economists, and politicians have the same affliction.

The kindest thing we could do is tell these people about their, ahem, unattractive condition. They might not react well, but at least we will have tried. So that is what I will do today. I’ll show how, the Fed’s lack of concern notwithstanding, inflation is a serious problem for many Americans.

In addition to Federal Reserve officials, most economists look at yet another set of inflation data and argue that inflation is too low. From their perspective they are right. But that doesn’t mean that you and I aren’t experiencing inflation in what we buy.

Furthermore, the way we measure inflation has been changed many times over the years. It may be time to do yet another adjustment to our inflation measures to better reflect the economic reality of the average American.

Hedonic Fantasies

Today I’m talking about price inflation, i.e., changing prices of the goods and services we all must buy.

Price is, as we learned in Econ 101, the intersection of supply and demand. Prices change when one of both those curves move, which they do for many reasons. Monetary policy is a big one but not the only one.

Consumers and producers both have many constraints, such as wages and wage growth, disposable income on the one hand and cost of goods and actual demand for their products on the other hand. Somewhere in the middle they find balance, and that is where prices settle.

That’s the economic theory. In practice it is a lot messier since we have such a dazzling array of goods, services, people, and places. Not every market is equally efficient. Therein lies the problem: how to distill this complexity into one meaningful number?

Wonks tell us, with all sincerity, things like “the US cost of living rose 2.1% last year.” Really? To an actual numerical decimal place? On something as vague and as complex as inflation? Now, to give them credit, they are looking at the total national inflation rate and it is extraordinarily complex. They do the best they can.

But the inflation you and I experience? They don’t know that. They can’t know it, at least not with any precision because the cost of living is so individualized. Everyone spends their money differently, and the things they spend it on vary in price for many reasons.

That doesn’t stop the wonks from trying, of course, and it’s not entirely their fault. They work for policymakers who demand information. Whether it’s accurate information is less important than simply having something on which to hang their hats.

One of the most important economists of the last century was Kenneth Arrow. During World War II, he was tasked with predicting the weather on D-Day, when the Allies would attempt a beach landing in France. The weather would be critical.

Arrow told his commanding general there was an extraordinary amount of uncertainty for his prediction. The general answered, “We know that. But we need a number to work with. And you have to give us the number.” Talk about a no-pressure environment. Government statisticians, while maybe not feeling the same pressure, are also responsible for millions of lives since so much personal income is tied to that inflation number.

Note also, policymakers have preferences on what the number should be. Many government programs have inflation adjustments. Higher inflation forces politicians to make tough decisions about taxes, spending, and borrowing. These same politicians hire and pay the people who compile the inflation numbers. That’s what we would call in the investment world “a disclosable conflict of interest.”

Having said all that, I believe the analysts try to be fair and scientific. They have to work within boundaries that don’t always make sense. So we get crazy things like “hedonic adjustment.” That’s where they modify the price change because the product you buy today is of higher quality than the one they measured in the past.

This is most evident in technology. The kind of computer I used back in the 1980s cost about $4,000. The one I have now, on which I do similar work (writing) was about $1,600. So, my computer costs dropped 40%. But no, today’s computer isn’t remotely comparable to my first one. It is easily a thousand times more powerful. So the price for that much computing power has dropped much more than 60%. It’s probably 99.9%.

Louis Gave surfaced another example. According to Consumer Price Index data, a television set that cost $1,000 in 1996 is now $22. You can’t buy any such product today, but the fact you can spend the same amount of money and get a better TV depresses the inflation rate.
 


Source: Gavekal

 
They do the same thing for cars, as Peter Boockvar noted earlier this month.

Last week Edmonds.com said the average price of a new vehicle sold in 2019 was $37,183, a new record high and up 30% from where it was 10 years ago. Within today’s CPI, the price of a new car reflected a 2% increase in TOTAL since 2009. This is magically done via hedonic adjustments which discount the value of new add-ons with each subsequent iteration of cars.

Unfortunately the actual buyer of a car has to pay what the price is and that is why delinquency rates are rising (according to the NY Fed, loans 90 days late totaled 4.7% in Q3, the highest since 2011) and the average length of a loan is at a record high (Experian said in November that 7-year auto loans amount to 31.5% of new vehicle sales vs 10% in 2010). The average price of a car is about 60% of median income in the US and incentives in December were a record amount of $4,600 per vehicle on average according to JD Power.

The Fed relies on hedonically-adjusted data points and not the price that people are actually paying out of pocket.

 
Exactly. Hedonically-adjusted prices exist only in theory. They don’t reflect what people actually have a choice of spending.

Health insurance is another good example. CPI says it rose 20.4% in 2019. That’s a national average that could be much more depending on your age and location. But worse, is the policy you can buy now identical to the one available a year ago? Certainly not. It could have a higher deductible, narrower network, smaller drug formulary, and a wide variety of internal differences in coverage for various conditions, which you will never know unless you seek treatment.

The real price change is impossible to know. That 20.4% is a national average of local guesswork, bearing no connection to anyone’s reality.

It gets even more complicated. I quoted CPI above. The Federal Reserve actually prefers something called PCE, Personal Consumption Expenditures. The two indexes have different estimates of the appropriate basket. The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling. Social Security uses the CPI for adjustments. The Fed uses PCE when targeting inflation. PCE is generally lower, as we can see from the chart below.
 



Meaningless Averages

I mention cars and health insurance because they are two of the larger budget items for most households. And both are broader in reality. The car takes you nowhere unless you also buy fuel, insurance, and maintenance. Health insurance helps only after you pay your deductible and co-pays, which can be substantial.

But housing is the biggest single living cost for most people. Here again, the individual variation is so huge as to render national averages meaningless, even if they were accurate (and they’re not).

For instance, if you bought your home years ago with a fixed-rate mortgage, your personal housing inflation rate has been zero. Your monthly payment is the same as it was then. If you have a variable-rate mortgage you might even be paying less for the same house, depending on when you bought it, because your rate dropped.

But housing costs aren’t just mortgage payments because a house can be more than housing. If you’re lucky, it is also an investment that will give you a profit someday. Meanwhile, you get to use it as your home and avoid paying rent. CPI recognizes this. Its housing component is a combination of average rental rates and something called “owner’s equivalent rent (OER).” That’s the amount you would expect someone else to pay if you rented your home to them. You are, in effect, “paying” it to yourself.

According to the December 2019 CPI report, “rent of primary residence” rose 3.7% last year and “owner’s equivalent rent” rose 3.3%. Those two combined are about 33% of CPI. Do they reflect reality in any significant way?

Maybe. It depends on the kind of housing you need and where you need it. According to Apartment List, the national average increase in apartment rent was 1.4% last year. But it was considerably more in some places. Mesa, Arizona (Phoenix area) tops their ranking at 5.1%.
 


 
Those are apartments. House rental rates are something else completely, as are home and condominium purchase prices. As noted above, your home’s resale price has no impact on inflation unless you actually sell it, and even then it doesn’t show up in the inflation measure. But home values can give us a rough approximation.

CoreLogic data shows something interesting.


Source: CoreLogic

 
Price changes in the last year were highest at the low-priced end, up 5.6%., compared to 3.4% in the highest tier. But according to BLS, national average owner’s equivalent rent for homes of all prices rose only 3.3%. So that doesn’t fit and again, the national variation is dramatic. CoreLogic’s home price index rose 10.2% in Idaho and actually fell slightly in Connecticut.

Now, you might say the difference between 3.3% and 5.6% isn’t so dramatic. Remember, we are talking about a full third of the budget for most families. So if CPI has been understating housing costs by as much as it (hedonically) understates vehicle prices, it’s enough to make a difference—a dramatic difference if compounded over time. And especially if you are on Social Security or other inflation-adjusted income.

Desperate Ideas

The agencies don’t simply adjust their inflation measures on a whim. They have reasons, most of which make sense, but they add up to a number that doesn’t reflect actual experience. This causes policy errors and greater problems.

We have other, non-government inflation figures. One is the venerable ShadowStats, which adjusts the published CPI numbers using the methodologies the government itself used in 1990. That adjustment has its own limitations, but might be closer to the reality you experience.


Source: ShadowStats

 
Recently, the CPI under the old methodology has been running about four percentage points annually above the official numbers.

Another alternative measure is the Chapwood Index. Twice a year, Chapwood checks the price for 500 common consumer items (see list) in the 50 largest cities. As of mid-2019, the five-year average annual cost-of-living change in those cities ranged from 6.6% to 13.1% (in Oakland, CA, if you’re wondering).

That’s more dramatic and possibly overstated, even if you chop Chapwood’s numbers in half. And remember, they measure retail prices. If you measured wholesale items that businesses purchase, you might even see deflation.

Now, the people who sit on the Federal Open Market Committee aren’t foolish. They are aware of data limitations. So why do they persist in thinking inflation is under control or (shudder) look for ways to generate more of it?

To answer, I’ll summarize a very complex argument among economists. Forgive me if I oversimplify it.

Essentially, if you used ShadowStats or any other statistic showing higher inflation, you have to assert that GDP has been shrinking for 30 years. That is clearly not the case. The US economy has grown, albeit slower in the last 10 years, but we are certainly not in a constant negative 2% per year recession. Looking at actual nominal GDP (yet another imprecise measure), we are clearly growing.

Again, this can be very misleading to any individual. Your personal GDP may be either growing or shrinking. A lot depends on how your business is doing if you are a business owner, your salary or wages, etc. National GDP is the theoretical (and let me emphasize the word theoretical) total production of 330 million people.
 


Source: FRED

 
So, when economists say inflation measures are too high they are making a macroeconomic argument from top-down data. Others who argue inflation is significantly understated rely on bottoms-up data.

Both sides are arguing a particular point of view, using data to buttress their viewpoint. A man hears what he wants to hear and disregards the rest. I understand both arguments and they both make extraordinarily valid points, but for those of us living in the real world, are hard to swallow.

Nominal average weekly earnings for all employees rose 28% in the last 10 years. If we can believe that data, the average worker has roughly kept up with average inflation, if average inflation accurately reflects the cost of living. For many people it clearly hasn’t. So the average worker has probably fallen behind.
 
How much?

It depends on what you buy. Seriously.
 


Source: Gavekal

 
We started out talking about nose blindness. Most people don’t keep careful track of their spending and income. They don’t know their wages rose x% and spending rose y% in the last decade. They just know making ends meet is tough and getting tougher.

So if both the public and the Fed are nose blind to inflation, where does it take us? Nowhere good. But we’re going there fast.
 
 
Statistic

I believe the pressure on the average American can’t be expressed in wages or inflation. For most people, disposable income is where they live and breathe. Fixed costs, whatever yours are, eat into disposable income. That’s what we feel.

The yellow vest protests in France arose from a rather small increase in the (subsidized) diesel fuel price. Similar fuel-price protests recently swept Iran. Chile has had major riots in protest over public transportation costs rising a few pennies. Similar situations have occurred elsewhere.

Relatively small price increases for an item or two can be the straw that breaks the camel’s back. When disposable income is so tight that even a few pennies mean the difference between food for your children, or not, anger can explode into riots. The actual prices at stake may not be significant except they act as “the straw.”

I have serious concerns about how we measure GDP. We double count some items, not the least of which is government expenditures, making the economy seem bigger than it actually is. What we call inflation is an imprecise measure of an artificially created government statistic. When we measure “real GDP” we are using that imprecise measure on yet another imprecise measure of artificial government statistics called nominal GDP.

The irony is that we think we can measure GDP or inflation out to two decimal points. I have always contended anything to the right of the decimal point is simply economists trying to demonstrate they have a sense of humor. Like a weather forecast for D-Day, we need a number. But we should recognize the limitations.

Furthermore, remember that these measures are for 330 million people in an extraordinarily chaotic and complex society. We count some items and ignore others. Or we apply adjustments which aren’t real-world. As they say, your mileage may vary.

This is yet another reason the Fed shouldn’t be allowed to control short-term rates except in the most extreme circumstances, and then only to provide liquidity. The use of artificial measures to set the price of the most important commodity in the world (the interest rate of the US dollar) of necessity leads to imbalance and occasional crises. A low-interest-rate environment misallocates capital into financial transactions which are not necessarily productive. While it may make money for some people, it doesn’t add to the general well-being.

And that is not going to change. Those of us responsible for allocation of capital for clients and ourselves have to recognize reality and invest accordingly. All the while knowing that imbalances are increasing and we will eventually face a reckoning. Sigh…

Philadelphia, Dallas, and New York

I find myself in Philadelphia for a last-minute but worthwhile trip. I fly back Friday evening to Puerto Rico. I will now have to be in Dallas in two weeks and Shane wants to come with me. And I still have to get to New York at some point. And write my book and help plan a conference and, and, and…

The conference this year is going to be the best ever. The names we are lining up are impressive. Set your calendar for May 11–14 to be in Scottsdale, Arizona. We are limiting the number of attendees this year, so when you get the opportunity to register, I suggest acting quickly. That will likely happen in the next few weeks.

And with that I will hit the send button. You have a great week!

Your laughing at “statistics” analyst,

 
John Mauldin
Co-Founder, Mauldin Economics

The great Treasuries binge

Investors at home and abroad are piling into American government debt

Fiscal profligacy can continue for now, but is it economically sensible?



IN THE GOOD old days, America’s budget deficit yawned when the economy was weak and shrank when it was strong. It fell from 13% to 4% of GDP during Barack Obama’s presidency, as the economy recovered from the financial crisis of 2007-09. Today unemployment is at a 50-year low.

Yet borrowing is rising fast. Tax cuts in 2017 and higher government spending have widened the deficit to 5.5% of GDP, according to IMF data—the largest, by far, of any rich country.

It could soon widen even further. President Donald Trump is thought to want a pre-election giveaway. Fox News is awash with rumours of “Tax Cuts 2.0”. This month the Treasury announced it would issue a 20-year bond, which would lengthen the average maturity of its debt and lock in low interest rates for longer.

All this is quite a change for many Republicans, who once accused Mr Obama of profligacy, but now say that trillion-dollar deficits are no big deal. Democratic presidential candidates, meanwhile, are talking about Medicare for All and a Green New Deal. A new consensus on fiscal policy has descended on Washington. Can it hold?

Fiscal hawks worry that continued high levels of government borrowing will lead to economic chaos as the engine overheats. Many of them felt vindicated by the turmoil last year in the repo market, through which financial firms lend to each other. To buy Treasuries, investors must hand over money to the government. So rising bond issuance caused demand for cash reserves borrowed on repo markets to rise, sending rates soaring. The Federal Reserve was forced to step in to provide short-term funding.

Aside from that hiccup, however, markets have taken America’s debt binge in their stride. In recent months the yield on ten-year Treasuries has been below 2%. Interest repayments, as a share of GDP, are half the level of the early 1990s. That is despite there being a far higher stock of debt relative to GDP, a sign of investors’ voracious appetite for safe assets.

One source of this demand is investors at home. Much has been made of companies’ rising stock of debt. Yet America’s firms are now net suppliers of savings to the rest of the economy—probably because the money they have raised has been recycled to investors through dividends and share buy-backs. Those corporate savings have to be parked somewhere. Treasuries are an obvious destination.

Post-crisis reforms to the financial system have also played a role. Commercial banks, for instance, are now required to hold more high-quality liquid assets. Treasuries are an ideal candidate, points out David Andolfatto of the Federal Reserve Bank of St Louis. Meanwhile, a rule change in late 2016 has reduced the attractiveness of money-market funds that invest in corporate-debt securities. That, in turn, has increased demand for funds that invest solely in Treasuries.
Households have been saving more. When the financial crisis hit, families, fearing for their jobs and pay, began to stash money away. Despite the recovering economy they have not stopped, perhaps because of lingering economic uncertainty. The personal-savings rate is much higher than it was in the 2000s. In the past three years households’ holdings of public-debt securities have risen by 70%.

Domestic investors have soaked up two-thirds of the extra government borrowing since 2016. Foreigners have bought the rest, equivalent to $800bn-worth of Treasuries. As a consequence, America is now an even bigger net borrower from the rest of the world. Its current-account deficit has widened to around 2.5% of GDP.

It is no surprise that investors have an appetite for American debt. Policy uncertainty abounds, not least thanks to Mr Trump’s enthusiasm for threatening trade war. There are few other havens. Germany’s insistence on running super-tight fiscal policy means there is an undersupply of bunds, argues Brad Setser of the Council on Foreign Relations, a think-tank.

Traders moan that the market for Japan’s government bonds is illiquid.




Investors based in Europe appear to have been the most enthusiastic buyers (see chart). In part that reflects some countries’ large trade surpluses. In the past year Norway, a big oil exporter, has doubled its holdings. But that does not explain why Belgium, a country of 11m people, is one of the world’s biggest foreign buyers of Treasuries. Although official purchases by China look stable, some suspect that it is making some of its purchases through Belgian intermediaries.

Can America’s government deficit remain so wide for much longer? Some economists worry that loose fiscal policy at a time of low unemployment will cause the economy to overheat, rousing inflation.

That would force the Federal Reserve to raise interest rates, and push up government-borrowing costs. So far, though, there is little sign of that. Inflation is oddly soggy; the Fed cut rates three times last year.

America’s fiscal profligacy may be able to continue for now, especially if the Treasury borrows more at longer maturities. But whether it is economically sensible is a different matter. Despite all the loosening, long-term GDP growth is middling and productivity growth weak.

That may be because the splurge has been largely focused on tax giveaways, while federal investment spending has fallen as a share of government outlays. America’s fiscal policy may not be dangerous, but it may not end up doing much good.

Free Exchange

The costs of America’s lurch towards managed trade

China’s vow to buy more American goods carries the risk of waste and distortion




Standing before the global glitterati at the World Economic Forum in the Swiss mountain resort of Davos, President Donald Trump bragged of a “transformative change” to America’s trade policy. The newly inked “phase one” deal with China, he said on January 21st, would lower trade barriers and protect intellectual property.

He crowed about China’s promise to buy an extra $200bn of American services, energy, agricultural produce and manufactured goods over the next two years. He was not exaggerating. The agreement on a level of purchases, rather than on the rules of trade, does indeed mark a fundamental shift in American policy. But not one for the better.

America has embraced outcome-based rules in its trade relations before. Mercantilists like Mr Trump manage trade in two ways: either by restraining foreigners’ sales to America, or by encouraging them to buy more American goods.

In the 1980s American negotiators spent most of their efforts on the first, as they faced political pressure to contain a burgeoning trade deficit and became convinced that Japan’s trade practices were unfair. At their peak, these “voluntary” restraints affected around 12% of all exports to America, including cars, steel, machine tools, textile products and semiconductors.

Voluntary import expansions, where a trading partner agrees to import more, as China has, were less common. Most famously, Ronald Reagan’s administration negotiated a commitment from the Japanese government that 20% of its semiconductor market would be imported.

The aim was not so much to target the trade deficit directly, but to prise open what America thought was an unfairly closed market. The hope was that the intervention would jolt suppliers into investing in new economic relationships and lead to a sustained shift in trade patterns.

A generous interpretation of Mr Trump’s deal with China is that he is simply trying to do the same. He is not alone in feeling that China’s market shuts out outsiders, or that its policymakers do not always play fair. Veteran trade negotiators tell of haggling away one Chinese trade barrier, only for another to pop up elsewhere. (Economists recognise this problem as the difficulty of writing down a “complete contract” that covers every contingency.)

An outcome-based trade deal, tied to easily verifiable trade flows, should help to overcome distrust, and could force China to provide real market access. If it led to more investment in supply-chain infrastructure, then it could have lasting effects.

It could even be argued that managing trade with China would be easier than it was with Japan. Later attempts to repeat Reagan’s semiconductor tactic failed, as Japan’s government had grown tired of cajoling its private sector into changing its sourcing decisions.

It had no direct control over who bought the managed products, and had to resort to pleading letters to firms, as well as surveys asking about who they were buying from. By contrast, China’s government has the purchasing power of its state-owned enterprises at its disposal, and sway over the private sector too.




Dig into the details of Mr Trump’s new deal, though, and the risks of waste and distortion become clear. The agreed increase in sales to China is large and rapid.

According to an analysis by Chad Bown of the Peterson Institute for International Economics (with whom your columnist hosts a podcast), China has, in effect, pledged to increase its purchases of certain American agricultural products by 60%, and manufactured products by 65%, by the end of this year compared with levels in 2017 (see chart).

This must happen regardless of economic conditions in China. Whereas Japan agreed to increase the share of imported goods in domestic demand, China has signed up to buy fixed dollar amounts.

The risk is that China has promised to buy products that it either will not need or would rather get from elsewhere. State-owned enterprises could suck up American commodities and leave them to rot. American exporters, lured by higher prices to Chinese buyers, could switch from more sustainable relationships to ones that fizzle once their artificial advantage ends.

Or China could resort to logistical gymnastics to make it appear that it is buying American, such as by transporting goods from third countries through America. It could also have more American goods shipped directly to China, rather than through Hong Kong, so that they appear in the mainland’s trade figures.

Another danger is that China simply diverts trade from its other trading partners, prompting complaints that the biggest actors are carving up markets between themselves—and carving others out. Admittedly, members of the World Trade Organisation (WTO) are already allowed to agree on broad tariff cuts among themselves, which could lead to similar diversionary effects.

But trade deals are permitted, whereas discriminatory managed-trade arrangements are not.

And if, as Mr Bown warns, Brazilian and Argentine sellers of soyabeans or Russian and Canadian lobster-traders find themselves pushed out of China’s market, they are unlikely to react well.

Managed decline

If the deal sticks, it will threaten the world’s trading system. That system, ironically, is the result of America’s turning away from managing trade in the 1990s. Realising that it could not preach the virtues of free markets while itself practising something so different, America sought the creation of the WTO, as a shift towards a system based on rules rather than power.

Mr Trump’s presidency has consistently undermined those rules, and the deal with China again reinforces the idea that they do not matter. Now that he has won his share of the Chinese market, other countries may demand the same.

But the deal could also very easily fall apart, ushering in another round of hostilities. America is tightening its export controls, which could limit the goods available for China to buy. So, whatever the deal’s fate, disruption looks inevitable.

Whether Mr Trump will still be in office when that becomes clear remains to be seen. Official figures on whether China’s purchases have met this year’s target will not become available until early 2021, after the presidential election.

Basel derivative rules point to more pain for fund managers

Attempts at preventing ‘another Lehman’ will have limited upside for taxpayers

John Dizard

Christie’s employees walking into the auction rooms with the main sign from the Lehman Brothers office collection during a photo call at Christie’s in west London. PRESS ASSOCIATION Photo. Issue date: Wednesday September 29, 2010
Rules aimed at preventing ‘another Lehman’ threaten to freeze up capital flows and create an unintended systemic disaster © John Stillwell/PA Wire


Only a few days into the decade and finance people are being forced to confront another year of regulatory deadlines that will be impossible to achieve, in particular those imposed by Brexit, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

How about finding a way of not doing this to ourselves? 

On Brexit, we can only hope that each side is exhausted enough to abandon fantasies of a wealthy pirate ship or the bureaucratic destruction of London. Europeans need each other too much to indulge in revenge and domination. 

The Basel regulation mess should be easier to deal with than Brexit, as there seems to be less cultural and geopolitical noise intruding. But the post-financial crisis regulation has created a swamp of self-serving professionals masked as honest brokers, “fintech start-ups” and in-house profit centres. They do not want a solution for financial instability. They want career success for themselves. These are not the same thing.

There is a point in bureaucratic negotiations, as in war, where participants should realise that their maximalist demands and victory fantasies are pointless and destructive. For the Basel process, that would be now.

For the first years after the financial crisis, the global regulatory process was able to make real progress on reducing risk in banking and securities dealing. The rulemaking concentrated on major banks and dealers, as well as key pieces of financial market infrastructure. This made sense: those are the institutions that the public would be forced to bail out to save its own interest come the next crisis.

Also, the big banks, along with infrastructure bits such as the clearing houses, have the compliance bureaucracy and quasi-monopoly status that comes with their licensing. Top management of big banks can be reasonably expected to spend much of its time going to Basel, or mini-Basel, meetings on how banks should be regulated. 

But as the Basel regulatory process reached into asset management and operating companies, it has become self-defeating. By trying to turn every participant in the capital markets into a bank, Basel risks freezing up capital flows and creating an unintended systemic disaster.

I am thinking in particular of the uncleared margin rules (UMR) for derivatives transactions that are set to be imposed by next year on several thousand capital markets participants, most of them non-bank asset managers. The idea, easy to sell to the world’s politicians, is that we can avoid “another Lehman” by requiring a large number of investors to put up high quality liquid assets against their exposure to financial derivatives. 

Sounds good. Until you look at the details. Lehman was one of about a dozen key New York dealers, a bad apple at the centre of the dollar system. The Lehmans of the world are already covered by the Basel requirements intended to avoid another systemic disaster in derivatives markets.

According to the International Swaps and Derivatives Association (ISDA), the major institutions covered by the first phases of the UMR had already posted $170bn in two-way regulatory margin by the end of 2018. That margin comes in the form of high quality liquid assets that are segregated and unavailable for other purposes. 

But the planned extension of the UMR will cover not just top banks with taxpayer guarantees and a lot of staff, but many of their customers. BNY Mellon, the custodial bank, estimates the remaining phases of the Basel margin requirements will cover at least 640 institutions with more than 9,000 interconnecting relationships in the market. Based on my discussions with asset managers, there could be thousands of asset managers and companies that will be shocked to find out how many government bonds they have to put up as sterilised capital if they are to comply with the rules. 

Regulators already know this, as the UMR were originally intended to be in place by this September. Last July they were postponed until September of 2021. But that does not offer much relief, as counterparty banks and dealers will insist that a compliance process must be in place at least a year in advance.

The Basel compliance process favours banks and large dealers over asset managers and investors. For example, the mathematical model that ISDA endorses to calculate initial margin runs to 29 pages of equations. One of the effects of the “simplified” model, by the way, is to make it easier for banks to reduce the initial margin requirements that might otherwise burden their illiquid assets.

In other words, the Basel regulatory process has been partly captured by those it was intended to regulate. Asset managers and capital markets, which have taken away some of the banks’ capital allocation function, will now be burdened by higher technology and staff costs, and prospectively required to buy trillions of dollars in government debt.

This is not going to happen. Stop postponing initial margin rules — rethink the process in a realistic manner for non-banks.

The benefits are going to consultants, lawyers and therapists, not the tax paying public.

Banks labour under negative interest rates and ‘zombie’ loan threat

WEF assesses risk of corporate debt shock as fragile companies kept on life support

David Crow

FT Montage


When bank executives descended on Davos last year for the annual meeting of the world’s elite, they did so under a cloud. Just a day before the gathering began, UBS issued a profit warning after its predominantly rich clients pulled $13bn of assets from the bank.

Here was Switzerland’s largest bank and one of the top global wealth managers sending a distress signal from its own doorstep. The world’s wealthy had apparently turned bearish on the economy because of geopolitical tensions and sluggish growth.

It proved to be a sign of things to come. The outlook for global banks has since only deteriorated. In September, the European Central Bank cut rates further into negative territory, putting extra pressure on banks’ profit margins. The Federal Reserve cut US rates three times in 2019, reversing almost all of the increases implemented in 2018.

Moody’s, the rating agency, cited lower rates as one of the main factors behind its decision last month to change its outlook for global banks from stable to negative. Driving this are “rising global trade tensions [and] lower for longer or lowering interest rates, depending on the jurisdiction”, says Laurie Mayers, associate managing director at Moody’s.

Ms Mayers adds that banks are operating with “very high cost structures” that they are “struggling to bring down”.

Improving cost efficiency is particularly tough when banks are having to invest billions of dollars in new digital platforms to compete with fintech start-ups. The spectre also looms of Big Tech companies like Amazon and Google pushing further into financial services.

Other observers are less bearish. Analysts at Morgan Stanley recently turned positive on the European banking sector, though not because they predict a glorious period ahead, but rather because the worst might be over.

Magdalena Stoklosa, Morgan Stanley head of European banks research, notes that interest rates, in Europe at least, have probably reached their nadir. Few expect Christine Lagarde, the new ECB president, to implement further cuts.

“Yes, we are going to stay in this lower for longer structural backdrop and of course [profit] margins are going to be challenged,” Ms Stoklosa says. But she adds that, given the sense that rates may go no lower, “the confidence in earnings is much higher than it was a couple of months ago.”


Mandatory Credit: Photo by STEPHANIE LECOCQ/EPA-EFE/Shutterstock (10489796i) European Central Bank (ECB) President Christine Lagarde attends her first hearing by the European Parliament Committee on Economic and Monetary Affairs, a the European Parliament in Brussels, Belgium, 02 December 2019. European Central Bank President Christine Lagarde at European Parliament, Brussels, Belgium - 02 Dec 2019
New ECB president Christine Lagarde © Stephanie Lecocq/EPA-EFE/Shutterstock


Ms Stoklosa adds that in the third quarter of 2019, 80 per cent of eurozone banks managed to beat earnings expectations, albeit after they were revised lower by analysts. “Analysts have spent the last six months relentlessly cutting our earnings expectations for the banks, particularly for 2020. And I think we’re done, or we’re broadly there.”

Signs suggest that global regulators think that banks have enough capital, after a decade during which lenders were forced to build their buffers to prevent a repeat of the 2008 financial crash. The higher requirements have dragged on profitability, while crimping the amount of excess capital that banks can return to investors by way of dividends or buybacks.

The introduction of new global rules on capital — commonly known in the industry as Basel IV — had raised fears that the buffers would have to be built further when the standards are implemented from 2022. But Randy Quarles, the Fed governor in charge of financial regulation, last month told a congressional panel that overall capital levels at US banks did not need to rise. “We don’t believe that the aggregate level of loss absorbency needs to be increased,” he said.

The ECB is tweaking its rules to make it easier for banks to use debt rather than equity to meet the requirements, giving banks more leeway when deciding whether to return capital to shareholders. The Bank of England last month said it would consult on reforms that would “leave overall loss-absorbing capacity in the banking system broadly unchanged”.

“It looks like Basel IV will be the biggest non-event in the history of capital regulation,” says John Cronin, a banks analyst at Goodbody.

Even if some risks for banks do start to recede, however, there are new threats on the horizon.

They include a surge in loans to highly indebted companies that could quickly fall into difficulty in the event of a recession and struggle to make their repayments.

Last month, the Bank of England warned that the global stock of “leveraged loans” — which tend to be made to highly indebted companies, especially those owned by private equity — had reached more than $3tn, a 30 per cent increase since 2015.

The threats associated with leveraged loans have not escaped the attentions of the organisers of this year’s gathering in Davos. They have scheduled a session entitled “The Rise and Risk of Zombie Firms”. The programme asks: “With cheap money keeping fragile companies on life support, will a recession cause a reckoning in corporate debt?”

If the answer turns out to be an emphatic “yes”, bankers can count on more downbeat Davos gatherings to come.

Erdoğan Wades into the Libyan Quagmire

Turkey’s president, Recep Tayyip Erdoğan, is the epitome of today’s strongman political leader, but his decision to send Turkish troops to Libya may be a step too far. By the time his Libyan gamble sours, as it inevitably will, he will have run out of both luck and friends.

John Andrews

andrews7_Mustafa KamaciAnadolu Agency via Getty Images_erdogansarrijlibyaturkey


WINCHESTER, UK – Foreign critics of Turkish President Recep Tayyip Erdoğan deride him as a quasi-dictatorial megalomaniac. But Erdoğan – who was Turkey’s prime minister for 11 years before being elected president in 2014 – is now a reckless gambler, too.

In short order, Turkey will send troops to Libya at the request of the United Nations-backed Government of National Accord (GNA), which has been besieged in Tripoli for the last eight months by the advancing forces of Field Marshal Khalifa Haftar’s Libyan National Army (LNA).

This will be a military and diplomatic folly. Erdoğan already has the distressing example of the Syrian conflict on Turkey’s own doorstep. Does he really imagine that sending a few hundred – or even many thousand – Turkish troops to aid the beleaguered GNA will somehow resolve Libya’s tragic and bloody turmoil, itself the result of the 2011 intervention by foreign powers that toppled Colonel Muammar el-Qaddafi’s regime?

If Erdoğan expects either a GNA victory or an imminent peace settlement, he is deluding himself. Haftar’s well-equipped LNA has the support of Egypt, the United Arab Emirates, Saudi Arabia, Russia, and (at least covertly) France. With mercenaries from Russia and Sudan on his side, Haftar must feel rather more optimistic than Fayez al-Sarraj, the GNA’s prime minister. Support for the GNA from Turkey and Qatar, along with the fig leaf of UN recognition, weighs rather less in the military balance.

So, what explains Turkey’s entry into Libya’s dreadful conflict as yet another proxy warrior? One factor, often baffling to outsiders, is the ideological and political influence throughout the Middle East – or at least its Sunni Muslim parts – of the Muslim Brotherhood. Founded in Egypt almost a century ago, the Brotherhood favors a transition (peaceful, it has always maintained) to theocratic government. As its slogan proclaims, “Islam is the solution.”

That is a problem for the ruling families of Saudi Arabia, the UAE, and Bahrain, all of which regard the Brotherhood as a terrorist organization seeking to undermine their power. So, too, does the oppressive Egyptian regime led by President Abdel Fattah el-Sisi, who mounted the 2013 military coup that ended the Brotherhood’s disastrous year governing the Arab world’s most populous country.

Only Turkey – specifically, Erdoğan’s Justice and Development Party (AKP) – and tiny Qatar (very much at odds with neighboring Saudi Arabia) view the Brotherhood with enthusiasm rather than alarm. On the almost frivolous premise that my enemy’s enemy is my friend, the fact that Saudi Arabia, the UAE, and Egypt support Haftar is excuse enough for Turkey and Qatar to support Sarraj and the GNA.

The bigger reason for Erdoğan’s adventurism in Libya, though, is that it fits his desire for Turkey to play a determining role in its region for the first time since the demise of the Ottoman empire (of which Libya was once a part). On the surface, that ambition sounds reasonable enough.

Turkey has a population of more than 80 million, the second-largest military in NATO, and a relatively developed economy. It deserves to be treated with respect – which is why the European Union’s obvious reluctance to advance the country’s membership bid is a blow to Turkish pride.

But Turkey’s pursuit of its regional leadership ambition has come at a high cost. When the AKP came to power in Turkey almost two decades ago, Erdoğan’s mentor was Ahmet Davutoğlu, an academic who then became foreign minister and eventually prime minister. Davutoğlu was keen to expand Turkey’s influence abroad, but under the slogan “zero problems with our neighbors.”

How ironic, then, that Erdoğan has created problems with almost all of his neighbors. The EU cannot accept Turkey’s appalling record on human rights, especially following the military’s failed coup attempt of 2016. Israel cannot abide Turkey’s support for Hamas (which is aligned with the Muslim Brotherhood) in Gaza.

And virtually everyone is exasperated by Turkey’s policy in Syria, which features attacking the Kurds – the most effective fighters against the Islamic State – and ambivalence toward several jihadist groups. Significantly, Davutoğlu has broken with Erdoğan and formed a rival political party.

True, Erdoğan’s supporters can justifiably argue that Turkey has become a regional player to be reckoned with. The EU has to be financially generous, or else Turkey may let hundreds of thousands of Syrian and other refugees from war and poverty flood into Europe.

Russia and Iran, which both support Syrian President Bashar al-Assad’s regime, recognize that a settlement of the Syrian conflict will depend on Turkey’s acquiescence – hence the continuing three-party peace process that began three years ago in Astana, Kazakhstan.

Even the United States under President Donald Trump has had to eat a slice of humble pie: Turkey, regardless of NATO sensitivities and American economic threats, stands by its decision to buy a Russian air-defense system.

But the Libyan venture may be a step too far.

On December 5, the Turkish parliament ratified an agreement between Erdoğan and Sarraj that sets a maritime border between their two countries. The Turkish-Libyan deal ignores international law – as the EU, Cyprus, Greece, and Egypt have pointed out.

It also ignores geography, because the Greek island of Crete lies halfway between the two countries. And it threatens the January 2019 agreement between Egypt, Israel, Greece, Cyprus, Italy, Jordan, and the Palestinian Authority to exploit the gas reserves of the eastern Mediterranean.

Erdoğan is the epitome of today’s strongman political leader. But by the time his Libyan gamble sours, as it inevitably will, he will have run out of both luck and Friends.


John Andrews, a former editor and foreign correspondent for The Economist, is the author of The World in Conflict: Understanding the World’s Troublespots.

The Perfect Way to Play Geopolitical Risk: Just Don’t

Equity investors have largely been rewarded for ignoring international political ructions, despite suggestions that such risks are at an all-time high

By Mike Bird


Geopolitical risk has been on the tips of many tongues in financial markets in recent years, but selloffs in equity markets associated with moments of high stress are now notorious for the rapidity with which they reverse.

The U.S. airstrike againstMaj. Gen. Qassem Soleimaniand the retaliatory Iranian missile attacks on Iraqi bases containing U.S. troops now count among the dozens of short-lived geopolitical market panics after which rallies in risk assets have resumed within days, or even hours.

It is taken for granted that political risk has risen.

Indexes like the Economic Policy Uncertainty Index and Geopolitical Risk Index have climbed in recent years; the former set a record high in 2019. Those indexes move up or down in part based on the number of times certain words related to geopolitics or economic uncertainty are used in selected newspapers over a given month.

Those indexes run the risk of circular logic: being told by experts that geopolitical risk is rising leads, perhaps, to more reports of rising geopolitical risk by journalists, jacking the indexes up further.

Nobel Prize-winning economist Robert Engle isn’t so sure that geopolitical risk in markets is all that high right now. In his work, he analyzes the factors driving cross-asset and cross-country volatility. When something affects all asset classes across countries, the cause is likely to be geopolitical. By his measure, such international events haven’t been particularly severe at all in recent years.




A funeral procession for Maj. Gen. Qassem Soleimani in his hometown of Kerman, Iran, on Jan. 7. Photo: Erfan Kouchari/Associated Press 


A significant problem with the relatively small selloffs generated by clashes in the Middle East or North Korean missile tests is that they represent a compromise that is uncomfortable for everyone.

Some investors may believe a missile launch or an airstrike will spiral into something far worse.

Others might think the panic will be short-lived and normal service will resume shortly.

With such bifurcated views, a headline-grabbing event such as Mr. Soleimani’s killing will either be very costly for equities—a major conflict seriously affecting corporate earnings, oil prices and economic policy around the world—or it will cost almost nothing.

Either way, it is hard to make the argument that it is worth the handful of percentage points that it actually knocks off the S&P 500.

The phenomenon of rapidly-reversing geopolitical selloffs isn’t particularly recent. After the September 11, 2001, attacks, Iraq’s invasion of Kuwait in 1990 and the use of American ground troops in Cambodia in 1970, analysts at State Street Global Advisors note that the U.S. equity index returned to its pre-selloff level within less than a month.

In recent years, equity investors have done best when they have largely overlooked geopolitical stress.

Without special insight into the likelihood of brief crises developing into something much worse, that may be the best course of action for most.


For Turkey, a New Chapter in an Old Rivalry

By: Caroline Rose


Turkey and Greece, two of the Mediterranean's greatest rivals, have long sparred over dominance of the region. The center of gravity of this competition has been Cyprus, an island split between its Greek and Turkish occupants.

The island has immense geostrategic value, sitting at the crossing of the Eastern Mediterranean’s main sea lanes, regional energy markets and trade routes.

Control of Cyprus would give a country access to the island's valuable natural gas reserves and exploratory drilling rights, helping it project itself as the dominant Eastern Mediterranean power.

It’s for this reason that Turkey and Greece have accelerated their push to defend their maritime claims in the region. They have done so by employing two competing concepts that attempt to revive their imperial pasts: the Blue Homeland, a notion that harkens back to the Ottoman Empire’s glory days and that Turkey has used to justify expanding its reach farther into the Mediterranean Sea; and the Megali Idea, which implies Greek reestablishment of the old contours of the Byzantine Empire.

These concepts are not just rhetorical; they are part of one of the most complex, entangled geopolitical rivalries today.

But the dynamics of the Eastern Mediterranean are also complicated by other factors. Russia, Syria, Iran and Libya all have interests there. And the growing competition in the region has increased paranoia among Mediterranean powers over sea lanes, navigation and energy resources.

The end result has been a rush to delimit exclusive economic zones (regardless of legal parameters), formation of tighter alliances, escalation of the crisis in Libya and an emerging risk of military confrontation.

The last time the Eastern Mediterranean was under such strain was in 1967, when the Soviet Union formed the 5th Mediterranean Squadron, causing an escalation in tensions between the Soviets and NATO member navies.

With such significant geopolitical shifts emerging in the region, it’s necessary to take stock of its naval landscape: the players involved, their capabilities, their restraints and, most important, their intentions.

An Emerging Naval Power

With competition over offshore gas resources intensifying, Turkey has found it increasingly necessary to bolster its naval capabilities. The Turkish navy is considered one of the four strongest navies in the Eastern Mediterranean. (Greece, Israel and Egypt have the region’s other dominant maritime forces, and the U.S. Sixth Fleet and Russia’s Mediterranean Naval Force also have a commanding presence.)

But over the past two decades, Turkey has pushed to expand its naval capabilities, particularly since tensions in the Eastern Mediterranean have escalated, indicating an increasingly ambitious Turkish naval agenda in the years to come.

For much of the 20th century, naval development was not a priority for Turkey. The inward-looking foreign policy of Mustafa Kemal Ataturk and his successors, in addition to Turkey’s accession into NATO, led to a more limited naval strategy. Ankara didn’t feel the need to enhance its maritime capabilities beyond the ability to defend the Turkish Straits, the Sea of Marmara and the Aegean Sea.

One of Ataturk’s key principles was “peace at home, peace in the world,” an isolationist motto that allowed Ankara to focus on domestic infrastructural and social reforms. The current government has attempted to change this, beefing up the country’s naval capabilities with an accompanying neo-Ottoman narrative led by the Blue Homeland concept, in an attempt to revive what it believes is Turkey’s rightful place as a key naval power in the region.

Geography, however, remains a key constraint in its naval development. The Turkish coastline is long, and the country’s access to the wider Mediterranean is restricted by a series of Greek islands, some located less than 45 miles (72 kilometers) from Turkish territory.

The limited breathing room between Turkey and Greece makes it difficult for Turkey to focus on conventional naval capabilities, particularly since its primary imperative remains defense of its littoral waters.

The Turkish navy therefore has mostly been geared toward coastal defense with a narrow set of operational capabilities.

Still, Turkey has an interest in pushing its buffer zone farther out into the Eastern Mediterranean. Since 2014, it has used gunboat diplomacy – the pursuit of strategic objectives through acts of intimidation at sea – to protect its seismic and exploratory drilling activities across the Eastern Mediterranean, as well as its maritime trade routes. (Turkey conducts 87 percent of its trade through its ports.)

In fact, Turkey has been eyeing greater control of the Mediterranean since the 1970s. Its invasion of Cyprus in 1974, when it annexed 40 percent of the island in its first venture back into the Mediterranean since the collapse of the Ottoman Empire, was a pivotal moment. Since then, several geopolitical “openings” have given Turkey room to flex its muscle in the sea.

Greece’s financial crisis and inability to keep up naval defense spending opened the door for Turkish expansion in the region, while Ankara’s frustration with its dependence on foreign energy suppliers drove it to seek new sources of natural gas.

Turkey’s naval buildup has accelerated markedly in recent years. Its domestic industrial capacity has increased and its navy has been upgraded with retrofittings and new equipment, including cutting-edge propulsion, detection and navigation systems.

Since 2007, the country has tripled its military research and development spending, which totaled $1.2 billion in 2018. Its defense budget totaled $19 billion in 2019, an increase of 24 percent over the previous year.

In addition, Ankara has introduced the MILGEM program, an ambitious project to domestically produce frigates and corvettes for the Turkish navy. As an indication of just how ambitious this project is, the country plans to build 24 new ships – frigates, aircraft carriers (some compatible with the F-35B) and amphibious assault ships – and most are expected to be dispatched by 2023.

The country is also developing six new, slightly longer-range submarines and a series of destroyers for larger, sustained campaigns in the Eastern Mediterranean. Its acquisition of these types of vessels indicates a continuing need for convoy escort missions, as they can accompany Turkish seismic drilling ships in contested continental shelves where there is a risk of conflict between Eastern Mediterranean adversaries.

Turkey has also begun to promote its domestically manufactured equipment abroad in an effort to establish itself as a global arms exporter, which would give the country an economic boost and help it position itself as a Mediterranean industrial power. The expansion of Turkey’s defense industry is perhaps the single biggest development in Turkey’s naval advancement, which could pay dividends economically and strategically for years to come.

Ankara also hopes to begin adding more forward bases, including a naval base in Northern Cyprus, likely in the city of Famagusta close to the Iskele Strait. This base is the centerpiece of Turkey’s emerging maritime strategy, as it will allow Turkey to expand its naval logistics and drilling capabilities and conduct longer-range, long-term deployments deep into the Mediterranean.

In addition, the Turkish Republic of Northern Cyprus is renovating the abandoned Maras port in Famagusta at a cost of $10 billion, likely with Turkish support. The tempo of naval exercises has also increased. In early 2019, the Turkish navy hosted its second-largest drills, aptly named Blue Homeland, and conducted live-fire exercises in the Greek Cypriot exclusive economic zone.

And in May, Turkey will host its largest naval drills, dubbed the Sea Wolf exercises, in the Mediterranean, Black and Aegean seas. These developments all serve a symbolic as well as a strategic purpose: They send a clear message to Turkey’s rivals – namely, Greece, Israel, Greek Cyprus and Egypt – that it is a force to be reckoned with.

The Bigger Picture

While all of these moves to boost Turkey’s naval power may indicate that Ankara is increasingly considering the risks of a large-scale conventional conflict in the Eastern Mediterranean, it’s important to keep in mind that Ankara’s primary focus remains closer to home, especially the defense of its own coastline and Cyprus from threats posed by Greece and its allies.

It’s also worth noting that because of the naval limitations of Turkey’s main rivals in the Mediterranean, a full-blown conflict is extremely unlikely. Greece’s armed forces are estimated to total 360,500 personnel, half of Turkey’s roughly 735,000.

The two countries possess a similar range of submarines, patrol vessels, frigates and sea mine equipment, though Greece’s naval capabilities are more limited than Turkey’s, as many vessels have been decommissioned and are technologically obsolete. And since Greece’s financial crisis, naval modernization efforts have been sluggish.

Athens, however, has the advantage of having regional allies. Greece is a member of the recently launched East Mediterranean Gas Forum, which also includes Egypt, Israel, Greek Cyprus, Italy, Jordan and the Palestinian territories. While the consortium’s primary focus is energy resources, its members have increased naval cooperation and joint training.

Meanwhile, Egypt’s armed forces are larger than Turkey’s, and its naval assets are superior in both quantity and quality, since it boasts a greater number of helicopter aircraft carriers and patrol vessels. But only a few of its surface vessels and Type 033 Romeo-class submarines are serviceable, and the country has fallen behind with updates and refittings as its economy lags. 





Turkey also has its own limitations, which should cast at least some doubt on its prospects to be the undisputed naval power in the Mediterranean. It has nearly 200 naval assets, including frigates, submarines and patrol vessels, but most of them date back to the 1990s, some to the late 1970s, and require updating.

Moreover, Turkey’s possession of numerous short-range, fast-attack craft indicates a limited ability to engage in a distant, sustained campaign in the Eastern Mediterranean – including, for example, a mission to support Libya’s Government of National Accord, which Ankara agreed to assist with a troop deployment back in December.

Still, Turkey’s increased production of conventional naval equipment complimentary to the F-35 and drone capabilities, as well as its plans to bolster its forward bases in Somalia and Qatar and build a naval base in Northern Cyprus, reflects its growing intentions in the region.

Ultimately, to achieve greater power projection, what Turkey really needs is aircraft carriers, nuclear submarines and improved aerial defense to sustain supply lines and amphibious operations. So while it has made some ambitious moves and daring declarations of intent, it still has a long way to go.

For now, Turkey will continue to posture, posing as a dominant naval power while taking minor steps toward expanding its footprint in the Mediterranean.