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The trade war is just another symptom of the ongoing reshaping of the global world order

By David Scott | Monday 9 July 2018


Stock market selloffs, volatility blow-ups, collapsing crypto currencies. They’re all the symptoms of an unfolding global credit squeeze, according to famed HSBC Holdings Plc bond guru Steven Major. It just happens to be developing at a snail’s pace. Major and his team see what they call a “long list” of selloffs in risk market across the world as evidence of the disruption wrought by tighter dollar liquidity. In response they’ve slashed their forecast for bund yields, turned more bearish on credit and become even more cautious on emerging-market debt. “Market participants are typically looking for validation of a forecast from cyclical data or one-off events, but the reality can be different,” the bank’s global head of fixed-income research wrote in a note on Wednesday. “We appear to be in the midst of a slow-motion credit crunch.”

The concerns reflect a wider angst growing across financial markets, which started the year in melt-up euphoria but reached the half-way mark in turmoil. Rising U.S. rates, the demise of the easy money era and President Donald Trump’s approach to the established trade order have combined to drain cash from riskier assets. The diminishing appetite for risk is one of the reasons HSBC cut its year-end forecast for 10-year bund yields to 0.4 percent from 0.75 percent, and even predicted a drop toward 0.2 percent in the short term. A downward reassessment of European Central Bank rate hike expectations, plus the potential for further turmoil in the governing German coalition, have added to the conviction. In developing markets, HSBC said the time has come to take a “selectively cautious stance” on local debt, alongside a bearish position on hard-currency obligations. Meanwhile, the bank has moved back to “mildly bearish” for both investment grade and high-yield European credit. That view chimes with a host of Wall Street strategists and asset managers, many of who have been finding ways to short a credit cycle that looks increasingly long in the tooth. Money managers last month turned underweight European credit for the first time in seven years, according to a Bank of America Corp. survey. “The autumn may bring further Italian volatility, ongoing trade headlines, and anticipation of the final fizzling-out of ECB purchases,” HSBC strategists wrote.

Donald Trump has ordered the entire world to cut off Iranian oil imports by early November and although a few countries will be given slightly more time this is intended to be a total ban. If most of the world complies with instruction as even China will find it hard to defy the policy, it will reduce global spare capacity to zero by the end of the year. This is worse than during the oil shocks of 1979 and 2008, as spare capacity has never fallen much below 1pc in the post-War history of the oil markets. Once the reserves are gone the slightest supply shock or geo-political upset will create a violent squeeze. The crude glut of the last four years has been cleared and OECD inventories are back below their five-year average. China and India are the biggest buyers of Iranian crude, but neither is immune to US pressure in the global money markets. Iran has recently increased its exports to 2.8m b/d in a final drive to get in revenue before the sanctions hit. Washington is aiming to slash this number by at least 2m b/d by November or soon after. This is far more than markets had been expecting (450,000), and it is happening far more quickly. Trump has tweeted that Saudi King Salman will come to the rescue with an offsetting 2m b/d but with Saudi Arabia already producing a record 10.7m b/d, commentators question if it can produce much more at the present time.

Last week it was ten years since the European Central Bank raised interest rates, only to reverse course within months after Lehman Brothers Holdings. collapsed and markets seized up, policy makers are still defending their action. The decision on July 3, 2008, to lift the benchmark rate a quarter point to 4.25 percent was seen by investors as risky, but then-President Jean-Claude Trichet said at the time that it was needed to curb inflation. He also said the 21 Governing Council members were unanimous. So, it is nearly a decade ago since Lehman Brothers collapsed and whilst no two market shocks are identical, and no one has yet mastered the timing of market crashes, knowing where vulnerability lies makes for better risk management, and maybe more carefree holidays.

There are four main areas of worry that, taken together, suggest the global economy may be in a more fragile place than it was even at the eve of Lehman’s demise a decade ago.
First, as the Bank of International Settlements has repeatedly warned, there is a record level of indebtedness in the global economy. It is not just the amount of public and private debt which is worrying, but also the deterioration in average quality. There is now $63 trillion of sovereign debt outstanding, with total debt at $237 trillion, a full $70 trillion above pre-Lehman levels. There are only 11 sovereigns and only two U.S. firms left with an AAA rating, and there is a continuing decline in the average credit quality of outstanding loans and bonds. Servicing and rolling over this debt is likely to become much more expensive as monetary policy normalises after years of Quantitative Easing. The 2007 U.S. deficit at $161 billion or 1.1 percent of GDP pales in comparison to this year’s projection of $804 billion. America’s public debt-to-GDP ratio has risen to over 105 percent of GDP from around 65 percent of GDP in 2008, with projections of a continued rise. In the euro zone too, debt is now 20 percent higher, rising 60 percent in Spain; and Italy’s public debt, already high in 2008, has now breached 130 percent of GDP, a full 30 percent higher than its 2008 level. Clearly, there is far less room for governments to use increases in public spending and the so-called countercyclical policies that were crucial to avoiding a repeat of the great depression following Lehman’s demise.
Second, with quantitative easing having left central banks with a record $15 trillion of assets on their balance sheets, and interest rates still close to record lows, there is limited room for a robust monetary policy response to another shock. T
he last three recessions saw the U.S. Federal Reserve cut interest rates by 5 percent, while pre-Lehman European Central Bank and Bank of England maintained interest rates of 4 percent and 5 percent, respectively. With QE taps still open and real, and even nominal interest rates negative for several G-10 central banks, a repeat of the decisive central bank action that helped the world avoid a depression is impossible. In fact, it is quite possible that monetary policy, as we saw with the taper tantrum in 2013, may become the source of instability as QE is wound down and interest rates normalise.
Third, the political centre, which was strong in 2008, has imploded and fractured in almost all major economies. Populism of both the far right and far left variety is rising, partly in response to the crisis. The electorate is more dissatisfied after what amounts to an almost lost post-crisis decade in which few saw an increase in their real wages, with many more experiencing economic and other forms of insecurity. Political systems in most European economies have fragmented with an increase of small and even fringe political parties now represented in parliaments, as governing majorities become ever harder to cobble together.
Fourth is the collapse of trust and weakening in the international order. The U.S. is pursuing not just an empty chair policy at international forums such as the G-7 and the G-20, which were crucial in marshalling international co-operation to tackle the last crisis, but the Trump administration has actively taken a wrecking ball to global international co-operation. Perhaps even more alarmingly, the sensible political centre in the European Union is diminished, with populists in both core and periphery economies leaving little room for sensible euro zone-wide and pan-EU policies. Brexit, the rising East-West divides, particularly on immigration and the new Italian government, are just the most obvious examples of a deeper malaise in EU politics.

Yes, banks are stronger today than they were in 2008, and policymakers have a bigger crisis toolkit. But the combination of shrunken fiscal and monetary policy space, a record build-up of debt, the diminishing of the political centre, dismantling of the post war liberal world order and a nascent trade war means that things may be more fragile on every other count. Everyone is worried about growing "wealth inequality." But this inequality surge is driven by the wealth bubble. It's going to crash, and inequality will actually drop, but we'll be in a serious recession. We need to worry about this bubble, not inequality.

Why is the current U.S. household wealth bubble far larger than it was during the prior two bubbles (Dot-com and housing)? The answer lies squarely with the Fed and how long it kept interest rates at record low levels.

The U.S. dollar’s share of currency reserves reported to the International Monetary Fund fell in first quarter of 2018 to a fresh four-year low, while euro, yuan and sterling’s shares of reserves increased, according to the latest data from the International Monetary Fund. The share of dollar reserves shrank for five consecutive quarters as the greenback weakened in the first three months of 2018 on expectations faster growth outside the United States and bets that other major central banks would consider reducing stimulus. Still the dollar has remained the biggest reserve currency by far. However, the dollar strengthened in the second quarter on fears about a global trade war and the European Central Bank signalling it would not raise interest rates until latter half of 2019. Global reserves are assets of central banks held in different currencies, mainly used to support their liabilities. Central banks sometimes have used reserves to help support their respective currencies. Reserves held in U.S. dollars climbed to $6.499 trillion, or 62.48 percent of allocated reserves, in the first quarter. This compared with $6.282 trillion, or 62.72 percent of allocated reserves, in the fourth quarter of 2017. The share of U.S. dollar reserves contracted to its smallest level since reaching 61.24 percent in the fourth quarter of 2013, IMF data released. Ranked second behind the greenback, the euro’s share of global reserves reached 20.39 percent in the fourth quarter, up from 20.15 percent in the fourth quarter. This was its largest share since the final quarter of 2014, but well below the single currency’s peak share of reserves at 28 percent in 2009.  China’s share of allocated currency reserves increased for a third straight quarter to 1.39 percent.The IMF had reported the yuan’s share of central bank holdings for the first time in the fourth quarter of 2016.  Sterling’s share of currency reserves moved up to 4.68 percent in the first quarter, the biggest since the fourth quarter of 2015, IMF data showed. The yen’s share of currency reserves retreated to 4.81 percent from prior quarter’s 4.89 percent, which was its biggest since the fourth quarter of 2002.

Federal Reserve Chairman Jerome Powell is a Trump administration appointee and he shares his predecessor Janet Yellen’s appreciation that labour-market slack may be greater than estimated. He’s combined that with a sense that the range of uncertainty around guidepost estimates that govern monetary policy are highly uncertain tools.
 For Powell, the first non-economist to hold the job in more than three decades, conceptual benchmarks and models can’t fully describe the complexity of the U.S. economy. So, in this first five months, he’s brought a subtle but important change to the chairmanship at a key juncture in the business cycle: trust evidence as much as economic models. “Let’s be guided by what’s going on and what the real economy’s telling us,” Powell said on the side-lines of a June 20 central bank conference in Sintra, Portugal, at which he also repeated the case for gradual interest-rate increases. “And let’s also admit that our understanding of what the location” of full employment is must be “informed by reality and what’s actually happening. “Some Fed officials also worry that a long period of low interest rates amid scarce resources, including a smaller pool of available workers, could generate bubbles.Stylistically, Powell’s approach is closer to an earlier Fed chief -- Alan Greenspan -- than his immediate predecessors, Ben Bernanke or Yellen. Greenspan was an expert in “current analysis,” his own, often idiosyncratic, discipline of forecast updating that dove deep into esoteric economic data. The strategy requires nimbleness and sometimes sharp changes in policy. A more data-dependent approach can be frustrating for investors who have been spoon-fed guidance by the U.S. central bank much of the past decade, because economic data are often noisy. Against that backdrop, Powell is stepping up communication and will start holding press conferences after every meeting, starting in January.

One of the most important macro-situations that’s developing right now is the looming U.S. dollar shortage, not in the sense that banks don’t have enough dollars to lend out but at the foreign sovereign markets level. These are some of the things that’s causing liquidity to dry up...
1. Soaring U.S. deficits – the United States’ need for constant funding is requiring huge amounts of capital
2. A strengthening U.S. Dollar – which is weakening the rest of the worlds currencies
3. Rising U.S. short-term rates and LIBOR rates – courtesy of the Federal Reserve’s tightening
4. The Fed’s quantitative tightening program – unwinding their balance sheet by selling bonds
These four things are making global markets extremely fragile...

When the U.S. buys goods from abroad, they are taking in goods and sending out dollars, so they are selling dollars out of the country in return for goods. Those countries that sold to America now have dollars in return. But since countries don’t have a bed to store their money under – they must find liquid and ‘safe’ places to put it. With the dollar as the world’s reserve currency – and U.S. treasury market being the most liquid – countries usually take the dollars and funnel them back into the U.S. via buying bonds. Since the U.S. is a net-debtor – inflows of new money are constantly required to pay out outstanding bills. So, there’s always fresh debt that foreigners can buy. The national debt is over $21 trillion – and growing faster. The latest Congressional Budget Office (CBO) report stated that at the current rate – U.S. debt-to-GDP will be over 100% by 2028, if not sooner. U.S. deficit requires constant funding from foreigners. But with the Federal Reserve raising rates and unwinding their balance sheet through Quantitative Tightening (QT) – meaning they’re sucking money out of the banking system. These two situations are creating the shortage abroad. The U.S. Treasury’s soaking up more dollars at a time when the Fed is sucking capital out of the economy. In addition, the strengthening dollar and higher short-term yields are making it more difficult for foreigners to borrow in dollars. Especially at a time when Emerging Markets are imploding and as the dollar gets more expensive other currencies are getting weaker.
Here’s some of the largest Asian economies and how much their currencies have weakened against the dollar. Unfortunately – foreign Central Banks have only limited options of what they can do to protect their currencies.
One – they can raise rates to defend their local currency. The idea is that if they offer higher interest rates, investors will move their money in the country. But raising rates will slow their growth down and hurt the nations debtors. And with Trump’s trade policies causing concerns for export heavy economies – mainly the Emerging Markets – making borrowers pay more interest isn’t a good thing.
Two – they can sell their dollar reserves instead. The Central Bank can sell their reserves at a discount on the Foreign Exchange market. And buy their local currency in return – pushing the USD down against their own currency. The problem with this option is that it’s very costly and risky. . . All the years of surpluses it took for them to build up those dollar reserves can disappear in a blink of an eye. What they get in return is temporary stability of their currency until they run out of dollars to sell. This is what happened in the 1998 ‘Asian Contagion’ crisis that decimated Asian economies.

A number of countries are already approaching ‘critical mass’ as foreign Central Banks grow concerned with the Fed’s tightening. 
The Vietnamese Central Bank recently announced that they’re willing to intervene in the foreign exchange market to protect the stability of their local currency – the Vietnamese Dong (VND) – which just hit a record low. This means they’re using ‘Option Two’ – selling their dollar reserves (pushing the USD Forex down) and buying the Dong on the open market (pushing the VND up).  This will ‘stabilize’ their currency’s value – that is, until they run out of dollars. . .

The Reserve Bank of India (RBI) governor – Urjit Patel – wrote an article in the Financial Times urging the Fed to slow down their tightening to prevent further chaos in the emerging markets. Indonesia’s new central bank chief shared the RBI’s feelings – calling on the Fed to be “more mindful of the global repercussions of policy tightening.” With the U.S. Treasury requiring significant funding from abroad. And the Fed raising rates while pulling dollars out of the economy via Quantitative Tightening – this is the foundation of a dollar shortage. The soaring U.S. dollar, Emerging Market chaos, and depreciating Asian currencies are all effects from this. That means global economies and stock markets will grow far more fragile – until the Fed inevitably reverses their tightening to re-liquidize global markets.

The trade war between the US and China officially launched on Friday, as both countries imposed back-and-forth tariffs. In response to President Donald Trump's 25% tariff on $34 billion worth of Chinese goods, China's Ministry of Commerce announced tariffs of equal size on certain US exports to China. The first $34 billion will be followed up by another $16 billion once the US's second tranche goes into effect in a few weeks. While Trump's tariffs are mostly focused on industrial and tech goods, China is focusing heavily on agricultural products from the US. Not only will this focus direct pain on Trump's own political supporters, but the focus on perishable goods also leaves US farmers with fewer options to divert their crops. China released a preliminary list of goods that could face tariffs earlier in June. While its unclear if the final list is exactly the same, the speed with which China struck back suggests few changes were made.

If the central banks are the ones who have gotten us in to the current mess then they must by implication not be the ones that are going to get us out of it. We will always look at what Central Banks are doing, and they will be important, But I think that they’re no longer going to be the most important force for markets. What’s going to be dominant are the politicians. In the US everyone loves to hang on every word that Chairman Powell says, and they look at the Fed statement still overly trained to look at the Fed dot plots, which in all probability are going to go away. Professional Investors look at these factors because that’s what they’ve done their whole careers. But going forward they are just not going to matter that much anymore. Whether the Fed’s top interest rate is 2.25 or 2.5 or 2.75 – we’re not talking about much it will be immaterial. Like Europe in the US the big issues are immigration policy and trade policy and How are these policies going to impact all of the major corporations’ and global supply chains. These are the issues that are really going to matter irrespective of the level of interest rates and these are decided by short sighted politicians increasingly chasing the populist vote with policies that lack substance and sustainability. But offer the hope of a quick fix to those that have no appreciation as to how the global economy is undergoing a seismic shift in how nations and in particular the super powers interact with each other.

As usual – expect things to get worse before they get better. But what huge money-making opportunities lie ahead for those paying attention, prepared and positioned accordingly.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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