Economy

Happy FOMC week, everyone! Futures markets are pricing in another 75-basis-point rate hike from the Federal Reserve this week. That would bring the fed funds rate into a range of 3.75 to 4 per cent, which is high! Compared to the last 15 years, at least! The yield curve is looking extra recessiony and inverted, with the three-month bill yielding 4.2 per cent, above than the 10-year note’s 4.1 per cent. And Wall Streeters keep talking about an elaborate ritual called a “pivot”. (Rhymes with “Godot”, correct? Must be French.) The first step in this dance is apparently called a “downshift”, which we imagine is similar to a curtsy. The sellside expects this will occur early next year, or possibly even in December, depending on how the data play out. We saw the first inkling of a central bank curtsy in Canada last week, but the Fed is what matters.Deutsche Bank appears to be leaning toward next year for a prediction, while Goldman Sachs and Bank of America expect Fed Chair Jay Powell to hint that the pace of rate increases could slow next month. After this there will apparently be more waiting to see how the Fed’s dance partner (the economy) will respond. This pivot choreography doesn’t sound like it’ll be especially fast-paced. Instead it seems like a sombre, formal and measured departure from the herky-jerky pace of Covid-era monetary and fiscal policy. Goldman Sachs’s Jan Hatzius and his team highlight that they expect the Fed to move slower with its rate increases after November: We do not expect Powell to tie a slowdown to 50bp to meaningfully better inflation data, which is not a realistic expectation at such a short horizon. Rather, Powell will likely note that the FOMC aims to move deliberately but more cautiously now that the funds rate is in restrictive territory, and that the full impact on the economy of the very large tightening in financial conditions to date is not yet clear. We expect the FOMC to eventually pair that slowdown to 50bp in December with a somewhat higher projected peak funds rate in the December dot plot. We are adding another 25bp hike to our own forecast — which now calls for hikes of 75bp in November, 50bp in December, 25bp in February, and 25bp in March — and now see the funds rate peaking at 4.75-5%, as shown in Exhibit 1.Strategists at Bank of America also expect the Fed’s pace of tightening to slow in coming months. But they say it’s the final interest rate destination that matters most: Committee members may also be reluctant to signal a slower pace of hikes lest financial markets interpret the decision as a “dovish pivot”. In recent FOMC meetings, the Fed has been clear in its “higher for longer” communication and focus on reigning (sic) in inflation. In our view, one way to lean against this interpretation would be to emphasize that, despite any forthcoming step back in the pace of rate hikes, the committee’s view on the cumulative amount of tightening needed to remove labor market imbalances has not changed.In other words, appropriate policy is now ultimately about the final destination and not the journey. By reaffirming the September median policy rate path, repeating consensus FOMC views that risks to the outlook for inflation still reside to the upside, and emphasizing a willingness to err on the side of tightening too much over tightening too little, we think the Fed can be successful in pushing back against any interpretation that a slower pace of rate hikes implies a lower terminal rate or a quicker pivot to rate cuts. In other words, it is now about the destination, not the journey. We expect the Chair to emphasize these points in the press conference.So is it the destination or the journey that matters? Wall Street doesn’t agree. But maybe the real recession was the friends we made along the way 🙂 More

Good morning. The US stock market did not blink at last week’s supposedly apocalyptic tech earnings. The S&P 500 was higher at its close yesterday than it was a week before. It seems that people want some risk exposure going into this week’s Federal Reserve meeting. There are high hopes that Jay Powell will make a noise about slowing the pace of rate increases or even pausing them. We don’t know whether that will happen or not; we wouldn’t make those noises if we were Powell, given that “sticky” prices have hardly slowed; but we are not Powell. In any case, we lay out below a case that the markets are still sleeping on the Fed’s real intentions, and the consequences of those intentions. Email us: [email protected] and [email protected] bear caseJust as with yesterday’s bull case, we don’t necessarily endorse all of the arguments that follow. It is an attempt to lay out the best available argument for trimming risk exposure right now. Alert readers may sense that we are more sympathetic to the bears than the bulls; they will be right. But we are not banging the table (as some of the arguments below might seem to do). We just see an imperfect fit between prices and what we see as the most unlikely policy, economic, and behavioural outcomes over the next year or so. So here goes: The market has priced in policy rates beginning to decline soon after they peak, and this is probably wrong. Below is a chart of evolving market expectations for the end of this year (dark blue), May (red) and the end of next year (light blue). We include May because that is when the market expects to peak. What doesn’t make loads of sense is the idea that rates will fall between then and the end of the year. Yes, a recession next year is likely (see below) and that recession will bring inflation down. But as Don Rissmiller of Strategas has pointed out, the Fed will not want to risk committing the mistakes of the late 1970s and early 1980s, when rates were brought down too soon, inflation jumped again, and rates had to be put back up. We could end next year with rates still at their peaks.Valuations, though they have fallen, just aren’t that cheap. The S&P 500’s price/earnings ratio tells the story here. We are not anywhere near the lows of previous major drawdowns, such as 2001 and 2008. Lots of people think we need not approach those lows, because the recession, if there is one, will be mild. But that’s not a good bet (see below). Others will look at the chart of cyclically adjusted P/E ratio (that is, the S&P 500 price divided into 10-year average earnings) and point out that it is bang at its average since 1995 (28). But part of the reason Cape valuations have been high since the late 1990s is because inflation has been very low and rates have been falling. That’s all over now. Stocks are not cheap. That valuation point goes for corporate bonds too, by the way. Spreads are higher than they were, but don’t price in much bad news. Here are BBB spreads, which are right at their long-term average:There is going to be a proper recession. The 10-year/3-month yield curve recently inverted (see chart below). In the past this has predicted recession all but infallibly. It makes sense that it should do so. Such an inversion indicates that short rates (which determine so many other prices in the economy, from bank loans to mortgages) have been pushed very quickly to a level above long rates. Long rates are a very rough approximation of a neutral interest rate for the economy. If short rates are higher than long, short rates are restrictive; money costs so much it slows growth. The economy’s parking brake has been yanked. A recession follows. An argument is frequently made that this recession will be mild because consumer and corporate balance sheets are particularly strong right now. While balance sheet strength might reduce the chances of the types of financial contagion that personal bankruptcies and corporate defaults cause, remember that monetary policy brings down spending by reducing demand. Fed tightening will cause household and corporate spending, and therefore the economy, to fall significantly. That is what it is designed to do, because that is what brings inflation down. A shallow or “technical” recession could only result from perfectly calibrated policy that the Fed has often failed to achieve in the past.

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Margins have only started to compress. The coronavirus pandemic-era combination of rising input costs, shortages and high demand were a blessing for margins. Mark-ups surged as consumers spent without restraint and companies flexed their pricing power. But falling demand and an inventory bulge are now weighing on margins. And as Morgan Stanley’s Mike Wilson points out, today’s inflation is particularly menacing for margins, with producers’ input inflation falling more slowly than consumers’ price inflation. Margins, and earnings, are going to get worse.Tina is toast. It used to be that you had to buy stocks because the risk-free alternative, Treasuries, yielded nothing; hence “There Is No Alternative”. That, too, is all over now. Even though falling stock prices have pushed up their earnings yield, the yield differential between stocks and bonds is shrinking. Sentiment may have capitulated, but flows have not. Bulls make a big to-do about poor investor sentiment. It is poor, and that’s a contrary indicator. The idea is that we are near capitulation, that point where all the bad news is inscribed in the price and the only way to go is up. But the poor sentiment has not, crucially, been accompanied by net withdrawals from equity funds, which makes it seem as if capitulation remains some way off. Below are net flows into US equity funds on a three-month rolling average basis. They have only just touched zero as the extraordinary rush of money during the pandemic has subsided.Illiquid markets make for violent selling. The sell-off in stocks has been remarkably orderly so far, and we’ve seen no sudden surge in the Vix. But as liquidity has dried up, other markets, like sovereign bonds or currencies, have not looked so benign. Commonly used indices for bond-market volatility (Move) and FX volatility (Cvix) are at decade-plus highs. Historically, FX volatility drives bond market volatility, which in turn creates tumult in equities, notes Michael Howell of CrossBorder Capital. Put another way, the groundwork has been laid for panicky selling should any further shocks to equities, such as earnings deterioration, occur.If we’ve missed any brutally obvious points, on the bear or bull side, do let us know. (Armstrong & Wu)One good readJapan can, and should, defend the yen. More

When Federal Reserve officials last met to set US monetary policy, chair Jay Powell made it clear that a recession in the world’s largest economy could not be ruled out. “No one knows whether this process will lead to a recession or if so, how significant that recession would be,” he said at the press conference after the Federal Open Market Committee’s gathering in September.As the Fed convenes this week, inflation remains at the highest level in decades and is becoming more embedded, meaning policymakers are set to ratchet up their response and implement the fourth 0.75 percentage point increase in a row while also signalling more tightening ahead. Economists warn that means a more severe downturn is on the cards. “Each adverse [inflation] report and each adverse development in the outside world implies the Fed is going to have to do more in order to bring the situation under control,” said David Wilcox, a former Fed staffer who now works at the Peterson Institute for International Economics. He added: “Doing more means a higher probability of a recession, and if [it] happens, in all likelihood a deeper recession.”Since the Fed’s last meeting, there have been signs that the housing market is weakening while consumer demand has started to soften, but fresh inflation data has shown price pressures continue to build and labour costs have firmed. Most alarmingly, the October consumer price index reported an acceleration in “core” inflation, which strips out volatile items such as food and energy. Inflation had spread from industries hobbled by pandemic-related supply chain disruptions and the war in Ukraine to categories such as services. Sonal Desai, chief investment officer at Franklin Templeton Fixed Income, described this “migration” as a problem “a bit like whack-a-mole, with a different piece of the basket popping up with inflation pressures”. She added: “The reality is we are going to need to see some slowdown in the economy to take some of that demand-side pressure off.”Another 0.75 percentage point increase this week will lift the federal funds rate to a new target range of 3.75 to 4 per cent, a level that policymakers think will start to have a bigger impact on economic activity. In September, when FOMC members and branch presidents last published forecasts, most saw the benchmark policy rate hitting 4.4 per cent by the end of the year before peaking at 4.6 per cent in 2023. But given the economic data that has been published since then, many economists and traders betting on fed funds futures now think the rate will probably top out at a “terminal” level of 5 per cent. “The higher the terminal rate, the greater the window for all borrowing costs to continue to rise, [which] does suggest the growing risk of quite a severe downturn,” said James Knightley, chief international economist at ING. Knightley is among a growing cohort of economists and policymakers to question whether the central bank should consider slowing the pace of its rate rises. “By moving hard and fast, you just naturally have less control,” he said. But easing up when inflation is this severe could result in a repeat of communications problems that Powell was forced to rectify in August. Over the summer, the Fed’s declaration that it would need to slow the pace of rate rises “at some point” fuelled bets the central bank was losing the stomach for the fight against inflation and might start cutting rates next year. Markets rallied sharply, undoing some of the work that the central bank had accomplished in ushering in tighter financial conditions. Mohamed El-Erian, chief economic adviser at Allianz, said: “On the one hand, it should moderate the pace to see how the massive recent front-loading of hikes plays out in the real economy and for financial stability. On the other hand, it can ill-afford another blow to its inflation-fighting credibility.”

Priya Misra, global head of rates strategy at TD Securities, said one “graceful” way for the Fed to slow down without stoking scepticism about its commitment would be to indicate support for a higher “terminal rate” while also homing in on financial stability concerns. Those vulnerabilities became evident in the UK last month when government bond markets seized up and tipped pension funds into turmoil, forcing the Bank of England to intervene.“If you look at the US data, it is very hard to argue why they need to downshift. But the moment you look at the global picture, the UK situation should give them caution to downshift without pivoting,” she said.A moderation in the pace of policy tightening to half-point increments would be welcome news to some Senate Democrats, mostly on the left of the party, who have recently stepped up their criticism of the Fed and warned of excessive job losses in the future.But for now at least policymakers seem more concerned about doing too little rather than too much to fight inflation. “What’s at stake if they make the wrong call is that inflation stays higher, and that means at some point down the road they’ll have to do even more to get inflation back to 2 per cent,” said Steve Blitz, chief US economist at TS Lombard. More

Luiz Inácio Lula da Silva scraped a narrow victory to return as Brazil’s president after convincing more than 60mn voters he was the man for the job.His task now will be to persuade investors and financial markets, after a policy-light campaign and indications that he plans to ditch the pro-market model of defeated rival Jair Bolsonaro and restore the state to a bigger role in the economy.“There are potentially a lot of tensions in what [Lula] has promised: higher welfare spending, higher investment but fiscal responsibility. Investors will need to see that Lula is committed to fiscal responsibility as much as the other pledges,” said William Jackson, chief emerging markets economist at Capital Economics.The veteran leftwing politician had provided hints to investors that he would govern as a centrist, added Jackson. “But at some point he’ll need to show more concrete proof.”Traders adopted a cautious stance after Sunday’s win over far-right incumbent Bolsonaro, preferring to wait for clearer signals from the president-elect about economic strategy and his choice as finance minister. Lula has said he would prefer a politician to a technocrat, with ally Fernando Haddad, a former mayor of São Paulo, and Alexandre Padilha, ex-health minister, among those in contention. The Brazilian real climbed 2 per cent against the US dollar on Monday after an initial dip, while the local Bovespa stock index recouped early losses to trade up 1.3 per cent. However, shares in state-controlled oil producer Petrobras — Brazil’s most valuable listed company — slumped 8.5 per cent, reflecting concerns about a possible change in its direction under the new government.Lula, 77, has pledged to boost public spending, especially on infrastructure and social welfare, in order to spread prosperity after a decade of stagnating living standards. But he has inherited shaky public finances, with debt projected to reach almost 89 per cent of gross domestic product next year, and an economy forecast to slow sharply.Lula has called for a rise in the minimum wage and pension payments © Victor Moriyama/BloombergInvestors now want details on how the veteran Workers’ party (PT) leader, who was Brazil’s president between 2003 and 2010, intends to balance extra expenditure with responsible management of the public accounts.“Bondholders and equity investors are worried about what will happen to fiscal policy,” said Marcos Casarin, chief Latin American economist at Oxford Economics.On the campaign trail, the former trade unionist offered the broad strokes of a vision putting the state at the centre of economic development. Lula has called for a greater role for BNDES, the publicly controlled development bank, for state-run Petrobras to stop charging international prices for fuel, and for a rise in the minimum wage and pension payments.One campaign insider said: “The meetings we’ve had with the financial sector have been productive and our ideas have been well accepted. I have the feeling they go away calm and satisfied.” Not everyone agrees, with some mindful of how the last period of PT rule ended.Pedro Jobim, chief economist at hedge fund Legacy Capital, said such proposals were not only “bad economic policy” but “the same policies which created conditions for the recession, impunity and chaos into which the PT dragged Brazil, leaving scars that will take decades to heal”.A document published last week by Lula also pledged to improve public services such as healthcare and exempt low earners from income tax. But it was vague on how the government would pay for this.“The letter was just a declaration of broad intentions with a long wishlist of aspirational things the government should do,” said Alberto Ramos, head of the Latin America economic research team at Goldman Sachs, adding it lacked detail on “how to responsibly fund many of the fiscally expensive campaign promises”. However, many in the business and financial world are hopeful that Lula’s pragmatic approach can avoid the mistakes of Dilma Rousseff, his chosen successor in 2011. Her loose fiscal policy and interventionist meddling were blamed for pushing Brazil into a deep slump.Lula has pointed to his own record to show he can be trusted to run Latin America’s largest economy. Tens of millions of Brazilians were lifted out of poverty thanks to a conditional cash-transfer programme put in place during his presidency. As the country rode a global commodities boom, his administration largely stuck to economic orthodoxy.Lula has called for state-run Petrobras to stop charging international prices for fuel © Dado Galdieri/BloombergYet he will assume office on January 1 in very different circumstances. Growth in China, a major consumer of Brazilian raw materials, has cooled considerably, and the risks of a global recession are rising, as are interest rates around the world.Following forecasts for GDP growth of 2.8 per cent this year, according to a central bank survey, expansion in output is predicted to fall to 0.6 per cent in 2023.“He’s going to have to produce growth out of nothing,” said Mario Marconini, managing director at political consultancy Teneo. “It’s a really tall order . . . [Lula] hasn’t had to deal with that kind of thing before.”Winning approval for next year’s budget from a fragmented parliament tilted to the right will be a challenge. Spending has already risen because of enhanced social benefits granted by Bolsonaro in an attempt to win re-election, which Lula has said he would honour.The choice of finance minister will be crucial. Given the narrow margin of his win — he took 50.9 per cent of the vote on Sunday — Lula could opt for a moderate.“A more market-friendly figure could be good news,” said Rafaela Vitoria, chief economist at Banco Inter. “On the other hand, someone defending more spending and more state intervention in the economy would not be well received.”Additional reporting by Carolina Ingizza in São Paulo

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Rarely has a deal encountered such strong government opposition. Six German ministries came out last month against Chinese shipper Cosco’s planned acquisition of a stake in a Hamburg container terminal. But it went through anyway. The man who ensured its safe passage through the German cabinet was Chancellor Olaf Scholz. He insisted on a compromise — Cosco would have to make do with a 25 per cent stake, rather than the 35 per cent that was initially proposed.But the German foreign ministry remained opposed, even after Scholz pushed it through. State secretary Susanne Baumann wrote an angry letter to Scholz’s chief of staff, Wolfgang Schmidt, saying the transaction “disproportionately increases China’s strategic influence over German and European transport infrastructure and Germany’s dependence on China”.Scholz, however, clearly could not afford to see the deal collapse. On Friday he will become the first G7 leader to hold talks in Beijing with Chinese president Xi Jinping since the start of the Covid-19 pandemic. Nixing the Cosco transaction would have cast a long shadow over a trip with huge symbolic importance to both Beijing and Berlin.Still, China-watchers found his intervention puzzling. “It gives the impression he’s offering the newly crowned Xi Jinping a gift before the trip — one he was under no obligation to make,” says Noah Barkin of Rhodium Group, a New York-based research firm. The Cosco affair also disappointed those who had hoped that Scholz would adopt a new approach to Beijing and break definitively with the mercantilism of the Angela Merkel era. The coalition agreement negotiated last year by Scholz’s Social Democrats, the Greens and the liberal Free Democrats was notable for its critical tone on China and its focus on human rights. But the Hamburg deal shows deep divisions persist between the Greens and parts of the SPD about the future of the relationship. Green scepticism about China has only grown since last month’s Communist party congress, during which President Xi stacked the Politburo Standing Committee with loyalists and cemented his position as the most powerful Chinese leader since Mao Zedong. China’s lurch towards one-man rule, combined with the economic disruption caused by its zero-Covid policy, sabre-rattling over Taiwan and tacit support for Russia’s war in Ukraine have turned a country that was once one of the most exciting markets for German business into one of its biggest risk factors. A map of Taiwan shows where Chinese military exercises took place in August. If Beijing were to invade, sanctions could end up leaving German companies among the biggest economic losers © Florence Lo/ReutersBerlin is being stalked by a fear that history might be about to repeat itself — on a much grander scale. The Ukraine war exposed the folly of Germany’s decades-long reliance on Russian gas. Now, the pessimists fear, it may be about to pick up the tab for its even deeper dependence on China, a country that has long been one of the biggest markets for German machinery, chemicals and cars.Thomas Haldenwang, head of German domestic intelligence, summed up the concern at a hearing in the Bundestag last month. China, he said, presented a much greater threat to German security in the long term than Russia. “Russia is the storm,” he said. “China is climate change.”The focus of much of the anxiety is Taiwan. Xi’s rhetoric on “reunification” has raised fears that China may be planning to invade the island, a move that would bring down a hail of international sanctions against Beijing and likely decouple China from the western world. In the resulting turmoil, German companies could end up among the biggest casualties — with huge implications for an economy already reeling from its worst energy crisis since the second world war and teetering on the brink of recession.Germany’s president, Frank-Walter Steinmeier, a former foreign minister, said Germany must “learn its lesson” from Russia’s war on Ukraine. “And the lesson is that we have to reduce our lopsided dependencies, wherever we can,” he told public broadcaster ARD last week. “That applies in particular to China.”It is for that reason that the German government is engaged in a fundamental reassessment of its approach to Beijing — a process that will reach its fulfilment next year with the presentation of a new “China Strategy” designed to recast the relationship in more realistic terms.“It will designate China as an important trading partner but the Communist party as a systemic rival,” finance minister Christian Lindner says in an interview.German foreign minister Annalena Baerbock, left, has emphasised the risks of dealing with China, while chancellor Olaf Scholz, centre, has warned against cutting ties with the country. Also pictured in this August cabinet photo are finance minister Christian Lindner, second right, and interior minister Nancy Faeser © Florian Gaertner/Photothek/Getty ImagesPart of the planning for the strategy has been to evaluate German companies’ vulnerability to an escalation in tensions between China and the west. “There might come a time when the Chinese market is no longer available to us,” says one official. “After what happened with Russia, we can no longer say that will never happen. And we must act to prevent that becoming an existential threat to German companies.”The rethink is being driven by the Greens, who have long been mistrustful of China. Since entering the government last December they’ve wasted little time putting their China-sceptical stamp on policy.

Germany’s experience with Russia had shown “that we can no longer allow ourselves to become existentially dependent on any country that doesn’t share our values,” the Green foreign minister Annalena Baerbock told Süddeutsche Zeitung last month. “Complete economic dependence based on the principle of hope leaves us open to political blackmail.” But, as the row over the Cosco deal showed, the government is deeply divided on China. While Baerbock emphasises the risks of dealing with Beijing, Scholz has warned repeatedly of the negative consequences of severing ties with China.“Decoupling is the wrong answer,” the chancellor told a business conference last month. ‘Don’t put all your eggs in one basket’Scholz, who used to be mayor of Hamburg, has long believed that Germany has no choice but to trade with countries such as China. “You dance with whoever’s in the room — that applies to world politics just as much as the village disco,” he famously noted in 2018. On the other hand, though, basic risk management dictates that companies diversify into other markets. “It’s a basic lesson you’re taught in the third term of business school . . . that you don’t put all your eggs in one basket,” he said in August. “That goes for imports and supply chains as well as exports.”It is a message other prominent cabinet figures are pushing, too. “German business would be well advised to continue to open up new markets in the world, to invest in Asia, Africa, South and North America, so as to dilute the importance of China for the German economy,” Lindner says in the interview. “A sudden decoupling” would destroy many of the economic benefits and welfare gains of globalisation, he says. But China itself, he adds, is already moving to “decouple parts of its economy from the global division of labour”, and that should be a trigger to action. “Diversifying our technologies and supply chains will strengthen our resilience,” he says.An Aldi store in Shanghai. The discount retailer is planning to open hundreds more stores in China; German businesses have already invested €10bn in the country this year © CFOTO/Future Publishing/Getty ImagesThe problem for Scholz’s government, though, is that some of Germany’s biggest companies do not seem to be heeding that message. Instead of reducing their exposure to China, many are doubling down. BASF, for example, announced in July it had given final approval to a plan to build a massive new factory in the southern Chinese city of Zhanjiang that will cost €10bn. Meanwhile, it also plans to “permanently” downsize its presence in Europe, a region it says that high energy costs have made increasingly uncompetitive.BASF’s chief executive Martin Brudermüller has defended the approach and hit out at critics of his China investments. “I think it’s urgently necessary to stop this China bashing and look at ourselves a bit more self-critically,” he said last week.Experts say BASF has little choice but to focus its efforts on China. “China has 60 per cent of the world’s chemical companies and talent and 40 per cent of the resources,” says Wang Yiwei, professor of international relations at Renmin University and an adviser to the Chinese government. “If they don’t invest in China, where do they go?”BASF is not alone. Aldi, the German discounter, is planning to open hundreds of new shops in China. Automotive supplier Hella is doubling capacity at its factory in Shanghai. And Siemens said last week it was planning a major expansion of its “digital industries” division in China. According to the German Economic Institute, German businesses invested a record €10bn in China in the first half of this year alone. The title of the institute’s study: “full steam ahead in the wrong direction”.

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Irked by such statistics, ministers are taking action. Their weapon of choice are the guarantees the government offers to German companies in emerging markets, which protect their investments from political risk. In May, Habeck’s economy ministry refused to extend Volkswagen’s investment guarantees for China, citing the repression of Muslim Uyghurs in the western region of Xinjiang. The ministry is now working on plans to cap the number of such guarantees for China. “They . . . are massively skewed to China right now,” says one official.On the other hand, many in Berlin are sceptical that such moves have much impact. The evidence suggests that companies will continue to invest in China, if necessary without the guarantees. Officials acknowledge they wield little influence over corporate decision makers.“If Brudermüller thinks investing €10bn in China is the right thing to do, it’s ultimately a question for BASF’s shareholders,” says the official. “But I do think we have to send a signal to companies that if their shareholders endorse it — fine, but please don’t count on the German government to underwrite it.”Others, however, say no amount of government cajoling will persuade German companies to walk away from China. “You talk to businessmen and they say, ‘Are people crazy?’” according to one official. “They say, ‘Don’t they realise where all our wealth comes from?’”The era of ‘win-win’For years, Germany was one of the key beneficiaries of China’s opening to the world. Its appetite for German tools, fridges and automobiles seemed insatiable, and German exports to the Chinese market fuelled a 10-year economic boom last decade that was one of the longest in Germany’s postwar history. In 2021, China was Germany’s largest trading partner for the sixth consecutive year, accounting for 9.5 per cent of its trade in goods.Angela Merkel’s frequent trips to China — she went there 12 times during her 16-year reign as chancellor, often accompanied by huge business delegations — symbolised the close ties. She would occasionally criticise China’s human rights abuses in Xinjiang and Hong Kong, but the economic relationship always had primacy.Xi Jinping with Angela Merkel on a trip to Berlin in 2017. During her 16 years as German chancellor, Merkel visited China a dozen times, often accompanied by business delegations © Michele Tantussi/Pool/Getty ImagesIt was, in Merkel’s oft-repeated phrase, a “win-win” for both countries. When China allowed foreign car brands to enter its market through joint ventures with state-owned manufacturers, companies like VW were quickly able to access the country’s rapidly growing consumer base. And imports of German machinery, components and chemicals helped fuel China’s booming manufacturing and construction sectors. As a result, Germany’s footprint in the Chinese market continued to grow. Volkswagen now sells 40 per cent of its cars in China and the country accounts for 13 per cent of Siemens’ revenues and 15 per cent of BASF’s. A recent survey by the Ifo think-tank found that 46 per cent of industrial firms rely on intermediate inputs from China.But over the years Chinese companies have grown to overtake many of their German partners, through both fair means and foul. In the mid to late 2010s, China announced a series of targets for increasing domestic innovation and decreasing dependence on foreign technology. Germany’s machinery business association, the VDMA, listed the problems this created for its companies: subsidies to domestic competitors, standard-setting that discriminated against foreign firms, as well as the continuing issue of intellectual property theft.Volkswagen showcases an electric car in Shanghai in January this year. The German automaker now sells more than a third of its cars in China © CFOTO/Future Publishing/Getty ImagesChina’s industrial upgrading is one reason Germany increasingly sees it as a rival, says Wang, the Chinese academic.“In the global value chain, China has shaken and challenged the advantages of Germany’s manufacturing sector, particularly German companies’ profits in China, which are no longer as easily gotten as before,” says Wang. “But at the same time, the companies can’t leave China.”Anecdotal evidence, however, suggests that some are — or are, at least, considering their options. Jörg Wuttke, president of the EU Chamber of Commerce in China, said that while big companies were staying put, “other segments, mostly SMEs, are putting their China operations on autopilot and looking for alternatives around the world”. “Businesses can’t afford to wait until China sorts out its Covid exit strategy,” he added.According to Ifo’s recent survey, nearly half the German manufacturers that receive significant inputs from China plan to reduce their Chinese imports. When asked why, 79 per cent cite “diversification of supply chains and the avoidance of dependencies”.One factor driving this development is the financial sector’s changing perception of the risks of being too reliant on China. “It’s actually quite interesting to see that American rating agencies . . . are now including an assessment of geopolitical risk,” Franziska Brantner, state secretary at the economy ministry, told a recent conference in Berlin. “And it might become very expensive for European companies to refinance themselves if they don’t diversify.”Already, German companies that are heavily exposed to the Chinese market are facing real problems with their business. “We are getting the first German Mittelstand companies saying they are being shut out of international tenders if they say that certain parts only come from China, from their factories in China,” says Martin Wansleben, head of the association of German chambers of commerce and industry.The Hamburg terminalIt was in the midst of Germany’s continuing debate about China that the row about Cosco’s investment in Hamburg suddenly took centre stage. In a deal agreed last year, Cosco Shipping Ports was to acquire 35 per cent of the Tollerort container terminal in Hamburg port for €65mn, from logistics company HHLA. But the deal first had to be approved by the German cabinet, and six ministries opposed it on national security grounds. Chinese companies, they argued, should not be allowed to acquire Germany’s critical infrastructure.Scholz’s aides defended the deal. Cosco was “merely” buying a small stake in the operator of one of Hamburg port’s many terminals, not a share of the port itself, which is largely state-owned. Cosco already has interests in other European ports, such as Antwerp and Zeebrugge. And blocking the deal could be detrimental to Hamburg’s interests. “There is a danger it could lose Cosco’s business,” said one official.Cosco Shipping Ports planned to acquire a 35 per cent stake in a Hamburg container terminal, but six German ministries opposed the deal on national security grounds © Michael Probst/APOther ministries, however, sounded the alarm. Some officials drew parallels with the sale of some of Germany’s largest gas storage facilities to Gazprom, the Russian gas export monopoly, over the past decade. Scholz insisted on a compromise. That emerged late last month when Cosco was told it could only acquire a 24.9 per cent stake and would have no veto rights over strategic business or personnel decisions.Most ministries grudgingly accepted the compromise — but not Baerbock’s foreign ministry, which continued to oppose the Cosco deal. In a protocol notice, Anna Lührmann, German minister of state for Europe, said China had made clear “that it’s prepared to deploy economic measures to achieve political goals”. Allowing the sale of the terminal stake “would give China the ability to exploit a part of Germany and Europe’s critical infrastructure for political ends”. Barkin, of Rhodium Group, says by pushing through the Cosco acquisition, Scholz is making things too easy for Beijing. “China needs Germany, especially when US-China competition is heating up,” he says. “So Scholz has a degree of leverage. But with the message he’s sending, he appears to be relinquishing it.” More

After the end of every era, a handful of images tend to linger in the mind. For me, the period of financial exuberance that came to a messy end in 2008 will always be encapsulated by the jobs fair I went to in my final year of university in 2006. I remember strolling from one recruiter’s stand to the next to gather up their extravagant freebies. I got a very nice shower radio from Goldman Sachs. Another company (I forget which) was handing out popcorn machines. There was no real question we would get good jobs; the question was which we would choose.Of course it didn’t last. The decade that followed the financial crisis was grim by a number of metrics, notably in terms of people’s pay packets. Wage growth across OECD countries was unusually weak. In the UK, real wages grew an average 33 per cent a decade from 1970 to 2007 but didn’t grow at all in the 2010s.Now we are watching another era come to an end. Not, sadly, the era of tough economic times, but the era in which those problems were accompanied by very low interest rates. Central banks around the world are raising rates to combat inflation. So what will we remember of the age of cheap money?The answer probably depends on who you are. For homeowners, much lower mortgage payments helped to take the edge off stagnant wage growth. Low rates also helped to boost the prices of homes and other assets. People who owned houses had the weird feeling their properties were earning more than they themselves were. People who weren’t on the housing ladder watched the bottom rung move further away. In the UK, 55 per cent of those born between 1956 and 1960 were homeowners by the age of 30. For people like me born between 1981 and 1985, that figure was just 27 per cent.The car market changed too. Instead of buying a new car with cash up front, it became increasingly popular to use “personal contract purchase” schemes which allowed customers to pay a deposit and a monthly fee. This allowed people to drive fancier cars. In the UK in 2006, 46 per cent of new car registrations were financed at the point of sale by members of the Finance & Leasing Association. By 2019, that figure was almost 92 per cent. The UK wasn’t getting much richer as a nation, but you wouldn’t have known it from all the Audis on the roads.Low interest rates also sent money gushing into lossmaking start-ups that promised to grow quickly. From Uber and Deliveroo to quick grocery delivery apps like Getir and Gopuff, investors subsidised people’s taxi rides, takeaway meals and 15-minute deliveries of treats like beer and chocolate. Then there was the expansion of “buy now, pay later” companies, which partner with retailers to give customers the option to pay for their stuff via interest-free instalments. This business model was perfectly placed to help retailers drive up sales in an era in which young consumers were feeling the pinch in their pay packets. Swedish company Klarna, for example, has said US retailers that offer customers four interest-free instalments report a 68 per cent increase in average order value and 21 per cent higher purchase frequency. A survey by the US Federal Reserve in 2021 found that while 78 per cent of buy-now-pay-later service users did it for convenience, 51 per cent also said it was the only way they could afford their purchase.It would be overly curmudgeonly to say the opportunity afforded by low interest rates was entirely frittered away on services like these. Low rates also helped to foster important investments in renewable energy and to underpin the shale boom in the US. But I will remember the decade as a time when economic stagnation came with a veneer of affluence. Money was tight but people could summon cheap rides and buy things even when they couldn’t afford them. These business models are now under strain. Uber’s and Deliveroo’s share prices have tumbled. Rapid grocery delivery apps are closing down or merging. The valuation of Klarna, once Europe’s most valuable private tech company, has dropped from $46bn to $6.7bn.For that reason, I think the lasting image of the era of cheap money for me will be the recent announcement that customers can now pay for a Deliveroo takeaway in instalments via Klarna. Deliveroo and Klarna say this isn’t problematic, given that plenty of people buy takeaways with credit cards. Still, it’s hard to escape the impression of two drunks propping each other up at the end of a long [email protected] More

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Jay Newman was a senior portfolio manager at Elliott Management and author of the finance thriller Undermoney. Richard McNeil was a Goldman Sachs partner who spent more than 25 years working with sovereign debt managers in the emerging markets.The UK isn’t a banana republic, yet, but whether the nation, the pound and gilts retain their historic stature or whether it becomes just another dicey, badly-managed, and fiscally-irresponsible country hangs in the balance. Followers of the emerging markets will remember the late Rudi Dornbusch — a keen and trenchant observer of what works and what doesn’t when it comes to managing sovereign finances. Since the 1970s we have seen a series of what might be called “Dornbusch moments.” As a country issues more debt than it can afford to repay, at some point markets get jittery. Debt prices crash, the currency goes into free fall, and, even though interest rates spike, nobody seems willing to lend to the sovereign at any price, except, eventually, the IMF — and then, only with strict conditionality. Few of today’s market participants will recall that, in 1976, hard on the heels of Dornbusch’s seminal work, Expectations and Exchange Rate Dynamics, the UK turned to the IMF for a bailout. At the time, this was not a huge surprise. As Richard Roberts wrote in When Britain Went Bust, the UK was the biggest user of IMF funding from the mid-1940s through the mid-1970s, after exiting second world war with large debts and an uncompetitive exchange rate. Still, in light of recent developments, prime minister Rishi Sunak might well reflect on his predecessor James Callaghan’s frank admission at the 1976 Labour conference in Blackpool: “We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that option no longer exists, and that insofar as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.” In the years since 1976, policymakers have been reminded repeatedly and painfully of the speed with which financial markets abandon their infatuation with countries whose accounts are unbalanced. Unfortunately, unlike in 1976, the IMF is no longer a stalwart guarantor of predictability and confidence in its clients’ policymaking. For example, the big lesson from the recent debacles in Greece and Argentina is that, in the face of massive borrowing without a strong plan and political will, even an official lender of last resort can only postpone disaster.But debt and currency crises can be managed successfully. Here’s where the first lesson for the UK from emerging markets kicks in. Against long odds, Mexico’s handling of the so-called Tequila Crisis in 1994 was a standout success. Mexico had allowed its current account deficit to grow unsustainably following the rapid inflows of foreign capital associated with successful privatisations. When the Fed began to tighten in 1994, Mexico found itself trapped in the “impossible trinity” of a managed exchange rate, a free capital account, and an independent monetary policy. In the run-up to presidential elections, Mexico haemorrhaged international reserves, and, eventually, was forced to devalue. In its plan for recovery, announced in March 1995, Mexico committed to a free float, tightened monetary policy, trimmed spending, increased the VAT by 50 per cent, and raised fuel taxes, aiming to increase the fiscal surplus by over 2 per cent of GDP. Minimum wage increases were set at 18%, per cent, considerably below projected inflation of 42 per cent. In the short run, those were extremely painful measures, but they restored market confidence in Mexico’s policymaking. Perhaps most importantly: Mexico capitalised on Nafta, which enabled extremely rapid and sustained growth in exports. Those who foresee tough times ahead for the UK are right to worry. It’s easy to blame Liz Truss’ missteps, but it is worth bearing in mind that in contesting the party’s leadership, she and Sunak presented clearly different policymaking approaches, and the Tories chose her so-called growth plan. Sunak is Prime Minister today because of revulsion in the markets in response to the “mini” budget. It remains to be seen how many minds actually have been changed by the events of the last month. There have been massive changes in the structure of the British economy since second world war, and in particular since the mid-1970s. The UK has deindustrialised, an ever-greater share of its economic output has become linked to a London-centric financial services industry that already had begun to suffer from Brexit — even before these recent developments. Trade imbalances have become chronic, demographics are a challenge, and expanded energy production has been stymied by the political process, even though the UK is an island of coal and shale gas surrounded by a sea of hydrocarbons. To make matters worse, unlike Mexico joining Nafta in the 1990s, the UK has withdrawn from the EU — the largest, most valuable free-trade zone on earth. Viewed in hindsight, the assertions of “Brexiters” like Boris Johnson that any fall-off in EU trade would be recouped via trade with the British Commonwealth seem, at best, quaint, or, more apt, an early sighting of the “moron risk premium”. But the lessons from Mexico’s macroeconomic performance over the past 25 years are real. First off, Mexico accepted that it could not regain policymaking credibility through mere rhetoric, that it could not control terms of trade, and that access to free trade with the world’s largest trading partners was its surest avenue to economic growth. Mexican policymakers figured out where it could be competitive, actively courted investment in those sectors, and have since avoided allowing its fiscal situation to get out of hand. Of course, Mexico has its own multitude of problems. But it’s striking how financially disciplined it has remained. Even in the wake of Covid-19, Mexican accounts have remained, relatively, in decent shape. The UK has enormous strengths and massive societal infrastructure, even if it has recently failed to capitalise on them: a centuries-old commitment to the rule of law and property rights, a sophisticated (if sometimes weak-kneed) central bank, first-rate financial and educational institutions, enormous human capital, and a deep cultural affinity for trade and finance. But, dogged by hostility to immigration, and a stifling regulatory regime — particularly as applied to the housing and energy sectors — productivity has languished. The UK needs less nostalgia for its imperial history; and more deliberate policies aimed at becoming a beacon for global talent, incentivising entrepreneurs, broadening the base of economic activity, chainsawing red tape, significant investments in energy production, trading with the widest possible group of partners (including the EU) and, of course, swift, steady and disciplined fiscal management. Politicians in the US repeat an epigram, often attributed to Churchill, that one can count on Americans to do the right thing, after they have exhausted all other possibilities. They usually mean to describe the untidiness of democratic and legislative processes, and to reassert their faith that those processes ultimately yield the best outcomes for society. The stakes are high for the UK; it’s time to follow the Mexican example and just get on with it. More