This guest commentary was written by Alasdair Macleod of Goldmoney.
Ever since the last credit crisis in 2007/8, the next crisis has been anticipated by investors. First, it was the inflationary consequences of zero interest rates and quantitative easing, morphing into negative rates in the Eurozone and Japan. Extreme monetary policies surely indicated an economic and financial crisis was just waiting to happen. Then the Eurozone started a series of crises, the first of several Greek ones, the Cyprus bail-in, then Spain, Portugal and Italy. Any of these could have collapsed the world’s financial order.
But Mario Draghi steadied the sinking Eurozone banking system by promising to do whatever it takes. We derided him, but he has succeeded. The intention of zero interest rates and QE was to prevent a slide into deflation, a spiral of collapsing bank credit and asset values. Markets steadied. It was intended to restore private sector wealth by inflating asset prices. It enriched the hard-pressed financial sector, with bond and stock markets not only recovering, but going on to record levels. A sense of wealth has returned to the portfolio-owning classes. The DAX has risen over 225% and the S&P 500 nearly 250%. Inflation, by which commentators mean the rate of increase in consumer prices, has not yet reflected the massive injection of monetary inflation from the time of the crisis. At least, not on official CPI figures.
If there is a lesson for us all since the great financial crisis, it is that central banks, even though dealt an appalling hand, are very good at managing local systemic problems, real or imagined. Bearish hedge fund managers, those masters of the universe, are throwing in the towel. Valuations, according to their models, cannot be explained, let alone justified.
In truth, these investors have made the same mistake every cycle. They see the bubbles, but fail to fully understand their source. They think bubbles are solely the result of the madness of crowds, irrational bullishness ignoring fundamentals. They fail to dig a little deeper and understand the source is a repeating credit cycle. Only when you understand that financial bubbles are merely visible symptoms, can you begin to understand the underlying disease.
The global credit cycle is in a new expansionary phase, which can be expected to change market characteristics. Only now are we sufficiently advanced in the global credit cycle to speculate about its evolution into crisis. This article takes the reader through the likely manifestations of it, providing a road map for reference of its progress, and where and when it is likely to hit first.
Credit cycle recap
During a credit crisis, the expansion of the money quantity at the behest of the central bank is aimed at saving the banks. Otherwise, banks, which are highly-leveraged financially, would simply collapse under a combination of their customers’ bad debts and falling collateral values.
Assuming monetary policy rescues the banks from the crisis, the financial system becomes stabilised, the crisis is over, and we move into a second phase of recovery. Unemployment starts being cyclically high, and price inflation remains subdued. The banks are still traumatised, expanding credit only to the government and their largest low-risk customers. On the back of improving bond prices, they begin to expand credit towards their own and associated financial activities, remaining cautious over lending to the medium and smaller business sectors (SMEs), which between them form the bulk of non-financial economic activity. This recovery from the crisis is prolonged by government intervention, which generally seeks to prevent malinvestments being liquidated, freeing up capital to be used more productively.
As time goes on, the banks begin to grow confident that the crisis has passed, and memories of it fade. They gradually extend their lending to SMEs, which represents the silent majority of the non-financial economy. We have now entered the expansionary third phase, where banks increasingly compete for what they have now decided is low-risk business. The second half of the expansionary phase is characterised by low unemployment, growing skill shortages, and rising price inflation. Rising prices cheapen the real interest rate to a lower level than in the recovery phase, upsetting the balance between the expansion of credit and availability of capital and consumption goods even more. It is this that eventually forces the central bank to raise interest rates to the point where the next crisis phase is upon us. Central banks have no option but to address the falling purchasing power of the currency by raising interest rates sufficiently to stabilise it.
A debt crisis is triggered, because business models are undermined by rising financing costs. Companies collapse. In addition, the legacy of accumulated debt means high interest rates undermine the credit status of long-term debts and the asset values dependant on them, particularly of property. Government welfare costs rise and state finances deteriorate rapidly. As financial intermediaries, the banks are caught in the middle of the crisis, and being operationally geared, face bankruptcy. There comes that moment when even ordinary people wonder if they have lost everything.
That is why having triggered the crisis, central banks then rapidly change course and do everything, however financially unsound, to ensure the financial system survives and governments can continue to be financed.
Every credit cycle evolves on this approximate framework, but each has its specific characteristics. Progression from one phase to the other is often difficult to detect, and sometimes only obvious long after the event. But the repetition of crisis, recovery, expansion and crisis again is the structure of every credit cycle.
Over recent credit cycles, the magnitude of the crisis phase has increased, reflecting the enormous debt burden accumulating in the overall global economy. Since the financial reforms of the 1980s, there has been a new and growing element in the advanced economies: the expansion of credit aimed at financing consumption, which has now overtaken the application of credit aimed at production. This does not change the cycle framework, but it does alter its characteristics and visibility.
Global expansion is already here
The G20’s efforts to coordinate monetary policy globally have been undoubtedly successful. Unfortunately, they make credit expansion a truly international phenomenon, eventually feeding into a synchronised global credit cycle. International coordination of monetary policy increases the economic and price distortions for everyone, rolling up several smaller waves into one big tsunami. Furthermore, when the crisis hits one jurisdiction, the chances today are higher than before it will be transmitted to the others. So, we must consider this as a global experience, likely to be triggered from anywhere.
Investors based in Western capital markets often point the finger at China. We know that China’s massive credit expansion of recent years has already taken her into an expansionary phase. All the signs are there in plain sight, because the government is working to a predetermined published plan. The current five-year plan is intended to make China, in partnership with Russia, the dominant economic force on the Eurasian continent.
China is the most significant contributor to the current global credit expansion phase, benefiting all those that trade with her. Britain, a trading partner, has also been at full employment for some time. She has an open service-based economy, which permits it to expand in the direction of maximum opportunity. She is in the vanguard of providing services, technology and manufactured goods to China, and for all the other countries in Asia that are expanding with her. Germany is also expanding on the back of the Chinese story, but in her case principally as a supplier of capital goods. Japan, whose mighty corporations have factories throughout East Asia, is also doing well.
Commodity exporters round the world are similarly benefiting from Chinese demand for raw materials. Sub-Saharan Africa is now in China’s thrall, as is Australia and important South American countries. Canada and Mexico benefit. It is easier to list the countries not affected by China, so small is the number.
The expansionary phase of the credit cycle is all about how money is deployed. To make room for an increase in bank lending to non-financials, banks sell their low risk assets, predominantly short-term government bonds. Today, the consequential rise in government bond yields, an important indicator, remains suppressed by extreme monetary policy, and by the fact that large government deficits need to be financed at the lowest possible rates. Furthermore, different countries are expanding at vastly different rates, but they are all expanding on the back of bank credit becoming more widely available to the non-financial sector.
The sequence to look for ahead of the crisis
There is little doubt that the world is in the expansion phase of the credit cycle, with some economies responding better than others. China is driving the application of credit worldwide through her policies of infrastructure spending and economic progression. Her demand for capital goods and raw materials affects different countries in different ways, but China is the major global stimulant for credit demand in all her trading partners.
America is left out of this party, sitting it out in a grumpy mood. She frets about her trade deficit with China, threatening tariff retribution. However, even America’s economy is running towards capacity constraints, with unemployment, at least for the employable, at or close to cyclical lows. Credit is still fuelling financial asset values, as well as consumption and financing the government deficit. Investment in production, our marker for the application of credit, is taking a back seat, telling us that economic progress, as opposed to increases in GDP, is stagnating. But the expansion, even though weak, is nevertheless there.
All that’s needed to upset the Fed’s monetary planning is for consumer prices to rise significantly above the target rate of 2%. Even though the great American economy is mainly an internal affair, at some stage if the dollar continues to weaken there will be higher price inflation, despite domestic stagnation
Markets should give us a more predictable guide. The first market to turn is always bonds. Falling bond prices can be tolerated by equity markets to a degree, before the net flow of funds out of financial assets gathers pace. This is the current situation in most financial markets. One would expect to see improved trading prospects in the non-financial economy, encouraging inexperienced investors to continue to buy equities, before they too lose bullish momentum.
First bonds, then equities. Property prices should continue to rise, buoyed up by a combination of credit-fuelled economic expansion, wage rises improving affordability, and suppressed real interest rates. In this cycle, demand for retail space has been subdued by online shopping, but demand for office space, particularly outside the US, continues apace. The explosive growth in construction in Asian cities is our evidence. China’s property development programmes are massive, but state-directed with a purpose, so not the best indicator of credit-fuelled capital spending.
It is at this point that banks compete to lend, looking for market share rather than profit. Property is usually a major recipient of bank credit and the boom can be substantial. According to Colliers International, €12.2bn were invested in German commercial real estate in Q1 2017. This is the second time that quarterly transaction volume has exceeded €10bn since the 2007 record year. Japan’s commercial property price index has risen 17% since 2012, not a bad return in Japanese terms. In Dubai, a further 9.9 million square feet of office space is under construction. Similar stories abound elsewhere.
So, the theoretical sequence is bonds top out, followed by equities, followed by property. Bond yields started rising in 2012, and it’s likely the next rise will be enough to call the top on equities. Property prices should continue to rise after that, buoyed up by improved economic conditions, until central banks are eventually forced to raise interest rates to control price inflation. The time-lapse between these events can vary considerably, but as history has repeatedly showed, all three events must take place: one or two are not enough. The final collapse should be in property. In that sense, the great financial crisis of nine years ago was a classic example.
The source of the next crisis
Given the G20 now ensures that when the crisis hits, we all sink together, we must now speculate where the next crisis will arise. We shall assume that the world does not descend into a geopolitical and financial war, though that risk is significant. We must look for extremes between current monetary policy and economic reality, a task made easy for us by central banks, who are always too late in understanding the dynamics of credit and its effect on prices. It is a process of elimination.
We can eliminate the hedge funds’ favourite, China, because the expansion of bank credit is associated with financing genuine economic progress more so than anywhere else. Furthermore, the state tightly controls bank lending and capital flows, and she pays no more than lip service to the credit-cycle coordinating activities of the G20. We can also rule out the US, because her expansion phase has been subdued by her policies of economic isolationism, unless, that is, the dollar collapses against other currencies to the extent the reserve currency becomes the crisis.
Japan’s monetary policy has become less relevant to her economy, unless for some reason ordinary savers suddenly become scared by price inflation. Much Japanese manufacturing is now conducted overseas, and domestically the expansionary phase of the credit cycle is directed at financing the government’s deficit. The British economy is a potential source of systemic danger, given its strong performance and inappropriate monetary policies, but at last the Bank of England is beginning to reconsider its monetary stance.
By far the most likely and dangerous source of the next crisis appears to be the Eurozone. The ECB, distracted by the difficulties in Greece, Italy, Spain and Portugal, maintains a bizarre monetary policy of negative interest rates for bank deposits and a monthly injection of €60bn, aimed at keeping government funding costs as low as possible and the weaker banks solvent. The market distortions are extreme, with the “riskless” 2-year German Schatz bond yielding a negative 0.68%.
Trouble is brewing, with the euro rising 15% against the dollar this year so far. The reflationists at the ECB see this as deflationary, putting pressure on EU exporters, who always lobby for a low exchange rate. Therefore, the temptation to ride out currency strength with no change in monetary policy is strong.
Dollar and sterling interest rates are already rising. The underlying problem for the ECB is they have financed government spending by buying up Eurozone sovereign debt, underwriting inflated bond prices. Governments have got used to artificially suppressed funding costs and will not take kindly to seeing them rise. But even worse, Basel committee rules give sovereign debt a zero-risk weighting for banks, and so the Eurozone’s banks are up to their necks in overpriced government bonds.
Unlike American banking regulators, which since the last credit crisis have forced the US banks to increase their core capital, the ECB has done very little to improve the soundness of Eurozone banks. Therefore, they cannot afford to see government bond yields rise significantly, because the valuation losses will wipe out many banks’ capital. Yet, with the 2-year yield marker still deep in negative yield territory, and the Eurozone economy now demonstrably in the expansionary phase of the credit cycle, here lies the crisis in the making.
Rarely have the financial dynamics appeared more alarming. And as trade with China increases in the coming months, with container-loads of product being shipped overland both ways, the dilemma facing the ECB will worsen. Furthermore, with the dollar set to weaken on a combination of US economic underperformance and growing international antipathy against it as a trade currency, it is hard to see how the euro will not continue to strengthen further.
Notwithstanding these problems, we must expect an initial reversal of current monetary policy. Reluctantly perhaps, the ECB will stop buying financial assets and remove negative deposit rates. However, even this move will hurt the Eurozone banks as short-term bond prices fall, and the prevention of a new banking crisis will dominate monetary policy.
Assuming the systemic fall-out from this initial rise in interest rates and bond yields is contained by nursing the weaker banks, private sector non-financial business should continue to expand. Eurozone CPI inflation is already at 1.5%, with Germany’s at 1.8%. The 2% target rate could be breached early next year, and speculation is likely to mount about further interest rate rises from then on. Government bond yields in the Eurozone are bound to soar, guaranteeing widespread insolvency among the Eurozone’s banks.
For now, the end of negative interest rates and the asset purchase programme should buy some time, perhaps until the middle of next year, by when property prices should be rising strongly. Eurozone companies will be reporting improved trading and rising profits, and the sounder banks competing to lend by cutting their loan rates. Furthermore, with inflation rising, borrowing costs in real terms could be even more negative than they are today. Despite the relative strength of the euro, price inflation, always the balance between excess credit and limited supplies of goods, will become the dominant issue.
All major jurisdictions have this problem to a greater or lesser extent. The specifics differ, but rising rates of price inflation will become common. Thanks to the G20 ensuring everyone is in the same boat, thanks to China’s stimulus to most of the world economy, and thanks to the long-term accumulation of excessive debt, the dynamics behind the next crisis promise to be greater than anything seen heretofore.
Therefore, it looks like the timing will be set by the violent transformation of the ECB’s monetary policy from saving the system from the last crisis, to a realisation that if they don’t act quickly, we will be into the next one, and then the eventual realisation that they must raise interest rates even more sharply. We can tentatively pencil in a date sometime between the middle and the end of next year for this final act, and probably put a time limit on it of early 2019.
How it plays out is another story for another article, but at least we can begin to expect where and roughly when the next credit-fuelled crisis is due to happen.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor research note written by Alasdair Macleod for Goldmoney Insights. Macleod is head of research at Goldmoney and prior to that was a stockbroker on the London Stock Exchange for over four decades. This piece does not necessarily reflect the opinion of Hedgeye.
