I’ve been of the view, like so many other investors, that the would be dovish and a) launch LTRO early, b) cut rates, and c) do some form of QE (the market thinks outright QE, I thought unconstrained LTRO.)

This view has led me to be long EUR duration from Bunds to Italian and Portuguese treasuries. I have also been long Euro IG credit duration due to the steepness of the credit term structure. This was a over a year ago. It has been a good trade.

The past month has seen in acceleration in these trades. My view, however, has now changed. The European economy has been weak, victim in no small part, of the trade war raging between America and the rest of the world. Economic data suggests the ECB has to be dovish and increase its reflationary efforts. The TLTRO and LTRO calls are based on the details of what the ECB can or cannot do. QE is needed once again but the dearth of German ISINs and the need to buy more peripheral debt is constrained by teh ECB’s need to buy pro rata to its capital key. Repo operations allow the ECB to facilitate private commercial banks to do the buying on its behalf, without these inconvenient limitations.

The risk to the trade has always been political. The end of the Draghi term at the end of this October and the beginning of Lagarde’s leadership of the ECB is a risk.

Christine Lagarde is a consensus builder and communicator. She leans towards dovishness but is likely to be a moderator rather than a leader of the ECB’s policy committee.

On September 4, Lagarde called for European governments to do more in fiscal policy to boost Eurozone growth. While Lagarde is a supporter of monetary accommodation, it was a signal that she at least is listening to the views of the hawks, or that she thinks that further monetary accommodation will have limited impact with rates already through the zero floor. I expect that Draghi may announce another round of QE but a moderate one, (not more than 25 billion EUR of net purchases a month,), disappointing the market’s expectations of further blank check accommodation, or he may simply do nothing but talk, and hand the baton to Lagarde. Lagarde’s September 4 statement is a signal that she will be more circumspect and may demand that member states’ treasuries pick up the slack instead of leaving it to monetary policy.

If so, the impact on rates markets will be negative. Expect curves to steepen and rates to back up.

Inequality has reached acutely high levels. There are certain drawbacks.

1. An important impact of inequality is that the capital and resource allocation decisions are concentrated in the hands of the few. The efficiency of this capitalist, free market, economy, tends to the efficiency of the centrally planned (for example, Soviet) economy.
2. A related theme is that the consumption patterns of the population are distorted by the heavily skewed wealth and income distribution. The needs of the few outweigh the needs of the many.
3. Economic models based on aggregates or averages lose their explanatory and predictive power. Simple adjustments for skew fail to capture the dynamics of income and wealth disparity. Policy designed based on such models obtain unintended outcomes.
4. Inequality results in over saving, which results in a insufficient demand for goods and excess demand for assets.
5. Inequality suppresses interest rates which makes land and capital cheaper and therefore overemployed in production. Labour is forced to compete by restraining wage growth. This is a self-reinforcing feedback loop.
6. A redistribution of wealth from rich to poor would increase the velocity of money and spur economic growth. This is unpopular as it disadvantages the rich and influential and is unlikely to be implemented in a continuous fashion.

I don’t know how yield curves get inverted but when they do, recessions tend to follow after. Why? Banks borrow short term and lend longer term and an inverted curve means that the bank credit market fails to clear. It results in a credit shortage which chokes off growth.

We will still get our recession, but not for reasons of an inverted curve. Not this time.

The corporate bond market is 3 times larger than it was ten years ago. Big companies don’t fund via the banks. The squeeze will be felt by small and mid caps who cannot access the bond market, and households. However, quality consumer loans that get securitized will also escape the credit crunch to some extent as banks lend, warehouse and syndicate.

The curve inversion recession couple will be weaker this time. And yet we will get our recession and this data point will be a spurious one for the history books. All dynamic systems exhibit cyclicality and while policy and central banks have distorted the frequency and phase of the cycle they cannot prevent it altogether. The trade war will raise underlying inflation levels and weaken growth. But mostly, while QE supported growth it also exacerbated income and wealth inequality by rewarding asset owners over labour. Concentration of capital leads to inefficient allocation contributing to eventual decline. We will get our recession but its not the curve.

I have argued since 2013 that the world had been in a trade war since at least 2009, perhaps 2007. This war was fought at various times in the FX theatre and through the re-shoring of manufacturing. Re-shoring represented a reorganization of global supply chains to locate them in the countries of the parent companies. For the US, the main re-shorer, President Obama led a campaign to help facilitate and encourage re-shoring.

The Trump Presidency has been a more belligerent actor in the trade war essentially transforming it from a Cold War to a Hot one. The weapons of choice of the Trump administration are tariffs. Tariffs differ from re-shoring in some respects. In a globalized industrial system, a product begins life in one country and encounters various transformations and value additions in various countries before finding its way to the hands of consumers in a range of countries. Re-shoring aimed to bring supply chains back to the country of origin. Under this policy, an iPhone would be designed and built in America with American components. It would then be sold domestically and abroad, representing exports. In a globally optimized supply chain, an iPhone uses components and intellectual property sourced globally from companies sourcing for components and intellectual property globally. The finished product is shipped from the final fabrication locations, and there can be several, to customers globally. The complex supply chains and end markets result in complex trade relationships, forex flows, and current account dynamics.

Tariffs are a blunt instrument as they tax imports regardless of the multiple nodes of the supply chain, nodes which could reside in the country imposing said tariffs, and its trade allies. Also, it is trivially evident that import tariffs are paid by the residents of the tariff imposing country. Tariffs are also incendiary and invite retaliation. As tariffs proliferate they encourage companies to reorganize their supply chains. This can resemble re-shoring but whereas re-shoring involves bringing manufacturing capacity back to the home country, tariffs encourage companies to produce within the trade blocs of their target end customers. The potential for duplication of resources is high.

At risk of over generalization, in a world of increasing globalization, efficiency is rising and robustness is declining. (By robustness we refer to resilience against supply chain shocks.) In a world of declining globalization, as is likely under a trade war, efficiency is falling and robustness is increasing. Adoption of global standards becomes more difficult. Technologies and industries dependent on global standards and scale may face challenges. Balkanization of industries is a risk which can lead to duplication or incomplete networks. There is a tendency towards higher inflation as sub optimal supply chains are developed around policy and regulation. Cross subsidies of redundant capacity also raises prices.

Declining interdependency further weakens the tendency towards cooperative behaviour raising the risk of international conflict. The trade war between China and America is but one dimension of a wider competition, one for global hegemony. The nature of the competition has until the Trump Presidency been a state of Cold War and passive aggression with both countries engaging throughout their mutual competition. The Trump doctrine seems to suggest a disengagement approach. This approach appears to be part of a wider approach to dealing with the outside world as the US has engaged in various trade disagreements with Europe, Mexico and Canada. The stated intention to reduce participation in the affairs of the Middle East is further evidence of a new insularity. This approach to dealing with China is risky. It risks miscommunication and escalation at the governmental and social level.

The Chinese approach is to build bridges while America builds walls. The insular approach of President Trump represents an opportunity for China to grow its influence. Only the size and inertia of the Chinese status quo has prevented China from furthering its influence and challenging the American hegemony. As the US abandoned the TPP, China could have replaced it, thus confounding and co-opting a project started by then President Obama to counterbalance Chinese influence. The size and depth of SOE penetration in the economy prevented China from complying with TPP standards sufficiently quickly to join the coalition. China has on its side, time. Term limits on the Chinese President have been repealed. China is not a democracy and is ruled by a single party giving it the resolve to pursue long term policies beyond the terms of any Western government. That said, on the US front, the Trump administration’s position on China is largely accepted by the Democrats as much as the Republicans. This makes the China US Cold War durable. Détente is possible but improbable. The challenge for China is maintaining a coherent policy of competitive engagement with a variable US executive. The challenge for the US, is maintaining policy coherence through potentially variable domestic politics, in the face of a consistent and determined Chinese government.

Economic outlook

Growth is slowing. After ten years of expansion, it is to be expected that the global economy should slow down. The slowdown is very tangible in Europe, is evident in China and rest of Asia, and in the US is showing early but significant signs.

The Trade War is a drag on growth. 10 years ago, trade between China and the US began to decline as a share of the economy. This was a) a conscious effort by China to reduce its dependence on exports, and b) a reversal of US trade policy to outsource production. In 2018, President Trump escalated this trade war using tariffs, which are very blunt instruments and are paid by the aggressor nation’s people.

Central banks are in expansion mode. Balancing these growth reducing factors is a U-turn in Fed policy. Until October 2018, the Fed was raising interest rates and shrinking its balance sheet. Since then it has paused and there is talk of rate cuts. Two years ago the ECB signaled raising rates in the summer of 2019. Given the weakness in the European economy, it is doubtful if the ECB can raise rates at all and will more likely have to start QE again (via the LTRO). The Chinese central bank, the PBOC is also loosening to try to boost growth.

Credit spreads are tight. Contrary to popular opinion, the corporate sector has not increased its leverage or borrowings out of hand. The bulk of the credit creation has been in the government sector. While corporate indebtedness has risen in the past decade, they remain below pre 2007 crisis levels. In particular the banking system has reduced its leverage and maintains healthy balance sheets. Credit quality, despite some deterioration in the past few years, remains good. It is valuations that are the issue.

Market Outlook

Equity markets are rising because central banks are cutting rates, not because earnings are accelerating. If earnings slow and markets remain high it means equities are getting more expensive. In the past decade, earnings have been supported by cost cutting and rationalization. Growth cannot be sustained by making less investment and businesses smaller. Be cautious investing in equities.

Bond markets have been supported by the same loose central bank policy. Tactically, buying duration may seem attractive. However, duration (sovereign bonds) is volatile and central banks have used all their tools to support the market.

Within the bond market, corporate bonds offer the least value and the most volatility as they are most easily bought and sold by retail investors. This is especially true of the investment grade market, and to a lesser extent the high yield market.

Amid the noise of central bank policy, the mortgage bond market is interesting and more rationally priced. On a relative basis, commercial mortgages are more expensive than residential mortgages. Also, household balance sheets look healthier than corporate balance sheets which also favours residential over commercial mortgages.

Loans are the senior most debt issued by companies and because their coupons are floating, they also have no interest rate risk. Central bank policy has shifted investors’ interest away from loans to bonds and as a result there is good value in the loan market. Leveraged loans yield on average 3 month LIBOR + 4.5% and have a default rate of about 1.3%.

Bank perpetuals are attractive, especially in Europe. This may seem to be a niche market but banks are one of the largest and most important sectors in the economy. Up until 2008, banks were lightly regulated leading to all sorts of problems. Since then, banks have been tightly regulated, required to raise more capital and make their balance sheets safer. The logical strategy therefore is to buy the riskiest securities ranking just above equity in safety (since capital raising leads to equity dilution).

FX is the most difficult asset class to call. Whereas once FX was driven quite loosely by two competing theories (higher interest rates = stronger currency versus higher interest rates = weaker currency), today FX is driven by politics and central bank policy. Yet FX has important implications for investing. Emerging markets like a weak USD. If you think the USD will be strong, you cannot simultaneously favour emerging markets. In this era of FX inflexion, a good policy is to be hedged all the time. Putting the fundamentals of the economy aside, since they seem to have weak predictive power over FX, the psychology of investors is a reasonable guide. Europe faces much political instability and an inefficient single currency system. Only Europeans would keep EUR and they might keep other currencies as diversifiers. JPY has negative rates and a huge national debt. JPY can look like a haven currency and negatively correlate with markets because it is a funding currency but it is not a haven. That leaves USD. Americans will keep USD but so will Europeans and Asians. What about CNY (CNH)? This could be the reserve currency of the future if China keeps opening up its economy and builds bridges instead of walls, like America. CNY is weak today due to a slowing economy but if China opens it capital account, it will one day reflect the economic fundamentals of the Chinese economy, which are strong.

Strategy:

I am cautious because

a) it has been 10 years of growth and the business cycle is at a turning point,

b) sovereign balance sheets are not very strong anywhere in the world,

c) central bank policy is mostly fully deployed (except for the Fed) and there is not much room for further QE, and;

d) most assets are expensive, especially large liquid markets but also private markets like private credit and private equity.

• Cash is one solution but it is a poor one as inflation risk is rising as countries turn to fiscal policy. Market timing is also a losing game over time. It is better to be fully invested but to choose the risk exposures more carefully and to be LESS diversified. If general conditions are not so good, being more diversified means you guarantee you will earn the average just when the average is poor.
• Loans are attractive as they are the senior most corporate claim, and are often first if not second lien. They are also zero duration assets and are insensitive to interest rates rising or falling.
• Bank perpetuals are good value but market prices are volatile. We will take advantage of that volatility to buy them and as we are long term investors, tolerate the volatility when we hold them.
• US mortgages are stable as despite the slowdown, jobs are growing and wages are stable. Mortgages are getting expensive in some areas so we have to be selective.
• The Euro yield curve is still relatively steep and buying duration on a FX hedged basis is attractive. The Euro investment grade term structure is also steep and buying long maturity investment grade is attractive.
• The USD yield curve is flat but there is a steepening trade in the 5 and 30 year sector. In USD corporate bonds there is no value and low exposure is warranted.
• Equities are expensive globally and we would be underweight generally unless we had a real reason to be invested.
• Banks are cheap and growth is stable, however, the market is not recognizing the value. A slow accumulation at lower levels across US and European banks is recommended.
• Healthcare has underperformed this year and is good value. The longevity theme is a long term one and we will use this period of underperformance to accumulate exposure.
• Luxury brands is a niche market but an attractive one. The issue here is that brand leadership rotates and active management is important.
• Tech has been the best performing sector in the last 10 years. Banks outperformed from 2000 – 2008 when they were lightly regulated and underperformed from 2008 to 2019 as they were heavily regulated. The fate of tech lies in regulation. It has begun in Europe. If the US also begins to regulate tech, the sector could begin a multi-year underperformance.
• Private equity, credit and real estate: The liquidity premium has shrunk across illiquid markets as too much money has gone in search of a home. We would reduce the pace of investing in anything illiquid for now. The time for illiquid investments is just during (if you are brave) or just after, a recession. We haven’t had a recession in 10 years. There are pockets of opportunity or potential we see:
  • Tokyo real estate, specifically office and hotels.
  • London is not yet an opportunity but if there is a Hard Brexit, a London prime office asset could become a bargain.
  • SME lending in frontier markets struggling with Basel banking regulations. This has impact implications for employment and development.
  • Non-performing loans in China. The PBOC and CBIRC are cleaning house and banks have begun selling NPLs. The usual approach of sweeping the NPLs under the AMC carpet is longer acceptable to the regulators.
  • India’s 2017 bankruptcy code (which is liquidation and not reorganization) creates a gap for a private reorganization solution.
  • Financial inclusion. This is related to banking regulation. Banking regulation while making banks stronger is choking the provision of credit to small and medium businesses. Trade finance and other small scale commercial lending activities can become attractive as banks exit from the business.