Thoughts through the cycle: W3 October ’20

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  • Starting with a global economic depression and ending in a world war, it is a truism to describe the 1930s as a worldwide decade of failure. At a high level, the symptoms that precipitated the crisis can be summarised as followed: excessive debt, especially war debt, which hampered the post-war recovery but in particular led to ongoing international tension as the debt was owed between nations; instability in the international financial system, especially due to the loss of capital from the First World War (a problem most serious for Britain which lay at the heart of the global trading system); the return to the gold standard and the deflationary effect of that, particularly on commodity markets whose fall in 1928-9 acted as precursor to the Wall Street crash; financial speculation and ‘hot-money’ flows which created short-term asset-price growth of a highly-unstable nature due to its reliance on leverage for returns.
  • Superficially at least, some of the factors mentioned above which were true of the late 1920s are also true now, especially with respect to debt, leverage, and financial speculation. It is tempting too to cast the growing Sino-US rivalry as another Thucydides paradox (the upcoming nation challenging the incumbent, resulting in war) similar to the German-British rivalry which occurred in the run up to the First World War, although in the current case there is no real comparison in China (wolf-warrior diplomats not withstanding) to the slighted, Prussian militarism and the visceral hatred of the 1919 Versailles treaty which resulted from it. US tariffs on China in 2018-9 has been compared to the Smoot-Hawley tariff act, although one has to understand the 1930 tariff act in the context of a world where capital moved less and where tariffs were already present and acted in concert with capital controls.
  • Rather than simply making a tick-list of ‘events then’ and ‘events now’ as a means of justifying the comparison, it is better to step back and look at some of the overriding historical themes which may be held in common. The benefit of this thematic approach is that one isn’t necessarily looking at events in a purely causal and consequential manner, and one is therefore not bound into a predictive trap (because such-and-such happened then, it is bound to happen now etc). The theme most characteristic of the 1920s and which became even more apparent in the 1930s was the collapse of the international order, growing nationalism but also as importantly, the failure of those countries (notably Britain and the US) to perform their international roles to the fullness of their ability and thus to allow national interests to override what might be called the ‘international common good’. Britain’s failure to support France diplomatically against Germany and US insistence on full repayment of war debts owed by the European states are key examples of this.
  • 1914 marked the peak of the first age of globalisation, and despite tremendous efforts after 1918 to restore it, the glory days never returned. Britain’s loss of foreign capital from the war (money owed by Germany, Russia and elsewhere) meant that the flow of trade could not be financed as freely as before. Growing social demands meant the return to the gold standard was particularly painful and highlighted the conflict of interests between finance and commerce on the one hand, and the demands of workers on the other. This conflict, although different in content, is similar in form to the 99%/1% issue we have today. If one measures globalisation in terms of trade, it peaked in 2007 prior to the global financial crisis. Clearly the US under President Trump has taken a new path, one of America First rather than its traditional role in championing multilateral organisations such as NATO and the UN.
  • The 1930s was a period of increasing national self-interest. In monetary terms, this was characterised by ‘beggar thy neighbour’ policies of competitive devaluation, especially through the abandonment of the gold standard. Those countries who abandoned gold early like the UK in 1931 faired relatively better in the depression. Those who stuck to it, like France (which finally left in 1936), suffered more. The important point is that a policy of relativism took over, with countries becoming rivals in a currency war or a ‘race to the bottom’.
  • Back to 2020, it is notable that governments around the world have tended to act unilaterally rather than in unison. Trump’s criticism of the World Health Organisation (WHO) may stand out, but it is clear that the need to quarantine and thus to close borders is clearly a practical matter, but one whose consequence has been to undermine the general mood for international cooperation. Within Europe, Italy felt abandoned by its peers back in February, an issue which still causes rancour today. The contrast to 2008 is apparent too – the first ‘proper’ G20 summit took place in Washington in November of 2008, with America as the leader of the free world hosting a meeting of world leaders soon after the Lehman crash. This is exactly what hasn’t happened in 2020. With globalisation already in retreat, the reshoring of supply chains is now an emergent theme not only in the US but also in Europe. The question here is whether the rise in national self-interest will lead to a currency war similar to the 1930s.
  • In economic terms, the 2020 shock has been a deflationary one, with demand hammered by lockdowns, supply reduced, and both recovering only slowly due to the ongoing pandemic and the measures associated with it. The massive debt issuance that has characterised government reactions around the world is also deflationary, but there are also strong arguments to suspect that the huge monetary stimulus that has accompanied it will eventually prove inflationary, especially given the nature of government fiscal intervention (cash hand-outs) and the fact that these are proving hard to curtail due to the risk of spiralling unemployment. The first round of this war is the battle for reflation.
  • The graph below shows how this battle is starting to manifest itself. The blue line show USD 5y5y inflation (5yr inflation in 5yrs time) while the red line shows the EUR equivalent. While the starting point for the euro inflation was obviously lower (the Eurozone has struggled with deflation and negative rates prior to 2020), it is clear that while both initially bounced, USD inflation expectations continue to rise while the EUR are starting to roll over.

Source: Bloomberg as at 12 October 2020.

  • There are a number of reasons for this. Europe got a reflation bid during the summer as it appeared that it was recovering while Trump’s America was fumbling with Covid-19. The resurgence of the virus in Europe in the last month has knocked the wind out of this particular narrative. It is also the case that the money printing by the Fed has completely outmuscled the ECB (and everyone else). The Fed has been particularly aggressive buying inflation-linked bonds (TIPS) and now owns around 20% of the outstanding issue. Buying TIPS forces real rates lower and could be argued to create the ‘appearance’ of inflation, especially as Treasury bond issuance is ramping up. This may or may not be real inflation, but in terms of inflation break-evens at least, it certainly creates the appearance of being so.
  • The other element aside from monetary policy is fiscal. In Washington, negotiations continue over a new stimulus bill. Nancy Pelosi’s Democrats are $2.2tn offered, Trump’s White House appears to be $1.8tn bid (they briefly went no bid on 6th October and the market tanked), but McConnell’s Republicans in the Senate appear unwilling to pass any stimulus at present having miraculously found a heretofore well-disguised sense of budgetary responsibility just as it looks like a Biden presidential victory is now nailed-on. Not to worry, because the market is looking beyond the next few months to a potential Democrat three-and-oh sweep of the White House and both houses of Congress meaning a pant-splitting stimulus in Q1 2021, all financed by a Fed who has made a number of hints about yield curve controls and whose head honcho Jay Powell is daily urging Congress to spend more as fiscal policy now has to do the heavy lifting.
  • In Europe, the much-vaunted European recovery bill is on the rocks. Aside from the ‘frugal four’ of Holland and chums wanting spending controls for potential back-sliders like Italy, Germany is increasingly concerned about anti-democratic trends in Eastern Europe and while it is willing to up the stimulus budget itself, it is only willing to do so on the basis that there are rule-of-law clauses in the arrangement to act as a lever against non-compliance (“Germany tables EU budget offer to break impasse with parliament”, Financial Times, 07/10/2020). Needless to say, Poland and Hungary are outraged. It is still unclear if the bill can be passed in its current form in the various European national parliaments. This is before one even questions whether the recovery bill is enough, especially given the dismal performance of economies such as Spain where the tourist season has been a wash-out and the economy now appears to be in real trouble. The market is clearly doing the math on the battle of the US fiscal eagle vs the European push-me-pull-me bailout donkey. The problem for the Eurozone is that the euro is appreciating (up over 10% vs USD from the March lows, graph below), and this is deflationary. The ECB knows this and is bleating about it on an almost daily basis. This is the deflationary trap that necessitates the currency war. The ECB is angling to do more quantitative easing, the Bundesbank is opposed. Plus ça change.

Source: Bloomberg as at 12 October 2020.

  • It is not just the case that the US can pull out of deflation on its own, the problem in currency terms is that it does better on a relative basis, hence a currency war. Currency appreciation is deflationary, so it’s an ‘I win you lose’ equation. The Fed is not only able to print more, but, because of political constraints, the ECB can always only print less. If the votes go right, the US can mount a fiscal stimulus of war-time proportions to reflate its economy and help Main street in a way which has been sadly absent for decades. America’s depression experience means it fears deflation more than anything, and thus through friend-of-my-enemy logic, the Fed is willing to tolerate higher inflation than would be normal. Inflation is not the answer, nor is it ‘a good thing’ but it’s better than deflation and that is enough for now (until inflation becomes a problem that is…). This stands in contrast to Europe where hyperinflations are the bogey man for Germany, the Eurozone’s engine, and thus fiscal stimulus is always likely to be a punch which has been slightly pulled, at least so long as Germany has a say.
  • What of the other major currencies? One feels for Bank of Japan governor Haruhiko Kuroda, waiting for inflation all these years like a latter-day Miss Havisham in Dicken’s Great Expectations waiting for her groom to turn up decades after the wedding date. They continue to print, they continue to have the largest central bank balance sheet, they are even starting work on a digital currency (as is everyone else by the way – a tool for the helicopter money-drops of the future) but to no real avail. Japanese CPI inflation in August was still 0.2% YoY (the target is 2% and has been for decades).
  • The Chinese central bank, PBOC, has not gone on a printing binge and has not cut rates in the way the Fed has. PBOC is constrained by the yuan peg to the dollar. Bank lending has rocketed, as has forbearance on bad debt, and this creates an internal problem for China which may eventually spill over into the FX markets in the form of a devaluation. For now, China’s uneven recovery is light on domestic demand (Golden Week spending was down around 30% on 2019 for example) and heavy on exports, pushing up China’s current account surplus and causing the yuan to appreciate against the dollar. This also exports Chinese deflation around the world as can be seen from the negative trends in Chinese purchasing price index data (Chinese August PPI -2.0% vs -1.9% estimate and -2.4% prior).
  • This is clearly deflationary, and PBOC has just started to take action, reducing the FX reserve requirements for the banking sector to zero from 20% (‘China’s central bank to cut FX risk reserve ratio to zero’, Reuters, 10/10/2020). At the time of writing on the first day after the announcement, the offshore yuan is down nearly 1% against the dollar. This is how it starts. As countries act unilaterally to escape the clutches of debt-deflation, the market should expect to see more and more efforts by governments and central banks to weaken their currencies for relative advantage. It may be covert, it may be disguised or described differently, but ultimately it is a race to the bottom, and inflation is the prize.

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