The last decade

The last decade has seen a remarkable recovery in asset values, and a reasonable recovery in economic growth. The deployment of QE, rate cuts and bailouts were useful in the crisis years for ensuring the functioning of the financial system and the emergency funding of the economy. This prescription has not been without side effects. One of them has been that the bailouts and rising asset values relative to economic growth have increased the gap between asset owners, generally a wealthier group, and labour, generally a less wealthy group. The domination of capital over labour is not a new phenomenon but a secular one, exacerbated by the increasing importance of technology in our knowledge economy. The ability for corporations to accumulate generations of intellectual property whereas labour can accumulate but one, has placed labour at a relative disadvantage. The emergency policies after the last crisis and their continuation policies to boost growth have tended to favour asset owners over labour, extending this trend.

There are various justifications for tolerating inequality (encouraging inequality would be a radical concept). A certain level of inequality is a good thing as it tends to encourage competition and effort. However, what is desired is economic mobility and not the inequality itself. There are other defences of inequality. One is that the standard of living has improved for all, one of the arguments in trickle-down economics. Another is that the composition of the wealthy is constantly changing and that mobility is a sufficient aim. Other arguments point to the drawbacks of potential solutions such as raising minimum wages.

Raising the absolute wealth of the population is no longer sufficient. The distribution of wealth is also material. The wealthy bid up the price of goods and services crowding out the poor. A good example is urban real estate where mostly the rich can afford to own and the rest must rent or commute over long distances. Education and healthcare are other examples where wealth brings disproportionate access to quality. When it comes to retirement funding, the gap becomes glaring. Whereas a worker can only rely on their ability to continually supply labour, the wealthy earn passive income from asset returns. In ageing populations, this reality is precipitating and creating anxiety.

The stresses faced by the have-nots has reached a point where they turn to populist politics. Some of the populist policies are ill advised but not all. Benefits must be funded and policies that promise benefits without proper consideration as to how they are funded, or which increase national debts without bound are not sustainable. More aggressive taxation can fund social welfare but the devil is in the details and may require regional or global coordination. Chronic and increasing inequality is a drag on growth and needs to be addressed, but vested interests are aligned against redistributive policies. The risk is that policy does not go far enough in addressing the imbalance and people turn to more extreme ideas and politics. Extremist politics is gaining ground across the globe with risky geopolitical consequences.

The slow rate of growth in the recovery has created a general climate of contentiousness across multiple axes stoking xenophobia, trade protectionism, an increase in nationalist tendencies and rising populism. When growth is sufficiently strong, the pie grows sufficiently quickly that the division of the pie is less material. When growth slows, the division of the pie takes priority leading to increased competition and rivalry. The combination of inequality and slow growth can lead to declining wealth in the majority of the population even as aggregate statistics indicate growth. As a baseline, the real wealth and income of the majority of the people must be rising to avoid a regression and a challenging of the social and economic order. Such challenges tend to be disorderly and violent. Desperate people who see their livelihood, lifestyles and lives threatened do desperate things and are desensitized against extreme actions.

Inflexion point

We are at an inflexion point in the economic cycle. A decade of patchy but positive growth threatens to slow back into contraction. The fiscal expansion in the US is likely to offset the tighter monetary conditions imposed by the Fed and delay the slowdown. Indeed data is equivocal and the US economy is likely to expand for some time to come. The pace of this expansion will likely slow as the cycle ages, as fiscal expansion is halted or slowed by a Democrat controlled House of Representatives. The Chinese economy continues to slow, in part from the natural cycle and in part due to a policy of reducing leverage in unproductive areas of the economy. The European economy is most fragile being one of the most open economies and also one suffering from structural weaknesses from its choice to operate a single currency and monetary policy without further unifying fiscal policy and unified concept of Eurozone sovereign risk. European growth which rebounded in 2017 from a brief respite in global trade is now sagging. The risk of a European recession is now significant and the tools for mitigation appear inadequate.

Trade has been an area of contention since the financial crisis a decade ago. Then, efforts to grow through trade were seen as part of wider policy of reflation and recovery, and the rivalrous aspects were less an area of focus. With time this has changed and the American President Donald Trump has made this one of the pillars of his policy, escalating a Cold War into the open. The main protagonists of this war are the China and US, but the collateral damage will be their trading partners and countries in the supply chain. If the trade war escalates, the impact on global growth will be significant as productive efficiency is lowered leading to price pressures even as growth slows. In the interim adjustment period growth is likely to dip below the new low-trade equilibrium as the not insubstantial frictional costs of reorganizing supply chains take effect. This is already underway and will likely intensify.

The global slowdown is already eliciting policy response. The Bank of Japan was largely expected to reduce its QE efforts but has lately signalled that it will maintain course. It might even have to accelerate its accommodation in future if the economy slows further. The People’s Bank of China, while in the midst of engineering a great deleveraging is already compensating in other areas by infusing capital and liquidity in the banking system. It is expected to do more. The ECB has stopped expanding its balance sheet as a precursor to one day reducing it, and raising interest rates. Now it seems likely that it will have to postpone its planned rate hike from 2019 to 2020, and is likely to have to replace asset purchases with generous repo operations (LTROs), a sort of QE lite, or QE stealth. The Federal Reserve once resolute in hiking rates regularly through 2019 and 2020 has softened its message and will likely slow the pace of rate normalization.

The short view

FX

One of the most unpredictable markets is FX. The USD had been strong as the Fed first signalled QE taper, then executed it, raised rates and began to shrink its balance sheet. The Democrats winning the House probably marked the end of USD strength in the short term. However, the market still prices in eventual normalization at the Bank of Japan, and the ECB, a view that will likely fade as more data emerges in the coming months. The People’s Bank of China, has only just begun to compensate for its deleveraging efforts and will likely announce further cuts to reserve ratios, further relaxation of collateral standards for repos, and recapitalize the Chinese banks to enable them to lend. At a more visceral level, which is often useful in FX, in a more turbulent and uncertain world, it is hard to envisage viable alternatives to the USD as a haven currency.

Equities

Central bank accommodation the world over will support risk assets. However, valuations in US equities has not retrenched as much as it has elsewhere. While growth in the US will remain the most robust by comparison, Chinese, Asian and European equities have already priced in a slowdown.

Duration

USD duration could outperform given that the Fed has already tightened and could be approaching the last third of its cycle. The focus should be at the 3 – 5 year sector where the curve is still steep. The flatness of the curve further out suggests value in shorting the 30 year treasury. A less hawkish Fed might be construed as less responsible and justify a greater term premium.

EUR duration could outperform also and across the curve. The EUR curve is relatively steep and the ECB is likely to have its hands tied as to normalization.

Credit

Investment grade spreads widened throughout 2018, surging in the last quarter before tightening sharply in Jan 2019. There is some value in IG but there is also more leverage in issuer balance sheets. At best this is a neutral allocation. High yield spreads also widened over 2018, surged and receded. There is some value too in HY but there will be volatility.

The leveraged loan market, despite deteriorating lending standards, remains attractive. The floating rate nature of the debt removes the duration element and the seniority of claim provides more security than bonds of equivalent issuers. The complexity of this asset class and the risk of issuers playing creative games with assets and cash flows presents some risk, so these markets are best accessed through specialist fund managers. And then there is the CLO, which packages leveraged loans into leveraged vehicles that issue bonds of various seniority of claim, allowing the investor to choose their risk. The rules and limitations imposed on CLOs in order to support their credit ratings is a useful and important filter at a time when loan standards have declined. Loans and CLOs are some of the most interesting investments in credit given the uncertainty over growth and interest rates today. And finally, mortgage bonds. A tight labour market and moderate growth in the housing market make a sound basis for US mortgage bonds. The mezzanine tranches, known as credit risk transfer bonds are the most attractive in the residential arena.

Energy

The chronic underinvestment in capacity will create undersupply in the coming years. Oil prices are likely to rise under this scenario. However, given the flexibility and capacity of US shale, the short term price action will be driven by a strategic game theoretic evolution in the markets as OPEC, led by Saudi Arabia, attempts to limit the influence of US producers. This involves at times OPEC oversupplying the market to coincide with periods of stress in credit markets on which US shale is highly dependent upon. In the even longer run, the migration of dependency on fossil fuels to sustainable and renewable energy sources will see a decline in the importance of oil. At this time frame, the direction of oil prices will be unpredictable as both supply and demand contract.

Generally:

Once an analgesic has been discovered it is difficult to wean off. As the global economy has slowed, central banks have shown their propensity for accommodation. The weakness in Q3 of 2018 was largely due to Fed Chair Jerome Powell not rolling the so-called central bank put. As markets tumbled, he rolled the put, and markets have since stabilized. The ECB had talked an optimistic outlook up until the Jan 2019 meeting, but will very likely roll its put if the European economy continues to weaken. The PBOC already rolled its put with RRR cuts and expanded MLFs and a new policy to support issuance of bank perpetual bonds. For shorter time frames, central bank accommodation policies can be very positive for asset prices. As long as the central banks keep rolling their puts, maintaining ample liquidity and financial support, asset prices will be supported. This is the short view.

Threats to this outlook include a drastic slowdown in economic growth in one or more regions. Europe is an area of concern given how rapidly its economy has weakened. While it is this weakness that provides the ECB justification for slowing its normalization, if too acute, such a slowdown could trigger a change in the narrative and further accommodation could be a sign of panic.

The trade war is another factor. The current assessment is that tensions have peaked but will remain, a sort of regression to a state of Cold War. If, however, a volatile and unstable White House decides to escalate the confrontation, sentiment could deteriorate very quickly. The Chinese response and strategy is quite predictable, parry but do not escalate.

The short view thus recommends a largely risk on position justified by accommodative central bank policy and a moderately slowing economy avoiding recession.

The long view

We maintain our faith in price discovery except when prices are falling. This was certainly the case in 2008 during the financial crisis when central banks and governments mounted a concerted effort to support markets and maintain the proper functioning of the financial system. The policies we learnt and employed in the aftermath were palliative rather than curative, but sufficient for our short term purposes. The danger was that underlying causes would not be addressed or that the solutions would be used inappropriately or excessively as most palliatives tend to be.

Debt levels

Treasuries and central banks have been enlisted to support both asset prices and near term economic growth while borrowing ever increasing amounts from our own future, amounts which are unlikely to be repaid by the economy as a going concern. This implies that either there is a future slowdown as a result of servicing and repaying this debt, or some creditors will not be repaid. Alternatively, this can be achieved in continuous fashion by engineering inflation, either in the real economy, or in asset prices. The gap between inflation in assets versus the real economy, in say wages, has already widened exposing stress points and raising questions as to sustainability.

High debt levels also mean that interest rates cannot be allowed to rise too quickly or too far, lest debt service becomes unbearable. There is therefore a limit to how far central banks will allow interest rates to rise, unless they are unable to maintain that limit.

Policy:

The efficacy of quantitative easing and interest rate policy in providing short term relief and growth mean that the strategy will be deployed in case of recession or market crisis. History has shown that policy has never been able to be fully reset before the next crisis occurs. Policy is subject to strongly diminishing marginal returns. The result of this is that short term crisis management policies are deployed in ever increasing size, or more creative short term solutions are formulated to deal with crises and recessions. The Japanese experience provides some guidance as to the future of Western developed world policy, characterized by ever increasing debt, quantitative easing, de facto debt monetization and zero interest rates. Japan is able to operate this policy for protracted periods because of its high level of savings, even now declining, and that its debt is internally funded. Countries requiring external funding of its national debt will face rate and FX volatility and possible default, especially if funded in hard currency. The ECB is uncomfortably close to having a recession without having had the opportunity to reset or normalize policy.

Politics:

The rich poor divide coupled with slow growth resulting in the reality or perception for the majority of the populace, of declining wealth and purchasing power, is creating turbulence in the geopolitical landscape. Inequality between nations has receded as frontier and emerging markets have caught up to the developed world, reducing the inter-national rivalries to an extent. However, inequality within nations has risen to levels precipitating a desire for change, often any kind of change. While risks of inter-national conflict have declined, the lines of conflict within nations have sharpened. The razor thin margins of election results, the instances of hung parliaments, of weak coalitions, of the rising Far Right, are symptomatic of these conflicts.

Europe will be an interesting example to watch. Far Right parties control Italy and are gaining traction in Germany, Austria, Hungary, and most recently Spain. France is facing a popular revolt from the Gilets Jaunes. The coming European Parliamentary elections in May 2019 are a potential focal point for the Far Right. There appears to be a new coherence across Europe’s populists absent in previous elections.

Exacerbating political risks is the rise of strongmen like China’s President Xi, America’s Trump, Russia’s Putin, Turkey’s Erdogan, Hungary’s Orban, and most recently, Brazil’s Bolsanaro. A period of apparently unfair policies and unequal distribution of wealth and opportunities has created demand for the indignant, assertive, populist leader. General conditions today include, the failure of moderate parties to gain sufficient support individually, or indeed to work together to form stable coalitions, economic anxiety arising from slow growth and inequality despite healthy aggregate growth data, the perception that policy has favoured the elite at the expense of the masses and that the system is rigged.

The China – US rivalry will likely dominate the geopolitical topography for some time to come. The current trade spat is but one dimension in a wider struggle for supremacy. A confrontation between the greatest power and the power in ascendency is almost inevitable. It is likely that the rivalry will expand beyond trade to commerce, and to geopolitics and the projection of power and influence beyond their respective borders or regional spheres of influence. A technological arms race is already underway and is at risk of escalating in more aggressive ways.

Given current general conditions, the world cannot afford a sustained or acute slowdown, either globally or in any significant region or country. Even a single nation could serve as a focal point for wider conflict and division. A significant economic slowdown would potentially impoverish sufficient people to precipitate political change in an unconstructive fashion. The likely policy response to recession  or crisis is also likely to be unpopular and reinforce the view that the system is rigged against labour in favour of asset owners. The conditions would be conducive to the rise of an opportunistic, populist strongman to commandeer popular support against the status quo. Such an opportunist would likely emphasize nationalism, protectionism, and rejection of the current economic system.

In summary:

The short view is quite benign. A cyclical slowdown is already underway outside the US and will at some point find its way into the US. The slowdown is likely to be shallow given the policy tools available and the willingness of government to use them. Valuations are reasonable in most markets following the sharp corrections in Q4 2018. While the non-financial sectors have increased operating and financial leverage, banks have, by reason of increased regulation, reduced leverage. Consumer debt, which passes through the banking system is similarly deleveraged. The banking system has been strengthened to lower the risk of financial contagion.

The long view is clouded and fraught with risks from the economic to the political. A surfeit of debt, mostly sovereign and corporate, hangs over the outlook threatening default, devaluation or financial repression. The political risks are perhaps even higher than the economic or commercial and threaten potential regime change.

The short view recommends being risk on, at least as long as the central banks are willing to underwrite asset values. The long view recommends caution. Taken together this implies a strategy akin to the game of Chicken, or brinksmanship.

The latest ISM manufacturing number declined sharply from 59.3 to 54.1, a disappointing number, but not an unexpected one. Manufacturing is global whereas non-manufacturing is more domestic. Given the weakness in manufacturing PMIs in Europe and Asia, it was surprising that the US manufacturing PMI was so resilient. A decline was to be expected.

In the US and China, non-manufacturing PMIs remain robust, even as manufacturing PMIs decline, recalling the period 2010 – 2015, where global trade as a proportion of GDP was declining. This period might be regarded as a period of Cold War in Trade; a first salvo. The current situation is an escalation in this conflict and evokes comparisons with that period.

Corroborating this is the base metals index which fell from 2011 through 2015. Manufacturing recessions correlate with materials recessions. 2016 – 2017 was a reprieve in world trade where trade as a percentage of GDP rose. It coincided with a recovery in materials.

The USD strengthened in the periods of trade, manufacturing and materials recession. As the largest net importer in the world, and with the world’s most important trading currency, this is to be expected.

There is a difference today. Whereas from 2010 – 2015, central banks were accommodative almost universally, today the US Fed is raising rates and shrinking its balance sheet. This could threaten the general economy and cause non-manufacturing PMIs to decline in sympathy with manufacturing. Given where interest rates are, the risk remains low but will increase with each rate hike and as the Fed’s holdings of US treasuries dwindles. The impact on the USD could be further to the upside.

Early 2018 saw synchronized global expansion, but also saw the peak of it. Early 2019 is seeing the beginnings of global synchronized slowdown. The question is when it peaks and where does it peak first? In Q1, or Q2, or longer? In China, or the US, or Europe?

The US is latest into the slowdown. Europe and China were first. Should we expect Europe and China to lead in peak slowdown? Central bank policy will play a part. The ECB may not be able to be as hawkish as it has represented. It has already backtracked on economic forecasts. The PBOC has been tightening since early 2018 and has already had to backtrack on actual policy with reserve ratio cuts and increased credit facilities to the banking system. Will the Fed reverse course on its rate hikes and normalization? On current data, there is no need, but it may do so if the economic data weakens. This weakness could be delayed. Non-manufacturing, the larger portion of the US economy could prop up the economy for longer. However, we are now seeing data suggesting an incipient slowdown, in more equivocal labour statistics.

In order to understand what will drive markets in 2019, we need to understand what changed in October 2018 that caused the market to decline.

The Fed miscommunicated policy. In early October, Fed Chairman Powell signalled to the market that Fed policy would be tight, saying that rates were far from neutral. This was change in the consistent message that the Fed had been sending the market for over a year. The original message was that the Fed would be dovish to neutral and tightening gradually. The Fed had been sending a dovish signal to the market while resolutely raising rates. This was the narrative that provided the market confidence that the economy was healthy and could tolerate rate hikes and comfort that the Fed would maintain a very gradual path of rate hikes to keep financial conditions accommodative. The reaction to Powell’s hawkish October comments was declining markets and widening credit spreads. At the same time, the President was increasingly critical of Fed policy and calling for an end to rate hikes. The Fed’s second error which compounded the first, was to backtrack on its hawkish statement by saying that rates were just below neutral, signalling a dovish stance going forward. While the first signal took away the dovish tone of the Fed, the second signal took away the confidence in the economy. It made the Fed look reactive, weak, and open to influence from the White House. This exacerbated the weak sentiment in the market.

In December, Secretary of Treasury Mnuchin did something odd. The market was not looking at the solvency or liquidity of the banking system, yet Mnuchin conferred with the CEOs of the nations largest banks seeking reassurance of their liquidity. Mnuchin then Tweeted that his discussions reassured him of ample system liquidity and solvency. This was a mistake in communications. Where markets are concerned and when confidence is fragile, nothing confirms suspicions more than denials.

Trade war: It is difficult to ascribe blame for the market volatility on the trade war because there hasn’t been a major change in the substance or signalling around trade negotiations in the period in question. At the G20 summit in late November, Presidents Trump and Xi met, and agreed a ceasefire in the trade war, and an effort find agreement by the end of March 2019. Since that meeting, China has offered a number of concessions to the US which should de-escalate if not defuse the trade tensions. Given that no material deterioration or improvement in the situation has taken place since then, it is hard to pin the blame for weak markets on the trade war.

Economic growth. It is also hard to blame the market volatility on economic growth. Growth had been slowing in Europe and China all year. And their markets have been weak. US growth, however, has remained buoyant, and the latest weakness in global markets has been led by the US. Were growth concerns responsible for market weakness, the last quarter should have seen the US outperform China and Europe. It has not.

Therefore, it appears that the weakness in the last quarter of 2018 in global markets was driven by US markets, due to a change in sentiment and not fundamentals, triggered by a miscommunication of policy, and exacerbated by the relative richness of US assets compared with the rest of the world.

The longer term implications for markets in 2019 involve other factors, such as economic growth, earnings, policy and politics. However, the short term implications are that assets have become over sold on technical and sentiment driven factors and are likely to rebound.

Leveraged loans have been one of the best investments in the last decade, on a risk adjusted basis.

Using the S&P LSTA Index as a gauge, the 10 year annualized return has been 8.9% with a volatility of less than 1%. The high yield bond market, proxied by the iBoxx HY index has returned 9.6% with less than 5% volatility while the iBoxx IG index has returned 5.5% on roughly 5% volatility as well. In contrast, the S&P 500 equity index has returned 14.3% but with about 15% volatility. A strategy of leveraging a portfolio of loans to bring the volatility in line with HY or IG or indeed equities would have generated far better returns.

Putting aside the technicalities and complexities of leveraging a portfolio of loans and considering loans on an unlevered basis, the attractions are still clear. Loans are floating rate securities and therefore have very low interest rate sensitivity, a useful property in a rising interest rate environment. Loans are senior secured claims and are therefore structurally senior to bonds which are senior unsecured claims.

The US economy is still growing and still robust. While growth may slow in 2019 to 2020, recession risk is low. Credit markets are not without risks and we will address those, but at the fundamental level, the labour market is tight, wages are rising, the housing market is robust, consumer debt is under control and leverage is lower than it was in 2007. The leverage of loan issuers has fallen from 2015 to 2018, from 6.2X to 5.3X, cash flow coverage has risen from 2.7X in 2016 to 3.2X in 2018. Overall corporate leverage has risen in the last 10 years but this surge has taken place mostly in the HY bond market and not the loan market. Company earnings may slow in 2019 and 2020 but growth is expected to be remain positive.

Loan prices are technically capped at 100 since an issuer can repay a loan early, at par. At times, loan prices have exceeded par, notably in in 2005/2006 when direct investors and CLOs were heavy buyers of loans. Prices breached par again in 2014 as taper tantrum stoked fears of rising interest rates making the floating coupon of loans valuable. In 2017 and 2018, loans traded above par again, most recently in October 2018 when some 65% of the market traded above par. Today less than 5% of the market trades above par. The average price of the S&P LSTA Index is down from 98.70 to 95.60 in the space of 2 months, a 3.11% decline. It’s a small number for equity and FX investors but in the loan world where volatility is often around 1%, this is a big deal. In 2015 when the HY market was under stress and China was dragging global growth down, loans traded to 89.3. In 2008, the depths of the global financial crisis saw loans trade to 61, default rates were in the mid teens while recoveries were in the 50s. That point was one of the best buying opportunities in loan market in history. An investor who bought loans in September 2008 would have made 9.8% by the end of 2009 for an annualized return of 7.05%.

Loans are not without their risks, even if fundamentals are sound. Much has been said about the predominance of covenant lite issues. This is true but a) the number of cov-lites is already receding, and b)the phenomenon is more a technical issue where the largest marginal buyers of loans, CLOs, would give up covenants for yield in an effort to improve their arbitrage between assets and liabilities. This is of course no excuse but explains the trend in cov lites. Another risk is liquidity risk. Loans are not exchange traded and while the market has grown, capital dedicated to market making has shrunk as a result of greater bank regulation. This presents liquidity risk which can exacerbate market volatility in a downturn. An increasing number of loan only capital structures which eschew the senior unsecured layer is another concern which can impact recoveries and increase leverage for the loan investor.

What we are fairly certain about for now and for 2019 is that the US economy is healthy and in expansion but that the rate of expansion could slow. We can see loan prices at 95.60, default rates of 1.6% possibly climbing to 3.2%, and we see current coupons at 6%. Should you buy now? In 2015, we saw a healthy US economy except for one spot which was the energy sector. Energy represents about 7% of the loan market (and 16% of the HY bond market.) Loans traded from 99 in late 2014 down to 89 in early 2016. In total returns, this was a -2% return (-1.3% p.a.) From June 2015 to Feb 2016, the total return was -4.16% (-6.6% p.a.). Time and collecting a coupon makes a big difference. The current move resembles the move in mid-2014, which could be a signal of further weakness down the line. However, for smaller investors there is the option to invest in closed ended loan ETFs which currently trade at a 13-14% discount to NAV. Here the attraction is buying an asset whose value is 95.5 and paying 87 for it and collecting a 6% coupon while waiting for the price to converge to the NAV. Even at a 5% default rate, which would indicate a recession, and zero recovery, the investment exhibits ample room for error.

For long term investors who do not like the complexity of buying closed ended ETFs and later switching to NAV products, the loan market is already good value. It may get cheaper over the coming months, and it might be dead money for a year, but the downside is reasonably limited and the coupon is attractive. It is difficult to time the market so a reasonable strategy is to begin buying in stages.

Just to be clear, this is not my base (highest probability) case but market volatility is at the point where it is useful to consider what could go wrong, what if we are wrong about our base case, and how far could reality be from our expectations.

To reiterate, the global economy is actually in good shape, but, equity markets have become expensive, boosted by QE and other performance enhancers. Risk assets from equities to credit, are repricing fast, as expectations for a slowdown increase. And let’s be clear, the consensus expectations are for a very shallow slowdown.

So what could go wrong?

Monetary Policy has reached its limits. We can’t deal with the next recession.

The ECB is an excellent case in point. The European economy is already slowing and yet the ECB has yet to raise interest rates and is only at the end of this year, ceasing net purchases under its Asset Purchase Program (QE). It is far from beginning to reduce the size of its balance sheet and or raising interest rates. It may have to start easing policy before it gets a chance of tightening. This would be a blow to the credibility of the ECB, to central banks in general and to QE. It would be the second blow, actually, the first having come from the Bank of Japan, whose efforts have an exercise in gradual and long term futility.

The Fed is in a better position. It has raised interest rates 8 times since 2015 at the time of writing and is almost certain to make another 25 bp hike on Dec 20. The Fed also has the luxury, if you can call it that, of a fiscal policy driven extension of growth. This may give it room to raise rates a bit further, perhaps another 1% or 1.25% before the cycle turns. Or the cycle may turn too soon. All told, a Fed Funds rate of 3% is too low to cut from. The Fed needs at least a 4.5% or 5.0% level to cut from. In a downturn, the Fed might have to resume QE, not just halt the balance sheet reduction, proving QE to be a slippery slope and placing the US economy forever in a state of opioid dependence.

QE Normalization is bad for markets:

Of the countries who have employed QE, only two have tried to normalize. China and the US. China’s first attempt in 2015, precipitated a sharp slowdown and a capital markets decline. The US began this year and just take a look at the stock market. Europe will simply halt balance sheet expansion, but given that Europe is already in a slowdown, albeit just a deceleration in growth, it will be useful to monitor the European experience.

Trade war is stagflationary :

A trade war would slow growth while it raised prices as the economy became less efficient. It would present a real challenge to Fed policy. Depending on degree, it could be very damaging, since tariffs are a tax on the US economy and would slow it at a time when it was naturally slowing already. For China, a trade war would be damaging as well, and as the Chinese economy suffers, demand for imported goods would fall as well.

Societal and Political Issues:

Political cracks are appearing across Europe. Cinque Stelle and Lega rule Italy, and both parties are extremist and populist. They do not want to play by the EU’s rules and could eventually break it up. Alternative fur Deutschland holds 12% of the Bundestag’s seats and is progressing at local elections which is an ominous sign given their brand of politics. Vox is a far right party in Spain which has recently won seats at the Andalusian regional elections. Most recently, gilet jaune has laid siege to Paris and forced the government to back down from unpopular policies. Generally, poverty and inequality are driving people to alternative solutions, alternative to mainstream capitalism. After all, the modern form of capitalism is itself an alternative to mainstream capitalism, the one that advocates fair play and eschews bailing out elites. The gilet jaunes’ complaint is general and fundamental, that the cost of living is rising too quickly, an interesting complaint given how hard the ECB is trying to boost inflation and get Europe out of its deflationary rut. The plight of the majority of people is that they see costs of living outrunning wage growth, and wonder whose demand it is that bids up prices and why these price increases fail to find their way into official inflation data. The answer is simple and often found on Instagram or Facebook as the rich forget their place and flaunt their advantages unwisely in front of the poor.

War:

The rivalry between China and the US could lead to war. It is quite clear that the trade war between the two countries is but one battle in a broader struggle for supremacy. What if that rivalry spills out of the commercial theatre into the geopolitical one? Proxy wars could be fought in Africa where Chinese assets are already installed. The South China Sea could be an accelerant if the US challenges Chinese hegemony in the region. Taiwan could be an excellent reason for America to protect free peoples from oppression.

Civil war is more likely but less predictable or easy to characterize. Modern lines of conflict are more within each country, between rich and poor, young and old, left and right, liberal and conservative. They are hard to characterize because one side cannot easily mobilize the organs of state against the other. The complaints of gilet jaunes are an example. In Britain, the Tory party is at war with itself. In America, partisanship has reached acute levels which threaten to divide the country.

Oil: Rising oil may be worse than falling oil.

The oil price has been volatile of late. Oil prices rose from 27 in 2016 to 85 in 2018 before falling over 30% in 2 months. A falling oil price is a threat to US shale and to a good portion of the high yield market, but the damage of rising oil prices is more serious. With a tight labour market in the US, and rising inflation, rising oil prices could raise inflation expectations complicating the job of the Fed. Imagine a rising oil price and a slowing economy and ask what the Fed is supposed to do in that scenario. A slowing economy may take some pressure off oil prices but the oil market is more sensitive to supply than it is to demand. With the chronic underinvestment in new reserves the risk is that oil prices rise above 100 at a time when the economy is coming off the boil. A stressed HY market could impair US shale’s ability to grow its capacity. EM markets who are energy dependent such as India would suffer as well.

Financial markets lead the economy. Current market sentiment is poor and could tip the real economy into recession.

Consider the risk of an over leveraged economy, dependent on capital markets for price discovery and funding, where too much money has chased too little yield for too long and interest rates have been artificially depressed. What if there is a loss of confidence which leads market rates higher. It could be inflation or just a reversal of the optimistic outlook which triggers a change in direction. Bond markets fall, borrowing costs rise, the economy slows, which in turn triggers a re-pricing of credit risk and on and on. The government would find it more expensive to service its debts. Government could raise taxes but it would be hard to do with a slowing economy. They could cut taxes to try to spur the economy but that would make the fiscal position tougher and could lead to higher rates. What could trigger that loss of confidence? A trade war might. Societal turbulence might. Political upheaval might.

Increased buy backs reduce the sensitivity of the economy to the stock market. But while companies have been buying back shares, they have been issuing debt often to finance the buybacks. This is like a bank which keeps reducing its capital or its total loss absorption capacity and replacing it with debt. It increases the leverage of corporate America. The result is an economy which is less dependent on bank finance, but has swapped it for the bond market, a potentially less predictable source of funding, where liquidity is ample one day and absent the next, where pricing is at the whim of ETFs and retail or mutual funds or foreign investors who may not understand the business they fund as well as they should and could, in a slowdown, react hastily, triggering a recession. The corporate bond market has grown significantly over the last decade. Loans and mortgages, however, which have to pass through bank underwriting, have seen slower growth as new capitalization rules and underwriting standards were imposed. Consumer debt has therefore grown less quickly, and its credit quality remained better, in the last decade. Meanwhile, corporate balance sheets have become more levered as QE and low interest rates pushed investors into the corporate bond market, weakening lending standards, depressing yields and encouraging borrowing.

The dependence of corporate America on the bond market has grown to over eight and a half trillion dollars, just a touch smaller than the mortgage market, and a near threefold increase in size in just a decade. No longer do financial markets merely reflect or measure the real economy. The real economy is dependent on financial markets for their funding and therefore sensitive to market yields. Whereas when credit was primarily funnelled through the banks, the Fed’s control over the economy was better, the Fed’s control now passes through the bond market. If the bond market tanks and yields rise, it would be a considerable brake on the economy when it least needs it.