Financial markets party as global trade wars begin

More people left poverty in the past 70 years than in the whole of history, thanks to the BabyBoomer-led economic SuperCycle.  World Bank and OECD data show that less than 10% of the world’s population now live below the extreme poverty line of $1.90/day, compared to 55% in 1950.

Globalisation has been a key element in enabling this progress, as countries and regions began to trade with each other.  But now global trade is starting to decline, as the chart from the authoritative Dutch World Trade Monitor shows:

  • After a good start to 2018, February saw trade fall 0.7% in February and 1.2% in March
  • The major slowdown was in Asia, particularly China, as its lending began to slow

And then on Friday, President Trump confirmed the opening of his long-planned trade wars:

  • He imposed 25% import tariffs on steel and 10% on aluminium from Canada, Mexico and the European Union
  • Similar tariffs were already in place on imports from China, Russia and other countries
  • America’s longest standing allies have since imposed their own sanctions in retaliation
  • The stage is now set for a developing global trade war as more countries join in

PRESIDENT TRUMP IS IMPLEMENTING THE POLICIES ON WHICH HE WAS ELECTED
None of this should have been a surprise, as it simply follows the agenda that President Trump set out in his Gettysburg speech just before the election.  His policy proposals then, which I featured here in depth in January 2017, were crystal clear about his objectives, as the slide shows:

  • Those policies marked in red are now being introduced
  • Only 2 of them – around China being a currency manipulator, and infrastructure – are still to be delivered
  • Yet companies, commentators and analysts have preferred to ignore the obvious

It was clear then, and is even clearer today, that Trump intends to abandon the policies followed by all post-War Republican and Democratic presidents including Eisenhower, Reagan and Clinton, and summarised in President Kennedy’s 1961 Inauguration Speech:

“To those old allies whose cultural and spiritual origins we share, we pledge the loyalty of faithful friends. United there is little we cannot do in a host of cooperative ventures. Divided there is little we can do–for we dare not meet a powerful challenge at odds and split asunder.”

As I noted after Trump’s own Inauguration Speech in January last year, he broke very explicitly with these policies:

“We assembled here today are issuing a new decree to be heard in every city in every foreign capital and in every hall of power. From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first. Every decision on trade, on taxes, on immigration, on foreign affairs will be made to benefit American workers and American families.”

BAD NEWS HAS ALWAYS LED TO MORE STIMULUS IN THE PAST

Unsurprisingly, financial markets have chosen to ignore this rise in protectionism.  For them, bad news is always good news, as they expect the central banks to provide more stimulus via their money-printing policies.  As the left-hand chart shows of Prof Robert Shiller’s CAPE Index (Cyclically Adjusted Price/Earnings ratio) since 1881:

  • When Trump took office, the ratio was already at 28.5 – above the 1901 and 1966 peaks
  • Since then it has peaked at 33.3, above the 1929 peak
  • Only 2000 was higher at 44, when the end of the SuperCycle coincided with the Fed’s first liquidity programme to prevent any problems with the Y2K issue

The right-hand chart confirms the bubble nature of the rally:

  • It compares S&P 500 developments with the level of margin debt in the New York Stock Exchange
  • Until 1985, the Fed operated on the principle of “taking away the punchbowl as the party gets going
  • Since then, it has increasingly believed, as then Fed Chairman Ben Bernanke said in November 2010

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

As a result, the S&P 500 has risen along with margin debt, which peaked at $659bn in January ($2018).

FINANCIAL MARKETS HAVE AN UNPLEASANT “SURPRISE” AHEAD AS CHINA SLOWS
It is therefore no great surprise that financial markets have continued to ignore developments in the real world.

Yet a decline in world trade, and the rise in protectionism, will inevitably produce Winners and Losers.  This will be quite different from the SuperCycle, when the rise of globalisation created “win-win opportunities” for countries and regions:

  • Essentially the deal was that consumers in richer countries got cheaper, well-made, products
  • People in poorer countries gained paid employment for the first time in history by making these products

History also suggests President Trump will be proved wrong with his March suggestion that:  “Trade wars are good and easy to win”.  Like all wars, they are easy to start and increasingly difficult to end.

So far, financial markets have ignored these uncomfortable facts.  They still believe that any bad news will lead to even more central bank stimulus, and a further rise in margin debt.

But as I noted last week, China – not the Fed – was in fact the major source of stimulus lending.  Now its lending bubble is history, the party in financial markets is inevitably entering its end-game.

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Eurozone joins Japan’s ‘currency war’ versus the US dollar

US$ Index Jan15aThe last 10 days have seen turmoil in major currency markets:

  • The Swiss National Bank gave up trying to devalue versus the euro, and the franc jumped 30% in minutes
  • The European Central Bank (ECB) launched its €1tn Quantitative Easing (QE) programme, causing an immediate 3% fall in the euro’s value versus the dollar

These are major moves by any historical standard, and highlight how earlier ‘currency wars’ have broadened in scale.

Their origin was in 2009, when the US Federal Reserve launched its first QE programme.  One of its key impacts (whether intentional or otherwise) was to devalue the US$ – thereby supporting export growth and the US economy.  By 2011, after the Fed’s QE2 programme, the US$ Index was down 19% as the chart shows.

But then the Bank of Japan launched its own QE programme.  And in October last year, when the US$ Index seemed likely to fall again, it launched its QE2 programme.  Last Thursday, the ECB began its own QE programme, effectively joining the war on Japan’s side.

Japan and Europe have ageing populations and so cannot generate domestic growth.  By weakening the currency, the ECB and Bank of Japan expect to compensate for this by generating growth in export markets.  In turn, however, these competitive devaluations create major risks for the global economy, as the greatest central banker of modern times, Paul Volcker, has explained:

Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. I think it gets dangerous when they lose sight of the basic function of the central bank.  The key issue concerns what this “function” should be. The basic function of a central bank is to defend the value of the currency,” he insists, as his highly successful experience in the 1980staught him how limited a central banker’s powers really are”.

CHINA HAS ABANDONED STIMULUS FOR A ‘NEW NORMAL’ APPROACH
The problem is that currency wars are a zero-sum game.  Today, Japan and the Eurozone are winning at the expense of the USA and Switzerland.   Thus the US$ Index has broken out of a 30-year downtrend, and is at an 11-year high. 

Effectively, though, this means that 2 of the world’s 4 largest economies are effectively waging a currency war against the largest economy, the USA, as well as against Switzerland.  This cannot end well.

Within a few weeks, the Fed will find that the US recovery is suddenly weakening again:

  • The collapse of the shale gas/oil bubble means US jobs growth will soon reverse, and housing starts slow
  • US companies will lose market share in export markets as Japan and Europe become more competitive
  • The rise in the value of the US$ will also help to ensure that the US slips into deflation.
  • And so the Cycle of Deflation will likely move forward another stage, towards protectionism and tariffs

Of course, there is another way forward, which avoids this zero-sum game.

China’s new leadership realised 2 years ago that its previous policies had been a complete mistake.  It has since adopted ‘New Normal’ policies, based on an acceptance that ageing populations inevitably lead to lower economic growth.  As Zhou Xiaochuan, governor of the People’s Bank of China, told the World Economic Forum in Davos last week:

If China’s economy slows down a bit, but meanwhile is more sustainable for the medium and long-term, I think that’s good news”

Unfortunately, very few of his peers seem to be listening to his common sense message.

WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

Benzene Europe, down 57%. “Current market fundamentals do not support any significant upturn on benzene pricing”
Brent crude oil, down 53%
Naphtha Europe, down 53%. “Buying appetite in downstream petrochemical markets is thin as polyethylene players wait for the February ethylene contract to settle”
PTA China, down 44%. ”Buyers were mostly purchasing on a need-to basis, adding that the market outlook remains uncertain”
¥:$, down 15%
HDPE US export, down 23%. “Most domestic export prices continued to slip on lower ethylene and energy market values”
S&P 500 stock market index, up 5%

Volcker speaks out on central bank policies

Core slide.pngCentral bankers clearly read too many super-hero comics when they were young. Ben Bernanke at the US Federal Reserve, Mario Draghi at the European Central Bank, Mervyn King at the Bank of England and now Haruhiko Kuroda at the Bank of Japan, all see themselves as Superman solving the world financial crisis.

The only problem is that they are solving the wrong problem. As the slide above argues, based on our analysis in Boom, Gloom and the New Normal, it is completely wrong to suggest that today’s problems have the same underlying cause as the Great Depression in the 1930s. They are in fact caused by a perfectly natural, and entirely welcome development:

• Life expectancy has almost doubled over the past 100 years in the West, and almost trebled in the emerging economies
• As a result, fertility rates have almost halved in the West since 1950, and more than halved in emerging economies

We therefore have an entirely new generation of older people, the New Old 55+, alive for the very first time in history. Equally women no longer have to have large numbers of children, in order to ensure that they have some support in their old age.

Does anybody seriously think these are ‘bad things’, or ‘problems’ that needs solving? Of course not. They are surely one of the greatest achievements of modern society, and should be celebrated as such.

But what these changes also mean is that economic growth will be much slower in the future. Firstly, there are fewer younger people alive to do the ‘heavy lifting’ for the economy. And secondly, older people buyer fewer new things, as they already own much of what they require.

Thus the blog is delighted to see the words of wisdom from a former US Fed Chairman Paul Volcker. Central bankers do no normally criticise each other, but as Gillian Tett in the Financial Times reports, his meaning is clear:

“Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. “I think it gets dangerous when they lose sight of the basic function of the central bank.”

The key issue concerns what this “function” should be. In recent years, it has generally been assumed that a central bank’s core mandate is to keep inflation low and growth on track (and, in the case of the US, to deliver low unemployment too). Mr Volcker disagrees. “The basic function of a central bank is to defend the value of the currency,” he insists.

Ms Tett concludes that Volcker’s highly successful experience in the 1980s “also taught him how limited a central banker’s powers really are”.

Ben Bernanke and his friends are not the super-heroes they imagine. Companies instead need to put their trust in business model and technical innovation, and not wait for Super Mario and his friends to rescue them.