DB's Jim Reid lays out the "endgame" scenario, one which this website first said is inevitable back in 2009. With Citi and Macquarie already on board, expect what was once merely the figment of a "deranged tinfoil conspiracy-theory blog's" imagination, to become global monetary policy. And yes, the real endgame is the one we have said from day one: total fiat (and conventional economics) collapse.
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From Deutsche Bank's chief credit strateigst
Our thesis over the last few years has basically been that the global financial system/economic fundamentals are so bad that its good for financial assets given it forces central banks into extraordinary stimulus and for them to continue to buy assets in never before seen volumes. The system failed in 2008/09 and rather than allow a proper creative destruction cleansing, policy makers have been aggressively propping it up ever since. This has surely led to a large level of inefficiency in the system which helps explain weak post crisis growth and thus forces them to do even more thus supporting asset prices if not the global economy.
However since the summer this theory has been severely tested by China's equity bubble bursting, China's small 'shock' devaluation and the start of a rundown in reserves for the first time in over a decade. We've also seen associated commodities and EM woes, endless unsettling speculation about the Fed's next move and more recently the idiosyncratic corporate scandal around VW and funding concerns around Glencore. The hits keep on coming. Is it now so bad it’s actually bad again?
The most recent leg of the sell-off begun after the Fed held rates steady two weeks ago as the narrative focused on either this reflecting worrying economic concerns or a Fed that is a slave to financial markets and losing credibility. So do we think we're now entering a period where central banks are increasingly impotent? The answer is that they have been for a while on growth so not much has changed. However they can still buy more assets and continue to keep policy loose. Although we don't think QE and zero interest rates does much apart from prop up an inefficient financial system it’s all we've got until we have a huge policy sea change which probably only happens in the next recession (more later).
So for now we think central banks are trapped into continuing on the same high liquidity path. The BoJ and the ECB are likely to do more QE in my opinion and the Fed is going to have a real struggle raising rates this year which has been our long-term view. Indeed we have sympathy with DB's Dominic Konstam that they may also struggle in 2016. At the moment central banks are fortunate that they have the conditions to do more as virtually all are failing on their mandate to keep inflation close to or at 2%. The real problem would be if inflation was consistently looking like breaching 2%. Then central banks would generally be going beyond their mandate by printing money and keeping rates close to zero. So in short the 'plate spinning' era continues for a number of quarters yet and certainly while inflation is so low.
We think the end game is that when the next global recession hits, then QE/zero rate world will be re-appraised. Perhaps the G20 will get together and decide to try a different approach. In our 2013 long-term study we speculated how we thought the end game was 'helicopter money' - ie money printing to finance economic objectives (tax cuts, infrastructure etc). While it has obvious flaws and huge risks (eg political manipulation and inflation), one can argue it will always have more economic impact than QE in its current form. However that's perhaps a couple of years away still.
For now, a lot depends on whether the turmoil accelerates the next recession quicker than we think. If 2016 is a recessionary year for the US and the global economy with China growing notably south of 6% then risk assets will fall significantly further. However if the global economy stumbles on in positive territory then risk assets will likely recover, especially if the ECB and BoJ do more and the Fed continues to hold or as a minimum reduces the dots a fair degree on any small hike. That's our base case for the moment and fortunately our main asset class - namely credit - is starting to get to levels where we have only been wider during recessions or during the existential Euro crisis of 2011/12. So the risk reward looks decent. VW and Glencore have sucked Euro IG into the problems that US credit has been dealing with all year but I'm not sure they're symptomatic of a wider DM corporate governance issue in the VW case or a precursor for similar funding concerns elsewhere in the case of Glencore.
Yes we've moved into a higher volatility world. To be fair we thought this would be the case ever since the Fed stopped QE 12 months ago. This marked the point where there was a bit more two way central bank tension. The ECB and BoJ haven't been able to completely offset it. However higher vol usually brings better entry levels and therefore it isn't necessarily a bad thing when investing new money. Obviously it would have been better to have been more defensive this year which we regret but one has to regroup and look at things as they stand now.
For Q4, the seasonals start to look better. Experience tells you that if there is going to be a scare then August and September seem to be the months these scares get amplified. By mid October markets often enjoy a better run into YE and into the start of the new year. While it seems crazy to base one's entire investment strategy on the calendar it’s not usually wise to go against seasonals. China's data is probably the key macro factor though. If the data stabilises as our own economist Zhiwei Zhang thinks (he was more bearish than consensus in H1 but thinks stimulus will now kick in) then the market's nerves will calm and vol will fall. If he's wrong then we may have to consider a worst global growth outcome for 2016 and recession risks that mount. So a lot depends on China into YE. Given its opaque nature one can see why there is concern and confusion and whilst we're medium-term bears on China's economic sustainability we think for now they have ammunition to manage the economy - albeit one that is increasingly inefficient and propped up like many others around the world.
In short it’s a highly inefficient global economy and financial system absent the arguably necessary creative destruction post the GFC. However for now we still think we're in the highly accommodative central bank 'plate spinning' era and think assets will respond more positively in Q4.
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Because doing more of the same that has already failed, is all that's left. And, let's not forget, there's always this...