Bernard's Top 10: QE 4?; China's new US$101 bln lending spree; Peak globalisation?; Is Mr Market right about China; Clarke and Dawe; John Oliver

Here’s my Top 10 items from around the Internet over the last week or so. As always, we welcome your additions in the comments below or via email to bernard.hickey@interest.co.nz

See all previous Top 10s here.

My must reads are #4 on China.

1, Time for QE 4? – It didn’t take long for investors and economists to start calling on the US Federal Reserve to delay its long-hoped-for and long-feared increase in interest rates.

As recently as a month or so ago most expected it would be in September. Now less than a quarter do.

But there are also a few saying the Fed needs to go back to the old Quantitative Easing or money printing machine.

Larry Summers, who has been banging on about secular stagnation for ages, has suggested it.

And so has Ray Dalio, who is widely admired as a very big and canny hedge fund investor.

Here’s Dalio’s view:

Dalio points out that since 1981, every cyclical peak and cyclical low in interest rates were lower than previous points until short-term interest rates eventually fell to 0%, which prevented a further rate cut. In response, central banks had to print more money and buy bonds.

“That’s where we find ourselves now,” he said. “Interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.”

2. The end of the debt super cycle – Dalio speaks at length here in this LinkedIn post about his theory of the economy and the structural forces creating deflation.

There’s that word again. Although I also wonder what he is long or short in.

While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces.  These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.

While, in our opinion, the Fed has over-emphasized the importance of the “cyclical” (i.e., the short-term debt/business cycle) and underweighted the importance of the “secular” (i.e., the long-term debt/supercycle), they will react to what happens.  Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.

3. Maybe it is real – John Cassidy at the New Yorker takes a good look at the latest stock market slump and concludes a correction was due and there are some fundamentals driving the latest falls. He makes some good points about Brazil and Russia, which hardly anyone is talking about.

For a quite a while now, analysts who take seriously such valuation ratios as the price-to-earnings ratio and Tobin’s “q” ratio (which measures the price of investment assets relative to their replacement cost) have been warning about a crack in the market. Back in February, Andrew Smithers, a London-based analyst, warned that the U.S. market was trading seventy per cent above its fair value. In May, Bob Shiller, a well-known economist who teaches at Yale, said that there was a ”bubble element“ to the valuations present in the market.

As always, the issue is timing. Raging bull markets usually go on for longer than skeptics (such as myself) predict that they will, and they rarely end of their own accord. Sometimes, the precipitating event is the prospect or reality of the Federal Reserve deciding to raise interest rates. (That’s what happened in 1987 and 2000.) On other occasions, it takes some sort of shock, such as the collapse of Lehman Brothers, to set things off.

On this occasion, there was a surfeit of proximate causes. For one thing, the era of zero-per-cent interest rates and ultra-cheap money appears to be coming to an end. With G.D.P. growth picking up a bit after another slow start to the year, Wall Street expects the Fed to start raising rates either next month or in December. Then there is what’s happening in the developing world. It’s not just that the Chinese economy is slowing down and prompting the government in Beijing to take countervailing measures, such as trying (and so far failing) to prevent a stock-market bubble from bursting. Brazil is in terrible shape and may be headed for a financial crisis. The Russian economy, hit by sanctions and a collapsing oil price, is also in a slump. Of the original BRIC countries, only India looks to be in good shape.

4. Is Mr Market right about China? – Martin Wolf asks rightly at the FT if we should take any notice of the Chinese Stock Market slump or the Renminbi depreciation as any indicators of underlying economic problems in China, particualrly given both markets are so skewed and ‘fixed’ by China’s Government.

He also rightly concludes that China’s attempts to arrest these falls shows how worried the Government itself is.

Events in the Chinese market are of wider significance in two related ways. One is that the Chinese authorities decided to stake substantial resources and even their political authority on their (unsurprisingly unsuccessful) effort to stop the bubble’s collapse. The other is that they must have been driven to do so by concern over the economy. If they are worried enough to bet on such a forlorn hope, the rest of us should worry, too.

Nor is this the only way in which the behaviour of the Chinese authorities gives reason for concern. The other was the decision to devalue the renminbi on August 11. In itself this, too, is an unimportant event, with a cumulative devaluation against the US dollar of just 2.8 per cent so far. But it has significant implications. The Chinese authorities want room to slash interest rates, as happened this Tuesday. Again, that underlines their concerns about the health of the economy. Another possible implication is that Beijing might seek a revival of export-led growth. I find this hard to believe, since the global consequences would be devastating. But it is reasonable at least to worry about this destabilising possibility. A last possible implication is that the Chinese authorities are preparing to tolerate capital flight. If so, the US would be hoist by its own petard. Washington has sought capital account liberalisation by China. It might then have to tolerate a destabilising short-term consequence: a weakening renminbi.

5.  From investment to consumption? – Wolf also looks at the more important issue of whether China is successfully transitioning from investment and infrastructure spending to consumption and services. This is crucial for New Zealand. We want more of the latter than the former.

Suppose something like this were true. According to official figures, gross fixed investment was 44 per cent of gross domestic product in 2014. Figures for investment are more likely to be correct than those for GDP. But does it make economic sense for an economy to invest 44 per cent of GDP and yet grow at only 5 per cent? No. These data suggest ultra-low, if not, negative marginal returns. If so, investment could fall sharply. That might not lower potential growth, provided wasteful investment were cut first. But it would cause a collapse in demand. Everything the Chinese authorities have been doing suggests they are worried about just that.

This worry about deficient aggregate demand is not new. It has been a big concern ever since the west’s financial crisis, which devastated demand for China’s exports. This is why China then embarked on its own credit-fuelled investment boom. Remarkably (and worryingly), the share of investment in GDP rose just as the growth of potential output declined. That was not a sustainable combination in the longer term.

 6. Back to that global savings glut – Wolf goes on to make some ominous comments about China’s ability to achieve three things at once.

This now leaves the Chinese authorities with three huge economic headaches. The first is cleaning up the legacy of past financial excesses while avoiding a financial crisis. The second is reshaping the economy, so that it is more dependent on private and public consumption and less dependent on extraordinarily high levels of investment. The third is achieving all that while sustaining dynamic growth of aggregate demand.

Recent events matter because they suggest the Chinese authorities have not yet worked out a way of pulling this triple combination off. Worse, the expedients they have tried over the past seven years have made the predicament even worse. Maybe, Mr Market has grasped how difficult this is going to be and so how destabilising some of the options the Chinese might choose actually are. These include devaluation, ultra-low interest rates and even quantitative easing. If this is the case, the market turmoil might not be foolish. The global savings glut can get worse. That would affect everybody.

7. China’s overnight ‘shock and awe’ – Ambrose Evans Pritchard has a look at last night’s RRR cut in China, which frees up banks there to pump another US$101 billion of loans into the economy. You’d have to wonder how committed China is to rebalancing away from infrastructure if it does this sort of thing.

Wei Yao from Societe Generale said the RRR cut was “absolutely necessary” to stop liquidity drying up and to reverse the passive tightening over recent weeks caused by capital outflows.

It may not be enough to add any net stimulus to the economy. “Liquidity conditions are still under immense pressure,” she said.

The PBOC has intervened heavily on the exchange markets to defend the yuan, drawing down reserves at a blistering pace. The unwanted side-effect is to tighten monetary policy. It is a textbook case of why it can be so difficult for a country to deploy foreign reserves – however large on paper – in a recessionary downturn.

The great unknown is exactly how much money has been leaving the country since the PBOC stunned markets by ditching its dollar exchange peg on August 11, and in doing so set off a global crash.

8. Has globalisation peaked? – The FT reports figures from the World Trade Monitor are causing some people to wonder if global trade has peaked.

World trade recorded its biggest contraction since the financial crisis in the first half of this year, according to figures that will fuel a debate over whether globalisation has peaked.

The volume of global trade fell 0.5 per cent in the three months to June compared with the first quarter, the Netherlands Bureau for Economic Policy Analysis, keepers of the World Trade Monitor, said on Tuesday.

Those numbers built on what has been a grim pattern for global trade in recent years and the unwinding of a decades-old rule that saw trade grow at twice the rate of the global economy as a result of what some have called hyperglobalisation.

In the three months to June, global trade grew just 1.1 per cent from the same quarter of 2014, according to the new Dutch figures. The International Monetary Fund expects the global economy to grow 3.5 per cent this year.

Much of this year’s slowdown in global trade has been due to a halting recovery in Europe as well as a slowing economy in China, Mr Koopman said.

The global economy’s “growth engine” had been operating as if it had a mechanical fault for some time with “good growth in some countries offset by weak growth in others”.

But there is also clearly a structural shift happening in the global economy, he said, and that means slowing global trade is likely to endure for some time.

9. Totally John Oliver because he’s usually funny.

10. Totally Clarke and Dawe on Quantitative Easing. For old time’s sake.