A few thoughts on “Rise of the Robots”, risks to global rebalancing and much more

Foxconn replaces ’60,000 factory workers with robots’” was a recent headline in a BBC news report, and of course many other stories.

The global rebalancing story goes as follows: developed economies offshore production of goods in cheap labour emerging markets with strong growth prospects, benefiting from cheaper labour and also entrance into consumer markets with vast potential.  Developed economies experience declines in wage growth as manufacturing declines and service sector expands in relative terms, interest rates are lowered and consumer credit growth stimulated.   Lower cost goods and low interest rates cushion the impact of lower wage growth but the economy moves out of balance, towards consumption and debt (increasingly asset focussed) and away from production and investment.  

Ultimately this story depended on developing markets maturing their own consumer stories and wage growth/currencies rising to erase or at least obfuscate wage price differentials.  This rebalancing of developing economies to consumption and away from manufacturing/investment would have created demand for goods, services and expertise of developed economies, rebalancing GDP away from consumption and towards production and investment, raising wages and reducing dependence on credit for consumption with interest rates slowly re-ascending.

The story about Foxxconn factory workers being replaced with robots takes away important marginal flows from the rebalancing equation and reemphasises emergent income distribution inequalities: less income to labour, more to capital; reduced consumer expenditure growth to rebalance growth in developing/developed areas; greater stress on high debt levels accumulated in both areas, debt levels used to finance consumption in one and infrastructure and manufacturing in the other.  And of course, all the attendant asset price issues that have arisen as a result of low interest, financial shocks, asset price support and other unconventional monetary policy actions.

Technology is a good thing and we should always be striving to produce more efficiently and effectively and part of the move to robots in these developing markets is the reallocation of labour capital across the broader economy and the need to produce ever more goods for growing demand in many of these vast economies. 

But the separation of income flows, or at least higher growth higher value income flows to labour, is a disconcerting one and especially so given the ongoing deceleration of global economic growth and asset price divergence.  This not only accentuates the trend towards increasing income inequality and therefore damages the eco system’s ability to regenerate demand (and support asset prices), increasing reliance on loan growth (and hence debt support), but it also risks prevent a more rigorous and necessary rebalancing of growth between developing and developed that would have re-established the balance of power between labour capital and financial capital that would be necessary to keep the eco system’s flows at regenerative levels. 

Within the capitalist system there are numerous subtleties.   Human beings need a reason for being and the economic dreams of home ownership, durable goods consumption and various other lifestyle goals are gradually being hammered away and left to an increasingly small percentage of the population.   The objective of a capitalist system should be productive efficiency on the one hand and the regeneration of the model’s ability to support its asset, human and of course natural frame.   Technology has not historically been a blight on humanity, but that has been because of various forces that have coincidentally expanded the frontier of consumption and production capabilities.   

Productive efficiency is only one side of the equation and it requires balancing forces on the other to maintain a healthy “equilibrium” of sorts between all factors of production.   Talk of helicopter money, the drive for increasingly perverse unconventional monetary policy all strongly suggest that the equation that drives the eco system is out of balance.

Helicopter Money…increasingly likely if growth continues to slow….

Helicopter money is essentially central bank financed government expenditure: Central Bank issues money to buy government debt, government uses money to fund, inter alia, tax breaks and/or infrastructure spending.

China is transitioning to slower growth, Japan remains mired in slow growth/demographic decline, European growth rates remain constrained as does US growth and there are problems in other key economies, notably Brazil and Russia.  As this pattern remains in situ, the risks to the financial system rise higher and so do the chances of “helicopter money”.

US real per capital GDP growth based on high water mark analysis

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US Nominal GDP profile: rolling average quarterly change in GDP less inventories and Consumer Credit

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Annualised real GDP growth Japan over rolling 10 year periods:

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The same for Japanese household consumption:

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Euro Zone real growth rates: annualised over rolling 5 and 10 year time frames: image

And the same for household consumption:

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In the past, asset markets have typically reacted to late cycle interest rate rises as monetary policy looked to restrain growth in the face of increasing production/supply bottlenecks.  Asset markets would increase their preference for money relative to other assets, asset market leverage and consumption/production focussed loan growth would scale back; the economy would move into a “step back” or so called recession.  But, this retracement of markets and the stutter in monetary and economic growth was usually a short term phenomena: populations, technology, productive capital, and loans were in an expansionary phase.  Growth rates of populations, productivity and capital expenditure have fallen, to lesser/greater extent, across the world. 

At a point in the economic cycle when monetary policy would usually be rising, to hold off over heating economies, growth is not only slowing but reinforcing a long established slowing trend.  The recent US interest rates rise should not be considered as a counter cyclical rise but a “normalisation” of monetary policy.

A slowdown/well paced decline in growth should not in and of itself be a problem.  Capital depreciation is a natural way in which economies transition to lower growth/declining frame regimes.  There are two ways in which the current slowdown in growth is a much bigger risk to economic/financial system health:

1 – The first is that asset markets and asset focussed money supply growth have been juiced and expanded to stimulate growth on the assumption that weak growth was transitory/shock induced; these actions have raised the supply and value of assets (debt and equity) relative to economic growth; as growth slows, and the slower trend is established, expectations over future flows which give assets their value also decline.  In the absence of monetary policy aimed at asset values, asset values correct (equity) and/or default (bonds/loans).  This correction impacts present and future consumption as well as the financial system: bank deposits (broad money supply) are backed by assets; as assets devalue/default deposits/money supply are impaired further impacting economic stability. 

2- The distribution of national income has been increasingly skewed towards corporate profits and very small sections of the population.  Unequal distribution of income and capital impacts present and future consumption and capital expenditures associated with that profile.  These capital expenditures risk extending to core infrastructure/health/education spending.   Quality of life at so many levels risks being impacted.

US Capital expenditures

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Helicopter money may be needed to support the eco system in the event of an asset price and financial system shock, as growth slows further or experiences a decline, amidst dysfunctional distribution of flows (income inequality). The time for Helicopter money may be drawing near, but it should not be considered a saviour of asset markets, rather the last gate along this particular road.  How it impacts the economic/financial system is likely to be complex and especially so given that the asset price unwind and accompanying demand shock of excess financial system debt could be fast acting.

US employment figures in the context of consumer credit and inventories.

The US economy is no ordinary cake in the oven and the release of the latest employment numbers do nothing to disprove this analogy.   Global economic growth is continuing to slow as evidenced by trade numbers, manufacturing data and a host of PMIs.  The direction of cause in this most recent of trends has been from key emerging economic regions.  The direction of cause is one for concern given the importance of the development of consumer markets in emerging economies to aging and slowing developed economies.  A slowdown in emerging market growth is important for asset markets and financial stability (loan servicing and financing) given that asset values and debt financing are heavily predicated on a discounted future.  The possible impact on global growth and financial stability of this reversion of cause and hence flows may well prove to be of significance.

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A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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A debt/asset value/IR bounded endogenous monetary chokehold: Comments on “Patience is a Virtue When Normalising Policy”

The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to growth and the financial system.  Increasing income inequality and weak wage growth keeps the US and other economies within a debt/asset value/IR bounded endogenous money supply chokehold.    A successive series of debt/asset bubbles and interest rate lows are not a succession of unrelated incidents but a tightening of an extremely dangerous grip.

In the most recent Federal reserve Bank of Chicago Missive,  Patience Is a Virtue When Normalizing Monetary Policy, much interesting information was imparted on employment trends…but  there was little comment about interest rates and their relationship with the build up of asset focussed money supply growth……this build up of broad MS was and still is reflected in highly valued asset markets and global debt accumulation.  Its magnitude can be gauged by the large surge in broad MS growth over and above nominal GDP growth.

“With the economy undershooting both our employment and inflation goals, monetary policy does not presently face a conflict in goals;

I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.

So what happens when a conflict emerges?”

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As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

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We have two adjustment phases likely to impact growth: a debt and a structural economic adjustment…

A country heavily in debt will depend on a) future human capital earnings and b) returns on invested productive capital to reduce debt and increase GDP.  

Weak prospective returns on capital invested and low expected returns on human capital increase the risks of default where the present value of the debt exceeds the present value of future returns on capital. 

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Aggressive, desperate or, by necessity, both? Is this the last throw of the dice?

I hate the phrase quantitative easing, it is a bit like calling an apple, Malus Domestica-Borkh.  But QE is no apple, it is a rigged game as far as investors are concerned, and the Fed is playing on the market’s irrationality, and its passion for the short term, to pump a little more blood into the valves. 

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Growth dynamics have changed a bit and are in between times…

Historical equity returns reflect past growth dynamics, dynamics which may be either weaker or in transition, or both – indeed, dynamics in mature economies are weaker, and combined global dynamics are in transition.  Return expectations need to be cognisant of these structural drivers of return.

The main drivers of growth are well known: a) population growth and employment participation rates, b) capital investment and c) increases in total factor productivity, or rather efficiency gains from the combination of a and b. Continue reading

“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies. Continue reading

US Domestic Economic Dilemmas and Export Dynamics

Well known, widely accepted fact: the US needs to restructure its economy, increase investment, reduce domestic consumption, increase saving, export more, import less.  

Other well known fact: in order to do this, it is dependent on growth in developing and other developed economies.  

Well known fact 3: China (Asia represents 31% of world exports, 31% of world imports) appears to be slowing and Europe (37% of world exports/38% of world imports) is struggling.   Continue reading

Don’t worry, here comes the three horsemen of the apocalypse!

Ambrose Evans-Pritchard has neatly summed up some industry think in his latest piece, “Global banks see market rally on Greek exit”. 

But this type of industry thinking is also likely to scare away the retail investor, through rational cognitive dissonance or otherwise. 

Apparently, we are set for a big rally, once Greece leaves the Euro, as Central Banks the world over pump yet more liquidity into the financial system.  This will either be via LTRO Repo type (temporarily exchange your securities for cash) transactions or the better for the banks and sovereigns, QE (buy your duff securities for a price you would not be able to dream of otherwise). 

Here is my very quick, write it as you think it, opinion on this “play”. Continue reading

No Man’s Land

We have, most likely, recession in Europe (confirmed already in a number of countries) with very weak data on both the manufacturing and the service sector side. 

We have ambiguous growth in China on the same metrics, and uncertainty with regard to its main engine, investment led growth.

We have a pedestrian crawl in “bad demographics” Japan.

And, we have a weak US recovery hitherto dependent on good winter weather (recently),  the consumer (lower savings, a rise in debt, marginal improvements in employment framed within historically weak income dynamics) and central bank intervention, but a recovery logically, from here on in, ultimately dependent on growth in global demand for its goods and services.  Continue reading

Data, data, data and faith based economics…

Debt, and global structural economic and financial imbalances remain the key factors behind growth potential and risks to growth.  These have changed little, and if anything, dynamics and absolutes have worsened in many areas: think Eurozone sovereign and financial system debt; Japan sovereign debt; China dependence on investment led growth and also China debt; US sovereign debt and still significant consumer debt dynamics. Continue reading