Anticipating Future Economic Policy

It is clear that the market has been driven almost exclusively by policy. The market typically prices in economic situations six months ahead of time. This kind of makes sense as known policy gives an indication of what might happen six months out.

Today the market is declining partly in response to declining odds of further stimulus; and is also waiting for the markets to give an indication to earnings expectations which will help provide a reality check on expectations. What is forgotten for now is that the stimulus was always intended as a two year plan; so there is still juice left in it. Furthermore, with the deficit is where it is, the chances of further stimulus were already low.

This post looks at future policy action which might occur. In a sense, anticipating policy ahead of time is useful, once policy is known it gets quickly priced. The risk is huge, because the markets can continue to fall because of what is known as the knowledge gets priced; in addition the policy anticipation can be wrong.

Nevertheless it is something I like doing, particularly as markets fall, because in the long term, nothing is really ever quite as bad as is expected during periods of stress. And it is never as good as is expected during periods of exuberance.

From a fundamental point of view, earnings and outlooks are important; my guess is that results will be in-line to positive as the adverse guidance ahead of results has been on the low side.

And from a technical view point, it would be good to see where the fall is arrested by new money; ideally I would expect buying support to rise at 825-850 range; but even going to anything over 747 is okay (preferably over 806). An arrest of the decline at these levels would give a reverse head and shoulders pattern for the bear market with Nov 08 lows near 750, March 09 lows near 650 and then Aug/Sep lows near 8XX! We can never really know market direction, but there is no harm in making an educated guess and my guess is 806, then rising as the economy recovers.

From a strategic viewpoint economics and policy are all important. My view is that the recession has or is very near concluding; a period of anemic growth can be expected for the foreseeable future and the degree of growth will be heavily policy dependent for at least one year. I see the recession as ending because lagging indicators now continue to decline, but at a slowing rate; at the same time, leading indicators have started rising. It is not uncommon for recessions to end when this fact pattern emerges.

My speculation on how policy might evolve is set out below:

1. Financial markets were illiquid following the near simultaneous explosion of the debt and property bubbles. The collapse of Lehman and the situation at AIG resulted in a complete loss of confidence in both self and counter parties. Suspect paper quality coupled with counter party risk make liquidity freeze.
2. Fed steps in as lender of the last resorts. Interest rates are aggressively cut.
3. Fed expands its balance sheet. Investors seek safety and interest rates turn negative; I am surprised with government’s ability to borrow in the situation; I had expected use of seigniorage (creation of money by printing it). Deficit starts climbing rapidly as a result. Economy faces deflation despite a huge increase in money supply.
4. So far the deficits have not been inflationary possibly because of a circular flow of money - from the Fed at near zero rates and into low yielding Treasuries; money supply exists but it’s not going anywhere.
5. Financial Institutions (FI) take huge write-downs. They are shored up by fresh equity infusions from investors, sovereign wealth funds and the US. FIs cannot be allowed to fail. Leaving aside the impact on financial markets and main-street, FIs have borrowed heavily from the Fed by now; to have the risk crystallize into liability is unacceptable. At the same time, quality assets such as Treasuries could be used to first pay other debtors with superior rights.
6. FIs further supported by changes to accounting rules. Credit markets slowly limp back towards life. FIs can start showing profits as write downs slow; also income from investments Treasuries flow through while cost of funds from Fed is near zero.
7. Fiscal stimulus benefits start to creep in; deficit rises further. Since money is entering markets, deflation risks abate. Can you imagine where unemployment would have been absent the stimulus? The main target of the stimulus should be to reduce the adverse impact of the terrible economy on unemployment. The ability of human assets to generate income is critical; particularly during a time of stress to the consumer balance sheet.
8. FI asset portfolios improve in asset quality, the balance between risky debt and safe debt is changed dramatically because of write-downs in risky debt and new investments in safe Treasuries. With additional equity and government guarantees, the risks recede. Credit markets start moving and risk appetite returns.
9. We are about here.
10. As FIs start to exit Treasuries to towards higher yielding debt, that value could collapse. It is unlikely that there will be an active market because of the US dollar’s status as a reserve currency coming into question. In time the Fed could act as a buyer; but not yet. Deleverage and shrinkage of Feds balance sheet and the deficit are likely to occur after the economic risk abates visibly. The reduction in deficits will likely be financed through a combination of higher taxes, fiscal austerity and seigniorage. Future deleverage will be disinflationary. But before we get here we have to have reflation in response to the stimulus and as private borrowing rises.
    1. Expect future policy direction to guard against deflation as the bigger risk.
    2. Also expect future policy to focus on fiscal austerity; i.e. no further stimulus unless in response to new events.
    3. Expect policy to tame deficit through higher taxes and fiscal austerity; though use of seigniorage cannot be ruled out. I am moderately in favor of some seigniorage as it will be inflationary (weakened dollar) and offset the deflationary impact of deleverage; in addition I believe foreign investors in (China in particular since it played a part in creating the debt bubble – see more on this here) Treasuries need to pick up part of the cost through devaluation.
    4. Expect higher tolerance of inflation to near 4% levels as low short term interest rates and a weak dollar will be required to maintain sub-par economic growth rates while the de-leveraging process is ongoing.
    5. Expect long term interest rates to remain elevated as a consequence of rising risk premium demanded by lenders; expect treasuries to fall in value and drive up yield to maturity.
    6. In tax policy, expect to see aggressive moves to widen tax base including illegal foreign accounts; see increase in capital gains and dividend taxes, see change in laws to dis-incentivize/disallow US resident corporate from sheltering offshore profits, thus deferring payment.
    7. See higher marginal rates of tax for $200k and over income levels.
11. But I am jumping the gun. Stimulating the credit market is no easy matter. First of all the FI ability to take risk has to be improved by removing some risk assets. Disposition of such assets will provide FI liquidity in addition to improving asset quality of the balance sheet. The profit impact of such an action will be muted because heavy write downs have been taken. A buyer can draw some comfort on valuation from government guarantees associated with the private public partnership plan targeted at buying distressed debt. Policy implementation in this area has been somewhat slow; it is something I hope to see recommence – and fast. This is an important step because restructuring debt by experts in the field, who have bough distressed assets at fair value, will lead to the benefits of debt destruction (it is already destroyed through the write downs but benefits needs to pass through to borrowers) passing on to consumers and business. Today consumers and businesses are not in a fit to borrow condition, but with debt write downs and restructure, be it through chapter 11 or otherwise, the borrower’s balance sheet will heal and the ability to borrow will return. With FI’s in a fit to lend condition, strong policy is expected to be enacted requiring tighter regulation including of the derivative market. I expect significant regulation to apply to outbound capital flows.
12. Once risky debt is in the hand of PPP owners, the process of allowing consumers and corporate borrowers to deleverage and be in a fit to borrow condition can commence. Restructure and write down of debt is the way to go. The process has begun - as the savings rates climb, net debt falls. Consumer balance sheets while far from healthy, they are starting the process of restoration to health. But there is a long way to go. Once balance sheets are repaired, borrowers in a fit to borrow condition will create demand for credit. While the home market deleverages, demand for credit from emerging markets will remain high. While emerging economies are suffering as a consequence of reduced US demand, the domestic foreign economies remain robust from a demand perspective. It is likely that monies will flow to emerging markets, especially for investment in infrastructure, resources and for industry with a high degree of dependence on the domestic foreign economy.
    1. Expect capital flows into emerging markets to keep the foreign currency strong.
    2. Expect higher inflation rates and nominal interest rates to prevail in emerging markets alongside higher growth rates.
    3. Expect high global inflation rates and a weak dollar to lead to strong pricing in the materials and energy sector.