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FactSet StreetAccount Summary – US Weekly Recap: Dow (5.82%), S&P (5.77%), Nasdaq (6.78%), Russell 2000 (4.61%)
A Fine Fed Mess Are financial assets falling to match the slowing real economy?
(…) One lesson here is that the Fed’s great monetary experiment since the recession ended in 2009 looks increasingly like a failure. Recall the Fed’s theory that quantitative easing (bond buying) and near-zero interest rates would lift financial assets, which in turn would lift the real economy.
But while stocks have soared, as have speculative assets like junk bonds and commercial real estate, the real economy hasn’t. This remains the worst economic recovery by far since World War II, and we’ll be watching to see if financial assets now fall to match the slow real economy.
Nearby we reprint our table comparing GDP growth projections by the Fed’s governors and regional bank presidents to the actual results. Every year without fail they have predicted faster growth that never materializes. Fed policy was also supposed to raise inflation to its target of 2% a year, but it has failed even that test. (…)
The same monetary lesson applies to the rest of the world. Bond buying and near-zero rates spread around the globe in imitation of the Fed’s post-crisis policy, but the global economy also hasn’t responded with faster growth. The European Central Bank’s bond buying may have prevented a recession but European growth is still anemic.
Meanwhile, the emerging-market economies that benefited from capital inflows during the height of QE are now seeing those flows and economic growth recede. China is trying to clean up its stimulus excesses without going into recession.
The question for the Fed now is whether it has missed its opportunity to get off the zero bound. The economy survived, and even accelerated, as the Fed tapered its bond purchases two years ago. At any time in the last two years the Fed could also have comfortably begun to raise rates while the economy was strong enough to adjust. But it always lacked the nerve.
The monetary doves will say thank heaven the Fed didn’t move given the slowing economy, but if it had moved earlier it would now be better positioned to weather whatever economic storm is ahead. An earlier return to monetary normalcy would have reduced the Fed’s outsized role in allocating capital, while reducing the risk of financial instability by letting asset prices adjust more gradually. Growth would likely have been faster.
Instead the Fed now finds itself caught between a slowing global economy and its promise to begin normalizing rates this year. The chattering financial classes are once again shouting at the Fed to stand pat, and more than one Fed president has joined that chorus. One result has been to increase economic uncertainty and market volatility.
It all adds up to one fine mess of the Fed’s own making. Our own view is that this is what comes of relying on monetary policy as the only policy engine for economic growth. At the very least it’s time for the Fed to examine why its policies have failed to deliver the buoyant economic results it promised.
George Magnus: The Chinese model is nearing its end
(…) Rebooting the authority and primacy of the Communist party, the pursuit of often contentious reforms, financial liberalisation and rebalancing the economy while trying to sustain an unrealistic rate of growth are complex and mutually incompatible goals. (…)
To address these serious problems, President Xi Jinping has turned the clock back. He has accumulated more power than any leader since Mao and consistently emphasised the Leninist need for “party purity” to avoid the fate of the Soviet Communist party. Among his first policies was an extralegal anti-corruption campaign that continues to this day. He has usurped the authority of government institutions by establishing party bodies, known as “small leading groups”, that are more numerous than ministries and hold sway over the most important functions of the state.
(…) Yet while some reforms have made progress, many important ones affecting the role of the state in the economy and the introduction of market mechanisms have suffered from dilution and the opposition of vested interests. The clampdown on civil society, media, legal and non-governmental institutions has not helped. A strong central authority, perversely, has stifled important reforms, removed authority and accountability from those institutions responsible for carrying them out and produced conflicted decision-making.
(…) Caught between its roles as cheerleader and regulator, the government has shown a lack of trust in the very market forces it sought to introduce.
This month’s mini-devaluation of the renminbi was explained officially as an incremental change to China’s financial liberalisation, designed to help the currency’s admission later this year to the International Monetary Funds’s accounting unit, the Special Drawing Right. Yet the action was communicated poorly at best. Again, the authorities have been conflicted, torn between a strong renminbi policy to help rebalance the economy, and a softer one to respond to weakening growth. Economic statistics this summer, especially for exports, manufacturing and investment, were disappointing, underscoring that weaker performance for the past four years has become impervious to stimulus measures, which this year already add up to more than 1 per cent of gross domestic product.
A central part of the challenge for China will be its ability to manage employment, a more politically sensitive indicator than GDP. The official unemployment rate, supposedly about 4 per cent over many years, is fiction. Current developments in investment and labour-intensive construction, the low registration for unemployment benefits among those without urban registration status, the weakness of the benefit system and the difficulties of finding suitable work for 7m graduates a year are among many reasons to believe that the jobless rate may not only be higher than the 6.3 per cent estimated by the International Labour Organisation but rising.
China’s economic transition was always going to be difficult, but developments this year suggest that things are not going according to plan. The centralisation of power is proving to be a double-edged sword for reform, the anti-corruption campaign is choking off initiative and growth and the economy cannot be kept on an unrealistic expansionary path by unending stimulus.
The time for accepting a permanently lower growth rate is drawing closer. It will test the legitimacy and reform appetite of China’s leaders in ways that will determine the country’s prospects for years to come.
Michael Schuman: No need to idolise China’s accident-prone technocrats
There is a widespread perception that the Chinese technocrat is some sort of superior being who can tackle policy conundrums that would make mere mortals rush for their Prozac. Such officials are more efficient and capable, we are told, than the mediocrities mismanaging the west.
China’s leaders “may have a more realistic and constructive assessment of the macroeconomic policy challenge than their counterparts in the more advanced economies”, Stephen Roach, the respected Yale economist, wrote in April. Donald Trump, the Republican presidential frontrunner, was even crisper in his judgment: “Their leaders are much smarter than our leaders.”
But the average Chinese leader is just as adept at screwing up his economy as anyone else, perhaps more so. When executives and economists wake up to this reality, the fallout could be severe.
The fatal flaw of the Chinese policymaker is the primacy put on political imperative over economic reason. Legitimacy and public support for the often brutal Communist party regime are linked intimately with its ability to deliver rapid growth, good jobs and rising incomes. As long as the economy is proceeding as the party wishes, it turns a blind eye to potential dangers, only to be laid low by them later.
Take Beijing’s often-praised reaction to the 2008 financial crisis. By flooding the country with cash and credit, China pushed growth over 9 per cent through a historic recession. Only afterwards did China’s policymakers realise the potential catastrophe they had spawned. Debt exploded to 248 per cent of gross domestic product in 2014, nearly double the level of 2008, according to IHS Global Insight, a consultancy. Unsold apartments and useless factories stacked up across the land.
The same pattern took shape during the recent boom and bust on Chinese stock markets. The authorities encouraged Chinese to invest in stocks, and did not seem too bothered as share prices soared to bubble-levels, fuelled by an alarming build-up of margin lending. When shares tumbled beginning in June, the government scrambled to contain a self-inflicted crisis as inexperienced, debt-laden local investors vented their anger at state regulators.
The response — also politically motivated — was misguided. The government’s heavy-handed tactics to hold up the stock market — ploughing in cash, hunting for scapegoats, suspending trading for many companies — have tied the Communist party’s credibility to the Shanghai Composite index. Efforts to tackle the other problems it created — debt, excess capacity — are in their infancy. Optimists contend that Beijing has a long-term plan to fix the economy, approved at a 2013 party plenum, and short-term policy gyrations are to be expected. The past three decades of hyper-charged growth speak for themselves. But generating economic progress was easier when China was tossing its 1.3bn poor people into the global economy, unleashing productivity. With that low-hanging fruit picked, the choices between political and economic imperatives become more difficult, and the costs of getting things wrong higher.
It is worth recalling that in the 1970s and 1980s, when Japan was the rising Asian economic power, US experts characterised the Tokyo bureaucrat as a superman. Now Japan’s change-resistant bureaucracy is seen as one of the economy’s biggest problems.
If Beijing’s policymakers endure a similar reversal, that could be critical for China’s future. So far, global business has taken on faith that China’s leadership will steer the economy in the right direction. A loss of that confidence could convince investors and executives to spend their money elsewhere, further complicating the reform process, and perhaps even shake the Communists’ support among the Chinese people. The higher the pedestal, the harder the fall.
Perhaps we should also reserve our judgment on Fed leaders as well…
Evergren Gavekal’s Worth Wray: (my emphasis)
(…) Make no mistake, China has just changed the game in a thousand ways that are not entirely straightforward. While a 3% devaluation in the USD/CNY exchange rate is not the kind of global deflationary shock that some people are saying, the un-anchoring of expectations and the possibility of further depreciation in the coming months sets a series of events in motion that dramatically raises the odds of a global deflationary bust in the not-so-distant future.
I won’t bore you with all the details, but—even if China is simply moving toward RMB internationalization—I can think of a dozen ways the uncertainty surrounding PBoC’s latest move can destabilize global markets. Even if we were to assume that China can afford to allow capital to flow freely into and out of its debt-burdened economy without inducing a crisis (a big assumption in my opinion), the mere act of a dragon flapping its wings and preparing to fly will have unintended and unanticipated consequences. These include, but are not limited to, accelerating the unwind of fragile emerging market carry trades and raising the odds of global competitive devaluation.
Keep this in mind: In a world where everything is connected, where every major economy has a debt problem, where money has flooded the world for seven years, and where volatility remains low even in the face of collapsing commodity markets, the Federal Reserve is tightening at a time the rest of the world has been easing. And in the event that its first rate hike in nearly a decade sends the US dollar higher, Beijing will have the plausible deniability it needs—if it so chooses—to let the USD/CNY exchange rate drop like a stone. (…)
No one should think they can precisely time the market’s twists and turns—especially a market long distorted by unprecedented quantitative easing—but there comes a time when enough is enough. It’s not worth reaching for more upside when risks are so skewed to the downside. In fact, the greatest opportunities for wealth-creation at the end of a bubbly market cycle lie in reducing equities in favor of a more defensive portfolio posture that earns less in the short term and higher cash reserves that earn nothing for the time being.
Yes, I said wealth creation, not just wealth preservation. The opportunities are enormous, just not where most investors are looking at the moment. Paradoxically, the asset that earns you nothing over time can deliver the highest returns in a panic. Cash is an option that can be traded for any asset at any time, so its value is inversely related with asset prices. That is to say, cash becomes undervalued when markets are overvalued and overvalued when markets are undervalued.
The added deflationary pressure from a CNY shock could turn an already dangerous event for fragile emerging markets into an outright catastrophe for the entire global system—and create one whale of a buying opportunity for investors who still have money to work in that environment.
Louis Gave: A Solvency Crisis Or A Liquidity Crisis?
(…) All of which brings us to the most important question confronting investors today: is Asia facing a liquidity squeeze, or a genuine solvency crisis? This “solvency versus liquidity crisis” distinction matters because it takes years of heavy lifting from policymakers, belt-tightening from consumers, and downward asset price adjustments for investors, to get out of a solvency crisis.
In contrast, liquidity crises are usually short, but painful affairs in which those with the courage to redeploy capital during the crisis are handsomely, and fairly rapidly rewarded (usually after a few months of acute discomfort). As a result, the answer to the question “is Asia facing a liquidity crisis or a solvency crisis?” could well determine the performance of portfolios for the coming year and beyond.
If Asia, like the commodity producers, is in a solvency crisis, it is hard to imagine that the developed markets’ defense perimeter (described in The Four Horsemen Of The Apocalypse and composed mostly of what we have come to call “Knowledge Leaders”) will remain immune. In this scenario, the only thing to own would be long-dated G-7 government bonds. If on the other hand, as we have repeatedly argued, Asia is facing a liquidity squeeze as panicked investors redeem funds (note that a number of our usual indicators of a liquidity crisis, such as the growth in central bank reserves, have been negative all year), then the snap-back in Asian
equities could prove violent and the overall impact on developed markets will remain minimal (see chart below).
Needless to say, the answer to this “Asian solvency crisis or liquidity crisis?” question will be determined by China. Our view is still that over the coming weeks and months, China will continue to inject liquidity into its banks (thereby allowing them to make outsized profits on disjointed domestic bond markets), maintain the basic stability of the renminbi, and that it (along with the rest of the region) will register a dramatic improvement in its current account balance. Hopefully, decent banking sector profitability and positive trade balances will prove enough to convince the markets that Asia can service its debts, and that the region is not enduring a solvency crisis.
Michael Pettis: Do markets determine the value of the RMB?
Long, typical Michael Pettis piece worth reading.
The RMB almost certainly would decline in value today without PBoC intervention, but this does not indicate at all that the RMB is overvalued. In fact the best argument is that the market is driven largely by technical, and that if we try to extract information from fundamental markets, we almost certainly would arrive at a very different conclusion. The RMB, it turns out, remains undervalued, although I suspect not by very much.