“ Has the world grown smaller?”
– Around the World in Eighty Days, Jules Verne, 1873
Not much has changed, yet everything has changed since Andrew Stuart, befuddled by Phileas Fogg’s outrageous proclamation, asked one of the most ignorantly pertinent questions of his time. The decades of the mid-nineteenth century witnessed major advances in transportation technology, including the completion of coast-to-coast railroads in the United States and India, and the opening of the Suez Canal across Egypt. In the 130-odd years since, the world continued to shrink in temporal terms, with air and space travel taking the place of steamers and rail. NASA has designed airplanes to circumnavigate the world in just two hours, and commercial jets can now make the 80-day trip circa Jules Verne in less than 24 hours. While not much has changed in terms of our rate of progress against time, neither Stuart, nor Fogg, (nor the ECB for that matter) could have predicted the effects of a far more important advance underway, where everything has changed.
Information technology, more specifically the development of parallel processing, “gigabit-terabit-petabit” bandwidth and networking logic, is changing the way we conduct our lives today. While jet-setting executives (or policymakers) of this decade can be present in more places in less time than any predecessor, corporate information, corporate processes and corporate controls can now be shared around the world in real time via information superhighways. These advances in information technology are catalyzing the globalization of business and finance in ways far more important to global central banks than something as basic as physical transportation. These advances are driving the age of financial networking, and what has been described by some as leading to the vastly narrowing ecologies of finance.
In particular, information technology advances are dramatically increasing the number of “connections” we are capable of achieving and maintaining in our everyday lives. These connections allow us to specialize and super-specialize not only our manufacturing processes, but increasingly also our service-based processes, predominantly so in financial services. The mobility of capital combined with the mobility of information across countless interconnected nodes, hindered occasionally by politics and the transparency tolerance of various governments, gives the largest holders of capital something of a “God-complex” in today’s global economy. Small banks expand to become mega-banks, regional banks consolidate to become universal banks, and foreign central banks “self-insure” to become sovereign wealth funds. Wealth and capital supercede the common CEO, the everyday purchasing manager, and humble central bankers of today in velocity, mobility and connectivity. Global central bankers in particular need to catch up quickly.
Bear Stearns: Too Connected to Fail
On Monday, March 17, 2008, global financial markets opened to news of a Federal Reserve-enabled rescue of Bear Stearns by JPMorgan Chase. We learned, in the days that followed, of a weekend marathon meeting conducted by Federal Reserve officials to find a buyer for Bear Stearns. Urgency was warranted such that the hyper-connected global financial system might escape the effects of a medium-sized U.S. investment bank filing for bankruptcy and risking reverberations to thousands, nay, millions, of counterparties that were connected to it. Speculation grew of which institutions could be next, and more importantly, of which institutions comprised the Federal Reserve’s “too connected to fail” list. In reality, there was no such list at the ready; however, we can think of several universal banks and investment banks that, by virtue of the network age, play a significantly connected role in global finance such that bankruptcy of one or more would multiply the effects on financial markets globally in a cross-defaulting negative feedback loop.
Bear Stearns fell specifically due to a broadening “run” on its liquidity spurred by increasing skepticism about the value of assets on Bear Stearns’ balance sheet. The Federal Reserve responded with a suite of policy actions that was aimed at shoring up liquidity to the remaining commercial banks and investment banks, but the run on liquidity at Bear Stearns was only a symptom of the real problem incubating beneath it. Unfortunately, the liquidity provisions of the Federal Reserve only succeeded in delaying the process, not in curing it.
Real estate values across the U.S., residential and commercial, continued to deflate post-Bear Stearns. The same went for property prices in the U.K., Spain, Germany, Japan, Italy and Australia. Valuations and the increasing dearth of credit availability were equally to blame for this disease, with the prior a bigger factor in more developed economies, and the latter a bigger factor in more emerging economies. The real rub for policymakers around the world is that no legitimate firebreak was created and held between the cause of the epidemic and its multiplier. The global financial system is “too connected to decouple.” The economics of the oft-cited “hard decoupling” thesis are falling victim to the network effects of the hyper-connected global financial system, and nobody seems to be able to do much about it.
Global Aggregate Demand: Too Connected to Decouple?
Global financial markets and policymakers initially interpreted the events preceding the rescue of Bear Stearns as a U.S.-centric problem. The U.S. dollar dropped below 0.63 versus the euro on the day following the rescue, and the U.S. equity market’s share of global equity market capitalization touched a lowly 25.5% the same day. The rest of the world appeared to be in good health, with over-heating growth and rising inflation the chief concerns of non-U.S. central banks and most market participants. Network effects and the rising risk of negative feedback loops notwithstanding, major non-U.S. central banks turned their attention away from the U.S. asset deflation problem and looked increasingly to the emerging economies as a source of continued demand growth, higher commodity prices and rising inflation risks. Most major non-U.S. central banks actually followed the Bear Stearns rescue by raising interest rates in an effort to combat the rising risks of relative price changes in commodity markets and building cost-push inflation risks. They did not fully understand the deepening relationships between real estate asset deflation, financial sector balance sheets, liquidity provisions, and commodity price changes. There was a misdiagnosis of global hyper-connectivity en masse.
The crux of the disease incubating underneath Bear Stearns is not the availability of credit or the lack of liquidity. It is the value of globally-held financial assets, and their credit elasticity to the broader real estate markets. The lack of early and targeted policy measures to curb the accelerating deflation in real estate markets transmitted itself via the hyper-connected global financial system to all corners of the world. There is growing uncertainty as to the fundamental trough value of real estate assets, which leads to falling prices of financial assets connected to real estate, which leads to further write-downs on the tangible book value of commercial banks and investment banks around the world. Slowly, what was misdiagnosed earlier as a U.S.-centric liquidity problem is showing itself to be an epidemic-like global systemic financial capitalization problem. And, the credit freeze is suddenly turned on everywhere.
Financial sector incentives and central bank incentives appear to be increasingly misaligned today. While the Federal Reserve and select other central banks encouraged the financial sector to use liquidity provisions and raise capital to make new loans, the cost of capital to these very same banks and investment banks is becoming increasingly disconnected from the risk-free rates of capital globally. Financial sector management teams are relying on central banks to ease the cost of capital and force-feed the necessary medicine, while central banks are relying on management teams to self-serve the medicine no matter how bitter it is. Neither is willing or able to force the other’s hand. The window to raise “cheap” capital is quickly closing and the endgame as a result is becoming harder to predict.
The economic result of misaligned incentives and a fundamental asset valuation problem is the slow-moving spread of tightening credit conditions across the world. Industrial economies that were previously seen as healthy and far removed from the U.S. real estate problems are suddenly showing symptoms of domestic credit contractions and their own resulting asset and demand disinflations. The negative feedback loop from a hyper-connected global financial system is surfacing and downside risks from second-round effects on global aggregate demand are to follow.
At the time of this writing, 60–70% of global aggregate demand is growing below its trend growth rate, hurting global corporate profitability outside the financial system and encouraging a round of largely avoidable global cost-cutting and layoffs.
Global Supply Chain: Evolution?
As the global economy prospered from 2003 to 2007, corporate profitability sky-rocketed due to the positive feedback loop from a rapidly expanding global financial system. Aided by low interest rates at the onset, but fueled fundamentally by archaic leverage rules, pro-cyclical capital rationing models, significant credit rating innovations, and pure greed in most real estate markets, global growth surged with increasing shares of corporate profits to GDP in most countries. This self-fulfilling dynamic rapidly accelerated the pace of industrialization in emerging economies, as developed country consumer savings rates dropped to new lows amidst rapidly inflating asset prices, and demands on global production capacity increased significantly in a very short period of time. The result was a deepening linkage between the hyper-connected global financial system and the increasingly connected global supply chain from developed country consumers to emerging country producers.
In the pre-BRICs1 era, one could observe the vast majority of the U.S. supply chain from consumer to producer using the ISM index, its various domestic components, and select manufacturing data from Europe and Japan. However, in today’s increasingly connected global supply chain, these traditional relationships have broken down and are no longer an effective signal of the depth of the business cycle. They have been replaced, importantly, by a more geographically diverse map of consumers and producers, where the same intra-U.S. measures of the business cycle can be observed across borders and temporally downstream from the traditional U.S. business cycle. There has surely been a degree of decoupling, however, to date this decoupling is mostly temporal in nature because the distribution of wealth across borders is not yet broad enough to drive a truly diverse global demand function.
Global Central Banks: Disconnected
Global central banks need to better recognize the new world order of a hyper-connected global financial system and the inescapability of the coming global profits down-cycle from asset deflation and tightening credit conditions. Commodity prices, the scourge of central banks all summer, are showing early but dependable signs of correcting amidst recognition that global demand growth is indeed slowing to the tune of tightening credit conditions and a rapidly deteriorating global profits’ cycle. And it is important for the growing group of affected central banks not to mistake lower commodity prices for easier financial conditions. Asset prices are deflating or disinflating all over the world, and simultaneously driving a deep second-round wedge into the global demand function via tighter credit conditions. This dynamic is real and only addressable via coordinated policy actions from central banks around the world. Central banks need to reconnect with the global financial system quickly and successfully.
At PIMCO, we are focused on three moving targets in cyclical time. (1) Calculating the fundamental trough price of real estate markets in major economies worldwide based on cash-flow yields and market-equivalent cap rates. (2) Translating the trough price of real estate into an assessment of financial system losses and the related need to raise capital before regrowing credit. And (3) observing closely the second-round negative feedback loops from the continued tug-of-war between policymakers and the global financial system to the real economy and back to real estate trough values. Not an easy set of targets, but a critical set for any investor who wishes to emerge relatively unscathed from the good old-fashioned Minsky moment in which we are living.
It is important that central banks and others make their own assessments of these growing downside risks to global aggregate demand, and try to force a firebreak between the loss-generating hyper-connected global financial system and a thus-far vibrant but rapidly weakening global supply chain. In doing so, it will become clear that there is an immediate need to address the market costs of capital, either via lowering the global cost of risk-free capital further, or via the provision of a coordinated, new balance sheet. Time is becoming the most essential factor in this delicate balancing act, as negative feedback loops are in full flow and the asset deflation disease is spreading to narrow the ecologies of global growth.
Executive Vice President
1 Brazil, Russia, India, China