Markets are Underestimating “Brexit” Risk

June 9th, 2016


  • The June 23 referendum in which British voters will decide the country’s fate in the European Union (EU) has potential to unsettle markets if the vote is to leave.
  • The British Treasury contends such an outcome could catapult the U.K. economy into recession, and the Bank of England has warned about the consequences for sterling and financial markets. Proponents who favor leaving counter these are scare tactics. They claim Britain will benefit from diminished regulatory burdens imposed by the EU.
  • Financial markets are pricing in the likelihood that Britain will stay, but polls are very close and worries about terrorism and immigration could result in an upset. If so, sterling and U.K. markets are likely to sell off.
  • The spillover to the rest of Europe is harder to assess. Because sterling is not part of the eurozone, some observers do not foresee Greek-style contagion.  However, the British economy is much more important, with close trading ties to Europe and London’s role as a financial center. Should Britain opt to leave, moreover, the inevitable question becomes “Who is next?”

Background on the EU Referendum: Why Now?

Since Britain’s entry into the EU at the beginning of 1973, the UK’s stance has been lukewarm on the part of most supporters and more passionate by those who are opposed. Two years after Britain’s entry the Labor Government held a referendum in which voters opted to stay by an overwhelming margin amid worries that Britain’s economy was flagging and it would become increasingly isolated.  Over time, however, this support waned, and during Margaret Thatcher’s tenure as PM in the 1980s, she affirmed another vote should be taken when “the time was ripe.”  It never materialized, however, and her successor, John Major, sought to strengthen ties with Europe by having sterling included in the euro. However, this effort was undermined in 1992 by a speculative attack on sterling, which forced it out of the Exchange Rate Mechanism. Thereafter, the British Government opted to keep sterling out of the euro. Read the rest of this entry »

Origins of China’s Miracle and Relevance Today

May 12th, 2016


  • For those who believe individuals can shape history, Ezra Vogel’s award winning book on Deng Xiaoping offers a fascinating perspective of how he transformed China’s backward, socialist economy into a modern-day global power.[1] Among Deng’s greatest attributes were his pragmatism and openness to ideas, including allowing market forces to dictate resource allocation and applying lessons gleaned from the experiences of more advanced economies.
  • Deng’s approach combined strategic planning by the central government with decentralized decision making at the regional and local levels. He believed in experimenting with various reforms and assessing their success rather than undertaking “shock therapy.” He also understood human nature and the way that people respond to economic incentives.
  • While Deng had to tread carefully to ensure the reforms would not be rejected, Vogel notes he also benefitted from a functioning national party and unified government under Mao. Throughout his life Deng remained loyal to the Party and Mao’s leadership, but he rejected many of Mao’s economic doctrines.
  • By comparison, China’s current leaders are more doctrinaire and wary of foreign investment and ideas. Meanwhile western governments are responding to populist pressures by becoming more nationalistic, and political leaders in the United States are less committed to free trade. If these tensions persist, they could lead to disputes with China that would unsettle world markets at some point.

Deng’s Role in China’s Transformation

When I discovered economics in the 1960s, I wanted to understand what made some countries successful while others lagged. The Soviet Union attracted considerable attention then, as some observers believed its command economy might overtake the United States’.  I was also intrigued by the writings of Oskar Lange and Abba Lerner, who demonstrated how a socialist economy could use market forces to allocate resources while the state retained ownership of the means of production.[2] They referred to their approach as “market socialism.”  The Soviet Union, however, did not pursue this approach, and its command economy faltered in the 1970s and 1980s, the victim of widespread inefficiencies and poor resource allocation. Read the rest of this entry »

The Fed and The Markets: Who’s Calling the Shots?

April 21st, 2016


  • One of the oldest adages on Wall Street is “Don’t Fight the Fed,” which proved to be sound advice following the 2008 financial crisis when the Fed pursued unorthodox policies to bolster the economy and financial system.
  • Since the 2013 “taper tantrum,” however, the Fed has struggled to raise interest rates, as it has encountered market resistance at times. Recently Chair Janet Yellen has acknowledged the Fed will proceed cautiously amid risks to the global economy. While she noted that market participants understand the FOMC’s data-dependent approach, officials are reluctant to acknowledge the timing of Fed rate hikes is also market dependent.
  • Amid this, investors should look past Fed rhetoric and ask a basic question: Which interest rate forecast is more likely to be correct – the Fed’s or the bond markets? My view is rates are likely to settle somewhere between the two views over the next few years.

Background: Challenges for the Fed in Normalizing Interest Rates

One of the main lessons I’ve learned over my career is that it is wise to heed the Wall Street dictum about not fighting the Fed.  This was particularly important during and after the 2008 financial crisis, when Ben Bernanke pursued unorthodox policies such as quantitative easing (QE) to bolster the economy and financial system. Read the rest of this entry »

Market Reboot

April 13th, 2016


  • Returns for U.S. financial assets were little changed in the first quarter, but there was a large gulf between the first half, when risk assets plummeted, and the second, when they recouped their losses. The reversal mainly reflected diminished worries about the U.S. and global economy and a firming in oil prices.
  • The outlook for the U.S. economy continues to be mixed: Overall, we continue to expect a 2% trend-like growth this year. The Federal Reserve has signaled it will proceed cautiously in tightening policy in the wake of developments abroad.
  • In this context, we favor credit over equities, on grounds that credit spreads adequately compensate investors for risk of increased defaults. While we view the stock market’s valuation is fair, modest revenue growth, narrowing profit margins, and lower quality of earnings are concerns, as is the ongoing narrowing in the breadth of market advances.
  • The main risks to the outlook continue to be adverse developments abroad. Worries about China have diminished recently, but Brazil and several other emerging economies are struggling. Within Europe, the focus will be the June 23 referendum on whether the U.K. should stay within the European Union (EU).

A Topsy-Turvy Beginning

For investors who like thrills, the first quarter did not disappoint, as U.S. and global markets went on a roller-coaster ride. The stock market and other risk assets experienced one of the worst starts to a year in memory, as investors fretted about weakness in China, plunging energy and commodity prices, the possibility of Fed tightening, and the potential spill-over to the U.S. economy. At the low point in mid-February, the major U.S. stock indexes were down more than 10% for the year, and many observers believed a bear market decline of 20% or more was in the offing, while the high yield bond market was pricing in a significant risk of recession. Read the rest of this entry »

Coping with Illiquid Markets and Crowded Trades

March 30th, 2016


  • What factors account for large gyrations in currencies, oil prices and credit markets over the past one-two years? This topic was discussed both at an American Council of Life Insurers (ACLI) conference and an event sponsored by the Richard A. Mayo Center for Asset Management.
  • One of the key takeaways is that market moves have been exaggerated by diminished market liquidity since the 2008 financial crisis owing to increased regulation of financial institutions. This is especially evident in fixed income.
  • With central banks encouraging investors to shift into riskier assets, market moves are also amplified when there are “crowded trades” and events alter investors’ expectations. One example is the 70% decline in oil prices when excess supply in the market is at most 2% of total production. Another is the ripple effect that a 2% devaluation of China’s currency had on financial markets.
  • What can investors do to protect themselves? There are no easy answers as long as central banks pursue policies that distort capital market pricing. Consequently, investors need to be more cognizant of illiquid markets and crowded trades.

The New Reality: Markets are Less Liquid

Throughout the post-war era U.S. financial markets were the deepest and most liquid in the world, which gave investors the ability to enter and exit positions at low cost.  However, in the run-up to the 2008 financial crisis transactions costs increased in fixed income markets.  This development was first evident in trading of non-agency mortgage-backed securities and structured products, where the process of price discovery broke down.  Illiquidity then spread to the corporate bond market, first to high yield bonds and eventually to investment grade bonds.  It became extreme during the crisis period when attempts to sell bonds resulted in steep price declines.  Read the rest of this entry »

Is Globalization the Enemy? Free Trade and the U.S. Election

March 16th, 2016


  • Among the key issues to be decided in the U.S. presidential election is the future of U.S. trade policy. Free trade has been the guiding principle of both Republican and Democratic administrations throughout the post W.W.II era, but none of the contenders today has campaigned in support of it.
  • What’s at stake is much more than the fate of the Trans-Pacific Partnership (TPP). More worrisome is whether the U.S. will threaten trade sanctions against China, a stance favored by Donald Trump, who has asserted China is a currency manipulator.
  • Even if the threat of a U.S.-China trade war is mere rhetoric, it risks unsettling global markets when the global economy is fragile. Politicians instead should be focusing on policies to ensure our workers have the requisite skills to compete in a world where technological advances will render existing techniques obsolete.

The Post-War Order and Free Trade

Throughout the post-World War II era, a guiding principle of the U.S. Government under both Democratic and Republican Administrations has been support for free trade and international capital flows. This commitment is a legacy from the Great Depression, when countries turned inward and pursued “beggar my neighbor policies” that included passage of high tariff barriers, imposition of capital controls and widespread currency devaluations. Read the rest of this entry »

The Uncertain World of Negative Interest Rates

February 25th, 2016


  • An important factor weighing on investors today is concern that central banks have limited policy options to counter recessionary forces when short-term interest rates in many countries already are near zero or negative.
  • A study by J.P. Morgan’s economists concludes that central banks could drive interest rates on bank reserves deeper into negative territory than many people believe is tenable. However, the report also questions the effectiveness of negative interest rate policies (NIRP), considering the challenges in driving household deposit rates below zero.
  • My own take is that policy makers need to tread carefully, as there may be unintended consequences from pursuing such policies. Recent examples are the Japanese yen’s unexpected appreciation following the Bank of Japan’s (BOJ) decision to adopt NIRP, and the steep sell-off in European bank shares earlier this month that reflected worries about bank profitability in such an environment.
  • Finally, there is no reason for the Fed to adopt NIRP, especially with the economy performing satisfactorily and deflation not a meaningful threat.

Increased Central Bank Reliance on NIRP

Over the past two years an increasing number of central banks including those in Sweden, Switzerland, Denmark, the eurozone, and most recently Japan have introduced some form of negative interest rate policy on bank reserves to counter deflationary forces and stimulate economic growth.  Yet, while markets previously applauded unorthodox policies such as quantitative easing that were intended to bolster economic growth via asset price appreciation, there has been less receptivity to the adoption of negative interest rates.  According to the Financial Times, “Some investors and analysts fear the moves are an alarming reflection of dwindling central banking firepower, and that the new weapon could even be dangerous.” (See “Negative Thinking”, February 17, 2016.) Read the rest of this entry »

Currency Wars Revisited

February 9th, 2016

Since mid-2014, when investors began to anticipate eventual Fed tightening, the U.S. dollar has surged against most currencies.  For a while, China was one of the few holdouts that kept its currency tied to a strong dollar.  However, the Chinese authorities wavered last August, when they widened the band for the renminbi (RMB), and allowed it to depreciate by 2% against the dollar.  Reports in the media heralded it as the biggest devaluation of China’s currency in two decades, and pundits claimed that it threatened to lead to an escalation of “currency wars.”

Since then these fears have increased further as the Chinese authorities announced in December they would henceforth peg the RMB to a basket of currencies, and the RMB subsequently weakened against the dollar. This past week, moreover, the Bank of Japan surprised market participants by announcing it would begin imposing a negative 0.1 percent interest rate on any new excess reserves beginning on February 16.  The announcement caused the yen to depreciate against the dollar, and it has raised concerns that other central banks in Asia might be compelled to respond if the yen continued to weaken.

Some observers contend the situation could lead to a series of competitive depreciations such as occurred in the 1930s, when countries abandoned currency links to gold, intervened in foreign exchange markets to drive their currencies lower, and in many instances imposed restrictions on international trade.  However, my contention is the circumstances today are different in one important respect:  Namely, most countries have not been selling their currencies in the foreign exchange markets to weaken them; on the contrary, most have allowed market forces to determine the value of their currencies. Read the rest of this entry »

Is This China’s “Minsky Moment”?

January 29th, 2016


  • Do recent developments herald the bursting of a bubble in China’s economy that will presage a hard landing? While some observers believe the plunge in China’s stock market and in oil prices could signal such an outcome, these developments are not a reliable gauge of what is happening to the economy, where recent data are mixed.
  • The stock market sell-off occurred as a ban on sales of equities by large institutions that was set to expire was subsequently extended, and it is more an indication of loss of confidence in China’s policies. The recent drop in oil prices, moreover, appears to be mainly supply-driven, rather than demand-driven.
  • The risk of a hard landing would arise if property values were to plunge, as real estate is an important source of household wealth and it is also where banks have considerable exposure. However, the latest data does not indicate this sector is about to roll over.
  • Finally, in my view investors should be paying greater attention to Brazil, where the risk of a full-blown crisis continues to rise. 

Background: What’s Behind the Recent Market Upheaval?

For those who like drama, it’s hard to conceive of a more auspicious beginning to a year than a plunge in China’s stock market and pressures on the yuan reverberating around the world, and culminating in oil prices falling below $30 per barrelThe most common interpretation is these developments could indicate a significant slowing in China’s economy.  However, my own interpretation is that the market pressures are indicative of an ongoing loss of confidence in policymakers, which is evident from the sizable net capital outflows over the past year, which are estimated to have been in the vicinity of $1 trillion. Read the rest of this entry »

2016 Outlook: Growth Divergence to Continue

January 25th, 2016


  • The U.S. economy overcame a slowdown abroad and a strong dollar last year, while the unemployment rate dropped to 5.0%, which enabled the Federal Reserve to begin tightening monetary policy while Europe, Japan and China eased policies. This pattern will likely continue into 2016: The U.S. appears poised to grow above the 2.2% trend since mid-2009, while only modest improvement is expected for Europe and Japan, and China’s economy appears considerably weaker than the official growth target of 6.5%.
  • Financial conditions tightened somewhat in the past year, but they remain supportive of overall growth, and corporate credit spreads could narrow if default risks priced into markets prove excessive. U.S. equity market returns could stay subpar for a second consecutive year, however, as profit growth appears sluggish.  Following two years of strong appreciation, the U.S. dollar’s rise in 2016 is likely to be more muted, with the focus shifting to pressures on China’s currency.
  • One risk to the forecast is the possibility that problems in energy/mining could intensify and result in more widespread defaults if oil prices fall further. In the emerging markets, the key issues are whether China’s slowdown will remain gradual or intensify, and whether Brazil can avert a full-blown crisis. One of the main uncertainties in Europe is how it will cope with the influx of refugees from the Middle East.

The U.S. Economy’s Underlying Resilience

With the U.S. economic expansion now six and one half years old, a natural question is how much further it has to go, especially considering that the Fed has begun to tighten monetary policy when growth in other parts of the world is either sluggish (Europe and Japan) or slowing (China and other emerging economies).  While some observers are fearful that Fed tightening is a mistake and will ultimately be reversed, our take is that the U.S. economy is on solid footing, and the expansion is likely to continue for several more years. This conclusion reflects three primary considerations: (i) inflation is not an immediate threat that will cause the Fed to tighten policy precipitously; (ii) financial conditions remain generally supportive of the economy; and (iii) the economy is well diversified and not heavily reliant on demand from abroad. Read the rest of this entry »