Against the tide: The danger of a repricing
The big happening in the next 12 months will be the repricing of global capital. It will impact the price of every currency and asset. It’s a complex and exciting story.
There is no doubt capital is mispriced. Central bankers fix the price of assets. The money they print and price at the zero bound inflates asset prices. Central banks cannot knowingly bring the process to an end. The slightest whiff of inflation could make capital repricing happen. Rising inflation could provoke the Fed to get ahead of the curve and tighten (short rates up, long rates up but less – the yield curve flattens). Or the bond markets would do the tightening for the Fed. The latter outcome would be far more damaging to financial assets, both long-term bonds and equities.
This could happen because economic slack is much less than thought. There are reasons to think that the stock is smaller and productivity lower than consensus believes for both labour and capital. The demand side is impeded by leverage, low-income gains and unemployment. Poor supply productivity is why labour slack is being absorbed so fast at modest economic growth rates. Labour costs per hour might not be rising, but its cost to a company that has to employ more of it (more people per unit of marginal output) is.
If the output gap is smaller than is commonly thought, firms will get pricing power back earlier and prices could start to rise before hourly wage rates do. Or, if much of the ‘spare’ labour has not got the skills for the sort of economy we have now (construction workers might not be good at knowledge jobs), labour wage rates will start to rise, despite high unemployment.
There are reasons to be pessimistic about labour and capital productivity because of the overhang from the prior bubble of unproductive legacy assets, loans and jobs; barriers to efficient re-allocation of resources during the Great Recession (such as the hoarding of labour, the preservation of zombie assets and corporations); skill loss of long-term unemployed and the retirement of highly-skilled baby boomers; lack of productive investment during the economic recovery; a switch to low productivity services as the engine of economies; falling entrepreneurship and effectiveness of R&D; and diminishing willingness of the employed to make sacrifices to keep jobs and heft productivity as labour markets tighten.
In terms of drama, this is pale compared to the impact of the repricing of US capital on global liabilities and asset prices. Nearly two thirds of global foreign liabilities are in US dollars. Dollar domination of foreign liabilities means two things: a rise in dollar interest rates is immediately translated to the world; and tighter Fed policy and/or rising US interest rates will cause global liquidity to shrink, even if the ECB and the BoJ are still pumping money.The UK and US are the large economies most at risk from this in the next six months. The Fed and BoE could be tightening while the BoJ and the ECB are loosening. The ECB is going to be increasing the size of its balance sheet by between 25% and 50% at the same time as the Fed will be shrinking its own. US yields will be distinctly higher. Volatility will be on the rise. Capital inflows into the euro will flag. For the next six months this scenario leaves the yen in limbo.
Risk is the last piece of the repricing jigsaw. Assets, particularly higher-yielding (worse-quality) emerging market and corporate debt are now owned more by private investors – mutual funds and ETFs – than by traditional investment institutions. The new owners are illiquid investors and far more prone to sell if the going gets tough. And equity markets have a new layer of risk in addition to rising discount factors and risk premia. The new risk is that the mainstay of US equity buying has been borrowed money used by corporations for share buybacks. If this stops and US equities start to fall, contagion to global equity markets will be at once psychological and fundamental.
All of these risks increase the likelihood that the repricing of US dollar capital could cause the next debt crisis, starting in the universe of corporate debt, causing severe market disruptions and hurting individual investors most.