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Areté blog | Market review Q322
The third quarter was another rough one for investors as stocks and bonds (again) both took a dive. With three consecutive quarters of poor performance now, it's time for investors to take stock and re-assess the investment landscape. Is the poor performance year-to-date just a rough patch to grind through, or is there something bigger going on?
What is going on?
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In one sense, the events this year that got us to this point seem improbable and idiosyncratic. Inflation surprised a lot of analysts and policymakers. The Russian invasion of Ukraine came out of nowhere. The Federal Reserve got religion almost overnight and tightened monetary policy - and kept at it. Who, in their right mind, could have foreseen such an unlikely sequence of impactful events a year ago?
Unfortunately, this question, as understandable as it is, only addresses the specific outcome. In order to better understand what is going on, it is more useful to investigate the nature of the underlying conditions.
The Economist does exactly this in its recent special report on the world economy:
But even as monetary policy is on course to switch from stimulus to restraint, governments have moved in the opposite direction. During 2020 and 2021 they spent 10% of gdp supporting their economies and provided another 6%-worth of loans. Whereas after the global financial crisis of 2007-09 many quickly turned to trying to balance budgets in the belief that their debts risked becoming unsustainable, today they are continuing to borrow and spend, on everything from tax cuts to subsidising energy bills.
The Economist concludes, "a great policy reversal is under way in the rich world. The tight-fiscal, loose-monetary policy mix that defined much of the 2010s is being upended into a loose-fiscal, tight-monetary policy one."
Russell Napier’s argument
Indeed, there has been a major policy reversal and one of the few people to call it, and call it early, was Russell Napier. He made the case for a new inflationary regime after observing public policy responses early in the pandemic. I highlighted the argument later in 2020 and posted one of many follow-ups earlier this year.
Recently, Napier reiterated his thesis:
This [change toward inflation] is structural in nature, not cyclical. We are experiencing a fundamental shift in the inner workings of most Western economies. In the past four decades, we have become used to the idea that our economies are guided by free markets. But we are in the process of moving to a system where a large part of the allocation of resources is not left to markets anymore. Mind you, I’m not talking about a command economy or about Marxism, but about an economy where the government plays a significant role in the allocation of capital.
He goes on to describe that this change is being effected because "our debt levels have simply grown too high". As simple evidence of that fact, he describes, "We can’t stand normal, necessary recessions anymore without fearing a collapse of the system". He goes on …
My structural argument is that the power to control the creation of money has moved from central banks to governments. By issuing state guarantees on bank credit during the Covid crisis, governments have effectively taken over the levers to control the creation of money.
To sum up Napier's big picture view, there is too much debt and we have reached the end of the road on kicking the can. The Covid crisis opened the door for much greater fiscal policy and government involvement – that was not possible during the GFC. Through guaranteed loans and other policies, governments effectively commandeered the power to create money. That is the key to the inflation argument.
With the power to create money under control, governments now also have a pathway to manage excessive debt – and that is through financial repression. Ultimately, inflation will be allowed to run higher, say in the 4-6% range, while longer-term rates will be held below that. This will allow public debt to slowly, but surely, decline in value.
Seeing around economic corners
This raises the question: Why did Napier see inflation coming so clearly and almost nobody else did? At least part of the answer lies in the lens through which he viewed the situation. He trained for law and not finance. He is an avid reader of history and cut his analytical teeth in the Asian Financial Crisis of the late 1990s. As such, he has seen the patterns of excessive debt, government intervention, and inflation as policy many times before. None of this is new.
Interestingly, a number of the people most surprised by the intensity and persistence of inflation have been people with the strongest backgrounds in economics. This seems to be more than just coincidence.
Indeed, the recent award of the “Prize in Economic Sciences” to Ben Bernanke provoked a fair amount of criticism of Bernanke, in particular, but also of economics, in general.
Adam Tooze catalogs many of the relevant criticisms but sums it up with this statement:
I enjoy intellectual activity and game-playing for their own sake. In such an exercise, self-limitation, playing with rules, seeing how far a limited model will go, are all part of the point. But that activity should be pursued with a sense of modesty of purpose and a clear acknowledgement of the limits of the exercise one is engaged in.
What this year’s economics “Nobel” prize does is the opposite. It has the effrontery actually to celebrate one of the weakest dimensions of modern macroeconomic thinking - its extraordinarily limited ability to grasp the macrofinancial instability of modern capitalism.
Another critical analysis was issued by Daniel H. Nielson: “This entire newsletter, and frankly everything that I think about economics, begin from the failures, limitations and omissions of the viewpoints represented by this year’s [Prize] winners.”
In short, economics as an academic discipline lost its way. Whether the issue be bank runs or liquidity shortfalls or “the macrofinancial instability of modern capitalism”, economic theory is too often oblivious to the problem or late to the scene. Nonetheless, too many investors still give them the benefit of the doubt and too many economists just don’t seem to care they are misdiagnosing macroeconomic conditions.
This goes a long way in explaining why inflation has surprised so many people. It’s that too many people were reading the signs through the lens of economics rather than through the lenses of history and politics. By making this adjustment, the trajectory of policy, and therefore markets, becomes clearer.
I’m from the government and I’m here to help
Indeed, one pattern that becomes more evident is the trend toward increasing government intervention. To be sure, governments do legitimately have great authority to allocate resources in extreme conditions. Increasingly too, current conditions can be considered extreme.
While tensions with Russia and China do not constitute a shooting war at the moment, at least not with the US, they do arguably constitute economic war. Xi's emphasis on security (over growth) at the Party Congress and Putin's position regarding Ukraine suggest the feeling is mutual.
The relationship between people and their government often changes in such extreme situations. Russell Clark recently cited the example The Great Depression in the 1930s as an example of how the experience “destroyed the political support of free market capitalism”.
A similar dynamic is in play today. A lot of people have grown tired of the “Everything bubble” and rampant moral hazard. As a result, they want something other than free market capitalism - and governments are happy to step in to provide it.
Another related dynamic that can be seen more clearly through the lenses of politics and history are the principles by which wealth is allocated across society. As Napier describes:
People are screaming for energy relief, they want defence from Putin, they want to do something against climate change. People want that, and elected governments claim to follow the will of the people. No central banker will oppose that. After all, many of the things that are associated with financial repression will be quite popular.
He concludes, "Savers won’t like it, but debtors and young people will. People’s wages will rise." This really hits the point: Regardless of the arguments that might be made for free market capitalism, such a system systemically favors older people and savers at the expense of younger people and workers. As disparity increases and the latter group comes of political age, policy preferences shift.
Clowns to the left of me jokers to the right
Finally, there are a lot of public policy ideas floating around that can at best be considered unserious and at worst counterproductive. True enough. However, yelling and screaming about how bad many public policy ideas are misses a critical point: Given the fraught character of politics, thoughtful and perfectly reasonable policy ideas are too high a standard. Even these would be subject to massive political attacks and would be hard, if not impossible to enact.
One doesn’t need to have a great deal of sympathy for politicians to recognize that it is virtually impossible to pass policy initiatives under anything less than emergency conditions. A recent example in California, captured in a tweet by @TheStalwart, provides a great illustration.
In the midst of a heatwave, the Governor’s office sent out a tweet asking customers to reduce power consumption in order to prevent grid interruptions. Minutes later power consumption dropped noticeably, plenty enough to avoid a grid interruption.
The lesson learned: Provide credible evidence of a real emergency and people will act accordingly. Up until that emergency threshold, however, people treat warnings as mere background noise. Recognizing this, it is also fair to expect more “emergencies”.
To answer the lead-in question, yes, the conditions that have driven poor performance of financial assets this year are likely to be around for quite a while. This is not just a bump in the road to ride over. The conditions for inflation are structural in nature and therefore something to which long-term investors should adapt. While the road is unlikely to be a straight one, the destination is fairly clear.
One takeaway is that if you continue to evaluate the landscape from the lenses of economics and free market capitalism, you are likely to get really frustrated and miss important trends going in the other direction. Although this will be hard for many to stomach, the best advice is: Get over it.
Another point is while a strong case can be made for higher inflation, this is not widely discounted yet. The 10-year inflation expectation for September registered just 2.3%, still very close to the Fed’s 2% target. It did tick up in September, however, and core inflation measures remain stubbornly high. When long-term inflation expectations do break higher, a lot of longer duration assets will get hit.
Finally, the trends toward greater government intervention and public policy that favors labor over capital are happening because that is what electorates want. The implication for investors is that absent the tailwind of policies favoring capital over labor, passive investing is likely to be far less rewarding. In order to succeed against stronger headwinds, a more active effort will be required.
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