Markets are in free-fall for the third time in twenty years. Unlike the aftermath of the 2008-2009 Great Financial Crisis when the combination of Chinese stimulus and Western Central Bank Quantitative Easing produced a quick recovery for emerging markets, today a long slog appears more likely.
The hyper-globalization of the past three decades suppressed inflation and encouraged borrowing. As leverage increased through financial engineering, shadow-banking and creative derivatives, politicians, the U.S. Fed and Wall Street eagerly embraced mechanisms to backstop markets and preserve “financial stability – the Central Bank “whatever-it-takes” “put” – which repressed volatility and promoted more leverage. Asymmetric policies, capping the downside while cheer-leading the upside, tied the economy’s performance to the “wealth effect” experienced by the owners of financial assets.
The cycle of global debt accumulation in a deflationary environment may be on its last leg. Every new crisis requires an exponential increase in fiscal and monetary intervention to ease “investors” out of leveraged positions which have suddenly become illiquid. Investors have been trained to expect the “Fed put” and “buy the dips.” The size of the current intervention – expected to be in the order of 50% of GDP — more than ever undermines the essence of price discovery in a capitalistic system and is likely to provoke unprecedented “populist” opposition. This sets the scene for a new paradigm for the markets as we look forward beyond the tempest.
The new paradigm for financial markets, in many ways, may be diametrically opposed to that of the previous decades.
- The Rise of Populism. The protest votes that brought forth Trump, Brexit and Bolsonaro were symptomatic of the need for politicians to focus on the narrow sentiments of ordinary people.
- Anti-globalization. Shorter supply chains and more control of the domestic production of “strategic” industries. Having most of your medical equipment and 75% of your pharmaceuticals produced in China will be a thing of the past.
- Modern Monetary Theory. The current recession in the U.S. is likely to result in a fiscal deficit of $4 trillion, boosting the public debt to 125% of GDP. This comes at a time when Medicare and Social Security payments are ramping up. This debt will be monetized; initially under the pretense that deficits don’t matter, and then through interest rate suppression, which will start a process of deleveraging similar to the one the US went through following W.W II.
- Current Account Deficits and the U.S. Dollar. MMT will produce inflation and negative real interest rates in the U.S. The Fed will become increasingly tolerant of inflation to promote deleveraging and GDP growth. Foreigners that have been funding U.S. current account and fiscal deficits will sell U.S. assets. This will play out over time, but the end-result will be a weaker dollar and smaller current account deficits. This transition will take place around the world. It is unclear how this can happen without sovereigns imposing repressive controls on capital. A return to the capital controls which were normal before the current cycle (1960s-1970s) are likely.
- The end of U.S. Fed-Imposed Central Bank Orthodoxy. As the U.S. Fed became the back-stop for the financial market it has increasingly pursued policies which are at odds with the interests of other countries. As capital controls and other forms of financial repression are re-introduced, countries will be able to pursue policies which make sense for their own circumstances. The S.East Asia-Chinese model of capital controls and managed currencies will become more common. Strict controls on “hot money” – a policy already supported by the IMF – will rule.
- Multi-reserve-currency World. An increasingly insular U.S. pursuing financial repression will promote the rise of alternative reserve currencies. Gold is an obvious beneficiary, but the Chinese Yuan and the Euro will also gradually gain traction with trading partners.
- Multi-polar World. The rise of alternative reserve currencies is one example of the end of the U.S.-centric global economy of the 1950-2020 period. Supply chains also may increasingly regionalize and countries will insist on self-sufficiency for key industries, which will increase production costs and raise inflation. China has already created its own internet eco-system and is moving aggressively to develop key frontier industries. We can expect India and other large and growing economies to follow that path. Large emerging market economies which provide most of the growth in global demand will seek to keep that demand on-shore, and will make concessions only to strategic partners which are under their sphere of influence (e.g. Mexico and Canada for the United States; certain Asian countries for China). In this multi-polar world, China and the U.S. should fare relatively well; China because it sits at the center of Asia, the most dynamic region in the world; the U.S., because of its resources and an entrepreneurial class that can lead a renaissance of manufacturing. Smaller, export-oriented countries will have to carefully negotiate their way into the commercial networks of the two hegemons.
Most emerging markets are unprepared for the new financial paradigm. The successful ones will be those that have the social cohesion and political frameworks necessary to adapt. A few thoughts on specific countries follow.
Large countries with scale and demand growth (China, India and Indonesia)
These countries are well-positioned to pursue autonomous policies to promote domestic investment and partner in foreign trade. As of today, China is the only one that appears to have the planning and execution capacity to be successful.
Large countries with moderate scale and moderate demand growth (Brazil, Mexico, Turkey)
These countries are similar in some ways but also have major differences. Turkey and Mexico have benefited from the past forty years of globalization and are well positioned to continue on that path, if they can overcome current incongruent policy frameworks and political instability. Brazil missed out on globalization and suffers deeply from a lack of the confidence necessary to pursue independent financial and trade policies. Brazil is currently espousing archaic market liberalism, at a time when strong government dirigisme will be vital. Brazil also contends with a dysfunctional political system and a lack of social cohesion. It will also have to pursue financial repression to reduce the government debt burden which has resulted from ultra-orthodox monetary policy.
Small countries with small scale and moderate demand growth (Korea, Taiwan, Thailand, Chile…etc.)
These countries represent the bulk of emerging markets. Those that have thrived in the past did so because they took advantage of globalization and participated in the growth of global supply chains. Many did not do this, and they have been at the mercy of commodity and financial cycles. These countries face challenging times ahead. Through intelligent diplomacy, they will have to negotiate partnerships with the major trading blocks led by the U.S., China and Europe, without anything to offer. On-shoring through robotics will make it difficult for the traditional model of low-cost manufactuting of basic goods to work, cutting off a path of growth for the poorest countries.