Macroeconomics and Financial Markets

Separating fact from fiction

DR SAVVAS SAVOURI, CHIEF ECONOMIST, TOSCAFUND

Dr Savvas Savouri is Toscafund’s chief economist, the CIO of its metric fund and partner. He holds a PhD in econometrics and mathematical economics at the London School of Economics (LSE). After his PhD he taught statistical modelling at LSE and the University of Oxford. At this time he also led research in labour market economics with publications in the Economic Journal and also Economic Policy where he co-authored, among others, with the Nobel Prize laureate Christopher Pissarides. Dr Savouri then began to commercially apply his qualitative and economic knowledge, heading various quant desks at investment banks before he joined Toscafund seven years ago.

If there’s one thing I have tried my best to learn in the years that I have been involved in commercial finance, it is applying macroeconomics. The bit of frustration I have found over recent years is that rather than universities producing a higher calibre of macroeconomic knowledge, it’s worsening. Universities are increasingly geared to delivering students who understand finance, but don’t quite understand the economics of capital markets.

If you think there’s some inconsistency in that statement, there isn’t. Finance is like chemistry in medicine. Economics is biology. If you’re good at chemistry you’re a good pharmacist or anaesthetist. If you want to be a surgeon you need to understand biology. Similarly, if you truly want to understand commercial finance, you have to understand the nuances of macroeconomics. Never before has macroeconomics been so important, because never has the world been so interconnected. Never have asset classes or asset markets been so interlinked.

To put things into context, when I was a student of economics, back in the mid-1980s, there was no such thing as a global economy. I am not trying to be dramatic. Because back in the mid-1980s, there was the Soviet Union, which was a hegemon across Eastern Europe. China was closed. Africa and South America were basically ridden by tortuous civil wars and juntas. Australia and Canada were rocks that had minerals in them but whose value was somewhat limited, given that the economies of the world were relatively few in number. You had West Germany and the most powerful nation on the planet was Japan. Fast forward to where we are now, apart from North Korea you would be hard pressed to find a part of the global economy that isn’t interconnected – even Zimbabwe.

Astrology versus astronomy
Probably never before has the world been on the cusp of such a fantastic episode of global growth as it is now. One of the reasons is that China is part of the global family. Listening to journalists talk about China as being some flawed fiction about to land in some hard or at best soft fashion is utter nonsense. China is an economy that has done nothing wrong. Beijing is running China almost by taking the playbook that Japan used in the 1980s, and doing the exact opposite.

One of the things that I often hear from students who want to intern at Toscafund is, “I’m an avid reader of the FT. I’m a voracious reader of the Economist.” I’ll say, so what? If you’ve met journalists from these publications… they don’t fill me with much confidence. There’s more astrology in macroeconomics than there is chartism.

Those of you who understand sun spots and the way that crop cycles work will know that astrology doesn’t matter in macroeconomics. As far as I see it, chartism or tech analysis is more astrology than astronomy. My background is in quants. Modelling matters to me – but modelling using economics fundamentally. Big data, high-frequency data, algorithms, they’re incestuous. The ingredients that are used are invariably financial measures that become ingrained. This is the realm of processes rather than anything fundamental. So what I want to do now is just to move on from that abstract complaint about the background in which we operate and say markets aren’t efficient. Do not imagine that stability in asset prices or an exchange rate happens to be a sign of equilibrium. Always try to understand the fundamentals of the asset you’re looking at. An exchange rate is the relative price of two currencies. I wouldn’t expect the prices of tomatoes and cucumbers to be stable over time. Why should I expect two currencies representing two entirely different economies to have a seemingly perfect exchange rate that is stable?

What happens in each case is that inevitably and eventually gravity kicks in, as in every episode of FX correction that has happened in my career. Did I predict them? No. But I’ve learnt from them. The most recent one only happened when the Swiss Central Bank devalued the euro against the Swiss franc. Was that predictable? Yes, it was. When you see an exchange rate that is horizontal, the first thing you do is you ask questions. What is creating that fiction?

Currency shocks
Therein lies a wonderful opportunity to trade, effectively, the fiction. There are several currency shocks that are looming: for instance, the Polish zloty against the euro. For a while there seems to be a very striking horizontal in their relationship, which suggests the Polish currency is a facsimile to the euro. The fact that the Poles have an interest rate of 2% against a zero rate in the Eurozone suggests there’s a degree of yield support going on here.

In Croatia the interest rate is 8% – providing a degree of yield support there. We know that deflation is running rampant through Europe, including EU and non-EU economies. At some point central banks beyond the Eurozone will have to bring rates down to zero. When that happens the yield support will go and those currencies will have to correct. What that means is every asset class – equities, property and debt – that are traded in kuna or zloty will basically change price. This is telling you there is an implicit currency shock that exists in all assets that are zloty-denominated or kuna-denominated – just as there was with the Swiss franc.

Why am I so convinced about the shocks that are looming? For instance, take the relationship of Ukrainian hryvnia to the euro: here have been episodes when the exchange rate has been almost horizontal – where central banks have been keen to maintain the currency fiction. Then soon you see the big correction upwards. Then another episode of a fiction. What happened more recently was that the crisis in Ukraine saw the hryvnia weaken sharply against the euro.

Why is that important? Because had Ukraine fallen into the remit of Russia it wouldn’t matter. Ukraine is a functioning economy. It’s not like Syria. Farms still operate and factories still operate. Ukraine has access to European markets – so this is a fairly dramatic competitive shock, or competitive benefit for Ukraine.

Poland is a neighbour of Ukraine. It does broadly what Ukraine does. It has farms producing the same commodities. It has factories, broadly speaking, making the same semi-manufactured and manufactured goods. They even compete in similar markets. It is inconceivable that the shock to the Ukrainian currency has not had a direct competitive shock to Poland.

I don’t do politics; I do economics. Quite frankly the sanctions that have been imposed on Russia interest me only in the context of what economic implications they have created. What you’ve seen is that Lithuanians and the Poles and the Bulgarians and the Romanians, who can’t trade with Russia because they’ve been told there are sanctions against Russia, are dumping goods into the EU – not least food. So the Eurozone’s deflationary problems have been made a great deal worse. But deflation across all of Europe, whether Eurozone, EU, non-Eurozone or even non-EU Europe – whether it’s Serbia, whether it’s Macedonia, Croatia, Hungary, Lithuania, Latvia – there will be in 2015 a series of currency shocks across Europe similar to the ones we saw in 1992 (my first full year in commercial finance).

Back in 1992 it was the Deutsche Mark that we all devalued against. In 2015, in the European context, with the exception of the Swiss franc and sterling, currencies from Sweden, Croatia, Hungary, the Czech Republic, Turkey, Ukraine, and Norway will devalue against the euro, because they can and they will. Those that have interest rates that are elevating the currencies will see them cut by central banks desperate to respond to deflation. These are macro themes that have a direct implication on every asset.

These are macro themes that almost are ignored in journalistic commentary. I can’t think of an opportunity to read a story in one of the broadsheets or one of the financial press articles where the impact on Poland of Ukraine’s devaluation is being talked about.

FX fictions
There are probably half a dozen FX fictions around the world. One was the Swiss franc against the euro, and that fiction was exposed recently. Another fiction is why on earth Hong Kong – an SAR, an autonomous part of China – has its currency pegged to the US dollar? It is an anachronism. In the period since 2005, the RMB has strengthened by about 35% against the US dollar. Hong Kong assets have become about 35% cheaper. If you were to suggest to the population of Hong Kong that they should abandon their peg to the US dollar and peg to the Chinese currency you’d probably be drummed out the country – because it seems as if you’re sacrificing their sovereignty. As long as their currency is pegged artificially to the wrong currency their assets will become ever cheaper for Chinese buyers. China never needed to militarily invade Hong Kong after the UK gave it up. It has been buying it monetarily.

There are other fictions in the FX space. The idea that Greece can be rescued by leaving the Eurozone: it was absurd when it was spoken about in 2012; it’s absurd in 2015. In the event that Greece left the Eurozone, it will be reduced to Zimbabwe. Anyone who could leave the country would leave. The elderly receiving pensions and civil servants would be receiving a brand new drachma whose value was devaluing by the moment. All trade that mattered would be performed in sterling, euros or dollars. Now having said that, do I think nobody can leave the Eurozone? No. I think if you employ macroeconomics and you go through the 19 countries who are part of the Eurozone, one by one, you’ll finally come up to those that can leave the euro.

The Nordic bloc
The most obvious one I suspect in seven to 10 years’ time would have left the euro: the departee will be Finland. Why can Finland leave the euro? Because around Finland you’ve got Norway, Denmark and Sweden, as well as Iceland. Each of them have their own currency. Some of them are loosely pegged to the euro; others are entirely independent. What will happen as the problems in the Eurozone worsen and as the True Finn party, which is now the biggest opposition in Helsinki, grows its support, is that there will be meetings either in Oslo or Helsinki or Copenhagen – somewhere in the Nordic block – and a brand new Nordic krone will be forged, and that will be the currency that Norway, Sweden, Denmark, Finland, Iceland (possibly Lithuania, possibly Estonia) employ.

Will it happen tomorrow? No. Is it a certainty? Yes, it is. Because Greece can’t leave the Eurozone because it has no anchor currency. Ireland could have left the Eurozone in 2008 by simply moving back to sterling. That couldn’t be done politically. In the same way that there’ll be opposition in Hong Kong if the Hong Kong authorities announced that they were de-pegging from the US dollar, there would be riots in Dublin if the euro was abandoned in place of sterling. Is it a good idea? It makes every practical sense for Ireland to abandon the euro in 2008 and employ the pound. We had low interest rates, it would have been a devaluation – it would have been a haircut. They would have returned to a currency union that they had until 1978.

Just to summarise those points: there are so many nonsensical issues that you can expose by just using macroeconomics. You can only have a larger rental sector if you have major new building. Imagine you have a street and you have 10 houses. Five on the left and five on the right. Everyone lives in a home they own. Now suppose that everyone on the left side of the street moves across to occupy the home opposite as a tenant. So those houses on the left move to the right and those on the right move to the left.

If you were to ask the question in that circumstance, what is the proportion of home ownership? It is 100%. What is the proportion of rental occupancy? It’s 100%. It’s not simply home ownership.

There are so many issues: Ukraine’s problem is Russia’s problem. Utter nonsense. Had Russia won over Ukraine it would now be financing what is effectively an economy with a sharply weaker currency that needs significant investment in it. That problem is now the European Union’s. In the meantime the European Union has to deal with the fall-out of a vastly more competitive currency – where neighbours like Bulgaria and Poland have to deal with having to compete with Ukraine’s farms and factories, in which they do broadly in the same function.

India
Jim O’Neill is a fantastic economist: go back 12 years, he came up with BRIC, the acronym covering Brazil, Russia, India and China. If you ran a ruler over India as a macroeconomist you’ll see it has no right to be in that list. It is a macroeconomically flawed economy.

If you were forced to only have one measure of an economy in the emerging world to look at its progression towards development, the measure I would use would be the rate of food price inflation over time. India has a stubbornly high structural inflation problem. It’s woefully underinvested in its food supply chain. The reason it’s woefully underinvested in its food supply chain is it has stubbornly high interest rates and it has authorities – this big democracy that we’re supposed to fall in love with, this big democracy is full of self-interest. The big grocery empires do not want foreign competition. To maintain a presence in local parliaments the authorities encourage labour-intensive farming, which is not conducive to disinflation in food.

You can contrast India with China. It is a completely different food environment. When was the last time, for instance, you heard of an Indian company or even an Indian sovereign wealth fund (which  doesn’t exist) acquiring natural resources around the world? It doesn’t happen. Yet India is natural resource poor. China has been hoovering up natural resources around the world. It has been buying mines in Chile, Angola, Zambia; it has been buying arable land around the world. It’s been investing in Kazakhstan, Canada, Australia.

Washington has seen the US dollar strengthen dramatically across a number of dimensions over the last 18 months. It has seen it remain stubbornly stable against the Chinese currency. So natural resources have actually become much cheaper for China to buy. At some point Washington will go back to its old theme of demanding that the Chinese free their currency up and with time they will do that. If you know what happened in 1985 you will realise that, having forced their currency to be remarkably stable, the yen was remarkably stable against the dollar.

Finally the Americans badgered Japanese to the point where the Japanese devalued the dollar. The Plaza Accord was a meeting in the Plaza hotel in New York in September 1985, where central banks of West Germany, the UK, France, Japan and the US agreed to devalue the US dollar against the Deutsche Mark and the yen – more so against the yen. The yen trebled in three years to the point where they met again at the Louvre to actually stop the decline in the dollar. It didn’t quite work. Japan’s banks became richer than Croesus because Japan’s banks and pension funds had yen.

The yen was three times more powerful to use after the Plaza Accord. Did Japan’s banks and pensions funds, or the Japanese State go and buy the things they needed like natural resources? They didn’t buy dirty assets; they bought shiny assets. They bought Manhattan rather than Mozambique. They bought Piccadilly rather than Peru. They bought Hawaii rather than Honduras. The Chinese are not making that mistake. What is my point? My point is that whenever you hear someone telling you that China is somehow a fiction, it is utter nonsense.

Jawboning
We heard that the Shanghai market was down 8% because the authorities in China had imposed restrictions on leverage. We’re told that’s a bad sign. Yet isn’t that exactly what you want? You want active intervention in the capital markets. You think about Draghi and you think about Bernanke before Yellen, and you think about Greenspan; they just jawboned. When there was a need to bring down capital markets, Greenspan spoke about irrational exuberance. He didn’t act, he spoke, jawboned. The ECB should have acted in Europe three, four years ago. It’s too late now. Deflation is running rampant through the Eurozone. It has been made worse by the crisis in the Ukraine. The Chinese are loving events in Ukraine because for many years the Chinese were trying to engage with Russia. So the Russians could actually provide them with natural resources they were getting elsewhere. The reason Russia hasn’t been more engaged with China is it has been a bit lazy and it has preferred to sell west rather than south. That is changing now.

Just to make a few other points that journalists don’t understand: the idea that Russia is going to make the same moves in 2015 as it did in 1998 is nonsense. This is not 1998. Back in 1998, Russia was run by Yeltsin not Putin. Back in 1998 there was no China. Back in 1998 there was no sovereign wealth fund. Those of you who followed the history of the post-rouble crisis realise that Kudrin came along and amassed a war chest. It could be bigger, but it’s quite sizeable. The price of oil in US dollars has fallen sharply, but thanks to the correction in the rouble it hasn’t fallen as sharply in roubles. Russia operates in roubles. What matters is the conversion of oil it sells into roubles. It hasn’t been as dramatic a fall as you might think, because the currency has been a shock absorber.

The ignored stories
If you look at the Mexican peso price of oil and the naira price for Nigeria, these are the countries that are in more trouble. I’ve got no preference for Russia. I just like to know where the problem lies. I don’t like to be told it by someone else. I like to know it fundamentally. China has in foreign reserves $4 trillion. If Moscow needs it, Russia will be accommodating on its terms. This is macroeconomics at work. These are simply illustrations of a great many aspects of macroeconomics that really have an impact in microfinance, but seem to be ignored because they’re not themes that seem to excite interest. Yet for me they are fascinating.

Pricing derivatives is easy. If you’re pricing a derivative you have to understand it derives from a fundamental asset. If that asset fundamentally is priced in kuna, or zlotys or Hong Kong dollars, then clearly it can’t be perfectly priced if you’ve mispriced your fundamental asset. You’ve missed the fact that there’s an underlying exchange rate fiction that has to go.

Go back to the Swiss franc: it was always going to go. What you couldn’t be sure about was the timing. In the same way someone who eats saturated fat every day will eventually die from that diet; you can’t be sure whether it’s a Thursday or a Friday in the afternoon or morning, but you know it’s going to happen. You have to factor these things into your reasoning.

Edited extracts from a talk by Dr Savvas Savouri, Chief Economist, Toscafund at the LSE AIC