Category Archives: Economics

Productivity Therapy

The IMF has sponsored another paper from staffers on the global productivity slowdown, with the catchy title “Gone with the Headwinds”. The paper reiterates many of the arguments concerning advanced economies referenced in this post, such as total factor productivity (TFP) hysteresis due to the boom-bust financial cycle and resulting capital misallocation, “an adverse feedback loop of weak aggregate demand, investment, and capital-embodied technological change”, elevated economic and policy uncertainty.

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Also cited are structural headwinds including a waning information and communication technology (ICT) boom, an aging workforce, slower human capital accumulation, and slowing global trade integration (including the maturing of China’s integration into world trade). An exhibit on the ICT trends from the report is reproduced below.

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The report highlights short term remedies such as boosting private sector demand, efficient spending on infrastructure, strengthening balance sheets, and reducing economic policy uncertainty. Longer term remedies cited include policies to boost technological progress, policies to mitigate the effects of aging, policies to encourage migration, advancing an open global trade system, exploiting policy synergies, structural reforms, raising the quantity and quality of human capital.

Now, how many of these remedies are likely to be pursued in the current populist political environment? Although Trump has shown signs recently of doing the opposite to what he fought the election on, overall it does look like we are merrily going down a policy dead-end for the next few years in important advanced economies. Hopefully the policy dead-end will be principally confined to the US and they wouldn’t take too long in figuring out the silliness of the current journey and the need to get back to trying to deal with the big issues intelligently. Then again….

Crimping CDS

The post-crisis CDS market has undergone significant regulatory change including a substantial regulatory overhaul due to the Volcker Rule, requirements from reporting to central clearing under the Dodd–Frank Act and the European Markets Infrastructure Regulation (EMIR), and Basel III capital and liquidity regulations. Measuring the size of the market consistently is notorious difficult given different accounting treatments, netting protocols, collateral requirements, and legal enforceability standards. Many organisations have been publishing data on the market (my source is the BIS for this post) but consistency has been an issue. Although a deeply flawed metric (due to some of the reasons just highlighted and then some), the graph below on the nominal size of the CDS market (which updates this post) illustrates the point on recent trends.

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The gross market value (defined by BIS as the sum of the absolute values of all open contracts with either positive or negative replacement values) and the net market value (which includes counterparty netting) are better metrics and indicate the real CDS exposure is a small fraction of the nominal market size, as per the graph below.

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Critics of the regulatory impact on the liquidity of the CDS market argue that these instruments are a vital tool in the credit markets for hedging positions, allowing investors to efficiently express investment positions and facilitating price discovery. A major issue for liquidity in the market is the capital constraints imposed by regulators which impedes the ability of financial institutions to engage in market-making. The withdrawal of Deutsche Bank from the CDS market was seen as a major blow despite some asset managers and hedge funds stepping up to the mark.

The impact of rising interest rates in the coming years on the credit markets will likely have some interesting, and potentially unforeseen, consequences. With a plethora of Goldman Sachs alumni currently working on Trump’s “very major hair cut on Dodd-Frank”, amongst other regulations, it will be interesting to see if any amendments lead to a shot in the arm for the CDS market. Jamie Dimon, in his most recent shareholder letter, calls for an approach by Trumps’ lieutenants “to open up the rulebook in the light of day and rework the rules and regulations that don’t work well or are unnecessary”.

Age of Change

As if we all needed proof that the people across the so called developed world are troubled about the future, the election of Donald Trump to the US presidency last Tuesday is still a shock and unfolded in a spookingly familiar manner to the Brexit vote. “Wrong!” as Alec Baldwin has so aptly mimicked could be the call to the pollsters and commentators who are now scratching around despondently for reasons.

Why, we again ask, could an electorate so recklessly vote against conventional wisdom. I think the answer is in the question. Although the factors behind Trump’s vote are multi-faceted and reflect a bizarre coalition that will be impossible to satisfy, the over-riding factor has to lie at the door of an electorate that is troubled by future prospects and rejects the status quo. Why else would they vote for a man that polls suggests a majority acknowledge as been unqualified for the job? Aspects such as the worry of aging baby boomers at the diminishing returns on savings, the insecurity of the middle and working classes over globalisation, and the realisation that the technology from the shared economy is a cover for unsecure low wage employment have all contributed. Like in the Brexit vote, Trump tapped into a nostalgia for times past as an easy answer to the complex questions facing the world we live in.

The age profile of the Brexiteers in the UK and Trump voters in the US is interesting in that it highlights that Trump’s surprise victory is slightly less of a factor of age than Brexit.

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Aging demographics in the developed world has been highlighted by many as a contributor to the current low growth. I last posted on this topic before here and the graph below is a reminder of one of the current predictions by the UN.

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The impacts of aging on future dependency ratios can be seen below, again from UN predictions.

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A fascinating report from the research department of the FED last month, entitled “Understanding the New Normal: The Role of Demographics”, argues that demographic factors alone in the US account for 1.25% decline in the nature rate of interest and real GDP growth since 1980. The report concludes that “looking forward, the model suggests that low interest rates, low output growth, and low investment rates are here to stay, suggesting that the U.S. economy has entered a new normal”.

There was an interesting article recently in the FT called “The effects of aging” which included the graph below from UBS which strikingly highlights the changes in demographic trends and financial crises.

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Whatever disparate concoction of economic policies that Trump will follow in an attempt to tap the ghost of Reaganomics, it is clear that lower taxes and increased US debt will be feature. Trump may surprise everyone and use debt wisely to increase productivity on items such as rebuilding infrastructure, although it’s more likely to go on wasteful expenditure to satisfy his motley crew of constituents (eh hello, a Mexico wall!).

I constructed an index to show the relative level of debt dependency of countries using the 2020 debt level predicted by the IMF and the average 2020 to 2050 dependency ratios by the UN. Both the US and the UK are above the average based upon current forecasts and really can’t afford any debt laden policy cul-de-sacs. One only has to look at Japan for enlightenment in that direction. We have to hope that policies pursued by politicians in the US and the UK in their attempt to bring back the past over the next few years don’t result in unsustainable debt levels. Maybe inflation, some are calling the outcome of Trump’s likely policies trumpflation, will inflate debts away!

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In his recent book, “A banquet of consequences”, Satyajit Das articulated the choice we have in terms of a choice of two bad options by using the metaphor of the ancient  mythical sea monsters, Scylla and Charybdis, who terrorised sailors. Das said “Today, the world is trapped between Scylla, existing policies that promise stagnation and slow decline, and Charybdis, decisive action that leads to an immediate loss in living standards.

The character of Charybdis is said to be the personification of a whirlwind. Remind you of anyone….?

One Direction

Goldman Sachs says “we have more potential for shocks right now”. Deutsche Bank and Bank of America Merrill Lynch predict a pick-up in volatility to hit equities. The ever positive Albert Edwards of Socgen points to a recent IMF report on debt and trashes the Fed with the quip “these dudes will never identify an asset bubble at least before the event!

In the IMF report referenced above, and other reports published by the IMF this month, there is some interesting analysis and a sample of the accompanying graphs are reproduced below.

All of these graphs show trends going inexorably in one direction. Add in dollops of (not unrelated) political risk particularly in the UK and across Europe, and that direction looks like trouble ahead.

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Restrict the Renters?

It is no surprise that the populist revolt against globalisation in many developed countries is causing concern amongst the so called elite. The philosophy of the Economist magazine is based upon its founder’s opposition to the protectionist Corn Laws in 1843. It is therefore predictable that they would mount a strong argument for the benefits of free trade in their latest addition, citing multiple research sources. The Economist concludes that “a three pronged agenda of demand management, active labour-market policies and boosting competition would go a long way to tackling the problems that are unfairly laid at the door of globalisation”.

One of the studies referenced in the Economist articles which catch my eye is that by Jason Furman of the Council of Economic Advisors in the US. The graph below from Furman’s report shows the growth in return on invested capital (excluding goodwill)  of US publically quoted firms and the stunning divergence of those in the top 75th and 90th percentiles.

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These top firms, primarily in the technology sector, have increased their return on invested capital (ROIC) from 3 times the median in the 1990s to 8 times today, dramatically demonstrating their ability to generate economic rent in the digitized world we now live in.

Furman’s report includes the following paragraph:

“Traditionally, price fixing and collusion could be detected in the communications between businesses. The task of detecting undesirable price behaviour becomes more difficult with the use of increasingly complex algorithms for setting prices. This type of algorithmic price setting can lead to undesirable price behaviour, sometimes even unintentionally. The use of advanced machine learning algorithms to set prices and adapt product functionality would further increase opacity. Competition policy in the digital age brings with it new challenges for policymakers.”

IT firms have the highest operating margins of any sector in the S&P500, as can be seen below.

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And the increasing size of these technology firms have contributed materially to the increase in the overall operating margin of the S&P500, as can also be seen below. These expanding margins are a big factor in the rise of the equity market since 2009.

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It is somewhat ironic that one of the actions which may be needed to show the benefits of free trade and globalisation to citizens in the developed world is coherent policies to restrict the power of economic rent generating technology giants so prevalent in our world today…