Guest Haymaker - Louis-Vincent Gave

In The Ring - November 4th, 2022

Nov 04, 2022

Zero Tolerance for Zero Policies?

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“Nothin' from nothin' leaves nothin'…” -Billy Preston

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Hello, Haymaker Readers:

This week, we’re hosting a familiar name for your enlightenment – please welcome back to the ring my friend and partner Louis-Vincent Gave. Like me, and also his father, Charles, Louis has been highly critical of zero, or even negative, interest rates for years. In Charles’ case, his hostility towards them goes back as far as 2011. He memorialized that in his classic research note from those days, The High Cost of Free Money, an appropriately ironic title.

Our antipathy toward the long war on interest rates was based on a multitude of concerns. A key concern was that an artificially suppressed cost of money leads to asset bubbles, particularly if they are held down for an extended period. For most developing countries, interest rates gone missing has been a reality for well over a decade.

Because of the persistence of hyper-stimulative monetary policies for most of that timeframe, naysayers like us were derided as too bearish. Of course, there were episodes of market turbulence that allowed us to become bullish on risk assets, like stocks, on a short-term basis. The pandemic panic was the most graphic example of that; fortunately, our prior discomfort with central-bank-inflated bubbles meant we had plenty of cash available with which to capitalize on that nearly 40% collapse in stock prices. The fact of the matter is that you can’t take advantage of panics if you’re fully invested.

As I chronicled in my book Bubble 3.0, which I mostly wrote last year and we digitally published early this year, history is clear that bubbles always pop. Unquestionably, the relentless pursuit of zero, or sub-zero, interest rate policies by the planet’s leading central banks allowed the third mega-bubble of the last 23 years to expand far longer and to a greater degree than ever seen before. As I contended in my book, the buying hysteria seen last year in a multitude of pie-in-the-sky “investments” was without historical precedent. It was truly peak insanity when it came to profitless tech stocks, SPACs, NFTs, the meme plays like GameStop and AMC, as well as, of course, the cryptos like Bitcoin.

There’s simply no doubt that zero-interest rates turbocharged the parabolic rise in the most speculative niches of the investment world. The fact that this year we’ve seen the greatest wealth destruction since the 1930s, seems to me proof positive that last year was the Biggest Bubble Ever. (One could plausibly argue the 1929 bubble in stocks was worse than the one seen last year, but that would ignore how many other supposed asset classes also were insanely overpriced.)

As Louis points out in his intriguing note shown below, the obsession with zero has transcended interest rates. It has also spread to energy policies (zero carbon), pandemic responses (zero Covid infections), and geopolitics (zero technology transfers to China). It’s fair to say all of these had reasonable, even laudable, objectives. However, based on the extremes they were taken to, they morphed into the realm of the irrational.

The lowest interest rates in 5000 years played the starring role in that speculative frenzy. This left critical parts of the economy, especially housing, vulnerable to the type of interest-rate bludgeoning now being inflicted by Jay Powell. (There’s more to come by the way, as I’ve been warning… despite the market’s fervent hopes for a Powell Pivot, or, at least, Pause.)

Consumers around the world are suffering mightily as a result of the frantic rush toward eliminating fossil fuels. How rational was it to expect the West to move toward zero carbon emissions in just 30 years when prior massive energy transitions took far longer? As Goldman’s ace energy specialist Jeff Currie pointed out in a podcast I listened to this week, fossil fuels now represent 81% of energy consumption. This is down from 82% 10* years ago but that 1% has taken around $4 trillion of investment in renewables.

*Corrected from “20” - we regret the error.

Trying to inflict a zero-semiconductor policy on China is also likely to have some unintended and painful consequences. Retaliation is highly likely, as is collateral damage to almost all U.S. companies operating in China.

Similarly, it has proven to be a quixotic quest for China to insist on a complete elimination of Covid. This was, and is, even more unrealistic considering its insistence on inoculating its populace with inferior domestic vaccines. Chinese authorities – which, these days, essentially comes down to a single man, Xi Jinping – have also ignored the success of the much more relaxed Covid policies in Norway and Sweden. It’s becoming increasingly obvious that Zero Covid has about zero chance of succeeding.

As Louis implies, it also seems nonsensical for the U.S. to be taking on Russia, China, global warming, and, now, OPEC+, all at the same time. As the deleterious consequences of policymakers’ obsession with zero-based policies dawns on voters, perhaps there is a dramatic sea change looming. If so, 2023 might be a much better year for humanity, not to mention financial markets. However, the journey from here to there is likely to be anything but placid.

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Zero Point Zero — Louis-Vincent Gave

Originally Published October 27th, 2022 (Gavekal Research)

Comparing today’s central bankers with the badly-behaved frat boys of Animal House (see Misplaced Trust) clearly struck a chord with readers. Some even asked what other pearls of wisdom might be gleaned from the 1978 comedy classic. As it happens, there is one. The scene in which Jon Belushi’s character “Bluto” Blutarsky gets told his grade point average—zero point zero—holds an important lesson. Belushi was clearly a trend-setter, because zero is the number of our age. In the last few years, we have had “zero” policies wherever we look.

Zero interest rates. In his series of papers on The High Cost Of Free Money, Charles bemoaned the long term consequences of zero interest rates, in particular the massive misallocation that would result. Today, with the benefit of hindsight, it is becoming increasingly obvious that more than a decade of zero, or even negative, interest rates has had a deleterious effect not just on the capital allocation process, but on the very foundations of Western economies.
Politicians with experience of double-digit interest rates would have been less complacent than Liz Truss
After almost 15 years of zero interest rates, it is not only a whole generation of financial analysts and portfolio managers that has been mistaught. It is also CEOs, CFOs and policymakers. When you consider just how spectacularly the last British government faceplanted, you have to wonder whether politicians who had experienced double-digit interest rates at first hand would have displayed the gross hubris of Liz Truss and Kwasi Kwarteng.

Not that Truss and Kwarteng are anything unusual: after 15 years of near-zero interest rates, we now see US politicians trying to trigger a collapse in Russia, starting a new cold war with China, and picking a fight with OPEC, all while promising to battle climate change, even as their allies in the UK and Japan are visibly hitting financial walls. A generation of politicians accustomed to higher interest rates, and therefore to a world of altogether tighter budgetary constraints, would surely be more circumspect about picking so many fights at the same time.
Zero carbon equals zero growth, and sub-zero disposable income
Zero carbon. On paper, the idea of zero carbon sounded appealing to politicians everywhere. What politician wouldn’t want to be seen to be saving the environment for the next generation? However, the appeal rapidly palled as it became clear that the cost of zero carbon tomorrow is zero growth today—and a heavily sub-zero impact on people’s disposable income as electricity bills and pump prices for gasoline surged higher.
Zero Covid. Politicians who did not want to be accused of “destroying the planet” most certainly did not want to be charged with “killing grandma” (see The Guiding Principle Of Our Time). Cue zero Covid, probably the most economically, socially and humanly devastating policy initiative inflicted on the world since Mao Zedong’s Cultural Revolution.
Today, everyone but the most die-hard lockdown enthusiasts agrees that Sweden got it right, and that zero-Covid policies were a collective madness whose economic bill in the form of higher inflation and constrained fiscal spending we will be paying for years to come. In short, zero covid made about as much sense as zero carbon and zero interest rates.

The last China bulls are now capitulating

Given the lamentable track record of these policies, you might think politicians—and investors—would ease up on absolutist “zero” views. Fat chance. Now there is a new zero point zero in town: zero China. The escalation of US semiconductor sanctions against China, and the Communist Party’s burial of “management by technocratic committee” in favor of “one-man rule” has led to a catharsis for foreign investors who had been holding on to (massively underperforming) Chinese positions. Here, in plain sight, was the reason needed to unload what were by then rather attractively valued assets. The facts on the ground had changed, and action was called for.

Thinking it through
Still, given the disasters caused by zero interest rates, zero carbon and zero Covid, it is worth taking a moment to think through the long term repercussions of zero China. Surely, a zero-China world will cause problems far beyond a near term sell-off in Alibaba or Tencent?

The first obvious consequence of the new cold war between the US and China is that Chinese companies will no longer feel comfortable relying on US products or services. If the US can ban semiconductors today, why couldn’t the White House ban software tomorrow? Or chemical products? Or aircraft parts? Why would a Chinese airline buy Boeing aircraft when it may no longer be able to get them serviced? Surely Airbus planes will come with less risk?

Zero China means lower productivity and higher inflation

A zero-China world is a world in which US companies will struggle to sell more into China (and that’s before considering the strength of the US dollar). It is a world characterized by weaker global trade and lower productivity. And the direct consequences of lower productivity tend to be higher inflation and lower growth.

So, can we really have a zero-China world in which Alibaba and Tencent are the only victims? Isn’t it inevitable that in time the likes of Boeing, Caterpillar, and Apple will also be affected?

For now, it seems that markets have not fully thought this one through. On Monday, mainland Chinese stocks listed in Hong Kong fell by more than -7% in one of the worst trading days of recent decades. Meanwhile, the S&P 500 rose 1.2% on the day. The market is clearly saying that while zero China is bad news for China, it is no big deal for anyone else. This is surely wishful thinking.

Perhaps Western markets rallied on the assumption that zero China would continue to push the renminbi lower. And perhaps a weaker renminbi might be a welcome development in inflationary times? Maybe.

I would argue that the recent weakness of the renminbi is a key variable to watch, and that if anything pushes Beijing into a policy shift, it may well be China’s exchange rate. Let me explain.

The Communist Party has a deep aversion to inflation...

My starting point is that China’s policymakers are the only remaining inflation hawks left in the world. This is for a number of reasons, but among them is that as Communist Party members, they have been raised in the Marxist catechism that big historical shifts, such as revolutions, occur not because of individuals or ideas, but because of economic forces. It is economic forces that drive history, and few economic forces are as powerful or as socially disruptive as inflation. So why take the risk of inflation? The last Chinese policymakers who did, back in the late 1980s, woke up to find protesting students had occupied Tiananmen Square.

Today, there is a global inflation problem, although for now it has barely touched China. So perhaps one way to stop the inflationary waves coming ashore is to retain lockdowns, at least until global inflation abates.
But a depreciating exchange rate makes controlling inflation harder. Weak currencies are inflationary, strong currencies are deflationary.
Historically, the Chinese Communist Party has seldom shown much interest in stock market moves. Equity markets rise and fall, but unless the falls are so big they threaten social stability, the Party doesn’t care. This is partly because only a small minority of Chinese people are directly affected by equity price swings, and because the vast majority of Chinese companies do not use the stock market to fund their capital spending.
...and to unscripted exchange rate moves...
The same does not apply to the renminbi’s exchange rate. Beijing has always intervened in the foreign exchange market to keep daily, weekly, monthly and annual fluctuations within acceptable limits. The Party does not like exchange rate volatility, as it contributes to uncertainty for businesspeople and investment.

This brings me back to today’s zero-China mantra. Foreigners’ liquidation of their China holdings is putting the renminbi under pressure. This pressure leaves Xi (since he is calling the shots) with three options:

Do nothing. The renminbi will continue to weaken, at least in the short term. But if renminbi depreciation accelerates, it might start to be seen as a loss of face for the top leader. This leads to the second option.
...but currency intervention can appear impotent
Follow the Bank of Japan’s lead and intervene in the foreign exchange market. The problem with this option is that the BoJ’s interventions increasingly look like attempts to dam a raging torrent by throwing pebbles into the stream. Over the last month, the BoJ has reportedly spent some US$50bn trying to support the yen, yet the Japanese currency is still flirting with generational lows. This leaves the third possibility.
Surprise the market with unexpected policies. Here, Xi has one obvious arrow in his quiver. He could ease up on China’s zero-Covid policies. In other words, he could push back against the current zero-China narrative by jettisoning the zero Covid millstone weighing on China’s economy. Zero point zero.

Haymaker