Countering the Global Liquidity Crunch
The Expert View
Featuring Michael Howell
Published on: August 22nd, 2019 • Duration: 26 minutesMichael Howell, founder and managing director of Crossborder Capital, joins Real Vision to talk about his views on global liquidity and capital flows. He says that the global economy is sputtering, and that central banks will have to reengage in quantitative easing in order to inject liquidity into markets. Howell argues that this will ultimately lead to rallies in equities, gold, bonds and bitcoin. Filmed on August 7, 2019 in London.
MICHAEL HOWELL: The world's financial system is no longer a new money raising system. It's effectively a refinancing mechanism. And if it's a refinancing mechanism, what you need is balance sheet, in other words, size. You're not too worried about the level of interest rates.
There'll be a lot of pressure being put on the Federal Reserve now to try and cap any dollar appreciation by printing money.
So effectively, we're in a currency war, but the gold price comes out of this magnificently. And cryptocurrencies, which are pure liquidity play, should do extremely well.
I'm Mike Howell. I'm Managing Director of Crossborder Capital. We're a fund management and research company based in London. My background prior to that was that I was at Salomon Brothers involved in research. And what we focus on almost entirely is global liquidity and capital flows worldwide.
What's your macro thesis?
We think that the world economy is clearly stuttering. It needs a boost. Central banks have been behind the curve. They've basically been tightening too much collectively over the last few months. And what they're going to have to do is to embark on a major easing program. In other words, another QE. That is very bullish for gold. And it's pretty bullish for cryptocurrencies, too.
Can you explain the context of China's slowdown?
Yeah, I think one has to go back actually quite a long time or one's going to look at what happened to China starting in 2001, when China was allowed into the world trade organization. As a result of that China built up a huge trade surplus over time. It developed Chinese economy. China became very, very export-driven. And the US accommodated China, accommodated Germany too. But effectively, China was being accommodated by the US trade deficit.
America is now saying enough is enough. They're no longer prepared to accommodate these big deficit diet China surplus. And this is the background to the tariff dispute. China was reacting to that. America imposed 10% tariffs, I believe, on the 17th of September, within five days, China went and started to tighten monetary policy. Through October, China hit the monetary base very, very hard and curtailed liquidity injections into Chinese money markets. We've seen the biggest slump in liquidity in these Chinese money markets that we've seen for five years probably, and effectively, that is slowing the economy hard.
Now, if you look at the backdrop, not only is Chinese manufacturing slowing down significantly in the Chinese economy, but China dominates global value chains, in other words, supply chains globally. And as China has slowed down, world exports have also shrunk. And that has hit manufacturing companies worldwide, but particularly in those locations that are involved in these supply chains. In other words, Japan, Taiwan, Korea, and Germany. And those markets have been among the hardest hit through the slowdown. America and service industry generally have come out of this relatively unscathed.
What are market crevasses?
We've described the market outlook, in other words, the stock market outlook as a market which is generally rising, but there is risk of very sharp selloff, so what we call crevasses. To protect against that, what you need in portfolios is effectively more bond convexity. Now, what's the reason that you're getting these major selloffs? The major reason really goes back to the restructuring of the global financial system, really in the wake of the GFC, the Global Financial Crisis in 2008.
We know there's a big buildup of debt, but debt needs to be refinanced. And the way to think about this is that the world financial system is no longer a new money raising system. It's effectively a refinancing mechanism. And if it's a refinancing mechanism, what you need is balance sheet. In other words, size. You're not too worried about the level of interest rates. So, the focus that the markets have and the media has on interest rate cuts, we think are broadly meaningless. What you need to understand is the volume of liquidity markets. In other words, balance sheet size, and in particular, if the private sector is not coming up with balance sheet with central bank balance sheet.
Now, the key issue with the private sector, which is what makes the whole system a lot more fragile, and contributes to these crevasses is essentially that there was a shortage of safe assets in the system. Now, what do we mean by this? Safe assets are basically high quality bonds, particularly Treasuries, particularly US Treasuries, but to some extent, corporate securities have crept into that collateral mix. And the reason they crept in is there are insufficient Treasuries in the system to provide collateral.
Most lending now is collateral-based. And the reason for that is that what you have is some very, very big new players in the markets, which we call corporate institutional cash pools that basically come out of foreign exchange reserve managers in Asia, or they come out of US corporates that are running major Treasury piles of cash. And what they need are safe short-term assets to invest in in the money markets. And effectively, what's happening is that the bonds are being repoed and sold back to the CICPs, and that is the mechanism of refinancing.
That works very well until you started collateral problems. And collateral problems can occur if you get an economic slowdown, for example, and the value of the corporate slice of that collateral tranche comes under pressure. And then the whole liquidity mechanism collapses. That's what we've seen a number of times. We saw it clearly in 2008 with mortgage backed securities. We saw it again briefly in 2018 in December when markets sold off.
And what's happened every time is the central banks have come in, particularly the Federal Reserve. And that's what happened through December and January. And this is the basis for changing central bank policy now. They're beginning to realize that behind the curve, liquidity has been way, way too tight. And now, what you're seeing is central banks beginning to ease but the leader is the People's Bank of China.
How tight are the central banks?
One of the ways that you can gauge the tightness of the US system is to compare Fed Funds Rate, which everybody knows, with the term premia, which is a slightly wonkish concept, but it's the premium that investors prepared to pay for long-term debt, long-term Treasury debt in the US, compare that to the Fed Funds Rate. Normally, the two move extremely closely together. But effectively in the last two years, term premia have collapsed relative to Fed Funds. The collapse in term premier is equivalent to a significant or it implies a significant monetary tightening. And that monetary tightening could be equivalent, on our estimates, to a Fed Funds Rate which looks at around about 5% points. So way, way above reported levels.
Has China changed its policy to re-ignite stimulus?
We think China has changed policy. And we think that the decisive move was around mid-May. Now, the geopolitical background of that time was right across the Chinese media, there are reports from Xi Jinping of three red lines that the Chinese put down that say they would no longer negotiate on these three aspects of the trade dispute with America. And those red lines meant that America effectively had to now yield, China wouldn't yield. And they're not going to go back on this because it would be a huge loss of face. In other words, this seems to be a very significant watershed in the whole trade tariff dispute.
What China did at the same time was to start to inject liquidity back into their money markets. Effectively, what they're saying is, we are ignoring trade. We are starting to stimulate the domestic economy. And we don't really care if the yuan now devalues. The reality is here with us now because the yuan has broken 7 against the US dollar. The magic 7 number.
China reside to plow money back through the money markets, liquidity injections by the People's Bank that has persisted through May, June, July and into August, and then they're backing that up with other measures of fiscal stimulus infrastructure programs and a lot more is likely in the pipeline.
How targeted is China's stimulus?
It is more targeted. It's looking much more at infrastructure programs as far as one can tell at the moment. It's been given certainly to the state-owned banks, and they'll be generally at more into state-owned enterprise. Now, I want to stress here that this is not a first best solution. This is the second best solution. China cannot continue to keep getting growth through debt. We know that. But in the short term, this is the reality that is happening.
The Chinese economy needs to get between 6% and 6.5% growth a year. China has estimated that the trade dispute could cost it 1.5% points in GDP every year that this persists. It pushed the growth rate significantly below their targeted rate. And therefore, they need to rebalance to get the growth rate up. And hence the stimulus.
Other central banks will follow the Chinese lead simply because of China's importance in the world economy and the importance of the yuan in terms of a currency within these global value chains. Essentially, what you're seeing at the moment is as China has devalued and started to push in more liquidity, you've seen devaluations generally of companion currencies or peer currencies against the US dollar. Other countries that are experiencing fallout from the slowdown in China will want to try and boost their economies.
And so we're starting to see an increasing debate in Asia and in Europe about easy monetary policy, already a lot of countries, for example, Australia, are already doing that. The Federal Reserve is starting to cut interest rates. But the most important thing that the Federal Reserve can do is to expand liquidity. And that's what it's doing.
Now the $64,000 question, which comes back to the dollar is will America allow the US currency to appreciate? In other words, to put it another way, other units to devalue again the US unit? And that with the answer that we think is no. In other words, there'll be a lot of pressure being put on the Federal Reserve now to try and cap any dollar appreciation by printing money. So effectively, we're in a currency war, and every currency, every economy is trying to leapfrog every other economy in terms of monetary ease.
Who wins out of that? Financial assets should generally do pretty well. But the gold price comes out of this magnificently. And cryptocurrencies, which are pure liquidity play should do extremely well.
Will we see another coordinated currency accord?
We call this Shanghai 2.0, which parallels the Shanghai Accord that occurred in early 2016 following the G20 meetings. After those meetings, the G20 countries agreed to stimulate their economies. And that broadly came through in terms of central bank balance sheet expansion, or what we call QE. That launched an equity rally. Equity markets rallied strongly through the back end of 2016, through 2017 and until they hit the hiatus in 2018.
This is happening again. It is not coordinated this time around, but it's coinciding. It's coinciding, because every country is now trying to react to the slowdown, which we say is China-induced by basically trying to stimulate their economies. And as each one tries to beggar thy neighbor, so to speak, you get a general lift in liquidity worldwide.
What will the Fed have to do?
There'll be a lot of pressure now for the US currency's rise, particularly if other countries are beginning to leapfrog the US in terms of monetary easing. Therefore, the US has to keep up. And we think the pressures will start to build on the Federal Reserve and the Treasury to try and maintain dollar parity at current levels. And that will mean more monetary stimulus coming through. So there'd be a lot of pressure on the Federal Reserve to do even more QE.
The point is against this ground, where generally central banks are easing, this is the environment where equity markets tend to do pretty well. The best time for investors in equities are when central banks are trying to stimulate economies that are very sluggish, such as now. There's a lot of competition now to see who needs the most. And unless the US matches other major economies, you're going to start to see the US dollar rise. And that's something that the administration clearly doesn't want, so they're putting a lot more pressure on the Federal Reserve to expand the QE programs.
In terms of what this will actually mean, we think there'll be a significant easing of policy. To try and put it into perspective, probably you're going to see the equivalent of 100 basis points of US rates that will be bullish certainly for the front end of the yield curve. It will mean that the yield curve likely steepens and there is a chance that long yields could come down as well. But generally in this environment, when central banks are trying to stimulate economies that are very sluggish, equity markets are the big winners.
Will monetary easing increase growth or just asset prices?
Can we grow away out of a slump with credit or debt alone? And the answer is probably not. But it does help to alleviate some of the symptoms. What you're likely to get is much stronger financial asset prices. In other words, if you look at equity markets, we can't expect very much from the E, but the P can expand probably quite significantly. And generally speaking, as far as we can see, well, the equity markets, while not being cheap, are comparatively inexpensive.
What the big danger for markets is, is if you get a major cracking liquidity as we saw previously in 2008. Now, we don't think that's on the cards, because basically central banks are now beginning to act. That's clearly something one has to watch very carefully.
Equity markets generally should do pretty well in this environment. And if we're correct, then what we're looking at is what we've termed a quick recession. In other words, investors prepare to look through the outside. What you could easily get is a rally in value with cyclical stocks which have clearly been under great pressure in the last 12 to 18 months. If you look worldwide, we think there is scope for Asia to rebound based on this China reflation trade. And there is scope for Europe to rebound based on what the ECB is likely to do. And in particular, when Christine Lagarde gets into the helm of the ECB, it is likely that there will be some significant easy moves there too.
I don't think there's any good price inflation in the system. We're in a secular disinflationary environment, which is being compounded by the fact that you've got long-term demographic problems. There simply is excess supply in the world economy. Therefore, if liquidity goes into the system, what you will get is further asset price inflation. And that's the name of the game.
There's a good chance that bond yields could go down. Now, this is a very dangerous trade. And I think that one has to say wholeheartedly that buying bonds on negative and very low yields, on what could only be a 2, 3 or 5-year view, is a crazy investment. But more and more investors are being browbeaten into doing it. And the reason being is that there is a shortage, a structural shortage of duration in the world economy, and particularly in the US system.
And what that means is that the duration of US pension liabilities is, for example, around 20 years, whereas the duration of the assets is around 10 years. Now, a lot of pension plans have been holding off, closing that duration gap, because they feel, they believe that bond yields already are too low. But there's a pain trade. And the lower the bond yields get, the more that those plan sponsors will begin to capitulate, and start to buy more bonds. And that's when you cook in a downside flip.
So there's a very clear asymmetry in the system, because investors will be browbeaten into buying bonds as the yields drop. So it's what he's called in the pound's negative convexity. And that could be a problem. In other words, even though this environment would seem to be unfavorable for bonds, because normally when central banks ease, yield curve steepen. We could be in an environment where actually the curve steepens, but across all maturities, the entire term structure drops.
Commodities in our view should go up. And I think there's a very interesting parallel here with maybe what went on in the 1930s. Now, it's always very dangerous to go back and look at history. But one of the things that