As excerpted from the latest letter by Eric Peters, CIO of One River Asset Management
Late and Awkward: “The March 2020 downturn resembled a natural disaster rather than a recession that cleansed imbalances,” said Marcel, our head of research, discussing economic cycles. “This was most evident in the goods sector. The global PMI survey fell from 50.3 in Jan 2020 to 39.6 in April, then fully recovered by July. It is equally evident in the finer details of today’s global good sector. US delivery times are currently equivalent to the period of the 1970s oil embargo. The supply-side of the economy is constrained and pushing on demand will merely crowd it out with higher prices. This is the root of an inflationary impulse.”
The High Debt Dance: “It is worth reflecting on the stylized facts of high debt countries,” continued Marcel. “Living standards go down in phases of high government debt. Per capita GDP declines 0.3% per annum on average. The path to then normalize government debt has two distinct regimes":
- Orthodoxy – a long period of moderate primary surpluses with moderate inflation (Belgium 1993, Canada 1995), and
- Inflationary – disregard of fiscal, proactive inflationary pursuit (Germany 1918).
"The important point is that moderate inflation outcomes always coincide with taut fiscal policy. And we are not there now. Not even close.”
Monetary/Fiscal Interaction: “The way forward will almost surely include macro prudential policies to regulate credit,” explained Marcel. “We are seeing this in New Zealand, where home prices are now mandated as part of price stability. The US historic example is a useful marker. Post WWII, the Federal Reserve was responsible for intervening to buy bonds if prices fell below par. This capped nominal interest rates, with the T-Bill at 0.375% and the long-term bond at 2.50%. Regulation Q capped rates on various types of bank deposits that, in turn, constrained banking competition and private credit activity. These are the types of policies that can emerge in conjunction with extraordinary Fed accommodation.”
Exchange Rates: “Given widespread concern about competitive devaluations, the overriding objective of postwar US exchange rate policy was the maintenance of a fixed par value of the dollar as established by the Bretton Woods agreement,” said Marcel, continuing to provide historical context for what is unfolding today to help us position portfolios for tomorrow. “Moreover, given that there were relatively few revaluations or devaluations of foreign currencies against gold, the overall system ensured fairly stable exchange rates during that high-debt postwar episode.”
Balance of Payments: “There were few external imbalances in those historic periods, which is very different from today,” he said. “Thus, external imbalances are rarely part of today’s conversation on inflation dynamics as there are no historic norms to rely upon. Consider the US balance of payments (BOP) in the 1960s: gross trade and financial flows were 11% of GDP. Gold was the nominal anchor. The USD was too rich, a BOP deficit emerged, a drawdown of gold followed (it was transferred to foreigners), which pressured for policy orthodoxy. The net financial balance to be closed was just 0.5% of GDP in 1960 – tiny. Today, trade and financial flows are 40% of GDP (nearly 4x the 1960s level). The nominal anchor today is no longer gold, but rather US policy credibility.”
Moving Off the Gold Standard: “Policy makers were aware that the end of the US dollar tether to gold would threaten reserve status. The ‘substitution account’ is something that was considered by the IMF and the NY Fed and would have allowed a controlled reserve diversification into a basket of currencies, thereby preventing USD fire sales. It was not needed for two reasons. First, the US brokered the beginning of petrodollars in 1974. Second, policy moved rapidly to orthodoxy with rapid rate hikes in the early 1980s.”
Orthodoxy and EM: “US policy orthodoxy reinforced the central role of the US dollar through the emerging market debt strains that followed. The Latin American debt crisis in the early 1980s saw an increase in USD debt to $327bln in 1982 from $29bln in 1978. The Asia crisis that began in the Summer of 1997 yielded a similar outcome for different reasons. The successive crises terrified emerging market governments and they responded by accumulating an unprecedented quantity of US dollar reserve assets. It was a golden period for the US and the dollar. Large and growing external imbalances didn’t matter.”
Unprecedented US External Imbalance: “This sets the table for a very different external position today. The US net international liability is 65% of GDP and rising. It was less than 10% of GDP in 2007. It was a surplus in the early 1970s when the world fretted about the US dollar standing as a reserve currency. There are two broad ways to cleanse today’s imbalance – fiscal/monetary orthodoxy with a very deep domestic recession or inflation to revalue assets and devalue liabilities. This is precisely why there is scant domestic focus on today’s imbalances – a weaker dollar is the cure, and scares nobody. It is the foreigners who are growing nervous."
Blind Spots: “I focus on balance sheet imbalances precisely because the setup we observe today has no good precedent and is therefore absent from the data sets that most investors rely upon when considering the future,” said Marcel, tying it all together. “There are interconnected domestic policy and political choices that will be made as the global system is increasingly drawn toward a rebalance. But it is not just foreign official reserve managers who are nervous players in this game – private foreign portfolio managers have large US equity holdings and have ‘hot money’ characteristics. And this set up produces an inherent non-linear, reflexive dynamic with a range of possible market outcomes that reside well beyond consensus expectations.”