Nicholas Glinsman | January 4th, 2022
Another global macro crisis is a definite possibility, and it could start in Europe
Unlike the GFC, it is not private sector credit or asset prices that are of concern, but the toxic interaction between governments and central banks. Back in 2007, it was a relatively small rise in interest rates that popped the US mortgage market, and by extension, the market for credit derivatives. This time, it may take only a small rise in inflation to prick a sovereign debt bubble.
The really eerie parallel is that once again, Europe is not the worst offender, but possibly the most affected. The euro area’s sovereign debt crisis arose from a spillover. European countries have expanded their fiscal policies during the recent pandemic, but not nearly on the scale of what happened in the US. The massive global demand boost from fiscal expansion, combined with the structural shock of Covid-19, led to a rise in global inflation. If the inflation forecasting models turn out to be wrong, central banks and governments will have to make a choice between tolerating higher levels of inflation, or risking a return to sovereign debt crisis. This is the Ponzi game of our era. It is a game of fiscal expansion supported by central bank asset purchases. And like a Ponzi game, it ends with a foreseeable event, in this case a rise in inflation.
The technical mechanism is fiscal dominance, of which we have spoken much over the last couple of years. It defines the situation in which a central bank’s ability to achieve its inflation target is constrained by the dependency of governments on central bank asset purchases. Quantitative easing was a justified measure when it was taken in 2015 for the European sovereign debt crisis. Indeed, many advocated for it earlier. It is the failure to take it back in time that has created today’s toxic dependency. As such, the ECB will struggle to take back purchase volumes, and in later years, reduce the stock of net assets on its books. In doing so, it will run an excessively loose monetary policy over a longer period of time.
On the other hand, if there is the desire, then the US will find it easier to wean itself off the central bank as the main support pillar for government debt. Despite its many problems, do not underestimate the resilience of the US economy, and its ability to adapt. The Europeans are reluctant latecomers to the idea of discretionary fiscal stimulus and QE. Yet, the euro area is indeed more vulnerable because it refuses to create a fiscal union with the capability to manage macroeconomic shocks and reduce inter-regional imbalances. What we will get at most is an enlarged EU budget, but this is not a fiscal instrument. The recovery fund, too, is a structural facility.
Back in 2007, the euro area, then eight years old, was merely a fair-weather construction. It had a central bank and a few fiscal rules, but nothing else. There have been numerous institutional changes since, like the creation of the European stability mechanism, but the fundamental source of vulnerability, the presence of imbalances without a central fiscal authority, is unchanged. As such, another global macro crisis is definitely a possibility.
However, as you have probably realized from my missives, I fear that there are many potential causes of a global crisis. Another possibility is a further strong run up in the US dollar, especially if the Fed does go ahead and raise rates. Now, in this instance, based on the median of past Fed tightening cycles since the fall of Bretton Woods, the USD has tended to weaken more often than not in the early stages of a Fed tightening cycle, after typically strengthening in the 6 month run-up to the first rate hike. Historically, the USD only strengthened again thereafter in the second year after tightening!
Six months after the start of Fed tightening, USD weakness has occurred in all cycles, barring the major USD bull run in 1984. There appears to be a ‘buy the rumor, sell the fact’ initial USD response to Fed rate hikes. That said, I can bear personal witness to the idea that every USD cycle in the last 40 years has felt materially different to each other, and different to what is shaping up to be the start of another tightening cycle this year.
To understand how the forthcoming cycle might both resemble and differ from patterns of the past, it is worth considering some of the dominant forces that were occurring during tightening cycles over the last four decades, and how this shaped the USD’s reaction:
If you consider the above history, there were at least six important and relevant themes:
However, this time around, the US dollar has a number of forces working to its benefit:
For the start of the coming Fed tightening cycle, the USD is seen as only moderately overvalued based on an average of PPP, BEER and FEER metrics. While this should not stop EUR/USD breaking 1.10 (vs fair value of 1.20+), to break 1.05, many market participants would have to believe that parity is possible, otherwise long-term EUR dip buyers are prone to emerge near or above 1.05.
To summarize, each Fed tightening cycle has had different characteristics as it impacts the USD. Nonetheless, the USD’s experience during past Fed tightening cycles, is a cautionary tale against a knee-jerk view that tightening automatically means a stronger USD.
The stronger USD we expect in 2022 is in no small part contingent on the Fed gradually catching up with the scale and durability of the US inflation problem, prompting US rate hike expectations to continue to be brought forward, while in contrast the ECB in particular holds the line on no rate increases in 2022. And remember, a stronger USD can have destructive effects on non-USD markets
Now, the above represent clear and present macro risks. Let me add one more, using some charts from the latest presentation (“Fear of crowded spaces”) by the always relevant and eminent Matt King of Citi. As he rightly points out, tightening to date has been greeted by market rallies. However, expect tantrums in risk if central banks respond to inflation, or tantrums in bonds if they do not, which is something that may have started as of yesterday.
Supply chain problems could well face more Chinese Covid issues
The market is very focused on omicron developments in the US and Europe. But the big elephant in the room is China’s zero covid strategy and what this means for supply chains and inflation. Ningbo – the world’s biggest port – is once again enforcing a partial lockdown. We have been highlighting signs supply chain issues for a while, and of note, some benchmark container indices are making new record highs again. China’s persistence with Zero Covid and harsh lockdowns will be critical for the supply side of goods in 2022.
DC will be consumed with at least 4 big bills through November, alongside the Federal Reserve hearings/confirmations:
Who prevails on China policy – the dictates of Wall Street or the Biden Administration
Harry Truman spoke in unvarnished, crystal-clear sentences when saying what he was thinking and would do. Dwight Eisenhower’s garbled syntax was designed to make his thinking and plans unclear to friends and foes alike. Ronald Reagan used the sugar of soft language to make his hard, consistent foreign policy messages go down more easily. Presidents have their styles.
Which brings us to Joe Biden. He is neither precise nor deliberately garbled, and often contradicts himself. But on China, he is clear: “If we don’t get moving, they’re going to eat our lunch.” He has already signed into law a bill passed unanimously in the Senate and 428 to 1 in the House of Representatives. It would ban imports containing forced Uyghur labour. Whether or not that is enforceable remains to be seen.
In any case, he must decide what to do about an American financial sector that has decided to act as an enabler of Xi Jinping’s goal to replace America as the dominant power in global finance. Those titans seem unworried that China has purchased only 58 per cent of the $200 billion in goods it promised to buy as part of the phase-one trade deal negotiated by president Trump — one reason our ports are unable to handle the inflow of its products, while cargo containers are returning to China empty. Or that Xi’s “Made in China 2025” plan calls for massive subsidising of his country’s exports, especially in products key to prosperity and security in the 21st century — no matter the promises China made when President Clinton piloted its entry into the World Trade Organisation.
China has kept one promise: it has opened its economy to participation by US financial firms. This suits the regime, which needs access to foreign investment as its faltering economy slows under the weight of the restrictions placed on its entrepreneurs, its unsustainable debt burden, and the collapse of its overly indebted property sector. China-based American firms can provide that access while at the same time giving Xi control of their operations.
Whether or not Lenin, the Soviet Union desperate for foreign investment in 1921, actually said that the capitalists would sell him the rope with which to hang them matters not; it captures Xi’s strategy. China’s president-for-life knows that when he objected to several hotels and airlines listing Taiwan as a country in their travel ads, they issued grovelling apologies and re-did their maps. He knows that the disappearance of tennis star Peng Shuai has not prompted Coca-Cola, Intel, Visa, Airbnb or Procter & Gamble to cancel their sponsorship of the Beijing Winter Olympics.
Citigroup, Goldman Sachs and JP Morgan Chase are among the investment banks setting up shop in the People’s Republic. Ray Dalio, billionaire founder of Bridgewater Associates, the world’s largest hedge fund, raised $1.25 billion for investment in China. Dalio argues that it is not for him to “be an expert” on government policy… “Should I not invest in the United States because [of] our human rights issues?” “Obviously, what we can do in China is largely dictated by how the Chinese government allows us to operate,” Goldman Sachs’s chief executive, David Solomon told an interviewer. Equally obvious is that once China has these companies by their investment, their hearts and minds will follow — to make a phrase attributed to Teddy Roosevelt suitable for a family newspaper. Xi knows that American bankers, salivating at the prospect of profits from entry into the Chinese markets, will dance to his tune rather than opt for mention in the next version of Profiles in Courage. As did Jamie Dimon, head of JP Morgan, who joked in a speech in Hong Kong that both his bank and the Chinese Communist Party are 100 years old and “I’d make you a bet we last longer”. Xi took umbrage. Abject apology followed “because it’s never right to joke about or denigrate any group of people whether it’s a country, its leadership or any part of a society and culture”. If that rule were followed in the US, there would have been no Will Rogers — “America has the best politicians money can buy.” And no Charlie Chaplin to produce The Great Dictator, spoofing Hitler to the consternation of appeasers in Britain and non-interventionists in America.
Biden now faces some hard decisions. Should he remove tariffs on Chinese goods, as the business community is requesting and as Treasury secretary Janet Yellen says would reduce inflation? Should he mount a serious subsidy programme to reduce US dependence on China for key raw materials, despite the messy environmental consequences of such mining? Should he tell US bankers what he is telling US manufacturers — “come home” — or allow them to strengthen China’s economy, its Communist Party and its military? While pondering those questions, he will face opposition from the new de facto pro-China lobby formed by many of the Wall Street bankers who backed his presidential campaign. A formidable group with lots of rope for sale.
Inside Joe Biden’s disastrous negotiations with Iran
One of the West’s great foreign policy failures of 2021 was the Iran nuclear negotiations, which remained bitterly unresolved as the clock passed midnight. Having spoken to a number of diplomatic sources on different sides in recent weeks, it is hard to avoid the conclusion that the process has been woefully inept. Not only has there been a dramatic failure to extract any concessions from Tehran – even a meaningful freeze on progress towards the bomb has remained elusive – but western negotiators have become enveloped themselves in an Asterix-style dust cloud of infighting, competing agendas and tension.
All of this, of course, is a gift to the Iranians, who have entered 2022 in a commanding position. In truth, the project was all but doomed to begin with. Before he was even elected, Joe Biden telegraphed his desperation to re-enter Obama’s JCPOA deal. ‘The good news is there remains a better way,’ he wrote for CNN. ‘A Biden administration will make it a priority to set Iran policy right.’ The President might not have said in so many words that he would bend over backwards for a deal. But the Iranians are skilled at reading between the lines; and so are the senior members of his own administration. Diplomatic sources have described Robert Malley, the US Special Representative for Iran, who is leading the negotiations in Vienna, as ‘the most dovish official we’ve ever seen’. In fact, the former head of the International Crisis Group – a think-tank devoted to dispute resolution, the very embodiment of the doctrine of softness – has bent over backwards so far that, as one official put it, he now speaks to Tehran from between his legs.
The talks began with a spectacular American misstep. As soon as the starting-gun was fired, US negotiators amazed international partners by tabling a proposal that was so generous that the Iranians had to rub their eyes to believe it. In the minds of the Americans, this was a take-it-or-leave-it offer, straight out of the box. But it did not come across that way to Tehran. Once the Iranians had caught their breath and climbed back onto their chairs, they set about demanding further concessions, in the belief that this was only the US opening position. The Americans continued to insist that this was a one-time offer – but crucially failed to back this up by walking away from the table or putting forward punishing consequences. So the Iranians kept on demanding. This resulted in what can only be described by the Hebrew term balagan, as any real sense of pressure and jeopardy dissolved.
Jake Sullivan, Biden’s national security advisor, has been consistently sidelined by Robert Malley, who has been able to craft his own version of the negotiations when reporting to Antony Blinken, the Secretary of State. As a result, the true scale of the debacle is hidden from the White House – and President Biden has been preoccupied with domestic matters anyway. As the impasse dragged on month after month, and the Iranians continued to strengthen their position by delaying things further while enriching uranium to higher levels, the mood among western diplomats became fractious. Officials could almost hear the Iranians rubbing their hands.
It is hard to avoid the conclusion that 2022 will be Iran’s year. The Ayatollahs have already eased the effects of western sanctions by pivoting economically to China and Russia, and are picking off Gulf states one-by-one. Despite an alliance with Israel, the UAE is now Iran’s second-largest oil customer. Only the Saudis continue to hold entirely firm against Iranian influence. The Israelis, meanwhile, have been ferociously lobbying the Americans to place a credible military option on the table, without which the negotiations lack teeth. But even if they were successful, there is little guarantee that strikes would work.
Iran’s nuclear installations are buried deep in multiple locations across the country, many of which are in civilian areas. This leaves the West with two options: either an Iraq-style mass ground invasion, or the biggest air campaign since the second world war. Both of these can only be carried out by one country. And given the mood of the public in that country, and the instincts of its political leadership, there’s more chance of a Pride parade in central Tehran this year. Moreover, Iranian proxy militia have long been embedded throughout the region. In the event of war, they may be activated to strike multiple targets at once. Tehran could even shut down the Strait of Hormuz, which 30 per cent of the world’s gas passes through.
Is there any glimmer of hope? Traditionally, the Americans tend to let their negotiators and envoys run until they fall, then replace them. There is a palpable feeling in diplomatic circles that the clock is ticking for Mr Malley. If his head were to roll soon, the negotiations would be thrown into temporary disarray, and the ensuing delay would benefit Iran. But this creative destruction may allow a more serious player to lead the American delegation. That, I’m afraid, is the best we can currently hope for.
Latin America Outlook
The coming year will prove challenging for most, if not all, countries in the region. Governments will still be grappling with the tail end of the pandemic while trying to return to a more normal life of preserving stability and improving living standards. However, the conditions in the region in 2019 and early 2020 were already quite challenging, with protests and unrest in many countries—such as Chile, Bolivia, Honduras, Ecuador, and Peru. In other words, the region was primed to explode, and in some cases explode it did.
The region’s politics has shifted to left of centre, with Boric’s election in Chile, Arce in Bolivia, Castillo in Peru, and Castro in Honduras. This could continue in 2022, with presidential elections in Brazil, Colombia, and Costa Rica. This suggests that governments may try to address concerns about growth and inequality through more expansionary fiscal policies, yet many countries already face wide deficits and high debt after supporting their economies during the pandemic. It may also provide an opening for China to expand its influence in the region as countries seek closer ties with an important trading partner and want to show more independence from the US. Chinese investment is already a problem for the US and it is also a problem in debt relief talks. Furthermore, there could be broader implications for the region’s approach to foreign, economic, and investment policies, including the growing prospect of nationalization (especially on energy and minerals), whether creeping or direct.
In 2022, Argentina will be focusing on its programme discussions with the IMF, to which Argentina owes about US$45 billion that mostly falls due in 2022 and 2023. These discussions are likely to proceed more slowly than many in the markets expect, and Argentina is currently on track to incur arrears to the IMF this year. The Argentine government has long warned about the costs of excessive fiscal adjustment in terms of harming growth and adding to poverty and inequality. Plus, there is no strong constituency in the country that favours a significant reduction in inflation. In fact, many see little problem with stable inflation of 40-50 percent a year and note that, with widespread indexation and powerful unions, the output cost of reducing inflation would be quite high. Add to this mix the fact that the central bank’s true international reserve position is quite weak, in that it does not have sufficient funds to pay $20 billion a year to the IMF over the next two years. The internal politics in Argentina do not favour compromise, as the two Peronist factions and the opposition have strong incentives to try make the others fail. For its part, the IMF will be cautious after a failed programme that created significant financial and reputational risks and is unlikely to agree to a weak programme with poor credibility, at least not one that is so weak as to be acceptable to the relevant political parties in Argentina. The recent IMF ex post assessment of the programme essentially blamed the Fund staff and the Board cannot afford to approve to two failed programmes in a row, especially for such large amounts, to the same country. There will be political pressure brought to bear on the Fund to demonstrate flexibility towards Argentina, but it will unlikely be sufficient to avoid arrears.
AMLO remains popular midway through his six-year presidential term and is seeking to hold a referendum in mid-2022 that would affirm popular support for his presidency. His supporters have been gathering the number of signatures required to go ahead with the referendum and hope that in January the National Electoral Council will decide whether the process can go forward.
AMLO is moving ahead with his agenda to gut the 2013 energy reforms that opened the way for much greater private sector involvement in the energy sector. He is taking steps to shore up PEMEX through direct transfers from the government and reduced taxes and giving PEMEX back much of its control over production and exploration and refining of oil. His electricity reform aims to bring CFE back to the center of all aspects of the electricity sector.
While he continues to keep the fiscal deficit low, he is still going forward with white elephant investment projects, such as the refinery and the train. He will continue to pursue prosecution of officials of previous governments for corruption to burnish his anti-corruption credentials. In terms of US relations, he will show flexibility on migration so he can have room to move on the energy sector and security. Mexico was furious when the US arrested Cienfuegos in Los Angeles and forced his return to Mexico, after which he was exonerated. This shows just how much AMLO depends on the military for his support.
While Gabriel Boric takes office on March 11, the main issue in 2022 will be the new constitution, which is to be submitted to a popular referendum in the third quarter. The constitutional convention is reviewing all options. Given the outcome of the 2021 elections, it is likely that the new constitution will propose major changes to the social safety net, the pension system, the role of the mining sector in the country and many other issues. It will be important to watch Boric’s cabinet nominations to gauge his policy intentions, even though his power at least in 2022 will be constrained by the debate over the new constitution.
Chile’s efforts at constitutional reform will be a focus as it represents the leading edge of establishing green transition at the Constitutional level. Chile benefits from a large stock of lithium, which is essential to global efforts to transition to green energy. These include whether lithium mining will be nationalized or subject to hefty royalty payments and income taxes, how environmental impacts will be treated and water rights – including whether the brine associated with lithium will be considered as a public good (water) or as an input covered by the law on mining.
Changes in Chile could have important implications for world markets for copper and lithium and for attitudes towards economic policies in emerging markets. We think these implications will be bullish for both.
Colombia has experienced political unrest like that in Chile, over concerns about inequality, poor social mobility, ineffective government, pressures from Venezuelan migrants, the effects of the pandemic and probably other issues as well (some probably related to the peace process). As a result, the current president, Ivan Duque of the center-right is registering record low popularity. For the upcoming election in April-May 2022, Gustavo Petro, now a left-wing senator and a former mayor of Bogota, is way ahead in the polls. Petro’s platform in the 2018 election (which he lost to Duque in the runoff) contained some extreme proposals, and he belonged to the M19 guerilla movement in the 1980s. For this reason, he scares many in the Colombian establishment. However, one could make a case that he would probably govern along the lines of many European Social Democrats, and looks like Boric. After all, he did run Colombia’s largest city reasonably well for four years. Moreover, Colombia’s policy institutions build in a lot of continuity, making it hard for any president to implement radical change right away.
Peru’s politics are a mess and have been for some time, with little hope of change for the foreseeable future. The current president, Pedro Castillo who took office in 2021, hails from the extreme left, while the Senate leans much more to the right. Castillo was forced to appoint a more moderate cabinet than he initially proposed, including naming a Minister of Finance who had worked at the World Bank. He also had to reappoint Julio Velarde as central bank governor to avoid a run on the currency. Moreover, the congress was on the verge of impeaching him a few weeks ago over allegations of corruption, but it held back partly because it had impeached the previous elected president in 2020 and thought it would be too soon to impeach yet another. In his campaign Castillo had proposed to reform the constitution, but such a prospect now seems highly unlikely.
Nicolas Maduro remains the most entrenched leader in the region, in spite of earlier speculation that his days were numbered and that Juan Guaido was ready to assume power. The US remains focused elsewhere and Venezuela remains a lose-lose for any Administration that seeks to resolve tensions, so political calculations dictate that Venezuela remains off the White House radar for as long as they can manage it.