Why the global economy is due for a downswing

Alarm bells should start ringing when so many countries are performing so well at once

Stephen King

© FT montage/Getty

After so many years of anaemic growth and low wages, it might seem unreasonable to suggest that the next economic downswing could be lurking just around the corner. It is true that unemployment rates have dropped dramatically and wages have picked up a touch in a number of countries, and both are useful “end-of-cycle” indicators.

On the other hand, interest rates are mostly low, President Donald Trump is offering fiscal stimulus in the US, the eurozone is more dynamic than it has been in many years and earlier fears regarding a Chinese economic meltdown now look absurd.

Why, then, worry about the next downswing? Simply put, alarm bells should start ringing precisely when so many countries are performing so well simultaneously.

Starting with the 1994 bond market crash, through to the 1997 Asian crisis, and from the 2000 Nasdaq collapse through to the 2008 global financial crisis, history shows that periods when many countries are simultaneously growing above their long-run trends are associated with financial and economic upheavals. The only exception to this rule is the aftermath of recessions, most obviously in 2004 (following the dotcom bubble and 9/11) and in 2010 (after the global financial crisis).

Synchronised growth creates an “adding up” problem. What might be possible for one country to achieve economically when others are relatively weak may become more difficult to sustain when others are stronger. This might seem counter-intuitive — after all, export prospects are better when others are doing well — but the evidence suggests that economists and policymakers too often fail to recognise the three main “costs” of global economic success.

The first, more widely recognised since the financial crisis, is excessive risk taking. Put simply, the good times don’t tend to last because we collectively start to do stupid things that bring them to an end. Until the equity market wobbles in early February, most investors appeared to be as complacent about potential risk as they had been ahead of the global financial crisis.

The second cost is simple: as the world economy strengthens, so does demand for commodities and capital. That brings unpleasant side effects, such as rising oil prices and higher bond yields.

The third is an inevitable consequence of the first and second. Periods of synchronised growth tend to be associated with unexpectedly rapid monetary tightening. Since the 1994 bond market collapse, the US Federal Reserve has boosted interest rates faster than economists or investors expected in only seven years. Those seven episodes correspond almost perfectly with periods of synchronised global growth.

These costs can create localised or global financial and economic shocks. In the 1997 crisis, Asia’s woes proved to be an unexpected boon for the US. Capital was repatriated (driving US long-term interest rates lower and boosting domestic demand) and commodity prices fell (pushing inflation down). But when the costs are global there is no easy escape: the 2008 financial crisis was as much a challenge for Norwegian pension funds as it was for owners of subprime real estate in Florida.

Today, inflation is mostly well-behaved. The same cannot so easily be said about asset prices. Judged by burgeoning demand for emerging market debt, booming housing markets and, on some metrics, blistering US equity market valuations, it may be that risk-loving behaviour has returned.

Debt levels are higher than they were before the financial crisis. And, should things go wrong, interest rates are already so low that most central banks cannot ride to the rescue with sizeable rate cuts, as former Fed chairman Alan Greenspan did whenever the US economy wobbled.

How should policymakers respond? The Bank for International Settlements has long argued that it is difficult for central bankers simultaneously to achieve both price and financial stability. There is a case for pursuing what I call “positive ambiguity”. It may be better to downplay the goal of price stability in order to deflate a financial bubble.

Central bankers should also be on the lookout for foreign “feedback loops” and co-ordinate their policies accordingly. To date, overseas influence has often been ignored.

Meanwhile, politicians should try to avoid the late cycle hubris — often accompanied by slack fiscal policy — that typically emerges when global growth is firing on all cylinders. Too many nations have ended up on the economic rocks in pursuit of a “new economy” dream. In the current climate, however, that is easier said than done.

The writer is HSBC’s senior economic adviser and author of “Grave New World: The End of Globalisation, the Return of History”

The Difference Between Xi and Mao

By Jacob L. Shapiro

This week will be an auspicious one in China’s long and storied history. Chinese lawmakers are expected to rubber stamp a proposal by top Chinese Communist Party officials to abolish term limits on the presidency. It is a major break with more than 40 years of Chinese political norms, and it puts an inordinately large amount of power in the hands of a single person: President Xi Jinping, who is already a peerless figure of authority in China and who, after all, presumably initiated the abolition of term limits in the first place.

How Xi wields this power will have a profound effect on China’s future, and the early signs of his intentions have been strange, to say the least. At a gathering to celebrate what would have been the 120th birthday of Zhou Enlai, the first premier of the People’s Republic of China, Xi gave a long and effusive speech, during which he praised Zhou as a model of Chinese virtue. (When the speech was over, Premier Li Keqiang – whose power Xi has methodically curtailed in the last five years – praised Xi’s leadership of the CPC into the future.) This stands in stark contrast to the speech Xi delivered in 2013 on what would have been Mao Zedong’s 120th birthday. In so many words, Xi said Mao was a human being like any other who should be held accountable just as much for his failures as for his successes.

On the one hand, Xi is raising the possibility that he might become the first Chinese leader since Mao to govern China as dictator-for-life. On the other hand, Xi has gone out of his way to criticize Mao and praise Zhou, Mao’s closest and most loyal comrade, who, despite his service and devotion, was purged from power for trying to curb Mao’s excesses. Like I said, strange to say the least.

A Man Like Mao

Mao was a leader of world-historical importance, but it’s perfectly reasonable for Xi to point out his failures. There are many such failures to choose from, including ignoring his military commanders during the Korean War and the brutal purges of the Cultural Revolution. But none of Mao’s missteps were more destructive or more representative of his leadership style than the Great Leap Forward, Mao’s ambitious plan to vault China into the top industrial powers of the world. The Great Leap Forward failed for many reasons, but among the most important was that provincial Chinese bureaucrats were so terrified of Mao’s retribution that they falsified the data they gave the CPC.

Seeing only what he was provided, Mao thought China was becoming stronger when in fact it was falling deeper into disrepair. By the time he got wise to reality, more than 45 million were dead.

The irony is that the paranoia and ambition that led to mistakes such as the Great Leap Forward were also responsible for Mao’s overall success. Mao believed that China could be free and strong only if it abandoned its past. He blamed China’s weakness in part on Chinese culture, and he sought to obliterate that culture and to replace it with a new resilient spirit of Chinese nationalism. Mao distrusted China’s vast bureaucracy because it had collaborated with foreign invaders, only to realize upon coming to power that China was too vast to rule without a bureaucracy. This led to a never-ending cycle of chaos, whereby Mao would carry out wide-ranging purges even if it meant rendering policy initiatives ineffective because China was more important than any single policy initiative. By the end of Mao’s rule, China was in chaos, but China was also independent and united.

The price China had paid for its sovereignty was extremely expensive. After Mao died, presidential term limits were instituted in 1982 in China as part of a broader effort to prevent men like Mao from coming to power ever again. The CPC still admires Mao, but the party line is that 70 percent of what he did was right and 30 percent was wrong – a remarkable party line in a country where political dissent is so carefully regulated. The CPC saw that a man like Mao, necessary as he was to unite China under the rule of one government, could not make China a world-class power. In fact, at a certain point, a man like Mao only prevented China from reaching its true potential. Mao’s successor, Deng Xiaoping, himself purged by Mao three different times, knew firsthand how destructive Mao’s leadership style was, and it was Deng who decided that the most important thing he could give China was a model for a peaceful and orderly transition of power to a younger generation. In place of these men now stands Xi, who is erasing Deng’s model as he claims the throne of the Middle Kingdom.

Xi is not Mao, and his praise of Zhou is meant to make sure the Chinese people know it. Mao ruled by chaos; Xi rules with orderliness. Mao destroyed the bureaucracy; Xi is molding it to serve his purposes. Mao purged friends and foes alike; Xi purges only his foes. Mao was a fervent communist; Xi is a communist in name only, who in the same breath speaks of Lenin and of supply-side reform. Mao was the son of a wealthy farmer. Xi is a “princeling” whose father was purged during the Cultural Revolution. Indeed, no one knows the depredations and bloodletting that Mao oversaw better than Xi, who had a front row seat for all of it.

A Different Turn

And yet, despite Xi’s intimate experience with tyranny’s discontents, he has deemed it necessary to tear down the safeguards erected to prevent a man like him from seizing power comparable to Mao’s.

The fact that Xi is compelled to praise Zhou, who tried to protect the Chinese people from Mao while still paying fealty to the Chairman, shows just how nervous Xi is. Xi is not claiming the mantle of power because he is a power-hungry megalomaniac but because he believes that China is in just as precarious a situation today as it was in 1949, when no one knew if the republic would last more than a decade.

Xi does not face the same challenges Mao did, of course. The country Mao conquered was a poor, abused, humiliated mass of people in the throes of civil war and governed by warlords.

Forging the republic out of such a country required a man with Mao’s unique virtues and vices.

The country Xi leads is proud and more united than China has been in centuries. Xi’s China is a major power, boasting the world’s second-largest economy and a rapidly improving military.

But it is also a country rife with corruption and inequality. If Xi is to redistribute wealth to the 350 million people still living on less than five dollars a day, the government-by-consensus model that has governed China will not be enough. Xi needs to show those who stand in his way that he will crush them if they don’t bend the knee.

China is about to embark on a period of intense internal change, albeit a different kind of change than Mao wrought. Xi will aim to create the legitimacy of change not with revolution but with national pride. And nothing is more generative of national pride than powerful enemies abroad. It is not a coincidence that as Xi claims more and more power for himself, China is engaging in provocative behavior in the South and East China Seas, is attempting to upend the U.S. security alliance in Asia, and is presenting the One Belt, One Road initiative as a way to return China to its rightful place at the center of the world. China’s peaceful rise is over – its confrontation with the world is beginning. Xi will use that confrontation to justify the excesses he will have to oversee if the PRC is to survive his presidency.

In his speech about Zhou, Xi said that, were he able to speak with Zhou, he would tell him “the Chinese nation that experienced great hardships for a long time since the start of modern times has ushered in a great leap from standing up and getting prosperous to becoming strong.” Mao propped China up. Deng made China prosperous. Xi means to make China strong, and he means to do so in his own way. Mao turned on the Chinese people. Xi will turn the Chinese people on the world.

Trump’s Tax on America

J. Bradford DeLong

 Pedestrians pass in front of the NYSE

BERKELEY – Mitch McConnell, the US Senate’s Republican Majority Leader, recently proclaimed that “2017 was the best year for conservatives in the 30 years that I’ve been here,” not least because President Donald Trump’s administration “has turned out to be … very solid, conservative, right of center, pro-business.”

One would undoubtedly hear Republican donors express similar sentiments over their shrimp hors d’oeuvres. After all, the Trump administration has rolled back environmental regulations and cut taxes for the rich. What’s not to like?

Sure, Trump and his family are aspiring kleptocrats. But that means they are against the government taking “their” wealth. They are natural allies for those who think that America’s income and wealth gap could stand to be even wider than it already is.

And never mind that the Trump administration is utterly inept, or that last year’s tax legislation was the most poorly drafted bill in living memory. Trump’s cluelessness, if anything, affords congressional Republicans even more opportunities to create legislative loopholes and ensure preferential treatment for their donors. It would seem that for the Republican Party, an incompetent, erratic kleptocracy might just be the best form of government.

Or at least it was until March 1, 2018, the day Trump signaled his intention to impose across-the-board import tariffs of 25% on steel and 10% on aluminum. That decision, notes Pat Roberts, a Republican senator from Kansas, “is not going to go down well in farm country.”

As Roberts points out, Trump’s move toward protectionism this year is at odds with his earlier policy achievements. “We have a tax reform package that’s bringing a lot of benefits to the business community,” Roberts told the Kansas City Star, “and this is a policy move that is contrary to that.” His worry now is that Trump will pursue “a trade policy that will basically result in all the benefits of the tax reform being taken away by higher manufacturing costs being passed on to consumers.”

He’s right. In the end, American consumers will pay for Trump’s tariffs. Such broad protectionist measures will affect every sector of US manufacturing in one way or another, and manufacturers certainly will not eat the full costs of higher-priced steel and aluminum inputs.

At the same time, other countries will introduce tariffs of their own against US exports. The European Union, for example, is now planning to slap tariffs on such American staples as Harley-Davidson motorcycles, bourbon whiskey, and Levi’s jeans.

So, Trump has essentially proposed a new tax on US consumers and export industries, the costs of which will be borne largely by his own supporters in the American heartland and Rust Belt.

Moreover, Trump seems to have arrived at his decision almost out of the blue. Stock markets were caught off guard, and immediately fell by around 1.5%. And according to the Kansas City Star report, “[Roberts] and other Republican senators received no formal heads-up from the White House.”

And yet the Republicans have been so cowed by Trump that the best response Paul Ryan, the speaker of the House of Representatives, could muster was that he “is hoping the president will consider the unintended consequences of this idea and look at other approaches before moving forward.”

It turns out that Trump’s decision was taken against the advice – indeed, over the objections – of not just his chief economic adviser, Gary Cohn, but also his national security adviser, General H.R. McMaster, his treasury secretary, Steven Mnuchin, and his defense secretary, James Mattis.

On the other hand, Secretary of Commerce Wilbur Ross apparently favors the tariffs. But it is not at all clear why. The Department of Commerce itself surely recognizes that more Americans benefit from lower steel and aluminum prices than from higher prices.

Another supporter of the tariffs is Peter Navarro, who was recently promoted to Director of Trade and Industrial Policy and Director of the White House National Trade Council. That comes as no surprise. Navarro has written a number of alarmist books about America’s trade relationship with China, including one titled Death by China. Nevertheless, Navarro has not yet been able to explain how creating a larger domestic steel industry through tariffs will yield a net benefit for the US economy.

A final key supporter of the tariffs is US Trade Representative Robert Lighthizer, who formerly worked as a lawyer for the steel industry. As with Ross, it is not entirely clear what Lighthizer is thinking. He has to know that Trump’s tariffs will have little to no chance of boosting the US steel and aluminum industries without also imposing substantial costs on the economy. Doesn’t he realize that his own reputation will ultimately depend on whether the administration has a successful trade policy or an obviously stupid one?

Now that Trump has set a match to the global trading system, one wonders if America’s plutocrats and their congressional lapdogs will soon realize that a bungling government chained to the unpredictable whim of a labile president is not, in fact, ideal for sustaining and creating wealth. In a kleptocracy, predators often discover that they are the prey.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

Angry Analytics

Jared Dillian
Editor, The 10th Man

Usually I don’t put explicit trade ideas in The 10th Man, because, well, you should pay for ‘em!

This idea is free, so it is probably worth what you paid for it.

The idea: there is too much panic about interest rates going higher. It has become a consensus trade. I have been pounding the table on short bonds for years, but… now is the time to go the other way, at least for the time being.

Here is a chart I borrowed from @HayekAndKeynes. It shows the divergence between tech on the one hand, and rate-sensitive stuff (in this case, REITs and Utilities) on the other. If there are any mean reversion people left, now is probably a good time to bet on mean reversion.

Source: @HayekAndKeynes

A good heuristic to find trade opportunities is to think about what sort of trade ideas make people angry. The folks at Mauldin gave this a nickname a couple of years ago: “angry analytics.”

One of the attractive things about the short duration trade is that it is mathematically perfect.

We are going to be running huge deficits, far out into the future, and this supply of bonds will far exceed the dwindling demand from overseas.

Well, the funny thing about demand is that you never know where it is going to come from. We are running $1 trillion deficits now; back in 2009/2010 we were running $1.8 trillion deficits—and interest rates went down! People showed up at those auctions, and bid lustily.

They might show up at these auctions yet, if they are incentivized to do so.

First of all, yields are starting to look attractive. We’re getting near 3% on tens, and 3% on ten year notes (risk free, I might add) is going to look tasty to a lot of people. In fixed-income land, they call this the Rule of Fives. Every time bonds get near a big figure, people find value.

Because they are dumb.

And remember, it’s not just the magnitude of the move that counts—it’s the velocity. Yields are up about 140bp off the lows, but it’s taken a long time to get there. 140bp over a year means something different than 140bp in a month. People have had time to adjust. They are panicking, but there’s no reason for it.

You want to be bullish on the thing that if you told people, they would be angry. People would call you a fool for buying bonds. If you went on CNBC and told Rick Santelli you were buying bonds, he would probably call you a fool (actually I have no idea what Santelli’s position on bonds is, but he seems like the kind of guy who would be bearish).

You could buy bonds, or you could buy things that are correlated to bonds. In which case you would be an even bigger fool.

Fools Rush In

Let’s take this one step further. Let’s come up with the stupidest trade idea in the world.

So buying bonds is stupid. Buying REITS is doubly stupid, because they have adverse exposure to rising interest rates.

You know what is the stupidest idea of all?

Mall REITs.

And it’s genius.

Everyone knows malls are all going tango uniform. Amazon has killed them all. All that is left is a Hot Topic and maybe a $15 massage kiosk.

Hell, the mall in Myrtle Beach actually has a physical compact disc store. You can’t get any more donkey than that. It also has an Abercrombie & Fitch, which is deserted (and doomed).

They might as well capitulate and put the Planet Fitness in there.

Everyone knows all malls are going out of business. It is only a matter of time.


What if…

We have reached peak bearishness on malls?

The mall REIT trade isn’t priced for perfection. It’s priced for whatever the opposite of perfection is. So by buying a mall REIT, you want…

• Interest rates to go down (which is mathematically impossible), and…

• Malls to recover (which is insane). Really what you need is…

• Amazon to go down. Madness.

That, my friends, is the essence of 10th Man trading. It is the duty of the 10th Man to disagree.

And it works a lot.

I’m not going to select any tickers in there—you can do the last bit of research. Let’s revisit this about a year from now and see how the idea worked out. I bet it’s up.

Actually, I bet it outperforms the S&P. I bet it is negatively correlated to the SPX. I bet it generates alpha.

Go on CNBC and tell them that your best idea is buying mall REITs, and see what happens.

You’ll get laughed off the set. Everyone knows malls are going to zero.

Have fun, guys.