The Silver Bullet | Rebalancing and Revolutions
Thursday, 20 July 2017
“Fantasy. Lunacy. All revolutions are, until they happen, then they are historical inevitabilities.” ― David Mitchell, Cloud Atlas
At the beginning of the 18th century, a group of young philosophers, intellectuals and scientists started advancing a range of revolutionary ideas. These included the pursuit of scientific progress and intellectual truth, the achievement of progress through reason, the separation between church and state and equality amongst men. The ideas stemming from the age of enlightenment were largely ignored by the governing elites, while some of their proponents were jailed or silenced. But their ideas survived. In 1775, they erupted in the American War of Independence, in 1789 in the French Revolution. The British Army was defeated. French revolutionaries killed hundreds of thousands, including King Louis XVI and many other nobles.
It took almost a century to develop the ideas inspiring these revolutions, and only a few years for them to play out. Today, we may be facing a similar structural change in the economic and social equilibrium that accompanied the western world following World War II. Western democracies have relied on rising public and private debt to stimulate the economy and maintain a social contract between government and voters. In turn, central bankers have lowered interest costs to make the resulting debt more sustainable. The United States in particular, together with the UK, have championed these policies and enlarged their geopolitical influence as gatekeepers of the global financial system.
This growth model, and the social contract that comes with it, are now under attack. Debt levels are high and developed economies have grown addicted to low interest rates. Productivity has remained stagnant, with less investment in infrastructure and education and an over-allocation of resources to leverage-heavy industries, like property, commodities or finance. The cycle of rising debt and central bank low interest rate puts has generated an advantage among large-scale corporates, which borrow in bond markets, vs small businesses which rely on banks, as well as boosting wealth inequality among individuals. The millennials generation will be the first in modern history to be poorer than their parents. Like wealth and social opportunity, politics have become increasingly polarised too.
Investors have largely overlooked these developments: over the last ten years, they have been buying stocks for yield and bonds for capital gains, dancing to the tune of central bank stimulus. But very soon, the music will slow: extraordinary stimulus has become less useful, and less acceptable due to its collateral effects. How will the economy look when the lights turn on? And which way will politics and geopolitics go? Who will be the winners and losers from the end of QE infinity? Will there be an orderly rebalancing, or a revolution?
1. Economics: Searching for a New Paradigm
The history of economics is driven by revolutionary thinking, often emerging at times when existing theory could not explain real-world phenomena. In the Great Depression of the 1930s, prevailing theory of a self-adjusting economy failed to provide an explanation or policy solution to the severe economic downturn. John Maynard Keynes’ ideas gained prominence as a result, as he demonstrated the importance of fiscal stimulus in driving up aggregate demand and mitigating the effects of recessions. However, Keynesianism was challenged in the 1970s, when it had no appropriate policy response to stagflation. This led to the rising popularity of monetarist theory, which argues that the key to control optimal growth and inflation is money supply, as argued by Milton Friedman.
However, both schools of thought seem to be breaking down today. On the one hand, monetary expansion has become less effective in stimulating growth and inflation. Subdued core inflation across major developed economies despite rates at historical lows has challenged conventional wisdom and lent support to Neo-Fisherian theory: higher nominal interest rates may actually lead to higher inflation, especially in bank-driven financial systems. On the other hand, fiscal stimulus has often been slow in raising aggregate demand, as shown by Japan’s lost decades, or carries side effects including credit bubbles and resource misallocation, as happened in China.
These shocks may make a return to normal more difficult for an economy. Decades of fast and uninterrupted credit growth in developed economies pre-crisis have led to significant debt overhangs on the liabilities side and to overcapacity on the asset side of corporate balance sheets. As economist Richard Koo argued, the burst of a debt-financed bubble could send the economy into a balance sheet recession, during which the private sector is incentivised to minimise debt rather than maximising profits. This renders lower interest rates less relevant, and means fiscal stimulus is often offset by rising private sector savings. In addition, neoclassical growth theory rests on the assumptions of ample resources, a growing population and technological advancements to drive long-run growth. Yet today we are faced with limited resources, an ageing and shrinking population and less productivity-enhancing technological developments, as we discuss below. This also means monetary expansion isn’t enough to bring back inflation, as O. Blanchard and more recently B. Cœuré have argued.
2. Technology, Job Markets and Inflation
When Adam Smith discussed productivity growth from improvements in technology, he was probably contemplating the positive impact that a corn-mill would have on an agricultural economy rather than the disruption caused by Amazon’s delivery-drones.
Technological advancements over the past decade have not always been followed by productivity or wage growth. Why? One argument says that wage growth lags technological improvements and the boost is yet to come, as has sometimes been the case historically. Another argument suggests that it won’t. This is because technological advancements have focused on replacing middle and low skills jobs, leading to increasing wage and job polarisation (MIT). Additionally, the speed of these advancements and high socio-economic barriers has meant that middle and low skills workers haven’t been retrained and redeployed. This means workers could permanently drop out of the work-force, part of the so-called hysteresis hypothesis. While hysteresis may be less apparent in the Eurozone (according to a recent speech by ECB Board member Benoît Coeuré), it may be more evidenced in the US. In the US, despite consistent decreases in unemployment, wage growth remains stagnant. The Phillips Curve – which measures the responsiveness of wages to unemployment – has been steadily flattening in the US since the 1950s.
3. Social Imbalances and the Politics of Rage
Protest and illiberal political forces, in the form of economic populists or neo-nationalism, have risen across western democracies as incumbent political parties have failed to address growing structural and economic imbalances.
On the one hand, technological advancements have had a negative impact on labor’s bargaining power in the middle and low skill sectors of the economy, which has increased income inequality. On the other, enabled by QE-fueled cheap debt, the acceleration of the concentration of industries’ market share in fewer players both across the US and Europe over time has helped keep wage growth subdued, despite economic growth (see also: Hello Goldilocks! Bullish on Asia/EM Equities by BAML Equity Strategy). Under-investment in education and re-training have, in our view, been the culprit for the failure of incumbent politicians to provide a remedy to the above issues through the means of social mobility.
Income inequality, however, has only accelerated in recent years. Wealth inequality has, as a result of the financial crisis and the subsequent asset-price QE-based recovery, increased significantly as well, as we wrote last year.
The rise of inequality has proven a reliable indicator for the potential successes of populism in developed economies, as argued by INSEAD professor Pushan Dutt. Without structural reforms, we think these disequilibria are set to grow. Countries that have already lost to populism like the UK to Brexit or the US to Trump, will likely find it harder to recover the social and political consensus required to achieve reforms – populism has acted so far as a polarising, not a unifying force.
For those who have managed to hold on to a social consensus – most importantly France and Germany – the jury is still out on whether they will manage to concurrently tackle structural inequality and deliver sustainable economic growth. Among others, some of the critical outstanding disequilibria in need of a solution are:
1. The increased divide between asset rich and the old vs the debt-laden, unemployed young, which has been discussed regularly by the Guardian, FT and retirement specialists such as Prudential. A recent report by McKinsey argues the current young generation is at risk of becoming poorer than their parents.
2. The erosion of education systems’ old role as a social equaliser, its rising costs and the associated ballooning student debt, which are becoming problems in their own right in some developed countries – again with the UK and the US at the top of the list.
Solving these issues may be a good start to help regain social consensus and stabilise western liberal democracy. The upheaval liberal democracies have suffered has not occurred in a vacuum however. Their internal problems have combined at the international level resulting in a tougher, riskier geopolitical scenario.
4. The End of the Pax Americana
“I’ve been in revolt for years against ignominy, against injustice, against inequality, against immorality, against the exploitation of human beings” – Hugo Chavez (2005)
In January 2017, the Economist Intelligence Unit downgraded the United States from a “full democracy” to a “flawed democracy”. EIU data shows flawed democracies and hybrid regimes have been on the rise in recent years. Illiberal powers such as Russia and China have used – and sometimes supported – this disarray to their benefit, in order to increase their own economic, diplomatic and political clout.
Long-standing regional disputes have resurfaced or have become less manageable without the US as a stabilising diplomatic force. The US President has shown to be more reluctant to promote international stability, which would have been unthinkable previously. The new order will be one without the United States acting as policeman of the world and Asian countries reclaiming a larger share of the international power. We see geopolitical risk increase over at least four fronts in Asia, the Middle East, Eastern Europe and Latin America.
China/Korea: We think there is a possibility that President Trump could unexpectedly launch a strike on North Korea, as made clear by the ample preparations made in recent months.
Middle East: Notwithstanding the unpredictable turn the Syrian war may take following the defeat of ISIS, we think the growing dispute between the Saudi-led group against Qatar over their Iranian-friendly diplomacy could potentially devolve into a more serious conflict, particularly due to President Trump’s past lack of interest or current inability to resolve the crisis.
Eastern Europe: We see the region as less vulnerable to Russian influence and illiberal forces today, in so far as President Trump’s weak commitment to NATO’s article 5 has helped solidify the growing Franco-German consensus to become independently more assertive in the region.
Latin America: We think the United States may prove to be a stabilising force in Venezuela, if the recent ultimatum to force Maduro’s regime to back out of their Constituent Assembly plan pays off. If Maduro does not back down, and President Trump enacts meaningful economic sanctions, it may tip the country into default and further internal conflict.
The changes happening in our society, politics and technology are in turn triggering a new approach to fiscal and monetary policy.
5. Fiscal Policy Turning Aggressive
In the Keynesian school of thought, fiscal stimulus works to jump-start growth during an economic downturn by raising aggregate demand, often more than proportionately to the initial spending thanks to the multiplier effect. Following 2008, however, several hurdles have limited the potential for fiscal stimulus, or its effectiveness.
The first hurdle is rising private sector savings which may offset higher government spending, as in Japan’s lost decades. Traditionally this phenomenon is explained by the Ricardian Equivalence Theorem, which suggests that debt-financed government spending will fail to stimulate aggregate demand, as individuals anticipate future tax increases and reduce consumption. While empirical studies so far have found limited evidence of Ricardian effect in Japan’s case, they have shown that other drivers like population ageing and debt-minimising incentives have encouraged private sector savings.
Second, the format of stimulus matters, with productivity-enhancing measures like infrastructure spending carrying higher multipliers. As an IMF empirical study has shown, a 1% GDP increase in public infrastructure investment could raise the level of output by 1.5% in the same year and 3% in four years. In contrast, stimulus measures like the UK’s Help-to-Buy scheme turned out to more useful to inflate asset prices and worsen inequality than as a stimulus to the economy. In addition, fiscal stimulus is yet to happen in Europe’s periphery, as high public debt levels have limited public spending. While Germany and core countries have additional room for stimulus, they have so far focused on maintaining a balanced budget. Other pan-European initiatives like the Juncker Plan are steps in the right direction, but lack the resources needed to achieve bigger impact. This stalemate could change after German elections, as a likely Macron-Merkel Franco-German alliance should lead to greater Euro area integration and fiscal spending. In the US, expectations on the Trump administration’s fiscal plans are becoming uncertain. This is likely to be delayed until next year, with a smaller expansionary impact than initially foreseen, given internal disagreements within the Republicans and political controversies around the President. The extreme scenario could be a reversal of austerity policies into aggressive spending – something which could be possible in the UK, for instance, should the current Conservative government leave way to Jeremy Corbyn.
6. A Difficult Exit from QE Infinity
Central bankers want to exit Quantitative Easing. For one, central bankers need to rebuild a policy buffer to help fight the next economic downturn. As accommodative monetary policy has been in place for over a decade, central bankers are aware that they may need to normalise rates over a longer time horizon than previous tightening cycles. Also, as the global economy improves, the collateral effects of QE may be becoming unjustifiable. QE prevented the crisis from deepening, but exacerbated inequalities by increasing asset prices and the disparity between asset-owners and have-nots. Finally, allowing QE to run for longer risks a further increase in global leverage and inflating asset bubbles.
Can economic growth be sustained if QE is withdrawn? Yes, if accommodative monetary policy is replaced with structural reforms and fiscal expansion. We think this is more likely in Europe as a stronger Franco-German alliance may support EU-integration initiatives and fiscal spending. In the US, the Fed has begun to exit from accommodative policy, but progress on President Trump’s plans looks increasingly challenging. In the UK, QE life-support is likely to remain, given limited room for an expansionary budget and persistent structural hurdles to growth.
Exiting QE may not be easy for central bankers or markets. Over the last decade, central banks have expanded their balance sheets, pushing bond yield and bond volatility to record lows. In the hunt for yield, investors bought equities for yields and bonds for capital gains. In this low volatility environment, any market shock may seem disproportionate and be amplified. This puts central bankers in a catch-22 situation, having to choose between destabilising markets today or maintaining the status quo but creating a greater crisis in the future.
7. Conclusions: A Revolution in Investing
The current equilibrium in society, politics and financial markets is the fruit of a long super-cycle in debt, which developed over the past five decades. During this period, monetarist theory and neoliberal economic policies worked, demographics were positive, technology was inflationary and textbook economics was a good guide to the real world. This is changing.
Financial markets have been anticipating gains on central bank stimulus, but our economies have not grown stronger in the process. Total debt levels remain high, productivity low and inequality across individuals as well as corporates has put a lid on a recovery in wages as well as in competitiveness.
Today, central bank stimulus is becoming less sustainable and less politically acceptable, as we recently wrote on the Financial Times. The road to Quantitative Tightening will be treacherous: for policymakers, because they are trying to revive a patient still in fragile health as well as for investors, who will need to dance with central banks no longer holding their hand.
There are few winners and many losers from QT, in our view. The losers are assets which investors bought purely for yield or as a cash-park in a negative interest rate environment, like long-dated investment grade debt, utility or technology stocks, property, art and collectibles. The winners may be the few beneficiaries of higher interest rates and of stronger fiscal policy, like commercial banks in the Eurozone, the Euro and Greece.
More importantly, investors will need a flexible approach to deal with these future challenges. A strategy that breaks down bond risks into its components: rates, spreads, default, complexity and liquidity risks – and that selects only the risks it wants to be exposed to – is likely to perform better than a long-only fixed income portfolio.
Ten years ago, Citigroup chief executive Chuck Prince said investors should “keep dancing” until the music stops. Today, the music is still playing and many are still dancing.
We prefer to stay much closer to the exit door.
“A revolution is not a bed of roses.
A revolution is a struggle between the future and the past.” – Fidel Castro, 1959
The Silver Bullet is Algebris Investments’ macro letter.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan, Aditya Aney and Pablo Morenes.
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