Nose Blind to Inflation

By John Mauldin

Source: Gavekal

Source: Advisor Perspectives

Source: Apartment List

Source: CoreLogic

Source: ShadowStats

Source: FRED

Source: Gavekal

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?

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


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




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.”



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.