by Christopher Whalen, Kroll Bond Rating Agency
A number of investors have asked Kroll Bond Rating Agency (KBRA) about our view of the market and economic environment after the November 2016 election in the U.S. The short answer is that we expect most of the major trends in terms of the global economy, interest rates, and currencies to be largely unaffected by the outcome of the U.S. poll. Simply stated, what happens within the U.S. political system has less and less impact on the rest of the world.
Americans like to flatter themselves that events inside our increasingly raucous political economy are somehow more important than developments in other parts of the world. The post-WWII political order imposed by the U.S. provided the illusion of stability and predictability for more than three quarters of a century, but Pax Americana is unraveling, making assumptions about the direction of future events around the globe far less reliable.
At the same time, the political and financial structures that emerged from the two world wars are also breaking down, proof once again that entropy is by far the best model for thinking about complex systems like nations and financial markets.
If you consider that the period of relative economic and political stability that prevailed after WWII represents the concentration of political and economic power in the hands of the U.S. and other allied nations, today the dispersion of these forces is an illustration of entropy. Another example is regulation. The financial markets were highly regulated by government and controlled by large banks and corporations from the 1930s through the 1970s, when deregulation resulted in a renaissance of non-bank finance and economic expansion that lasted through 2000.
Managing markets and risk was a relatively simple matter when the U.S. economy was largely closed and dominated by the U.S. government and the large banks and corporations that helped the allies prevail in WWII. Today, however, the dispersion of economic and financial power that has occurred due to the impact of globalization and particularly the liberalization of capital flows has added enormous volatility, risk, and unpredictability to the global political economy. Regardless of who occupies the White House, we believe that this tendency towards greater volatility and unpredictability in global markets will remain a central theme in the years ahead.
The slow motion disintegration of the E.U. illustrates this danger.
Weaker member nations that used the credit standing of the stronger nations to borrow solely to maintain consumption levels are now preparing to exit the union, an eventuality that could create enormous economic disruption and uncertainty. Neither of the presidential candidates from the major political parties seems to be cognizant of this looming hazard.
Regardless of which candidate wins the White House, the U.S. will see continued political paralysis. America will remain distracted by internal political considerations and will thus be unable to exercise effective leadership in Europe or anywhere else at a time when the post-war economic world is literally disintegrating.
One issue that does hang in the balance with the election is regulation. KBRA notes that this year’s G.O.P. platform is, on its face, more pro-growth than the Democrats’. Even so, U.S. markets have responded more favorably to news events that have favored the Democrats, at least at the top of the ticket. That seeming contradiction may reflect the split of probable outcomes between the White House and Congress. A Democratic victor in the presidential race would likely be more constrained enacting new regulation than a Republican president would be in rolling it back.
While the U.S. economy has shown some promising signs in recent months, we believe that the 2010 Dodd-Frank legislation, the Basel III capital rules, and other initiatives have largely canceled out the efforts by the FOMC to stimulate the US economy via low interest rates and open market purchases of debt. Were it not for the salubrious effect of strong foreign capital inflows and the natural tendency of the American people to thrive in the face of adversity, KBRA believes that economic growth rates would be considerably lower than the official statistics currently suggest.
Another risk that has gone largely unnoticed...
... by either presidential candidate is global capital flows, which are proving to be more of a detriment than a benefit in many respects. Even relatively closed economies such as China and Russia cannot avoid the pressures of swings in interest rates, credit spreads, and currencies. The flow of capital leaving China and moving into western markets alone is massive and totals some $400 billion so far this year, according to published estimates.
The recycling of trade surpluses from China and the other Asian exporting nations fueled the U.S. housing boom in the 2000s and led to the financial disaster of 2008. Today, an even larger flow of capital from Asia is fueling the significant uptick in home lending volumes in the U.S., as evidenced by the rapid growth of Ginnie Mae. Once the smallest of the government-sponsored entities, Ginnie Mae now has a larger issuance of securities than Freddie Mac and is headed to $2 trillion in total issuance by this time next year, according to Ginnie Mae President Ted Tozer. The torrential flow of foreign capital coming into the U.S. has distorted asset prices in many markets and has also helped to compressed credit spreads, as shown in Chart 1 below.
The flow of funds out of Asian nations with low or no population growth is an economic boon for the U.S. and promises to keep interest rates low for the foreseeable future. KBRA believes that regardless of which party wins the White House and the Congress next week, and regardless of who sits on the Federal Open Market Committee (FOMC), interest rates are likely to remain low for years to come.
Indeed, even if the FOMC does raise benchmark interest rates this year and next, we anticipate that the yield curve and spread relationships will continue to be effected by strong capital inflows. But these same inflows of offshore funds may create severe bouts of short-run volatility in both debt and equity markets.
Regardless of who wins the White House next week...
We believe that, absent strong capital inflows from abroad, some degree of regulatory reform is needed to get the U.S. economy back on track in terms of sustainable, long-term economic growth. But regardless of which party prevails next week, we believe that there is a strong likelihood that most major trends in terms of the financial markets and the economy more generally will be unchanged.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor research note written by Christopher Whalen of Kroll Bond Rating Agency. Whalen is a Senior Managing Director in the Financial Institutions Ratings Group. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
