Pari Passu

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Jefferson V. DeAngelis

Jefferson V. DeAngelis

Pari Passu

June 24, 2019

The ongoing trade war between China and the United States is exposing their opposing worldviews. The Chinese government prefers to control production whereas the US authorities find it easier to promote demand. Increasingly though, these differences are blurring, and striking similarities are emerging as both governments attempt to avoid a serious recession. Both are vulnerable to the high levels of debt that they have incurred to avoid a downturn. They are finding fiscal and monetary stimulus programs increasingly less effective as debt levels increase. Easier credit conditions in China have exposed speculators to the risk of a residential real estate collapse, and Chinese banks are laden with the non-performing loans of a failed state-owned enterprise system. Meanwhile, in the U.S., the unconventional monetary policies of the Federal Reserve have forced interest rates lower to levels where the liabilities of pension funds and insurance companies are unlikely to be met. The recent changes to corporate tax rates, intended to stimulate investment and jobs, were diverted to stock buybacks and leveraged balance sheets.

While the Chinese have gradually moved to a more free-market response as growth has slowed., the U.S. is relying more on central planning. Of course, the Chinese still prefer state ownership while the U.S. respects property rights. Neither can afford to let economic growth contract or deflation to occur, and as such, both governments are open to any policy that averts the political reality of failure.

In this light, a burgeoning trade war is self-defeating. Tit-for-tat tariffs expose their respective vulnerabilities. The Chinese economy, still dependent on its export markets, will suffer a poorly timed contraction in its employment growth. The U.S. will experience higher prices for imported goods and potentially a reduced standard of living. Further escalation of the trade war means both will lose to varying degrees.

The Keynesian mechanism of countercyclical policy has given way to a system of condition response. The tools used by governments to cushion the pain of the economic cycle are being used to avoid the downside altogether. As a result, the potential opportunity set created from the transference of risk never occurs. The upside also becomes muted. The prolonged economic cycle experienced since the financial crisis has been subpar while the performance of financial assets has been spectacular. In the U.S., we have identified that if we lower the discount rate we can increase the valuation of most financial assets. Yet, understanding the how is not quite like understanding the why.

Historically periods of market-driven, low-interest rates have been associated with depressed economic environments. Only in the recent period of central bank manipulation does it make sense to speculate on the outperformance of financial assets to economic performance. Ultimately, there must be a convergence between the valuation of financial assets and economic activity. Despite efforts by the Bank of Japan to perform the same trick, Japan has been in a 20-year period of economic recession, zero interest rates and lagging stock performance. Europe may have recently entered a similar fate despite Mario Draghi’s 2011 promise to be all in. In fact, he may be all out of options. The U.S. and China remain the outliers, for now.

The trade war will no doubt force the Chinese to get serious about stimulus. Their system has the advantage of central power and control, with President Xi holding the ultimate authority. Doubt remains, however, over how much credit conditions can improve given the heavy burden of China’s banking and shadow banking system. Nevertheless, the Chinese government have at its disposal many resources. They are most likely to weaponize their currency as a tool to maintain competitiveness.

The U.S., as President Trump is so quick to tweet, has a slight arithmetic advantage by its nature in any trade dispute with China as well as has a sounder financial system and enjoys reserve currency status. Unlike his counterpart in Beijing, Trump does not have the ultimate control of all the policy levers. Chairman Powell will choose the path of short-term interest rates, the magnitude of his balance sheet and maybe even the shape of the yield curve. But even the Chairman of the Federal Reserve is less powerful given the rapid rise in our own shadow banking system.  Today, corporate balance sheets and investor risk profiles are more vulnerable than they were prior to the financial crisis.

The world cannot bear higher interest rates. Chairman Powell’s admission of an asymmetric policy did not surprise investors, who had already factored interest cuts into yield curve expectations. Shocking, however, is the fact that a short-term interest rate of three percent may represent the peak of this economic cycle. Central planning may be more constrained than we think. Interest rates may be lower for longer not because central banks want them there but because markets put them there.

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2019-06-24T10:52:24+00:00 By |