Anbang and China's Mortgage Bubble

Doug Nolan
The Shanghai Composite traded as high as 3,587 intraday on Monday, January 29th, a more than two-year high. This followed the S&P500’s all-time closing high (2,873) on the previous Friday. On February 9th, the Shanghai Composite traded as low as 3,063, a 14.6% decline from trading highs just nine sessions earlier. In U.S. trading on February 9th, the S&P500 posted an intraday low of 2,533, a 10.7% drop from January 26th highs. Based on Friday’s closing prices, the Shanghai Composite had recovered 43% of recent declines and the S&P500 70%.

Global equities markets demonstrated notably strong correlations during the recent selloff. Few markets, however, tracked U.S. trading closer than Chinese shares. From the Bubble analysis perspective, tight market correlations provide confirmation of the global Bubble thesis. It’s also not surprising that Chinese markets were keenly sensitive to the abrupt drop in U.S. stocks. The U.S. and China are dual linchpins to increasingly vulnerable global Bubble Dynamics. Moreover, intensifying fragilities in Chinese Credit – and finance more generally – ensure China is keenly sensitive to any indication of a faltering U.S. Bubble.

February 21 – Bloomberg: “China stopped updating its homegrown version of the VIX Index, taking another step to discourage speculation in equity-linked options after authorities tightened trading restrictions last week. State-run China Securities Index Co. didn’t publish a value for the SSE 50 ETF Volatility Index on its website Thursday. An employee who answered CSI’s inquiry line said the company stopped updating the measure to work on an upgrade. The move was designed to curb activity in the options market, said people familiar with the matter… It’s unclear when the index will resume.”
Derivatives rule the world. Of course, Chinese authorities had few issues with booming options trading when markets were posting gains. Here in the U.S., regulators will supposedly now keep a more watchful eye on VIX-related products. In China, “the VIX goes dark,” as regulators place various restrictions on options trading. It’s not clear to me why international investors at this point would be drawn to Chinese markets. As Bubble fragilities turn more acute, Chinese officials will assume an even more heavy-handed approach.

February 23 Wall Street Journal (James T. Areddy): “When Anbang Insurance Group Co. paid about $2 billion to buy New York City’s Waldorf Astoria Hotel three years ago, the deal seemed to define an era for China Inc. President Xi Jinping shortly afterward dropped in to stay at the Park Avenue landmark. China’s business priorities have since changed, turning real-estate trophies into symbols of risk. Regulators in Beijing on Friday said they seized control of Anbang to keep the privately held insurer from collapsing, while prosecutors in Shanghai said they indicted Wu Xiaohui, Anbang’s swashbuckling ex-chairman, for alleged fraudulent fundraising and abuse of power. China’s government makes no secret of its penchant to guide commerce, even with private companies, but the boardroom takeover still rattled analysts used to Beijing’s applying its influence more quietly. ‘This is an unprecedented step, putting into receivership a Chinese company in such a public direct way,’ said Scott Kennedy at the… Center for Strategic and International Studies. ‘They are so worried about risks that they will stop at nothing to avoid them.’”

Wu Xiaohui, Anbang’s former chairman, disappeared (was detained) this past June. Married to the granddaughter of Deng Xiaoping, Wu for years operated as if protected by the Chinese establishment. As the WSJ article noted, Chinese President Xi stayed at the Waldorf Astoria hotel shortly after it was purchased by Anbang in 2015. At breakneck speed, Wu built a financial (“insurance”) empire with assets surpassing $300 billion, largely financed through high-yield wealth management/“shadow” deposits. Anbang’s ownership structure was opaque, which didn’t matter so long as Wu was in good graces with Beijing.

How quickly the world changes. Wu has been charged with fraud and embezzlement - “illegal business operations which may seriously endanger the company’s solvency”. It would appear the game of freewheeling – and well-connected – billionaire Chinese dealmakers tapping the shadow “money” spigot to buy prized international real estate assets has come to an end. The immediate impact on global trophy property values is unclear. Yet the government takeover and charges against Wu certainly send a strong message to the Chinese business community. Beijing is exerting control and pursuing President Xi’s priority to rein in financial risks.

February 23 - Bloomberg Gadfly (Nisha Gopalan): “Beijing’s interventions in the economy don't always merit applause, but the government's unprecedented seizure of Anbang Insurance Group Co. deserves a round. Anbang was a toxic threat to China's financial system after a debt-fueled global acquisition spree -- including trophy assets such as New York's Waldorf Astoria hotel -- that was funded by the sale of high-yield insurance policies. Those risky products propelled the company from obscurity into the ranks of the country's biggest insurers in the space of a few years. The government will take temporary control of Anbang for a year starting Friday… Markets reacted calmly to the announcement, underpinning the sense that regulators have acted in time to head off potentially bigger problems down the road.”

Anbang has been considered “too big to fail,” so the government takeover had little general market impact. And I suppose we can applaud Beijing for actions against one of the more conspicuously egregious high-risk financial operators. But in terms of an effect on overall systemic risk, this move barely registers on the risk-o-meter. Analysts have noted that Anbang’s assets have ballooned to a hefty 3% of Chinese GDP. But as a percentage of banking system assets, Anbang is less than 1%. With unrelenting rapid growth in Credit of deteriorating quality, systemic risk continues its parabolic ascent.

February 12 – Reuters (Kevin Yao, Fang Cheng): “China’s banks extended a record 2.9 trillion yuan ($458.3bn) in new yuan loans in January, blowing past expectations and nearly five times the previous month as policymakers aim to sustain solid economic growth while reining in debt risks. While Chinese banks tend to front-load loans early in the year to get higher-quality customers and win market share, the lofty figure was even higher than the most bullish forecast… Net new loans surpassed the previous record of 2.51 trillion yuan in January 2016, which is likely to support growth not only in China but may underpin liquidity globally as major Western central banks begin to withdraw stimulus… Corporate loans surged to 1.78 trillion yuan from 243.2 billion yuan in December, while household loans rose to 901.6 billion yuan in January from 329.4 billion yuan in December…”

The crackdown in shadow finance was surely a factor in January’s record-setting bank lending. The first month of 2018 saw major slowdowns in trust loans, entrusted loans and bankers’ acceptance lending, all key shadow instruments. Overall, Total Social Financing increased $483 billion in January, seasonally the strongest month of growth annually. This was gargantuan Credit growth, but actually 17% below January 2017. And looking at the most recent four-month period, growth in Total Social Financing was actually down 15% from the comparable year ago period.

Notably, household debt jumped $145 billion during January. This was easily a record and 21% above what at the time were record monthly household borrowings back in January 2017. 
For perspective, Chinese household debt growth averaged about $90 billion monthly in 2017, $80 billion in 2016, $50 billion in 2015 and $40 billion in 2014.

China faces major Credit issues from years of excessive corporate and local government borrowings. Chinese officials have moved somewhat to rein in these sectors. Meanwhile, household debt growth continues to accelerate. Apartment mortgages represent the largest component of China’s household borrowings, and I would argue that the Chinese mortgage finance Bubble is operating in the perilous “Terminal Phase.” It’s worth noting that the trajectory of China household borrowings is similar to mortgage Credit growth during the U.S. Bubble period.

Chinese officials used to claim they had studied and learned lessons from the Japanese Bubble period. They clearly learned little from the U.S. mortgage crisis. To be sure, mortgage Credit is seductive and too easily manipulated by government officials. It appears sound so long as housing prices are inflating. And the greater housing inflation, the greater the growth of self-reinforcing Credit. Risk, while growing exponentially, remains largely hidden.

Mortgage Credit is prone to rapid acceleration, as housing inflation spurs both rising prices and increasing quantities of transactions. Especially during the boom period, mortgage Credit becomes a major – and unrecognized - source of system liquidity – both in the financial system and throughout the real economy. As was certainly the case in the U.S., boom-time mortgage finance spurs consumption excesses along with mal-investment. A prolonged mortgage finance Bubble inflation fosters deep structural maladjustment.

China’s crackdown is no doubt having a major disciplining effect on the Chinese billionaire business community. Meanwhile, the Chinese mortgage and apartment Bubble runs mostly unchecked. Literally hundreds of millions of Chinese aspire to rising wealth and social mobility through the purchase of apartments that only go up in value. Virtually everyone believes Beijing will never tolerate a housing bust. This unwieldy episode of borrowing and speculation will continue to prove quite difficult for Beijing to control. The bust will be brutal.

I understand why Beijing would choose to crackdown on the likes of Anbang, HNA and Wanda. They’re conspicuous risk-takers outside of the core of the banking system (paying top renminbi for international non-essential assets). They can be easily and publically disciplined, providing a stark warning to the business community without risking a systemic shock. I also assume it is somewhat of an opening act to what will evolve into broadening measures to rein in total system Credit growth and accompanying excesses. Such a strategy makes some sense, except for the reality that mortgage Credit is in the throes of dangerous “Terminal Phase” excess. Household debt expanded 21% in 2017, after 23% growth in 2016. And if January borrowings are an indication, 2018 could see Chinese household debt growth surpassing $1.3 TN, about three times the level from 2015.

Mortgage finance Bubbles don’t function well in reverse. At some point, lending tightens and the marginal buyers lose the capacity to bid up home/apartment prices. In China, a lot of serious problems are being masked by ever-rising apartment prices. It is said that in many markets up to one in four apartments remain vacant, purchased purely to speculate on higher prices. Deflating prices would likely see tens of millions of empty units transferred to lenders. Credit losses will no doubt be enormous, compounded by widespread fraud and shoddy construction.

A case can be made that household debt is rapidly becoming the greatest threat to China’s banking system and economy. They’ve clearly waited much too long to get mortgage Credit under control. At this point, the boom is an expedient to meet GDP targets. A burst apartment Bubble would now pose great systemic risk. Of course, the Beijing meritocracy believes they can adeptly manage through any circumstance. Their dilemma is that this type of Bubble becomes only more perilous over time, though mounting latent risks remain unappreciated. Chinese officials would prefer that new Credit finances productive endeavors. But at this late stage of the cycle a reliance on productive Credit would leave the system with woefully insufficient finance to sustain the Bubble.

In years past, it received a decent amount of attention. Yet few analysts these days bother to mention the Chinese housing Bubble, despite its historic inflation. The problem didn’t go away; it instead got much bigger than anyone could have imagined. Indeed, Bubble risk has inflated to the point of risking peril for China as well as the world – financially and economically. And while January’s lending data evidenced a boom replete with momentum, I would caution that there may be more near-term risk than is generally perceived.

The shadow banking crackdown will likely have a significant impact on higher-risk lending generally, including mortgage Credit. Moreover, regulators are demanding bankers slow loan growth, this after household lending expanded to a significant proportion of overall system Credit expansion. There are indications of tighter lending conditions and even an incipient slowdown in housing transactions. And let’s not forget rising global yields, one more factor to weigh on inflated Chinese apartment prices. Anbang, HNA and their ilk make for interesting reading, full of nuance and intrigue as Beijing plots a financial crackdown. The real story, however, might be unfolding in Chinese household and mortgage finance.

The Elder Statesman of Latin American Literature — and a Writer of Our Moment

Mario Vargas Llosa isn’t a household name among American readers. But at 81, he remains a literary and political colossus across the Spanish-speaking world, and his novels have never felt more relevant.


‘Shall we sit outside?” Mario Vargas Llosa asked me, gesturing through the library’s floor-to-ceiling windows at the brilliant September afternoon. The only Peruvian ever to have won a Nobel Prize, Vargas Llosa now lives in an eight-bedroom mansion on the fringes of Madrid, in the neighborhood known as Puerta de Hierro. When I arrived, a butler in a white jacket led me through the enormous two-story foyer, across gleaming black and white tiles, into a library lined with dark wood bookcases. A crystal ashtray sat next to silver dishes of chocolate and cigarettes. This imposing casona seemed like a fitting residence for the last living giant of a golden age of Latin American literature, a man who may well be the most politically important novelist of our time, but the house does not belong to Vargas Llosa. Over the library’s fireplace hung a portrait of its owner, Isabel Preysler, in a red dress.

Preysler, who was born in the Philippines but has lived in Spain since she was 16, built the home with her third husband, Spain’s former Minister of Economy and Finance Miguel Boyer, who died in 2014. Paparazzi often loiter around its gates; Preysler, 67, has been an object of fascination for Spanish-language tabloids ever since she married her first husband, the pop star Julio Iglesias, in 1971. (Her second husband was a Spanish marquis.) And it was something of a scandal that Vargas Llosa now had a desk with tidy piles of books and a bust of Honoré de Balzac in a little corner of her library amid Boyer’s old science and math books. He used to live in a floor-through apartment in the heart of historic Madrid, steps away from the Royal Theater, where the streets are as narrow as trenches. But in 2015, he left his wife of 50 years for Preysler. As I followed him out onto the terrace, I wondered briefly if part of Preysler’s appeal had been her ability to wrap him in such luxury.

We took seats under a white awning on a pair of white couches facing an aquamarine pool. My coffee arrived in a delicate pink china cup. As we talked, the sun slid behind a narrow forest of closely planted trees, which hid the street, the high stone walls and the long gravel driveway, giving the garden the illusion of a park. We talked for more than two hours in Spanish, about the Mississippi modernist William Faulkner and the Spanish superagent Carmen Balcells, about the TV shows “The Wire” and “Vikings.” For most of our conversation, Vargas Llosa was strikingly self-contained. He barely touched his glass of water and rarely moved his hands, though he said almost everything with a smile and ended many sentences with a laugh. He was like the home itself: a fortress camouflaged in the warmth of social grace. “He can strike one as being a very formal person, and he has cultivated that to some degree,” said Marie Arana, a Peruvian-American writer and former editor of The Washington Post’s books section. “People who are enormously attractive compensate by trying to be formal, to look serious.”

In March, Vargas Llosa will turn 82. He once looked like a dark-eyed John Travolta: full lips, strong chin, thick black hair. The hair is now white, but the serene manners and the prodigious self-discipline remain. He has written almost every morning of his life, publishing 59 books in 55 years, among them some of the greatest novels of the past half century: “The Time of the Hero,” “Conversation in the Cathedral,” “Aunt Julia and the Scriptwriter,” “The Feast of the Goat.” “If I didn’t write,” he told The Paris Review in 1990, “I would blow my brains out, without a shadow of a doubt.” This week Vargas Llosa has three books coming out — English translations of a novel (“The Neighborhood”) and of a collection of political essays (“Sabers and Utopias”), as well as a new volume in Spain, “The Call of the Tribe,” which is not yet available in English. It’s a condensed history of three centuries of classical liberal thought, from Adam Smith to Jean-François Revel, that doubles as a kind of intellectual autobiography.

For Vargas Llosa, writing has always been a weapon against both despair and despotism, and “The Call of the Tribe” feels like his attempt to beat back the waves of nationalism and populism now flooding our world. He is a defender of individual liberty and democracy in Latin America. His attacks on authoritarians have made him enemies among both socialists and conservatives. What he most respects in a person, he told me, is integrity: “Consistency in what you believe, what you say and what you do.” And while his insistence on saying and doing exactly what he himself believes has left a scorched path in his personal life, it has also been the making of his career. 

Vargas Llosa with a friend in Lima in the 1950s. Credit From Mario Vargas Llosa 

Until he was 10, Vargas Llosa enjoyed a pampered childhood in a house filled with members of his mother’s sociable, middle-class family, which can trace its pedigree to early Spanish colonists. Grandparents, aunts and uncles looked indulgently upon his pranks — spying on women from trees, bringing his entire class home for tea. He played Tarzan with his cousins and memorized poetry with his grandfather. His father, he was told, lived in heaven. He kissed a photo of him every night before bed. In truth, Ernesto Vargas was very much alive, but he had abandoned Mario’s mother, Dora Llosa, several months before his birth. Then, in 1946, Ernesto and Dora reunited and carried Mario off to Lima.

“When I went to live with my father, and I was feeling alone, feeling completely isolated, separated from the people whom I felt were my family, reading saved me,” Vargas Llosa told me. He buried himself in novels by Alexandre Dumas, Victor Hugo, Charles Dickens and Honoré de Balzac, dreaming of a life filled with adventure. “It was a marvelous way of not living the horrible life that I had.” 
“When [my father] beat me,” Vargas Llosa writes in his 1993 memoir, “A Fish in the Water,” “I went off the deep end, and terror many times made me humble myself before him and beg his pardon with my hands joined. But that didn’t calm him down. And he went on hitting me, screaming and threatening to put me in the army as a private as soon as I was old enough to be a recruit so that I’d be set on the right path. When the whole scene was over and done with, and he could lock me in my room, it was not the blows, but rage and disgust with myself for having been so afraid of him and having humbled myself before him in that way, that made me spend a sleepless night, weeping in silence.”

Fiction and poetry were Mario’s refuge from Ernesto’s domestic despotism. They were also his defiance. “My father saw literature as something extremely dangerous,” Vargas Llosa said in the garden, brushing aside his old traumas with a laugh. “He thought that literature was a passport to failure in life, that it was a way of starving to death.” Novels, Ernesto also believed, were the work of drunk bohemians and homosexuals. Bent on turning Mario into a real man, Ernesto enrolled his son in Leoncio Prado Military Academy when he was 14. “I went to Leoncio Prado because my father thought that the military was the best cure for literature and for those activities that he understood as very marginalized.” Vargas Llosa chuckled at the paradox. “On the contrary, he gave me the subject of my first novel!”

Even now, “The Time of the Hero” (1963) still has the power to shock with its scenes of bullying and dissipation among cadets. Highlights include: the gang rape of a chicken, blow jobs endured for liquor, officers’ kicking students and the killing of a boy nicknamed “Slave,” who marks himself for special humiliation when he makes the mistake of pleading for mercy with clasped hands. Incensed by the exposé, administrators at Leoncio Prado Military Academy rounded up 1,000 copies and set the books aflame in an official ceremony. But a judge for Spain’s prestigious Premio Biblioteca Breve Prize declared it “the best novel in the Spanish language in the past 30 years.” “The Time of the Hero” was among the first sensations of a transformative age of Latin American literature known as the Boom. (All its other major writers — Gabriel García Márquez, Julio Cortázar, Carlos Fuentes, José Donoso, Juan Rulfo, Miguel Ángel Asturias and Guillermo Cabrera Infante — have died.)

Vargas Llosa’s masterwork is “Conversation in the Cathedral” (1969). It’s Faulkner cross-pollinated with Balzac, modernist techniques used to paint a sweeping historical panorama. The structure of the novel spirals out from a single point: an unexpected meeting in 1960s Lima between Santiago Zavala, a 30-year-old reporter estranged from his upper-crust family, and Ambrosio, his family’s former chauffeur. The two run into each other at a pound, where Ambrosio slaughters dogs for money. Together, the men get drunk at a dive bar called the Cathedral, and from their conversation rises a blistering vision of the whole of Peru under Gen. Manuel Odría’s eight-year military dictatorship in the 1950s. Vargas Llosa implicates everyone in the moral catastrophe, from the bickering student dissidents to the cowardly media to the rich women drowning themselves in alcohol and gossip.

It is outrageous that “Conversation in the Cathedral” has never gotten the traction it deserves in the United States, and the novel’s English translation bears some of the blame. Gregory Rabassa — whose stunning translation of Gabriel García Márquez’s “One Hundred Years of Solitude” helped make that novel an American best seller — stumbles over Vargas Llosa’s more complex style, which shifts continually between the sinuous and the slangy. “Conversation in the Cathedral” will never be an easy read in any language — it’s a book for fans of Faulkner, Proust and Bolaño — but Rabassa’s errors dull its noir patina and obscure its thrilling tonal rapids. The Peruvian-American novelist Daniel Alarcón told me he shoved aside Rabassa’s version when he saw Flaco translated as “Skinny.” “It could have said, ‘Hey, Slim,’ or just kept Flaco,” he pointed out. “But ‘Hey, Skinny’? No one ever says that. That’s not a thing that’s said in human speech in English anywhere that I’ve ever heard. And I’ve been speaking English since I was 3.”

Why has García Márquez’s magical realism cemented its place on American bookshelves and syllabuses while Vargas Llosa’s gritty masterpieces are neglected? Vargas Llosa’s best books are harder to read than García Márquez’s. He’s less sentimental, dirtier, raunchier, angrier. “One Hundred Years of Solitude” looks like a Hallmark card next to “Conversation in the Cathedral.” You might be fired for assigning Vargas Llosa in high school English. And Vargas Llosa has published so many novels — 18 in all — that the tours de force can get lost among the mediocrities. His buttoned-up public demeanor hasn’t helped. “Gabo” was not only a tremendous writer; he was an expert showman who once worked in advertising and cannily played up his Caribbean exoticism for foreign audiences. When the two fell out in the 1970s, many intellectuals leaned left toward García Márquez, while Vargas Llosa was shunned.

Yet Vargas Llosa is the more daring, more democratic writer. While García Márquez cozied up to Fidel Castro and refined a distinctive style, Vargas Llosa reinvented his over and over again while defending free markets and reproductive freedom, gay rights and open elections. His political tracts underscore the value of diversity, of stellar public education, of equal opportunities for the poor. And his novels, whether they are kaleidoscopic histories, political thrillers, generational sagas or slapstick comedies, are remarkable for their ability to inhabit a host of perspectives. He’s especially good at the psychology of collaborators — the people who surround authoritarians and make their administrations function. Such characters were not popular among readers in the 1960s, ’70s and ’80s, who preferred García Márquez’s romantic heroes, but they might feel especially relevant to Americans today.
Two days after our meeting in Preysler’s garden, I saw Vargas Llosa at a news conference held inside the Casa de America in Madrid, in a small room baroquely decorated with cherubs, nudes and gold leaf. A bust of Simón Bolívar, the 19th-century Latin American freedom fighter, stared through a flank of television cameras. When Vargas Llosa entered the room, photographers rushed toward him, chirping “Mario, por favor” in hopes of cajoling him into a good shot. But that morning Vargas Llosa’s expression hovered near patrician indigestion — downturned mouth, indifferent gaze. As he faced the reporters arrayed before him, you could almost see the thought bubble rising above his head: I gave up a morning of writing for this?

The sacrifice was provoked by the debut of another book in Spanish. This volume, “Conversación en Princeton,” provides a view into a seminar that Vargas Llosa gave in 2015 with Rubén Gallo, a professor of language and literature at Princeton University. For months, Vargas Llosa, Gallo and his students discussed five of Vargas Llosa’s most famous books, including “Conversation in the Cathedral.” The whole project, Gallo explained, was inspired by his desire to do a careful, point-by-point questioning of “the Goethe of our own time” in a utopian space “free of any political pressure, and of any other pressures, save the pleasure of reading itself.”

Politics, however, were inescapable that week in Madrid. The leaders of Catalonia, the semiautonomous region that is home to Barcelona, were threatening to hold a referendum on the question of whether Catalans ought to secede from Spain. Prime Minister Mariano Rajoy had already declared such a referendum illegal, and Spain’s Constitutional Court had also ruled it unconstitutional. But Catalonia’s regional president, Carles Puigdemont, looked determined to proceed.

“How do you see what’s happening in Catalonia?” asked the first reporter during the event’s question-and-answer session. “I think we should focus on the book,” Vargas Llosa responded affably. Then he segued into a four-minute answer in which he recalled that Catalan nationalists were regarded as “little old reactionaries” during the 1970s; opined that the current referendum was “an absurd blunder, an anachronism that has nothing to do with the realities of our time”; and suggested that Catalan nationalism was a kind of “illness.” “My hope,” he said, “is that the government will have the energy necessary to impede a coup — that is really what’s gestating — from taking place and to give it the appropriate sanctions.” Within hours, these pronouncements had made headline news in Spain, Venezuela and Peru.

It’s almost impossible to imagine the same reaction happening here if, say, Toni Morrison or Philip Roth voiced a political opinion. But Vargas Llosa looms as a political figure in his own right: He almost became the president of Peru in 1990, and he is still admired and loathed as one of Latin America’s most influential champions of limited government, free enterprise, democracy and rule of law. For the past 25 years, he has penned an op-ed column called “Touchstone” for the Spanish newspaper El País that is devoured by politicos in Spain and Peru. When Casa de America held an event to celebrate Vargas Llosa’s 80th birthday in 2016, attendees included the president of Chile (Sebastián Piñera), a former president of Uruguay (Luis Alberto Lacalle), two former presidents of Colombia (Álvaro Uribe and Andrés Pastrana) and two former prime ministers of Spain (José María Aznar and Felipe González). The event was kicked off with a speech from Prime Minister Rajoy.

“Words are acts,” Vargas Llosa said while we sat on Preysler’s terrace, emphasizing each word as if pointing at the sentence hovering in the air. This phrase by Jean-Paul Sartre, he told me, crystallized his understanding of the novelist’s political role in the 1950s. Back then, he was a Marxist. The scenes of Communist resistance in “Conversation in the Cathedral” were inspired by his own activities at the University of San Marcos in 1953.

“Imagine the ’50s, when I was very young and began to write,” he said. “A young Peruvian, Chilean, Colombian lived in a country where literature meant very little. It was the activity of a tiny elite, right? So if one had a certain social conscience of the problem in countries where there were enormous inequalities, well, many times that young man with a literary vocation would ask himself, what is the point of writing if I am Peruvian, if I am Chilean, if I am Colombian? Well, there Sartre was incredibly important, because Sartre had some ideas about literature that fit perfectly with a muchacho in an underdeveloped country. He had the idea that literature has a social, political, historical function, and that of course you could change things through literature. You could affect reality.” 
Vargas Llosa at home in Madrid. Credit Christopher Anderson/Magnum, for The New York Times 

In 1959, Vargas Llosa enthusiastically supported Fidel Castro’s socialist revolution in Cuba. At one point, he even housed Che Guevara’s mother in his apartment. But as Castro’s regime developed, Vargas Llosa grew uneasy. During a trip to Havana, he learned that gay Cubans were being imprisoned with counterrevolutionaries and common criminals in forced-labor camps. “Some of them had that totally idealistic idea that the revolution was not only going to bring socialism, but it was also going to change customs, that there would be a homosexual liberation,” he said. He told me he sent a private letter to Castro, expressing his confusion and surprise.

By 1971, however, such private protest felt insufficient. When the poet Heberto Padilla was subjected to a Stalinist show trial, Vargas Llosa gathered several friends at his home in Barcelona to draft a public denunciation of Castro. This famous “Padilla letter” appeared in the French newspaper Le Monde and was reprinted all over Latin America, signed by Susan Sontag, Octavio Paz, Carlos Fuentes, Julio Cortázar, Simone de Beauvoir and Jean-Paul Sartre, among others. The fallout from its publication was atrocious, including accusations that Vargas Llosa worked for the C.I.A., as well as the beginning of the disintegration of his close friendship with García Márquez. 
“But at the same time I felt a great freedom, you know?” Vargas Llosa told me. “Because until then ‘you can’t give weapons to the enemy.’ So you had to swallow all kinds of frogs and snakes” — the Soviet invasion of Czechoslovakia, the labor camps in Cuba — “but after the Padilla affair, I never again swallowed a frog or snake.”

Vargas Llosa’s break with Castro precipitated a fundamental reconstruction of his political beliefs. By 1982 he was having dinner with Prime Minister Margaret Thatcher and the classical liberal philosopher Isaiah Berlin at the home of the historian Hugh Thomas in London. This political conversion had an impact on his literary reputation. Gerald Martin, who wrote the definitive biography of García Márquez and is now working on another about Vargas Llosa, believes it was the most important factor keeping him from a Nobel win. “It was generally believed before with Lundkvist” — Artur Lundkvist, an influential member of the Swedish Academy — “that he preferred the Socialist, Marxist, Communist, radical, progressive writers,” Martin told me. Vargas Llosa received the prize for literature only after the Nobel committee had changed by the early 2000s.

It didn’t help that Vargas Llosa’s beliefs were often subject to gross distortion. Carlos Granés, the editor who assembled “Sabers and Utopias,” told me that he once heard the Peruvian author Dante Castro Arrasco declare that if Vargas Llosa had become president of Peru, he would have replaced the national coat of arms with a swastika. In truth, Vargas Llosa’s politics are closer to libertarian, and he has denounced every Latin American authoritarian of his lifetime. “Sabers and Utopias” shows him inveighing against not only leftists like Hugo Chávez in Venezuela but also Gen. Augusto Pinochet in Chile and the Peronist military dictatorship in Argentina.

“Mario Vargas Llosa has been a central figure — central, central, central — for democracy, human rights and fundamental freedoms,” José Miguel Vivanco, the Americas director of Human Rights Watch, told me. “I don’t think I’m exaggerating. He’s some sort of father of the current Peruvian democracy.”

In the weeks after I saw him in Madrid, Vargas Llosa traveled to Chile — where he endorsed Sebastián Piñera for re-election and insulted the country’s conservatives for trying to repeal a new law legalizing abortion — then to Moscow and to Barcelona, where he addressed thousands of Spaniards rallying in the streets against the prospect of Catalan independence. Then one night in early November, he and Preysler landed in New York City. Before sitting with me at the Four Seasons, he walked for an hour in Central Park, as he did every morning while staying in Manhattan. Early constitutionals were once a staple of Vargas Llosa’s routine, but he no longer takes them in Madrid. “The problem is that being with Isabel, it’s impossible to have a public life,” he said. “We can only go from house to house.” Everywhere they appear, paparazzi materialize.

“I think that one of the things he loves about New York,” Gallo told me, “is that he can walk, he can go into any restaurant for dinner. It’s funny because generally the people who recognize him, when I’ve been with him, are the Latin American waiters.” Shortly after Vargas Llosa received the Nobel in 2010, however, he and Gallo were almost crushed on Princeton’s campus by thousands of Peruvians who swarmed them after a public event. Most of them lived in nearby Paterson, N.J. Gallo recalled them shouting: Mario, an autograph for my grandma! Mario, I voted for you! 

Mario Vargas Llosa, September 2017. Credit Christopher Anderson/Magnum, for The New York Times 

The mobs were not always so friendly when Vargas Llosa campaigned for president of Peru in the 1990 election. His house received bomb threats. His van was attacked. Members of his political party, the Freedom Movement, were murdered. His candidacy had emerged unexpectedly in 1987, after he penned a vitriolic op-ed against President Alan García’s plan to nationalize Peru’s banks. Soon after, Vargas Llosa stopped writing fiction to create the Freedom Movement. His eldest son, Álvaro Vargas Llosa, then 23, became the campaign spokesman.

Vargas Llosa’s platform attracted new people to Peruvian politics, including the corporate executive Beatriz Merino, who later served as prime minister of Peru. But most Peruvians were fed up with political parties. During the 1980s, the incompetence of Peru’s political class had turned the country into a nightmare. Terrorist groups killed some 17,000 people and controlled large swaths of the sierras. Hyperinflation hit 7,650 percent in 1990. At least one-third of the country’s population lived in poverty. Vargas Llosa’s call to reduce state subsidies terrified many of these citizens, as did his connections to the rich, white elite that dominated Peru like an oligarchy. Nevertheless, for much of the campaign, polls predicted a Vargas Llosa win. Then, in the final laps of the campaign, an unknown agricultural engineer named Alberto Fujimori started closing in. 
Fujimori mocked and attacked Vargas Llosa relentlessly, drawing attention to his agnosticism, his international connections, his earnest intellectualism and his racy novels. A son of cotton pickers from Japan, he presented himself as an outsider who would defend Peru’s poor and working class from a foreign neoliberal “economic shock.” Fujimori himself sometimes appeared on a tractor. He had a gift for vague, emotionally resonant statements. But Fujimori won only because Peru’s leftists and centrists swung behind him for the sole purpose of sinking Vargas Llosa. Then almost immediately after he took office, Fujimori pivoted right and implemented a version of the “economic shock” that Vargas Llosa had recommended. This reversal depended on the collaboration of the same economists, lawyers and business owners who had rallied around the Freedom Movement. But by 1992 — after Fujimori used tanks to shut down Peru’s Congress because it resisted his reforms — it became obvious that many of Vargas Llosa’s former supporters did not feel as strongly about freedom as he did.
Fujimori foreshadowed a new wave of authoritarians in Venezuela, Ecuador and Bolivia. The political scientists Steven Levitsky and Lucan Way have coined a term for this kind of regime: “competitive authoritarianism.” On paper, it looks a lot like democracy. In practice, it operates more like autocracy. Yet Fujimori’s popularity remained high for much of the 1990s. As Vargas Llosa predicted, economic reforms finished hyperinflation. And in 1992, Peruvian police officers captured the leader of the most grotesquely violent guerrilla group in Latin American history, the Shining Path, allowing them to dismantle it. These two triumphs are why some Peruvians claim that Fujimori “saved” Peru, even though his government formed military death squads, suspended habeas corpus, crushed the free press, mishandled a cholera epidemic, sterilized thousands of indigenous women, blackmailed opponents and fomented widespread corruption.

Sitting over a glass of tomato juice at the Four Seasons, Vargas Llosa emphasized that he never worked against Fujimori until he brought out the tanks. “Not only did I respect the election, I was one of the first to congratulate Fujimori, to wish him luck,” Vargas Llosa said. “And during the two years that he governed legally as president, I did not make the most minimal opposition.” But when Fujimori shut down Congress, Vargas Llosa became his enemy. He asked the international community to cut off aid to Fujimori and noted (correctly) that Latin American militaries often favor coups d’état. In response, Fujimori’s head of the armed forces, Nicolás de Bari Hermoza, suggested that Vargas Llosa was deliberately harming Peruvians. Álvaro Vargas Llosa told me that they learned of a plan to strip the entire Vargas Llosa family of its Peruvian citizenship. Mario appealed to Spain, and in 1993 it granted him citizenship. In Peru, this event was widely perceived as the petulant betrayal of a sore loser.

Vargas Llosa’s last masterpiece (so far) was written in the midst of his battle with Fujimori. “The Feast of the Goat” recounts the final days of the notorious Dominican dictator Rafael Trujillo, a man who modernized and savaged the Dominican Republic for three decades until his assassination in 1961. Vargas Llosa first studied Trujillo in 1974, when he visited the Dominican Republic for a few weeks to work on a French documentary about the country. But it was only after 1992 that he felt a compulsion to write a novel on the narcissistic dictator and his love of macabre spectacle.

If you have never read Vargas Llosa before, this is the place to start. Gorgeous and harrowing, “The Feast of the Goat” is also the most accessible of his great political fictions. Here his taste for baroque narrative multiplicity has been simplified to just a handful of perspectives, and Edith Grossman’s translation is superb. Trujillo, Vargas Llosa writes, is an “astute exploiter of men’s vanity, greed and stupidity.” Almost every character collaborates with him as long as they believe that he can help them gain power or money. Even the man who organizes Trujillo’s assassination first guards the dictator’s life. Trujillo nevertheless murders his brother and destroys his reputation. Trujillo had killed him in stages, the man reflects later, “taking away his decency, his honor, his self-respect, his joy in living, his hopes and desires, turning him into a sack of bones tormented by a guilty conscience that had been destroying him gradually for so many years.”

Fujimori’s regime came apart the same year that “The Feast of the Goat” was published in Spanish. On Sept. 14, 2000, the media aired footage of Fujimori’s head of secret intelligence, Vladimiro Montesinos, paying a congressman $15,000 to switch to Fujimori’s party. Two months after the tape surfaced, Fujimori made an unscheduled trip to Japan and faxed his resignation from a Tokyo hotel room. By then more than $50 million had been located in foreign bank accounts in Montesinos’s name. Five years later, Fujimori was arrested in Chile, and he was eventually extradited to Peru. In 2009, he was sentenced to 25 years in prison for, among other atrocities, his role in creating a death squad that murdered an 8-year-old boy.

Álvaro moved back to Lima during the final year of Fujimori’s regime to join the democratic resistance, and after Fujimori’s collapse, Vargas Llosa’s influence in Peru soared. In 2011, father and son used their new political capital to derail the presidential hopes of Fujimori’s daughter, Keiko. To defeat her, Keiko’s opponents rallied behind Ollanta Humala, a man Hugo Chávez endorsed in Peru’s 2006 election. After interviewing Humala in Vargas Llosa’s office, Álvaro helped arrange a public meeting at which Humala swore a democratic oath. Vargas Llosa sent a video endorsement that played at the event. “If Vargas Llosa had not supported Ollanta Humala against Keiko Fujimori, Ollanta Humala would not have won,” the Peruvian political scientist Alberto Vergara told me. “They moderated Humala so that he could win the runoff.”

“Half the country hated us, obviously,” Álvaro said. “And until this day they won’t forgive us. But in the end I think that what they won’t forgive us is that we were right.” Humala did not become an authoritarian. When his term in office ended, he stepped down. He is now in jail awaiting trial for corruption.

A week after our meeting at the Four Seasons, the Getty Trust presented blue-ribboned medals to Vargas Llosa and the German artist Anselm Kiefer at the Morgan Library in Manhattan. The evening began with a cocktail party in a room that felt like a giant sinkhole lined with rare books. Vargas Llosa and Preysler stood near each other in one corner of the room. Neither of them held a cocktail. (Vargas Llosa does not like hard liquor.) Preysler, who is known for her fashionable wardrobe, appeared deliberately understated in a simple navy dress that matched Vargas Llosa’s blue tie. Álvaro and his wife, Susana Abad, were there as well, chatting with Carlos Pareja, the ambassador from Peru. Three of Vargas Llosa’s granddaughters stood in a clutch, one of them in a brilliant white jumpsuit that made her look like the reincarnation of Bianca Jagger, circa Studio 54. 
As the cocktail hour dragged on, Vargas Llosa became restless. “It’s marvelous to sit or to walk,” he said, “but standing around is horrible.” He is a man who likes to be doing, not waiting, and I got the sense that for him and Preysler all their charming, pre-awards chitchat was a kind of necessary work. Finally the bells chimed for dinner. Vargas Llosa escorted Preysler to the meal on his arm.

In our conversations, Vargas Llosa declined to discuss his romantic entanglements. When I asked him what had fractured his marriage to Patricia Llosa, which produced three children, he dropped all his smiles and chuckles. “Look,” he said, “that topic has to do with love. Love is probably the most enriching experience that a human being can have. Nothing transforms a person’s life as much as love. At the same time, love is a private experience. If it’s made public, it becomes cheap, shoddy, full of commonplaces. This is why it’s so hard to write about love in literature. You have to find the most clever ways so that it doesn’t lose its authenticity and become commonplace. So I think that a person shouldn’t talk about love precisely if love is so important in his life.”

You’re a romantic, I said.

“I think we all are. I think that romanticism has marked our lives very much, that it’s very difficult not to be romantic in some way, although many of us don’t realize it. You live it or you reject it. You vaccinate yourself against it. Let’s say that I haven’t rejected it. When it’s happened, I’ve lived it.”

The first time he lived it was in 1955, when he eloped with his aunt’s sister, Julia Urquidi Illanes. At the time, Vargas Llosa was a 19-year-old university student, and Urquidi was a 29-year-old divorcée. Ernesto Vargas was so enraged by their marriage that he threatened to kill Mario. But the couple refused to divorce. The day Ernesto accepted the marriage, Vargas Llosa writes in his memoir, marked his “definitive emancipation” from his father. But nine years later, they divorced, and a year after, in 1965, he married his first cousin Patricia Llosa Urquidi, Julia’s niece. In her memoir, “What Varguitas Didn’t Say,” Julia suggests the cousins began their romance when Patricia visited them in Paris in 1960, when Mario was 24 and Patricia was 15.

Forty-five years into their marriage, Vargas Llosa declared in his Nobel lecture that Patricia “does everything and does everything well. She solves problems, manages the economy, imposes order on chaos, keeps journalists and intrusive people at bay, defends my time, decides appointments and trips, packs and unpacks suitcases and is so generous that even when she thinks she is rebuking me, she pays me the highest compliment: ‘Mario, the only thing you’re good for is writing.’ ” The year she turned 70, however, he left her for Preysler. 

A younger Vargas Llosa. Credit From Mario Vargas Llosa 

“What you have to understand about him is that he’s a person who gives himself with absolute passion to what he believes in, even when he is wrong,” Álvaro told me. Of all Vargas Llosa’s children, Álvaro has been the most accepting of his father’s new relationship, perhaps because their ties go far beyond the familial. Vargas Llosa’s daughter, Morgana, a photographer and documentary filmmaker who lives in Peru, told me that she was shocked when Vargas Llosa appeared with Preysler in the Spanish-language celebrity weekly ¡Hola! just days after the entire family had gathered to celebrate Patricia and Mario’s 50th anniversary. Now she takes the situation more stoically. “Seeing how marriages fall apart after two, three, five or 10 years, I think it’s an absolute success to have shared a life together for 50 years,” she said.

But Vargas Llosa’s younger son, Gonzalo, who works with the United Nations in Britain, still reels from the way Mario handled the divorce. “We had a very special and very close relationship, and I love him greatly,” he told me. But he was enormously disappointed when Mario told ¡Hola! that his first year with Preysler had been the happiest year of his life. “If the year in which you leave your wife of 50 years and you don’t speak to your son is the happiest year of your life, well, that doesn’t say a great deal about whatever he may have really felt,” Gonzalo told me. “So this is fine to think, but why say it publicly? This what I find distasteful but also hurtful.”

Divorce, and its painful aftermath, can happen in any family. But what galls many people, including Gonzalo, is that Preysler embodies the celebrity entertainment culture that Vargas Llosa long claimed to abhor. A woman of feline poise and beauty, she has shrewdly parlayed tabloid attention into a kind of proto-Kardashian career: hosting television shows, promoting luxury goods like Rabat jewelry and Porcelanosa tiles. Their social life is now extensively documented by ¡Hola!, where Preysler herself once worked, as well as by many less savory gossip sheets. A quick online search turns up images of the couple sailing on the Costa Azul, watching bullfighting in Seville and attending parties at Dumfries House with Prince Charles. 
“There are hundreds of publications, radio and television programs, that feed a kind of morbid curiosity that consists of basically revealing the private lives of people,” Vargas Llosa told me in Madrid. “Many people are delighted. On the contrary, it’s a real profession to show your privacy. It’s a kind of striptease, no, of a life, especially sexual, erotic. And it’s a world that literally produces horror in me.”

This “profession” is Preysler’s, however, and as long as they are together it will be, in some way, Vargas Llosa’s profession as well. In December the Spanish edition of Harper’s Bazaar magazine published a soft-focus video of the couple embracing and talking about their life together — precisely the sort of thing that, to listen to Vargas Llosa, “literally produces horror” in him. This sudden, major gap between what Vargas Llosa says and what he does reminds me of a conversation we had about his puckish character Fonchito, a boy with the face of an angel and a taste for Egon Schiele. In “The Discreet Hero” (2013), Fonchito develops an interest in religion and asks his father, Don Rigoberto, “Could you tell me what this Sodom and Gomorrah is, Papa?”

Sometimes I wonder if Fonchito is your alter-ego, I said to Vargas Llosa.

“Who knows?” he said, chuckling. “He’s a character who disturbs me a bit because I don’t really understand him very well.” A moment later he added, “I can’t tell if he’s really so innocent or if he’s concealing something or if it’s a way of behaving that’s clever, no?”

Fonchito first appeared in Vargas Llosa’s erotic comedies “In Praise of the Stepmother” (1988) and “The Notebooks of Don Rigoberto” (1997). Most critics ignore these libertine novels when they discuss Vargas Llosa’s work. His own fans tend to regard them with either distaste or hilarity. But the skittishness about sex has kept readers and critics from appreciating how erotics pervade all of Vargas Llosa’s fiction. Even the novels that are best known for their political dissections are filled with a kind of transgressive sexual realism: scenes in brothels, secret homosexual affairs, rapes. “People don’t tend to think of him as an erotic writer, but his literary project is so interesting in part because of the way it connects sexuality with politics,” Gallo told me. “I think there is an idea, and he’s said as much, that a dictatorship affects all the levels of citizens’ lives, including the sexual sphere.”

Nowhere has this connection been as explicit, or as graphic, as in Vargas Llosa’s latest novel, “The Neighborhood.” The story opens with best friends Marisa and Chabela in bed. A few pages in we find the words “perspire,” “clitoris,” “scratching” and “happiness” — their platonic evening has transformed into a lesbian affair. In Vargas Llosa’s opinion, this scene, and the novel’s many other triple-X plot twists, realistically capture the bedroom adventures that occurred during the darkest part of the Fujimori years. Lima’s authoritarian curfew, which forbade residents to travel through the city at night, turned many dinners and parties into spontaneous sleepovers, he told me, with some inevitably kinky consequences. 

Mario Vargas Llosa, author, and Nobel Prize laureate, running for president in Peru. 1989 Credit Photograph by Ian Berry/Magnum Photos 

“In those periods of tension, of terrible aggravation, eroticism often springs up as a compensation, no?” he said. “It’s a way of distracting oneself, of losing oneself. It’s like the idea of the end of the world. The world is ending: All sins are allowed.”

The last time I saw Vargas Llosa was on a freezing night at the Cato Institute in Washington. He looked exhausted. He and Álvaro had spent all day planning the next round of meetings, debates and conferences for the International Foundation for Liberty, the organization they use to support their political agenda all over Latin America. After some 14 hours of work, he stood in the Hayek Auditorium — a high-tech space of white walls and red velvet chairs — before a multinational audience of reporters, diplomatic professionals, Cato staff members and friends who expected him to explain the global rise in populism.

“Communism has destroyed itself by its total incapacity to fulfill all the expectations that were put into this system to bring prosperity, justice, happiness, culture to a society,” he said in English. “But populism is much more difficult to fight because it’s not an ideology, not a system with principles, with ideas that we can refute rationally.” 
As recently as three years ago, it seemed as if Vargas Llosa’s political values had conquered the world. Almost everywhere in Latin America, the totalitarian regimes that he opposed had collapsed — while free markets, democracy and sexual liberation found favor. But in 2016, the tide seemed to change. During our conversations, he recalled feeling astonished during a visit to England shortly before the vote on Brexit. For Vargas Llosa, London had long been a model of how polyglot pluralism, democracy and free markets should work together. Yet there was Boris Johnson on his hotel television, shamelessly declaring that Britain’s payments to the European Union subsidized bullfights in Spain.

“To lie so brazenly, so cynically,” Vargas Llosa told me. “Well, I was amazed.” He never imagined that such retrograde tactics could work in Britain. “Now,” he said, “it’s been proved that no country is really vaccinated against demagogy or populism.” In Europe, it’s easy to name major political figures, like Angela Merkel in Germany, who embrace the principles of liberal economics while also defending a liberal society. That’s rare in Latin America. “The attraction to a caudillo is a characteristic that many Latin American countries share,” the Peruvian journalist Diego Salazar told me. “And not just Latin Americans. In fact, President Trump is the first Latin American president of the United States in that respect.”

In 2016, Keiko Fujimori lost the presidency by only 0.2 percent of the vote, and her party, Popular Force, gained a majority in Congress that she has used, in true competitive-authoritarian fashion, to attack her strongest opponents. In late December, Popular Force nearly deposed President Pedro Pablo Kuczynski in a legislative coup. Kuczynski was saved only by the intercession of Alberto Fujimori and his son, Kenji, who persuaded nine congressmen to sit out the key vote. Soon after, Kuczynski granted Alberto a Christmas Eve pardon. It’s widely believed that the abstentions were quid pro quo for this release.

“We have always had to choose between the lesser of two evils,” Gustavo Gorriti, editor of the investigative-news outlet IDL-Reporteros, said about Peruvians. “And we have had substandard democratic candidates, which we chose to elect just in order to avoid the return to the Fujimori dictatorship.” But the Fujimoris are now essentially in power — Kuczynski’s political survival depends upon their favor — and Peru’s loose coalition of democratically minded forces may not pull off another win in the 2021 elections.

Vargas Llosa’s own role in these battles is diminishing. The pain and friction of his unexpected divorce have estranged him from Peru and strained many of his old friendships. He does not travel to Lima as often or stay long when he goes. The apartment where Álvaro met with Humala now belongs solely to Patricia Llosa, who has dismantled Vargas Llosa’s office and is turning it into a TV room. His political opinions will always matter in Lima, but now that he has opted to join Preysler’s jet set, they will carry less weight. Gonzalo Vargas Llosa predicted this shift at the start of his father’s affair. “He was a god for me not just because I loved him as a father,” he told me, “but because I thought he was the most brilliant and important and inspiring intellectual that I had ever come across or read about. And when I see a Nobel Prize winner giving interviews to ¡Hola!, I feel sad that he has allowed himself to become part of a world which is intellectually so absolutely poor.”

Nothing may transform a life as much as love, but Vargas Llosa has always been hard to comprehend. He’s a modernist and a comedian, a politician and an aesthete, an intellectual and a libertine. Writing was not simply a refuge from or a rebellion against Ernesto, he told me in Preysler’s garden; it was “a way of revealing myself to be different from what he wanted me to be.” His whole life has been a series of these startling revelations. Perhaps we all contain multitudes, but Vargas Llosa has put his contradictions into action, in his life and on the page.


The markets still have plenty to fret about

With share valuations so high, volatility, junk bonds, growth and China are all cause for concern

BULL markets always climb a wall of worry, or so the saying goes. For much of 2017, the main concerns were political and the markets seemed to surmount them as easily as a robot dog opens doors (the latest internet sensation).

But February has shown that the market is still vulnerable. The immediate trigger seems to have been the fear that inflationary pressures would cause bond yields to rise and central banks to push up interest rates; this week’s surprisingly high American inflation numbers will only add to the worries. In a narrow sense, that makes bonds look cheaper, compared with equities. In a broader sense, it increases the discount rate investors apply to future profits, lowering the present value of shares. (A caveat is needed: if higher rates reflect stronger growth, then estimates of future profits should rise, offsetting the discount-rate effect.)

The immediate effect has been to create uncertainty for investors about the direction of central-bank policy, after many years in which it could reliably be assumed that rates would stay low.

This translates into a more volatile market, as illustrated by the sharp jump in the Vix, or volatility index, in early February.

The danger is that many investors seem to have treated volatility as an asset class, and have organised their portfolios accordingly. Eric Lonergan of M&G, a fund-management group, warned in a blog that “endogenous instability is rising, and volatility is at the core. Volatility has virus-like properties. It started as the domain of a small specialist group of quants. And it has spread to infect everyone.” Too many people use volatility as a measure of risk, but the real risk is the permanent loss of capital, he points out. A focus on short-term volatility may lead to herd behaviour on the part of investors, creating the risk of a sudden sell-off.

Another area which could be subject to stress is the corporate-bond market. According to Moody’s, the yield on American speculative (or junk) bonds reached 6.44% on February 9th, the highest since December 2016. The value of the largest junk-bond exchange-traded fund fell sharply (see chart). If the world economy keeps strengthening, companies should be able to meet their interest payments. Moody’s thinks the default rate on junk bonds will fall from 3.2% to 2% by the start of next year.

But the market has changed since the crisis of 2007-08. A decline in bank lending has forced European companies to turn to the bond markets; high-yield bond-issuance in the years 2013-17 was three times higher than in 2008-12, says Ironshield Capital, a fund-management firm. Banks are also devoting less capital to market-making, meaning bonds could be hard to sell quickly. “Corporate credit could be the next crisis in the making,” warns Absolute Strategy Research, a consultancy, raising concerns about “potential liquidity issues associated with high yield”.

A third possibility is that markets may be too optimistic about economic growth. China’s purchasing-managers’ index for manufacturing has slipped back in recent months, and its credit growth has fallen to its slowest rate in 31 months. John-Paul Smith of Ecstrat, a consultancy, worries that the risks for the Chinese economy will be compounded by worsening tensions with America, and that these are likely “to become much more visible over the coming weeks, across a broad range of policy areas in addition to trade.” Both the Bloomberg Commodity index and the Baltic Dry (shipping) index, indicators that are sensitive to global demand, have dropped back in recent weeks.

Of course, over-optimism about growth would mean that central banks have to be less vigilant about inflation and bond yields might come back down. But this would not be great news for equities, especially as analysts are forecasting nearly 18% profits growth this year for companies in the S&P 500, according to Andrew Lapthorne of Société Générale, a French bank. That leaves plenty of scope for disappointment.

A related problem is that the American market represents more than half the MSCI World index, which means that people who think they have a diversified portfolio actually have a concentrated bet. As Mark Tinker of Axa Investment Managers points out, the last time one country comprised so much of the global index was Japan in the late 1980s. That did not work out so well.

Some or indeed all of these worries may never be realised. But with the cyclically adjusted price-earnings ratio on the American stockmarket around twice its long-term average, equities are vulnerable to any kind of bad news.

Kim Jong Un gives Donald Trump a lesson in diplomacy

Strip out the noise, and the North Korean leader has outsmarted his opponent at every turn

Philip Stephens

He is a madman, a crazed dictator who cannot be allowed a finger on the nuclear button. Talk of containment and deterrence is meaningless. These strategies only work when the adversary is a rational actor. Who could say that of North Korea’s Kim Jong Un?

So has run the story in Washington. Few would dispute that Mr Kim presides over one of the most repressive and inhumane regimes on earth. By most measures it is probably the worst — witness millions left to starve for the sake of the nuclear obsession and the brutal suppression of the slightest hint of dissent.

For all that, the US has made a mistake. It has confused ruthlessness with mental instability. Mr Kim knows what he is doing. So do those around him.

Last autumn a delegation of North Korean officials met with western foreign policy and defence experts at a closed gathering in Switzerland — the latest of several secret and thus deniable attempts over the years to explore prospects for ending the nuclear stand-off between Pyongyang and the international community.

The North Koreans were implacable. Mr Kim was going to put a nuclear warhead on an intercontinental ballistic missile. There was no other way to deflect US “aggression”. Pyongyang would never bow to international sanctions, a subject on which its diplomats had some choice words for Russia and China as well as for the US. This latest meeting broke up in gloomy deadlock, though not before the westerners had noted how the bearing of their interlocutors defied familiar stereotypes. These were smart people.

Unfortunately, Donald Trump is more comfortable with cartoon caricatures of his adversaries.

The US president eschews diplomacy for Twitter fusillades. “Little Rocket Man” is his description of the North Korean leader. “My button is bigger than your button,” is the playground boast about the two countries’ nuclear arsenals. More recently. Mr Trump has called Mr Kim a “sick puppy”. Pyongyang fires its own salvos — the US president is a “dotard”. Strip out this noise, though, and Mr Kim has outsmarted his opponent at every turn.

The louder Mr Trump shouts, the more plausible becomes North Korea’s claim that its nuclear programme is a necessary insurance policy against a US plan for regime change. Even before Mr Trump reached the White House, America — and the world — were still paying for former president George W Bush’s “axis of evil” speech.

The North Korean despot’s decision to send a high-level delegation, complete with cheerleaders, to the Winter Olympics in South Korea’s Pyeongchang has been widely acknowledged as a coup. It was more than that. It was a masterclass in international diplomacy that at once made the US look weak and, by buying time, advanced Mr Kim’s quest for long-range nuclear missiles.

The purpose was transparent — to drive a wedge between Washington and Seoul and to present a more humane picture of North Korea to the wider world. By despatching his sister Kim Yo Jong alongside ceremonial head of state Kim Yong Nam, the North Korean leader guaranteed wall-to-wall coverage in the international media. Ms Kim said nothing publicly, but smiled at the right moments — in striking contrast to the sulking presence of Mike Pence, the US vice-president.

Kim Jong Un wants recognition as a nuclear weapons state before he is willing seriously to negotiate © AP

The White House had offered an open goal. Mr Pence arrived in Seoul insisting that Washington would open negotiations only if Pyongyang halted its nuclear programme. He left saying that the US would sit down for talks without preconditions. Not so long ago Mr Trump was promising to rain “fire and fury” on Pyongyang. Now, South Korean president, Moon Jae-in, is pondering whether to accept an invitation to a summit with Mr Kim in the north.

Seoul is under no illusions about the nature of the regime in the North. South Koreans will not be fooled by the Olympic gambit. But they also know that Mr Kim has the capacity, in Mr Trump’s words, to rain fire and fury on the South.

Pyongyang’s diplomacy, wholly cynical though it may be, has blurred some of the lines. As long the two sides are talking, Mr Trump faces intense regional and international pressure to keep his finger off the button.

North Korea scarcely has friends among America’s allies, but Mr Trump has squandered whatever slight international support he might have had for a military strike.North Korea, for its part, has been creating facts on the ground. Mr Kim wants recognition as a nuclear weapons state before he is willing seriously to negotiate. A few months during which South Korea and Washington are at odds may well give him the time he needs.

Mr Trump could still launch a pre-emptive attack, and Mr Kim may overplay his hand. But there are no good military options. Experts with access to the Pentagon’s planning say that the only certain way to avoid North Korean retaliation against the South would be a massive US nuclear first strike. That is unthinkable; anything less is dangerous.

There is no good ending to this story. China is unwilling to risk the collapse of the regime through sanctions. So the odds must be that Pyongyang will get its missile, with all the risks that entails of further proliferation. The US would be left with containment and deterrence. That Mr Kim is not a madman would be the smallest of consolations.

Currency Cold War

Donald Trump's Dangerous Game

By Tim Bartz and Martin Hesse

Despite a booming economy, U.S. President Donald Trump is calling for a weaker dollar, a move that threatens to jeopardize Europe's fragile economic upswing. There's very little the European Central Bank can do to fight back. 

For the past 15 years, Rolf Philipp has manufactured "bones for airplanes" in the town of Übersee on Bavaria's Chiemsee lake. That's what the founder and CEO of Aircraft Philipp calls the aluminum and titanium parts his company produces for the aerospace industry. His company has a combined 250 employees in Bavaria and at a second German plant in Karlsruhe -- and business is going well, with the family-owned enterprise bringing in over 60 million euros in revenues last year.

Recently, though, developments overseas have been making life more difficult for Philipp. Within the past eight months, the United States dollar has lost more than 10 percent of its value, with the exchange rate now standing at $1.24 to the euro. Just one year ago, Aircraft Philipp found itself profiting from an exchange rate of under $1.10 to the euro.

Philipps' most important customers, Airbus and Boeing, sell the majority of their aircraft in dollars, and their sheer power in the marketplace allows them to pass the currency risks on by also paying suppliers in dollars. If the dollar loses value against the euro, Aircraft Philipp's profits also drop because the company's costs are generated largely in euros.

"We have a technological edge in Germany, but that doesn't help much when the dollar falls on us like a hammer," says Philipp. He says that if the euro exchange rate was to rise to $1.35 or higher over an extended period of time, it would become increasingly attractive for customers to make purchases elsewhere.

In principle, of course, the euro's rise, which began around a year ago, is good news. It signifies the degree to which the economy on the Continent has recovered after years of weakness. That development has been bolstered by the growing willingness to cooperate among the European Union's core countries that has become visible since the Brexit vote -- primarily because of France's new president. "Skepticism of Europe has disappeared since Emmanuel Macron's election," says David Folkerts-Landau, chief economist at Deutsche Bank. "The major investors have returned to Europe because they see that things are running again."

Donald Trump's Controversial Cocktail

But the European developments that have strengthened the euro represent just one side of the coin.

The flip side is Donald Trump's "America first" policies: his open interest in a weak dollar as well as a controversial cocktail of supply and demand policies -- lowering taxes, rolling back regulations and the repatriation of wealth that has been parked abroad. The president's policies are laden with enormous risks.

Even though the U.S. economy has already been growing robustly for years and, with an unemployment rate of just 4.1 percent, is approaching full employment, Trump is continuing to stimulate growth -- a focus that could result in an overheated economy, which would present a danger to the entire global economy.

On the surface, everything appears to be in good shape. America, Europe and Asia alike are producing, consuming and investing more, and the International Monetary Fund just issued an upward revision of its forecast for worldwide economic growth to 3.9 percent for 2018 and for 2019.

But the speed with which euphoria can turn into panic was on full display at the beginning of last week, when fear suddenly began to spread among markets over excessive government deficits, inflation and interest rate increases, sparking the largest point loss in Wall Street history.

Even if the percentage slide on the markets was less dramatic, it is still likely that it bothered Trump a great deal. But when it comes to the weak dollar, his administration has literally talked it into existence. Trump wants to weaken the currency to promote exports, curb imports and to reduce his country's current accounts deficit -- one of the central pledges he made during the election campaign.

At the World Economic Forum in Davos, U.S. Treasury Secretary Steven Mnuchin said that a weak dollar was good for the U.S. economy. Trump himself may have sounded a little more conciliatory later on, but the genie was already out of the bottle, and Mnuchin's verbal intervention was already having an effect. The dollar fell rapidly, and the nasty term "currency war" could suddenly be heard in the hallways of Davos.

Irritated, But Relatively Powerless

"There is no longer any doubt that the U.S. government is not only waging a currency war, but is also in the process of winning it," Joachim Fels, chief economist at mutual funds giant Pimco, says. Trump's policies represent a threat to Europe's recovery, a situation that has displeased the European Central Bank (ECB). But there isn't much the ECB can do about it.

By pursuing economic policies that ignore the needs of America's trading partners -- an approach economists refer to as "beggar-thy-neighbor" -- Trump has revisited an old American tradition. In the early 1970s, it was Treasury Secretary John Connally who raised the prospect of a budget deficit of $40 billion -- a massive sum at the time -- and justified it as "fiscal stimulus." In response to concerns voiced by his European counterparts, worried as they were about the weak dollar, he responded with his legendary line that the dollar "is our currency, but your problem."

Lloyd Bentsen, treasury secretary under Bill Clinton, informed the Japanese in 1993 that he urgently desired a stronger yen in order to stem the Asian trading partner's high export surpluses.

With "America First," Trump has now elevated "beggar thy neighbor" to the status of administration doctrine.

The first part of Trump's economic policy agenda envisions stimulating the economy through tax cuts and public infrastructure investments. That would help American companies, and the rest of the world could also profit initially if the U.S. economy were to grow more rapidly and companies in Europe or Asia were to receive more orders.

But it's the second part of the Trump program that reveals the real strategic thrust. During the same weak that the treasury secretary could be heard preaching the virtues of a weak dollar, the U.S. government imposed steep import tariffs on washing machines and solar cells. The combination of a weak dollar and protectionist measures are aimed at creating a competitive advantage for American companies versus their competitors from around the world.

"The government clearly wants a weak dollar right now because inflation is moderate and a weaker dollar will make it easier for the manufacturing sector to grow," says Barry Eichengreen, a professor for economics at the University of California at Berkeley.

Loose fiscal policy does in fact create downward pressure on the currency. If taxes are lowered and the government increases its spending, households then have more money at their disposal.

Demand increases for goods from abroad, thus weakening their own currency. Domestically, higher demand drives prices upwards, especially when cheap imports are slapped with tariffs, so that the purchasing power of the dollar sinks.

Playing with Fire

Unless, of course, the Federal Reserve steps in to counter that development with higher interest rates. That would attract investors from abroad looking for better returns and the dollar would be strengthened, but it would also jeopardize the upswing. The situation in the economy and on the financial markets is so tense right now that Trump's policies are tantamount to playing with fire.

His policies have the potential to overturn years of delicate crisis management on the part of the central banks in the U.S. and Europe and to force them into an abrupt change of course.

"It's not the right time for that kind of fiscal policy program," says one of the world's most influential central bank heads.

Few past upswings have been as completely dependent on low interest rate policies of the kind put in place after the global financial crisis a decade ago. In addition to getting the economy back on track, they also drove up stock and real estate prices. Indeed, astronomical prices are once again being paid for company acquisitions -- prices of the kind last seen in 2007.

The crash in stock prices seen on Feb. 5 also revealed that banks and hedge funds are once again playing with risky bets on the financial markets that can magnify upheavals if the markets get spooked. So-called exchange-traded notes (ETN) valuing in the billions are a bet on calm market conditions and minimal changes in stock prices, but they suddenly lost all their value in last Monday's turbulence and also intensified the downward market trend.

Fear is now rampant that the best of all imaginable worlds for companies, governments and speculators may soon come to an end -- a world of zero percent interest rates, making debt almost completely unproblematic, investments unbelievably cheap and financial investments of all kind seemingly without risk.

An Impossible Task

The volatile situation has transformed Jerome Powell into one of the most interesting appointees in Washington at the moment. His predecessor Janet Yellen has left behind an almost impossible task for the new head of the Federal Reserve.

Powell likely already sensed what he was up against on this first day of work at the massive Fed headquarters on Constitution Avenue, just four blocks from the White House. Right at the start of his new job, global stock markets collapsed. It's possible the central banker might face the same challenges as his predecessors Alan Greenspan and Ben Bernanke did when they were appointed.

Greenspan had barely been in office for two months in 1987 when he had to deal with the biggest market crash seen since 1929. In 2007, meanwhile, just a year after his appointment, Bernanke was tasked with saving the country from the consequences of the subprime mortgage crisis and the massive recession that followed.

The Fed is scheduled to make its first interest rate decision under Powell in March and it's possible he will be forced to signal to the markets whether he expects to increase interest rates at a higher frequency than the three times that have been forecast for 2018.

"The risk of inflation in the U.S. is increasing, the interest rates for the bond markets are far too low," says Folkerts-Landau, who regards Powell as an independent thinker. "He's very pragmatic and is unlikely to just do what others want."

Given the high sovereign debt level, it's unlikely that Trump wants either higher interest rates or a stronger dollar. Experts estimate that Trump's tax plan could increase the budget deficit over the next 10 years by an additional $1.5 trillion.

The question as to whether Trump prevails, or Powell puts up a forceful challenge to the president is also of major importance for Europe. If interest rates remain low and Trump maintains his weak dollar policy, the Europeans will have a problem.
'New Headwinds'

Inside the European Central Bank skyscraper in Frankfurt, the mood is more charged than it has been in a long time. Members of the ECB's powerful Governing Council only recently stated that they were close to the benchmark goal of 2 percent inflation, but they now worry about the fruits of their labor.

"We are confident, but at the same time vigilant because our monetary policy is working and has made the upswing more robust, which is bringing us closer to our goal," says ECB Chief Economist Peter Praet. "But there are a number of international risks and we are watching them very closely."

The Governing Council considers the weak dollar to be the greatest risk. For years, the ECB kept the key interest rate under 0 percent and bought up large quantities of government and corporate bonds to stimulate the economy. Even if the ECB always stressed that it was not engaging in exchange-rate policy, it too was deploying its currency as an economic weapon. A (desired) side effect of its policies, after all, was weaker euro, with the European currency even approaching parity with the dollar a year ago.

The euro's rapid rise since then has been inopportune for the ECB, which explains the unusually curt reaction from Frankfurt to the American comments that sent the dollar into a tailspin. "The last thing the world needs today is a currency war," Benoit Coeure, a member of the ECB Governing Counsel, groused recently at the World Economic Forum in Davos. And speaking in front of the European Parliament in Strasbourg at the beginning of last week, ECB head Mario Draghi said that the strong volatility in the euro exchange rate had created "new headwinds."

"A currency war works like this: If you don't react to a thrust of the kind America has just made, then the assailant will be emboldened to continue doing it," says Ulrich Kater, chief economist at Germany's DekaBank. "That's why the ECB has to respond quickly and strongly, and it has done so."

At the moment, it remains a war of words, but it has the potential to escalate.

"A stronger euro could slow growth, especially in the periphery countries," says Deutsche Bank Chief Economist Folkerts-Landau. "That's why the ECB could see itself compelled to delay its exit from ultra-loose monetary policy if the dollar continues to fall."

U.S. economist Eichengreen thinks that the Trump administration's toying with the exchange rate is dangerous for another reason. A moment could come when investors have doubts about the U.S. government's determination to maintain a high credit rating. "Then they could push dollars onto the market, leading the dollar to fall faster than expected. That wouldn't be in anyone's interest."

Mid-Size Businesses Could Take Hit

Particularly not in the interest of European businesses.

At the moment, the dollar hasn't yet become a problem for the European economy. Most experts view the fair exchange rate as being between $1.25 and $1.30 to the euro. But that picture will change if the U.S. currency continues to weaken.

"For European exports, things will get difficult with a euro exchange rate of $1.35 or $1.40 -- and it is very possible that the rate will continue to move in that direction," says economist Folkerts-Landau.

He also says a weak dollar won't be such a problem for firms on the DAX index of German blue chip companies, but it would present significant difficulties to the mid-sized businesses that form the backbone of the German economy. Their profit margins tend to be lower. Companies in Italy in Spain would likewise be affected, says Folkerts-Landau, because they "export products that tend to be slightly lower quality and are more likely to compete on the basis of price."

DAX index companies like Fresenius, SAP, Daimler, Bayer and Linde can draw up to 20 to 50 percent of their revenues from the United States, often even more than they generate in Germany. But they no longer suffer as strongly from currency fluctuations as they used to, before globalization had advanced this far.

"We have strongly internationalized value creation in the past 10 years and thus considerably reduced the risk created by fluctuations in the dollar and other currencies" says Norbert Mayer, senior vice president of finance and group treasurer at BMW. He learned his lesson shortly before the global financial crisis, when the euro had risen to a rate of $1.50 to the euro, which led BMW's business in the U.S. to suffer considerably. BMW and many other companies made major changes in response to the currency fluctuations, beefing up or establishing plants in the dollar area.

The result is that in 2017, BMW sold 353,000 vehicles in the United States, but manufactured around 400,000 at its plant in Spartanburg, South Carolina. Despite this shift, the company still has a dollar risk in the single-digit billions, in part because the company also sells engines in the U.S. in addition to vehicles. But because BMW purchases raw materials in dollars and also hedges its currency risks through financial market mechanisms, its remaining risks are manageable.

For mid-sized companies like Airbus supplier Rolf Philipp, however, manufacturing abroad usually isn't worthwhile. And the lower your position in the supply chain, the harder it is to, for example, procure raw materials in dollars, Philipp explains. The only option really available to him and many other companies is to hedge the currency risks for as many of their orders as possible through the bank. But doing so is expensive, and it will get even more so the longer the weak dollar continues and the further the exchange rate falls.

Even worse than a weak dollar -- for Philipp, for other corporations and for the entire global economy -- would be if Trump's risky policies led to inflation, higher interest rates and an abrupt end to the economic boom. That would mark the end of a cold war -- and everybody would lose.