In depth analysis of the post QE world.
Since the election of Donald Trump, politics has become the key driver of the world financial markets, replacing G7 central banks which had been the main driver since 2008. The turbulence of the recent weeks brought in in the investing world by trade and tech wars is a reminder of the importance of politics.
The central banks maintain their importance and the paradigm "bad news is good news" is valid more than ever. Almost any bad news from the real economy, like an unexpected slowdown, is interpreted as an opportunity for the central banks for cutting rates and therefore promoting a new rally. Central banks are expected to have the magic wand for procrastinating the current cycle indefinitely. It is now common jargon mentioning the FED "put" as the expectation of the FED acting at the minimal sign of market unease.
It is thought necessary to distinguish the present positioning of the FED vs the central banks of the rest of the world. The FED today has more strings to its bow as it both raised interest rates and reduced the balance sheet substantially. The ECB did not go through the same path. The BOE is stuck between a rock and a hard place with Brexit.
On the US specifically, the increase in interest rates is bound to harm consumption in an economy like the American one where income is distributed so unevenly.
The American real economy was already slowing down, notwithstanding trade and tec wars because of the effects of the rate increases. We can assume that the tightening cycle has come to an end. The most aggressive forecast (DB) point to three rate cuts in the next 12 months.
We are not implying a recession for the US at this point, but as the slowdown does not discount the US-China trade war, this increase the recession risks. This is why, if Donald Trump makes a U-turn on China as he did with Mexico on June 7, macro investors could start betting again on a delay of the rate cuts.
What is of main concern to us is the cooling of the labour market in the US. All metrics show a slowing down. Additionally the number of adult Americans not in the workforce has peaked to 96.2 mn!
Inflation expectations have an impact on FED decisions. Recent downturn movement of the expected inflation will open the door to all kind of discussion within the FED, including new and alternative monetary policies. This creates a unique opportunity for investing in gold. Gold seems to have finished the bear period.
The intervention of the FED could focus on the curve as the BOJ did in Japan. This would result in targeting specific durations, i.e. the 10yr, giving even more support to the thesis that the yield of the Treasury could converge to zero in the long term.
As for the US yield curve, its inversion does not necessarily imply a recession, but it has preceded a recession by 18/24 months most of the times.
USD denominated corporate debt.
The actual elephant in the room few dares to talk of is the gigantic proportion of the sum of the US non-financial corporate debt (10tn, up from 6tn in 2008) + all EM USD denominated non-financial corporate debt (3.7tn, up 1.5tn from 2008. BIS data).
The critical issue is what happens to the dollar, and consequently to the USD corporate debt, if all of the above actions on the yield curve are put in place. It's difficult to predict the future level as many forces pull in opposite directions, but USD volatility is likely to increase. While an expectation of rate cut would imply a dollar weakening, this hasn't happened. The actual risk is that if the American economy slows down more than currently anticipated (see nowcast chart), the result will be a dollar rally driven by risk-off and deleveraging. Credit spreads surge stressing the corp debt in USD, especially in the EMs. Short term, this is not our central scenario, but we know that "debt is not a problem until it suddenly is, for everybody". Such an adverse outcome would imply some QE from the FED, which is gold bullish.
This downside scenario is bullish for gold also in light of the impossibility of G7's central banks to normalise monetary policies. From a political standpoint, this will renew the focus on radical fiscal and monetary alternatives such as the so-called "modern monetary theory". MMT is the result of the blurring of the distinction between monetary policy and fiscal policy, which was the central characteristic of quantitative easing (and the separation of political power from that of the central bank).
The condition of the Chinese economy has a more direct and short term impact globally. Nominal GDP growth slowed two percentage points to 7.8% YoY, and the real one is running at 26 year low. Investments in productive assets diminished too.
We should not be surprised if markets remain very sensitive to the evolution of these data, most notably given the dragging on of the trade and tech controversy. Tech war looks more worrisome as, in practice, trade wars impact a minimal part of China and world GDP. The tech sector in China employs more than 100mn people, and the Chinese government is susceptible to employment issues.
The Chinese economy might be slowing down, but it's far from collapsing. It is worth remembering that the trigger for last year slowdown had been the squeeze on shadow banking. The action has probably peaked out, and the rise in corporate bond issuance in renminbi supports this thesis. The banking system is following Beijing's directive of an increase of 30% lending to SMI. This is, compared to LEH crisis era, a mild stimulus. Beijing is avoiding using mega-stimulus for obvious reasons. The more the new on trade and tech wars come out, the more the CB will be obliged to lose the strings of the purse.
The swing factor risks is the Chinese residential property that so far, data show, have held up well.
Even in this case, the price of the new residential property is a function of the involvement of the government (development of new towns). By contrast, in the main cities, demand is steady.
Another consequence of the shadow banking squeeze is the consolidation of the development sector.
At this point it might look stretched going back to politics but, we think it is worth mentioning the controversy for the extradition bill in Hong Kong. The concern here is that should the confrontation escalate, and the mood becomes more confrontational and violent, the property market could be struck (-57% in 1997 when the HK dollar came under attack due to the uncertainties around the separation of HK as a British colony). The lesson to be learned in this case is that it has always made sense to invest in such panics in HK.
We can summarise in that politics have taken the investment scene over. Central banks, especially the FED, are expected to intervene in favour of the markets and procrastinate the economic cycle indefinitely. This is all new and can have unexpected results. The winner in this scenario are gold and high quality bonds. USD denominated corporate debt could become under stress one day and the chinese economy is holding well. The dollar trend is difficult to call but volatility is expected to raise). Factor to watch are the tech war more than the trade war (for the impact that could have on chinese unemployment). The US economy is slowing down independently from politics as the sugar high of the tax cut is coming to an end and the labour market is showing signs of cooling.
In case on panic in the east, the HK residential property has proved to reborn from his ashes more than once.
We are pleased every time you contact us requesting more information on what we briefly outline in our letter to the investors.
Simplify Partners Management Team