Cirrhosis and Walls
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· A few weeks ago, a central banker said that ‘a policy objective may merely be to buy time’. Few would disagree that ‘buying time’ might be an ideal tactic, but only if more time is what is needed to determine, or to implement, a solution. However, if there is no realistic probability of any near-term solution, then ‘buying time’ could be seen as a desperate measure. Frequently, buying time eases the pains of today (like an opiate), but can make conditions worse in the future.
· Narcotics treat symptoms rather than root causes. The more an opiate is used, the greater the withdrawal effects will be. With ballooned balanced sheets and low (or negative) rates having resulted in massive increases in global indebtedness, central bank stimulus might now be venturing toward fatal damage to the patient. Stresses in high yield and CLO markets for example are warning signs of severe side-effects. There is no free lunch.
· The G-20 discussed sub-par global economic demand, yet the group was only able to agree on a vague and hollow statement ‘to use all tools necessary to strengthen the recovery’. Few countries though are willing to accept the burden of further fiscal expansion and lighter regulation. Most stimulatory policy measures, therefore, have continued to fall extensively onto central bankers.
· The G-20 warned of over-reliance on central banks. China quickly ignored this warning by (again) cutting its bank reserve requirements (RR) by 50 basis points. The move frees-up over $100 billion for the bloated banking system. Despite the G-20 warning, the move by the PBOC whipped the stimulus-addicted financial markets into another euphoric frenzy. However, market elation resulting from stimulus is beginning to be sustained for ever-shorter periods, as market participants realize it only ‘buys time’, while under the surface it is cultivating larger imbalances and longer-term problems.
· The RR cut was done to help arrest China’s slowing growth trend and to support its faltering stock market (Shanghai down 23% y-o-y). In the midst of their joyfulness, global markets seem to have missed the Reuters report today that “China aims to lay off 5-6 million state workers over the next two to three years as part of efforts to curb industrial overcapacity and pollution”. Admittedly, market sentiment was also improved by higher oil and some better-than-expected economic data.
· Understanding oil price movements have become a challenging double-edge sword for markets. Few would argue that lower oil prices help consumers and energy importers. However, equity prices have been counter-intuitively directly-correlated to oil prices. In other words, lower oil prices have been viewed as a problem due to the huge amount of loans tied to the energy sector (and their spillover effects and impacts on banks). For Japan, lower oil prices have amplified the BoJ’s concerns that they feed the ‘deflationary mindset’.
· Moreover, the negative impacts of declining oil are felt immediately, while the benefits to the consumer are distributed more slowly over time. In addition, it is likely that (compared to historical parallels) consumers are saving (rather than spending) their benefit. The Ricardian Equivalence hypothesis holds that consumers are forward-looking in their consumption decisions and will ‘save’ if they believe the benefit is temporary, or if a higher tax rate is expected in the future. Rapidly aging developed-world economies and inadequate retirement savings are uniting with elevated economic and political uncertainties to curtail the spending of the oil benefit.
· Lower energy (and other low commodity) prices have also damaged the fiscal budgets of many exporting countries. The damage is extensive enough to have forced some sovereign wealth funds to sell assets to plug the gap. This selling is occurring at the same time that many asset managers have used the post-Fed hike period to de-risk portfolios.
· It is well-advertised that many portfolios sought risk to capitalize fully on the Fed’s easy money stance. This is why the capital structure became so flat with junk credits at one point trading down to near 4%. This risk-seeking behavior is called the “portfolio-effect” and was a direct desire of Fed official’s policy actions. It should not come as a surprise that the portfolio-effect process has begun to unwind now that rate hikes have begun. Wider credit spreads, lower equity prices, and higher volatility in 2016 are a direct result.
· The drop in commodity prices has dragged some inflation numbers lower. FOMC members have labeled such a dynamic ‘transitory’. This stance makes perfect sense, because commodity prices will not fall to zero. When their prices stabilize, year-over-year effects will eventually catch-up, acting to lift inflation. However, if oil prices stabilize near $35, then inflation indicators will (indeed) eventually rise, but the ‘portfolio-effect reversal’ is unlikely to dissipate. This is particularly true if the Fed continues to lift interest rates. The result might be the bad combination of (temporary) higher inflation and a negative ‘wealth effect’.
· Political uncertainty is rising with many global elections approaching. This uncertainty adds to portfolio effect unwinds. Furthermore, with 9 EU countries closing their borders, refugee chaos has emerged, causing greater EU disunity and greater uncertainty. (Trump is not the only one wanting to build walls.)
· At the moment, a coordinated EU refugee policy seems distant. In the meantime, a humanitarian crisis has unfolded. The situation is expected to worsen as the weather improves and the numbers grow. Turkey is a key, but has incentives to provide only limited help to the EU at best. For Britain’s EU vote in June, a Brexit may now look less scary as the Brits may not know what inclusion in the EU actually looks like.
· “When the cockleshell shatters / And the hammers batter / Down the door / You’d better run” – Pink Floyd
Note: Whether the Fed hikes or not, long-dated Treasuries remain an attractive asset class (from too much demand). Generally speaking, it is still too early to catch a falling knife in EM or credit, and equities look far from attractive. Capital preservation remains critical at the moment.
Regards,
Guy
Guy Haselmann | Capital Markets Strategy
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guy.haselmann[at]scotiabank.com
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