"What generates war is the economic philosophy of nationalism: embargoes, trade and foreign exchange controls, monetary devaluation, etc. The philosophy of protectionism is a philosophy of war."

- Ludwig von Mises

Looking at the strong yet short bounce in equities following market jitters on Italian wobbles (while enjoying some much-needed R&R, hence our lack of recent posting), indicative of our "white noise" previous analogy, given the acceleration in the trade war rhetoric in the G7 - soon to be G6 by the looks of it - when it came to selecting our title analogy, we decided to go for the simple one of "Mercantilism." "Mercantilism" is a national economic policy designed to maximize the trade of a nation and, historically, to maximize the accumulation of gold and silver (as well as crops). Mercantilism was dominant in modernized parts of Europe from the 16th to the 18th centuries, before falling into decline, although we would argue that it is still practiced in the economies of industrializing countries in the form of individual rights.

High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Even if mercantilism and protectionism are applied through the same economic measures, they have opposite aims. Mercantilism is an offensive policy aimed at accumulating the largest trade surplus (China, Germany). Conversely, protectionism is a defensive policy aimed at reducing the trade deficit and restoring a trade balance in equilibrium to protect the economy (United States). Mercantilism is the economic version of warfare using economics as a tool for warfare by other means backed up by the state apparatus - that simple. In our previous conversation, we reminded ourselves of our thought from October 2016, namely that we were drifting towards the inevitable longer-term violent social wake-up calls: populist parties' access to power, rise of protectionism, the 30's model. Back in January this year, in our conversation "The Twain-Laird Duel," we looked at the recent rise in the trade war rhetoric, and we argued the following:

"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..."

- Source: Macronomics, January 2018

Hence our "Mercantilism" analogy, or basically the reality is that we are fast moving from a cooperative world to a non-cooperative world à la the 1930s. It isn't only tensions rising between China and the United States, or United States with Europe, there are as well growing tensions between European countries and internal tensions rising even in Germany, putting Merkel's feeble coalition at risk, thanks to political tensions surrounding immigration issues. We would like to repeat what we what we wrote in June 2012 in our conversation "Eastern Promises":

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."

Remember, it is still a game of survival of the fittest after all:

Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed."

- Source: Bloomberg

Also in June 2012, in our conversation "The Unbearable Lightness of Credit," we argued the following:

"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries".

This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"."

- Source: Wikipedia

The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.

"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way" - the Soviet Union was allowing these nations to go their own way."

- Source: Wikipedia

"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there."

- Source: Wikipedia

Could Europe allow for the adoption of the "Sinatra Doctrine?" We wonder, but nonetheless, before we enter into the nitty-gritties of our long-overdue new conversation, we thought it would be interesting to remind ourselves of the above, given our take for Europe from our November conversation "Chekhov's Gun" is still as follows:

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30's model…)."

- Source: Macronomics, November 2012

In this week's conversation, we would like to look at the continuous adverse effects of moving from QE to QT, and the impact it is having on Emerging Markets with rising tensions as well on the trade war front.

Synopsis

  • Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
  • Final charts - Capital Flows? This time it's really different.

Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...

Will the short-vol pigs house of straw was the first casualty to go in the change in the sea of liquidity provided by our "Generous Gamblers," aka our dear central bankers, emerging markets have been of course next in the line in the change of the narrative with the return of "Mack the Knife," aka a rising US dollar and positive US real rates. We wrote in our last missive that investors were moving back into assessing the "return of capital" rather than the "return on capital." This is creating rising dispersion, thanks to investors being more "issuer credit profile" sensitive with the return as well of US cash in the allocation tool box. The rise in dispersion should continue to make active management benefit from this trend after years of being in the shadow of passive management and consequent fund inflows into ETFs.

With the receding tide of cheap liquidity, there is no doubt an intensification in the competition for capital. When it comes to credit, we have recommended to start moving up the quality spectrum and tone down the high beta game, basically meaning being more defensive, i.e., as the game is changing.

Sure, some pundits when it comes to emerging markets would like to point out to "fundamentals." Yes, they do indeed matter, particularly when looking at current accounts, but in the end, if there is spillover and contagion from the "usual suspects" with Argentina, Turkey and now Brazil, then what will matter much more is "liquidity." Right now, liquidity is being drained by central banks, and this will ensure financial conditions tighten. As many have pointed out, including ourselves, the Fed will hike until something breaks, and in the end, what drives the credit cycle is simply the Fed. On the matter of liquidity, which we think is paramount, we read with interest Morgan Stanley's take from its FX Pulse note from the 14th of June, entitled "Liquidity Breaks Correlation":

"Global liquidity...

The pool of global liquidity appears to be starting to shrink. Several factors are at play here. First, the Fed's balance sheet reduction is increasing pace while the ECB and BoJ are reducing their asset purchases (Exhibit 8).



On net, global central bank liquidity is likely to turn negative over time when compared to GDP growth. Second, the global economic expansion suggests that capital will increasingly be allocated to 'real' economic uses as opposed to financial assets. A closed output gap suggests rising capital demand as spare capacity is eroded, and investment into new capacity requires financing.

Third, the flattening of the US yield curve has reduced the incentive of local financial institutions to transform short-term liabilities into long-term assets (maturity transformation). If banks are less willing to generate liquidity through the maturity transformation process, another buyer will have to step in to make up for the shortfall. Japanese banks liquidating their FX-denominated assets is evidence that demand for US assets is falling outside the US as well, meaning tighter liquidity conditions as demand for financial assets declines (Exhibit 9).



...volatility...

Tighter liquidity conditions suggest higher volatility as the risk-absorbing capacity of markets declines. When liquidity is ample, all boats tend to get lifted. The reverse effect may be more selective, though. EM volatility has risen sharply, but DM volatility, with the exception of some credit markets, has been relatively muted (Exhibit 10).



Indeed, US equity markets are trading near historical highs, while the 10-year Treasury yield fell back from the recent 3.12% cycle high. It seems the liquidity pool is both shrinking and becoming more concentrated, too. One explanation for the differential in volatility is that we have simply seen a rotation - out of EM and into DM - which explains why DM volatility has been relatively muted compared to EM. This too suggests that a positive outlook for US shares may no longer imply that EM assets will perform well too if they increasingly attract funds at EM assets' expense.

The feedback loop: It is likely that recent market thinking and positioning have been, at least in part, impacted by RBI Governor Patel's recent op-ed where he suggested that the Fed's balance sheet reduction, coupled with rising US public deficits and private debt levels, is leading to an absorption of offshore USD liquidity. Many EM economies experienced recessions following the US taper tantrum in 2013, which in turn resulted in balance sheet consolidation and reduced foreign funding needs. Still, EM countries require capital inflows to keep the economic expansions in place, particularly in the current environment of closed output gaps where spare capacity is increasingly scarce.



Indeed, 2017 saw record inflows into EMs, but this has turned into outflows, tightening local financial conditions and thus their economic outlooks. If not addressed, this issue could create bearish economic feedback loops where liquidity outflows worsen the growth outlook, resulting in more outflows, and leading to even more weakness.

Thus, it may be argued that the US fiscal expansion, implemented at a time when the US output gap was closed and global funding costs were at the lows (and are now rising), may actually reduce the length of the global economic cycle, sowing the seeds for financial asset volatility and investors increasingly seeking safety. Our bearish risk outlook projected for 2H18 has gained traction, we think.

The FX message: Currencies not requiring capital imports and running net foreign asset positions should perform best in this scenario, explaining our bullish JPY call. EUR and Nordic currencies offer value too in this regard. As long as markets only de-correlate but do not fall collectively, CHF should weaken, though. As noted above, the relatively low risk of its asset position suggests that it is not much exposed to waning risk sentiment; otherwise, its income balance would be far higher. Thus, CHF may benefit less than the other surplus currencies should risk sell off. CHFJPY shorts may begin to look attractive again."

- Source: Morgan Stanley

While we got out of EM equities back in January this year following impressive performance in 2017, we continue to believe that US equities will fare much better relative to EM in 2018, contrary to what played out in 2017. Fund flows-related wise, similar to US High Yield, where there is a large contingent of retail punters, emerging markets are starting an orderly retreat from the asset class at a rapid pace. This is confirmed by Bank of America Merrill Lynch GEMs Flow Talk note from the 14th of June, entitled "EXD & LDM outflows continue... 8th straight week down; big blow for EXD":

"EPFR fund flows down: EM debt 8th consec week down

• EXD, LDM and EM Equity were all down, while blended funds were slightly up.
• 8 negative weeks in a row for overall EM debt, outpacing the large negative trend recorded at the end of 2016 (six consecutive weeks down) but still not as bad as the one registered since Oct 15 - Feb 16 (18 consecutive weeks down).
EPFR aggregate EM debt flows were down -0.3% total.

-0.1% for Local Debt (LDM), -0.5% for External Debt (EXD),
+0.1% blended funds and -0.1% EM equity.

• ETF flows were down in LDM but positive in EXD (-0.2% and +0.2%).

EXD outflows are from retail and mild vs 2013

EXD funds now have a small negative total YTD outflow after this week. They are still quite small compared to the large wave of outflows in 2013, at a time when retail investors were a larger part of the EM market (Chart 1).



We do not think they returned.

The outflows reported by EPFR have been almost entirely from small retail accounts who are less than 5% of the EXD market ($66bn AUM of the $2.4tn EXD outstanding). The remaining funds monitored by EPFR are another 5% of the EXD mutual funds in the US, SICAVs in Europe and ETFs. (Table 5).



The rest, who do not report weekly, include mainly large privately managed accounts, pension funds, sovereign wealth funds, insurance companies and banks and who are the mainstay of the EM buyer base. Our institutional managers do not report these sorts of institutional outflows at this time, and we believe there are still EM mandates expected."

- Source: Bank of America Merrill Lynch

In a competitive system for capital allocation, with the receding QE tide thanks to QT, we are much more concerned about the "corporate sector" due to dollar funding and leverage in some instances. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar-denominated debt issued out of $116 billion, with the top sector being energy with $27.7 billion of exposure - so watch what oil prices do going forward, not only what the US dollar does. It is not a surprise to see LATAM High Yield down 3.8% YTD compared to Asia High Yield only down 3.3% YTD. Overall in both EM and DM, credit has suffered more than equities when US High Yield has been much more stable relative to EM as well.

One might ask itself that if indeed the short-vol yield pigs' house was made of straw, then maybe the EM yield pigs' house is made up of wood, and the next step could be a full-blown EM crisis on our hands. Bank of America Merrill Lynch made some interesting points in its Credit Market Strategist note from the 8th of June, entitled "When the tides goes out":

"EM crisis?

Other markets benefiting from QE include EM. With a rising dollar the greatest rollover risk is now for countries that have relied on external dollar denominated financing and are running deficits. Hence, this year's worst performing countries in terms of currency depreciation and sovereign CDS include Venezuela, Argentina, Turkey and Brazil (Figure 1).





In terms of spillover risk to US credit, we would de-emphasize the EM story and focus on Italy and the European sovereign situation, which has much more cross-exposures to the US and systemic risk to the global financial system. Of course, the Italian story is also partially an outcome of QE that allowed cheap deficit financing, and made worse with the coincident timing of ECBs coming final taper (Figure 2).



Another important contributing factor has been a fixed exchange rate (euro member), which used to be how EM countries got into trouble via large current account deficits."

- Source: Bank of America Merrill Lynch

Sure, fundamentals matter, but given the receding tide in liquidity thanks to central banks turning slowly turning off the tap, more and more liquidity will matter. There is as well the "L" word for leverage, and on that point we are worried about US corporate leverage, which has been creeping up in recent years on the back of a buyback binge. To illustrate this, we would point out towards another point made in Bank of America Merrill Lynch note about the state of credit fundamentals:

"Final update on 1Q credit fundamentals

Based on almost final data for 1Q (covering 97% of companies), gross leverage for US public non-financial high grade issuers increased to 3.04x in 1Q from 2.98x in 4Q, while net leverage rose to 2.67x from 2.54x. Both gross and net leverage are now the highest on record (Figure 36).



For our "core" issuers excluding Energy, Metals and Utilities gross leverage was 2.39x, up from 2.34x in 4Q but below 2.40x in 3Q-17. Net leverage increased to 1.79x from 1.59 in 4Q (Figure 37).



The coverage ratio fell to 8.23 in 1Q from 8.44 in 4Q for the full universe of issuers (Figure 38), and was a bit lower at 10.79 in 1Q compared to 10.91in 4Q for the core set of issuers (Figure 39).



- Source: Bank of America Merrill Lynch

It's not only the leverage which is higher in US Investment Grade credit, quality as well has been worsening in a market where secondary trading is much weaker than before, thanks to low inventories on US banks' balance sheets and less appetite in providing "risk" in a context where "passive" management through ETFs has exploded in terms of inflows. It isn't a good recipe for when things will start heating up, but we are not there yet in this credit cycle. Dispersion is rising still between issuers, as the competition to attract capital is ratcheting up thanks to central banks turning the liquidity spigot gradually until it hurts.

If L is for "Leverage" when looking at US credit, L is as well the word for "Liquidity." Liquidity, as many veterans from the Great Financial Crisis (GFC) know, is a coward. For EM it is already the case, as pointed out in another note from Bank of America Merrill Lynch, in its Emerging Markets Weekly from the 14th of June, entitled "It is the "L" word... Liquidity":

"It is the "L" word... Liquidity

  • Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
  • EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high.

Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons. First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether. Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions. Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.

It is a tale of two markets ‒ before and after April 16. Before April 16, EM debt was a different market, outperforming every other debt asset class, with continued EM inflows (2%) while there were outflows from US (-4%) and non-US HY (-7%). Unlike 2013, EM inflows persisted, even during the first 75bp of the US rate rise from Sept 2017 to April 16, 2018. Since then institutional flows are somewhat offsetting the small retail outflows and EXD ETF inflows have been fairly stable. EM issuance was up 8% through April 16, while that for US IG and HY was lower by 7% and 25%, respectively (EM supply? Relax. It is not as bad as you fear).

2017 to early 2018 large growth

EM economies are still booming and new markets have opened with new demand. First, GCC sovereign issuance and frontier markets have grown rapidly, offering investment opportunities for high credit quality crossover buyers, as well as higher yielding and promising credit stories offering diversification. In addition, China has become more than one-third of EM corporate issuance and as much as 90% of that is placed in Asia, much in China itself. Fundamentally, most of those markets have not changed in the last 2 months."

- Source: Bank of America Merrill Lynch

Yes, in illiquid markets, size matters. No matter what some sell-side pundits would like to spin, liquidity trumps fundamentals. It is your ability to trade that matters.

Having learned quite a few things from reading over the years the research from the wise Charles Gave of Gavekal Research for whom we have great respect, at this juncture from QE to QT, we think we needed to reminded ourselves of his wise words:

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

Last year's rush for the Argentina 100-year bond was indeed a case of more money than fools for EM. As the tide slowly recedes and we turn from QE to QT, we will, over the course of the next quarters, gradually discover who has been swimming naked, given capital will flow more discerningly, we think. QE was a period where money, thanks to NIRP and ZIRP, was chasing anything with a yield without distinction. Now, with rising dispersion, there will be truly more "credit analysis" done at the issuer level. Times are changing, as pointed out by Bank of America Merrill Lynch in its Credit Market Strategist note from the 15th of June, entitled "On the road from QE to QT, redux":

"On the road from QE to QT, redux

We have used this title before (see: Credit Market Strategist: On the road from QE to QT 29 March 2018) and this week's central bank meetings - Fed, ECB and BOJ - motivate us to recycle it. Quantitative easing (QE) was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed. There is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).



However, we are currently in this intermediate phase - i.e. on the road from QE to QT - where things remain orderly although technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).



Hence, we have seen higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4).





Domestic QT+ foreign QE/NIRP=OK

The reason we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5).



Thus, if US yields rose too much due to QT and rate hikes there would be large foreign inflows. Hence, US yields would not increase too much and fixed income volatility remains moderate. While this week the ECB announced the end to QE, they came out dovish by promising continued negative interest rates (NIRP) for a long period of time (Figure 6).



NIRP in the Eurozone works much like QE, as explained below, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.

How does the ECB influence the back end of the curve? It is very simple: with negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9).



That asserts bull flattening pressure on both rates and quality curves.

We have not seen this movie before

While QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years.



However, while we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020. This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate."

- Source: Bank of America Merrill Lynch

The escape route is somewhat less tricky for the Fed than for the ECB. It remains to be seen if Mario Draghi will rock the boat before the end of his term in 2019. We do not think he will. The Bank of Japan remains so far committed to QE, so there is still some time on the gradual tightening spigot, we think.

Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit-for-tat reactions from China to additional US sanctions. Obviously, equities markets are reacting to this. Emerging markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT, and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out. On the subject of disruption from trade wars, we read with interest Barclays take from its Thinking Macro note from the 1st of June, entitled "Trade war in perspective":

"US trade protectionism: Where do we stand?

This year, the US has implemented a number of protectionist trade actions. In March, President Trump announced a 25% tariff on steel (10% on aluminium) imports. The US Trade Representative (USTR) then proposed a 25% intellectual property (IP) related tariff on 1,333 Chinese goods. President Trump then asked the USTR if it was possible to impose tariffs on a further $100bn of Chinese goods. Import tariffs in the automotive sector are also being considered. Some progress has been made in trade negotiations with China (see China: Tariffs on hold, long negotiations continue, 12 May 2018). But escalation risks remain, since the steel tariff exemption will expire on 1 June and the White House said it will impose a $50bn IP tariff on Chinese products, with the list published by 15 June 2018.

We use a VAR model to quantify the potential impact of US tariffs on global growth and CPI inflation. The first year estimates are subject to high model and parameter uncertainty. We thus use second year estimates. These show that a 1% unilateral rise in US tariffs as share of US imports may reduce global growth by 0.3pp and increase inflation by 0.4pp. That said, the impact of the steel tariff, even without exemptions, would only lead to a 0.1pp decline in global growth and a rise of 0.1pp in CPI inflation, as steel is only 0.33% of US imports.

Large economic effects larger require big tariffs. If the proposed 25% tariff of $100bn of Chinese goods is added to the steel tariff, together with tit-for-tat retaliation, our model shows that such a scenario would raise CPI inflation by 1.1pp and cut growth by 0.9pp.
Our model suggests that the adverse effects of US trade tariffs on emerging markets are likely to be much larger and more persistent. This is intuitive, as these economies have been the largest beneficiaries of the most recent globalisation wave. According to our model, a 1% rise in US tariffs leads to a 1.1pp reduction in EM growth in the first year, versus 0.5pp for DM. For CPI inflation, the numbers are +1.1pp for EM versus +0.2pp for DM.

However, there are a number of mitigating factors. In the first age of globalisation, US tariff policy was very active, but large retaliations were rare. Similarly, their 70% success rate incentivises the US and EU to keep the WTO for resolving trade disputes. In addition, President Trump's drive for deregulation, by removing entry barriers, could encourage more services trade, which may mitigate the negative effect of higher tariffs on goods. That said, any rise in services trade flows is unlikely to fully offset the impact of higher tariffs on EM countries, given the size and persistence of the effects estimated in this paper.



The impact is larger for emerging, than developed, markets

Emerging markets have likely benefitted the most from the trade hyper-globalisation of the 1990s. The abundant and competitively priced labour supply in these countries, together with free trade, led to large FDI inflows, allowing these countries to export their way up the development ladder. Intuitively, this suggests that these countries should also be more vulnerable to a rise in protectionism. In this section, we split our global real GDP growth and inflation variables into corresponding variables for emerging and developed markets, to econometrically examine if EM economies react differently to DM economies.





Figure 8 and Figure 9 shows the results for EM and DM economies, respectively. This breakdown produces several interesting results. First, EM GDP growth is likely to shrink by roughly twice as much as DM. Second, the DM GDP effect is short-lived and not statistically significant after one year, but is much more persistent in EM. Finally, the impact on EM CPI inflation is approximately five times as large as in DM. This could be due to higher USD denomination of financing flows and trade transactions, as well as different monetary policy reactions to external shocks in EM than DM.

Not surprisingly, the effect of the current US steel tariffs is much larger for EM economies (Figure 10.) than DM economies (Figure 11).





We compare first year estimates, because of a lack of statistical significance for the DM GDP response after the first year. With the steel tariff alone, our model suggests that EM (DM) GDP growth could fall by 0.3pp (0.1pp) and inflation rise by 0.3pp (0.1pp). With steel tariff retaliation, EM growth could fall by -0.7pp, with inflation rising by 0.7pp, which are sizable effects. If the US unilaterally implements IP-related tariffs on $50bn of goods from China, then EM (DM) growth could fall by 0.9pp (0.4pp) and inflation rise by 0.8pp (0.15pp). In the case of tit-for-tat retaliation, EM (DM) real GDP growth falls by 1.7pp (0.7pp) and inflation rises by 1.7pp (0.3pp). Overall, DM would only really feel any effects from tariffs in this very last scenario, while the impact for EMs is already sizable if the current steel tariffs are retaliated against.

The return of US protectionism can be disruptive

In this section, we review the main lessons from our econometric exploration of US tariffs. Modelling the impact of US tariffs on short-term global growth and inflation is challenging. Academic work has focused on the long-term effect, and uncertainty about the impact in the first year after the tariff announcement is large. Our estimates are based on a gradual tariff reduction, while the current situation is a rapid tariff rise. The estimates presented in this paper should therefore be interpreted accordingly. However, they nevertheless provide a first econometric view on how President Trump's tariffs might affect the world economy.

Our results suggest that US tariffs act like a negative supply shock to the world economy, lowering global growth and raising inflation. However, only large tariffs produce large effects: the current US Steel tariff is only 0.33% of US imports and would reduce global growth only by 0.1pp, while raising global inflation by 0.1pp. It is only when $50bn of IP-tariffs are added and retaliated tit-for-tat that growth falls 0.6pp, while inflation rises 0.7pp.

The impact on emerging markets is much greater than on developed markets. The EM GDP growth impact is twice as large as on DM and significantly more persistent. The EM CPI inflation response is approximately five times as large as in DM. While there are a number of mitigating factors that are not accounted for, the analysis suggests that EM economies will be affected to a much greater extent than developed markets.

Overall, US protectionism could be disruptive, especially if tariffs are large and are retaliated. Emerging markets will likely be more affected than developed markets."

- Source: Barclays

So there you go, if you think EM woes are overdone because of "fundamentals," then again, you would be wrong. If trade war escalates, this could lead to a stagflationary outcome. Then, of course, there is as well the trajectory of the US dollar and oil prices to factor in. From a liquidity perspective, we think the second part of the year will be challenging as the central banks turn off the liquidity spigot. You should continue to be overweight DM over EM on a relative basis overall. Then again, there are as well different stories and different issuer profiles. In a rising dispersion credit world, you need to go back to "credit analysis," and this is why active management should be favored right now over passive management. It is time to become more "discerning."

For our final charts, given the increasing competitive nature of capital allocation when liquidity is being withdrawn, we would like to highlight how this cycle is unique.

Final charts - Capital Flows? This time it's really different.

When it comes to the acceleration of flows out of emerging markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing, as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility."

- Source: Macronomics, 24th August, 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015 and in 2018) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

- Source: Macronomics, August 2013

Capital flows react to real interest rates dynamic. Following years of financial repression in this cycle, the reaction and velocity of the moves we are seeing are therefore much larger from a standard deviation point of view. Our final charts come from Wells Fargo Economics Group note from the 13th of June, entitled "Capital Flows Part III: This Time Is Different" and highlights the unique nature of the current economic cycle which ultimately affects capital flows as per our reverse osmosis theory stated above:

"The relationship between interest rate expectations and exchange rates has become harder to quantify, largely due to the unique nature of the current economic cycle. This changing dynamic ultimately affects capital flows.

What About Expectations?

As we have discussed in two previous reports,* capital flows respond to relative interest rate and exchange rate dynamics across borders. We now turn to the effect of expectations on our three variables. Expectations have played an increasingly important role in market participants' reactions to global events. For example, recent Italian political developments led the euro to decline against the dollar, while Italian bond yields rose more than 100 bps (below chart).



While it is too soon to determine any effect these political tensions could have on capital flows, it is clear that expectations play a role in short-term exchange rate and interest rate dynamics. In the long run, these dynamics affect capital flows.

Expectations of central bank actions have also caused unpredictable swings in foreign exchange rates and interest rates. As previously discussed, our currency strategy team has found additional rate hikes from the Fed to be less supportive of the dollar, while at this stage, tightening on the part of foreign central banks has been more supportive of foreign currencies. Throughout much of 2017, short-term rate expectations moved in favor of the U.S. dollar, but the dollar declined (below chart).



This is likely due in part to the FOMC being further along its tightening path relative to other major central banks, and market participants having already priced in future rate hikes to a large extent. Market-implied probabilities of a rate hike are nearly 100 percent for today's FOMC decision. Market participants likely see the FOMC as only having so many rate hikes left before reaching its terminal rate, and this means the potential for rate hike "surprises" is much lower.

In turn, the effect of interest rate expectations on exchange rates has been harder to quantify. As the Fed began to tighten policy in 2015-2016, one could theoretically identify a more direct relationship between the probability of a Fed rate hike and its effect on the dollar. However, as global central banks have engaged in unconventional monetary policy measures, the focus has turned toward perceived policy stances through actions such as quantitative easing, rather than a pure reaction to actual rate hikes.

Reviewing Past Cycles: All Else Is Not Equal for Capital Flows

The evolving relationship between interest rate expectations and exchange rates confirms why this cycle is unique. We have found that country-specific characteristics lead to volatility in capital flows, and similarly influence expectations. In the U.S. for example, prior cycles may have had a rising rate environment, but lacked a fiscal stimulus. This difference is compounded by unconventional global monetary policy and a deteriorating fiscal outlook during one of the longest economic expansions in recent history (below chart).



These differences influence investors' relative allocation of capital, and decision makers would do well to pay attention to the unique outcomes that stem from differing market expectations."

- Source: Wells Fargo

More liquidity = greater economic instability once QE ends for emerging markets. If our theory is right and osmosis continues and becomes excessive, the cell will eventually burst. In our ,case defaults for some overexposed dollar debt corporates and sovereigns alike will spike, as discussed in our "Mack the Knife" July 2015 musing, to repeat ourselves. Why did past Mercantilism fail, and will fail again? Just read again Adam Smith's The Wealth of Nations published in 1776. In his book, Adam Smith argued that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He showed that trade can be mutually beneficial, an argument also made later by David Ricardo. In January 2017, in our conversation "The Ultimatum Game," we argued:

"The United States needs 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 therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its 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."

- Source: Macronomics, January 2017

Once again, it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits. But we ramble again...

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country."

- Adam Smith

Stay tuned !