The Fed has surrendered and here’s what comes next

Dear All

 

My latest piece on Macro – edited by the brilliant John Hardy, enjoy:

 

The Fed has surrendered and here's what comes next

Anyone familiar with my research of the last twenty year knows that I am no fan of central banks: glorified bureaucrats with an academic sense of infallibility who believe they have a supreme power's insight into the economy and markets. But yesterday marked a new low for world central bankers as the US FOMC completely threw in the towel.

Anyone who ever thought Fed and other central banks are truly 'independent' should spend twenty dollars on the great Paul Volcker book Keeping at It from 2018. Volcker tells the story of how both Jimmy Carter and Ronald Reagan tried and partly succeed in forcing easing on him and FED in the 1980s. Also have a look at Nixon and his relationship with Volcker's predecessor as Fed Chairman, Arthur Burns (https://en.wikipedia.org/wiki/Arthur_F._Burns) .

Jay Powell saw himself as a new Volcker but last night cemented his panicky shift since the December FOMC meeting, as he instead cut the figure of Alan "the Maestro" Greenspan, who set our whole sorry era of central bank serial bubble blowing in motion. The Fed's mission ever since has been a determined exercise in defying the business cycle with an ever expanding credit cycle. 

This latest FOMC meeting has set in motion a race to the bottom, with the ECB currently in the lead, but the Fed and BoE gaining fast.

I am presently in London on my way to China and Hong Kong doing Saxo Bank's Gateway to China events with the impressive Dr. Charles Su, of CIB Research, China. He and I agree on many things, but one in particular: 

Monetary policy is dead! 

My view has long been that monetary policy is misguided and unproductive, but the difference now is that we are reaching the most major inflection point since the global financial crisis because central bank policy medicine is rapidly losing what little potency it ever had. In the meantime, the harm to the patient has only been adding up: the economic system is suffering the fatigue from QE-driven inequality, malinvestment, lack of productivity, never ending cheap money and a total lack of accountability.

The next policy steps will see central banks merely operating as an auxiliary to a government fiscal impulse. The policy framework is dressed up as MMT, or Modern Monetary Theory, and it will be arriving soon and in force, perhaps after a summer of non-improvement or worse to the current lay of the economic landscape: no real improvement in data, a credit impulse too weak and small to do anything but to stabilize data and a geopolitical agenda which continues to move away from a multilateral framework and devolves into a range of haphazard nationalistic agendas.

 

For the record MMT is neither Modern, monetary or a theory, but it is the political narrative which is and will be used by central bankers and politicians alike. The orthodox version of MMT aims to maintain full employment as the prime policy objective, with tax rates modulated to cool off any inflation threat that comes from spending beyond revenue constraints (see, in MMT, a government doesn't have to worry about balanced budgets, as the central bank is merely there to maintain targeted interest rates all along the curve if necessary). Most importantly, however, is that MMT is the natural policy response to the imbalances of QE and to the cries of populists. Given the rise of Trumpism and democratic socialism in the US and populist revolts of all stripes across Europe, we know that when budget talks start in October in the US and in Europe after this May's Parliamentary elections, government globally will be talking up the MMT agenda: infrastructure investment, reducing inequality, and reforming the tax code to favour more employment at the low end.

We also know that the labor market is very tight as it is and if there is another push on fiscal spending the supply of labor and resources will come up short. Tor Svelland of Svelland Capital, who has been with Charles and me on the Gateway to China event, makes exactly this point. The assumption of continuous flow of resources stands at odds with the reality of massive underinvestment.

Central banker and indirect politicians are hoping/wishing for inflation - and they will get it in 2020 in spades, but it will be the wrong kind - headline inflation with no real growth or productivity. A repeat of the 1970s maybe? So get ready for bigger government and massive policy intervention on a new level and of a new nature – more driven by a fiscal impulse to stimulate demand rather than to pump up asset prices. It will lead to stagflation light or even heavy depending on how far the MMT is taken and could even mean something as dire as Paul Breitner hair coming back into style. (For non-football fans under the age of 50, please look it up!).

A client asked an excellent question last night - how much of this scenario is already priced in? Here is my take:

The Saxo Bank macro theme since December was the coming "Global policy panic", which is now fully realized. The Fed proved slower than even the ECB to cave but last night they entirely gave up. The US-China trade deal, another key uncertainty, is priced for perfection despite plenty of things that can go wrong.

The Brexit deal is extremely mispriced. The UK's biggest challenge may not even be the circus act known as Brexit, but rather the collapsing UK credit cycle which our economist Christopher Dembik has put at risking a 2% drop in UK GDP. If nothing changes over the next 6-9 months, and nothing will change, the UK economy will be in free fall. Forget Brexit, UK assets are simply mispriced from the lack of credit juice in the pipeline.

China is misunderstood and mispriced. If our two talks so far with clients on China and its opening up of markets have taught me anything, it is that the western 'reservation' on anything Chinese is entirely built on personal bias.

Governance is the word that keeps coming back in discussions. I am no fan of Chinese styled governance, but... Currently, less than 10% of global AUM is in China. But this year alone will see inclusion of China's bonds in global indices like Barclays, Russell, S&P and the allocation to China in the MSCI's emerging markets index will quadruple from 5% to 20%. The overall China-bound inflow over next 3-5 years will exceed $1 trillion using very conservative estimates.

 

China is perhaps the single country in the world least likely to treat inbound capital poorly. China has transitioned from being a capital exporter to now being an importer. It has a semi-closed capital account, which means little money flows out, but a massive inflow is beginning to stream in to acquire Chinese assets. 

China and its growth model now needs to share its burden of becoming an industrialized country, and it knows that only treating investors well will keep the capital flowing in 2019. On the domestic front, meanwhile, the CPC seems to be signaling that it wants domestic investors to move excess savings from the 'frothy' and less productive housing market to the equity market where capital can flow to more productive enterprises. Foreign investors are more likely to want to participate in the more liquid and familiar equity market.

2019 for China is like 2018 for the US. The first ten months of 2018 the US stock market was almost entirely driven by the buy-back programs fueled by Trump's tax reform. US companies plowed over $1 trillion into buybacks over the year. Now in 2019 the Chinese government is telling its 90 million domestic retail investors: you should raise your allocation to the stock market and meanwhile global capital allocators/investors will need to increase their exposure to China as its capital markets are reweighted.

But where does this leave me on asset allocation at the moment:

Equities – the Fed, ECB, BOE, BOJ have all given up because they only believe in credit cycles. The price of money going down is not enough for growth as it's only the second derivative of the growth engine. The first derivative is quantity of money. It's stabilizing but because of base effects (starting point very high) it will not be enough, but for now market is euphoric for the usual lack of integrity from the merry bureaucrats. A new high could be on the cards, but....slowly change overweight to China vs. US mainly, but also MSCI.

Fixed income - 250 bps in 10 year - where are all the sell side analysts calling for 400 bps ? The FOMC panic took out 260 bps floor - next? 200? Probably - observe how the 2-10 yield curve is now attacking 10 bps. My economic studies really only taught me three useful things (but I'm a terrible economist if that at all):

The yield curve is never wrong

Say's law (supply creates its own demand)

Productivity is everything

An Inversion of 2-10 is coming, I don't see 200 bps before the late summer, when concern about the lack of growth overtakes the global policy panic in place.

 

Commodities - it's all structural - Tor Svelland taught me that. We like all commodities, especially all sectors which have a foot in infrastructure, due to MMT coming, but mostly underinvestment en masse.

Cash - Love it!

 

FX

Underweight the two credit monsters: GBP and AUD, Overweight the US dollar, NOK, CHF, JPY

Like carry for the summer of TRY, ZAR and BRL.

 

I wish you safe travels,

 

PS Thank you for to those of you attending the Gateway to China events, hope to see some of you in Hong Kong on the 27of March. I really enjoyed the speakers and your company.

 

Med venlig hilsen  |  Best regards
Steen Jakobsen  |  Chief Economist

 

Saxo Bank A/S  |  Philip Heymans Allé 15  |  DK-2900 Hellerup
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