Introduction – Investment Regimes
With regards to the current investment regime (a period we define as one which spans from post-GFC till now), market narratives, we reckon, were dominated by expectations of a prolonged period of subpar growth and inflation – secular stagnation and the Japanification/zombification of major economies, highly accommodative monetary policies, coupled with rising domestic socio-political polarization and geopolitical tensions. Asset markets have largely mirrored such views (low but positive growth/inflation, stimulative monetary policy – high opportunity cost of holding cash with no carry, low “default” risks, reach for yield/growth), with risk premiums low and anchored, and volatility suppressed across most markets. Most expect a continuation.
In contrast, the release of this note reflects our belief that we are much nearer to the critical juncture than most expect; investment regimes can only sustain insofar as underlying conditions and fragilities are not pushed to the extremes. Indeed, we believe that the current regime is nearing its end as it approaches its breaking point, as prior deep fragilities and fault-lines of the current regime have been further amplified by the Covid-19 pandemic. This calls for a re-evaluation of key prior assumptions, and correspondingly the need to adjust one’s portfolio to reflect such realities.
Much of the note uses data from post-GFC to pre-Covid-19 to illustrate prior underlying conditions of the global economic/financial system. The article(s) will be divided into parts, focusing on i) a brief description of the current regime, ii) why the regime is nearing its end, iii) expected scenarios, iv) conditions and paradigms underlying the scenarios, and v) asset allocation most fitting for the scenarios.
Defining the Current Investment Regime – Low Growth/Inflation was the most plausible outcome
The lack of sustainable global aggregate demand underpins the current predicament of subdued global growth and inflation – with deep-lying trends driving the 3Ds of the global economy (elevated Debt levels, aging Demographics in major economies, & the lop-sided Distribution of income – both domestic and global). The over-reliance on monetary policy over the span of the current regime has also exacerbated leverage levels globally, impeding economic adjustments, and has played a role in widening income inequality (see box 1) – via high concentration in financial asset ownership, lack of efficacy on growth, outperformance of financial assets vs. economic growth etc). This further worsens the forces at play, essentially leading to a negative feed-back loop. The lop-sided income distribution (skewed extremely heavily towards economic/financial capital owners) in turn led to domestic political instability via rising polarization, subsequently, inevitably, leads to geopolitical tensions.
Box 1: Declining Labor Share of Global Income
Since the 1980s, the labour share of income has declined around the world, reflecting a mix of factors[1], coupled with rising inequality. This shifted income away from the consuming classes (labour, median and lower income households, debtors) with higher propensity-to-consume towards capital owners, especially rentiers, and wealthier households who save a high proportion of their incomes, working to dampen overall potential aggregate demand.
The global economic/financial system also operated under a dysfunctional global financial architecture[1], one which has failed to allow flexible/automatic adjustments of global imbalances, nor allows for global excess savings to be balanced in a growth-conducive manner. The existing global financial architecture is far from a deliberate and well-designed system, rather, it is more a concomitant of a confluence of major historical events – including Bretton Woods I & II – USD based global reserves system, the Cold War, Asian Financial Crisis, dominance of neo-liberal policies/Washington consensus, the ascension of China and its entry into the WTO, and the creation of the Euro, amongst others. The result is a combination of elements which, considering feedback loops and dynamic interactions within the system, produced a high degree of stasis with regards to global re-balancing (i.e. the presence of persistent deficits/surpluses in the same economies with no automatic adjustment mechanisms in place). These elements include i) USD as the global reserve currency, ii) the dominance of capital flows over trade flows in the modern financial system, iii) the development of “efficiency” maximization global supply chains/hubs and tax regimes, and iv) divergent and distorted political/financial/economic structures of major players in the global trading system.
These elements allowed the weakening share of labour income and rising inequality to be enabled and reinforced by a corresponding global dimension (two sides of a balance sheet), as reflected by the “secular” group of current account surplus/deficit (creditors/debtors) economies. Certain economies have doggedly pursued an export-driven, neo-mercantilist growth model to safeguard domestic stability, growth and employment. These surplus economies employed a mix of policies which directly/indirectly suppressed the labour (consumption) share of income, including financial repression, undervalued FX, fiscal conservatism, negative labour welfare reforms[2], and mandatory saving schemes, in turn forcing up their savings rate and maintaining them persistently. This came at the expense of economies with institutional setups that are “compelled” to absorb such surpluses – these usually involve free and open capital account markets (US/UK/AU/NZ/CAD, the pre-euro-zone sovereign crisis peripheral EU; these economies were recipients of capital inflows and the corresponding current account deficits). This too led to a decline in potential aggregate demand as income shifts to surplus economies, and away from the consuming classes.
The post-GFC rebalancing of excess savings did not address the root cause under-lying the weakness of aggregate demand. The US remained the most important ‘consumer of last resort’, running the largest current account deficit in absolute terms by some extent. Amongst surplus economies, a key part of EU’s post-crisis strategy was to double down on Germany’s existing growth model (which generates large surpluses), forcing a mixture of unit labor cost compression (largely via unemployment), collective FX devaluation, exploitation of regional tax regimes by specific economies (NTL/IR), and fiscal austerity across the entire Eurozone. China, on the other hand, shrank its external surpluses largely via a rapid build-up of leverage (but without a corresponding improvement in its credit-allocating institutions/processes), thereby significantly aggravating its domestic imbalances. This, together with the structural oil price decline in 2014 (inherently a massive one-off wealth transfer from oil exporters to the global consumer; giving respite in particular to major oil-importing economies such as CN/EU/IN/ID), were key drivers which helped maintain the global expansion post-GFC.
Back in 2015, we envisaged a prolonged period whereby global competition for demand will further intensify (hence the increasing reliance on monetary policies) and increasing risks of direct/indirect retaliatory measures by the US to reject its status as the global consumer of last resort. We believed global cooperation enabling structural reforms (the onus lying more on surplus economies) and the re-calibration of the global financial architecture were extremely unlikely.
Underlying Fragilities and Fault-lines
We did not see the current regime as stable even before the global pandemic, instead we argue that the above-mentioned support structures were reaching its limits, inevitably necessitating a change in the regime soon. We discuss the key factors (mostly mutually reinforcing) below.
A. Politics
US President D.Trump’s policies have essentially led to a unilateral dismantling of the current global order. Prior cooperative games among countries have shifted to one based on short term, transactional-based relationships. President Trump have made access to US demand, markets, defense and geo-political support, dependent on explicit gains that the US can recognize in the short term. Correspondingly, the fallout of such policies forces the Rest of the World to recognize the explicit costs. As such, the coming Nov 2020 presidential election is, we believe, an important event in determining the future trajectory of the global economic and political regime. The relationship between capital and labour, the role of the state, and the US’s place in the world – economic, finance and trade, geopolitics, global order – will undergo a seismic change contingent on who occupy the White House come 2021.
In addition, the world is shifting towards greater polarization, both domestic and international, reflecting a prolonged period of slow progression, if any. This is happening in many parts of the world, most evident in the US, UK and parts of Europe and Asia. Violence has also erupted in countries with weaker institutions and social stability in parts of Central/South America and the Middle East. A prolonged/deeper slowdown will inevitably lead to a further flare up of domestic/international tensions.
B. The impotency and rising side-effects of accommodative global monetary policies
We also see signs of ill effects brought about by an over-reliance on monetary policy easing globally; going forward, we are likely to enter a period in which the omnipotence of central banks will get increasingly questioned by markets. Such signs include:
i. The level of global leverage limits the scope for future debt expansion to support growth as debt servicing costs starts to bind. Furthermore, both portfolio re-balancing and signaling channels of monetary policy transmission are blunted by low interest rates and financial asset risk premiums, limiting monetary stimulus via the asset inflation channel. At current asset valuations, further non-earnings-based asset inflation would intensify existing imbalances (see box 2)
ii. Competitive devaluation, driven by divergent global monetary policies, works earlier in the cycle as economies (China, EM, US, Japan, Europe during stages across 2010-2018) with stronger demand were able to provide a lift to other economies as demand is shifted around globally via the REER channel. However, the global economy is now in a synchronized slowdown and monetary policies are moving in the same direction (growth and policy convergence) which limits the extent of potential stimulus that the FX channel can provide, going forward. In addition, protectionism is on the rise globally, partially in response to such devaluations. This is especially evident in current account surplus economies as despite falling FX (less so for their REER), trade activities continued to slow.
iii. Further, in economies where internal imbalances reflect low household share of income (vis-à-vis corporate, financial, government sector), low returns on monetary assets (risk-free rates and REER) transfer wealth away from the consumption class, leading to wider imbalances (exactly the wrong antidote).
iv. Evidence thus far suggest that JP/EU are nearing ‘reversal rates’ given the substantial negative trade-offs when rates are in negative territory. These trade-offs (based on Scandi/EU experience thus far) include lower banking system profitability, reduced rather than increased credit growth, higher rather than lower savings rates, reduced liquidity in bond markets, increasing pension liability mis-matches, and widening income inequality
Box 2: Weakening Economic Dynamism
Distortion of capital markets and ossification of the economy structure: An extended period of accommodative monetary policies have led to a preference of economic entities to inflate prices of existing assets (low costs financing, acquire existing share of demand) – financial engineering, share buybacks, M&As – over economic capital/asset creation (uncertain growth outlook), leading to depressed asset yields (income generated to asset capital values). Such behavior has also reinforced the rising monopolistic/oligopolistic nature of markets as companies with preferential capital market access are able to acquire other companies. The survival of loss-making companies and lack of aggregate supply rationalization (consolidation and corporate exits) due to low interest rates have also worked to weaken economic dynamism. The rise of loss-making “unicorn” companies with questionable business models which are supported by accommodative capital markets (typically NBFIs) are increasingly challenged by shifting investor behavior due to the fear of capital losses. All these factors weigh on the economy and have led to a further expansion in Minsky’s speculative and Ponzi finance.
C. Pain Distribution Have Extended to Surplus Economies
Political changes in the two largest current account deficit economies, the US and UK, will add further headwinds to the global economy. US President D.Trump has made trade a key policy focus, threatening and imposing tariffs and other administrative measures on economies that ran sizeable bilateral trade deficit (Asia, Europe, Canada, Mexico) with the US. US demand to the rest of the World, as such, will become increasingly volatile and uncertain, and arguably, at a lower magnitude[3]. In the UK, massive income inequality (education, employment, health opportunities), coupled with the rise in political charlatans, have led to Brexit. The weakening of the UK economy will impose costs on the rest of the world with the UK economy being the 2nd largest current account deficit economy[4].
The increasing ‘unwillingness’ or ‘incapacity’ of large deficit nations to absorb excess savings by a much larger extent are now worsening conditions for surplus economies to make the necessary adjustments. Without sufficient external demand, maintaining balance sheet resilience via current account surpluses at the current juncture (as opposed to before when conditions were favorable) will surely entail much slower growth (S-I can only widen in a limited number of ways). Furthermore, prior tailwinds to global growth – drop in global commodity prices and CN’s build up in leverage (as mentioned earlier) – will remain limited. Without prior growth tailwinds, surplus economies are now at a critical point whereby they need to choose between economic reform/restructuring (likely at the expense of political capital and/or erosion of well-entrenched interests), or face possibly a far larger and more prolonged period of pain absorption. We briefly focus on the most important/major surplus economies:
China. China’s debt-driven economic model is increasingly reaching its limits, with the build-up of debt and financial stability risks leading to a fall in China’s debt servicing capacity[5]. Since 2008, in order to support economic growth, efforts have been made to “re-balance” the economy towards domestic demand (with massive demand spillover globally as the current account fell by close to 6%pts). First via investment by SOEs, then the local governments and LGFVs, followed by the central government through higher spending supported by the PBoC and the policy banks and more recently via higher consumption by households (through household credit – mortgage and consumer credit and proceeds from the shantytown redevelopments). As a result, the economy cyclically rise/fall depending on the policy easing (both monetary and fiscal) cycle, all the while leverage (both public and private) builds, debt servicing capacity worsens and, inevitably, growth slows further.
US President D.Trump’s trade agenda against China poses an additional risk, considering that external demand is one of the few sources of demand (outside of income-driven domestic demand) that does not require a further build-up of debt in China.
The government, under Xi, has (seemingly) changed its approach (from a signaling standpoint thus far), focusing more on increasing the income share of households and the private sector (eg. tax cuts, fee rebates, hukou reforms), while tightening its grip on credit expansion across 2018-2019. In addition, a more assertive China (in its longer-term objective to fulfill its great power ambitions) will likely seek to augment its economy structure, strategizing to acquire technology, shorten its supply chain, support onshore demand and attain economic dominance (China 2025).
The path(s) chosen, going forward, to resolve its domestic imbalances will have significant impact on both China and the rest of the world.
Europe. The recent EU recovery fund – importantly led by GE & FR – is undoubtedly a step in the right direction. At the minimum, this serves as a precedent for regional burden sharing in times of crises while potentially improving the political legitimacy/support for the EU in the South – helping reduce fragmentation risks. Taken in isolation, however, the scale of the fund is unlikely to meaningfully lift the EU out of its growth stagnation (address tail-risk but does not improve the medium-term economic circumstances). We have also noted meaningful positive shifts in debate with regards to fiscal policy/banking union domestically in GE since 2019; although this seems to be at least partially motivated by a relatively sharper domestic growth slowdown pre-Covid-19 and more importantly, a gradual erosion of its labor cost competitiveness vis-à-vis the rest of the EU in recent years. It remains to be seen if the temporary departure from its constitutional debt break induced by Covid-19 will eventually lead to a more permanent, and flexible counter-cyclical approach to fiscal policy for both itself and the EU.
Beyond that, we still see Euro-zone growth dynamics as being structurally constrained by its internal architecture (lack of fiscal union/burden-sharing, poorly-designed fiscal rules/sovereign fiscal flexibility, lack of banking union, inseparable linkages between sovereign bonds and domestic banking systems, monetary hegemony from core/creditor EU, lack of uniform regulatory capital, tax regimes, divergences in competitiveness across countries etc.) As the de-facto monetary hegemon, more structural reforms, we believe, will have to be led by Germany to be politically enforceable/sustainable.
Since the GFC, adjustments via internal and external devaluation, coupled with deleveraging, have taken a huge toll on the populace of the current account deficit economies (peripherals) as income were squeezed via a mix of unemployment, falling wages, cuts in public benefits, and weakening external purchasing power. Regional re-balancing did not occur as the Euro-zone current account surpluses were generated almost exclusively via external demand with key current account surplus economies (Germany, Netherlands) continuing to run wide current account surpluses while deficit economies gained via demand suppression/import compression, coupled with adjustments elsewhere. This acts to dampen global aggregate demand.
This led to increased domestic and intra-EU socio-political/economic tensions, and the rise in “alternative”, both extreme left/right, political parties seeking another path. A sustained period of weak growth, going forward, is unlikely to be politically stable (domestically and regionally) as the European populace – through the democratic process – will force changes, one way or another; risks of revolts against regional “rivals” and the distant, centralized, bureaucratic European institutions remain high.
Covid-19 Accelerates Cost Recognition; an Amplifier of Underlying Fragilities
The above factors, together, suggest to us an inevitable shift in the global economic/investment regime, regardless of the Covid-19 pandemic. As prior imbalances, implicit costs and tradeoffs are forced to the surface and explicitly recognized, adjustments, one way or another, will occur. Covid-19 has accelerated the timing of cost recognition, in our view, having intensified the prior tendencies contributing to the regime’s fragilities. The pandemic has brought about severe demand destruction (relative to supply), of which part of it will likely be permanent. The additional debt buildup thus far serves primarily to partially offset lost income (expensed not spent) and are unlikely to be self-liquidating – higher indebtedness to output (adding to the zombification of major economies). Income inequality will also likely worsen, with monetary policies mainly supporting capital owners while the consuming classes continue to bear most of the costs. Global cooperation – much-needed to address issues surrounding the global financial architecture – continues to be severely lacking.
We think prior fragilities are now being brought to extremes which render the current investment regime unsustainable; we are now likely to transition into a world which pushes the need to generate sustainable domestic demand to the forefront as key to safeguarding one’s place (sovereignty and domestic stability, both politically and economically). The alternative path is stagnation, but unlike before, one which is likely far more volatile and violent, economically and politically.
This will, either by choice or circumstance, force a fundamental re-think from policymakers on their respective major economic/political constructs; thereby accelerating the shift away from what is already a fragile regime near its breaking point. The transition should also entice a re-think (at the very least) over prior assumptions hardened over the past decade.
Key assumptions include:
– Global growth and inflation will remain low but positive while recession risks ebb and flow
– Central banks will be forced to keep policies highly accommodative indefinitely
– Subdued commodity prices for an extended period
– Current account deficits/surpluses (regardless of funding/growth dynamics) are inherently negative/positive
– Lenders/capital/savers will continue to dominate vis-à-vis borrowers/labour/consumers with regards to dictating future adjustments/policies
– Outperformance of asset markets vis-à-vis underlying economic performance (financial cycles > economic cycles)
Part 1: The End
[1] See http://www.theasianhedgehogandthefox.com/?p=11
[2] Labour is forced, sorely in most instances, to adjust to negative shocks vis-à-vis other sectors. Adjustments can be through uncompensated firings/unemployment, reduced hours/compensation, reduced welfare payments and state support, stringent means-testing leading to fear and exploitation, loss of insurance/medical coverage/pensions, etc.
[3] Impact of the protectionist measures on the US current account is uncertain and depends on how income is shifted among US households and corporates (consumer/produces prices), and the government (tariff redistribution among sectors), and external parties (terms-of-trade, FX, prices, margins). Others factors include the elasticity of demand and supply, degree of openness of US’s capital account, and degree of global balance of payment distortions. We believe, on the whole, that cyclically adjusted, protectionist measures will have positive implications on US’s current account dynamics – considering elasticity of demand/supply (importance of US demand) and global supply-side shifts (as surplus shifts from highly distorted economies to economies with less external distortions).
[4] Analysis based on exports to/from UK/EU is highly flawed without determining net flow of demand.
[5] PV of the future increase in production generated by the investment must be =/> than the cost of the investment. Debt has grown quicker than income.
