Macro economic commentary – February 2018

Author: Ntsekhe Moiloa.

Early in February the US Bureau of Labor Statistics reported that US average hourly earnings rose year-on-year by 2.9 percent in January 2018. The market consensus was for a rise of 2.6 percent. The upside surprise sparked a fear that labour constraints would drive up overall inflation faster than previously expected. The consequence of that, investors seemed to deduce, was that the US Fed would be compelled to raise policy rates faster than previously anticipated.

Beyond this data point there was hardly anything else to spark worry. Inflation remains sensible and interest rates remain close to long-term lows. While property affordability is stretched, property prices are not climbing at a runaway pace. Recent US tax breaks are expected to be beneficial to corporate profits despite burning a bigger hole in Uncle Sam’s pocket. So why did the S&P500 enter correction territory, declining more than 10 percent?

Over the past few decades it has rarely been the economic reality that has precipitated market meltdowns. The cause of meltdowns has often been an accumulating risk somewhere in the capital markets. In 1987, Black Monday was triggered by a growing mass of portfolio insurance strategies moving the same way as increasing numbers of futures were shorted due to spot prices sliding. The scale of money committed to portfolio insurance ensured that the shorting turned into a vicious cycle. In 2008, collateralised debt obligations and their close cousin, collateralised loan obligations, sent markets into a tailspin. This past month it was ETFs designed to capitalise on low market volatility. Investor delight in the persistently low level of the Chicago Board of Exchange Volatility Index (VIX) seemingly knew few bounds, and investing in VIX exchange-traded funds became a crowded trade. Amongst the variations of VIX exchange-traded funds were inverse VIX ETFs which would lose money if the VIX level spiked but otherwise made money for investors.

Inverse VIX trades made money for long enough to lull many investors into a sense of complacency about the product type. There were at least a few people who warned that the construction of the VIX was open to manipulation. Thus, the abnormal and persistently low levels of the VIX should have raised greater suspicion or at least caution in the minds of anyone investing in products tied to the index. But where there was money to be made, a sort of hubris set in. The Bibliotheca of Pseudo-Apollodorus carries the myth of Icarus, the son of a master craftsman who made him a set of wings constructed from feathers and wax for their attempt to escape from Crete. Before their attempt, Daedalus warns his son to neither fly too low nor too high, for complacency could see them plunge into the sea while hubris would see them come too close to the sun and melt the wax. So it was with investors who ignored warnings that such unusual levels of the VIX presented elevated risk, with some investors reportedly investing in inverse VIX exchange-traded funds on a geared basis. A number of those inverse VIX exchange-traded funds went to zero in the February correction.

It is useful to step back for a little perspective. Even at the lows of the correction, equity indices were still higher than they were 2 and 3 months earlier. Furthermore, there was no indication of systemic risk such as we saw during the Great Financial Recession. The path of interest rate policy in the US has not been fundamentally altered; in fact, there is no indication that the US Fed is likely to pause its baby-step march toward higher policy rates.

Locally, the likely direction of policy rates is more likely sideways to down than up. Economic growth remains pedestrian at best while consumer price inflation printed lower at 4.4 percent from a previous print of 4.7 percent on the back of a lower rand fuel price. Food and non-alcoholic inflation at the consumer level moved lower and likewise producer price inflation moved from 5.1 to 5.2 percent on the back of food and fuel.

While policy rate directions may differ in the near term, it is worth remembering that in most regions of the world interest rates are closer to multi-decade lows than highs. For that reason we think that an overlooked and mounting risk to the global economy is the sustenance of companies that continue to survive largely on the back of cheap borrowing. The longer a low interest rate environment persists, the greater the risk that capital is misallocated to enterprises of this nature. Like inverse VIX exchange-traded funds, these could easily become a crowded trade with negative consequences.

Deutsche Bank reports that over the past two decades the number of zombie companies in the FTSE All World Index has tripled on the back of a low interest environment. Zombie companies are defined as having price-to-sales ratios below 3 as well as an interest cover ratio below 1 for at least 2 years running. At 2 percent of companies presently, it does not seem like a great number, yet a closer look at distributions shows that three-fourths of such companies are concentrated in the energy and financial sectors. Moreover, Europe leads in the number of such problem countries, North America comes second, the rest of the world third and Asia Pacific fourth. These statistics suggest the potential for a vicious cycle; to counter capital misallocation interest rate policy normalisation should not be delayed, especially in those regions (like Europe and North America) and sectors (like finance) that have been at the heart of quantitative easing, but central bankers are likely to be hesitant of being accused of spooking markets.

It is not only the investment markets that pre-occupy the minds of policy makers. At the end of February, the Chicago PMI showed business activity expanding at a softer pace. In particular, purchasing managers expressed concern about input costs and warned that they could soon pass the costs on to consumers. American central bankers face being forced to weigh cost push inflation against investment market stability.

In mid-February the Deputy General Manager of the Bank for International Settlements, Luiz Awazu Pereira da Silva, along with a senior economist at the BIS, Jochen Schanz, delivered some remarks at a conference in Skopje, Macedonia. Their remarks were titled: How to transition out of a “Goldilocks economy” without creating a new “Minsky moment”? A Minsky Moment is essentially a crash in asset prices that comes about after a long period of increases that attract the entry of speculative positions. Their remarks focused on the first eight days of February when the market corrected as we have mentioned earlier. A part of their remedy involves an enhanced communication strategy; according to Pereira da Silva and Schanz, investors have to be told clearly that volatility can be expected as normalisation proceeds. Presumably talk of a soft-landing lulls market participants into thinking that volatility will remain low throughout a normalisation super-cycle. The BIS representatives laud the communication strategy of the FOMC of the US Fed regarding caps on reinvestment into assets that formed part of the overall quantitative easing program in the United States. There remain at least two difficulties with open-mouth operations. The first is that they cannot account completely for how severely contemporaneous economic data can alter market expectations despite central bank assurances; and secondly, they cannot account for chaotic behaviour from politicians as we have witnessed in places as different as Washington, D.C. and Pretoria, Gauteng.