August 2017

The political scene in the United States continues to confuse. In the US Trump has fulfilled one’s worst fears – in December one could give him the benefit of the doubt; in February I commented he was a maverick; in March I thought there was still a possibility that if he could learn to distinguish between the trivial and the important and resist starting skirmishes with everyone in Washington, some legislation could be brought forward. This hope has proved forlorn. It is clear that the US administration has been ground to a halt and the only chance that some vitally necessary tax reforms could take place rests on the Republicans in Congress and the Senate getting together to draft legislation before the midterm elections next year. Without some move forward in this area after the holidays, an unpleasant change of attitude towards the markets could develop.

The market is on the high side by historic standards, buoyed by the optimism of tax reform and improved apparent earnings. The earnings improvement, however, is in many areas suspect. Low interest rates and the availability of large amounts of debt finance is causing a build-up in the misallocation of capital. There are many complex mechanisms here, however the simplest, promulgated by bankers and private equity funds, is borrowing to buy stock. This gives apparent improvement in accounting earnings, but in reality usually reduces the actual return on capital employed, the real measure of a company’s long term management effectiveness.

The knotty problem of quantitative easing that has encouraged the financial engineering in the American market has also had distorting effects on the European economies. The Fed is working hard to flag “a return to normality”, i.e., an increase in interest rates. The ECB is beginning to make the same sort of noises, albeit in a halfhearted fashion, but the Bank of England governor seems to be adrift. Thecomplacency in the institutional markets has reached an extraordinary level. The long term decline in interest rates combined with QE have created a group-think that seems to have suspended intelligent analysis. It is inconceivable that the downward trend will not at some point reverse, particularly as interest rates in general cannot go negative.

The Fed has started to raise interest rates and has so far been successful in reversing the trend without alarming the market. To use an analogy, the point at which the tide turns is difficult to see, , but at the moment the QE generated liquidity in the market is keeping general interest rates flat. It can only be hoped that the trend reversal will be manageable but there are many warning signs that there are excessive debt build ups in the economy across the western world- even the rating agencies are beginning to flag danger signals in the areas of consumer related debt. The BIS flagged a warning

Financial markets aside, the world’s political stability is being undermined by Trump’s lack of historical understanding. The visit to the Middle East fanned the flames of instability by seemingly agreeing with the prejudices of the leaders of each State he visited; his visit to Europe also left a trail of confusion and conflicting messages. Most dangerous of all is his inconsistent and confusing approaches to the leaders of China and Russia, which serves to push them into each other’s arms as they face the Maverick President.

On a more parochial front, it seems that the Brexit negotiations move from posture to pragmatism. Monsieur Bernier’s original stance of cash before negotiation and no cherry picking, and May’s, no deal is better than a bad deal, both implied a so-called Hard Brexit. Today compromise noises are coming out of both camps, including a realisation that there will probably be interim agreements, enabling the normal movement of goods and people to continue. The movement of people across borders is exceedingly simple to manage and only requires a few rules. The movement of goods and services on the other hand is vastly complicated today and little understood at the level of government negotiators. A small bureaucratic shambles of documentation and rules could bring trade across the Channel to a juddering halt, bringing large swathes of the economy, both in Britain and on the Continent, to a standstill. Customs officials, not known for their pragmatism, would simply cause borders to shut if faced with confusion in documentation. From a wider perspective, any trade deal will eventually have to be agreed by all twenty-seven members of the EU, an extraordinarily unlikely proposition, leaving interim agreements as the only way forward.

back in June and the Bank of England managed to make a statement of the blindingly obvious – “very low long term interest rates make assets vulnerable to a re-pricing”. The structured debt instruments of a decade ago have reappeared in the financial markets and are rising rapidly in the mortgage area as well. Debt instruments of all  kinds, from government to car finance are mopped up by a desperate savings industry who need yield to fulfil their obligations. From pension funds to insurance companies, encouraged by regulation, there is overexposure to loans and debt of all kinds. The regulators, since the last crisis, have encouraged this and also rules about valuing debt have been introduced that mean that debt instruments have to be “mark to market”. This rule ignores the fact that there may be no market for certain instruments and is in conflict with a common assumption that bonds are safe as money is returned at maturity. The problem here is that, on a quarterly basis, should interest rates rise and a bond portfolio has to be mark to market, it will go down in value, i.e. it is liable to cause investors to sell, regardless of whether a footnote says ‘don’t worry if you hold it to maturity you will get all your money back’. Bond sales at this point are highly likely to cause markets to further decline, something which as liquidity disappears could precipitate a rapid and uncontrollable rise in interest rates. To quote the great philosopher, Mark Twain. ‘History may not repeat itself, but it often rhymes!’

 
While I have outlined many confusing issues, the world economy in general is chugging along nicely in spite of everything. People and businesses are getting on with running their affairs and the steady, albeit slow, growth of the last five or six years is good news. There are, however, capacity constraints appearing in raw materials, machinery and electronic components. Wages will also start to rise as labour shortages appear. This combined with an increase in raw material prices, including oil, will start to bring on inflation – the misguided desire of Central Bankers.
Damon de Laszlo
1st August 2017