Saturday, 21 January 2017

Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor
Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:
"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."
Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:
"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016
While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), Given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies
The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia
 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 
"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017
Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporates in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:
Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 
So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:
"In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.
For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp.
As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds. Also the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality.
Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016
We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.
While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":
"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017
There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

  • Macro and Credit - The wage / productivity paradox
  • Final chart - International trade and Nash equilibrium

  • Macro and Credit - The wage / productivity paradox
While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":
"Employers and employees deaf to government's calls for wage rises
No sign of a pickup in the rate of wage rises from New Year events
Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.
Deep-seated reluctance of employers to increase fixed costs
While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.
The unions are also cautious about demanding wage rises
A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).
Limits to how far working practices can be reformed without freeing up the market for regular employees
In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura
Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:
- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 
On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":
"The biggest medium-term macro surprise?
We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.
Tackling Japan’s wage paradox
The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.
Approaching full employment
However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.
Wages growth to double in FY17, reach 2% in FY18 
The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold
Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.
However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch
Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:
"Disconnect between job growth and wages
Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).
Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).
But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.
That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).
Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.
Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).
Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.
Reasons for optimism
The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch
The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":
"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.
For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia
So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  
In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia
In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia 
As we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg
So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

In similar fashion and as highlighted above in our quote from David Rosenberg, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and avoid the same pitfalls, then again, it is not the "quantity of jobs" that have mattered in the United States and as shown in Japan and it's fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

  • Final chart - International trade and Nash equilibrium
Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:
"International Trade game
Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.
However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.
What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch
If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends, it means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Friday, 13 January 2017

Macro and Credit - The Woozle effect

"When everyone is thinking the same, no one is thinking." - John Wooden, American basketball player and coach
Watching with interest more fake news such as more stories surrounding evidence by citations of Russian involvement in US elections and fake prices, leading to some violent market gyrations as in Bitcoin, given our last musing around the thematic of hoaxes, we decided that for this week's title analogy, we would stick with the theme. The Woozle effect, also known as evidence by citation, or a woozle, occurs when frequent citation of previous publications that lack evidence misleads individuals, groups and the public into thinking or believing there is evidence, and nonfacts become urban myths and factoids. More importantly, "The Woozle effect" describes a pattern of bias seen within social sciences and which is identified as leading to multiple errors in individual and public perception, academia, policy making and government and markets as well (herd mentality). A woozle is also a claim made about research which is not supported by original findings. Given the creation of woozles is often linked to the changing of language from qualified ("it may", "it might", "it could") to absolute form ("it is"), we found interesting that the "Trumpflation story" has suddenly morphed from "it may" to "it is". To some extent, the Woozle effect is yet another example of confirmation bias we think. People tend to interpret ambiguous evidence as supporting their existing position. A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work re-interpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way. Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts but, also in financial markets. As we have often indicated in our past musings, our contrarian stance comes from our behavioral psychologist approach given we would rather focus on the process of the woozles rather than their content. In our last musing, for instance we indicated we had turned slightly more positive on gold and gold miners alike. We must confess we have been adding in late December.

In this week's conversation we would like to discuss our contrarian stance surrounding "Mack the Knife" aka King Dollar + positive real US interest rates and why we think that eventually "Trumpflation" could morph into "DeflaTrump", meaning a lower dollar thanks to that 30s model we discussed as of late,  namely that populism and discontent means we are potentially facing a global trade war with the rise of protectionism.

  • Macro and Credit - All the promises we've been given...
  • Final chart - The central bank "put" has been weakening

  • Macro and Credit - All the promises we've been given...
From a Woozle effect perspective, we find it very interesting how easy weighing up the costs of being wrong leads to overconfidence.

We might sound a bit philosophical in these early days of 2017 but, we do share Jim Chanos and Steen Jakobsen, that we are going to see some tectonic shifts.

These shifts will have some significant consequences in terms of allocations rest assured. You might be wondering why we have entitled our bullet point this way? Well as goes the lyrics for an Electro House song we like "All the promises we've been given", government and central bankers have been very good at promising:
"All the promises we’ve been given
All the fires that we’ve feedin’
All the lies that we’ve been livin’ in
Wouldn’t it be nice if we
Could leave behind the mess we’re in
Could dig beneath these old troubles return
To find something amazing" - The Presets - Promises

This is somewhat the "Trumpflation" story playing out. Unfortunately, we cannot leave the mess we are in thanks to so many years of lax policies, lies and fires which our central bankers have been feeding. But, there is more to it. and at this juncture, we would like to remind ourselves with our November 2013 conversation entitled "Squaring the Circle" in which we tackled the paramount issue between "explicit guarantees" and "implicit guarantees":
"We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"
We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference." - source Macronomics, November 2013
And this is the great swindle politicians have been pulling selling entitlements based on "implicit" guarantees rather than "explicit" ones. Let us explain, the developed world is awashed in unfunded liabilities, therefore "it may" has for so many people clinging to their pension benefits has become "it is". The woozle effect in that case is that many think that what is in reality clearly "unfunded" is "funded". It isn't. 

While everyone is focusing on the asset side of the "Trumpflation" story (lower corporate taxes, cash repatriation, etc.), no one has really been focusing on the liability side, which could have some important implications. What has been weighting so much on bond prices since the US election has been once again the Japanese investors crowd. Again what we indicated back in 2016 in our conversation "Eternal Sunshine of the Spotless Mind", still holds in 2017, namely that you want to track what these investors are doing flow wise:
"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"- source Macronomics July 2016
On this subject we read with interest Bank of America Merrill Lynch's Japan and FX Watch notes from the 12th of January entitled "Japanese investors sell foreign bonds after US election":
"Surplus structure keeps yen in check
Japan's Ministry of Finance today released the November international balance of payments and a preliminary portfolio investment report for December. Japan’s current account stood at a ¥1.8tn surplus in November to match the recent trend (Chart 3).

We are seeing a gradual recovery in Japan’s real exports, which seems in line with the positive cyclical trend in global manufacturing. Oil imports have stabilized, but remain low. Outward direct investments exhibit structural strength, but the yen’s significant depreciation since the summer suggests “tactical” large-scale purchases of foreign companies (eg, Softbank buying ARM) are probably behind us for the time being (Chart 4).
The BoJ’s yield curve control has widened the yield gap between foreign and yen rates, which should support Japan’s thick income surplus. Overall, the surplus structure marginally stabilizes the yen’s move especially as Japanese investors first reacted to the US election by selling foreign bonds (Chart 2).
Trump shock led to foreign bond sale
In December, Japanese banks and lifers sold ¥1.48tn of foreign bonds, the biggest sale since June 2015 amid the Bunds tantrum. This is in line with our view given the rise in volatility in the US and the likely loss from the move in rates after the election. Details are yet to be reported, but we would assume this is a continuation of November where most of the sales happened in the US rather than Europe (Table 1).

Given our core view in the US remains bearish duration while the BoJ’s monetary policy helps keep JGB yields relatively low, this likely leads to some repatriation of Japanese money to the JGB market, which explains the rise in JGB purchases at both banks and lifers in November.
Pensions rebalance into bonds, out of equity
In Oct-Dec, trust accounts–represented by pension accounts–sold domestic and foreign equities and bought JGB and foreign bonds (JGB data up to November) (Chart 6).

In our view, the GPIF portfolio is close enough to its target that large moves in financial markets would lead to rebalancing activities where appreciating assets are sold and depreciating assets are bought, reducing market volatility at margin.
Flows may keep USD/JPY basis from widening for now
Meanwhile, foreign investors net-sold ¥123bn of JGBs in December. This most likely resulted from quarterly redemption of JGBs as a data from the JSDA, which excludes redemptions, shows foreign investors were net purchasers for a 29th straight month in November. We argued that tightening in USD/JPY basis spread is unlikely to become a trend, but a combination of cautious Japanese investors in foreign bond investment (and some repatriation into JGBs) and demand from foreign investors for JGBs will keep the USDJPY basis off the high seen in November for a while." - source Bank of America Merrill Lynch
So, from a "flow" perspective, no matter what the latest woozle is, namely the "great rotation" from bonds to equities pushed forward by many pundits, when it comes to Japan, not only the voracious foreign bid from Japanese investors has tempered it's pace, but if indeed, Japanese are more cautious about their foreign allocations, then indeed this will put some additional upward pressure on sovereign bond yields we think.

For the time being, the dollar woozle is still working its way, being the largest consensus trade around for many pundits, also for the likes of Deutsche Bank from their FX Blueprint note entitled "King Kong Dollar" from the 12th of January:
"King Kong Dollar
The most prominent theme in our 2017 FX blueprint is that a Trump presidency changes everything. The US economy is the 800-pound gorilla in the room – policy shifts are too important to not matter for global FX. Our overall assessment is that Trump will be highly supportive of the dollar. Whether this mostly happens against the low-yielding EUR and JPY or EM FX will depend on the policy mix that is delivered: greater emphasis on growth and the euro and yen will suffer most; greater trade protectionism and EM, particularly Asia, will bear the burden. Either way, the broad trade-weighted dollar should strengthen, with a Trump administration coming at a convenient time for our medium-term bullish view. First, the greenback has finally entered the ranks of a G10 FX top-3 high-yielder, an important driver of dollar appreciation in the past. Second, a rally that is front-loaded to the beginning of a Trump presidency fits in nicely with the mature stage of a typical 7-10 year dollar up-cycle.
It is tempting to only talk about President-elect Trump, but currency drivers run beyond the US. From Brexit to European elections and China’s ongoing battle with outflows, politics and de-globalization stand out as the broader FX drivers of 2017. In most instances, particularly in Europe, idiosyncratic stories provide further support to a bullish dollar view. In other cases, local drivers allow for useful diversification against dollar longs, with ZAR, RUB and IDR standing out in particular. 2017 promises to be another exciting year for FX.
Looking for the dollar catalysts
We see Trump’s Fed appointments and corporate tax reform as the most important drivers of the dollar in 2017. Four out of seven board nominations are due this year, including Yellen’s replacement. These are likely to lean hawkish and entirely reshape the Fed. Corporate tax reform may well mean lower rates, but far more important would be an imposition of a “border tax” –potentially the biggest shift in global trade since Bretton Woods and leading to a big US competitiveness gain. Beyond America’s shores, idiosyncratic drivers point to a stronger dollar against both the JPY and EUR. In the Eurozone, negative surprises in either the French or potential Italian election open up existential risks. Even if all goes well, the beginning of ECB taper could accelerate record portfolio outflows: wider spreads (and redenomination risk) and more volatility in bunds should further lower demand for European assets. Japan stands out for the opposite reasons: political stability will allow the BoJ to continue targeting JGB yields unhindered, further increasing policy divergence with the US. We expect EUR/USD to break parity and USD/JPY to approach its all time-highs this year.
It’s all about Trump’s tax policy
While most attention is focused on US fiscal stimulus, we think corporate tax reform stands out as the biggest positive driver of the dollar in 2017. Lower tax rates, border adjustments and a tax holiday on unrepatriated earnings all matter. Border adjustments would impose a 15-20% tax on all US imports while exempting export income from taxation. The policy would amount to a 15% backdoor competitiveness gain for the US economy. A mechanical application of trade elasticities would imply that the US basic balance would go back to the highs seen at the start of the
century (chart 1).

A tax holiday and shift to a territorial system of taxation would allow more than $1 trillion of dollar liquidity and $200bn of annual future earnings to be brought back to the US. Most of this cash is already in USD: but the withdrawal of offshore liquidity will maintain widening pressure on cross-currency basis pushing offshore dollar yields higher. Corporates are likely to use the liquidity for buybacks and dividend hikes which together with corporate tax cuts would encourage equity inflows and further support the dollar. With foreigners not having invested in US equities for the last five years, there is plenty of potential for foreign buying of the S&P (chart 2).

- source Deutsche Bank
Like any woozle, while the above narrative is enticing, we are not buying it. Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:
"Ramifications and Investment Advice
Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 
Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016
This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think. In this previous conversation we showed in our final chart that gold could indeed shine after the Fed and guess what it has:
"Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again." - source Macronomics, November 2016
So if indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar. This is a point put forward by Nomura in their FX Insight note from the 5th of January entitled "The weak dollar revolution could be tweeted":
"Weak dollar policy is a natural extension of protectionist policies
Clearly, the one area of trade policy that has been so far little discussed is FX policy. In a detailed interview on 30 November 2016, soon-to-be Treasury Secretary Steve Mnuchin evaded a pointed question on whether he supports a strong dollar. Instead, he responded:
“I think we’re really going to be focused on economic growth and creating jobs and that’s really going to be the priority.” (CNBC, 30 November 2016).
FX policy cannot be ignored in trade policy. A weak currency can be effective in giving domestic industries an advantage over foreign industries. Indeed, this has generally been the policy of emerging Asia economies from China to Thailand. Their substantial growth in FX reserves since the Asia crisis in 1997 is testament to a concerted policy to curb strength in their currencies. For Donald Trump, at a fundamental level, any appreciation of the dollar would offset some if not all of any import tariffs introduced.
As for the practicalities of introducing a weak dollar policy, the Plaza Accord of 1985 under a Republican administration is the last such example. However, it was coordinated with key trade partners and monetary policy was moving in a supportive direction. Replicating such an Accord would be a gargantuan task. The other precedent of sorts is the Nixon shock – again under a Republican administration. This was a unilateral move and involved both a currency devaluation and the imposition of import tariffs.
However, the better reference points may actually be emerging markets. They have pursued weak currency policies without coordination and often at odds with domestic monetary policy. Admittedly, the presence of capital controls makes it easier to separate FX and monetary policy (thereby overcoming the so-called Triffin dilemma).
The success of their policies has often hinged on the scale of their interventions whether through direct currency intervention or sovereign wealth fund purchases of foreign assets. One study featuring 133 countries over the past 30 years found that such state-directed outflows were a significant positive driver of the current account (i.e. pushed it into surplus)9. An IMF study featuring 52 countries (13 advanced and 39 emerging) from 1996 to 2013 found that currency intervention had a larger and more significant impact on exchange rates than interest rate differentials10.
It should be noted that Japan, which has been the most active G7 intervener in currency markets, has typically engaged in sterilised intervention. That is, intervention that would not affect domestic money supply (and so not impact monetary policy). Studies have shown that Japanese intervention has at times been successful even though it was sterilised. Moreover, one study by former Deputy Vice Minister of Finance for International Affairs, Taktatoshi Ito, showed that FX intervention over the 1990s, which was predominantly uncoordinated with other countries, resulted in a profit of JPY9 trillion ($75 billion). This showed that the MoF was buying USD/JPY at the lows and selling at the highs11. Therefore, there could be nothing to stop the US engaging in FX intervention to weaken the dollar. " - source Nomura
It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier.

What appears to be clear to us is that the Woozle effect from a central banking perspective has been fading as shown below in our final chart.

  • Final chart - The central bank "put" has been weakening
What has clear in recent months has been rising signs of the Woozle effect fading when it comes to central banks credibility. With rising populism, which in recent ways has been driven by central banking interventionism, there are growing indications that the cosy relationship between politicians and central bankers is getting tested. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 9th of January entitled "Yielding to populism" and displays how the central bank "put" has been weakening:
"Yielding to populism
We expect to return frequently to the theme of “populism” as 2017’s big narrative. For credit investors, populism doesn’t have to be all bad news. As our US credit strategy colleagues have highlighted, potential Republican tax reform could be very beneficial for some parts of the US market. In Europe, though, we worry that populism will manifest itself in two bearish ways this year: a weaker ECB “put” (read: weaker credit technicals), and rising political risk, which we believe is not reflected in European spreads.
Thus, while Euro corporate bonds have nudged tighter in the first week of 2017, with reach for yield behaviour still evident, we think Euro spreads stand to end the year wider. We look for the Euro high-grade market to finish the year 15bp-20bp wider than today’s levels, and for high-yield spreads to end 50bp wider (applying some tweaking to our Nov ’16 forecasts given the big high-yield tightening in December).
Draghi’s populist moment
In our view, Dec 8th 2016 should be seen as a game changing moment for Euro credit markets. We think the ECB yielded to another form of “populism” – namely pressure from a hawkish governing council to step away from the negative yield era, given undesirable side effects. So from April this year, ECB monthly QE buying will decline from €80bn to €60bn.
But we think that Draghi’s actions highlight a bigger story: namely that the central bank “put” (or influence on the market) is already showing signs of weakening. Chart 1 shows cumulative central bank asset purchases including EM FX reserves (which we think should be viewed as another form of QE buying). Note the peak in September last year, due to declining EM FX reserves (such as China). 

But in 2017, we know that the ECB is set to tone down its asset buying, and we also expect the BoE to stop buying gilts and corporate bonds once their respective targets have been reached (which we estimate to be in February ’17 and April ‘17, respectively). A weakening influence of central banks therefore means a weakening of the very strong technicals that have been asserting themselves on European fixed-income markets."
- source Bank of America Merrill Lynch

From a credit tightening perspective, we think you ought to monitor US Commercial Real Estate (CRE) because as reported by UBS in their latest US Credit Strategy Outlook for 2017, CRE nonperforming loans are likely to rise for the first time since 2010 and monthly CMBS deliquency rates were up 6 bp to 5.23% Y/Y in December. Bank loan officers have started to tighten lending standards since the first quarter 2016. US CRE is therefore something you want to keep a close eye on 2017. If the equity crowd are indeed the eternal optimist and suckers for the Woozle effect, the credit crowd is often the eternal pessimist, but then again, regardless of the narrative, as indicated above, in a world stifled by very high debt level, both duration risk and credit risk have been clearly extended meaning that price movements like we have seen in the Energy sector in 2016 are larger. When things will turn nasty at some point, recoveries this time around are going to be much lower, so forget the assumed recovery rate of 40% when you price your senior CDS but, that's a story for another day...or year...
"Every swindle is driven by a desire for easy money; it's the one thing the swindler and the swindled have in common." - Mitchell Zuckoff, American journalist
Stay tuned!

Wednesday, 4 January 2017

Macro and Credit - The Great Wall of China hoax

"The secret of life is honesty and fair dealing. If you can fake that, you've got it made." -  Groucho Marx
Looking at the Chinese currency falling against "Mack the Knife" aka King Dollar + positive real US interest rates, moving in sympathy with Bitcoin sailing through the 1000 threshold, with 2016 closing on arguably the epic failure of Mainstream Media (MSM) being the most prominent feature as pointed recently by Ray Dalio from Bridgewater Associates, we reminded ourselves for our title analogy of the Great Wall of China hoax faked newspaper story concocted on June 25, 1899 by four reporters in Denver, Colorado about bids by American businesses on a contract to demolish the Great Wall of China and construct a road in its place. The story was reprinted by a number of newspapers. We found it interesting that this hoax was created at the height of imperialism during late 19th Century when Great Britain obtained its 99 year lease for the New Territories, extending the Hong-Kong colony that had been ceded in 1841 while Germany seized the Chinese port of Kiaochow and used it as a military base, and French leased Kouang-Tchéou-Wan from China. Of course, this hoax coming at the very height of imperialism is reminiscent of our October 2016 musing "Empire Days" in which we pointed out that the "status quo" was failing:
"It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "status quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016
The hoax began with four Denver newspaper reporters, Al Stevens, Jack Tournay, John Lewis and Hal Wilshire, who represented the four Denver newspapers - the Post, the Republican, the Times and the Rocky Mountain News. met by chance at Denver Union Station where each were waiting in hopes of spotting someone of prominence who could become a subject for a news story. Seeing no celebrities and frustrated with no story in sight and deadlines due, Stevens remarked: 
"I don't know what you guys are going to do, but I'm going to fake it. It won't hurt anybody, so what the Devil." 
The other three men agreed to concoct a story and walked on 17th Street toward the Oxford Hotel to discuss possible ideas and came up with a story in which the Chinese planned to demolish the Great Wall, constructing a road in its place, and were taking bids from American companies for the project. Chicago engineer Frank C. Lewis was bidding for the job. The story described a group of engineers in a Denver stopover on their way to China. That's how the hoax began and spread like wildfire, even making a comeback in 1939 as an urban legend due to Denver songwriter Harry Lee Wilber claiming in a magazine article that the 1899 hoax had ignited the Boxer rebellion of 1900. The cultural historian Carlos Rojas comments that the original hoax being perpetuated by a second hoax, a "metahoax," illustrates the ability of the Great Wall to "mean radically different things in different contexts."

By now, you are probably asking yourselves where are we going with our analogy? Have we already lost the plot early on in 2017? Recent geopolitical events have clearly shown that in some instances MSM like to fake it. This of course can have some unintended consequences leading to a hoax becoming a metahoax as pointed out by Ray Dalio from Bridgewater Associates in his latest missive:
"If you have a society where people can't agree on the basic facts, how do you have a functioning democracy?" Distorted pictures lead us to make bad decisions. In my opinion, if people don't correct such inaccuracies and don't fight against this problem, continued distortions in the media will prevent the public's accurate understanding of what is happening, which will threaten our society's well-being. We in the financial community now openly talk about fake or distorted media being used to manipulate market prices to the harm of many, and similar conversations are taking place in most areas.
This is not just a fringe media problem; it is a mainstream media problem. And while it is widely recognized, there is no discussion underway about how to rectify it." - source Linkedin Pulse, Ray Dalio, Bridgewater Associates
Fake news and fake prices thanks to central banks meddling with interest rates for too long can obviously lead to "unintended political" consequences as we have seen last year. Given 2017, is the 100th anniversary of the Russian revolution, we will not be surprised to see some more "sucker punches" being delivered in various asset classes and issuers (such as what we have seen with French issuer Vinci in 2016, Japanese Toshiba, UK retailer Next as of late). Both the MSM and central bankers are losing their aura, this will have some "unintended consequences" on asset prices rest assured.

Before we go into the nitty gritty of this year's musing, we would like to extend dear readers our best wishes for 2017 and we are looking forward to more discussions and comments. Moving to what we will cover in this conversation, we would like to turn our attention to the impact "Mack the Knife" is going to have on housing demand, and therefore gradually and most probably putting a dent into the much vaunted "Trumpflation" story. While the feel good effect on the year might be lasting some more thanks to better macro data from PMIs overall, it remains to be seen how long hope and complacency will trump reality...

  • Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets
  • Final chart - Chinese credit is currently under-pricing rising risks in CNH

  • Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets
In numerous conversations we have pointed out about our difficulty in embracing the recovery mantra story playing out in the United States thanks to lack of solid evidence in wage growth which would as well confirm the reflation story playing out, in a world awash in debt which, is no doubt weighting on growth prospect. As an illustration of political hope versus economic reality, no offense to ex French Prime Minister Manuel Valls but, his 1.9% GDP growth hypothesis in his just published political program for the presidential run of 2017, where he indicates that he will reduce the budget deficit while increasing public spending by 2.5% is hogwash. It just doesn't add up when public spending is already close to 58% of GDP (we are still laughing about this). No matter how ambitious a political program is, even with the benefit of the doubt, that market pundits seems willing to give, it seems to us that expectations are going to get at some point a reality check in 2017. 

When it comes to fake prices and fake inflationary expectations, Japan comes to our mind given its prolonged monetary easing stance and its consequences, leading to a vicious cycle of low growth where Europe seems to be heading thanks to a similar "japanification" process, and unresolved nonperforming loan issues in large swath of the European banking system. Japan is as well of interest, not only due to poor demographics (as in Italy these days) but also from the perspective of low-yield assets becoming nonperforming. To that instance Japanese real estate is a good illustration of the process as highlighted by Deutsche Bank in their Real estate sector note from the 4th of January entitled "Investment strategy for 2017: time to heed warnings of intellectuals":
"Heading for a world predicted 150 years ago
We believe the election of Donald Trump as US president and the UK's Brexit decision are outcomes of overly successful capitalism instead of heightened populism. These events expose the risks of capitalism that were predicted by Karl Marx, Adam Smith, and other intellectuals in the past. Japan has not recognized the trend changes, and we expect Japan’s real estate market to worsen in 2017.
Karl Marx, Adam Smith, and other intellectuals from the past predicted these risks 150 years ago. Continuing deregulation leading to a world dominated by "survival of the fittest" naturally breeds success for those with capital and intelligence. It fosters dominance by the elite. Capitalism is fundamentally aggressive. Various regulations have been enacted for dampening this aspect of it. However, continuous deregulation has created a "winner takes all" world and expanded disparities between rich and poor.
Several intellectuals understood the risks of capitalism. For example, Karl Marx warned that "successful capitalism means victory for those with capital and knowledge, and when left unaddressed, creates a society with large disparities and monopolies and leads to higher prices." Adam Smith, known for the "invisible hand," wrote "The Theory of Moral Sentiments" in 1759 prior to the "Wealth of Nations" (1776). In this book, he acknowledged that competition is important, but explained that the spirit of fair play and consideration for others is an essential premise. Even Max Weber, who argued that making money is good, noted that capitalism requires high moral sensitivity in order to succeed.
In Japan, Sontoku (Takanori) Ninomiya famously stated that "economic activity that ignores morality is a crime, and morality that forgets economic activity is nonsense." Japan also had the “Sanpo Yoshi” spirit exemplified by Omi merchants that calls for benefits to the buyer, seller, and local communities together. In other words, risks of capitalism were predicted in both the east and the west.
However, it is getting difficult to find a new frontier beyond extension of the frontier to the middle class through deregulation. Capitalism appears to be reaching its limits in its current form. Natural redistribution (trickle-down theory) has failed, and calls for redistribution are making headway among the middle class. We believe this sentiment is behind the results seen in the election of Trump as US president and the UK's Brexit decision. The world may be entering a chaotic age as it seeks new types of capitalism.
Important elections will take place in Europe in 2017, including legislative elections in the Netherlands in March, presidential votes in France in April and May, legislative elections in France in June, and a general election in Germany in September. Results in Italy's national referendum in December 2016 forced the resignation of Prime Minister Matteo Renzi. We believe people may follow the Italian case in quite a few countries and expect disruptions and crises to pick up momentum worldwide in 2017. 
NIRP transforms low-yielding properties into non-performing assets
We believe that lowering nominal interest rates via the NIRP (negative interest rate policy) weakens the financial intermediary function and leads the Japanese economy to deflation. As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth. We see the risk of low-yielding assets becoming non-performing and triggering a significant setback to the NAV in Japan during 2017 in light of the approaching limits to monetary easing amid increased uncertainty in global political and economic conditions.
String of failures
Measures such as monetary easing that exceeded market expectations, a consumption tax hike amid a recovering economy to spur fiscal structural reform, and a strong ROE emphasis on shareholders have been adopted by the BoJ, the government, and the private industry, with each of them considered optimal. However, all have contributed to deterioration in Japan's economy and its real estate market. This is a classic example of the proverb, ‘the road to hell is paved with good intentions’. Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.
To avoid the extreme ultimate decision
As countries worldwide reconsider their positions due to widened disparities driven by overly successful capitalism, Japan has yet to reflect on this. It remains one step behind, as it moves forward with minor government and deregulatory policies. Japan should realize that it needs to foster stronger ethics and morals and pursue policies that break away from excessive focus on ROE and encourage long-term investment and higher wages for employees. Unless these changes are adopted, we see increasing likelihood that Japan will be faced with the ultimate decision.
Bursting of "quiet bubble" to accelerate in 2017
In 2016, the real estate market started heading towards the end of the “quiet bubble”. We see this move picking up pace in 2017. We see hardly any factors supporting optimism. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks include: 1) a rise in risk premiums due to a decline in bank lending to the real estate sector; 2) the hasty implementation of a hike in consumption tax and/or income tax, or a decline in government spending due to a rush toward fiscal restructuring; and 3) deepening NIRP amid another monetary easing. Upside risks include: 1) significant salary increases in private sector companies, and 2) consumption tax and income tax cuts as well as large-scale fiscal spending." - source Deutsche Bank
As clearly highlighted by Ray Dalio in his latest missive, playing a hoax for too long, ultimately has unintended consequences and bring about political instability. The impact of globalization have been clearly leading to some political discontent given it has fostered dominance from the elites as highlighted by Deutsche Bank in their note. We touched on the impact of globalization back in February 2015 in our conversation "The Pigou effect" and we indicated Populism was bound to happen as predicted by the maverick Sir James Goldsmith and his 1993 insightful book The Trap which was followed by The Response:

"We also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015: 
“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey. “And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian 

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. 

He violently criticized the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais. 
In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided above): 
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 
While MSM is still wondering why there is a global rise in populism and why Trump got elected, for us it  fairly is very simple, the social contract between society and the economy has been truly broken. 

So the poor "schmucks" or "deplorables" as some politicians were calling them that were initially sold the "greatness" of "globalization" are now realizing they have been fleeced and obviously they are not happy about it:

U.S. Wage Growth Since 1973* Upper / High Income: +52% Everyone Else: -4.6% 

Distribution of U.S. Household Wealth to the Bottom 90% 
2016: 22% 2005: 30% 2000: 31% 1995: 32% 1985: 37%
Young Americans living w Parents*
2016: 40%2000: 31%1990: 30%1980: 30%1970: 23%1960: 23%1950: 22%
*18-34 yr olds - H/T Lawrence McDonald

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":
"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014
Clearly the latest spat between president elect Donald Trump and Ford might be an illustration of the US administration's trying to counter the fundamental aggressiveness of US capitalism that strongly benefited from the Fed's generosity. Put it simply, it might look as an attempt (or a hoax) to favor Main Street against Wall Street. It remains to be seen what the new US administration will set in motion and to paraphrase Groucho Marx, maybe faking is making it after all and the deplorables might have once again been conned, we shall see.

But, moving back to low yields becoming nonperforming, we remain very wary of the destructive trail of "Mack the Knife". 

While we continue to see pressure building up on China and capital outflows, we are eagerly waiting for the 7th of January where we sill the publication of the latest state of Chinese FX reserves. On that subject Bank of America Merrill Lynch in their Asia FX Strategy Watch note from the 4th of January anticipates that China FX reserves have fallen by $25 billion in December:
"We forecast China’s FX reserves to fall by USD 25bn in December to USD 3,027bn. Our forecast is less than the Bloomberg consensus forecast for a fall of USD 42bn to USD 3,010bn in FX reserves.

We estimate an intervention effect of USD -15bn in December, which is less than the USD -40bn reading for November (Chart 1). Onshore FX volume rose from USD 670bn to USD 740bn in December; an increase in onshore FX volumes are associated with a larger estimated intervention effect. Some of that impact on the estimated intervention effect may have been offset by the narrower average CNH-CNY basis of -55bps in December, from -167bps in November, leading to our smaller than consensus forecast decline in China’s FX reserves.

Our estimate of the valuation effect in December is USD -10bn. While the USD continued to strengthen against the EUR, GBP and JPY, the rate of USD appreciation
was less than the previous month.
As China’s FX reserves falls towards the USD 3trn level, we believe officials may act to contain RMB depreciation expectations because:
  1. The USD 3trn could be of psychological importance to investors and officials. We show in our year-ahead report that this will ultimately be crossed in 2017, though capital controls are being engaged to sure-up credibility.
  2. Capital outflows from China picked up to USD 205bn 3Q 2016, especially through trade credits and the use of CNH.
  3. Inflation has maintained its upward trend in 2016, especially according to the PPI measure, raising concerns over FX inflation pass-through.
Indeed, the USD/CNY fixing rate has been notably lower than that implied by the 16:30 closing rate and the basket implied change throughout December 2016. Furthermore, FX purchases by individuals are now under greater scrutiny than before as the annual USD 50,000 limit was reset on 1 January 2017." - source Bank of America Merrill Lynch
On top of the unabated outflows from China thanks to "Mack the Knife", US rate hikes envisaged by the Fed will no doubt have an impact not only on US housing but, on the US economy as a whole as pointed out in Deutsche Bank aforementioned note:
"Are there any adverse impacts from the US rate hike?
We view 2017 as the start of major changes in trends as we mentioned above. The FRB increased the interest rate in December 2016 despite the increased possibility of major changes in global tides. We agree that conditions are healthier in the US than in Japan and Europe, which have adopted negative interest rates. However, the US rate hike may weaken its economy.
We are particularly concerned about auto loans and student loans in the US, which are now at all-time highs, having increased to $1.1tr and $1.3tr, respectively. Home mortgage loans have not recovered to the level before the Lehman collapse but are substantial. We believe that the US rate hike holds the risk of causing a downturn in housing demand.
 (click to enlarge)
We expect the rate hikes to gradually have a negative impact on the US economy and thus force a rate reduction in 2017 rather than further increases in rates. Hence, we believe investors should consider the potential for a shift back to yen appreciation. The risk of the economies in the emerging countries needs to be closely monitored as well. Even if faced with such conditions, the BoJ lacks additional options as it is already approaching limits of monetary easing.
The only possible action by the BoJ is widening negative interests. However, this may further undermine financial intermediation in the economy and accelerate a deflationary trend. We believe widening the negative interest rate would be a critical failure that adversely affects not only the real estate and stock markets but also the entire economy.
We expect a new era of global disruption over the long-term horizon, while we believe it will become apparent in 2017 that the US rate hike will have an adverse effect on the global economy and that Japan will not be able to cope with the impact. The environment for the Japanese real estate market is likely to present even stronger headwinds, in our view." - source Deutsche Bank
Of course, if the reflationary story turns out to be a hoax in a world where growth is stifled by high levels of debt, it will materialize itself at some point in 2017 and one would expect, the bond bears to retrench and yields to resume their downward trajectory during the course of the year. While hope is the ongoing "winning" strategy", at some point reality could reassess itself. On a side note, we have turned slightly positive on gold and gold miners over the course of December.

But moving back to Japan being a case study for monetary experiments, the impact of monetary policies have clearly shown their effect on real estate as pointed out by Deutsche Bank in their long interesting note:
"When expanded low-yield properties become nonperforming assets
As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth.
In fact, Mitsubishi Estate's yield on leased properties has slumped from over 9% (FY3/00) to the 5% range, and Sumitomo R&D’s yield has fallen below 5%. A flurry of designation of special economic zones led by deregulation has created incentives for investment in low-yield assets. Low-cost finance also enables it.
Cumulative free cash-flow deficits at Mitsui Fudosan, Mitsubishi Estate, and Sumitomo R&D totaled ¥1.9tr from FY3/00 to FY3/16, due to continuous excessive investments over a long period (free cash flow: operating cash flow -
As long as the current level of large investments continues, these companies cannot buy back shares or raise dividends significantly because they simply do not have the necessary funds.

Locations that previously did not have offices have suddenly transformed into cutting-edge office districts, further heightening supply. The office stock in Tokyo's 23 wards has increased 1.7x since 1991. Rents, meanwhile, are at all-time lows following repeated ups and downs over economic cycles because of flat demand.
Alongside excessive investment in rental assets, inventory assets have risen sharply and the turnover ratio has dropped to an all-time low. For example, Sumitomo R&D's inventory assets have increased by ¥720bn, from ¥128.3bn in FY3/00 to ¥846.7bn as of end-FY3/16.
Meanwhile, Sumitomo R&D's real estate sales rose modestly from ¥150.5bn in FY3/00 to ¥274.8bn in FY3/16, reducing the turnover rate from 1.17 to 0.32, an all-time low. Similarly, Mitsui Fudosan's turnover ratio dropped to an all-time low of 0.4.
Low-yielding assets have been accumulating in Japan due to the prolonged monetary easing climate. We believe the BoJ's negative interest rate policy, which lowers nominal rates, is worsening the situation, since the policy further undermines the function of financial intermediation and thereby encourages deflation.
Japan, which is approaching the limits of monetary easing, has limited response options and faces significant risk of low-yield assets becoming nonperforming assets if the yield upswing, yen strength, or other factors create headwinds for the economy amid heightened uncertainty in global political and economic conditions in 2017. We believe this implies the possibility of significant erosion in the NAV." - source Deutsche Bank
Clearly the prolonged downturn of the Japanese economy in conjunction with the implementation of Negative Interest Rate Policies (NIRP) have led to excessive investment in rental assets and inventory assets have risen accordingly.

But, for us, the greater distortion coming out from NIRP is the distortion it is creating in terms of "credit allocation". As we pointed out in our conversation "Goodhart's law", back in June 2013, there is "good credit" (infrastructure and productive investments) and "bad credit" (real estate):
"Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).
When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.
In 2008, we came very close to a global heart failure. The world had a stroke.
But, what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.
Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession" (Japan).
Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story..." - source Macronomics, June 2013
In terms of Japan, there is clearly indication that NIRP is already leading to "bad credit" as per Deutsche Bank's report:
"Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.
The first problem is BoJ’s policy. We believe its monetary easing policy has been excessive. We are not negative about monetary easing, but we believe this has started doing more harm than good.
The worst setback has been the decline in demand for non-real estate loans since the adoption of the NIRP, creating tightening rather than easing effects. Recent data actually show a 7.2% increase in loans to the real estate industry versus a slowdown to 1.4% in other areas (Figure 11).
The NIRP has proved dysfunctional in Japan due to record-low loan-deposit ratios (demand for bank loans is low and has moved little in response to lower interest rates). In addition, the NIRP, which lowers nominal interest rates, promotes deflation by weakening financial intermediation. Slowing loan growth to industries other than real estate is evidence of this.

Furthermore, the BoJ has adopted yield-curve controls because the volume of JGB holdings at banks that can be sold to the BoJ has already reached a limit. This has raised the risk of investors pricing in the limitations of monetary easing. We believe this is a problem too.
The BoJ's introduction of measures to control the yield curve amid NIRP promotion of deflation negates any benefits from lower interest rates. Yield-curve controls that prevent yields from declining are contradictory to the NIRP's reduction of the nominal interest rate. We believe this presents a nightmare scenario for the real estate sector.
Put differently, we see expected revenues declining, risk premiums rising, and risk-free rates trending upward. This means the three key determinants for stock prices in the real estate sector should move into a direction that is detrimental for the sector.
Our worst-case risk scenario would be widening of the negative interest rate by the BoJ that prompts banks to impose account management charges on large deposits. We believe this would start triggering further deleveraging.
Many Japanese companies are effectively debt-free and take bank loans mainly to maintain friendly relations with banks. If they are charged management fees for those accounts, we suspect many of them would reduce their deposits as much as possible and work to repay their loans.
Banks would then suffer not only a narrowing lending spread but also a drop in the lending balance. Japan would experience credit contraction (deleveraging), and as a result, slip into deflation again, in our view.
It is also important to consider market risk. The BoJ's massive JGB purchases have lowered JGB liquidity. Therefore, we see the risk of a sudden steep rise in interest rates if some type of shock occurs.
Furthermore, dark clouds are gathering over upbeat lending in the real estate industry because restrictions may be imposed on loans to the industry (as reported by some media sources). In fact, banks’ outstanding loans to the real estate industry have climbed to a record high of 14.8% of total loan value. We believe this already exceeds the acceptable level.

Second culprit is excessive focus on ROE
We believe the second culprit is an excessive focus on ROE. The behavior of Japanese corporations changed considerably after the 1997 financial crisis, and companies have stopped increasing employee compensation even with profit growth.
Since then, their more shareholder-centric stance has resulted in a greater tendency to distribute profits to shareholders rather than use them to boost employee compensation. If we assign 1997 a base value of 100, dividends would now be 500 while employee compensation is still 100.
We believe the domestic demand economy cannot grow without corresponding growth in employee compensation. On the other hand, executive compensation has been increasing. This would be understandable if management generated strong results, but in one case, executive compensation increased by more than ¥200m YoY even when the firm made a loss due to failed M&A and other initiatives. This is the tragedy of Japan copying the negative aspects of a shareholder-centric stance.
Shareholders are not a company's only stakeholders. Other stakeholders include clients, employees, and the society to which the company belongs. Although shareholders can easily cut off their ties by selling their shares, clients and employees are unable to end their relationship so easily. From this point of view, shareholders are not even the most important stakeholders.
We are not suggesting that companies ignore shareholders. Rather, we believe that insufficient attention given to employees and other stakeholders could destabilize a society. This is already happening in other advanced nations. In our opinion, it is a big problem for Japanese companies when managements fail to consider the experiences of other nations as related to its own issues." - source Deutsche Bank
The Japanese story, to some extent is clearly indicative of the challenges faced by the new US administration. This is for us the biggest headwind for the Fed, given it has accentuated through its loose policies the rift between the have and the have not. We have reached the limit of what monetary policies can do and the toxicity it has brought in terms of mis-allocation. It remains to be seen how the new US administration can encourage real wage growth and the latest Ford episode, lack for us an essential part to ensure a real recovery taking place and not a hoax, namely that the new Donald Trump administration needs more than having companies investing "in America", because if the new elected president wants to "make America great again", it certainly needs to learn from the Japanese experience and ensure US companies invest "on Americans" we think.

Deutsche Bank's note also clearly makes some solid points relating to the Japanese tragedy:
"Need to avoid ultimate decision
We see voters worldwide are calling into question the widening disparities caused by capitalism's overwhelming success, as evidenced by Trump's victory in the US presidential election, the UK's decision to exit the EU, and the resignation of Italian Prime Minister Renzi as a result of a national referendum in December.
However, the changing trend poses risks that were predicted long ago by intellectuals like Karl Marx and Adam Smith. Continuing deregulation funnels control to the elites, expanding disparities between rich and poor in a "winner takes all" scenario. Furthermore, it is difficult to find new frontiers because they have already been expanded to the middle class, raising the specter that capitalism in its current form will disappear. Natural redistribution (trickledown theory) has failed, and calls for redistribution are making headway among the middle class.
Even as the “quiet bubbles” approached their demise in 2016 and will likely accelerate in 2017, Japan remains mired in a dilemma. Instead, it seems to be standing still as a laggard, unaware of the growing chaos and crisis and the major changes taking place worldwide.
At this juncture, we believe Japan needs to foster a spirit of fair play that takes into account the interests of all parties and cultivates strong ethics and moral values, stop focusing too much on ROE, and enact policies that encourage long-term investment and higher wages for employees, as were outlined in the writings of Adam Smith, Karl Marx, and other intellectuals in the past. Without these changes, Japan may not be able to avoid the ultimate decision.
Specifically, companies are expanding shareholder returns to boost their share prices and increasing M&A because their own R&D reduces ROE. Innovation cannot be achieved this way. Companies should not refrain from long-term investments. Honda's ASIMO, linear-motor bullet trains, hydrogen engines, carbon fiber, and Japan's other impressive technologies obtained through long-term investment would not have been realized in a world focused on ROE.
We also believe that profits should be fairly allocated to employees, not just to shareholders and executives. Unless this happens, the cycle of "widening disparity → excess savings → low rates and low growth → asset price gains → bubble collapse → monetary easing" will continue unabated. Nevertheless, it seems that this cycle is at its limits.
We see need for tighter regulations, not just deregulation. This is particularly important in the real estate industry. Locations that did not have offices are suddenly being transformed into cutting-edge office districts, further heightening supply as a result of continuous deregulation. Therefore, rents are at all-time lows after repeated ups and downs during economic cycles.
We believe it is possible to achieve strong economic growth by ending sluggish consumption and increasing new products through innovation if Japan stops focusing excessively on ROE, and ends wage-curtailment for ordinary employment and restraints on capital investment. It is also time to halt deregulation and restore strong ethics and morality, along with more measured competition.
We believe the "quiet bubbles" started to collapse in 2016, and expect the downturn to accelerate in 2017. The economy and the real estate market will likely remain sluggish because of inadequate policies being pursued in the public and private sectors. We find almost no factors that support optimism. We believe Japan will likely face an ultimate decision unless the reforms we discussed above are enacted." - source Deutsche Bank
The wise words of Sir James Goldsmith from 1993 we mentioned back in June 2013 in our conversation  "The Pigou effect"  still resonate with the above and the risk for capitalism's demise:

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith
The ongoing rise in populism thanks to globalization and aggressive capitalism, in search of maximizing ROE and shareholders return have had the desired effects in leading towards a surge in populism, it remains to be seen how the new US administration will ensure that the economy serves the US society, or put it simply, make sure Main Street gets its fair share of the pie which has been lacking in recent years thanks to the Fed's bold monetary policies which were a boon to Wall Street.

In similar fashion, China is playing a difficult balancing act in trying to deflate its induced credit bubble while ensuring social stability which is illustrated in our final chart.

  • Final chart - Chinese credit is currently under-pricing rising risks in CNH

Our final chart illustrates the complacency between upwards pressure on the Chinese currency thanks to "Mack the Knife" and China credit risk and comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 4th of January entitled "Let's get technical". It displays the rise of USD/CNH 3 months ATM (At the Money) volatility versus China exposed names 5 year CDS index:
- source Bank of America Merrill Lynch
If "Mack the Knife" continues its unabated run, it remains to be seen how long China related credit is going to be able to hold the line. When it comes to Great Wall and hoaxes, it remains to be seen if indeed The Great Wall of Mexico will be one after all, but we ramble again...

"This nation is notorious for its ability to make or fake anything cheaply. 'Made-in-China' goods now fill homes around the world. But our giant country has a small problem. We can't manufacture the happiness of our people." - Ai Weiwei, Chinese artist
Stay tuned!

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