Peru: Staff Concluding Statement of the 2019 Article IV Mission

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country.
Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
Recent Developments, Outlook, and Risks
1. Peru continues to be one of the best-performing economies in the region, but economic activity has lost momentum in recent years. With annual real GDP growth averaging 5.4 percent over the past fifteen years, Peru has been one of the fastest economies in the region, which enabled it to make significant progress in reducing poverty. Since 2014, however, a less benign external environment and adverse domestic factors have weakened considerably the pace of economic activity.

Trade tensions have reduced global growth and increased uncertainty, international financial markets have become more volatile, and commodity prices have only partially recovered from the 2011-15 decline. Domestically, the adverse 2017 El Niño weather event caused significant economic disruption and the findings of the Lava Jato investigation hampered large investment projects.

2. Growth is expected to remain modest in the short term before strengthening gradually. GDP grew by 2.2 percent in the first nine months of 2019, but the measures taken by the government to speed up execution at all levels of government should help public investment recover. Lower extraction and social unrest in mining and weather-related transitory factors in fishing should also recede.

As a result, GDP growth for 2019 is projected to be 2½ percent. With the negative output gap expected to persist, inflationary pressures should remain subdued. A gradual strengthening of demand from Peru’s main trading partners and resilient private consumption and investment would raise GDP growth to 3¼ percent in 2020 and 3¾ in the following years.

3. Risks are tilted to the downside, but policy buffers are strong enough to mitigate the impact of adverse shocks. Prolonged uncertainty and continued trade tensions could undermine growth prospects in Peru’s main trading partners, reducing exports and the prices of mining and agricultural commodities. Likewise, external risk-off events could determine a sudden tightening of financial conditions and trigger contagion effects.

The associated exchange rate movements could be magnified by balance sheet effects owing to the partial degree of dollarization still present in Peru’s financial system. Domestically, prolonged political uncertainty and ongoing corruption investigations could stifle business investment and growth. However, a favorable public debt position buttressed by considerable financial assets, a large stock of international reserves, and a solid financial system should help cushion the impact of adverse shocks.

Policy Recommendations
To re-kindle growth amid increasing uncertainty, a broad set of policies is needed to continue strengthening Peru’s resilience to shocks, enhance productivity, and improve social protection.  The current slowdown in activity and heightened uncertainty would justify fiscal and monetary stimulus.  A stronger financial infrastructure would buttress the system’s capacity to absorb a wider range of domestic and external shocks. Structural reforms would enhance competitiveness and productivity and make growth more inclusive.   Fiscal Policy

4. To provide a fillip to the economy, the authorities should make full use of the space available under the fiscal rule. While policy is focused on bringing the fiscal deficit below the 1 percent of GDP ceiling by 2021, budget under-execution has led to a tighter policy stance than required by the fiscal rule. This has contributed to slowing growth amid rising uncertainty.

In this context, the measures taken by the government to remove financing and capacity constraints of local and regional governments should help speed up the execution of capital spending, but close monitoring and other supporting measures may be necessary to ensure success. In the medium term, significant efforts are also needed to enhance the quality of public investment management, including formulation, assessment, and selection of projects.

5. If fully executed, desirable plans aimed at boosting public investment could require additional measures to comply with the deficit ceiling. Enhancing the quality of infrastructure is a key component of the government’s strategy to increase the economy’s competitiveness.

The National Plan of Infrastructure for Competitiveness identifies significant infrastructure gaps, which would be partially bridged by priority projects—amounting to 13 percent of GDP—to be executed in the next decade.

To be consistent with the fiscal rule, this effort will require enhancements in revenue administration, improved performance of public enterprises, and reduced current spending, but projections of these items seem subject to significant risks.

6. Addressing priority needs while preserving fiscal sustainability makes it imperative to bolster revenue mobilization. Despite significant efforts by the authorities to mobilize revenues, Peru’s tax revenue ratio remains comparatively low, with modest progress being made in the last twenty years.

But without higher revenues, Peru will be unable to address priorities in several areas, including infrastructure and the social safety net.

In this context, continued improvements in revenue administration are paramount and require maintaining SUNAT’s ability to focus on its core activity and attract top quality staff.

Measures taken in recent years to reduce non-compliance, such as the introduction of electronic invoicing and the adoption of best practices on international taxation, should start bearing fruit.

The authorities’ intention to simplify tax regimes for small businesses should also help reduce loopholes and increase compliance.

7. To avoid a procyclical fiscal stance and to create space for infrastructure spending, the authorities could also consider introducing more flexibility in the fiscal framework. Although frequent revisions may weaken the integrity of the rules-based system, low debt and the strong fiscal framework would limit the risks associated with a modest increase in the deficit ceiling. The erosion in fiscal buffers would be minor and the existing expenditure rules would continue to limit current spending even under a higher deficit ceiling, thereby reducing reputational risks.

Monetary and Exchange Rate Policies

8. The recent easing of the monetary policy stance is appropriate, given weakening growth, increased uncertainty, and muted inflationary pressures. Inflation expectations are well anchored, the output gap is expected to remain negative for some time, and fiscal policy is contractionary. The recent forward guidance from the central bank—indicating that the last policy rate cut did not necessarily imply that further cuts would follow—is helpful in clarifying that policy remains data-driven. In this regard, further policy easing might be needed if downside risks to the inflation outlook materialized. Nonetheless, with the real interest rate now close to zero, the monetary stance is clearly expansionary, and the authorities should remain vigilant against the emergence of financial sector vulnerabilities.

9. As dollarization declines, the central bank could allow greater exchange rate flexibility to absorb external shocks and promote financial development. In fact, the use of foreign exchange intervention (FXI), which largely reflects the authorities’ concerns for liability dollarization and its impact on financial stability, has declined over time. With loan dollarization now at 39 percent for firms and 10 percent for households, greater exchange rate flexibility would carry lower risks. Limiting central bank intervention to cases of disorderly market conditions could help reduce dollarization further, encourage the use of hedging instruments, and strengthen the interest channel of monetary policy.

Financial Sector Policy

10. The authorities have taken important steps to strengthen financial sector oversight, but additional efforts are needed to complete the legislative and regulatory reform agenda. The coming-into-effect of the new law on credit cooperatives is an important milestone. In addition, in response to last year’s recommendations of the Financial Sector Assessment Program, the SBS has implemented measures to: limit systemic risks; enhance its governance and control frameworks; broaden the supervision of bank and insurance sectors; and strengthen financial integrity.

Further steps are, however, needed to reinforce the legal protection of supervisors; mandate the SBS to exercise consolidated supervision; and enhance the effectiveness of the AML/CFT framework. It will also be important to bring some regulations in line with Basel III, including those regarding risk weights for foreign currency loans, which would help reduce dollarization further.

Structural Reforms

11. A stronger focus on key priorities would help more rapid progress on the authorities’ broad structural reform agenda. The National Competitiveness Plan released in June covers a large spectrum of reforms which might require a focused approach with clear timelines. Legal and product market reforms would ensure the best growth payoff while commanding enough popular support.

The authorities have already made significant progress in improving public sector transparency and governance. These efforts should be complemented with additional anti-corruption reforms, such as: making the government procurement system simpler, more transparent, and competitive; reforming the National Control System to better manage risks and increase accountability; and introducing independent internal auditors in some entities while strengthening external audits. In addition, it will be important to foster economic diversification, for which an extension of the agriculture promotion law appears crucial.

12. Improving social protection is necessary to make growth more inclusive and sustainable. Peru has made significant progress in reducing poverty since the turn of the century. Nonetheless, action is needed to address critical needs, including by reforming the pension system to ensure its sustainability and enhance its coverage, providing a more equitable distribution of natural resource revenues across regions, and deepening financial development and inclusion, which the authorities have identified as a priority in the National Competitiveness Plan.

These actions should be accompanied by reforms that reduce labor market rigidities and other costs that prevent workers and firms shifting from the informal to the formal sector.

 The mission would like to thank the authorities for their generous hospitality and the candid and constructive discussions that took place during November 5–18, 2019.  
Peru: Selected Economic Indicators
Social Indicators

Poverty rate (total) 1/
Unemployment rate
(Annual percentage change; unless otherwise indicated)
Production and prices

Real GDP
Real domestic demand
Consumer Prices (end of period)
External sector

External current account balance (% of GDP)
Gross reserves

In billions of U.S. dollars
Percent of short-term external debt
Money and credit 2/ 3/

Broad money
Net credit to the private sector
(In percent of GDP; unless otherwise indicated)
Public sector

NFPS Revenue
NFPS Primary Expenditure
NFPS Primary Balance
NFPS Overall Balance

Total external debt
NFPS Gross debt (including Rep. Certificates)
Savings and investment

Gross domestic investment
National savings
Memorandum items

Nominal GDP (S/. billions)
GDP per capita (in US$)

Sources: National authorities; UNDP Human Development Indicators;
and IMF staff estimates/projections.

1/ Defined as the percentage of households with total spending below
the cost of a basic consumption basket.

2/ Corresponds to depository corporations.
3/ Foreign currency stocks are valued at end-of-period exchange rates.
IMF Communications Department

Rise of autocracies spells end to the west’s global supremacy

The post-1945 rules-based order is being eroded and will never return

Tony Barber

FILE- In this Nov. 9, 2017, file photo U.S. President Donald Trump, right, walks with Chinese President Xi Jinping during a welcome ceremony at the Great Hall of the people in Beijing. Trump is to meet with Xi at the Group of 20 summit in Buenos Aires, Argentina, on Friday, Nov. 30, and Saturday, Dec. 1. (AP Photo/Andy Wong, File)
Presidents Xi Jinping of China, left, and Donald Trump of the US. According to Freedom House, both leaders have overseen declines in freedom in their respective countries © Andy Wong/AP

The rise of autocracy and of rightwing populism, its western democratic cousin, gives rise to understandable concern that liberal political values and the rule of law are heading towards terminal decline.

However, neither autocratic states such as China and Russia nor rightwing populist leaders in the US, Italy and other western countries have had everything go their way in 2019.

Their mixed fortunes suggest that it is premature to write off the prospects for global governance, even though the rules-based order constructed after 1945 largely to US specifications is decomposing and will never return in its old form.

In its closely followed annual “Freedom in the World” report, Freedom House, a non-partisan, US government-funded organisation, stated this year that global freedom had shrunk for 13 consecutive years between 2006 and 2018.

During this period, some 116 countries experienced a net decline in freedom and only 63 experienced a net increase, Freedom House said.

The US ranked as a free country, but it trailed France, Germany and the UK as a result of erosions of the rule of law under the Trump administration.

Similar concerns appear in the latest “Rule of Law Index” of the World Justice Project, a Washington-based civil society initiative.

According to this study, limits on governments’ powers, such as independent judiciaries, free media and legislative oversight of executives, have declined significantly in countries such as China, Egypt, Hungary, the Philippines and Turkey.

“One of the most striking things about the degradation of the rule of law is that it is being effected through laws and legal institutions.

The law itself is being hijacked and used to erode checks on power,” says Elizabeth Andersen, WJP’s executive director.
Mandatory Credit: Photo by ROMAN PILIPEY/EPA-EFE/Shutterstock (10371693z) Protesters wearing gas masks in action agains the police during an anti-government rally in Tsuen Wan, in Hong Kong, China, 25 August 2019. The protests were triggered by an extradition bill to China in June, now suspended, and evolved into a wider anti-government movement with no end in sight. An anti-government rally in Kwai Fung and Tsuen Wan in Hong Kong, China - 25 Aug 2019
Protestors take part in an anti-government rally in Hong Kong in August 2019 © ROMAN PILIPEY/EPA-EFE/Shutterstock

A no less disturbing trend is the threat to free expression in the form of censorship laws, attacks on independent book publishers and official pressure on scholars who refuse to toe the line.

Ziya Selcuk, Turkey’s education minister, announced in August that President Recep Tayyip Erdogan’s government had removed more than 300,000 books from schools and libraries since a failed 2016 coup and had destroyed them.

Under President Xi Jinping, China’s paramount leader since 2012, the authorities have shut down bookstores that sell material critical of the communist party, turned up pressure on independent academic authors and sealed most access to uncensored information on the internet.

Despite these setbacks for individual liberties, political pluralism and the rule of law, the world’s autocrats and rightwing populist leaders have encountered rising resistance from their countries’ citizens and public institutions in the course of 2019.

Matteo Salvini, leader of Italy’s hard-right League party, lost his jobs as deputy prime minister and interior minister after overestimating his ability to force snap parliamentary elections and become his nation’s undisputed strongman.

Although the League retains more support than other parties, its popularity has tumbled since Mr Salvini’s unsuccessful gambit, which matched his failure to lead a clutch of far-right EU parties to victory in May’s European Parliament elections.

Likewise Donald Trump finds himself in arguably the most serious crisis of his presidency after implicating himself in an attempt to discredit Joe Biden, a former Democratic vice-president and rival in the 2020 presidential race, with the help of a foreign ruler, President Volodymyr Zelensky of Ukraine.

An impeachment inquiry is going ahead in the House of Representatives despite the White House’s refusal to co-operate.

Meanwhile, mass public protests in Hong Kong have evolved over the past seven months from opposition to an extradition law to broader demands that the Chinese government should honour basic democratic rights that it promised to respect after resuming control of the territory in 1997.

Protesters gather as they take part in a march to protest against the alleged impunity of law enforcement agencies in central Moscow on June 12, 2019. - More than 200 people including opposition leader Alexei Navalny were detained as police sought to break up a peaceful Moscow rally against the alleged impunity of law enforcement agencies. Russian police in riot gear moved in against the unsanctioned march of more 1,000 people amid screams of protesters shouting
Demonstrators gather in Moscow in June 2019 to protest against the apparent impunity of Russia's law enforcement agencies © AFP

Moscow was gripped this year with the largest anti-government demonstrations seen in the Russian capital since the winter of 2011-12.

The spark was the decision of the authorities to ban opposition candidates from standing in city council elections.

In the event, President Vladimir Putin’s ruling United Russia party suffered heavy losses after an opposition campaign that recommended “smart voting”, or votes for any candidates other than self-declared Putin loyalists.

The bigger picture is that Mr Putin’s popularity is falling as a result of public discontent with stagnant living standards, changes to the state pension system, environmental damage, and the high-handed behaviour of the police and security services.

The Chinese and Russian states possess immense resources of violence and intimidation that allow them to suppress dissent with ease, as long as the authorities have the necessary willpower.

China’s Communist party displayed such willpower on Tiananmen Square in 1989 and has never regretted doing so — an unyielding state of mind that augurs badly for the Hong Kong protesters.

However, there is far less tolerance for politically related violence in European societies, as was demonstrated by the public backlash in Slovakia against the murder of Jan Kuciak, an investigative journalist, and his fiancée.

Should rightwing populism fail to make deeper inroads in western political systems, owing to its unrealistic promises and policy confusion when in power, the deliberate disruption of the post-1945 global order would arguably slow down.

This particularly applies to the US, where a transfer of power after the 2020 election might significantly reduce the White House’s hostility and scepticism about multilateral global institutions.

The growing internal challenges of autocratic systems in countries such as Russia and Turkey might reinforce this trend.

However, the most important long-term trends in international relations over the past 30 years have been the rise of China and the accelerating shift of economic power from the west to the Asia-Pacific region.

This in itself ensures that the Washington-designed post-1945 order, built mainly for the benefit of the US, Europe, Japan and their allies, will give way to a more dispersed form of global governance.

For the west, the cold reality is not that autocracy will triumph and democracy will fail, but rather that the 500-year-long era of western global supremacy is coming to an end.

This Is Not Capitalism

by: Cashflow Capitalist

- Capitalism is being debated in the United States today like never before. Is it at fault for the stagnation of lower income groups and the expansion of the wealth gap?

- Extreme monetary stimulus and especially quantitative easing have distorted capitalism in unprecedented ways.

- In past asset bubbles, companies with strong sales but weak earnings were most vulnerable. But today, the numerous companies with strong earnings but weak sales are also vulnerable.

It's a word that means everything and nothing.

To some, it alludes to a system in which oligarchic owners of capital are allowed to shape the economy in their favor.

To others, it's the natural result of the property rights inherent in a free economy.
The dictionary definition of capitalism is simply an economic system in which a nation's land, resources, industries, and capital are owned by private individuals and businesses rather than the government.

It's often associated with for-profit business, specifically, but private ownership does not necessarily require a for-profit structure.

It does, however, give control over capital and assets, including the income streams generated by them, to their owners or shareholders.
The "stakeholder theory," which has surged in popularity recently, asserts that the owners or shareholders of capital/assets do not (or should not) have full control of these but rather (should) share control with other stakeholders such as employees, customers, communities, and the environment.

Some proponents of stakeholder theory are of the view that this should be a voluntary decision made by owners/shareholders, while others assert that it should be the law of the land, enforced by the government.
So often, economic debates in the popular sphere revolve around this dichotomy between the shareholder and stakeholder theories of capitalism, even if different terminology is used.

Sometimes the debate is framed as "free market capitalism" versus "Scandinavian-style socialism."

Of course, there is some influence from Jeremy Corbyn-esque quasi-socialists in the political debate, but the majority fall into either one of the two capitalist camps.

However, there is one economy-altering element at play in today's world that doesn't fit well into either shareholder or stakeholder capitalism (or quasi-socialism).

Neither theory would inherently predict or prescribe the emergence of this element, and yet it has emerged everywhere, in countries that would fall more into the "shareholder primacy" camp as well as those that adhere to a more stakeholder view.
Image Source

Quantitative Easing's Distortion of Capitalism
I won't belabor the anticipation.

Regular readers already know that this relatively new element (historically speaking) is quantitative easing from central banks.

The Federal Reserve has created trillions of dollars' worth of digital money credits over the last decade in order to purchase assets on the open market.

Most of the purchases were of federal government Treasuries, which had the effect of reducing the supply and making rates lower than they otherwise would be.

A significant minority of purchases were of mortgage-backed securities in an attempt to support the housing market.

Earlier this year, I explained in "Blame The Fed For The Plight of The Average American" how monetary policy stimulus, resulting in ultra-low interest rates, has financially hurt the poor and middle class.

People often assume that lower rates give the non-wealthy a boost by making it more affordable to buy a home through a mortgage, buy a car through multi-year financing, etc.

But as I explained, ultra-low interest rates have actually lured consumers into spending more and taking on more debt than they otherwise would.
We've seen this lately with auto loans. Rather than reign in total spending on vehicles, American consumers have increased their borrowing for car purchases recently as interest rates have fallen.

Rather than looking at the total cost, these ultra-low rates induce big-ticket-item buyers to look only at the monthly payment, which may remain unchanged or even fall as the total cost over the long run actually increases.
What's more, consumers (and dealerships) have stretched out loan terms in order to keep the monthly payments down.

Terms lasting longer than six years are a growing part of the auto loan market.

Now, it's true that the average lifespan of cars on the road today is over 11 years, but paying monthly interest for over six years on a depreciating asset seems like a universally unwise financial decision.

It results in a total cost well above the purchase price.

This is partially why we've seen auto debt as a percentage of overall household debt jump from 6% in mid-2009 to 10% today.
Another example of low rates paradoxically hurting the non-wealthy comes from the United Kingdom, in which household debt is "worse than at any time on record" as of 2018.

And, by the way, to the extent that the wealthy are more likely to make big ticket purchases with all cash (no debt) while the non-wealthy are more likely to use financing (debt), the Fed's monetary policy decisions have exacerbated wealth inequality.
In my article, I also explained how the inflation produced by the Fed's monetary policies have differing effects on the various income levels.

The lower one's income level, the higher the percentage of that income is spent on utility bills, internet, gas, groceries, rent, cell phones, car notes, etc.

The poorest quintile spends over double that of the rich to heat and air condition their homes, for instance.

Rising consumer prices for these everyday items are more of a burden for the less well-off than they are for the rich.
Source: BBC

Pedro da Costa explains in a recent MarketWatch article that companies producing luxury products for the wealthy are experiencing increasing degrees of competition, and the prices of those goods are growing slower than goods geared toward the non-wealthy.
Meanwhile, the poor and middle class are significantly more likely to have less competition for everyday items such as internet or health insurance providers, resulting in faster price growth. Da Costa's article is based off a new study from Columbia University's Center on Poverty & Social Policy, which found that real (inflation-adjusted) income growth from 2004 to 2018 was slower than the official measurements for all but the highest-income quintile.
Source: MarketWatch
And yet, the Fed makes policy decisions based on one inflation measurement that averages consumer price growth for all income groups, ignoring the disparity in how this one metric is experienced by different groups.

Whenever that inflation metric begins to dip, presumably reflecting some relief for spenders, the Fed steps in with monetary stimulus in order to give it a boost.
Hence we find the lower half of the income spectrum increasingly opting to shop at discount retailers and grocers such as Walmart (WMT), Costco (COST), Dollar General (DG), Ross (ROST), T.J. Maxx (TJX), and Aldi, where they perceive consumer prices to be more reasonable.

Meanwhile, the rich are significantly more likely to benefit from the low-cost products of Amazon (AMZN) via the Prime service, as both their membership and their total spend are higher than lower-income groups.
Here's the crucial question to ask: Were these economic effects the result of capitalism? Were they the natural consequence of private ownership of capital and assets?

The answer, of course, is no.
If we imagine a world in which monetary policy is much more hands-off, with central bank-set rates following market forces of supply and demand rather than (mostly) the other way around, there would still be some price inflation.

There would still be inequality.

The rich would still have lower personal debt-to-income ratios than lower-income groups.

But there wouldn't be a powerful government agency making these issues dramatically worse.

Quantitative Easing's Amplification of Inequality

In this imaginary world of fully market-determined interest rates and little-to-no assets on central bank balance sheets, wealth inequality would be significantly less extreme. And not just for the reasons mentioned above.
Earlier this year, I explained in "Blame (Or Thank) The Fed For Meteoric Wealth Inequality" that stimulative monetary policies that have been pursued since the 1980s have played a huge role in compounding wealth (and, to a lesser extent, income) inequality.

Stocks tend to fare better when real interest rates decline, and vice versa.

Plus, the savings vehicles preferred by the non-wealthy tend to perform better when real rates are higher, and vice versa.

Thus, as real rates have fallen since the 1980s, wealth inequality has soared.
When interest rates hit zero a decade ago, central banks used quantitative easing to continue suppressing rates across the curve.

By lowering the supply of safe income assets, this injection of liquidity into the financial system caused rampant yield-chasing activity that boosted the risk assets primarily owned by the rich.

Some of the biggest stock market gains in American history occurred during the Fed's large-scale asset purchases.

By making risk asset returns more attractive compared to safe asset yields, QE manipulated the price signals that would otherwise have determined the performance of those assets.

Furthermore, corporations took advantage of ultra-low costs of debt to increase their debt loads while buying back record amounts of their own shares, further boosting profitability and stock prices.
The result?

According to the Congressional Budget Office (via Stephen Roach), "virtually all of the growth in pre-tax household income over the QE period (2009 to 2014) occurred in the upper decile of the US income distribution, where the Fed's own Survey of Consumer Finances indicates that the bulk of equity holdings are concentrated."
As pointed out by Sven Henrich, the latest round of Fed balance sheet expansion, just like prior iterations, has rendered the market void of intraday price discovery, pushing stocks on a one-way journey upward.

It has decoupled stock prices from fundamentals and driven investors into "extreme greed" territory, according to CNN's Fear & Greed Index.
Source: CNN
Regardless what Fed officials want to call it, this central bank balance sheet expansion has resulted in six straight weeks of upward market movement, with each major index hitting multiple record highs, even while the S&P 500 (SPY) delivers its third quarter of aggregate earnings declines and is expected to hit a fourth in Q4 2019.
Don't take my (or any market commentator/practitioner's) word for it. Listen to the Bank of International Settlements, which recently found that central bank stimulus is distorting financial markets.
QE has negatively impacted the functioning of asset markets, the BIS says. "These [negative impacts] included a scarcity of bonds available for investors to purchase, squeezed liquidity in some markets, higher levels of bank reserves and fewer market operators actively trading in some areas." They also include lower credit spreads among this list.

According to the BIS, "Negative impacts have been more prevalent when central banks hold a larger share of outstanding assets."

In other words, as central bank balance sheets grow as a percentage of the economy, these negative impacts will have correspondingly greater effect.
A question springs to mind about a recent anomaly in the Fed's wheelhouse.

What caused the spike in overnight rates a few months ago?
In short, banking regulations force large banks to hold a certain amount of liquidity, which prevented them from lending en masse during the brief rate spike.
Lending at mid-single-digit rates in the overnight market should have been attractive for any market participant, but the banks themselves said they didn't do it due to the constraints of liquidity regulations.
Now, the point here is not to make a claim about the efficacy or prudence of certain banking regulations, but rather to ask: Is this capitalism?

Is something inherent in capitalism broken to cause these negative impacts on the financial markets?
Again, the answer is no.

Capitalism without price discovery is hardly capitalism.

"Free" markets that are dominated overwhelmingly by a government agency are not free markets.
The Reigning Monetary Regime's Effect On Stock Valuations
Lance Roberts & Michael Lebowitz recently provided an insightful commentary on the Shiller CAPE ratio:
This ratio, which is the price of the market divided by the 10-year average of trailing earnings, has been widely discussed in the media, and often dismissed during bull market advances, because of it does not timely signal turning points in the market. 
The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.
But you will notice an issue with using historically high (greater than 20) readings of the CAPE as an indication of market overvaluation: by this measurement, the S&P 500 has been overvalued for the better part of the last three decades!

There have been no undervalued times to buy into the index since the early 1980s.

In fact, there's only been one period in the last thirty years of even average valuation - during the doldrums of the Great Recession.
As Roberts & Lebowitz put it, "The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a 'mean reverting' event, occurs."

This was true prior to the late 1980s, but thereafter, the market has been stuck in this lofty position.
The average CAPE valuation from 1900 to 1990 was 14-15, but the average from 1990 to today has been around 24-25. What changed between those two periods?

The Greenspan Put.
When the stock market crashed in 1987 on the back of of high valuations but a fundamentally strong economy, Fed chairman Alan Greenspan (himself an Ayn Randian free marketeer in philosophy, if not in action) ignored the economic fundamentals and swooped in with monetary easing to cushion the market.

As a result, stocks kept their high CAPE multiple instead of reverting to the mean as they had in the past. This happened multiple times, such that Greenspan became termed the "Maestro" of the markets.
Following Greenspan came the Bernanke Put.

And then the Yellen Put.

And, finally, the Powell Put.
Investors need to come to grips with the fact that ultra loose and accommodating monetary policy has reset the mean to an indefinitely higher level.

Readers may raise their eyebrows at that, being reminded of Irving Fisher's statement in 1929 that the stock market had reached a "permanently high plateau."

But central banks were not the economic force in the 1920s that they are today.

They did have an effect, but only fractionally compared to the contemporary regime.

During the currently reigning monetary regime, the stock market has reached unprecedented valuations based on several metrics.
Take the Tobin's Q ratio, which is the total market capitalization measured against the underlying assets' replacement value, currently about as high as the tech bubble peak.
So, also, is total market capitalization measured against GDP, coming in at around 147%.
Let's look at one more valuation metric.

This one is a bit more obscure: S&P 500 market cap to aggregate net income.

Unlike earnings per share, which can be manipulated by share buybacks (which we'll return to below), net income is a measurement of total profits.
The SPX market cap as of April 30, 2019, was $23.7 trillion.

Dividing that by the SPX's ~$300 billion aggregate net income shows a multiple of 79x.

Compare that to the beginning of 2011: $11.2 trillion divided by ~$200 billion in aggregate net income, coming to a 56x multiple.
This record-setting valuation expansion is not the result of the normal fluctuations of the market cycle natural to capitalism.

They're the result of the ever more consequential policy decisions of central banks.
The Financialization of Capitalism
Lastly, let's zoom in a bit further to examine the distortion of capitalism from a slightly different angle - that of financial engineering or financialization.
By "financialization," here, I'm referring to the ability of businesses to generate increased profits from the same amount of revenue without increasing productivity.

It's the ability to convert the same amount of sales into a higher amount of earnings without adding additional value to the economy.

"Financialization is profit margin growth without labor productivity growth," says Ben Hunt of Epsilon Theory.

It is the systematic conversion of product and service sales (mainly to the non-wealthy) into expanded profits (enjoyed mainly by the wealthy).

This process happens primarily through two mechanisms: cost cutting and share buybacks.
For most of the history of capitalism, financialization has been limited by some basic factors.
On the cost-cutting side, there's a limit on the amount of costs that can be cut from the production or administrative process before business functioning begins to suffer.
In other words, cut costs too much and the ability to continue generating revenue growth will eventually be hindered.
And buybacks have long been limited by prohibitively high costs of capital relative to the shareholder returns that they purchase.
In other words, when interest rates floated in a historically normal range, buybacks were mostly impractical due either to the cost of debt or to relatively high investment hurdle rates.
As interest rates have fallen, so too have the hurdle rates for corporate investment, incrementally making unproductive uses of capital like buybacks seem like better uses of cash.
One example of financialization is Texas Instruments  (TXN), a semiconductor and technology company.
Hunt digs into TXN's finances from recent years to paint a picture of where the cash flows have gone.
Over the last five years, he estimates the company generated roughly $25 billion in free cash flow.
About $3.3 billion of that went to capital expenditures, with most of that probably going into maintenance capex rather than growth capex.
Another $1.6 billion went to M&A.
Where did the lion's share go?
Dividends and buybacks.
The company paid out $9.1 billion in dividends over the five-year span, while share buybacks accounted for $15.4 billion.
Combined, the total return to shareholders has come to $24.5 billion - nearly all of FCF.
The remaining spending was funded with debt issuance.

Over that five-year period, TXN bought back 228.6 million shares at an average price of $67.37 per share, while it issued 90.8 million shares to employees and board members as compensation at an average  $27.51 per share.
It's a revolving door of share existence in which insiders can purchase newly minted shares at discounted prices while a much greater amount of shares are purchased at market prices in order to diminish the float.
Hence we find that revenue has grown at an average annual rate of 4.1%, while diluted earnings per share have risen at an average annual pace of 33.9%.
Texas Instruments


Meanwhile, since November 2007, just prior to the official onset of the Great Recession, top-line revenue growth has come in at 6.6% while costs have been significantly reduced - especially for cost of goods sold ("COGS").


The same general process has occurred with one of my favorite dividend growth companies, Illinois Tool Works (ITW), as well as International Business Machines (IBM).

Illinois Tool Works


Over the last ten years, ITW's revenue has been basically flat, while EPS has plowed ahead at a pace of 26.7% per year.
Notice the red line at the bottom: the number of shares outstanding has been diminished by 3.6% per year over the last decade.
Meanwhile, both COGS and sales, general, and administrative ("SG&A") expenses have dropped, illustrating a steady regime of cost-cutting that has juiced profit margins.

The picture is worse for IBM. The following chart shows how buybacks have been used to cushion sliding revenue.
From 2010 to 2015, it translated slight revenue growth into magnificent EPS growth.
But since 2015, all it has managed to do is slow the fall.
International Business Machines
And then, of course, you've got the cost-cutting, which has helped, too.
These are just three examples of a widespread trend across public companies. Cost-cutting may have hindered revenue growth across the economy, but corporations have been able to mask it with increased net income (from cost reductions) and EPS (from buybacks).
It's a system that has massively benefited a few at the expense of the many.
Unlike productive uses of capital that expand the total wealth of a country, it merely redistributes an otherwise fixed pie of wealth.
Writes Ben Hunt:
Public companies are managed today to mortgage the future OVER and OVER and OVER again, for the primary benefit of management shareholders and the secondary benefit of non-management shareholders.
This is the reason why CEOs today make about 271 times more than the average worker compared to 1978 when they made only 30 times the average worker.
In fact, the average pay of CEOs today is high even for members of the top 0.1% of income earners; the average CEO of a large firm makes 5.3 times the average annual earnings of the 0.1%.
It's the value of the stock options that push corporate execs so far above their wealthy peers.
And yet, this dramatic disparity in pay has not resulted in correspondingly improved fundamentals.
According to the website Multpl, S&P 500 sales are roughly 20% higher today than at their pre-recession peak in 2007, translating into annual growth of 1.67%.
Compare this to the peak of earnings in 2006 vs. today, marking total growth of 23.5% or 1.96% per year.
From 2009 to today, S&P 500 sales have grown 32%, or 3.2% per year, while EPS has grown 55% or 5.5% per year.
The SPY is trading at a price-to-sales of 2.2x, well above the 1.7x reached in late 2000.
And the SPY's current price-to-book value of 3.3x is meaningfully above the 2.9x reached prior to the Great Recession.
And yet, SPY price-to-earnings at around 23x is only slightly above the pre-recession peak of 22.4x in November 2007 and well below the bubbly 30s-40s P/Es hit in the late 1990s and early 2000s.
Cost-cutting has expanded profit margins, thus boosting net income, and buybacks have juiced EPS off of the base of boosted net income. Thus, the price of the index appears much cheaper against the engineered EPS than it would be otherwise.
And, again, what has made this financialization not only possible but prevalent? Monetary policy support of asset prices since the Fed chairmanship of Alan Greenspan, including quantitative easing. It's that simple.
There still would have been wealth inequality in lieu of this monetary policy regime, but it would not be nearly as pronounced as it is today.
Stocks still would have performed well, but not nearly as well as they have.
This is not capitalism.
It's something else entirely.
Investor Takeaways
I see three primary takeaways from the preceding analysis.
1. Price-to-sales matters in the long run.
When bubbles eventually burst, the stocks typically hurt worst are those with strong sales but little or no earnings. B
ut this most recent multiple expansion run-up is different.
In recent years, the number of stocks with strong earnings but weak sales growth have proliferated.
Certainly, the next time the market experiences a significant pullback, those stocks that are richly valued based on strong sales growth but little-to-no profits seem poised for pain.
But investors should be cautious about those stocks that are showing strong earnings growth but little-to-no sales growth - Illinois Tool Works, one of my core holdings, included.
Looking at price-to-sales is one way to offset this trend.
2. Consumer-oriented companies increasingly need to "pick a lane," designing their products to target either the wealthy or the non-wealthy.
It would seem intuitive that, eventually, consumer debt would reach a limit such that financing more expensive consumer products becomes impossible or impractical.
How expensive do iPhones need to be before consumers hold back on buying?
What about Ford (F) trucks?
Or sectional couches?
Some of the most successful companies today have definitively "picked their lane" and serve it well, either with their entire business model or with specific products.
3. There's no telling how high equities can go or how long they can stay elevated with the Fed's preemptive QE ongoing.
This point speaks for itself.
To me, it signifies that a balance between continued stock exposure to enjoy the remaining upside and a meaningful cash allocation for dry powder is necessary.