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QuickHit: How robust is the global financial system in the wake of Covid?

This week, we are joined by Seth Levine of the Integrating Investor, a professional investor and investment market blogger, sharing to us his thoughts on the current financial system, central banks, and debt cycles.

 

Seth Levine is the author and creator of the Integrating Investor Blog. Seth is also an avid coffee roaster, who influenced Tony Nash into roasting as well.

 

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This QuickHit episode was recorded on February 19, 2021.

 

The views and opinions expressed in this How robust is the global financial system in the wake of Covid? QuickHit episode are those of the guests and do not necessarily reflect the official policy or position of Complete Intelligence. Any content provided by our guests are of their opinion and are not intended to malign any political party, religion, ethnic group, club, organization, company, individual or anyone or anything.

Show Notes

 

TN: We have a new administration in the U.S. We have Jerome Powell, Central Banker who’s been there for a while. We have Janet Yellen coming in as a treasury secretary. But we’re also late in this Covid cycle with a lot of overhang and bad policy decisions. Some people may like them. But we’ve got a lot of things that need to restart. At the same time, we have Europe that is still shutting things down and the ECB and we have demographic issues in Europe. All those sorts of things.

 

I’m really curious about in the financial system, but more specifically, central banks and treasury. What are your thoughts on where we are and where we’ll likely go in the next year or so with those financial system central banks and treasuries, what does it look like from your perspective?

 

SL: The financial system is just a really interesting topic all together because it is a very big word, a very big concept. And it’s an abstraction that a lot of people grasp onto, and some of the work I’ve done a couple years ago, I really tried to untangle that abstraction and concretize it and what I found is that, when we say “financial system,” we’re really just talking about a system of interconnected banks.

 

So at its base, we’re talking about very simple banking. Banking is complicated. But when I think about banking at its core, what is it? It’s really just a carry trade. If you have bank XYZ, you take in deposits and then you try and invest those and earn an asset yield that’s an excess of your deposits. And you keep a little bit in your deposit and you keep a little bit behind for reserves, i.e. liquidity.

 

It’s a leverage system. When we talk about the global financial system, we’re really talking about a leveraged system of interconnected, financial services companies. And that’s what we see on the screen. They’re in the markets for bond stocks, derivatives, all sorts of things and it is giant. Because we not only we have Central Banks. We also have what’s called the shadow banking system. Or some people call it the Euro-Dollar system.

 

So we look at what has happened over the course of my life. I really see this carry trade being squeezed in one direction. The funding side has perpetually been squeezed lower. And what’s that done? The asset side has come down as well. But I see all these like market events, whether it be Covid or the bombing event of a couple years ago or any number of market sell-offs. That is a signal that the market is trying to deleverage.

 

There’s been asset mis-pricing on the market and because we’re levered, again the impact is so much greater so the response out of policy makers has always been to lower the funding costs. If the asset yield is coming down, the funding cost has to come down too to keep that carry trade together. And now as asymptotically reach zero, maybe even going the other way, it’s really interesting to see what’s going to happen with that asset yield because again if there’s a mismatch of any sort, that’s when we can start hitting some turbulence.

 

TN: Do you think we’re hitting that mismatch point? We have a lot of precarious events like right now, whether you’re looking at big events like the demographic handoff from baby boomers to millennials, or if you’re looking at Covid or if you’re looking at some specific corporate events or even cryptocurrencies. There are so many different things happening right now that could mess with that carry trade.

 

SL: If you want to talk about cryptos, that’s a separate conversation. It depends on your time frame. If you look long-term, it’s the millennial taking over from the baby boomer and just a giant debt burden that we’ve amassed and I’ll claim it squarely on the fiat currency regime because again if you look at all fiat currency regimes they tend to go in this direction where the spending gets and the debt load tends to overwhelm the productive capability of the current economy and that is an issue that I think has to resolve and how that resolves, I’m not going to say anything unique here, but I believe there’s only three ways out.

 

You can either inflate it away. You can either restructure the debt or the obligations and in this case would probably mean restructuring social security and medicare benefits or you can repay it or default on it, right, which I think repayment is going to be difficult. And default, I’m not sure we need that considering that it’s a fiat currency and we could print it ourselves and that actually leads into what I think is the war of MMT right now and again, if bitcoin is one bottle of tequila I think MMT is a bad case of it.

 

That’s the draw of that because people are trying to find a way out of this and that’s longer term. If we go back to the more near-term view, I think inflation is really an interesting development here. And when we say inflation, I mean we’re specifically talking about CPI growth.

 

So we get to a point where the CPI is going up and bond yields for whatever reason follow CPI growth up, then let’s go back to that carry trade. Now we’re talking about our funding costs going up and asset yields don’t go up. That’s going to be a problem for the financial system and keeping that carry trade together.

 

However, it’s also how to get the asset yields up. Well the price has to come down. So that I think is a pretty interesting potential risk that we may be facing in the economy unless we can really generate the growth so we can get the asset yield up to match the increase in funding costs.

 

TN: I believe we’re in that very precarious position right now as we look at bond yields rising we look at other things. There’s a lot happening right at this very moment and so if you are a Janet Yellen or a Jerome Powell, what are you thinking about, I mean aside from these big problems we’ve talked about, what kind of tools do you think you’re looking at aside from dump trucks of trillions of dollars? Like, is there a lot… Do they have other options, really?

 

SL: I’m gonna answer this in some really different ways. The stimulus route that most people would like to go to, I actually think that’s counterproductive because I think about stimulus right, as opposed to say QE for example, you’re actually giving money in the hands of citizens. These are not institutions. These are actual citizens who are going to go out and purchase things.

 

So that actually I think puts upward pressure on CPI growth in a way that QE just simply did not, just from a pure mechanical perspective. So if that’s the case, we start seeing… So if you go and unleash some stimulus and then you start seeing CPI growth and then you start seeing bond yields go up, I mean you’re actually exacerbating the problem, right.

 

So my preferred method as a pure capitalist here, if I’m Jerome Powell, if I’m Yellen, I’m thinking of ways to get the asset yield up and I mean like bona fide get the asset yield up and from my perspective that’s purely deregulation and going to as free market and economy as possible. But that to me would be the only way of really getting the asset yield up and the growth up that we need to grow our way out of out of the debt load that we’ve created.

 

TN: Okay, interesting. So what are some of those deregulation paths you’d go down? Like again, the broad swallows of them and and how would you sequence that to not have immediately negative impact on the on everything? What would you focus on and how and when would you focus on it?

 

SL: So this is gonna sound like a punk, but it’s not. I think this is a very specialized issue and there are and they’re probably like really good policy makers, policy experts who can actually opine on this. But the way how I like to think of these problems and I get a lot of criticism for this, but it’s really to me the only way, the best way that I know to think about them is think of the end state, think about where we are now.

 

Like, let’s devise the ideal end state and then once we agree on the ideal end state then we could talk about the strategy to get us from here to there in the least disruptive way possible. So I mean ultimately my end state would involve going to a free banking regime. We’ve tried this throughout history. There’s been periods of it in the US. There’s been, it’s been tried best probably in Scotland. There’s also some in Canada.

 

If you’re looking for resources on free banking, I highly recommend the work of George Seljun and Larry White, definitely the foremost experts on the topic. If I were Jerome Powell, the way how I would go. I would try and think of how to put myself out of a job in a sense, which we know is probably unrealistic and probably doesn’t have a lot of consensus behind it but, that’s the way forward I see. These prescriptions that we’re talking about are going to be financial because we are talking about Jerome Powell who’s the head of the central bank. So he is a banker in the financial system.

 

And Janet Yellen is treasury secretary. I don’t really know how much power she has because she’s just trying to fund the government. If I’m Janet Yellen, I’d probably have to get a little bit shorter and then, maybe try and try and lobby for some deregulation angle and take some of that pressure off me to actually to have to fund a large government with that has a very big reach.

 

TN: Sure. Okay and so when we look at going down that path and we look at say the US Dollar as, like it or not, as a global currency, how do other say central banks or financial systems interact with the US as we would potentially move down that path?

 

SL: Sure. So the dollar is very important in the global financial system. It is the base reserve currency. But right now, all currencies are floating right. So I think perception probably has a lot more to do with it than anything else. At least from a fiat perspective, it ultimately, the buck is going to stop with the strength of the US economy. And it’s going to and that’s with any currency.

 

In order to keep the US Dollar as reserve currency, we need the strongest currency possible. That also means honoring the obligations possible. So that puts a lot more pressure on the inflation prescription and on the default prescription. And really I think leaves you with the growth angle as a way to maintain the Dollar’s importance in the system.

 

TN: It sounds to me like you’re fairly concerned about inflation in the coming years. Is that fair to say?

 

SL: I am sort of a secular deflationist and I am for a couple reasons, and it’s probably none that you’ve ever heard before. One I’m just pro, I’m a big believer in human ingenuity and a lot of this has to do with definition, right.

 

If we’re talking about inflation’s definition, right, it’s… Today, people are talking about CPI growth, right. The rate. So that is just the price of consumer goods and services. Right, I mean, that should fall over time. I mean just no… that is, I mean, that is the way of human prosperity. In fact, the only way CPI growth increases are times during shortages and tough times actually, if you look at the inflation we’re seeing now, right? The CPI growth that is like coming because we are seeing shortages throughout the supply chains, right. And that’s okay.

 

TN: So let’s stop there and let’s talk about that in terms of shortages. Do you think we’ll continue, like are those shortages something that are here to stay, let’s say in the short to medium term? Because like you, I’m a technologist.

 

I started technology for a reason mostly because I’m an optimist. So over the long term I certainly believe that prices go down generally because of innovation. But these supply shocks will say almost, a generalized supply shock, that we’re seeing in the wake of Covid, do you think that will be with us for a sufficient amount of time to have an impact on short to medium term CPI and provide a disruption to that balance that you’ve talked about?

 

SL: That’s an interesting question. I think it’s a matter of time frames because I think longer term, right I mean, you’re in business, I’ve been a bottoms-up analyst for 17 years here. And if there’s one takeaway is there’s no better cure for high prices than high prices. And why is that? Well that’s because businessmen and women innovate, they do bottleneck processes and they find a way to improve productivity and bring those prices down.

 

These Covid shortages I believe are temporary because I believe that we’re gonna see business people innovate and try and meet the demand with as much supply as possible for as low as price as possible and to make simply as much profit as possible for them as well.

 

So I think it’s short-term. I don’t have a way to really gauge how long that’s going to be because quite honestly it’s going to be a very micro-analysis. Are you talking about meat supply or talking about the chip shortages, and you know chip shortages that we’re seeing or are we talking about, you know, what what industry?

 

TN: So right. But in general, you think, it’s pretty short-lived. So we may see a short shock but for the most part where that equilibrium that you talk about can remain.

 

SL: Let’s go back to the financial system right back. How quickly is the bond market going to react? I think that’s probably the most interesting part of this conversation.

 

TN: Treasuries have risen like 33% since feb 1.

 

SL: Treasures have more than doubled, right.

 

TN: Exactly. Yeah. Doubled from zero, right.

 

SL: So from a pretty low base, yeah, the ten years specifically. Investors are forward looking and the question is how are people going to react to the perceived rise in CPI growth? How far will this take it? What are also supply demand imbalances within the financial system?

 

These are very complicated systems with a lot of inputs and I think we all tend to fall for this. We try and we oversimplify these because we hang on to a narrative. Let’s just be blunt. Like, I have no idea where else we’re going to go.

 

TN: I think everybody does. We make this stuff up as we go along, right. So bringing this back to say Yellen and Powell and central bankers, the tools that they have, they’re facing the dilemma of stimulus versus let’s say near-term say CPI inflationary activities. Do you see an easy path for them in the near term?

 

SL: I don’t see them as the main players in this argument at all. The central banker’s job, if you go back to the early central banks, it is just simply to try match the assets and liabilities and keep everything together. How much power does he have to juice the asset yield of the economy, and I would say very little. The proof is in the pudding. When look at how economies have performed over the past couple years, no matter how low they’ve taken, treasury yields, you haven’t really seen,  a boom in GDP at all.

 

It’s completely elusive. That’s just because that’s not within his power even though there’s just this belief out there that if you control the liability side cost then, all of a sudden you can control the asset costs and the only lever in there that gets tweaked with is actually the leverage and I think that’s probably the most dangerous thing.

 

TN: So in the short term, we’ll live belong, it sounds like, as usual. Okay. But in the longer term and I want to wrap this up fairly quickly, it sounds like we have to transfer liabilities from baby boomers onto millennials. Do you see any feasible tools for them to do that in a way, you know, that can happen in an organized, won’t be painless, but a relatively organized way. Or will it have to be some sort of disruption?

 

SL: I think the only organized way to do it is through growth, right. You need to come up with policies and again my biases as a capitalist for many reasons, we may need tothrow an extra case of tequila on the truck to get down that path. So that is a tool set that I think is necessary to tackle these problems.

 

If you don’t bring up the asset yield, then you have to deal with the funding costs and again you’re left with three issues and I think they’re all pretty ugly.

 

TN: Great. Seth, on that optimistic note, we’ll wrap it up. Thanks to everybody for tuning in for this QuickHit. Please subscribe below on the page and we’ll see you for the next QuickHit. Thanks very much, Seth. Thanks.

Categories
Visual (Videos)

CNA’s Asia First: US market pullback, less intense fear of COVID

Tony Nash joins the Asia First team again for another look at the US market pullback. What was the reason for that — is it the Biden’s VP candidate, the stimulus, or others? Also discussed were the market sentiments and what Nash thinks is lacking in the US economy right now. He also shared what Americans feel about COVID right now and what it means for businesses. Lastly, they discussed East Asia versus South Asia.

 

This video is the segment of Tony Nash from the August 12, 2020 full-length video episode, which was originally published by CNA for their Asia First show. You can find the source https://www.channelnewsasia.com/news/video-on-demand/asia-first/wed-12-aug-2020-13015722 

 

Show Notes

 

CNA: Tony Nash joins us now. He’s founder and CEO Complete Intelligence. He’s speaking to us from Houston, Texas, USA. Tony, we’re seeing this pullback in the markets overnight. I don’t know if it comes as a surprise to you. Is this the realization that the stimulus package might not be imminent. Is this who Biden has picked for a running mate or are there other factors at play here that have influenced the market?

 

TN: It’s really more about yields than anything. We’ve seen the impact of yields on precious metals. The impact on silver was most dramatic. But with equities, we saw a little bit of a pullback then. But we don’t necessarily feel like equities are in at a correction point at the moment. It might be some political news on Joe Biden’s VP candidate but I don’t necessarily see that being a disappointment. I don’t think there were huge expectations there.

 

There isn’t big COVID news in the U.S. There’s not necessarily major China news outside of the Alex Azar’s visit to Taiwan and the Hong Kong stuff, but there isn’t huge market impact on that. So really, it’s about yields and it’s about the expectation of stimulus.

 

CNA: Right, how much further downside do you see for the markets then?

 

TN: In the U.S., we think markets are fairly healthy assuming stimulus is coming. Now, U.S. legislators have gone for the rest of the summer. But there’s really nothing keeping Trump from issuing more stimulus like what he did over the weekend. I mean, there are things legally but he’s issued an executive order over the weekend to do that and it was a fair bit of stimulus coming down the pike.

 

What’s missing is stimulus for small and mid-sized businesses, which we had in May, June, but that really dried up at the end of July. So, we’ve seen almost 200,000 small businesses close in the U.S..

 

Really the question is, will there be more stimulus there in terms of cash flow to help the demand issues that small and medium-sized businesses are seeing in the U.S.? One of the key things that we’re finding, over the last week we’ve seen a lot of clarity come around whether American kids will go back to school at the end of August or in September. We’re seeing more and more school districts coming online saying yes they want kids back in school. Many of them in person some of them virtually but that helps American workers get back into the office as needed and where needed and gives them focus. So I would expect productivity to improve quite a lot in Q3 as parents and kids are back in school and many of them are back there physically.

 

CNA: But the case counts in the country. I mean, that certainly is weighing on sentiment is it not? And you know the idea that the country hasn’t quite got a hold on it, there is a possibility that they will have to start, stop the economy and it’s not as straightforward as going ahead with those lockdowns. When you do it a second, third time, that’s just going to have this permanent damage to the U.S. economy?

 

TN: Sure, that’s right. But I think the focus in the U.S. has really gone away from case counts. People are really looking at mortality. They’re really looking at clusters. They’re really looking at transmissibility. And so, I think in the U.S., the sentiment and the desire to close down. Generally, people are kind of over it. The fear of COVID is not as intense as it was two months ago. People realize that it’s a disease, it’s a virus. It comes and goes. The incidence rate and the death rate is actually fairly low.

 

The U.S. has done tens of millions of tests and so people are realizing that the high case counts are very related to the tests and this is going out through a lot of different mechanisms at the state level and the national level in the US. It’s not to say it’s gone. It’s not to say that we have zero cases. But a lot of countries in a lot of locations that say they have zero cases. I’m not necessarily sure that the testing is being done as thoroughly as it could be.

 

CNA: All right we’re also seeing that improvement of economic indicators in the Asian region, industrial output, some export figures look like they are on the uptrend in China for example. How much of this is going to be a divergent play east Asia versus south Asia for example?

 

TN: We really see east Asia lagging, although the Chinese data like the auto data that came in yesterday it looks okay. On year on year basis it looks pretty good. But I’m not necessarily convinced that that’s sustainable, given the demand issues that we saw in the first half of the year. There are ongoing worries that we’ll see issues in China’s economy and political issues in China with Hong Kong and other places.

 

We’re expecting east Asian markets to really not do well this month. We’ve expected kind of more than a one percent decline this month in east asian markets generally between say one and three percent based on the market in south Asia because they’re less China connected. We expect them to be flat to slightly down. So,  this month generally we’re expecting a slight pullback in Asia but south Asia fares a bit better than east Asia, although it’s not that dramatic.