Could the G-7th cavalry ride to the rescue?

At present, our working hypothesis for 2019 is that, following a potentially quite bright start to the year as the US approaches its ‘peak fiscal stimulus’ and the Administration runs down some of its savings deposit holdings at the Federal Reserve (for reasons connected with the Debt Ceiling), global liquidity conditions and in particular dollar liquidity conditions are likely to tighten quite significantly – and possibly severely – during the second quarter. US liquidity trends are always quite seasonal and the second quarter is often a period of weakness in the data, although in 2019 specifically we may also find that the Fed may also be obliged to react to still robust US wage trends by tightening proactively.

We are also expecting that there may be some form of ‘event’ in China following the Lunar New Year Holidays: either the authorities will ease and the RMB will fall quite sharply as a consequence, or the authorities will not ease, and the PRC economy will find itself flirting with a recession.

Furthermore, we expect that the Euro Zone will find that economic growth has indeed slowed quite sharply by the second quarter (particularly in the event of any form of Hard BREXIT – the EU would certainly feel some very real consequences from a dis-orderly exit by the UK) and this will no doubt have (further) political ramifications. In fact, by the second quarter of next year, we may find ourselves facing a world trade recession and slow global growth trends in general. We therefore suspect that, if there is going to be a ‘moment of stress’ within financial markets, it is likely to be around March to May next year.

The ‘conditioned’ response for markets – based on the last thirty years of revealed behaviour of both central bankers and the world’s fiscal authorities – is to seek to buy such dips on the basis that any volatility in markets will force an (often coordinated) easing of policy settings around the world. The G5 started this trend in 1985 but the G7 refined it in 1987 and Greenspan formalized such actions in the 1990s and 2000s.

We might argue that while the perceived existence of the ‘central bank put’ has made the frequency of market cycles longer, it has made their amplitude very much larger but nevertheless markets will expect that any ‘financial events’ in 2019 will trigger some form of stimulative policy response. However, and unlike the situations in 1995, 1998, 2001, 2003, and of course the QE-dominated post GFC period, there may be practical difficulties when it comes easing for many of the individual economies concerned – and even in organizing a coordinated policy response in today’s more nationalistic world.

Moreover, it could be argued that many of today’s political problems and the rise of the more extreme parties owes much to the increase in income and in particular wealth inequality that is itself at least partly the result of the central banks’ deliberate suppression of interest rates and fostering of asset price booms. The central banks’ slavish pursuit of ‘wealth effects’ (which may or may not be important) has created societies in which the existing owners of assets have become notionally wealthier but those that need to buy assets in order to finance their retirement or simply to gain shelter have found themselves ‘priced-out’ of the ownership of these essentials.

We must therefore wonder whether for societies in general, another round of (monetary) policy stimulus would be either desirable or sensible, even if it could be achieved. The pursuit of stable / rising asset markets over the last 20 years has contributed to the productivity slowdown and sense of angst in many countries and we would doubt the wisdom of pursuing more of the same in the event of any market turbulence.

In terms of the practical difficulties to any further easing by the authorities, we must also be aware that many of the G7 / G20 have specific problems of their own that could taking affirmative action somewhat problematic. For example, it is not clear to us that the US inflation data will be conducive to an easing by the FOMC in 2019. Our explanation for the failure of US wage inflation rates to accelerate over much of the last decade revolves around the fact that so much of US growth since the GFC has been concentrated in perhaps only half a dozen quite specific locations (three cities on the West Coast, Texas and North Florida) and that, while these hot spots have experienced supply bottlenecks and inflation, the relative weakness in the remainder of the country and the willingness of the population to move into the hot areas has kept aggregate wage trends in check. However, we would also argue that in 2018 economic growth began to broaden as the hot spots simply ran out of space, and that the recent acceleration in wage trends is due to an increasing lack of weakness / weaker months rather than an increase in strength in the hot spots.

This situation, coupled with the failure of Asian export prices to deflate in the way that they have done in previous global slowdowns, could leave the Fed facing a degree of ‘stickiness’ in the inflation data that complicates its deliberations on interest rates. Moreover, the FOMC still appears to be under political pressure to shrink the size of its balance sheet, thereby implying that Quantitative Tightening may in any case have further to run….

Meanwhile, China’s repressed economic system is, we believe, flirting dangerously with inflation over the longer term. The population is now quite simply satiated with deposits (hence their attempts to diversify into alternative savings vehicles and the necessary re-imposition of capital controls) and, if the authorities were to add yet more deposits to an already flooded system by easing either their fiscal or monetary regimes, then they could conceivably trigger an Eastern European (circa 1970s – 1980s) style ‘dumping’ of deposits that triggers a sharp rise in inflation. Moreover, China has over recent years become more rather than less dependent on imported hydro-carbons and any easing that weakened the RMB could directly rise the population’s living costs.

It is also unclear whether any monetary easing in China would lead to faster rates of credit growth – history suggests that following a major credit burst of the type that the PRC has recently experienced, it can be hard for a North Asian Economy to initiate a new credit cycle. China will undoubtedly wish to ease – and we suspect will ease – its stance during 2019 but the effects may not be as straight forward as in the past….

In Japan, it is clear that the BoJ would face some very real impediments to any further easing in its policy stance, not least of which being the fact that it has almost run out of JGBs to purchase. At present, the BoJ seems simply to be absorbing any ‘supply’ that emanates either from the government or those few foreign sellers remaining; Japan’s banks and insurers have probably now sold all of the JGBs that they can do from a practical / regulatory standpoint. It would therefore be difficult for the BoJ to buy more bonds unless the government chose to issue more bonds, but we suspect that the MoF would be reluctant to attempt yet another expensive fiscal easing given the country’s already high public debt burden. However, this being said, it is not impossible that the MoF’s concerns could be overridden.

Moreover, we must also recognize that, not only does the BoJ continue to fear that one day it might lose control of the value of the JPY (given the high levels of demand pressure in the economy and the twenty years of monetized deficits that have occurred…), there also seems to be a theoretical sea-change occurring within the Bank itself.

Many in the Bank now recognize that the Bank’s interference in the asset markets has distorted the financial system and in all probability helped to undermine productivity, not least of all within the hard-pressed banks. It is recognized that Japan’s banks and its wider financial system desperately need positive rather than negative / zero rates and that to attempt to reduce yields further would be counterproductive and damaging (in fact, raising rates might be a better idea but that is probably too bold a step for the authorities to take…).

With these considerations in mind, it could be argued that the only practical way in which the BoJ could ease would be to buy more equities and to in effect achieve the same level of public sector domination of the equity market that has already occurred – somewhat problematically – in the debt markets. Such a policy would imply a massive nationalization / expansion of the state which would also tend to damage long term prosperity trends.

It is also increasingly obvious that interest rates are too low in the EZ from the perspective of the Region’s private sectors. As in Japan, the domestic banking systems in many of the EZ countries are finding it hard to ‘make money’ under the current ECB regime and we have drawn attention many times to the fact that interest rates are now so low that household savings rates (particularly in Northern Europe) are being obliged to rise as households attempt to reach their savings targets. Of course, if people are saving more, they must be saving less of their incomes.

Germany: Household Savings Rate

 Household Savings Rate

Moreover, the ECB also faces a similar problem to the BoJ when it comes to increasing the size of its asset purchases, in that there are relatively few bonds left that the ECB can buy unless either Germany expands its fiscal deficits, or the ECB abandons the ‘capital key’ ratio with regard to its bond purchases. Moreover, the ECB must also know that the more bonds that it buys, the harder it will be for the central bank to ever tighten (or even merely raise interest rates back up to more rational and optimal levels) without in effect bankrupting itself via the negative carry that it would then face on its now immense portfolio.

One way in which the ECB can – and we suspect probably will – ease will be via expanding its stock of loans to the Region’s banks, most notably within France and Italy. However, as we have already noted, expanding the size of the ECB’s balance sheet further will not be without its costs for (and opposition from) the banking systems in the creditor countries. At the very least, we suspect that Germany and the Netherlands will oppose any further expansion of the ECB’s balance sheet even via this ‘back door’ route and this could well create some friction within intra-regional relations (that could ultimately limit just how helpful the ECB can be).

Of course, any increase in funding by the ECB for the region’s banks will likely be reflected in the currency as the banks use funds from the ECB to replace their current stock of foreign liabilities (i.e. a similar problem to that facing China currently), although we doubt that a weaker EUR would worry the politicians over-much.

In practice, and even despite the potential for it to increase its lending to the banking system, we suspect that the ECB has all but run out of room for manoeuvre and hence – as we have already witnessed in France over recent days – the responsibility for any policy response will ultimately fall on the fiscal authorities.

Indeed, we suspect that Europe’s decision makers, who of course live and work inside the public sector will likely use any new crisis as an incentive to further expend the state’s role in the economies, and to further subjugate the markets despite the longer-term costs of such policies for growth, prosperity and of course (public sector) debt sustainability. We suspect that Europe will ease in 2019 but that it will do so by increasing the banking system’s reliance of the ECB and expanding the public sector’s budget deficits – their tried-and-trusted routes for ‘kicking the can yet further down the road’.

In summary, the notion that the world’s authorities have all but run out of ammunition to ‘fight’ the next crisis is of course not new – some even in the Fed have suggested that part of the reason to raise rates in 2018 was to ‘re-load’ the interest rate gun. However, we would ask whether the authorities should even try to ease if and when a new crisis begins, since their likely responses will all have significant costs in the long run.

In practice, if there is some form of ‘event’ in financial markets in 2019 – and we suspect that there will be – we expect that there will be some hastily convened G7 / G20 meeting to talk about a response and that markets may for a time take some heart from such a meeting but we very much doubt that there will be a new super-effective QE1 type response available to policymakers. Instead, policymakers will simply have to decide whether they will look to support long term growth by handing control back to the private sectors (i.e. letting markets find the price level that allows them to clear, wherever that may be), or whether to continue down the path of ever more state intervention and artificial support of asset prices, despite the longer term economic and social costs that these policies are already causing (and which occurred in the 1960s and 1970s when the authorities also thought that they could interfere in the market system with impunity…).

As a consequence, we suspect that 2019 may prove to be a defining moment for the Global Economy as it is forced to choose between more or less state interventionism.