Today’s commentary
I am concerned about what is happening in the emerging markets but not alarmed. Fed tapering was a proximate trigger but not a cause. All indications are that the crisis is hitting only the most exposed and vulnerable markets and that this doesn’t have to boomerang onto other markets. The worry has to be that contagion causes the locus of stress to spread to economic agents that should be less vulnerable, causing the crisis to metastisize and spiral out of control. Policy co-ordination in foreign exchange will be key if this occurs.
Let’s start with Albert Edwards of Societe Generale. He is already alarmed. His most recent piece is titled “Tapering is tightening, which inevitably ends in recession, bailout and tears”:
Our warnings throughout last year that an unravelling of emerging markets (EM) was the final tweet of the canary in the coal mine have still not been taken on board. The ongoing EM debacle will be less contained than sub-prime ultimately proved to be. The simple fact is that US and global profits growth has now reached a tipping point and the unfolding EM crisis will push global profits and thereafter the global economy back into deep recession.
Our thesis on how EM would be pushed to crisis was simple, especially as we saw close parallels with the 1997 Emerging Asia currency crisis. We saw yen weakness further undermining an already weak balance of payments situation in the emerging world as a direct replay of 1997. A strong dollar/weak yen environment is typically an incendiary combination for EM, and so it has proved once again. Having reached tipping point the yen will often rally strongly as it has now and as it did in May 1997. This may or may not delay the impending EM implosion for a few weeks. Indeed the Thai Baht, the first domino to fall in the Asian crisis, briefly rallied strongly (vs the US$) in early June 1997, reassuring investors just ahead of its ultimate collapse (see chart below).
Here’s what I hear him saying: profit growth in the US and globally has been receding even while markets have vaulted higher. The Fed wants us to believe it isn’t tightening, but it is. The emerging markets crisis, triggered by the Japanese volley in the currency wars with Abenomics, is going to bring these issues into full view and create a full blown crisis.
I think underneath this view is a sense that the real economy in Europe and the US is not as robust as most analysts would have us believe. And that the emerging markets volatility is merely a trigger for a re-evaluation of risk that makes plain how fragile the real economy is in developed economies. It is a compelling narrative that concerns me. But I have been on the other side of this line so far this year, talking of risk to the upside and credit accelerators in the US as well as recovery in Europe, especially in Spain. However, the recent downdraft in US interest rates does call the credit accelerator theme into question. We do have to be concerned about feedback loops into the real economy because wage growth is so weak.
After the jump, for subscribers I will break down what I am seeing.
First, tapering IS tightening. Yes, I agree with Albert on this. The reason I have been talking of 2013 as 1994 is because I see tapering as tightening. 1995, the year after the Fed tightened, was a weak year, with only 4.3% nominal growth. But, what helped overcome the tightening afterwards was the credit accelerator. This allowed the US to power through into the “irrational exuberance” phase.
Rethinking the 1994-96 period makes me reconsider my 2013 as 1994 theme regarding whether we are at a bond bearish point yet. In the US, tightening meant slower growth before the credit accelerator kicked in. And slower growth meant a flattening yield curve. 1995 was a mid-cycle slowdown coming out of a jobless recovery. So it was a dicey year economically, which is bond bullish. The credit accelerator did not kick in until 1996. Moreover, Niels Jensen notes that the bond bearish view is a crowded trade and that a contrarian would see this as a bullish signal.
So what we have in the US is a 2% growth rate bolstered or diminished by inventories, credit growth and exogenous shocks. We are not in a 3-4% GDP growth phase because the GDP growth rate in the last two quarters has been artificially high due to inventory builds. I think 2% is enough to get through negative shocks. We are no longer at stall speed. But my rethinking of what actually occured in 1995 has me thinking my ‘risks to the upside’ position could be flawed. Let’s put a marker on this and revisit after we get more data from the real economy.
As far as policy, fiscal policy will continue to be restrictive and the deficit will decline. The Fed wants to taper and Plosser is making it seem he will dissent if they don’t taper faster. There are enough hawkish voices at the Fed that make me believe that QE is done and the Fed is going to rely on forward guidance alone. A major correction could change this but my sense is that the tightening that tapering represents will continue. And if the problems in emerging markets continue and real economy data aren’t forthcoming, the yield curve will flatten instead of steepening as I anticipate. So there are a lot of ifs at the moment for the US.
A lot of this has to do with the emerging markets and contagion from there then. I believe much of the problem is political or has to do with macro imbalances in particular markets like Turkey, South Africa and Brazil. Tapering in the US brought a new risk-off source of volatility to EM that has not extended everywhere. Poland is not being hit. EM corporates are not being hit. And other high yield risk assets in developed economies are not selling off.
That’s what happening now. What makes a crisis a crisis is contagion. It isn’t a ‘real’ crisis until you get contagion. And by contagion I don’t mean infection of vulnerable markets that should be in crisis or that always had to be on the radar screen. Rather I mean contagion to markets or debtors that should feel relatively safe except in dire circumstances. For example, Bear Stearns and Lehman Brother were clear targets in 2007 and early 2008. But Goldman Sachs was not. It was because the crisis spiralled out of control that Goldman, as an investment bank dependent on wholesale funding, became a target. In most reasonable cases, we should have expected Goldman to survive a crisis. So you know you are in a crisis when Goldman is at risk.
So what we should be afraid of is a Merrill Lynch or a Morgan Stanley — less vulnerable than Bear or Lehman but more vulnerable than Goldman — becoming the subject of contagion. If I put this into eurozone crisis terms, Merrill and Morgan Stanley are the Spain and Italy to Bear Stearns and Lehman Brothers’ Greece and Portugal. The proximate trigger of the eurozone sovereign debt crisis was a risk re-evaluation after the Dubai World blowup. The biggest problem cases: Greece, Portugal and Ireland came into view immediately. But it was Spain and Italy, the big fish that has made the European sovereign debt crisis so difficult.
Analogously I am not concerned about Argentina. And Turkey is known to have problems. I would be much more concerned if we started to see problems in Brazil and India – two BRIC countries – especially if those problems were in the corporate sector. Last week I wrote that “I see corporate debt as the EM safe haven, more so than sovereign debt or equities.” And I noted that leveraged loans and junk bonds in the US were doing just fine. If any of that changes, we have a major crisis on our hands.
In terms of emerging markets, I believe continued declines in foreign exchange rates will make a middling crisis into a real crisis by creating contagion. If the foreign exchange rates in India and Brazil were to start dropping from here after having stabilized, we would see one of two things.
The central banks in those two countries could hike rates to make their currencies more attractive but doing so would stress corporate balance sheets where domestic corporate debt is high. That would precipitate cuts in staff and capital investment and slow credit growth, precipitating a serious real economy slowdown. These are major economies, and the real economy effect would be felt elsewhere. The corporate balance sheet stress could trigger a crisis.
On the other hand, the central banks could leave things alone and let the foreign exchange rates adjust. Doing so, however, could cause an overshooting that made healthy corporate balance sheets unhealthy by exposing corporates borrowing in foreign currency to a huge increase in debt liabilities. That too would trigger a real crisis.
A number of well-respected economists have lashed out at developed market central banks for allowing it to get as far as it has in emerging markets. Raghuram Rajan and Willem Buiter both have said policy co-ordination is necessary. But what kind of co-ordination do they see as necessary?
The Fed, for example, is trying to finesse its move away from QE as a policy tool by telling markets that QE and forward guidance are two separate tools with QE working via the term premium and forward guidance working via expectations only. The Fed wants us to believe that ending QE is not tightening but a shift away from term premium-focused accommodation. After all, forward guidance is still showing huge accommodation. The problem here is that forward guidance is time inconsistent; the Fed’s reaction function and the real economy are mutually dependent. So if the economy improves more than anticipated, then the Fed’s guidance will change. Now, the Fed tried to take a rules-based approach with the Evans rule of 6.5% unemployment as a threshold for tightening. But we are already there and now the Fed has no rule to guide policy. That makes forward guidance much less useful. And so tapering in that circumstance is tightening.
Should we expect the Fed to change its stance then when it has been concerned about asset market bubbles in leveraged loans, auto ABS, and high yield bonds? I say no. The Fed is boxed in. The Fed has to continue tapering unless the real economy in the US falters – especially since the unemployment rate is dropping. So that means, by definition, there can be no policy coordination on rates to help ease the pain on emerging markets. If the Fed is tightening in the world’s biggest economy and market, there can be no co-ordination on rates.
Where I do see scope for co-ordination is in the currency market. If currencies of key emerging markets resume their fall – they had risen recently – there should be scope for co-ordinated intervention. If the ECB, the Fed, the Bank of England, the Swiss National Bank and the Bank of Japan said they would all intervene if exchange rates in Brazil, India or Turkey fell too rapidly, then we would see a big effect in foreign exchange markets. And I believe this would be enough to keep the emerging markets crisis at bay. With the emerging markets crisis at bay, the only weak link in the global economy would be China and its economic slowing as the economy rebalances. The momentum in Europe and the US is up and these are the only events outside of leveraged finance and high yield which could disrupt that momentum now.