Our comment this month seeks to distill a range of views put forward at a recent BCA (Bank Credit Analyst) Conference held in New York in late September. Speakers included Paul Volker, Larry Summers, Kevin Warsch, senior strategists from BCA, a range of external speakers and Michael Hayden, former director of the CIA. The theme of this year’s conference was how best to navigate a 4D world: debt, deflation, divergence and disruption. Not surprisingly the views of speakers were divergent and in some cases quite disjunctive. Before dealing with the 4Ds we observed that the degree to which economists jostle for power is not far off the power struggle for the US presidency. Views expressed by Summers, Volker, Warsch and others are so divergent that common ground is often not easy to find. Summers expects secular stagnation whilst Volker, who set the stage for taming inflation in the early 80’s, questions how deflation became such a big word in today’s narrative. He is also rather scathing about the newly adopted policy of forward guidance by the Fed, believing that this has little or no place. Warsch similarly opined that the Fed seems to have acquired a taste for power and publicity with market participants hanging on every word. The key point here is that the boundaries governing the Fed and the functioning of financial markets have blurred. The role of central banks is often front page news with the influence of luminaries such as Summers seemingly relevant to both the debate and policy response. Many feel that the Fed has not moved away from the model it implemented at the time of the GFC (global financial crisis) and is, as a result, poorly positioned to deal with the next recession. The structural problems associated with this lack of regime shift in Fed policy create a range of challenges going forward.
Core to all debates was the issue of growth in the US and elsewhere. In broad terms the debate is that the US does not appear to be growing quickly enough, the Eurozone is not growing much at all whilst China is constrained by structural issues such as excessive debt, lower margins and the persistent threat of capital flight. Emerging markets reflect weakness as a result of their dependency on foreign capital flows to fund trade account deficits, with many having seen sharp declines in their revenues as a result of the decline in oil prices.
In order to understand what the future may hold, we need to step back to understand how we got to this position in the cycle. Three key drivers are evident, namely: the debt super-cycle, demographics and as Mervyn King puts it: “the great monetary experiment”. Linking the debt super-cycle to demographics creates a powerful headwind to growth. When Volker took over the Chairmanship of the Fed in 1980, inflation in the US was running at circa 14%. A series of aggressive interest rate increases brought the economy to its knees, with a significant amount of surplus capacity being expunged as an economic recession took hold. The Fed has, since that time, intervened on a number of occasions through rate hikes, in order to ensure the equilibrium rate in the US economy declined with each successive business cycle. With the current equilibrium rate around 1% and inflation maintained at around the target of 2%, the US economy has not enjoyed the same upward surge in the business cycle, as a result of a number of headwinds to both the supply and the demand side of the economy. Surplus capacity as measured by the output gap, a lack of wage pressure in most sectors due to oversupply, deflation being exported from China to the West, ageing populations, a rise in inequality within countries, a lack of any meaningful capex spend on the part of corporations and persistently high levels of debt at private and public level all contribute to the current environment. With many of the traditional multipliers of monetary policy failing to manifest, the balance sheet recession aptly described by Japanese economist Richard Koo lingers on. Not surprisingly then, the debate at the conference turned to fiscal stimulus, reflation and protectionism, all against the background of rhetoric from the Trump camp which is decidedly populist in nature. But the debate went a lot deeper. Paul Volker pondered whether the “pseudo-science of economics” even understands the real questions of the day. Models designed by the Fed and others to describe the current economic situation don’t always reflect reality. He is far more concerned with leverage in the economy than deflation which he points out is nowhere to be seen and that the broader economic numbers that are so in focus often fail to measure key elements such as changing demographics, rising levels of inequality and even the inter-relationship between external factors and domestic monetary policy. In a nutshell the perfectly exact science that measures GDP, inflation rates and the like to two decimal places is, at best, a broad estimate of general trends. He emphasises that the current thinking directed at introducing just a “small amount of inflation” to stimulate price levels higher and thus elevate growth is woefully ignorant of history and would amount to an entirely arbitrary process, the outcome of which would be far from certain. Volker also points out that the modern day practice of electing a tradeoff between employment levels and inflation / interest rates is not at the core of the Fed’s mandate. The Federal Reserve Act specifies that the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Herein lies the core problem. Following the GFC the combination of economic headwinds mentioned above has resulted in low nominal and real rates that reflect a lack of increase in both monetary and credit aggregates. So the Fed, along with all other major central banks has had to resort to alternate measures.
Views expressed on China by the prior director of the Chinese Investment Corporation focussed on 4 different Ds: deceleration, deleveraging, decapacitation, and detoxification. With productivity growth having fallen from 9% prior to 2009 to current levels of around 3%, GDP will decline in the years ahead. Off-balance sheet debt is slowly being brought on board through debt swap arrangements. The magnitude of the debt build-up is staggering, with the PBoC’s balance sheet 4x greater than in 2009 and a number of 20trn RMB (roughly 3trn USD) mentioned as the total debt swap required to recognise all off-balance sheet debt. China is having to make some tough choices about industries that are no longer profitable and the environmental degradation it can no longer accept.
The overall impression left after all the analysis had been presented is that the US is not in bad shape nor is China. The former needs to rethink its policy response while the latter needs to address key structural changes needed to move the Chinese economy forward in ways that are value-adding and domestically driven. Europe has to move to a position of fiscal union as the constraints do not permit member states to leave. Debt levels do remain an issue but, in the absence of materially higher interest rates, do not pose as much risk as in 2008. Deflation should be deleted from the narrative, while divergence and disruption present more of a challenge to future policy. It seems that many regions are handing the baton over to politicians. This adds a 5th dimension to the future.
Source: Tony Bell – KI, MiPlan; Fund Manager & CIO, Vunani Fund Managers