Market Reports

Market Discipline and Lessons for Long Finance

Jonathan Howitt
February 2012

The Public Debt Mountain
Whilst it has always been in the nature of monarchs and sovereign states to finance their ambitions with debt, only during the 20th century did the acceptance creep in that it might be economically beneficial for governments to continually borrow to stimulate the economy given the cheap cost of funding. It was, after all, politically convenient and since the 1930s arguably quite successful for Western economies, whatever the debate about how the public money was spent. In the post war era of relative growth and stability, it seemed quite affordable and even the more independent central banks went along with it.

Deficit spending has now perhaps become the victim of its own success. Almost all G20 countries are running deficits. In particular in the US, the UK and Japan, budget deficits are now at least 8-10% of GDP, a significant proportion of this being interest payments on accumulated debt. Given growth rates of less than 2%, this is clearly unsustainable.

Had there not been a banking crisis followed by a Eurozone crisis, the concern might not be so immediate. Despite a near doubling of gross public debt(1) in the past 30 years in the US and the UK to 115% and 86%(2), and a fourfold increase in Japan to 253%, the cost of funding this government debt dramatically cheapened in the same timeframe. 10 year rates in the US and the UK plunged from well above 10% to less than 2% and in Japan from more than 7% to less than 1%. This pricing of risk is entirely illogical. It may reflect the relative safe haven of sovereign debt versus other financial assets – certainly this is the implication of Basel capital rules which in true self-serving fashion designate OECD sovereign obligations as ‘risk free’ – but it has also no doubt been helped by the expectation that central banks will repurchase their debt as part of quantitative easing efforts and that they will keep short term rates low for a prolonged period to stimulate growth. What this suggests is a deliberate attempt by central banks to ‘inflate away’ their debt, a kind of default by stealth, in which case it is again counterintuitive that markets should have chased yields down and allowed them such effective control of their long term interest rates.

Governments have been encouraging their central banks in this endeavour: the political incentives are certainly there for them to continue with debt financing if interest rates can be kept low, and it is in the nature of governments to persist with such anomalies until the point they unravel.

At what point, though, does this confidence trick fail, and when does market discipline take over? The Eurozone experiment is finding out. One of the most illogical market movements in recent times was the convergence of interest rates for countries expected to join the Euro in the late 1990s. For several years, all Eurozone countries were able to borrow at near German rates. Not anymore.

The reality of market discipline for the Eurozone has been a sudden re-pricing of risk: the scale of problem wasn’t apparent until the crisis, at which point it was too late to fix without a managed default. Greek 10 year interest rates were still 5% at the end of 2009, having held steady for almost a decade, but were more than 35% by the end of 2011 in the midst of a series of debt renegotiations and bailout discussions. The story may be similar for Portugal: 10 year rates of 4% at the end of 2009 had backed up to more than 15% by the end of 2011. With potential contagion spreading to Spain and Italy, political pressures have subsequently weighed on the ECB to purchase the debt of weaker Eurozone members and contain the back up in long term rates. Uncertainties remain and the Eurozone seems trapped in a low growth scenario for some years to come.

The simple lesson for Long Finance is that you can’t rely on market discipline to resolve a mispricing of risk in time. In the Eurozone context it is the buffer at the end of the track, a backstop with dangerous consequences if hit at speed.

Global Trade Imbalances
Public deficits and trade deficits are often related, although perhaps not directly in the case of Japan. Japan’s perennial trade surpluses have nevertheless been trending steadily downwards as the economy ‘hollows out’ under pressure from an ever appreciating yen, a phenomenon which by 2011 had been marked by an almost fivefold increase in the yen versus dollar since the collapse of Bretton Woods in 1971. By any measure, this is a staggering economic adjustment for a trading nation.

It must terrify China, whose currency actually depreciated between 1980 and 1994 from 1.5 to 8.5 renminbi to the dollar, and still stands stubbornly above 6 renminbi. Yet the imbalances which drove the yen’s appreciation over 40 years are even more marked with China, which has an annual trade surplus with the US of over $300bn and has accumulated over $3tn of reserves, in large part to keep its currency cheap. This is not sustainable, any more than it was for Japan.

What was the consequence for Japan? For almost 20 years, one might not have noticed, as domestic demand boomed, and the economy rode through the oil shock of the 1970s and the US recession of the early 1980s, all this against a backdrop of a threefold increase in the yen by 1989 to 120 versus the dollar. Then the party ended. Japanese equities reflected the malaise, the large cap Nikkei index collapsing at one point by more than fivefold since 1989, and smaller companies faring worse. Only by more than trebling its national debt and ratcheting interest rates to near zero has Japan been able to cushion the blow for the wider economy.

Arguably now though, this policy has run its course. With excessive levels of public debt, the private sector has been crowded out as banks and pension funds are replete with JGB holdings rather than commercial loans. Economic reality, then, has still to bite in Japan, which will have enormous fiscal adjustments to make when it eventually resolves itself to reduce its national debt. With an ageing population, more than 25% over 65 and only 12.5% under 15, the political will may not be there.

History could be repeating itself. China’s trade surplus with the US alone is 5% of its GDP. Whilst there is significant scope for China to boost domestic demand given its minimal government debt (16% of GDP and falling), the export-driven economy remains very exposed to a sharp appreciation in the renminbi. Better that China allows this to happen gradually rather than waiting for the hard landing.

The experience of Japan is salutary if its lessons can be learned. In particular for Long Finance: the more prolonged the market imbalance – in Japan’s case at least the latter half of 25 years of Bretton Woods – the more severe the market adjustment will be. Japan’s experience is still not over and China’s is yet to unfold.

Nor does the US trade deficit, at more than 3% of GDP across all its trading partners, make happy reading. The US has, however, gradually allowed the dollar to depreciate, by more than 25% on a trade weighted basis since the early 1970s. Given the size of its domestic economy, the problem may be less for the US than for China, which accounts for more than half the US deficit.

Commodities and Reserves
Commodities, by definition, should be cheap and readily available. Prices are nevertheless subject to quite dramatic fluctuations if supply is interrupted, whether by force of nature (e.g. a poor harvest) or by the consequence of human action (e.g. industrial accidents, strikes, embargos). This suggests that whilst commodity markets are generally liquid and actively traded, there is often a fine balance between underlying supply and demand.

Reserves, by contrast, should be long term stores of value. They are accumulated over time and are not expected to diminish in value or be subject to sharp price fluctuations. The US dollar has been the de facto reserve for central banks since the abandonment of the gold standard in 1971, although not universally so. Of approximately $10.2tn in global central bank reserves, about a third or $3.4tn is known to be held in dollar assets. Another $1.7tn (about 1bn ounces) at current prices is still held in gold, even though there is no obligation to back up fiat money with it anymore.

Gold has certainly been a good store of value for the last 10 years though, rallying more than six times from $300 to over $1900/ounce in 2011. Prior to that, except for a short-lived rally in the early 1980s, it was better labelled a commodity than a reserve. Its price will be very different depending on which it really is.

This begs the question at what point a commodity becomes a reserve and vice-versa. Since the oil shocks of the 1970s and the establishment of OPEC, there have been significant movements in oil prices despite relatively abundant proven global reserves (currently about 1.4tn barrels). Prices rallied from less than $10 to $145/barrel between 1998 and 2008, and back below $40/barrel in early 2009 and are currently over $110/barrel again. Short term, oil has behaved like a commodity but longer-term and strategically, with a steadily rising trend in global energy consumption and limited commercially viable alternatives, it behaves like a reserve.

Efforts to protect and guarantee the supply chain of natural and industrial minerals in particular by China have been behind much of the rally in mineral commodities over the past decade. Copper, for instance, has seen a similar six fold rally in prices and its commercial use is more apparent than gold. In this context control of resources may be a reserve currency in its own right, a hedge against ever increasing costs of production if growth is sustained. The most significant cost of production in more developed economies is human and intellectual capital. Reserves of human talent in high margin sectors such as technology, pharmaceuticals and professional services are sustaining growth in economies where the cost of manufacturing labour has become increasingly uneconomic. Parts of the developing world are catching up fast: whilst developed countries struggle with ageing populations, China and India are producing more than 2 million science and engineering graduates every year.

Long Finance has posited the idea of an eternal coin, a reserve currency that is not subject to market fluctuations and may act as an instrument rather than an object of market discipline. Rather than looking at volatile currency and commodity assets, we ought to be designing a new currency around human capital and ingenuity, which is perhaps our most abundant and stable long term reserve. problem may be less for the US than for China, which accounts for more than half the US deficit.

Confidence and Volatility
History however teaches us that humanity is often its own worst enemy. At his inauguration in 1933, Franklin Roosevelt’s assertion in the depths of a financial crisis that ‘The only thing we have to fear is fear itself’ has a familiar ring today too.

Human capital may be relatively stable and productive, but human business and consumer confidence can be fickle, frequently over-reacting to uncertainty and creating self-fulfilling and pro-cyclical mood swings in economic activity.

Surveys of consumer confidence in the US and the EU over the past 30 years show just how volatile the economic mood can be, with direct impact on demand and often severe consequences for asset prices. At the turn of the millennium, the Conference Board registered US consumer confidence at a score of 145 (1985=100) but by early 2009 this had fallen to only 25. It remains depressed at around 60 today, up from 40 in October 2011.

The EU confidence indicators similarly fell from a peak of +3 in May 2000 (2000=0) to -34 by early 2009 and stand at -20 today. European large cap equities have tracked consumer confidence downwards – the Eurostoxx 50 index is less than half its value since the turn of the millennium. European corporate bond markets have also felt the malaise, with investment grade spreads backing up from near zero 5 years ago to 400 basis points by late 2011, and non-investment grade spreads from 200 to 800 basis points by late 2011, having peaked at 1200 basis points in early 2009. Symptoms these may be, but they have a real economic cost in terms of business planning, funding, and hedging of risk. Market discipline implies a consistent, one-directional correction, but economic uncertainty has instead created dramatic swings in a ‘risk-on, risk-off’ world. The CME’s tradable volatility index (VIX) reflects this best of all: it rallied from a low of 10 in 2007 to a peak of almost 90 in October 2008, and has since fallen to 15 and peaked again at 50 twice since then. With such huge swings in economic expectations and asset prices, how can business make any long-term decisions?

Uncertainty and the ensuing market volatility with which it is characterised is therefore the real enemy of Long Finance. To some extent we can mitigate its impact by addressing known economic anomalies and imbalances in good time if we can find the political will to do so. We can continue to invest in our deep global reserves of human talent and invention to strengthen supply side stability. Demand-side dynamics, however, conquering the excesses of our collective confidence – irrational exuberance or stubborn risk-aversion – will remain our greatest challenge if we are to usher in a golden era of Long Finance and become the masters of market discipline rather than its slaves.

(1)IMF forecasts to 2016 for the US and Japan, 2013 for the UK
(2)If public pension obligations were added, this ratio might be double