Entering the Next Stage of a Race to the Bottom

August 6, 2019

 

Macquarie Research just came out with an excellent report and outlook on the next 12 to 18 months, clearly demonstrating that we are sailing into the danger zone. And yet, complacency is still very high, while volatility is low.

 

 

 

 

Key points from the report:

 

  • The next 12-18 months should see the end of the monetary ‘Deus ex Machina’.

  • It will be replaced by neo-Keynesian policies. In the meantime, confusion reigns.

  • ‘Beggar thy neighbour’ will dominate ST - value struggles through transition.

 

Real 10Y Bond Yields - ~US$17 trillion of Gov & Corp bonds now have negative yields

Source: Bloomberg, Macquarie Research, July 2019

 

Sailing into maelstrom of ‘beggar thy neighbour’ strategies…

 

The challenge facing investors over the next 12 months is to finally accept that modern highly financialized and asset-based world can no longer tolerate volatilities, price discoveries or even positive interest rates. The ‘time value of money’ as the core of finance theory no longer exists. As leverage rises, the credit intensity (or how many units of GDP can be generated from a unit of debt) declines. This requires an ever higher stimulation of debt. Hence, interest rates must continue to fall, eventually turning negative everywhere. The ‘Japanification’ of the world is no longer a theoretical exercise, it is the reality, and as long as monetary levers are used to provide ‘inoculation shots’, it is bound to get worse.

 

This has serious consequences. First, destruction of the cost of money not only interferes with credit cycles but also keeps ‘zombies’ alive, preventing clearances while accelerating tech disintermediation. Second, it encourages speculation and discourages productive investment. Third, it spurs a race to the bottom with ‘beggar thy neighbour’ strategies, as nations compete to maximize returns from an ever declining utility of debt. Fourth, as long as monetary policies dominate, inequalities will continue widening. Eventually, most societies will simply blow-up.

 

Hence, we maintain that 2020-21 will be the last gasp of purely monetary levers, with a growing switch towards different policies, focused on neo-Keynesian and MMT ideas of the state’s responsibility to drive economic and social outcomes. The new world will be more insular and locally-driven. However, we do not believe that this change will be a once-off policy switch, but rather a multi-year process that will eventually lead to an environment closer to 1950s-60s than 1990s.

 

In the meantime, the next stage in this transition, will be a greater acceptance of ‘beggar thy neighbour’ strategies (trade/currency wars). While led by the US, these are likely to be popular in most countries. Fed will fight to maintain its independence but to no avail. As political pressures rise, whether it is Fed, ECB, BoJ or BoE, there will be a growing incentive to compromise. A slippery slope, shredding CBs independence one cut at a time on a winding road towards a likely merger of fiscal and monetary policies. China will be carefully watching this evolving saga, trying to avoid adding fuel to the fire. But at the end of the day, it will be forced into the maelstrom, trying to limit damage inflicted on its economy.

 

…before policy settings are changed and greater reflation ushered

 

It seems that governments are embracing currencies and trade to offset the impact of low rates. While we can’t all export our way to growth and devaluations are unproductive, it has never prevented anyone from trying. These uncertainties and the desire to maintain stability are likely to delay the onset of much stronger liquidity and reflationary supports, until economies deteriorate further. Today’s macro signals are too shallow for asset prices, but are not yet sufficiently poor to prompt a more robust support. The good news - maelstrom will ultimately lead to different policies and a far more aggressive reflation. It is just a question of when. Eventually value will be rerated and enjoy a multi-year rebound.

 

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