Year of the Octopus, Part 1

Greetings from Hong Kong, where the locals are preparing to welcome the new year on February 16. While 2018 is the Year of the Dog on the traditional Chinese calendar, on the nontraditional Mauldin calendar we call it the Year of the Octopus. I don’t know exactly what’s coming, but I’m pretty sure it has more than four limbs.

Photo: Getty Images
In last week’s letter, “Economy on a Roll,” I gave you my own fairly upbeat 2018 forecast. I think the US economy and markets will probably hold up well, thanks to tax cuts and deregulation – assuming the Federal Reserve gets no more hawkish than it already has.
That assumption may be a stretch, given the Fed’s changing composition, but I’m feeling optimistic anyway.
The one real potential wrench in the works that I did not mention last week was Trump’s actually enacting significant tariffs or tearing up NAFTA, which would cost millions of jobs and cause significant backlash. I am hopeful that mistake won’t be made.
This week and next we’ll look at forecasts from some of my most trusted friends and colleagues. I have so many that our project may even stretch into a third week. Some disagree with my own views – and that’s perfectly fine. I want you to see all sides so you can make good decisions for your own family and portfolio. I’ll let these forecasters speak for themselves in longer quotes than I usually allow, then add my own comments.
Before we start the trek, I want to mention that we’re closing the doors to the Alpha Society soon – on January 15, to be exact. While my instinct is to always keep doors open, the Alpha Society needs to stay exclusive in order to thrive. I talked about it in a two-minute video we recorded over the holidays. Please do me a favor and watch here.
I am looking forward to meeting many of my Alpha Society and VIP members in Hong Kong this Sunday late afternoon/evening. I always find such times to be great learning experiences.
Hunt: Chaotic System
Let’s start not with a forecast but with an important story about forecasts. It appeared on Ben Hunt’s always-excellent Epsilon Theory site last month, in a piece he titled “The Three-Body Problem.” Keeping it in mind as I read the various annual reports and year-ahead forecasts has proved quite helpful.
Ben’s wide-ranging essays are hard to summarize or excerpt in a way that captures their breadth and depth. I’ll give you a tiny snippet; but please, set aside some time this month to read the entire article. It is long but worth your while.
The Three-Body Problem is a famous example of a system which has no derivative pattern with any predictive power, no applicable algorithm that a human could discover to adapt successfully and turn basis uncertainty into basis risk. In the lingo, there is no “general closed-form solution” to the Three-Body Problem. (It’s also the title of the best science fiction book I’ve read in the past 20 years, by Cixin Liu. Truly a masterpiece. Life and perspective-changing, in fact, both in its depiction of China and its depiction of the game theory of civilization.)
What is the “problem”? Imagine three massive objects in space … stars, planets, something like that. They’re in the same system, meaning that they can’t entirely escape each other’s gravitational pull. You know the position, mass, speed, and direction of travel for each of the objects. You know how gravity works, so you know precisely how each object is acting on the other two objects. Now predict for me, using a formula, where the objects will be at some point in the future.
Answer: You can’t. In 1887, Henri Poincaré proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating.
This is a chaotic system, meaning that the historical pattern of object positions has ZERO predictive power in figuring out where these objects will be in the future. There is no algorithm that a human can possibly discover to solve this problem. It does not exist.
And that of course is the basic problem we have in economics and investing. When we say that past performance is not indicative of future results, that aphorism is more than just legalese.
I’ve written before about chaos theory and complexity economics. Such ideas can easily discourage us from even thinking about the future. Ben Hunt explains why that’s not the right response. The real answer is to think about the future differently.
With that prelude, let’s move on.
Gavekal Trifecta
If I had to rank economic forecasting groups (as opposed to individuals) for consistent quality, Gavekal would be high on the list. They publish a staggering amount of good research on wide-ranging topics. I especially like that they don’t have a “company line”: The Gavekal partners and analysts frequently disagree with each other, often with considerable vigor. Watching their arguments from the outside is a bit voyeuristic but enjoyable.
Here are just a few Gavekal snippets from the opening week of 2018. We’ll start with Anatole Kaletsky, who zooms in on inflation as this year’s key unknown factor.
Will inflation accelerate in the US, but not in other major economies? I think the answer is “Yes”, for the same reasons as above. However, I also expected inflation to accelerate and bond yields to increase last year. Instead, both inflation and growth ended the year exactly where they were.
The simple answer is that US unemployment is now 4.1% instead of 4.8%. I was wrong about 5% unemployment being a non-inflationary growth limit, and maybe 4% isn’t either. But whatever the exact number may be, the US is certainly closer to its non-inflationary growth limit now than it was a year ago. In addition, the Trump tax cuts, if they actually stimulate higher US consumption and/or investment (which they may not do by any meaningful amount) will add to US inflationary pressures, since new production capacity will take several years to boost non-inflationary trend growth.
My prediction of higher US inflation and bond yields last year was partly motivated by the expectation of Trump tax cuts. Since these tax cuts passed only two weeks ago, the risk of economic overheating also subsided. But 2018 could well be the year when Trumpflation actually happens, especially if Trump is emboldened by the tax cuts to follow through on his protectionist promises too. If the prediction of higher US inflation turns out to be right, it will be a game-changer, producing much more volatile market conditions and even greater under-performance by US equities and bonds relative to assets in Europe and Japan, where inflation is not a risk.The follow-on question, if Anatole is right about inflation, is how the Fed will respond to it. The ideal response would have been to start tightening about three years ago. That opportunity having past, the remaining choices are all varying degrees of bad.
Now let’s move on to Louis Gave, who gives us some stock market ideas at the end of a long, thoughtful essay on liquidity.
Putting it all together, 2018 does seem to be starting on a different note than 2017. While the bull market may not be in peril, it is a tough environment for a price/earnings ratio expansion to occur. Such an outcome usually relies on excess liquidity moving into equities. Yet in 2018, equity markets are more likely to be a source of liquid funds than a destination for them. It follows that if a multiple-expansion is off the table then equity gains will rely on earnings rising. The area where such an improved profit picture is likely is financials (higher rates and velocity) and energy (higher prices). The fact that both of these sectors presently trade on low multiples also helps.
If you want specific sector ideas, there are two good ones.
Personal aside: the corporate tax cut is estimated to add as much as $10 per S&P share to overall earnings, which should in fact contribute to an upward bias for stocks, at least by the end of the year.
Lastly, here is a note from Chen Long, who covers China for the Gavekal Dragonomics service.
From a financial market perspective, the biggest question is what the “key battle” against financial risk means in 2018 after a year of regulatory tightening throughout 2017. Some press reports of the CEWC [Central Economic Work Conference] claimed that the government is already soft-pedaling efforts to control debt, on the grounds that the communiqué made no specific mention of “de-leveraging” and that the early December Politburo meeting talked about “keeping macro leverage under control” rather than “de-leveraging”.
I disagree: the policy stance on leverage remains pretty much the same as it has for the past year or more. As I have repeatedly stressed, the “de-leveraging” goal pursued by Chinese policymakers is not a reduction in the gross debt-to-GDP ratio that many analysts focus on. Instead, Beijing wants to de-leverage the corporate sector (by cutting debt-to-equity ratios) and the financial sector (by cutting the claims that banks have on each other and on non-bank financial firms). The overall aim is not to bring down total nationwide leverage, but to reduce financial risk while maintaining credit support for the real economy (see The View Into 2018).
Seen in this light, the language from the latest meetings might represent a slight softening in tone, but certainly signals no policy reversal. The communiqué of the 2016 CEWC talked about making “corporate de-leveraging as a priority under the precondition of keeping total leverage ratio under control” – essentially the same as the statement from the December 2017 Politburo meeting.
Kotok: A Permanent Shift Upward
Swinging back to US markets, my friend David Kotok of Cumberland Advisors had some New Year’s Day thoughts on the Republican tax bill’s impact.
Once the transitional shock of yearend is absorbed, we think the tax bill will raise the valuation of US stocks. Simply put, the tax bill will generate a permanent shift upward of somewhere between $10 and $14 in the threshold of S&P 500 earnings. Once you adjust for that permanent shift, you may continue to factor in the earnings growth rate that you expect from a US economy that is going to grow at 3% instead of 2%. We believe that growth rate is likely for a couple of years.
So, S&P 500 earnings should range up to and then above $150 by the decade’s end.
They will do so while the Fed is still engaged in a gradualist restoration of interest rates to something more “normal,” whatever that word means. And those earnings will occur while a repatriation effect is unleashing $1 trillion of stagnant cash in some form of robust redistribution (dividends or stock buybacks) or as productivity-enhancing capex spending. Bottom line is no recession in sight for at least a few years; and low inflation remains, so interest-rate rises will not derail the economic recovery, nor will they alter rising stock market valuations.
Years ago we projected a 3000 level on the S&P 500 Index by 2020. Those writings are archived at We stick to that forecast.
That is considerably more bullish than most 2018 forecasts I’ve seen. Rather than argue with David, I’ll say this: Be ready for anything this year. The future is no more uncertain than it always is, but the consequences of a mistake are growing as the bull market and economic expansion grow long in the tooth. They will end at some point.
That means you need a strategy that will let you both participate on the upside and defend yourself when the bear appears. I reiterate that you should be diversifying trading strategies, not just asset classes.
Krugman: Return to Normalcy
Next we turn to Paul Krugman, who is not generally one of my favorite economists. I quote him this time because he sounds a lot like, well, me.
So we’re living in an era of political turmoil and economic calm. Can it last?
My answer is that it probably can’t, because the return to normalcy is fragile.
Sooner or later, something will go wrong, and we’re very poorly placed to respond when it does. But I can’t tell you what that something will be, or when it will happen.
The key point is that while the major advanced economies are currently doing more or less OK, they’re doing so thanks to very low interest rates by historical standards. That’s not a critique of central bankers. All indications are that for whatever reason — probably low population growth and weak productivity performance — our economies need those low, low rates to achieve anything like full employment. And this in turn means that it would be a terrible, recession-creating mistake to “normalize” rates by raising them to historical levels.
But given that rates are already so low when things are pretty good, it will be hard for central bankers to mount an effective response if and when something not so good happens. What if something goes wrong in China, or a second Iranian revolution disrupts oil supplies, or it turns out that tech stocks really are in a 1999ish bubble? Or what if Bitcoin actually starts to have some systemic importance before everyone realizes it’s nonsense?
That was from Krugman’s January 1 New York Times column, and his assessment is not far from my own view. I wrote the previous day that the economy is pretty good and will likely remain so until something makes it change course. Like Krugman, I don’t know when that will happen, or exactly how, but I’m sure it will.
The difference between us is that Krugman has made a remarkable turnaround since the imminent doom he predicted right after the election. In fairness, he utters a little mea culpa in this column, admitting that he let his political feelings distort his economic judgment. So I’m glad to welcome his Damascene conversion. I hope it sticks this time.
Rosenberg: “Pretty Late in the Game”
I don’t know any economic forecaster more prolific than David Rosenberg is. I don’t know how he even finds time to sleep, frankly. His Breakfast with Dave is often the same length as my weekly letters, and he writes it every working day.
Dave’s December 29 letter was a tour de force on world markets, which I can’t possibly summarize and do any justice to the original, so I’ll cut straight to his conclusion.
In other words, expect a year where volatility re-emerges as an investable theme, after spending much of 2017 so dormant that you have to go back to the mid-1960s to find the last annual period of such an eerie calm – look for some mean reversion on this file in the coming year. This actually would be a good thing in terms of opening up some buying opportunities, but taking advantage of these opportunities will require having some dry powder on hand.
In terms of our highest conviction calls, given that we are coming off the 101 month anniversary of this economic cycle, the third longest ever and almost double what is normal, it is safe to say that we are pretty late in the game. The question is just how late. We did some research looking at an array of market and macro variables and concluded that we are about 90% through, which means we are somewhere past the 7th inning stretch in baseball parlance but not yet at the bottom of the 9th. The high-conviction message here is that we have entered a phase of the cycle in which one should be very mindful of risk, bolstering the quality of the portfolio, and focusing on strong balance sheets, minimal refinancing risk and companies with high earnings visibility and predictability, and low correlations to U.S. GDP. In other words, the exact opposite of how to be positioned in the early innings of the cycle where it is perfectly appropriate to be extremely pro-cyclical.
So it’s either about investing around late-cycle thematics in North America or it is about heading to other geographies that are closer to mid-cycle — and that would include Europe, segments of the Emerging Market space where the fundamentals have really improved, and also Japan. These markets are not only mid-cycle, and as such have a longer runway for growth, but also trade relatively inexpensively in a world where value is scarce.
Dave gives us some geographic focus, and it’s mostly outside the US and Canada. He likes Europe, Japan, and some emerging market countries because they are earlier in the cycle.
He’s certainly right on that point, though I think we may differ on how long the cycle can persist. The past doesn’t predict the future.
For the record, in my own portfolio design, we are about 50% non-US equities. My managers are finding lots of opportunities outside of the US.
Wien: “Speculation Reaches an Extreme”
We’ll wrap up today with an annual tradition: Byron Wien’s annual “Ten Surprises” list. It always causes me a little cognitive dissonance because by definition you can’t “expect” a surprise. That aside, Byron’s list is always a useful thought exercise. Here it is.
1. China finally decides that a nuclear capability in the hands of an unpredictable leader on its border is not tolerable even though North Korea is a communist buffer between itself and democratic South Korea. China cuts off all fuel and food shipments to North Korea, which agrees to suspend its nuclear development program but not give up its current weapons arsenal.
2. Populism, tribalism and anarchy spread around the world. In the United Kingdom Jeremy Corbyn becomes the next Prime Minister. In spite of repressive action by the Spanish government, Catalonia remains turbulent. Despite the adverse economic consequences of the Brexit vote, the unintended positive consequence is that it brings continental Europe closer together with more economic cooperation and faster growth.
3. The dollar finally comes to life. Real growth exceeds 3% in the United States, which, coupled with the implementation of some components of the Trump pro-business agenda, renews investor interest in owning dollar-denominated assets, and the euro drops to 1.10 and the yen to 120 against the dollar.  Repatriation of foreign profits held abroad by U.S. companies helps.  
4. The U.S. economy has a better year than 2017, but speculation reaches an extreme and ultimately the S&P 500 has a 10% correction. The index drops toward 2300, partly because of higher interest rates, but ends the year above 3000 since earnings continue to expand and economic growth heads toward 4%. 
5. The price of West Texas Intermediate Crude moves above $80. The price rises because of continued world growth and unexpected demand from developing markets, together with disappointing hydraulic fracking production, diminished inventories, OPEC discipline and only modest production increases from Russia, Nigeria, Venezuela, Iraq and Iran.
6. Inflation becomes an issue of concern. Continued world GDP growth puts pressure on commodity prices. Tight labor markets in the industrialized countries create wage increases. In the United States, average hourly earnings gains approach 4% and the Consumer Price Index pushes above 3%.
7. With higher inflation, interest rates begin to rise. The Federal Reserve increases short-term rates four times in 2018 and the 10-year U.S. Treasury yield moves toward 4%, but the Fed shrinks its balance sheet only modestly because of the potential impact on the financial markets. High yield spreads widen, causing concern in the equity market.
8. Both NAFTA and the Iran agreement endure in spite of Trump railing against them. Too many American jobs would be lost if NAFTA ended, and our allies universally support continuing the Iran agreement. Trump begins to think that not signing on to the Trans-Pacific Partnership was a mistake as he sees the rise of China’s influence around the world.  He presses for more bilateral trade deals in Asia.
9. The Republicans lose control of both the Senate and the House of Representatives in the November election. Voters feel disappointed that many promises made during Trump’s presidential campaign were not implemented in legislation and there is a growing negative reaction to his endless Tweets. The mid-term election turns out to be a referendum on the Trump Presidency.
10. Xi Jinping, having broadened his authority at the 19th Party Congress in October, focuses on China’s credit problems and decides to limit business borrowing even if it means slowing the economy down and creating fewer jobs. Real GDP growth drops to 5.5%, with only minor implications for world growth. Xi proclaims this move will ensure the sustainability of China’s growth over the long term.
Whatever your predisposition, there’s plenty to both like and dislike in there. On #7, I think 10-year Treasury bonds at 4% or more will look like the end of the world to younger folks.
It’s been more than a decade since we saw any such thing, and at that point they were falling, not rising. But if he’s correct that CPI pushes over 3%, then bond yields have to rise.
Personally, I think I would take the other side of that bet. I think the yield on the 10-year actually has a chance to fall.
On another note: If Byron is right that “speculation reaches an extreme,” the resulting correction will be a lot deeper than 10%. I don’t think we are there yet and probably won’t reach that point in 2018. But we will get there eventually.  
All right, my stack of New Year’s predictions is barely any smaller, but we’ll stop here and pick up again next week.
Jet-Lagged in Hong Kong, Sarasota, and Boston
Shane and I are in Hong Kong, and the first 24 jet-lagged hours have been difficult, to put it mildly. But one soldiers on, and I did get my new shirts. This is the third time in six years I have visited the same tailor, and he was really surprised about the change in my neck size. It’s a full inch larger than it was two years ago. Now I again have shirts that I can button and wear a tie with.
When I get back I will spend one day in Sarasota (in and out) and then a few days in Boston.
I think I will forego making any personal remarks so I can relax a little before the evening’s activities begin. You have a great week.
Your hoping I can sleep tonight analyst,

John Mauldin

Inequality is a threat to our democracies

One possible development is the rise of ‘plutocratic populism’

Martin Wolf

Between 1980 and 2016, the top 1 per cent captured 28 per cent of the aggregate increase in real incomes in the US, Canada and western Europe, while the bottom 50 per cent captured just 9 per cent of it. But these aggregates conceal huge differences: in western Europe, the top 1 per cent captured “only” as much as the bottom 51 per cent. In North America, however, the top 1 per cent captured as much as the bottom 88 per cent. These extraordinary facts prove that aggregate growth itself tells us very little — indeed, in the case of the US, virtually nothing — about the scale of improvements in economic welfare for the population as a whole.

These striking data come from the World Inequality Lab’s recently released World Inequality Report 2018. The broad picture is one of convergence among countries and divergence within them. But the latter has not happened to the same extent everywhere. Thus, “since 1980, income inequality has increased rapidly in North America and Asia, grown moderately in Europe, and stabilised at an extremely high level in the Middle East, sub-Saharan Africa, and Brazil.” The report also shows that, after the second world war, shares of the top 1 per cent were relatively low, at least by prewar standards, across the west. But, since then, these shares have jumped in the anglophone countries, especially in the US, but little in France, Germany or Italy.

Walter Scheidel, a historian of the ancient world and author of the The Great Leveler, would say that rising inequality is just what one should expect. In this remarkable study, he argues that after agriculture (and the agrarian state) was invented, elites were amazingly successful in extracting all the surplus the economy created.

The limit on predation was set by the need to let the producers survive. Remarkably, many desperately poor agrarian societies approached this limit, the Roman and Byzantine empires among them. In times of peace and tranquility, argues Mr Scheidel, powerful interests so manipulated society as to enlarge their share (and that of descendants) of the pie. Power creates wealth and wealth creates power. Can anything halt this process? Yes indeed, argues the book: the four horsemen of catastrophe — war, revolution, plague, and famine.

Some will argue that the past was not quite as grim as the book suggests. When states relied on military mobilisation, for instance, they had to take some account of the prosperity of the people. But, in all, the inequality in premodern societies was often staggering.

What has this to do with today’s far wealthier, post-industrial societies? More, it appears, than we might like. Again, in the 20th century, revolutions (in the Soviet Union and China, for example) and the two world wars reduced inequality dramatically. But, when revolutionary regimes softened (or collapsed) or the exigencies of war faded from memory, quite similar processes to those of the old agrarian states took hold. Vastly wealthy new elites emerged, gained political power, and again used it for their own ends. Those who doubt this should look closely at the politics and economics of the tax bill now going through the US Congress.

The implication of this parallel would be that, barring some catastrophic event, we are now on the way back to ever-rising inequality. Global thermonuclear war would be equalising. But catastrophe is not a policy.

Yet we have three more appealing reasons for being relatively optimistic. The first is that our societies are far less unequal than they might be: our poor are relatively poor, but not on the margins of subsistence. The second is that high-income countries do not all share the same tendency towards high and growing inequality. The last is that states now possess a range of policy tools with which to ameliorate income and wealth inequality, should they wish to do so. A comparison between the distribution of market and disposable incomes in significant high-income countries (Canada, France, Germany, Italy, Spain, the UK and US) demonstrates the last point well. In all these cases, taxes and public spending reduce inequality substantially. But the extent to which they do so varies significantly, from the US, the least active, to Germany the most.

The big question, however, is whether the pressures for inequality will go on rising and the willingness to offset them generally decline. On the former, it is quite hard to be optimistic. The market value of the work of relatively unskilled people in high-income countries seems very unlikely to rise. On the latter, one can point, optimistically, to a desire to enjoy some degree of social harmony and the material abundance of modern economies, as reasons to believe the wealthy might be prepared to share their abundance. Nevertheless, as the military mobilisation of the early to mid-20th century and the egalitarian ideologies that accompanied industrialisation and mass warfare fade away and individualism becomes ever stronger, elites may become more determined to seize whatever they can for themselves.

If so, that would augur badly, not just for social peace, but even for the survival of the stable universal-suffrage democracies that emerged in today’s high-income countries in the 19th and 20th centuries. One possible development is the sort of “plutocratic populism” that has become such a signal feature of the contemporary US — the country that did, we should recall, ensure the survival of liberal democracy during the turmoil of the previous century. The future could then consist of a stable plutocracy, which manages to keep the mass of the people divided and docile. The alternative might be emergence of a dictator, who rides to power on the back of a faux opposition to just such elites.

Mr Scheidel suggests that inequality is sure to rise. We must prove him wrong. If we fail to do so, soaring inequality might slay democracy, too, in the end.

Complacency Will Be Tested in 2018

Stephen S. Roach

 Traders work on the floor of the New York Stock Exchange

NEW HAVEN – After years of post-crisis despair, the broad consensus of forecasters is now quite upbeat about prospects for the global economy in 2018. World GDP growth is viewed as increasingly strong, synchronous, and inflation-free. Exuberant financial markets could hardly ask for more.

While I have great respect for the forecasting community and the collective wisdom of financial markets, I suspect that today’s consensus of complacency will be seriously tested in 2018. The test might come from a shock – especially in view of the rising risk of a hot war (with North Korea) or a trade war (between the US and China) or a collapsing asset bubble (think Bitcoin). But I have a hunch it will turn out to be something far more systemic.

The world is set up for the unwinding of three mega-trends: unconventional monetary policy, the real economy’s dependence on assets, and a potentially destabilizing global saving arbitrage. At risk are the very fundamentals that underpin current optimism. One or more of these pillars of complacency will, I suspect, crumble in 2018.

Unfortunately, the die has long been cast for this moment of reckoning. Afflicted by a profound sense of amnesia, central banks have repeated the same mistake they made in the pre-crisis froth of 2003-2007 – maintaining excessively accommodative monetary policies for too long.

Misguided by inflation targeting in an inflationless world, monetary authorities have deferred policy normalization for far too long.

That now appears to be changing, but only grudgingly. If anything, central bankers are signaling that the coming normalization may even be more glacial than that of the mid-2000s.

After all, with inflation still undershooting, goes the argument, what’s the rush?

Alas, there is an important twist today that wasn’t in play back then –central banks’ swollen balance sheets. From 2008 to 2017, the combined asset holdings of central banks in the major advanced economies (the United States, the eurozone, and Japan) expanded by $8.3 trillion, according to the Bank for International Settlements. With nominal GDP in these same economies increasing by just $2.1 trillion over the same period, the remaining $6.2 trillion of excess liquidity has distorted asset prices around the world.

Therein lies the crux of the problem. Real economies have been artificially propped up by these distorted asset prices, and glacial normalization will only prolong this dependency. Yet when central banks’ balance sheets finally start to shrink, asset-dependent economies will once again be in peril. And the risks are likely to be far more serious today than a decade ago, owing not only to the overhang of swollen central bank balance sheets, but also to the overvaluation of assets.

That is particularly true in the United States. According to Nobel laureate economist Robert J. Shiller, the cyclically adjusted price-earnings (CAPE) ratio of 31.3 is currently about 15% higher than it was in mid-2007, on the brink of the subprime crisis. In fact, the CAPE ratio has been higher than it is today only twice in its 135-plus year history – in 1929 and in 2000. Those are not comforting precedents.

As was evident in both 2000 and 2008, it doesn’t take much for overvalued asset markets to fall sharply. That’s where the third mega-trend could come into play – a wrenching adjustment in the global saving mix. In this case, it’s all about China and the US – the polar extremes of the world’s saving distribution.

China is now in a mode of saving absorption; its domestic saving rate has declined from a peak of 52% in 2010 to 46% in 2016, and appears headed to 42%, or lower, over the next five years. Chinese surplus saving is increasingly being directed inward to support emerging middle-class consumers – making less available to fund needy deficit savers elsewhere in the world.

By contrast, the US, the world’s neediest deficit country, with a domestic saving rate of just 17%, is opting for a fiscal stimulus. That will push total national saving even lower – notwithstanding the vacuous self-funding assurances of supply-siders. As shock absorbers, overvalued financial markets are likely to be squeezed by the arbitrage between the world’s largest surplus and deficit savers. And asset-dependent real economies won’t be too far behind.

In this context, it’s important to stress that the world economy may not be nearly as resilient as the consensus seems to believe – raising questions about whether it can withstand the challenges coming in 2018. IMF forecasts are typically a good proxy for the global consensus. The latest IMF projection looks encouraging on the surface – anticipating 3.7% global GDP growth over the 2017-18 period, an acceleration of 0.4 percentage points from the anemic 3.3% pace of the past two years.

However, it is a stretch to call this a vigorous global growth outcome. Not only is it little different from the post-1965 trend of 3.8% growth, but the expected gains over 2017-2018 follow an exceptionally weak recovery in the aftermath of the Great Recession. This takes on added significance for a global economy that slowed to just 1.4% average growth in 2008-2009 – an unprecedented shortfall from its longer-term trend.

The absence of a classic vigorous rebound means the global economy never recouped the growth lost in the worst downturn of modern times. Historically, such V-shaped recoveries have served the useful purpose of absorbing excess slack and providing a cushion to withstand the inevitable shocks that always seem to buffet the global economy. The absence of such a cushion highlights lingering vulnerability, rather than signaling newfound resilience – not exactly the rosy scenario embraced by today’s smug consensus.

A quote often attributed to the Nobel laureate physicist Niels Bohr says it best: “Prediction is very difficult, especially if it’s about the future.” The outlook for 2018 is far from certain. But with tectonic shifts looming in the global macroeconomic landscape, this is no time for complacency.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.

Watch the bond market, not equities

Governments and leveraged borrowers would suffer if interest rates rise quickly

Gillian Tett

Traders in New York: this week the yield on 10-year Treasuries jumped to nearly 2.6 per cent, its highest level for almost a year, before falling back © Reuters

A few years ago, the head of a leading western central bank predicted that his job would soon be akin to flying a plane. The reason? Eventually, central banks in Europe, US and Japan would tighten monetary policy. After all, the supposedly emergency stimulus that central banks provided after the 2008 crisis could not remain in place forever.

But what central banks desperately needed to do, he explained, was withdraw that stimulus at a controlled pace, like a pilot landing a plane. The goal was to deliver such a smooth glide path for this “landing”, meaning a return to more normal interest rates, that investors would barely notice, let alone panic.

Can this glide path ever be achieved without tipping markets into a tailspin? That is the question investors must contemplate. In recent months, the issue that has grabbed most market headlines has been the sky-high level of equity prices, particularly in the US.

But it is the behaviour of bond prices that is more remarkable. A decade ago, popular investing wisdom posited that bond prices should fall when equities rise, especially if central banks were raising rates. But although the US Federal Reserve under the tenure of Janet Yellen has raised rates five times, and is likely to do so three times this year, bond prices have stayed sky-high, keeping long-term yields ultra low (prices and yields move inversely).

That means that the US yield curve (or the gap between long and short rates) has flattened. It also means that financial conditions in the markets “are extremely accommodative”, as Jan Hatzius of Goldman Sachs says.

But now bond prices are wobbling. This week the 10-year US yield jumped to nearly 2.6 per cent, its highest level for almost a year, after speculation that the central banks of China and Japan might be scaling back their Treasury purchases. Yields later fell back. But the swing was sharp enough to prompt Bill Gross and his rival and fellow guru Jeffrey Gundlach to warn that the three-decade-old bull market for bonds might be coming to an end (although they differ on the precise timing).

If so, this shift might not necessarily be a bad thing. After all, the current low level of rates looks peculiar and has fuelled all manner of asset price bubbles. An adjustment is inevitable at some point, and desired by the Fed. “The bond market is waking up to what the Fed is doing,” says Stephen Macklow Smith, an analyst at JPMorgan.

But the crucial issue now is the slope of the glide path. If rates start rising steadily there is every chance that the financial system can absorb this. But if they climb quickly, that could create a snowball effect of a kind last seen in 1994 (when the Fed unexpectedly raised rates).

The reason is that the long era of ultra-low interest rates has lulled many institutions into complacency. Investors have been reaching for yield, that is taking additional credit risks, on the presumption that rates will stay low, and using derivatives to magnify their bets. Nobody really knows how much exposure this has created, since the $400tn over-the-counter swaps market is so opaque.

But there will almost certainly be big losses in the system if rates did jump higher. Leveraged corporate borrowers, and even governments, would also suffer shocks. The Congressional Budget Office calculated that costs on US federal debt will rise from $270bn to $712bn over the next decade if 10-year yields rise from 1.8 per cent to 3.6 per cent (excluding the Trump tax cuts). If that happened in just one year, it would be deeply painful.

Thankfully, there is no sign of this type of shock yet. And there are plenty of factors that could prevent a sudden surge in rates. Inflation is subdued, the economy seems to have plenty of spare capacity and investors still appear keen to buy bonds. When the US Treasury held an auction of 10-year bonds this week it was more over-subscribed than at any point for a year.

But the essential lesson is that the longer investors, governments, companies and financial institutions think that rates will stay low, the greater the risk that any sudden decline in bond prices will lead to a repeat of what happened in 1994.

Conversely, the more that investors worry about a “bondmageddon”, the greater the chance that they will start positioning their portfolios in a manner that enables central bankers to deliver a smooth glide path. So central bankers should say a hearty “thank you” to Messrs Gross and Gundlach. Sometimes a whiff of drama is just what is needed to produce a calmer world.

Foreign Debt: The Price of Turkey’s Rise to Power



A country’s finances, studied in isolation, can’t tell us much about that country’s motivations or flexibility. Yet finances play a critical role in how a state funds things like social services and defense, pillars of the state’s geopolitical power. Finances can also help or hurt economic growth, which affects domestic politics. A geopolitical assessment of a country is therefore incomplete without an investigation of its finances.
When looking at a state’s finances, however, it’s easy to get bogged down in technical complexity or to be led astray by ultimately trivial aspects. This analysis will zoom in on one aspect of Turkey’s financial system: its external debt position. It will discuss the risks inherent in Turkey’s debt position, but with the purpose of describing how those risks will influence Turkey’s actions in the international arena. We chose to focus on external debt because it can, under certain circumstances, diminish the control that a sovereign government has over its own economy.
GPF anticipates that Turkey will become a more powerful regional actor, asserting itself farther abroad – including into the chaotic Middle East – both to protect its borders from groups it considers terrorists and to prevent Iran from gaining and holding territory that it can use to threaten Turkey’s interests. We do not, however, expect a smooth ascent. As with most events that unfold in the tides of history, trends emerge not in linear progressions but in fits and starts. Turkey’s external debt poses a real, albeit not a catastrophic, threat to that progress.
A man passes a money exchange office on Dec. 2, 2016, in Istanbul. OZAN KOSE/AFP/Getty Images
What Is External Debt?
External debt is money that is borrowed from abroad in a foreign currency. Turkey’s currency is the lira, so when it borrows in the dollar or euro – that is, the debt security itself is denominated in the foreign currency – that is a form of external debt.
External debt comes with challenges that debt denominated in a domestic currency does not. In the case of Turkey, if it borrows in liras, then it pays interest and principal back in liras. If the lira depreciates against other currencies, Turkey’s debt doesn’t get more difficult to service. In fact, it gets easier to service, since it owes the same amount of liras, but the currency is worth less. Increasing the money supply (printing money) lets a country pay back its debt with cheaper currency, effectively inflating its way out of a debt burden. Though printing money carries its own risks, it still leaves the state and its central bank as masters of their debt destiny.
External debt, however, doesn’t offer this flexibility. Instead, it links the borrower’s ability to repay to the exchange rate between the lira and a foreign currency. Since the debt must be repaid in a foreign currency, if the lira depreciates against that currency, then it will take more liras to service the same amount of debt. For example, if Turkey were to borrow $100 million at a 10 percent rate in U.S.-dollar denominated debt, it would owe $10 million per year. If the exchange rate between the lira and the dollar were 2-to-1, then Turkey would owe 20 million liras per year. If the lira depreciated relative to the dollar and the exchange rate became 4-to-1, then Turkey would still owe $10 million, but that would be equivalent to 40 million liras per year. In effect, the cost of its debt service would double simply because of exchange rate fluctuations.
Though Turkey may have dollar reserves to help alleviate this situation, it cannot print dollars to inflate its way out of this debt as it could with lira-denominated debt. This is the fundamental problem of external debt: If the borrowing country’s currency were to depreciate, its debt would become costlier to service. In the public sector, this forces the government to allocate more of its budget to debt repayment. In the private sector, it restricts investment capital, since money that could have been used to invest in productive enterprises must instead be diverted to service debt. More money spent on debt service means less spent on consumption and investment, and, therefore, slower economic growth.
Turkey’s Increasing External Debt
Turkey’s total external debt (public and private) has been rising gradually over the past five years, reaching 52 percent of gross domestic product by the second quarter of 2017, a relatively high figure for a developing country.

Most of Turkey’s external debt – about 70 percent – is held in the private sector. Turkey’s state finances are relatively unburdened by debt, with central government debt accounting for only about 30 percent of GDP in 2016. As we will discuss later, however, the increasing burden of private-sector external debt nevertheless has ramifications for the Turkish government.
If external debt is so risky, then why is Turkey taking on so much of it? The answer lies at the intersection of politics and economics. Much of Turkey’s external debt is a result of the need to attract sufficient capital to fund domestic stimulus projects. President Recep Tayyip Erdogan is pushing stimulus to maintain economic growth to keep both the public happy and himself in power. The most notable of these stimulus projects is a credit guarantee – extended by the government following the failed coup attempt last year – in an effort to encourage more lending and investment. Much of the investment capital that Erdogan hopes to unlock, therefore, comes from private banks extending new loans, albeit with a government guarantee.
To lend money out, however, the banks have to have money to begin with. Banks acquire funding through two basic sources: deposits and borrowing. In Turkey, however, where the national savings rate is low, banks are struggling to attract sufficient deposits to meet the investment demands of Erdogan’s stimulus. They therefore have had to turn to foreign borrowing to provide those funds.

Turkey’s savings rate has been decreasing steadily since 1990, and currently it has one of the lowest savings rates in the world. A low savings rate means that to attract more deposits, interest rates on deposits must be higher. In fact, Turkey has a higher deposit interest rate relative to average rates in the rest of the world.

The Turkish government has been working to attract more domestic deposits, since it would enable banks to extend more credit funded by domestic capital rather than money borrowed from abroad. In addition to high interest rates, the government has begun subsidizing those who choose to save by matching up to 25 percent of savings, up to a threshold equal to 25 percent of the minimum wage.
The problem is that as interest rates on deposits increase, banks must increase interest rates on their loans to maintain a spread and, therefore, profitability. Higher interest rates, however, work against Erdogan’s stimulus plan, since higher rates increase the cost of borrowing – and borrowing is what the government wants people to do. Turkish banks, therefore, are left with a second source of funding to fill the gap: borrowing.
Banks can borrow domestically or from abroad. The challenge with borrowing domestically in Turkey is that, again, deposit rates are low and interest rates are high. There’s only so much capital in the banking system to go around. Turkish banks can borrow from other Turkish banks, but that doesn’t solve the profitability issue – the banks must still maintain a spread by charging high rates to their borrowers. On the other hand, foreign debt – denominated in U.S. dollars or euros – can be secured at lower interest rates (for example, a 10-year U.S. Treasury bond is currently yielding roughly 2.4 percent, and a 10-year German bond is yielding 0.29 percent). This is the main impetus for the increase in Turkey’s external debt.
One important aspect of Turkey’s growing external debt is that consumers are not allowed to borrow debt denominated in foreign currency. Instead, banks are responsible for most of the debt taken on in the private sector; they borrow from abroad in foreign currency and lend capital out domestically in lira. It’s a quick way to get additional capital into the Turkish economy, but it poses a serious risk: If the lira depreciates, banks will receive interest income in cheapened liras and be forced to pay the cost of their own borrowing in more expensive foreign currency.

Having enough foreign currency reserves can somewhat – although not entirely – mitigate this risk, since it provides the borrowing country with a certain amount of funds that can’t depreciate relative to the size of the debt denominated in that currency. To assess the degree of risk posed to Turkey by this external debt, therefore, we must look at the amount of foreign reserves that Turkey has on hand.
Foreign Reserves
As it turns out, Turkey has quite a bit of foreign currency in its banking system: 45 percent of all deposits in Turkey are in foreign currency, primarily dollars and euros.
Two questions arise from this observation. First, is the quantity of foreign exchange reserves sufficient to substantially mitigate Turkey’s risk from lira depreciation? And second, why does Turkey have so much foreign deposits in the first place? The first question can be answered by looking at what’s called the loan-to-deposit ratio, which measures outstanding debts relative to the amount of money deposited at banks. Loan-to-deposit ratios below 100 percent indicate that there are more than enough deposits to cover outstanding loans. Ratios above 100 percent, conversely, indicate that there is more credit than can be covered by deposits.

Loan-to-deposit ratios can be broken down by currency. Though Turkey’s lira loan-to-deposit ratio is above 100 percent – indicating that there are not enough lira deposits to fully cover lira-denominated loans – its foreign exchange loan-to-deposit ratio is closer to 100 percent. Its foreign exchange loan-to-deposit ratio has been growing consistently since 2010, however, indicating that Turkey has been taking on more foreign currency-denominated debt than it has been accumulating in foreign reserves. In other words, its external debt balance is becoming gradually riskier since it has relatively fewer foreign currency deposits to cover that debt.
The second question – why Turkey has so much foreign reserves to begin with – is somewhat more complex. It has to do with a tool first implemented in 2011 called the reserve option mechanism.
Banks must hold reserves against their outstanding loans. Usually, those reserves are in the same currency as the loans. In Turkey, however, the central bank lets banks hold reserves against lira-denominated loans in either gold or foreign currency. Though this is at the commercial banks’ discretion, if they choose to hold gold or foreign currency against lira-denominated debt, they must deposit these reserves at the central bank.
The purpose of the reserve option mechanism is to stabilize exchange rates and capital flows in and out of the country and accumulate a reserve of foreign currency. It was designed to work like this: If the lira appreciates, it becomes more expensive to hold lira reserves. Banks will therefore be incentivized to hold more reserves in foreign currency. The greater demand for foreign currency increases the value of the currency and decreases the value of the lira, in theory stabilizing the exchange rate. The same mechanism works in reverse: If lira is relatively cheaper to hold, more banks will sell foreign currency and increase their proportion of lira-denominated reserves.
The reserve option mechanism is not a fixed mechanism. Foreign currency can be held as reserves in place of lira, but it is not at a 1-1 ratio. For example, the central bank might require more dollars or euros to be held in reserve for the same value of liras. This reserve ratio – the proportion between the amount of foreign currency that can be held in reserve – can be changed, turning it into a separate tool of monetary policy. Indeed, this month, the central bank adjusted the reserve ratio to increase the amount of lira-denominated credit offered to the Turkish economy.
The details of the reserve option mechanism get quite technical, but the most important takeaway is this: Despite Turkey’s growing levels of external debt, it has accumulated a substantial amount of foreign currency reserves. These reserves somewhat, but not entirely, mitigate the danger inherent in the accumulation of external debt. Nevertheless, Turkey’s external debt is still a growing risk. Since Turkey cannot print foreign currency, if the lira were to depreciate, the country would have only limited foreign reserves to act as a buffer before being forced to pay back all its external debt in lira. A run on the lira, therefore, could quickly put the brakes on economic growth and threaten Erdogan’s political position.
Though this analysis has focused on the specific details of a specific vulnerability, ultimately it is Turkey’s broader geopolitical position that we are interested in. Turkey has recently been able to get more involved in tackling threats across its border in Syria. Were its economy to suddenly stumble, the government would be forced to refocus inward. Turkey’s economy isn’t pristine even now – unemployment is hovering around 10 percent – but it is nevertheless growing rapidly (11 percent GDP growth in the third quarter of this year), and so long as profits are coming in, Erdogan’s opponents will be less inclined to speak up. If the Turkish elite began to lose money, however, and unemployment rates increased, people would start to ask whether Erdogan’s policies are really working in their best interest, casting doubt on Turkey’s growing interventionism in the Middle East. Threats to its economy, such as its external debt position, therefore constrain Turkey’s ability to project power beyond its borders.