Financial markets have of course endured something of a roller-coaster ride over the last four or five weeks and quite naturally this has led some to re-consider their perceived outlook for the global economy, interest rates and of course inflation. Truth be told, we suspect that the decline in markets (even though many of the equity markets have now regained their old highs) has unsettled many investors, coming as it did so fast and almost violently, and many are still trying to rationalize and understand what happened. Variously, some worrying ‘inflationary data points’ from the US labour market have been blamed while some brokers have re-kindled talk of the US suffering a ‘Twin Deficit Problem’, just as it did around the time of the 1987 Equity Market Crash.
For our part, we think that inflationary pressures are indeed rising within the global economy, but only slowly. Although we do not yet believe that the developed world economies are overheating, demand pressure is clearly rising and they could begin to overheat later this year on the basis of current trends. There are some signs of higher rates of unit labour cost inflation in parts of the developed world - most notably in Germany and Japan – but we have yet to see conclusive proof that these pressures are affecting actual selling prices. Consequently, on this particular basis, we could still be a year away from a concerted anti-inflation regime from the central banks.
Where we do however find clear and unequivocal signs of higher inflation is in Asia: China’s increasingly inflationary environment is beginning to infect the rest of the world through its rising export prices and rampant demand for imports but, even here, we find that the pass through to consumers has been modest. Certainly, the prices of exported goods shipped from Asia to the OECD are rising, the OECD’s import prices are rising and wholesale prices of goods have begun to move up but, thus far, retailers and wholesalers have either decided to, or been obliged to, absorb these higher supply chain costs - albeit at the expense of their margins and profits.
Clearly, this type of behaviour is unsustainable: eventually even the famed ‘Disruptors’ will have to pass their higher costs on (and as a recent visit to Seattle showed, even Amazon’s costs are rising strongly) but in the near-term retailers are absorbing higher prices and this will cause a ‘lag’ in the pass through from higher import prices. Therefore, it still seems a little too early to become ‘properly’ concerned over the outlook for inflation.
North Asia: Export Prices in USD
USA: Nominal Profits
Clearly, we believe that there is indeed inflation starting to occur within the (goods) supply chain but thus far the inflation rate for goods prices within official CPI has only moved up by around 20 basis points or so over the last six months as a result of the compression of margins at the ‘consumer-facing’ end of the chain. Moreover, these pressures have been visible for around 6 – 12 months and so it seems a little strange that markets should suddenly have chosen to react to these pressures last month….
An alternative explanation for the selloff (particularly in the bond markets) that has bene advanced is the anticipated increase in net Treasury supply from the public sector as the Trump Administration attempts to borrow more and the Federal Reserve also begins to shrink its own balance sheet. There is of course some truth in this hypothesis, based on current information we estimate that the net supply of marketable Treasury bonds from the Treasury / Fed combined will increase by around $700 billion in 2018, somewhat more than 2017’s $340 billion total level of net public sector issuance.
USA: Net T Bond Issuance
However, we are also expecting there to be around $200 billion less in corporate bond issuance this year (as a result of the higher rate environment and some repatriation of funds) and an increase in the household sector’s savings rate, which should imply that the net increase in USD denominated bonds that will need to find a home should only be around $200 billion this year. Such a large number might initially sound demanding, but it is actually quite small in relation to the quarter to quarter fluctuations that are frequently witnessed in the levels of foreign buying of US bonds.
When one mentions ‘foreign buying’, we suspect that most readers will automatically think of the level of demand for Treasuries from Asian governments, most notably China and Japan. However, in reality, Japan has been recycling its current account surpluses into acquisitions of productive real assets elsewhere in Asia over recent years (Japanese investors in both the public and private sectors have sold $200 billion of T bonds since early 2015), while China’s weaker balance of payments and shrinking FOREX reserves have resulted in it reducing its holdings of bonds at a relatively consistent rate since late 2014. Instead, it has been Euro Zone private investors that have come to dominate the US (and many other) international bond markets.
During 1987, it was Japan’s portfolio investors that provided the funding (and therefore set the price) for the US twin deficits by recycling their country’s current account surplus into the US bond and equity markets, primarily on the basis of the higher yields that were on offer in the US vis-à-vis Japan’s markets (although there were those that viewed some of Japan’s official sector purchases of Us bonds as representing payments for the US’s military presence in the area). This model functioned tolerably well until the then Treasury Secretary, James Baker III announced that he was going to sink the value of the USD and in so doing caused foreign investors to flee the US markets in October that year...
Today, the place of these Japanese portfolio investors in the US debt markets has been taken by German, Luxembourg, Italian and Dutch savers, as they have sought to escape the ‘tyranny’ of the ECB’s low yield regime. Quite simply, many European portfolio investors have been pushed into foreign higher yielding markets in search of higher yields and despite the increase in risk that this has entailed. Even more amazing (to us) is the fact that these investors have continued to acquire large new holdings of foreign assets over recent months despite the fact that their post 2001 track-record in these endeavours has been so poor: we estimate that since 2001 the ‘historical cost’ of acquiring Europe’s foreign assets in terms of the cumulative current account surpluses has been around EUR31 trillion, whereas the EZ’s net foreign asset position has only improved by EUR200 billion over the same period! These numbers appeared so bad that we had to check them three times and we must wonder what they will imply for Euro Zone retirement incomes in the future….
EuroZone: Net Acquisition
We can only assume that the ECB’s policies with regard to interest rates (and perhaps even the EUR’s existence itself) has pushed Europe’s savers into assets that they might not otherwise have acquired and which they probably should not have acquired. Nevertheless, this situation has resulted in Europe becoming the ‘marginal funding source’ for the World’s deficit countries (including the USA) and therefore we would suggest that it has become the EZ bond yield that has become the ‘base yield’ from which most other differentials and yield levels are determined. This implies that it will not have been the Trump fiscal plans per se that might have disturbed markets, but rather the outlook for the ECB’s own policy regime.
At this point, we must admit that we have encountered a problem when presenting even our own forecasts to clients. At present, the Euro Zone economies are expanding and we suspect that the region is getting close to what constitutes its own sustainable level of output (i.e. it is getting closer to overheating). The most recent monetary data from the ECB has been a little brighter and, most of all, the Region is continuing to reap the benefits of strong export growth to China. Judged on a cyclical basis, the ECB needs to withdraw some of its stimulus.
However, at the same time, it is difficult to see just how the ECB might seek to tighten materially without creating a crash in the local debt markets that in turn would cause financial stresses in the Region’s public and private sectors; weakness within the peripheral banking systems; bankrupt the ECB itself (the ECB does not have sufficient capital to cover the losses it would occur on its bond portfolio if it raised rates – a rather ironic situation); and finally cause global bonds to sell off, potentially quite violently.
During our presentations, we would like to say – and we do in fact believe – that the second group of factors will dominate the ECB’s thought process and so cause Draghi to do nothing this year. However, our years of visiting the ECB have left us ever-cautious when it comes to assuming rationality from that particular central bank. To us, the ECB has always appeared to represent the product of a particularly bad multinational merger in which vested interests and national groups still dominate what is supposed to be a super-national organization. For example, at present we find that some of the Core member central banks are in fact rather more dove-ish (for the reasons mentioned above) than some of the periphery and, hence, one must always have a rather large ‘confidence interval’ when it comes to predicting just what the ECB will do…. Unfortunately, this situation matters for markets that are notionally far beyond the EZ’s borders.
At present, we continue to hope that Draghi does in fact do very little this year and that, as a result, real interest rates in Europe will tend to decline rather than rise from here, something which could provide a little good news for global real interest rates for a time at least. Therefore, it would seem that it may not even have been the outlook for EUR rates that so scared markets last month.
To our mind, last month’s problems in markets were instead caused by one factor, namely a 1% decline in the US’s effective monetary base over a 3 – 4 week period. During late January, the Federal Reserve sold around $15 billion of securities (or at least failed to rollover that amount) and at the same time the US Treasury over-issued bonds in relation to its current funding needs, ostensibly so that it could raise its own holdings of deposits at the Federal Reserve of New York by $106 billion. As a result of these bond sales by the public sector, there was effectively a net transfer of more than $120 billion of bank reserves from the investment banks (principally JPM, since it was their depositors that purchased the bonds) to the public sector, where upon the reserves became ‘sterile’.
As a consequence of the weaker reserve situation, the investment banks were obliged to reclaim some of the estimated $550 billion of short term credit that they had advanced to foreign financial entities and the $140 billion that they had advanced to domestic fincos over the previous 12 months, a period during which the Treasury had been reducing its own deposit holdings and therefore implicitly adding reserves to the investment banks.
We have no doubt that the circa $700 billion of new USD lending to financial entities that the Treasury’s actions in 2017 helped propagate had much to do with last year’s seemingly stellar performances in the asset markets and hence we are equally convinced that the removal of some of these funds, and the change in lending attitudes that this withdrawal apparently initiated was the real cause of rise in dollar LIBOR rates, Treasury yields and even equity yields in the middle of last month.
More recently still, we find that the Treasury has again conducted U Turn and we find that over the last three weeks it has added $95 billion back to the markets at a time during which the FRB appears to have all but suspended its bond sales. Consequently, the US monetary base has inflated by almost 1% over the last three weeks and markets have again reacted accordingly….
Quite frankly, this represents an absurd situation; what should in fact be merely technical transactions between the Treasury, Federal Reserve and the investment banks have become so large and unstable that they are affecting global credit conditions on an almost daily basis but this is a by-product of the Trump Administration’s reaction to the debt ceiling saga (although it must be said that they are not doing anything that the Obama Administration hadn’t already done).
Unfortunately, this state of affairs has resulted in two unfortunate conclusions for the asset markets. Over the medium to longer term, the outlook for global real yields – and hence most asset markets – will we believe be determined by the internal maneuverings of the ever-unpredictable ECB. In the near term, however, effective global credit conditions will be determined by the shenanigans that accompany the US Debt Ceiling. At times, these two sources may combine deliver positive influences on the markets while, at other times, they may reverse in an unpredictable fashion, a situation that not even the world’s best traders are likely to prosper in. At the very least, we expect the recent uptick in volatility to persist a while longer – and that is before the inflation threat that we discussed at the outset arrives in earnest. Clearly, 2018 looks set to be a more trying year for investors.