This week I attended several conferences, the NABE conference in Chicago, the Columbia University Energy Conference in NYC and part of the IMF/WB meetings in DC. Collectively, they gave the chance to touch base with consensus views on macro economic outlook, geopolitical risks and market interpretations. And that consensus was unsurprisingly quite gloomy. This shouldn’t have come as much of a surprise – there are slowdowns around the world, many engineered by central banks to fight inflation and the rising costs of debt service and still high food and fuel costs remain a drag.
Jump ahead to Debt woes or Energy price cap and US -Saudi spat.
Most attendees viewed the IMF forecasts (completed over a month ago) as too optimistic even though they included significant downgrades, recessions in many developed economies and a key metric – that countries accounting for almost 40% of Global GDP were in recession. Others, including the NABE group of forecasters believe the US too will enter recession, but later next year, and relatively milder than many trading partners. On top of that there were considerable worries about contagion risk stemming from rising interest rates and debt burdens, both in hitting demand but also feeding through into the financial sector. Many were seeking to learn lessons from the experience of the UK gilt blowup, exposure of pensions and subsequent BoE response and whether further such episodes are likely. Overall the quality of corporate credit and risks of future write downs remains a key worry as debt service payments increase.
Several people I spoke to framed them as the most pessimistic meetings they’d been to, which made me think about the GFC and EZ debt crisis ones, which I hadn’t attended. One thing that may be different is that while those meetings presented concerns about painful acute shocks that made it hard to assess demand, especially in 2008, there was less concern about medium-term malaise and damage to balance sheets, especially in the emerging world. In fact expansion of balance sheets not only of DM central banks but also Chinese credit stimulus was key to avoiding that negative feedback loop. Such policies are not feasible today. And there is quite a different set of views on the USD strength vs its Asian and European peers and no consensus on how to address it.
Lack of Coordination amid no easy choices
While it wasn’t a surprise that coordination was lacking, especially on global issues like dealing with debt burdens of the poorest countries, scaling up development and climate change funding and coping with some of the externalities of the ongoing Russian war, the degree of concern was amplified by concerns about the strength of the dollar, the extreme gyrations of the UK economy and financial markets.
The worries included the continued food and fuel (especially natural gas prices in Europe), the lack of coordination on climate change, externalities of the war, and limited coordination to address the policy costs of cooling a global economy which had been overheating.
While contagion worries from developed economies were an area of particular concern, there was (appropriately) less worry about contagion from larger EM such as Turkey or Brazil, This reflect both lower contagion risk and more differentiation, less involvement of macro tourists and in the case of Latam countries, relatively ahead of curve policies. While there are no shortage of frontier markets with unsustainable debt burdens (see section below) which do impair the EM hard currency asset class, there was little worry about overall contagion risk from these countries. We may be underestimating the political risk from these developments however.
Instead among the biggest fears stemmed from the strength of the USD, the lack of potential global coordination at a time when many countries are tightening. The combo of US overheating, the resource support to the terms of trade (for now) and other macro trends, suggest this will continue. Overall, for a government going out of its way to keep coalitions together on Russia and build them on other issues, the WH messaging that there is no dollar problem but rather a problem of other countries poor policies (like the UK mess), seemed tone-deaf and was a reminder of economic issues even between the developed economies allies (including protectionist EV policies and other efforts to avoid overt support of ROW with some of the new industrial policies). That’s not to say that there aren’t efforts to coordinate, but the relative strength of the US and the desire of the Fed not to stay behind the curve is likely to imply overcorrection.
Those looking for relative optimism, pointed to some of the commodity rich emerging economies, who had been a bit ahead of the curve policy wise after the lockdown. sluggish domestic demand and decent commodity exports have helped local markets and kept current accounts from blowing out, especially those more diversified across the commodity space, but worried about domestic issues like Brazil’s election and policy catalysts. Many of these large EM were ahead of the curve in terms of tightening and have been relatively fiscally conservative, which has dampened the impact of dollar pressure. Nonetheless the growth crisis I pointed to back in January still seems present for many as these coordinated tight policies leave little policy space.
Others pointed to extreme pessimism as as contrary indicator – noting the historical precedent. While this may ultimately be true, and I’ll try to highlight some areas of optimism. Its probably too early given that we are far from the rates topping out and those who hope a quick reversal are likely far too optimistic (on markets side) or pessimistic (on macro side)
Debt worries: Is Market Access Over for Some Frontiers?
There was more concern about some of the frontier markets with the dodgiest balance sheets, a handful of which are facing slow debt restructuring. Coordination issues remain though some optimists point to some admittedly slow improvements with the G20 Common framework. Perhaps one of the more concerning, and surprising things is the increased expectations that some of these countries restructuring may remain without market access for the foreseeable future, relying instead only on bilateral aid. Given high DM rates, spreads for frontier markets are likely to be incredibly costly of course, but relying only on concessional loans from multilateral and bilateral institutions does not seem realistic or optimal. Creativity on creating new investment channels and perhaps sustainability based loans may be necessary to for some of the needed climate adaptation and resilience.
Overall, many agreed that we may have seen the high water market for official foreign currency reserves as strong dollar has led to a lot of currency intervention in late Q4, following currency depreciation earlier in the year. Even by mid 2022 the levels of USD reserves had fallen, tho changes in currency valuations meant that the dollar share remained stable. If anything the takeaway from coordinated G10 sanctions may have been to reduce diversification into other DM currencies. At present there still aren’t meaningful alternatives. Some energy producers were still adding to their reserve holdings until recently, but the preference has been more to diversify within USD denominated assets (to equity, private credit and others) rather than from it internationally.
Although there wasn’t a lot of discussion about it, the meetings were overshadowed by the announcement of US controls on the export of semiconductor equipment to China which are likely to restrict its efforts to indigenize its supply chain. As with many restrictive measures I watch, there seemed to be some extensive knee-jerk derisking. Chinese tech fabs asking US persons to stop working, at least until there is clarity on rules. Many smart people on export controls have noted that the measures so far are pretty targeted, and US allies like South Korea and Taiwan have reported that compliance will not be that difficult (tho other reports suggest that they have been granted temporary exemptions. Overall, there direction of travel, including greater use of the entity list and directed export controls suggests that overcompliance, at least in the short-term is rational and these measures are unlikely to end quickly. Overall, selective decoupling for critical industries including semiconductors, but also batteries and critical materials is the direction of travel, even if overall US imports of Chinese goods remain strong and Chinese LT commitment to take up US resources is comparably strong.
Oil Price Cap, Russia sanctions and Energy Risks
On the side lines of the meetings, there were many discussions on the oil Price cap, and next steps in the economic pressure campaign on Russia. Representatives of the gathering of sanctions coalition met on Friday, emphasizing that some of the most effective measures continue to be export controls on technology. The goal of the sanctions writ-large in Russia continues to be degradation of the military industrial complex and the war effort. Indeed while the IMF reflected consensus in admitting that Russia’s economy didn’t contract as much this year, they expect a similar decline next year, when the impact of current fiscal drag, especially for the private sector, more costly and lower quality imports, weaker fuel and resource exports kicks in. The current additional mobilization is adding to this disruption both as some human capital flees to neighboring countries and as others are called up even if they work for key sectors. This own goal is likely to continue to weigh on Russia’s economy this year.
The G7 and especially the US remain committed to the oil price cap, despite many lingering questions on implementation and associated potential disruptions as it comes into effect early in December. From the US perspective, the cap remains the key way to mitigate the potential damaging baseline of the planned EU fuel embargo. The OPEC+ debacle and associated US-Saudi critiques have if anything increased the commitment to the price cap rather than reducing it. US officials, especially at Treasury seem most focused on keeping Russian molecules flowing without boosting revenues. Others in the coalition are more focused on cutting Russian revenues. In the last few weeks, more details have become available about the price cap, which aims to provide an exemption to the EU ban on providing services to cargos of Russian fuel as long as the price is right, below a maximum that has yet to be set. In fact the initial price remains a major piece of the puzzle. Numbers ranging from $40-70/barrel being mentioned as potential price targets, with $55-60 being more likely. It remains to be seen if this is really a sweet spot.
US officials are holding to their plan to avoid use of secondary sanctions as a penalty and preferring to focus on the carrot (cheaper fuel) rather than sticks (sanctions, especially on allied-based entities). Many members of Congress see things differently, but realistically its unlikely that a major administration constraining measure is passed in the near-term. Overall, I hold to my view that the administration would see partial compliance as a win or relative success. This would involve big EM buyers getting close to the target price, use of some G7 services and perhaps some alternate services. These countries are unlikely to formally join the cap, but may arrange discounts at close to the price. That might be considered a win. The big uncertainty remains whether Russia would continue to produce at these levels. Given the weaker energy prices due to global slowdown, some of the discounted volumes being negotiated are not far off the price being considered.
The US believes that unlike gas, Russia needs the oil export revenues. While that’s true, ultimately (oil is a bigger share of the Russian budget), I wouldn’t put it past Russia to cut production in the short-term looking to test out whether the pain is asymmetric in the short-term, especially while buyers and sellers are adjusting to the new rules. Thus the USG may be over estimating Russian export volumes and need for cash (particularly since they are struggling to spend some of what they have).
Another element of this partial compliance goal is evident in how US officials talk about alternate service providers. Rather than insisting that there are no viable alternatives, In his speech in NYC, Wally Adeyemo conceded that countries could use alternate providers, but suggested that they would likely be costlier (perhaps in the short-term), poorer quality and untested. Overall, the net result is likely to be more competition among service providers and eventually lower US/G7 leverage. We may be a long ways from such fragmentation, but the incentive to create them is rising and is likely to add to frictions and costs of operations.
Overall, last week’s OPEC+ meeting and the war of words between the US and Saudi Arabia also hung over many discussions. I’ve written elsewhere about the meeting and how it reflected both OPEC concerns about sluggish global growth, a need to level set for underproducers and likely interest in not making it easy for the US price cap to be implemented, given their concern about disruption and replacement. Since then, there’s been some bachkchanneling about some producers who may have had qualms (most likely targets are those few with spare capacity) and increased and dangerous ire from many US officials elected and appointed. Overall, its probably more noise than policy change, but its dangerous noise which is unhelpful in building resilience. It also contrasts with the carrot rhetoric for importing countries. The US has important decisions to make about how to incentivize countries operating in the grey zone who are important for sanctions implementation and global resilience. threatening the end of ties with another major energy producer while trying to squeeze one of the largest ones and continuing to coerce policy change from two medium-sized ones does not seem wise.
One piece of slightly better news came from Europe. The extreme high gas prices and soft rationing seem to be dampening household demand for natural gas in Germany, which along with storage facilities seem to suggest that Europe might eke its way through the winter at high cost, but perhaps without outages. The market “working” is a costly adjustment tool with many industrial users idled. Moreover, weak demand and diversion to China helped redirect cargos from Asia, something that’s unlikely to be replicated next year. Here’s hoping that the winter that is coming is not too cold. After all, there are a lot of other sources of uncertainty, higher financing costs and negative feedback loops that might not yet be in our baseline scenarios.
Ziemba Insights 