How to destroy an economy!
Writing in my weekly “Richard Cluver Predicts” column which goes out to subscribing readers every Friday, I wrote last week of a problem which has confronted South African friends who went to live in England some years ago and recently returned to sell their family home in one of our most desirable leafy suburbs. Having completed the transaction they were now, however wondering whether it was the smart thing to do. After all, they said, Jacob Zuma’s leadership has in the past few years virtually destroyed the Rand so in foreign currency terms they will get little out of a lifetime investment.
In local market terms they got a very fair price, they believe though the equivalent property would have fetched at least ten times more in Britain. However, taking back the proceeds of the sale will give them barely enough to meet their living costs overseas for two years. Would it not be smarter, they wondered, to leave the money invested here in blue chip shares in the hope that it would grow and the Rand would improve over time.
Well I have to confess that I closely watch the Rand relative to the US Dollar and the Euro, but I have not recently studied the Pound, and so what I saw really shocked me. When the graph below slopes upwards it means the Rand is getting weaker because it takes more Rands to buy Pounds.
Since our esteemed president came to power, the rand has been losing over a fifth of its buying power each year relative to the British Pound. That is a dramatic change from the long-term trend traced out by the red least squares line representing the average over the past 28 years during which the average loss of value was just 6.1% annually.
Now the reason why currencies gain or lose value over time is a function of a country’s inflation rate. So, if you note that our inflation average over the past decade has been 5.29% and Britain’s has been 2.7%, you would have expected the Rand to lose 2.6% annually. That it has been losing at more than twice that rate long term and, more to the point, since Britain’s average inflation over the past three years has been 2.97% and South Africa’s has been 5.8%, the fact that the Rand has currently been losing value at 7.5 times the inflation differential, implies a massive foreign loss of confidence in South Africa as an investment destination.
Furthermore, if ShareFinder’s usually reliable projection system is to be believed, then the immediate future does not look too good for the Rand’s relationship with the Pound. Noting the graph below, the Rand’s recent recovery is over and we are likely to see the exchange rate rising to R18.38 by September from a current R17.81 before strengthening again to around R17.51 at the end of the year.
There is some good news, however. Money has been streaming out of the US ahead of an anticipated collapse of the New York stock exchange with the result that the Rand has been gaining relative to the Dollar since early February and, ShareFinder thinks it is likely to continue doing so until mid-September when the exchange rate is likely to be around R9.86 to the Dollar compared with R10.54 currently and R11.22 at its weakest point in January this year.
Calculating since January 1990, the mean decline of the Rand relative to the US Dollar has been 4.9% though, during the Zuma years, it similarly accelerated to 19.3% annually. Its best value was R6.65 to the Dollar on June 6 2011 and its worst recently has been R11.39 on January 30 this year.
Relative the Euro, the Rand has lost at 4.2 percent annually long term but During the Zuma years it has been losing at 19.8%. Recently it has recovered from its weakest value of R15.34 to a recent R14.48. It is likely to go to R15.81 by September.
So would I leave the money here if I were they? Well let’s pause to consider a few facts about South Africa! In this pre-election time there are lots like these going around and I do not know the source. But they seem accurate and they are sobering indeed when considered as a whole.
We actually know all of these facts and still most or my readers elect to stay here anyway and most of us still think South Africa is the best country in the world…better still if we can fix these things and of course we can if we put a better government in place. But the reality is we need foreign investors if we are to turn around our sluggish economy and end our critical unemployment problems. And the sobering reality is that if our Rand keeps on sinking at its present rate we won’t attract them. Furthermore, those that are already invested here will depart. Consider first the graph composite below:
Here the overwhelming case has always been the superior capital growth offered by South African share investments. As you can see, the JSE All Share Index has grown at 11.5% compound between 1997 and the present. And if you subtract the long term deterioration of the Rand, investors here would see a “Real” return of 6.21%. A similar investment in London would have yielded 0.9% and in the US 1.6%.
So on a long-term basis South Africa clearly won with returns seven times better than Britain and four times better than the US. That is what made us the flavour of the month internationally. However, during the Zuma years things have changed dramatically . Over the past three years US inflation has averaged 2.26% which implies that Wall Street has been offering a real return of 19.13% to US investors whereas if they sent money to South Africa and bought local shares they would have achieved a real return of just 0.8%. In other words, US residents investing in their own country would have done 24 times better than they would if they had invested in South Africa.
British residents buying shares in London would have achieved a real return of 11.3% whereas had they sent their money to South Africa and bought local shares they would have achieved a real return of MINUS 1.3%.
Now the problem with these things is that the Rand’s strength is recent years was entirely a factor of foreign investors sending their money to this country to take advantage of perceived higher returns. The result was that something like half or all South African shares are now owned by foreigners. Furthermore, when the Rand started losing value in January 2011 it was a function of the fact that foreign investors had formed the perception that First World share markets were likely to offer better returns than the Developing World due in the main to the signs of economic recovery occurring in the US.
We should have used that investment inflow to build up our reserves and to develop the infrastructure which would have fuelled a future local business boom. Instead we used it to plug a negative international trade balance and to fund things like the so called “Social Wage”: civil servant pay, social welfare grants and, dare I mention it, Nkandla. So, now, as the penny drops among overseas investors that South Africa is no longer a land of milk and honey and they can get better returns at home, we might expect an acellerating torrent of money flowing out of this country which might in turn start a domino effect, both further diminishing the value of the Rand and attacking share price values on the JSE.
Currently, the outlook is gloomy in the extreme. That is why it is so important that voters use the polls next week to register their unhappiness in order that, at the very least, the ANC gets the message that it needs to replace the people who are currently running things so badly. First prize would be to give another party a chance to run things!
The third in a new series in The Investor
by Richard Cluver
Now for some practical examples
The five-graph composite below illustrates how one can bring together many of the disciplines I have been describing in order to profitably predict the price movements of a share. For the experienced analyst, interpreting all the information contained in it is a quick and simple process which should not take you long to grasp.
Note that the topmost graph plots the actual price of Barclays Africa over a four-year period between 2010 and 2014 and, further, observe the mauve trend line that I have superimposed upon the topmost graph to underscore the fact that despite regular short-term up and down movement, the overall trend was upwards until recently.
However, from the end of 2012, the trend turned down as emphasised by the straight green line in the topmost graph. However, on the extreme right, traced out in red, I have generated a Fourier projection which is the result of a computer analysis of an inherent medium-term sine wave that was observable within the historic price data. By identifying this regularly recurring wave and then replicating it forward into the future we are able to observe the probability of a medium-term upward break which would signal the end of the down-trend that we identified with the green trend line.
Notice, however, that this rising medium-term Fourier Projection is turned back once it encounters a downward-trending curving red line which is in turn the result of a long-term Fourier analysis. Simply-explained, as can be clearly seen in the topmost graph, Barclays Africa share price has been very volatile in recent years and the outlook for 2014 was for a continuation of the same. But note that from an upward trend that lasted for all of the years covered by this graph, the long-term Fourier wave had been rising but late in 2013 it began cycling down and appeared likely to continue doing so for the foreseeable future.
Moving down to my Mass Indicator in the second graph, this tracks a combination of price and volume. Note that from late 2011, each subsequent cycle was slightly lower than the last which, simply stated, might be interpreted as implying that in the long-term holders of these shares had been gradually disposing of them whenever prices rose. Superimposed upon the second graph is a daily vertical line traced in green which represents the daily traded volume of these shares. Apart from one very large line in October 2012 which marked the onset of a strong buying phase that saw the share price rise 27 percent in the next four months, daily volumes did not vary greatly which made it clear that, notwithstanding the observation that overall there was disposal selling going on, nobody was in any rush to dump their holdings and run.
Graph three plots the direction of price momentum which was clearly accelerating until mid 2013 when it peaked and then began trending downwards, echoing the trends of the previous two graphs.
Graph Four plots the direction of price volatility which is the extent of daily price movements. When this graph rises it is a sign that investors are growing nervous that a trend change is imminent. Note how the sharp upward spike of this indicator in July 2013 anticipated the subsequent share price increase in September and October.
Graph Five tracks the daily Dividend Yield of this share. When this graph trends upward in the absence of a reciprocal downward movement of the price graph, this is a sure sign that a price improvement is imminent. The converse is equally true.
Now it is important to recognise that each of the graphs uses a different set of data. Thus, overall, the important thing we are looking for is for times when all five are trending in the same direction. If just one graph were moving downwards and the rest upwards, it would be fair to assume that the downward-trending graph was providing false information. But when the majority of graphs agree, it is fair to assume that they are predicting a highly probable market direction change.
Do note, however, that some of these graphs tend to give earlier warnings than others and so, if one graph is out of step, it is not necessarily wrong. It might just be earlier than the rest.
The improved return on capital invested by SA business
By Brian Kantor and David Holland
Why it is good economic news even though the new darling of the left, Thomas Piketty, thinks that high returns on capital raise income inequalities and thus should not be encouraged.
If a company can generate a return on capital that beats the opportunity cost of the capital it employs, it will create shareholder value. The market will reward the successful company with a value that exceeds the cash invested in the company.
The inflation-adjusted cash flow return on operating assets, CFROI®, for listed South African firms has improved consistently and impressively since the 1990s. Using CFROI® we have been able to demonstrate that political freedom has proved fruitful for SA businesses and their shareholders.
The economic return on capital has improved spectacularly over time, with today’s median firm reporting a very healthy CFROI of 10%. Until 1994, the average South African company was sporting a CFROI at or below the global average of 6%. South African companies were generally destroying shareholder value before 1994, especially when considering how much higher the real cost of capital would have been in those highly uncertain times.
Since 1994, the median CFROI has sloped upwards and remained above 6%. The new South Africa has been a value-creating South Africa! Note that at the peak of the commodity super cycle in 2007-8, the median CFROI was a stunning 12%. The top and bottom quintiles have also sloped upwards, indicating greater value creation for the best firms and less value destruction for the worst firms. Presently, 20% of South African firms are generating economic returns on capital above 15%, which is world-class profitability.
The benefits of efficient business and excellent returns on capital can be widely shared in inclusive share ownership, through pension and retirement plans as well as perhaps via a sovereign shareholding fund that can be built up to fund genuine poverty relief and opportunities for the poor. Broad-based empowerment in the form of employee- and community-based share options can be used to turn outsiders into insiders.
Such attempts to broaden the ownership of productive capital perhaps accord well with the recently revived critics of capitalism, following Piketty, who have found new reasons to question the advantages to society of high returns on capital. It is argued that such high returns on capital may well increase inequalities of income because they go mainly to the wealthy. Even should such high returns raise the rate at which national income is increasing, it makes such outcomes a mixed blessing, especially for those who have come to regard income equality as an important goal of economic policy.
Some facts about the distribution of SA incomes, taxes and government expenditure.
Let us give a South African nuance to this debate. Any discussion of the causes and consequences of economic growth and the distribution of benefits always has a distinctly racial bias in that white South Africans, on average, enjoy significantly higher incomes than black South Africans.
The distribution of wealth in South Africa is even more unevenly distributed in favour of white South Africans, given the much higher past incomes and the savings realised from them. The middle and higher income classes, those who are likely to become important sources of savings and contributors to pension and other funds, are increasingly made up of black South Africans. The times are changing and dramatically so, Loane Sharp, labour market analyst writing for Adcorp, indicates:
“Changes in the labour market after the end of apartheid have worked spectacularly well for blacks. Since 1995, on a like-for-like basis adjusting for skills, qualifications and work experience, blacks’ wages have been rising at 15% per annum whereas whites’ wages have been rising at just 4% per annum. Average wages for blacks and whites should converge as early as 2021 though, admittedly, average wages for entire race groups belie vast variations between individuals. The number of high-earning blacks – that is, those earning more than the average white – has increased from 180,000 in 2000 to 1.5 million today, with more than 40% of these employed in the public service, which has been used to great advantage, much like the predecessor apartheid state, to promote the welfare of a particular racial group.” (Source: Adcorp Employment Survey.)
According to the UCT Unilever Institute, the black middle class went from 1.7 million in 2004 to 4.2 million in 2012 to 5.4 million in 2014. The white middle class has been roughly stagnant: 2.8 million in 2004 to 3.0 million in 2014 (Source: UCT Unilever Institute). The number of high-earning blacks (i.e. those earning more than the average white) went from 120,000 in 2001 to 1.9 million in 2014 – 77% of these were in the private sector (Source: Adcorp).
The income differences within the different racial groups have probably widened with the rapid growth in the black middle class and the transformation of the public service that now provides much less protection for low-skilled whites. Most important, the unemployment rates indicate that a regrettably low percentage of the potential black labour force is not working in the formal sector and therefore not earning or reporting any income.
The income statistics and the GINI coefficient that measures income inequalities in SA do not indicate the important role the SA government plays in ameliorating poverty and therefore supporting consumption expenditure. The distribution of expenditure, including the benefits of expenditure by government agencies, especially if divided by racial categories, will look very different to the distribution of income or wealth. Of all government expenditure, equivalent to 33% of GDP, some 60% is classified as social services, that is spending by government on health, education and protection services. Much of these budgets are allocated to the improved employment benefits of the black middle class who work for government, supplying so-called social services. But measuring the quality of delivery is much more difficult than measuring how much is spent on them.
Yet of this expenditure on welfare, spending that constitutes 60% of all government expenditure, some 15% or nearly 5% of GDP, consists of cash supplied on a means tested basis to the identified poor. That is cash paid monthly as old age pensions, child support grants or disability grants. These payments have been growing strongly over the years, keeping up fully with inflation, and have provided an important form of poverty relief.
The taxpayers who have paid for this relief (and other government expenditure) are to an important degree income tax payers. Of all government revenues, which amount to about 30% of GDP, some 55% come from taxes on income and profits of businesses. Registered companies are budgeted to contribute nearly 35% of these income and profit taxes, or nearly 20% of all government revenue, in this financial year 2014-15. Of the personal income taxpayers, the highest income earners, those expected to earn over R750,000, will pay over 40% of all the income tax collected, while earning about 24% of all personal incomes – which include all reported income, interest, dividends and rents generated from assets.
These relatively high income earners constitute only 4.6% of all the 15.254 million potential income tax payers on the books of the SA Revenue Service (SARS). Of these registered for income tax purposes, some 8.835 million will fall below the income tax threshold of R70,000 income per annum and so will not contribute income tax. These low income earners will generate only 11.5% of all expected reported incomes in fiscal year 2014/15. (Source: Budget Review 2014, National Treasury, Republic of South Africa, Table 4.2).
These statistics from SARS confirm how unevenly distributed income is in South Africa and also how much redistribution of income is taking place via income taxes as well as via the distribution of government expenditure, which is biased in favour of the poor.
Higher income South Africans, it should be recognised, will be consuming and paying for almost exclusively private education, health care and will also employ privately supplied security services. The relationship between taxes paid and benefits received is not at all as balanced as it may be in the developed world where the biases in spending are often in favour of the middle class, who make up a large proportion of the electorate. To stay competitive in the global market for skills, this relatively unfavourable balance of taxes paid for benefits received by the high income earners and income tax payers has to be made up in the form of higher pre-tax salaries – purchasing power adjusted – compared to employment benefits and government services available for scarce skills in the developed world.
The scope for raising income or wealth tax rates would seem very limited – given the mobility of skilled South Africans and their capital. Higher tax rates, at some point, would inevitably mean lower tax revenues. The government appears well aware of this trade off, given that the Budget plan for the next three years is to maintain hitherto very stable ratios to GDP of government expenditure (33%) and government revenues (30%). Clearly the limits to government expenditure and redistribution of incomes will be set by the rate of economic growth. Redistribution with growth, to which efficient use of capital will play an important part, would seem the only realistic option.
Economic reality means trade offs, not least for economic policy
That growth in SA historically has occurred unfairly, with unusual degrees of income and wealth differences, is a fact of economic life that even SA governments, whose best intention is to reduce income and wealth inequalities, would have to take account of. Policies designed to achieve greater equality of economic outcomes may restrict growth rates and thus growth in government revenues that support redistribution of income and wealth. These are developments that would make achieving a greater degree of equality of economic outcomes and (what is not the same thing at all) realising less absolute poverty, that much harder to achieve.
South Africans have only to look north to Zimbabwe to recognise how the aggressive redistribution of wealth (without compensation) can destroy wealth creation and economic growth. While perhaps achieving greater equality it has also resulted in significantly greater poverty.
The consequences of income redistribution and transformation in SA: more consumption spending and lower savings.
The transformation of the income levels and prospects of the black middle class in SA as well as the income and welfare support provided for poor South Africans has had the effect of raising consumption spending as a share of GDP and reducing the gross savings rate. Gross savings, of which more than 100% are now made by the corporate sector from cash retained and invested by them, have fallen from around 25% of GDP in the early 1980s to current levels of about 14%. Fortunately the rate of capital formation, encouraged by high returns on capital has held up much better to the advantage of economic growth and tax revenues.
But the difference between domestic capital formation and savings has to be made up by infusions of foreign capital. By definition the difference between national gross savings and capital formation is the current account deficit on the balance of payments (see below).
South Africans have had to rely on foreign capital to an important degree, in order to maintain their consumption expenditure, much influenced as it has been by the transformation of the economy, in the form of the rise of the new middle class and the redistribution of income and government expenditure towards the poor. Foreign investors, essentially attracted by high returns, have become very important shareholders in JSE-listed corporations and rand-denominated government debt. Some 40% of SA government debt denominated in rands is now held by foreign investors. South Africans have been significant net sellers of SA equity and debt and foreigners net buyers over recent years.
Raising consumption expenditure rates has been no free lunch for South African wealth owners. They have had to gradually give up a share of their wealth and income from capital invested in JSE -listed companies, mostly held in the form of pension and retirement funds managed for them, to foreign share and debt holders. Of the current account deficit, which is running at about 6% of GDP, an increasing proportion, now equivalent to about half or 3% of GDP, is accounted for by net payments of interest and dividends abroad.
High returns on capital have made higher levels of real expenditure by lower income South Africans and previously disadvantaged black South Africans not only possible, but relatively painless for the wealthy share and debt holders who have gained directly from a rising share and debt market. The tax outcomes, and strongly rising government revenues, have not destroyed this growth process.
The implications for South Africa seem clear enough: to encourage economic growth so as to be able to redistribute more income and wealth to the poor. Any bias in favour of redistribution without growth would be destructive of wealth and incomes. Local and foreign investors, upon whom we depend to maintain our current levels of income and expenditure, don’t like uncertainty and much prefer transparency in government and corporate policy.
If global risk appetite is diminished, then shareholders in all countries will suffer. But those with the least uncertainty when it comes to corporate governance, government policy, inflation, and tax policy will be perceived as safe and suffer less. There are immense benefits to aligning policy with uncertainty reduction. A lower real cost of capital will increase market values, and make marginal investments more attractive. This fuels growth and reinvestment, which create more jobs and tax revenue. Typically, a 1% change in the cost of capital or required returns for investors means a 20% change in equity valuation! This is the old fashioned goal: less risk, more growth should be the aim of economic policy, rather than the chimera of enough income equality.
Pat on the back but much work needs to be done
South African companies should continue to focus on generating world beating returns on capital while government focuses on minimising uncertainty for them. In particular the government should remove the constraints on employment growth in South Africa and encourage labour intensive entrepreneurs to compete with the labour-shy formal business. More competitive labour markets (and the lower labour costs that would come with it) might allow smaller businesses, with less easy access to capital markets, to compete more effectively with formal business, if only they were allowed to do so.
Most important is that South Africans should recognise what should be obvious to all but the ideologically blind. When it comes to delivery, SA business has proved successful and our society should be building on this success. Business to business relationships in SA – subject to competitive forces – work well. By contrast, positive government to business relationships have been profoundly compromised and government delivery of services, despite an abundance of resources provided mostly by taxpayers, has been gravely inadequate.
If we can beat the world in managing businesses for return on capital, we can complete the job in building a South Africa where all prosper. South Africa is its own worst enemy by not according successful business enterprise the respect it deserves from policy makers.
The successes of business can be widely shared beyond current shareholders in the form of higher incomes and in revenues for the state, as well as increased employment. Growth with distribution is a worthy goal for policy and high returns on capital can contribute to this.
David Holland is Senior Adviser, HOLT and adviser to Credit Suisse. The views expressed are his own and not necessarily those of HOLT or Credit Suisse
The US Viewpoint
By John Mauldin
To listen to most of the heads of the world’s central banks, things are going along swimmingly. The dogmatic majority exude a great deal of confidence in their ability to manage their economies through whatever crisis may present itself. (Raghuram Rajan, the sober-minded head of the Reserve Bank of India, is a notable exception.)
However, there is reason to believe that there have been major policy mistakes made by central banks – and will be more of them – that will lead to dislocations in the markets – all types of markets. And it’s not just the usual anti-central bank curmudgeon types (among whose number I have been counted, quite justifiably) who are worried. Sources within the central bank community are worried, too, which should give thoughtful observers of the market cause for concern.
Too often we as investors (and economists) are like the generals who are always fighting the last war. We look at bank balance sheets (except those of Europe and China), corporate balance sheets, sovereign bond spreads and yields, and say it isn’t likely that we will repeat this mistakes which led to 2008. And I smile and say, “You are absolutely right; we are not going to repeat those mistakes. We learned our lessons. Now we are going to make entirely new mistakes.” And while the root cause of the problems, then and now, may be the same – central bank policy – the outcome will be somewhat different. But a crisis by any other name will still be uncomfortable.
If you look at some of the recent statements from the Bank for International Settlements, you should come away with a view much more cautious than the optimistic one that is bandied about in the media today. In fact, to listen to the former chief economist of the BIS, we should all be quite worried.
I am of course referring to Bill White, who is one of my personal intellectual heroes. I hope to get to meet him someday. We have discussed some of his other papers, written in conjunction with the Dallas Federal Reserve, in past letters. He was clearly warning about imbalances and potential bubbles in 2007 and has generally been one of the most prescient observers of the global economy. The prestigious Swiss business newspaper Finanz und Wirtschaft did a far-reaching interview with him a few weeks ago, and I’ve taken the liberty to excerpt pieces that I think are very important. The excerpts run a few pages, but this is really essential reading. (The article is by Mehr zum Thema, and you can read the full piece here.)
Speculative Bubbles
The headline for the interview is “I see speculative bubbles like in 2007.” As the interviewer rolls out the key questions, White warns of grave adverse effects of ultra-loose monetary policy:
William White is worried. The former chief economist of the Bank for International Settlements is highly skeptical of the ultra-loose monetary policy that most central banks are still pursuing. “It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin,” he warns.
Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?
The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.
But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?
Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.
So, the first quantitative easing in November 2008 was warranted?
Absolutely.
But they should have stopped these kinds of policies long ago?
Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultra loose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.
But wouldn’t large-scale debt write-offs hurt the banking sector again?
Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep ever-greening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.
Where do you see the most acute negative effects of this monetary policy?
The first thing I would worry about are asset prices. Every asset price you could think of is in very odd territory. Equity prices are extremely high if you at valuation measures such as Tobin’s Q or a Shiller-type normalized P/E. Risk-free bond rates are at enormously low levels, spreads are very low, you have all these funny things like covenant-lite loans again. It all looks and feels like 2007. And frankly, I think it’s worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.
Do you see outright bubbles in financial markets?
Yes, I do. Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity-driven thing, not based on fundamentals.
So are we mostly seeing what the Fed has been doing since 1987 – provide liquidity and pump markets up again?
Absolutely. We just saw the last chapter of that long history. This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.
What about the moral hazard of all this?
The fact of the matter is that if you have had 25 years of central bank and government bailout whenever there was a problem, and the bankers come to appreciate that fact, then we are back in a world where the banks get all the profits, while the government socializes all the losses. Then it just gets worse and worse. So, in terms of curbing the financial system, my own sense is that all of the stuff that has been done until now, while very useful, Basel III and all that, is not going to be sufficient to deal with the moral hazard problem. I would have liked to see a return to limited banking, a return to private ownership, a return to people going to prison when they do bad things. Moral hazard is a real issue.
Do you have any indication that the Yellen Fed will be different than the Greenspan and Bernanke Fed?
Not really. The one person in the FOMC that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.
The markets seem to assume that the tapering will run very smoothly, though. Volatility, as measured by the Vix index, is low.
Don’t forget that the Vix was at [a] record low in 2007. All that liquidity raises the asset prices and lowers the cost of insurance. I see at least three possible scenarios how this will all work out. One is: Maybe all this monetary stuff will work perfectly. I don’t think this is likely, but I could be wrong. I have been wrong so many times before. So if it works, the long bond rates can go up slowly and smoothly, and the financial system will adapt nicely. But even against the backdrop of strengthening growth, we could still see a disorderly reaction in financial markets, which would then feed back to destroy the economic recovery.
How?
We are such a long way away from normal long-term interest rates. Normal would be perhaps around four percent. Markets have a tendency to rush to the end point immediately. They overshoot. Keynes said in late Thirties that the long bond market could fluctuate at the wrong levels for decades. If fears of inflation suddenly re-appear, this can move interest rates quickly. Plus, there are other possible accidents. What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20 percent of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The prob lem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.
And what is the third scenario?
The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.
Which of the major central banks runs the highest risk of something going seriously wrong?
At the moment what I am most worried about is Japan. I know there is an expression that the Japanese bond market is called the widowmaker. People have bet against it and lost money. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation. And now happens what Professor Peter Bernholz wrote in his latest book. Now we have a stagnating Japanese economy, tax revenues dropping like a stone, the deficit already at eight percent of GDP, debt at more than 200 percent and counting. I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.
Many people have warned of inflation in the past five years, but nothing has materialized. Isn’t the fear of inflation simply overblown?
One reason we don’t see inflation is because monetary policy is not working. The signals are not getting through. Consumers and corporates are not responding to the signals. We still have a disinflationary gap. There has been a huge increase in base money, but it has not translated into an increase in broader aggregates. And in Europe, the money supply is still shrinking. My worry is that at some point, people will look at this situation and lose confidence that stability will be maintained. If they do and they do start to fear inflation, that change in expectations can have very rapid effects.
More from the BIS
The Bank for International Settlements is known as the “central bankers’ central bank.” It hosts a meeting once a month for all the major central bankers to get together for an extravagant dinner and candid conversation. Surprisingly, there has been no tell-all book about these meetings by some retiring central banker. They take the code of “omertà” (embed) seriously.
Jaime Caruana, the General Manager of the BIS, recently stated that monetary institutions (central banks) are at “serious risk of exhausting the policy room for manoeuver over time.” He followed that statement with a very serious speech at the Harvard Kennedy School two weeks ago. Here is the abstract of the speech (emphasis mine):
This speech contrasts two explanatory views of what he characterizes as “the sluggish and uneven recovery from the global financial crisis of 2008-09.” One view points to a persistent shortfall of demand and the other to the specificities of a financial cycle-induced recession – the “shortfall of demand” vs. the “balance sheet” view. The speech summarizes each diagnosis [and]… then reviews evidence bearing on the two views and contrasts the policy prescriptions to be inferred from each view. The speech concludes that the balance sheet view provides a better overarching explanation of events. In terms of policy, the implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.
Coming from the head of the BIS, the statement I have highlighted is quite remarkable. He is basically saying (along with his predecessor, William White) that quantitative easing as it is currently practiced is highly problematical. We wasted the past five years by avoiding balance sheet repair and trying to stimulate demand. His analysis perfectly mirrors the one Jonathan Tepper and I laid out in our book Code Red.
How Does the Economy Adjust to Asset Purchases?
In 2011 the Bank of England gave us a paper outlining what they expected to be the consequences of quantitative easing. Note that in the chart below they predict exactly what we have seen. Real (inflation-adjusted) asset prices rise in the initial phase. Nominal demand rises slowly, and there is a lagging effect on real GDP. But note what happens when a central bank begins to flatten out its asset purchases or what is called “broad money” in the graph: real asset prices begin to fall rather precipitously, and consumer price levels rise. I must confess that I look at the graph and scratch my head and go, “I can understand why you might want the first phase, but what in the name of the wide, wide world of sports are you going to do for policy adjustment in the second phase?” Clearly the central bankers thought this QE thing was a good idea, but from my seat in the back of the plane it seems like they are expecting a rather bumpy ride at some point in the future.
Let’s go to the quote in the BoE paper that explains this graph (emphasis mine):
The overall effect of asset purchases on the macroeconomy can be broken down into two stages: an initial ‘impact’ phase and an ‘adjustment’ phase, during which the stimulus from asset purchases works through the economy, as illustrated in Chart 1. As discussed above, in the impact phase, asset purchases change the composition of the portfolios held by the private sector, increasing holdings of broad money and decreasing those of medium and long-term gilts. But because gilts [gilts is the English term for bonds] and money are imperfect substitutes, this creates an initial imbalance. As asset portfolios are rebalanced, asset prices are bid up until equilibrium in money and asset markets is restored. This is reinforced by the signalling channel and the other effects of asset purchases already discussed, which may also act to raise asset prices. Through lower borrowing costs and higher wealth, asset prices then raise demand, which acts to push up the consumer price level.
[Quick note: I think Lacy Hunt thoroughly devastated the notion that there is a wealth effect. Lacy gives us the results of numerous studies which show the theory to be wrong. Nevertheless, many economists and central bankers cling to the wealth effect like shipwrecked sailors to a piece of wood on a stormy sea. Now back to the BoE.]
In the adjustment phase, rising consumer and asset prices raise the demand for money balances and the supply of long-term assets. So the initial imbalance in money and asset markets shrinks, and real asset prices begin to fall back. The boost to demand therefore diminishes and the price level continues to increase but by smaller amounts. The whole process continues until the price level has risen sufficiently to restore real money balances, real asset prices and real output to their equilibrium levels. Thus, from a position of deficient demand, asset purchases should accelerate the return of the economy to equilibrium.
This is the theory under which central banks of the world are operating. Look at this rather cool chart prepared by my team (and specifically Worth Wray). The Fed (with a few notable exceptions on the FOMC) has been openly concerned about deflationary trends. They are purposely trying to induce a higher target inflation. The problem is, the inflation is only showing up in stock prices – and not just in large-cap equity markets but in all assets around the world that price off of the supposedly “risk-free” rate of return.
I hope you get the main idea, because understanding this dynamic is absolutely critical for navigating what the Chairman of the South African Reserve Bank, Gill Marcus, is calling the next phase of the global financial crisis. Every asset price (yes, even and especially in emerging markets) that has been driven higher by unnaturally low interest rates, quantitative easing, and forward guidance must eventually fall back to earth as real interest rates eventually normalize.
Trickle-Down Monetary Policy
For all intents and purposes we have adopted a trickle-down monetary policy, one which manifestly does not work and has served only to enrich financial institutions and the already wealthy. Now I admit that I benefit from that, but it’s a false type of enrichment, since it has come at the expense of the general economy, which is where true wealth is created. I would rather have my business and investments based on something more stably productive, thank you very much.
Monetary policies implemented by central banks around the world are beginning to diverge in a major way. And don’t look now, but that sort of divergence almost always spells disaster for all or part of the global economy. Which is why Indian Central Bank Governor Rajan is pounding the table for more coordinated policies. He can see what is going to happen to cross-border capital flows and doesn’t appreciate being caught in the middle of the field of fire with hardly more than a small pistol to defend himself. And the central banks even smaller than his are bringing only a knife to the gunfight.
The Fed & BoE Are Heading for the Exits…
In the United States, Federal Reserve Chairwoman Janet Yellen is clearly signalling her interest – if not outright intent – to turn the Fed’s steady $10 billion “tapering” of its $55 billion/month quantitative easing program into a more formal exit strategy. The Fed is still actively expanding its balance sheet, but by a smaller amount after every FOMC meeting (so far)… and global markets are already nervously anticipating any move to sell QE-era assets or explicitly raise rates. Just like China’s slowdown (which we have written about extensively), the Fed’s eventual exit will be a global event with major implications for the rest of the world. And US rate normalization could drastically disrupt cross-border real interest rate differentials and trigger the strongest wave of emerging-market balance of payments crises since the 1930s.
In the United Kingdom, Bank of England Governor Mark Carney is carefully broadcasting his intent to hike rates before selling QE-era assets. According to his view, financial markets tend to respond rather mechanically to rate hikes, but unwinding the BoE’s bloated balance sheet could trigger a series of unintended and potentially destructive consequences. Delaying those asset sales indefinitely and leaning on rate targeting once more allows him to guide the BoE toward tightening without giving up the ability to rapidly reverse course if financial markets freeze. Then again, Carney may be making a massive, credibility-cracking mistake.
While the BoJ & ECB Are Just Getting Started
In Japan, Bank of Japan Governor Haruhiko Kuroda is resisting the equity market’s call for additional asset purchases as the Abe administration implements its national sales tax increase – precisely the same mistake that triggered Japan’s 1997 recession. As I have written repeatedly, Japan is the most leveraged government in the world, with a government debt-to-GDP ratio of more than 240%. Against the backdrop of a roughly $6 trillion economy, Japan needs to inflate away something like 150% to 200% of its current debt-to-GDP… that’s roughly $9 trillion to $12 trillion in today’s dollars.
Think about that for a moment. At some point I need to do a whole letter on this, but I seriously believe the Bank of Japan will print something on the order of $8 trillion (give or take) over the next six to ten years. In relative terms, this is the equivalent of the US Federal Reserve printing $32 trillion. To think this will have no impact on the world is simply to ignore how capital flows work. Japan is a seriously large economy with a seriously powerful central bank. This is not Greece or Argentina. This is going to do some damage.
I have no idea whether Japan’s BANG! moment is just around the corner or still several years off, but rest assured that Governor Kuroda and his colleagues at the Bank of Japan will respond to economic weakness with more… and more… and more easing over the coming years.
In the euro area, European Central Bank Chairman Mario Draghi – with unexpected support from his two voting colleagues from the German Bundesbank – is finally signalling that more quantitative easing may be on the way to lower painfully high exchange rates that constrain competitiveness and to raise worryingly low inflation rates that can precipitate a debt crisis by steepening debt-growth trajectories. This QE will be disguised under the rubric of fighting inflation, and all sorts of other euphemisms will be applied to it, but at the end of the day, Europe will have joined in an outright global currency war.
I don’t expect the Japanese and Europeans to engage in modest quantitative easing. Both central banks are getting ready to hit the panic button in response to too-low inflation, steepening debt trajectories, and inconveniently strong exchange rates.
While the Federal Reserve, European Central Bank, Swiss National Bank, Bank of England, and Bank of Japan have collectively grown their balance sheets to roughly $9 trillion today, the next wave of asset purchases could more than double that balance in relatively quick order.
This is what I mean by Code Red: frantic pounding on the central bank panic button that invites tit-for-tat retaliation around the world and especially by emerging-market central banks, leading to a DOUBLING of the assets shown in the chart below and a race to the bottom, as the “guardians” of the world’s primary currencies become their executioners.
The opportunity for a significant policy mistake from a major central bank is higher today than ever. I share Bill White’s concern about Japan. I worry about China and seriously hope they can keep their deleveraging and rebalancing under control, although I doubt that many parts of the world are ready for a China that only grows at 3 to 4% for the next five years. That will cause a serious adjustment in many business and government models.
It is time to hit the send button, but let me close with the point that was made graphically in the Bank of England’s chart back in the middle of the letter. Once central bank asset purchases cease, the BoE expects real asset prices to fall… a lot. You will notice that there is no scale on the vertical axis and no timeline along the bottom of the chart. No one really knows the timing.
“Sell in May and go away” might be a very good adage to remember.