Financial market tops always exhibit elevated valuations (check) typically combined with weak or deteriorating economic conditions (check) and a backdrop of investor complacency (check). But the greatest bubbles exhibit far more than such excess; they exude exuberance. Are the financial markets in a current state of euphoria with a commensurate risk of a market downturn? Various metrics strongly indicate as such.
Citi provides their own proprietary index: the Citi Panic / Euphoria Model. This index utilizes multiple sentiment and trading indications to assess investor mentality. “Euphoric” measures exceed 0.41 on their scale. The market rarely reaches such levels: over the last 20 years, it breached this level only five times. Three of those were but brief touches before receding in quick order.
But two times, the market was solidly deep within the “euphoric” area of the index: 1999 to 2000 and 2020 to 2021. At the height of the technology bubble, the index neared 1.50. What does the index indicate today? In January 2021, the index sits solidly at 1.80 having gone hyperbolic over the last several months.1
Another commonly accepted signal of extreme bullish sentiment is the increased acceptance of and demand for riskier assets; for example, initial public offerings (“IPOs”). During such times, companies oblige by increasing the number of IPOs to avail themselves of such demand in raising capital. The following chart demonstrates the number of IPOs in 2020 exceeded even that of the technology bubble.2
Curiously, of the 480 IPOs in 2020, fully 248 of them were Special Purpose Acquisition Companies (SPACs).3 A SPAC is often called a “blank check” shell corporation because it pools investor funds together to finance an unknown acquisition within a future timeframe (generally two years).4 Investing in a SPAC is like paying to sit at the chef’s table in an unknown restaurant with an unnamed chef at some point in the future. Even the most fervent foodies would choke on the idea.
But not investors – not only were 248 SPACs debuted in 2020, but already to date in 2021, another 59 launched which tied the previous, pre- 2020 high set in 2019. And prior to 2019, SPACs averaged less than 17 per year during the previous ten-year period (2009 to 2018).5 If the Citi Panic / Euphoria Model seeks corroboration, IPOs and SPACs provide it.
While “euphoria” is a state of intense excitement and happiness, “phoria” is a misalignment of the eyes which breaks binocular vision. Investors are moving from euphoria to phoria: unable to focus on sound investment principles and blind to economic dangers.
As long the Federal Reserve continues aggressive monetary expansion, investors may continue to fuel financial markets to loftier valuations and higher euphoria. However, many variables could work to undermine or overwhelm the Federal Reserve’s efforts. If that happens, investor sentiment and demand may plummet, for their feelings are usually fickle. Financial markets will move accordingly.
Endnotes:
“A $13 Trillion Crisis-Era Debt Bill Comes Due for Big Economies” Bloomberg News. 04 January 2021
Anyone reading the regular Federal Open Market Committee press releases can easily envision Chairman Yellen and the Federal Reserve team at the economic controls, carefully adjusting the economy’s price level and employment numbers. The dashboard of macroeconomic data is vigilantly monitored while the monetary switches, accelerators, and other devices are constantly tweaked, all in order to “foster maximum employment and price stability.”1The Federal Reserve believes increasing the money supply spurs economic growth, and that such growth, if too strong, will in turn cause price inflation. But if the monetary expansion slows, economic growth may stall and unemployment will rise. So the dilemma can only be solved with a constant iterative process: monetary growth is continuously adjusted until a delicate balance exists between price inflation and unemployment. This faulty reasoning finds its empirical justification in the Phillips curve. Like many Keynesian artifacts, its legacy governs policy long after it has been rendered defunct.
In 1958, New Zealand economist William Phillips wrote The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957.2 The paper described an apparent inverse relationship between unemployment and increases in wage levels. The thesis was expanded in 1960 by Paul Samuelson in substituting wage levels with price levels. The level of price inflation and unemployment were thereafter linked as opposing forces: increasing one decreases the other, and vice versa. The US data from 1948 through 1960 comparing the year-over-year increases in the average price level with the average annual unemployment rate seemed irrefutable:3
The first dent in the Phillips curve came from Chicago-School economist Milton Friedman (as well as, independently, Edmund Phelps) who suggested it was more temporary than timeless, more illusion than illustration. Friedman’s “fooling model” posited that price inflation fooled workers into accepting employment at “higher” wage rates despite lower real rates as measured after the impact of price inflation. Once they realized the difference between “real” and “nominal” wages (the fools!), they would demand higher nominal rates as compensation. As inflation rose, unemployment declined, but only temporarily until a new equilibrium was achieved. This simple insight created quite a stir and troubled noted econo-sadist Paul Krugman: “when I was in grad school, I remember lunchtime conversations that went something like this; ‘I just don’t buy the … stuff — it’s not remotely realistic.’ ‘But these people have been right so far, how can you be sure they aren’t right now?’”4
The Friedman criticism was somewhat clever, but unnecessary, minor, and misguided, for cold data was far more damaging than Chicago doctrine. The Phillips curve not only evaporated with the 1970s, but reversed to show a positive correlation between price inflation and unemployment:
In light of this, like many Keynesian concepts, the Phillips curve should have been forever abandoned when the 1970s proved high price inflation and unemployment rates can coexist. But now the Phillips curve is back from the dead. Krugman, writing in 2013, introduced new data demonstrating the Phillips curve’s “resurrection.” According to Krugman: How many economists realize that the data since around 1985 — that is, since the Reagan- Volcker disinflation — actually look a lot like an old-fashioned Phillips curve?
This Krugman comment is correct, US data from 1985 through 2013 again shows an inverse correlation between the year-over-year increases in the average price level with the average annual unemployment rate:
Has the Phillips curve, as Krugman suggests, regained its former acceptance? Since 1985, why has its inverse relationship between price inflation and unemployment reappeared? The question is irrelevant: the fact that it had previously disappeared forever strips the Phillips curve of legitimacy.
Any apparent correlation between two variables may be coincidental and unrelated, directly casual, or linked by a third variable or sets of variables. For price inflation and unemployment, the last explanation is the correct one. Price inflation and unemployment are not opposing forces, but in large part effects deriving from the same causation — the expansion of the money supply.
More money cheapens its value and the price of goods and services accordingly rise in terms of money — hence price inflation. More money lowers interest rates which induce malinvestments (including the hiring of workers) which (who) are eventually liquidated (terminated) in a recession — hence unemployment. While both phenomena largely share a common origin, the timing of their manifestations may be quite different and heavily dependent upon other variables, including fiscal policy.
The death of the Phillips curve will eventually be served not from Chicago School gimmicks, not from the experience of the 1970s, but from greater acceptance of the Austrian School’s explanations of price inflation and business cycles. Unfortunately, in the interim, the monetary policies promoted by the Phillips curve have moved from 1970s lunchtime academic discussion to official government policy. In the hands of the Federal Reserve, the Phillips curve becomes weaponized Keynesianism.
Due to its unjustified acceptance of the Phillips curve and its related misconceptions about price inflation and business cycles, the Federal Reserve will never be able to trade higher price inflation for lower unemployment. Nor can it sacrifice higher unemployment for lower price inflation. But it can, and likely will, generate high levels of both. If the Federal Reserve’s economic controls appear broken, it is because they never really worked in the first place.
Endnotes:
Press release [2]. Federal Open Market Committee. Board of Governors of the Federal Reserve System. 30 April 2014.
William Phillips, “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957,” Economica 25, No. 100 (1958): 283–299.
Federal Reserve Bank of St. Louis. In the interest of aesthetics and clarity, years for which a negative price inflation or unemployment rate have been excluded. However, their visual exclusion does not alter the linear trendline presented in the following graphs.
Higher equity prices will boost consumer wealth and help increase confidence, which can spur spending. — Ben Bernanke, 2010.1
Across all financial media, between both political parties, and among most mainstream economists, the “wealth effect” is noted, promoted, and touted. The refrain is constant and the message seemingly simple: by increasing people wealth through rising stock and housing prices, the populace will increase their consumer spending which will spur economic growth. Its acceptance is as widespread as its justification is important, for it provides the rationale for the Federal Reserve’s unprecedented monetary expansion since 2008. While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness.2 Such is the purpose of this article. The wealth effect is but a mantra without merit.
The overarching pervasiveness of wealth effect acceptance is not wholly surprising, for it is a perfect blend of the Monetarist and Keynesian Schools.3While its exact parentage and origin appears uncertain, its godfather is surely Milton Friedman who published his permanent income theory of consumption in 1957.4In bifurcating disposable income into “transitory” and “permanent” income, Friedman argued the latter dictates our spending and consists of our expected income in perpetuity. If consumer spending is generated by expected income, then surely it must also be supported by current wealth?
But this may or may not be true. It will vary across time, place, and among various economic actors whose decisions about consumer spending are dictated by their time preferences. And time preferences — the degree to which an individual favors a good or service today (consumption) relative to future enjoyment — take into account far more variables than the current, unrealized wealth reported in brokerage statements and housing appraisals.
Regardless as to whether or not increased wealth will actually spur increased consumer spending, the most important component of the wealth effect is the assumption that increased consumer spending stimulates economic growth.5 It is this Keynesian concept which is critical to the wealth effect’s validity. If increased consumer spending fails to stimulate the economy, the theory of the wealth effect fails. Wealth effect turns into wealth defect.
Will increased consumer spending improve the economy? On one side of the argument, we have the aggregate individual conclusions of hundreds of millions of economic actors, each acting in their own best interest. These individuals and businesses are attempting to reduce consumer spending and increase savings.
Dissenting from their views are the seven members of the Board of Governors of the Federal Reserve. Each member believes in the paradox of thrift — the belief that increased savings, while beneficial for any particular economic actor, have deleterious effects for the economy as a whole. The paradox of thrift can essentially be described as such: decreased consumer spending lowers aggregate demand which reduces employment levels which negatively affects consumption which in turn lowers aggregate demand. The paradox predicts an economic death spiral from diminished demand. And mainstream economists believe we were (and potentially are) mired in such a spiral. As noted econo-sadist Paul Krugman noted in 2009: “we won’t always face the paradox of thrift. But right now it’s very, very real.”6
The inverse of this “reality” predicts flourishing economic prosperity when a society increases its consumer spending. But history suggests the opposite: it is higher savings rates which lead to economic prosperity. Examine any economic success story such as modern China, nineteenth century America, or post-World War II Japan and South Korea: did their economic rise derive from unbridled consumption, or strict frugality? The answer is self-evident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth.
So why do so many “preeminent” economists falsely believe in the paradox of thrift, and thus the wealth effect? It is because of their mistaken understanding of the nature of savings. The Austrian economist Mark Skousen addressed this in writing:
Savings do not disappear from the economy; they are merely channeled into a different avenue. Savings are spent on investment capital now and then spent on consumer goods later.7
Savings are spent. Not directly by consumers on electronics and espressos, but indirectly by businesses via banks on more efficient machinery and capital expansions. Increased savings may (initially) negatively affect retail shops, but it benefits producers who create the goods demanded from the increased pool of savings. On the whole, the economy is more efficient and prosperous.
Does this economic maxim hold even when the economy is in a recession?8Even more so. As all Austrian economists know, business cycles derive from government manipulation of the money supply which artificially lowers and distorts the structure of interest rates.9To minimize the length and severity of a recession, economic actors should save more which will reduce the gap between artificial and natural rates of interest.
Regrettably, this is not merely an academic discussion. Due to their mistaken economic beliefs, the Federal Reserve has quadrupled the money supply while bringing interest rates to historic lows.10The results will inevitably arise: significant price inflation, volatile financial markets, and severe economic downturns. In many respects, Sir Francis Bacon’s aphorism that “knowledge is power” is true. Unfortunately, in the economic realm, the Austrian economist F.A. Hayek was closer to the truth: those in power possess the pretense of knowledge.11
To date, most criticism focuses on the relatively minor increase in real GDP (11.2 percent from April 1, 2009 through October 1, 2013) relative to the substantial increases in the money supply and the stock market which have risen, respectively, 330.0 percent (Adjusted Monetary Base from August 1, 2008 through January 1, 2013) and 160.9 percent (S&P 500 from March 1, 2008 through February 19, 2014). The dates have been selected to measure the increase since the respective lows reached subsequent to August 1, 2008 to the most recent data.
The characterization of monetarism as an economic school can be disputed. By definition, a school of thought must be systemic, which means positions and theorems must be connected by underlying assumptions. The so-called Monetarist School consists of various unrelated hypotheses which are empirically “tested.” While the preponderance of the “school’s” positions may favor free markets (although often not for the most critical markets — e.g., money), they display inconsistency in application. This underscores the lack of an academic edifice built from fundamental axioms.
Milton Friedman, Theory of the Consumption Function. Princeton, N.J.: Princeton University Press; Homewood, Ill.: Business One Irwin. 1957.
The commonly cited support for this assertion, that personal consumption accounts for approximately 70 percent of Gross Domestic Product is, strictly speaking, correct. However, it is correct only because GDP overstates personal consumption as a by-product of a misguided attempt to avoid “double counting.” If non-durable capital goods and intermediate products (e.g., steel) were included in GDP (as they should be if one is attempting to measure economic activity), personal consumption would fall to approximately 40 percent of economic activity based upon the latest GDP component and Gross Output statistics. Mark Skousen, “Beyond GDP: Get Ready For A New Way To Measure The Economy.” Forbes. 29 November 2013.
Mark Skousen, Economics on Trial. Homewood, Ill.: Business One Irwin, 1991. p. 54.
It would be odd indeed if one argued that savings increases economic growth during normal times, but exiting a recession requires greater levels of consumption. As Ayn Rand wrote: “Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.” (Atlas Shrugged, New York: Random House, 1957). If economic growth during a recession requires increased consumption, then this business cycle theory does not comport with general economic theory — which is prima facie evidence that it is wrong.
It should be noted that an increase in consumer spending due to increased levels of real or perceived wealth in no way invalidates or contradicts Austrian business cycle theory (“ABCT”). While some economists have alleged increased consumption during the boom phase of a business cycle is in conflict with ABCT, Austrian economist Joseph Salerno has effectively squashed such criticisms as a misinterpretation. (Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics. 15, No.1. [2012]).
See footnote 2.
“To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.” F.A. Hayek, “The Pretense of Knowledge.” Lecture to the Memory of Alfred Nobel. Stockholm Concert Hall. Stockholm, Sweden. 11 December 1974.
Gold serves a unique role in investment portfolios, not only as insurance against extreme events, but as a timeless store of value in a world of multiplying paper currency. Why own gold? In simple terms, gold has been a store of value for thousands of years because it has retained its purchasing power while “fiat”
currencies, which are promises unbacked by precious metals, have eventually been overprinted and seen their value diminish or completely disappear. Gold is a currency that has no liabilities, is outside of the fragile global banking system, and cannot be printed out of thin air like other currencies. Gold is a particularly important asset to own when money is being printed as carelessly as it is today. Policy actions today heavily increase the odds of more extreme events in the future that should be keeping all investors up at night. Many investors view gold as “insurance” against extreme scenarios, which we address below. While true, they miss the multiple scenarios for owning gold, not all of which involve an extreme outcome to recommend it as a key holding.
Extreme Scenarios
Banking Crisis or System-Wide Collapse – Is a renewed banking crisis a valid concern to worry about today? Absolutely. The world was on the verge of the largest global banking collapse in modern history in 2008. Trillions of dollars were printed to paper over the problems, but the central issues still remain. At the center is the fact that modern-day banks act more like highly leveraged hedge funds than traditional lenders. With financial derivatives nearing 10 times global gross domestic product (i.e. GDP), the global banking system remains highly leveraged and susceptible to any spark that could ripple through the system.[1] A new worry has emerged for savers as the recent “bail-in” in Cyprus led to the seizure of nearly 50% of deposits held by savers over €100,000. Many other countries are working on legislation that may allow for future bail-ins as well (including the Europe Union, Canada and the U.S.). With this risk in mind, the idea of holding cash at a bank where it earns 0% and could someday be seized makes gold held outside of the banking system an increasingly attractive alternative for concerned savers. As the entire developed world continues to print money to manipulate markets higher in the absence of healthy organic growth, the risks of a systematic global banking crisis continue to rise. However, we believe that policy makers looked over the cliff of a global banking crisis in 2008 and decided they would print as much money as necessary to avoid that fate. Thus, events moving us closer to a banking crisis actually increase the odds for the opposite outcome – that policy makers print even more money, aiding the banks, but panicking investors about inflation.
Central banks have one potential “ace in their pocket” if we see renewed banking scares, but it is not a card they want to play. If a banking crisis lies ahead, policy makers will be desperate to do whatever they can to restore faith in the system. If the printing of money fails to deliver stability, then the reinsertion of gold into the currency system could be their Plan B. Napoleon successfully reinserted gold into the failing currency system during the French Revolution to restore faith. He stated “while I live I will never resort to irredeemable paper.”[2] In our opinion, policy makers would only take this action in a worst-case scenario where they have lost control of the system. As we discussed in our earlier pieces, re-backing the dollar with gold (as an example) at ratios similar to the 1930s could propel gold upwards of $8,000 per ounce.[3]
Loss of Faith in Currencies – If one extreme is a banking crisis and corresponding credit crunch, then the other extreme is a loss of faith in the fiat money system itself, a condition known as “hyperinflation”. History suggests that once central banks start printing money of significant magnitude, it is very hard to reverse course. This is because the effects of printed money serve to prop markets up artificially. Ultimately, policy makers get backed into a corner where the act of pulling back the support of easy money risks collapsing the overleveraged system from artificial levels. We believe this is the dilemma policy makers are facing today as they have become the buyer of last resort in many markets. For example, the Federal Reserve is now the buyer of over 90% of all newly issued treasury bonds, which has artificially suppressed interest rates and led to other assets rising on the opium of cheap credit.[4] At some point, the continued manufacturing of money out of thin air risks hitting a psychological breaking point. People may suddenly wake up to the reality that newly printed money is diminishing the value of their existing money. If history is a guide, the response is to swap their currency into hard or tangible assets as an alternative store of value since these assets are in relatively fixed supply versus the exploding supply of currency. At this point, the rate at which money changes hands in the economy (i.e., the velocity of money), which has been subdue since 2008, suddenly skyrockets and inflation soars. “Not worth a Continental” is a phrase many investors have heard before, but too few know its historical relevance. America’s Revolutionary War-era currency, the Continental, was issued in an amount equal to one dollar. By 1779, after being overprinted to fund war with England, it was worthless.[5] Weimar Germany after World War I is the poster child of this risk. They faced plunging their economy into a depression by stopping the printing presses, so they ultimately chose to print more money. For a period of time, it appeared to work. Their actions propped up the system, reduced unemployment, and gave the appearance of growth, until it ultimately buckled under its own weight and collapsed. Adam Fergusson, in his book When Money Dies: The Nightmare of the Weimar Collapse, wrote:
Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use.[6]
Investors today must recognize that we are conducting the largest monetary experiment in modern history with unknown consequences. We are not suggesting that these extreme scenarios are likely outcomes. However, we are suggesting that, in today’s uncertain world dominated by money printing and government manipulation, these scenarios require a serious level of understanding. Despite shielding their views from the investment public at large, our experience suggests the smartest investment minds speak of these fears behind closed doors.
Moderate Scenarios
Shortage of Physical Gold — There is compelling evidence suggesting that there is not enough physical gold relative to the amount of paper contracts written on it today. Some reports suggest that as many as 100 contracts of paper gold exist for every one bar of physical gold.[7] To benefit from this, investors do not need an extreme outcome to see the value of gold unlocked, but they do need to own the actual physical metal. Many investors think they own gold, but what they actually own are paper contracts with no ability to receive the actual physical gold. Recent actions by global banks such as ABN AMRO are early warnings that cracks may be developing in the gold market. They defaulted on delivering physical gold to clients who owned it (instead redeeming them in cash).[8] These paper claims dwarf the amount of physical gold that can be found at today’s prices. Paper claims include most precious metals mutual funds and exchange traded funds (“ETFs”) and gold held in “unallocated” bank accounts (i.e. those not held in the legal title of the account holder, but commingled with other investors on the balance sheet of a financial institution). Prospectuses of most ETFs allow redemption in cash to investors. Thus, this could result in an investor being redeemed out of their gold holding at an inopportune time well before gold reaches its peak value. The gold market mimics the fractional-reserve banking system in that a small amount of physical gold underlies many paper claims. As more investors realize this, there could be a scramble to secure the actual physical gold, driving prices up significantly. Under these conditions, we’d expect a wide premium to develop benefitting physical gold over paper claims on gold that can’t deliver the underlying metal. Compounding matters is the fact that gold is commonly leased out by central banks around the world. This makes it hard to accurately analyze who actually owns the gold as messy international accounting rules allow more than one party to claim the same gold on their respective balance sheets. Leading investment minds, such as Eric Sprott of Sprott Asset Management, have extensively investigated this issue, posing the question, “do western central banks have any gold left?”[9] We believe there is much less physical gold available than meets the eye – at least at today’s prices.
The physical shortage will accelerate as more investors include precious metals as a component of their portfolios. In addition to investor demand, governments around the world continue to increase their holdings of gold, especially countries like China where gold represents only a small portion of their reserves today. For those that doubt the viability of gold as an asset, it is instructive to see what the governments of countries bailing out other weaker countries generally require for collateral – a country’s gold! There is also a camp of thought suggesting there could even be a hidden game underway today, orchestrated by policy makers. Central banks may be active in suppressing the price of gold in the paper derivatives markets as they quietly accumulate physical gold on the cheap. Some believe that once they own the majority of physical metal on their balance sheets, they will cease these actions and gold will be revalued suddenly, perhaps over a weekend. This would suddenly give them a valuable asset to offset many of their liabilities. If this is true, the problem is that too few investors will be holding any physical gold at the time to benefit.
Hedge Against Inflation – Without having to assume any type of extreme scenario, gold will be a good investment if the world keeps printing money to try and solve its problems. We believe they will keep printing as the lessor of evils. Printing money will lead to a decline in the value of currencies versus gold, stoking inflation as devalued currencies buy fewer goods. This is the number one reason to own gold – as a hedge against central bank risk and the overprinting of money. We believe that irrespective of money printing ahead, the reckless printing since 2008 already makes currency devaluation versus gold a high probability event. Historical data suggests that inflation often follows money supply growth, but with a lag. Since 2008, we have increased the money supply upwards of 260% in the US.[10] In addition, we are currently printing approximately $1 trillion dollars a year as our long-term liabilities continue to grow out of control. To us, this suggests a high risk of inflation ahead at a time when inflation-protected investments are very cheap and unloved by investors.
In closing, gold is not a one-trick pony. Own gold for the likely moderate scenarios, but rest assured that gold is the best asset if we get pushed to the extremes.
Brett K. Rentmeester, CFA ®, CAIA ®, MBA is the President and Chief Investment Officer of WindRock Wealth Management (www.windrockwealth.com). Mr. Rentmeester founded WindRock Wealth Management to bring tailored investment solutions to investors seeking an edge in an increasingly uncertain world. Mr. Rentmeester can be reached at 312-650-9593 or at brett.rentmeester@windrockwealth.com.
All content within this article is for information purposes only. Opinions expressed herein are solely those of WindRock Wealth Management LLC and our editorial staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation.
And the Election Winner is … Inflation in a Landslide!
Christopher P. Casey
Regardless as to which candidate secures the Presidency on November 3rd (or some subsequent date), the administration must cope with unprecedented federal debt. This debt will only increase for the foreseeable future with record-breaking federal deficits caused by mounting pandemic relief and stimulus spending along with diminished tax revenues. The only available “solution” for the U.S. government to finance such debt and deficits will be through continued massive money printing which will inevitably lead to price inflation. How can investors protect themselves?
What Does and Does Not Cause Inflation?
Due to the widespread misunderstanding of what causes inflation, it first warrants a discussion as to what does not cause inflation. In particular, three inflation fallacies are often cited by mainstream financial pundits and Keynesian economists.
First, the “cost-push” theory of inflation states that price increases in certain commodities force the prices of all goods and services higher. The 1970s are often cited as an example: as increased oil prices permeated the economy, prices for fuel, plastics, and other oil-derived products would increase as well.
But as the price of oil or some other cost-push culprit rises, buyers have less money to spend on other goods and services. Having less money to purchase something else means less demand exists for that other product, and decreased demand reduces prices. So, while some prices may go up, it is ultimately at the expense of other prices which go down. Accordingly, no direct net effect to the overall price level is created by these price changes.
The second inflation misconception is the “demand-pull” theory. Keynesian economic theory believes inflation also materializes when aggregate demand for goods and services exceeds aggregate supply when the economy is at full employment and capacity (which also incorrectly assumes such “aggregates” can diverge from each other). When the economy is at full employment and capacity, increased aggregate demand forces producers of goods and services (soon to be followed by their suppliers) to increase prices. Here lies the origin of the belief in inflation from an “overheated” economy. According to this theory, inflation cannot develop during periods of weak economic growth. But the 1970’s American economy (as well as numerous other economic periods in history – see modern-day Venezuela) clearly disprove this.
Finally, many incorrectly believe inflation cannot develop until the “velocity” of money increases. Typically defined as “the number of times one dollar is spent to buy goods and services per unit of time,” monetary velocity theory originates from the so-called Fisher Equation of Exchange: MV=PT (where the quantity of money [M] times the velocity of its circulation [V] equals prices [P] multiplied by their related transactions [T]). But why would such a formula explain the general price level?
Almost all economists today recognize that the price for any particular good or service derives from the interaction of supply and demand. The “price” of money derives from the same supply and demand dynamic as any good or service. The word “price” in terms of money, to avoid confusion, can be thought of as “value”. If the demand for money increases, its value increases and the prices of all goods and services fall (deflation). If the supply of money increases, its value decreases and the prices of all goods and services rise (inflation). Inflation is simply caused by an increase in the money supply and/or a reduction in the demand for money.
Velocity is not a substitute for demand, but rather of volume. Lots of goods and services may transact at low prices just as they may trade at high prices. In either scenario, “velocity” is high while the demand for money may be low or high. Since velocity is not a substitute for demand, it cannot help explain inflation.
How Does the Federal Debt Situation Affect Inflation?
Federal debt can be deleterious for many reasons. Among other things, it crowds out private investment (by bidding up the price of capital) and must be repaid by taxpayers (in one form or another). The repayment must derive from future taxes or by printing new money to satisfy debt service.
As this chart demonstrates, the U.S. government can never repay its debt based upon tax receipts (nor do politicians have any intention of doing so) (in trillions):1
As of September 30, 2020, the federal debt stood at over eight times estimated 2020 fiscal year tax receipts.2
It would take that many years to repay all debt assuming the federal government ceased all spending. Paying back the federal debt through future budget surpluses is unrealistic. And the situation is getting worse.
The Congressional Budget Office, itself always opportunistic about government finances, recently stated “the deficit in 2021 is projected to be 8.6 percent of GDP.” And that “between 1946 and 2019, the deficit as a share of GDP has been larger than that only twice”.3
The only means by which the U.S. government can service its debt, let alone its future debt, is through continued, massive monetary expansion. And the Federal Reserve has already started in record-breaking fashion:4
Why Should Investors be Concerned?
Many U.S. investors have little memory of the 1970’s inflation and thus not only discount the likelihood of inflation, but are largely ignorant as to its negative impact. It bears remembering that the price level did in fact more than double (121% increase) in approximately ten years (from 1973 to 1982).5
The implications for traditional stock and bond portfolios can be devastating. For example, in real terms, a 60%/40% stock/bond portfolio from 1973 to 1982 returned an annual rate of less than 1% (when calculated using the Wilshire 5000 Total Market Index as a proxy for equities and the ICE Bank of America U.S. Corporate Index Total Return Index Value to represent bonds).6
Bonds were especially impacted, losing just over 4% per annum which disproportionately affected retirees, those approaching retirement, and any “conservative” investors.
The 1970s demonstrate that, at least in regards to inflation, stocks and bonds may not provide significant diversification to each other.
What can Investors do to Protect Themselves from Inflation?
Inflation-protection hedges fall into three categories. First, and perhaps most obvious, alternative currencies which are not experiencing the same inflationary pressures. For many years, foreign currencies such as the Swiss franc qualified (until the Swiss National Bank embarked on the same reckless monetary expansion as the world’s other major central banks). But precious metals and cryptocurrencies provide even better protection.
Second, any businesses which have costs in an inflationary currency with revenues tied to a stable (or at least less inflationary) currency profit from the currency valuation discrepancies, and should appreciate dramatically. Primarily, this involves commodity producers such as farmland or energy companies. Some potential examples would be American farmland in the 1970s (and in the future), Brazilian farmland today, or Russian energy companies during any ruble crisis.
Finally, assets utilizing extensive financial leverage (especially with long-term fixed rates) should also perform well. Since inflation helps borrowers to the detriment of lenders (since the money repaid is worth less than when lent), industries with large debt levels such as real estate benefit (especially if they have short- term leases with tenants that renew at the new, inflationary rents). Additionally, as inflation may increase interest rates which deters or limits future borrowing, such industries may experience less future competition, all things being equal.
But the marketplace already knows about these traditional inflation hedge categories. The time to act is before the prices of inflation-protection assets are bid up once inflation appears.
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.
“An Update to the Budget Outlook: 2020 to 2030” Congress of the United States Congressional Budget Office. September 2020
Federal Reserve Board of St. Louis https://fred.stlouisfed.org/
Ibid.
Ibid.
Investment Themes Your Wealth Manager Isn’t Telling You About: Cryptocurrencies
This article was originally published bythe Financial Repression Authority on April 12th, 2017
In 1994, most investors had heard of the Internet but had no real idea of what it was or how it would impact their lives. An episode of The Today Show that year featured Katie Couric and Bryant Gumbel discussing the topic when Bryant Gumbel asked “What is the Internet anyway?”1 By the time most investors truly figured that question out, fortunes had already been made and many other business models had been disrupted. The lesson: astute investors should take time to understand the technology that computer geeks are enthusiastic about. Today, that is Bitcoin and other cryptocurrencies.
Like the Internet back then, most investors have heard of Bitcoin, but few have a real grasp of the disruptive technology behind it – the blockchain. Blockchain technology has the potential to be as revolutionary and disruptive as the Internet itself.
What is Bitcoin?
Bitcoin was the first cryptocurrency, a virtual money and payment system. It is based on a revolutionary technology referred to as the blockchain. Understanding Bitcoin and other cryptocurrencies involves first understanding the blockchain itself, the genius behind all cryptocurrencies.
The blockchain is a digital accounting ledger. It is public, transparent, and includes the full history of all transactions on the system for all users to see and verify. Similar to a bank’s private banking records or ledger, the blockchain stores a registry of all user assets and transactions. This is done in a pseudo-anonymous way with users’ identifications only specified by a numeric address typically held in a “wallet.”
The “blocks” contain Bitcoin transactions. The most recent Bitcoin transactions are recorded on these blocks, which are verified with cryptography (an encryption system using advanced mathematics). Only a Bitcoin owner’s cryptographic keys can alter that segment of the blockchain. This prevents double-counting of or multiple claims to bitcoins. The blockchain is thus a “chain” of these many “blocks” registering ownership in one comprehensive and transparent accounting ledger. Bitcoin owners have access to their respective transactions within the blockchain available to them anytime, anywhere in the world.
Further, this requires no middleman’s trust or approval. It is as if each individual becomes their own bank and controls their own money. This bank is open 24 hours a day, seven days a week, and it can be accessed globally and transacted quickly with minimal transaction fees. It is portable beyond national borders with a value that is set globally.
Contrast this to an investor with money in the bank. An investor’s money is also an electronic entry, but this time on a private accounting ledger controlled by the bank. This requires dealing with the bank to get access to their own money. Worse, due to fractional-reserve banking, money in the bank is actually largely lent out (depositors are creditors to the bank). Transaction costs may also be high or it may simply be impossible to do certain global transactions.
Who maintains the system?
It is a global peer-to-peer system, managed by its members and not reliant on any centralized governing body, corporation, or government to function. In this sense, it is a pure free-market model where members maintain the system in a way that supports their own economic interests. Essentially, the system is run by the majority of its most active participants referred to as “miners.” These miners are a global community of individuals who keep the blockchain updated by authenticating transactions. As a reward, they earn new bitcoins. In this regard, they are given the name “miners” in reference to gold miners who are rewarded for their mining efforts with newfound gold.
Is Bitcoin secure?
The ledger is replicated across the entire network of users such that no centralized institution or server controls the blockchain data. Since the data is replicated thousands of times over on computers globally, hacking would require massive computing power. In any such attempt, the offending computers will be identified as corrupted by the tens of thousands of uncorrupted copies of the blockchain. For this reason, bitcoin and the blockchain are likely much more secure than most centralized systems we rely on today.
Although the blockchain has never been hacked, certain online accounts holding bitcoin have been hacked which created some negative publicity. However, it is critical to differentiate between the security of the blockchain itself and where a user chooses to store their bitcoin. Related to the security of each transaction, the miners help audit and confirm the validity of every transaction on the blockchain many times over, such that hacking and fraud of the bitcoin are highly unlikely. Imagine a dozen accounting firms auditing every transaction of a business and only approving them if all accounting firms agree.
Why is the blockchain concept so revolutionary?
Blockchain’s disruptive potential is most heavily influenced by its key attribute – that it allows for a trustless system. It is a peer-to-peer system with no middleman. Users rely on the integrity of the blockchain itself and thus have no need to know the identities or reputations of a counterparty or place any trust in them. The integrity of the system itself is all that needs to be trusted. The mysterious founder of Bitcoin, Satoshi Nakamoto, wrote: “we have proposed a system for electronic transactions without relying on trust.”3
What is the value of Bitcoin?
The value of Bitcoin or any cryptocurrency can be hard to grasp, although it has a price that is set globally and trades 24 hours a day. Thus, a global network of buyers and sellers act to set the price at every moment. At its core, bitcoin is a digital currency that can be used to transact, act as a store of value, or held as a speculative investment. Overstock.com was an early adopter to accept Bitcoin, but Bitcoin can now be used at over 100,000 merchants including household names like Starbucks, Walmart, Home Depot, Tesla, and Subway.4
The value is contingent on supply and demand. For Bitcoin, the supply is programmed to grow from approximately 16 million bitcoins today to 21 million bitcoins in the future.5 It has a finite supply (unlike fiat currencies today), supporting its longer-term value. Demand drivers include the utility or benefit users get from using Bitcoin. These include a trustless blockchain technology allowing individuals to become their own bank, an ability to transact or transfer value globally at any time to anyone at minimal costs, and the capability for micro-transactions (more on this below). With a market capitalization (or total value) of $18 billion, bitcoin is similar to the concept of owning a piece of other payment systems like PayPal ($52 billion market capitalization) or MasterCard ($120 billion market capitalization).
Micro-transactions today are totally uneconomical with financial institution fees, but Bitcoin can be transacted in any fractional amount. For example, imagine someone needing to do a transaction in a poorer region of the world. Today, they could transfer 0.0012 bitcoin or approximately $1.44 (based on a bitcoin price of $1,200). Transferring dollars would be cost-prohibitive with any normal level of financial fees. Applying this technology to regions of the world needing money in small denominations and lacking access to traditional banking could unleash the power of Bitcoin as the money of the internet.
There has been some debate about whether cryptocurrencies like Bitcoin represent money. Money is a medium of exchange and, as such, presupposes the ability to act as a store of value. Over two thousand years ago, Aristotle noted the primary qualities exhibited by money: portability, durability, homogeneity and divisibility. Bitcoin meets these criteria. Today, as most currencies are increasing their supply dramatically, bitcoin offers a unique alternative due to its finite supply. Interestingly, the price of bitcoin surpassed the price of gold for the first time ever on March 3, 2017.
Why do investors own Bitcoin or other cryptocurrencies?
Many owners of Bitcoin are using it for transactions. However, some view it as a store of value or speculative investment. This former view is a hedge against the risks of a future global currency crisis as most governments today have debt levels which can only be repaid by massive monetary printing. Bitcoin may be a hedge against monetary instability or capital controls as it allows individuals to be their own bank and control their money outside of the fractional reserve banking system. For speculators, it is an opportunity to be part of a vibrant and mushrooming industry where the value of Bitcoin may grow as more users enter its network.
What are the risks?
Technology is always evolving and its path is far from certain. In social media, early winners like Myspace gave way to Facebook, so the future of leading cryptocurrencies could change. Miners can also have disagreements leading to splitting a cryptocurrency in two separate coins, referred to as a “hard fork.” For example, there is currently a debate in the Bitcoin community about block size as it relates to speed and cost of transactions. If a hard fork occurred, current Bitcoin owners would get coins in each new currency that they could trade. Prices of any cryptocurrencies can be extremely volatile.
Also, cryptocurrencies pose a risk to governments as a store of value outside of the banking system. Since banks are reliant on depositors to keep a leveraged system afloat, governments could crack down on Bitcoin or tax it excessively. Today, most governments have accepted Bitcoin and, in the U.S., it is given favorable tax treatment under the capital gain tax laws.
What areas will be impacted by blockchain technology?
We see three branches emerging. First, money and banking as bitcoin and other cryptocurrencies gain acceptance as a store of value and payment system.
Second, titling and document retention. A group of open-architecture platforms, such as Ethereum, are creating smart contracts for many business applications to eliminate the need for a middleman due to the trustless nature of the blockchain. Ownership of their “coin” is somewhat akin to owning stock in their ultimate platform. This area is likely to disrupt many businesses as their platform allows developers to create business applications that act as smart contracts with a traceable system documenting all records, management, and transactions. This has the potential to disrupt any businesses that serve as a middleman to ensure trust amongst the transacting parties including title companies in real estate and even global stock exchanges.
Ultimately, we foresee many private and government applications built around the blockchain technology. Private uses of blockchain may be back office systems for banks and financial firms. We are even seeing disruptive social media sites like Steemit that reward key users and contributors with value in the social media network (akin to ownership) instead of these benefits only accruing to corporate owners (such as Facebook’s model). Securely storing and validating records (health, education, legal, etc.) and even authenticating voting remain likely possibilities.
This blockchain revolution is much bigger than Bitcoin alone, but Bitcoin remains the leader in payments and as an alternative store of value. While many of us may feel as lost about cryptocurrencies today as Bryant Gumbel was about the Internet, investors ignoring the potential of the blockchain may miss out on an equally lucrative opportunity.
About the Author:Brett K. Rentmeester, CFA®, CAIA®, MBA, is the President and Chief Investment Officer of WindRock Wealth Management. Mr. Rentmeester founded the company to bring tailored investment solutions to investors seeking an edge in an increasingly uncertain world.
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high net worth individuals, family offices, foundations and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock Wealth Management LLC and our staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Fee-based investment advisory services are offered by WindRock Wealth Management LLC, an SEC-Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
Problems with Today’s Wealth Management Industry
Christopher P. Casey
Question: Although WindRock Wealth Management is a U.S.-based Registered Investment Advisor which manages money for wealthy individuals, you certainly seem different from other firms out there. One of those differences is your macroeconomic viewpoints. Why is that important to WindRock?
WindRock: It is amazing but true, many wealth advisory firms have no view on the economy! I cannot tell you how many times I have asked Chief Investment Officers of major wealth advisory firms what causes recessions, and their response is either “we don’t know” or “we’re agnostic as to the economy” – whatever that means. If any firms hold any views on the economy, they typically adhere to Keynesian economics – they basically just parrot what the Federal Reserve and other mainstream organizations predict. And the Federal Reserve in particular has a horrific track record in this regard – having not only completely missed the 2008 recession and the 2007 housing crisis, but also by initially dismissing the impact of Covid on the economy.
So, we think having a well-thought-out view on the economy is a tremendous advantage. We think it’s important in designing portfolios. In particular, we favor the Austrian school of economics which is an alternative to Keynesian philosophy. Austrian economists, unlike the mainstream Keynesian economists, understand what truly causes inflation and recessions – the artificial expansion of the money supply by central banks. Since these are the two greatest threats to anyone’s investment portfolio, this understanding is critical. This is why many wealth advisory firms herded their clients right over the cliff with the crash in technology stocks and later with all equities in 2008 – which we can see repeating in the future. They could not foresee these events because those events don’t comport to their flawed models and theories. For the same reason, they do not foresee any danger with today’s overvalued U.S. stock and bond markets. By using Austrian economics, we have a time-tested tool to guide our decisions.
Question: Recessions pop asset valuations, and are thus a threat to anyone’s portfolio, but what about inflation? What do you see going forward and how do you position clients accordingly?
WindRock: The actions of the Federal Reserve since August 2008 – and especially since March 2020 – are truly unprecedented. Depending on how you measure it, the U.S. money supply has increased over 75% since the lockdowns were initiated. We’re at historically high year-over-year growth rates – and we have been since March 2020. Increasing the money supply to this degree will inevitably cause significant inflation. It may not show up soon, it may even be preceded by some brief deflation – although I doubt that, but it will develop. When this happens, stocks will, at best, be flat in real terms. And bonds will be decimated. The only way to protect one’s wealth is to invest in such thing as precious metals, cryptocurrencies like bitcoin, and certain types of real estate – mainly farmland and rental residential real estate in the Sun Belt states. Positioning one’s portfolio as such will not only offer protection, but great profit. And this isn’t just based in theory, but in experience. The historical performance of these investments in the 1970’s in America offers great guidance – while the price index more than doubled in 10 years, farmland and gold provided tremendous appreciation.
Question: How do you design portfolios?
WindRock: Our clients’ risk profiles and liquidity needs are integrated with our projections of real economic growth and price levels over the next twelve months. We then combine this with our judgment as to overall asset valuations in the equity and debt markets to determine the allocation between stocks, bonds, and hard assets such as real estate and precious metals. After determining these broad allocations, those same assessments dictate the constituent parts of each allocation. For example, if we are in equities, how much is in emerging markets versus the developed world? How much is defensive versus aggressive, etc.?
One additional item I should note about portfolio construction, we do not believe in “putting all of your chips on red” and waiting for the big payoff. By that I mean we select investments we expect to do very well when the economy plays out the way we expect, but they will also do well in the interim due to the compelling risk and return profile the investment itself offers. As an example, we believe multi-family rental real estate will do quite well in the U.S. when a housing decline unfolds due to rising interest rates and/or inflation hits. Our play has been to focus on new construction neighborhoods that rent like apartments but look and feel like single family homes. We did not go out and buy a publicly traded rental real estate vehicle – they are currently overvalued – which may do well in a housing decline and/or with inflation – we found an investment which believe will do well regardless since it is building a new type of multi-family housing community.
Question: What else differentiates WindRock from other wealth advisory firms?
WindRock: It’s not just about having a different view on how economies work. It’s about what you do with that knowledge. It’s about having an entrepreneurial mindset to act on these opportunities – to seek out and vet investment vehicles which the mainstream wealth advisory industry won’t touch. I think we describe this well on our website where we wrote:
Conventional wisdom associates the word “entrepreneur” with the assumption of risk. While risk can never be fully avoided, what actually makes entrepreneurs unique is their understanding of risk. Our unique insight of the risks posed by governmental interference in the economy serves to protect our clients’ wealth. As entrepreneurial-minded advisors, we emphasize independent and creative thought to boldly seize opportunities while minimizing key risks.
Farmland is a great example. There are very few public farmland vehicles – Real Estate Investment Trusts – or REITs, in the U.S. Accordingly, there are no investment benchmarks for farmland to be considered by mainstream wealth advisors (because the sample size is too small). Therefore, mainstream wealth advisory firms will not consider an investment in farmland. Mind you, it’s not because the investment opportunity isn’t there, but because they cannot be viewed as performing out of sync with the commonly used real estate investment benchmarks. To do otherwise will entail risking their careers. This is a real problem in the wealth advisory industry – advisors are worried about losing clients, not with losing clients’ money. The mainstream wealth advisors are happy tracking what everyone else is doing – because in so doing, they believe they are preventing their clients from switching to another firm. This “career risk” syndrome forces wealth advisors into short-term outlooks with a herd-like mentality.
This is a real problem in the wealth advisory industry – advisors are worried about losing clients, not with losing clients’ money.
Question: Besides the lack of an economic viewpoint (or an incorrect one), besides the “career risk” mentality, what other problems exist within the wealth advisory industry?
WindRock: Misaligned incentives. Many firms lack independence, meaning they create and market their own investment vehicles. So oftentimes they’re not just advising clients to own a particular type of investment – they’re advising clients to own their investment. Which certainly means additional fees and probably a sub- performing investment vehicle. I cannot tell you how many times I have reviewed a prospective client’s investments only to find they are heavily invested in their advisor’s funds. Is it really that likely that the best emerging market equity fund just happens to be owned and run by the advisor’s firm? That the very same advisory firm has the top currency fund? What are the odds?
Question: So, the XYZ Wealth Management firm owns the XYZ funds . . .
WindRock: I think common sense and anecdotal evidence suggests that if you examined client statements from all wealth advisory firms, you will not find the ownership dispersion you would expect if wealth advisors truly provided independent advice. This Wall Street sales culture permeates many firms. Unfortunately, the more wealth advisors serve as salesmen, the less they act as a trusted advisor.
Question: With all of these problems in the industry, why should investors even consider using a wealth advisor?
Unfortunately, the morewealth advisors serve as salesmen, the less they act as a trusted advisor.
WindRock: Doing it yourself can be an option. And perhaps a fairly viable one when compared to the alternative of using many of these firms. But there are still compelling reasons to use a wealth advisory firm. For example, since wealth advisors possess buying power by representing numerous clients, we can have access to certain investment vehicles which may simply be unavailable to the individual investor. In addition, we can negotiate lower fees and minimum investments with the funds we utilize. But in a greater context, maximizing returns and minimizing risks for any investment portfolio requires time, research, money, judgement, and knowledge. It’s a full-time job, especially in today’s world of massive government intervention in the economy and the financial markets, to manage a portfolio. This is why we created WindRock, because wealth advisory has its place – it just needs a different economic viewpoint, a unique investing mindset, and greater independence.
Question: How can anyone interested contact you to learn more about WindRock’s services?
WindRock: Of far greater importance than what we do is what we believe. All of our marketing is driven by thought-leadership, so I encourage any interested parties to visit our webpage at www.windrockwealth.com to read about our philosophy as well as our regularly posted research and analysis. I also suggest interested parties to sign up for our mailing list.
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.
This article was originally published by the Mises Institute on August 29, 2018
Fans of HBO’s hit series, Game of Thrones, know well the motto of House Stark: “Winter is Coming.” This motto warns of impending doom, whether brought on by the Starks themselves, devastating multi-year, cold weather, or something far more ominous north of the Wall.
At least since Soviet economist Nikolai Kondratieff wrote The Major Economic Cycles in 1925, recessions have been associated with winter weather.1 Although Kondratieff’s theories contained as much fantasy as Game of Thrones, using seasons as an analogy for the stages of a business cycle is intuitive. If spring represents recovery, and summer the peak of economic growth, then the U.S. economy may well be in autumn. All should be as wary as the subjects of Westeros (the realm of focus in Game of Thrones).
Why Winter is Coming
Few mainstream economists currently foresee a recession. They cite “strong” (a new-found, favorite term in Federal Open Market Committee minutes) economic statistics, a “healthy” stock market (despite gains highly concentrated in the so-called “FANG” stocks), and few warning signs among the “leading indicators.”2 3 But the same exact sentiment existed before the last recession. Most infamously, then-Federal Reserve Chairman Ben Bernanke stated in January 2008 – exactly one month after the recession technically began: “the Federal Reserve is not currently forecasting a recession.”4
How could Chairman Bernanke have been so wrong then, and why may mainstream economists be likewise wrong today? The answer lies in their erroneous business cycle theories. Without a theory which accurately describes recessions, watching leading indicators or other signs of a slowdown are as effective as reading tea leaves. One can only predict by first understanding causality.
The Austrian school of economics explains business cycles, for it describes their phenomena (e.g., the “cluster of error” exhibited by businesses and economic actors), why they are recurring, and why they first repeatedly appeared in the 19th century (with fractional-reserve banking and/or central banks). In short, when the money supply is artificially increased, interest rates are decreased and distorted. As interest rates are a universal market signal to all businesses and economic actors, investments and purchases which previously appeared unprofitable or untenable now seem economically profitable or reasonable.
However, these expenditures are actually “malinvested” relative to the natural level of interest rates. When interest rates revert to their natural level and structure, a recession ensues. Recessions are an inevitable condition which corrects malinvestments by returning capital to rightful purpose.
What causes the artificial boom to end and the winter to begin? Ludwig von Mises offered a succinct explanation:
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market.5
In the U.S., the growth rate of “additional quantities of fiduciary media” has flatlined (as represented by the red line below). The most relevant monetary metric to analyze is the Austrian definition of the money supply known as “True Money Supply” (“TMS”). Developed by Murray Rothbard and Joseph Salerno (and frequently commented upon by Ryan McMaken of the Mises Institute), TMS more accurately captures Federal Reserve activity than traditional measures such as M2. Since March 2017, it has averaged a mere expansion rate of just over 4%.6
Since Austrian business cycle theory describes the impact of monetary expansion and contraction upon interest rates which, in turn, impacts the economy, are interest rates likewise signaling a possible end to the current, artificial economic expansion?
When Winter is Coming
Interest rates have certainly risen. Since breaking below 1.4% just over two years ago, the 10-year Treasury has traded with a yield close to 3.0% for the majority of 2018.7 But in forecasting a recession, timing and probability are better served by analyzing the structure of interest rates (known as the yield currve) rather than the overall interest rate level.
The yield curve represents a graphical depiction of fixed-interest rate security yields plotted against the amount of time until their maturity. Various methods of measuring the “flatness” of the yield curve exist, but one of the most popular is the yield on a long-dated bond (e.g., the 10-year Treasury) minus the yield on a shorter-term bond (e.g., the 2-year Treasury). Based on this methodology, the yield curve has flattened extensively over the last several years to levels last observed just prior to the Great Recession.
Historically, a yield curve which flattens enough to become inverted; that is, when short-term interest rates are higher than longer-term interest rates, a recession typically follows. An inverted yield curve possesses a unique power of predictability.
As explained by economist Robert Murphy, in foreshadowing every recession since 1950:
Not only has there only been one false positive (which even here was still associated with a slowdown), but every actual recession in this timeframe has had an inverted (or nearly inverted) yield curve precede it. In other words, there are no false negatives either when it comes to the yield curve’s predictive powers in the postwar period.7
The acknowledgement of the yield curve’s prognosticative capability extends beyond Austrian school economists such as Dr. Murphy, for numerous studies – many by Federal Reserve economists – cite this phenomenon. The Federal Reserve Bank of New York, in introducing some of this research, recognizes “the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity.”8
Recognition is different from understanding as mainstream economists are largely unable to offer an explanation. However, yield curve recession signals adhere well to Austrian business cycle theory which demonstrates the importance of banks in creating money and lowering interest rates (which steepens the yield curve as most of their influence resides with shorter maturities). It is the reversal of money creation – and the impact of banks on interest rates – which causes shorter-term interest rates to rise disproportionately (the typical fashion by which the yield curve flattens).
In addition, if the artificial boom ends when interest rates are no longer artificially depressed, then it stands to reason the structure of interest rates will also revert to its natural state. A flatter yield curve comports with the natural structure of interest rates expected in a free market. The Austrian-economist Jesús Huerta de Soto described the underlying reason free markets generate flatter yield curves:
. . . the market rate of interest tends to be the same throughout the entire time market or productive structure in society, not only intratemporally, i.e., in different areas of the market, but also intertemporally . . . the entrepreneurial force itself, drive by a desire for profit, will lead people to disinvest in stages in which the interest rate . . . is lower, relatively speaking, and to invest in stages in which the expected interest rate . . . is higher.9
In short, the predictive power of the yield curve is matched only by the explanatory power of Austrian business cycle theory. If it continues to flatten and invert, a recession will likely follow as the previously created malinvestments are exposed.
But rather than wholeheartedly embrace yield curve analysis, high-ranking Federal Reserve officials consistently waffle at its utilization. Like Westerosi maesters in conclave to determine the advent of winter, they frequently recognize recessions only after their onset.10
Conclusion
The similarities between the climate in Game of Thrones and the state of the U.S. economy are eerily similar. Prior to the recent beginning of winter, Westeros experienced an unusually long time since the last winter. Likewise, according to the National Bureau of Economic Research, the current U.S. expansion is the second longest ever at just over nine years (110 months).11
Also, just as recessions are not phenomena endogenous to free markets (but rather, as discussed above, caused by an artificial expansion of the money supply typically produced/coordinated by central banks), so too the winters in Westeros appear to be generated from an artificial, exogeneous source. As protagonist John Snow explained in describing the supernatural White Walkers: “the true enemy won’t wait out the storm. He brings the storm.” The Night King is the Westerosi version of the Chairman of the Federal Reserve (with the primary difference being the Night King purposely brings about winter).
Finally, like the next winter in Westeros, the next U.S. recession may prove unusually severe by historical standards. In Game of Thrones, many characters (at least the peasants) believe this winter will be the worst in 1,000 years. Given the Federal Reserve’s unprecedented monetary machinations since 2008, the next recession may well prove worse than the last one, and potentially as devastating as the Long Night.
Approximately one year ago, speaking as confidently as a Red Priestess of R’hllor, then-Federal Reserve Chair Janet Yellen believed the next recession-driven financial crisis may be averted for at least a generation or so:
Would I say there will never, ever be another financial crisis? . . . Probably that would be going too far. But I do think we’re much safer . . . and I hope that it will not be in our lifetimes, and I don’t believe it will be [emphasis added].12
You know nothing, Janet Yellen. Winter is coming.
About the Author: Christopher P. Casey is a Managing Director with WindRock Wealth Management. Mr. Casey advises clients on their investment portfolios in today’s world of significant economic and financial intervention. He can be reached at 312-650- 9602 or chris.casey@windrockwealth.com.
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high net worth individuals, family offices, foundations and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock Wealth Management LLC and our staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Fee-based investment advisory services are offered by WindRock Wealth Management LLC, an SEC-Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
WindRock Roundtable: What Does the Rest of 2021 Hold for Investors?
Most financial publications have an annual roundtable of Wall Street economists or mainstream financial commentators, all of whom share very similar viewpoints.
WindRock’s annual roundtable features independent investment minds.
WindRock: Let’s start with the 2021 impact of three major 2020 developments: the election, social unrest, and the Covid-imposed lockdowns. First, we have a new Biden administration with a Democratically controlled Congress. What do you think will be the most likely major legislation to pass? Will that include rolling back anything Trump did?
Mauldin: In one sense, it’s not an ideal world if you’re a Democrat. You get blamed for everything, but you don’t have a whole lot of control. Even though they technically have control of Congress, if they lose a couple of moderates, you’ve lost your majority (with the tie cast by the vice president) in the Senate. So, I don’t think they’re going to be able to go too far with their agenda. [Speaker of the House] Pelosi has the same problem. She gets five or six of her members to switch party lines on votes, and she’s lost her majority. It’s a razor-thin margin.
So, I don’t expect radical legislation. I would expect to see an infrastructure bill for which, frankly, if we’re going to run up the national debt on stimulus acts, I would rather run it up with actual, honest-to-God infrastructure. I’m talking roads, bridges – the stuff that we need to get repaired.
I would like to see the creation of something like a Ginnie Mae for infrastructure so that cities can borrow money to fix their own infrastructure. There’s a lot of cities that need to rebuild their water systems. They can tack on a penny a gallon or whatever the number would work to retire that debt if you can borrow at 1- 2%. The Fed [Federal Reserve] can buy those bonds legitimately because it’s a government-backed asset. You’d have to put restrictions around it; it’d have to be something that would be self-liquidating as opposed to general obligation bonds. You could really do a whole lot of good. I mean, just spending $30-$40 billion on updating the utility grid will save us more than that on our power bills over a few years.
As much as I’m critical of lots of things that China has done, they’ve built an enormous amount of infrastructure, and it clearly shows in their growth rates. We can do that here. For example, we just finished dredging the Mississippi at its mouth so we can now get Panamax container ships up to Memphis. That’s going to be huge. Now they don’t have to stop at the Port of Los Angeles or anywhere else on the west coast. I mean, they can come right into the middle of America and get right off onto trains. That’s going to cut out an enormous amount of costs.
Dirlam: Our feeling – even prior to the Georgia runoffs – was that whatever the political composition of government, there was going to be a lot of spending. The budget deficit was just going to go through the roof. Part of that was seeing how 2020 played out and gauging how markets would tolerate so much deficit spending and with so much monetization of debt by the Fed. In the fourth quarter [2020], the Fed basically bought a third of all Treasury issuance which was about $600 billion. So, we think with this so-called a “blue sweep”, there will be even more spending involved.
They will also likely roll back some of what Trump did. I go back and forth on what will happen with Trump’s tax cuts [the 2017 TCJA]. They certainly don’t have to increase taxes – simply because the markets are so willing to tolerate these levels of deficits and debt monetization. It would be a very politically powerful move to roll back tax cuts, so if one of the administration’s first moves is to do that, I think that’s a pretty strong political statement, especially because there wasn’t a voter mandate in support of increased taxes.
Courtney: I would just highlight that some of these marginally centrist politicians, like West Virginia’s [Senator] John Manchin, become incredibly important now for each specific vote. Ultimately, we don’t think it will be enough to slow the trajectory of increased deficit spending, but to Aaron’s [Dirlam] point, it’s not a mandate for any sweeping action one way or the other. We don’t think the election represented that.
Casey: For a while, I went back and forth on Biden: would he accommodate and advance the progressive policies within his party, or instead be content with just being president – kind of like Clinton – and ultimately not implement any radical changes? His track record and the number of times he’s run for president suggest the latter. But now I fear the former. I think he will actively advance – and not just get pulled into – an extremely progressive, and flat-out dangerous, agenda. I think that conclusion is supported by the ferocity by which he’s issued executive orders, the severity of those executive orders, and the goofiness of doing such things as banning the term “Wuhan virus.” But if the economy deteriorates – and I think that is a strong possibility – maybe the threat of losing mid-term elections will reign him in.
So, what legislation will advance? My fear is that they [the Democratic party] will work to cement their power by enacting long-term, institutional-type changes: make DC [the District of Columbia] and maybe Puerto Rico a state, loosen and expand voting rights, and pack the Supreme Court. Then everything else is fair game. That’s worst-case scenario. Best case is that they content themselves with typical progressive stuff: increase taxes – especially by lowering estate tax exemptions, pass a slew of environmental rules and regulations, establish some sort of universal basic income, etc.
Can they do it? John [Mauldin] is right when he mentions their power is limited by any defection of moderates from their party, but that works both ways. Can we really be confident Republicans won’t defect to their side – especially if something like universal basic income is included in a “necessary” “stimulus” bill? Please put “necessary” and “stimulus” in quotes when you publish this.
WindRock: Whether by executive order or legislation, what do you think the impact will be on energy policy? Whether it’s offshore or fracking regulations or limitations, I imagine it could be good for the price of oil, right?
Courtney: I think it’s more positive for the commodity than it is for commodity-producing equities. We still think it will be broadly positive for the [commodity- producing] equities. The best estimate I’ve seen is that most shale supply will come back on line between $65 and $70 a barrel. There’s obviously been a dramatic reduction in the amount of drilling that’s going on – specifically, in the shale patches. So, we think the market is setting up for a dramatic supply-demand imbalance in the second half of this year. That said, there are some significant developments related to work-from-home culture and what that will do to demand. It’s a little bit more nuanced than “we’re going to return to normal” and “supply is significantly lower than where it was so oil is going to the moon.”
Dirlam: Certainly, a blue sweep paves the way for lots of spending on green initiatives, but I wouldn’t run out and buy any clean energy ETF just because we don’t really know how the government is going to incentivize the green initiative. You could have some companies that just get incredible subsidies that aren’t very profitable and sort of drive down the price of for-profit entities where you’re owning the stock. That to us is an interesting area but we still need to see visibility in an infrastructure bill. We want to see some of the details of how that is going to play out before we would allocate capital to try to take advantage of that opportunity.
WindRock: Do you see any further social unrest in 2021, resembling what we had last year?
Courtney: Without a doubt. I think the burden of proof would be for anyone saying that there won’t be civil unrest. Civil unrest is not uncommon especially in economies where there’s a wide gap between income and wealth levels at the bottom and the top. I think people need to just get comfortable with the fact that this is what the landscape will look like as long as we are trying to fix the economy with monetary policy – which is an extremely blunt instrument and obviously does it in a very unequal way. So, there will be continued social decay and disruption. That’s going to lead to more violence, unfortunately, and just more frustration. I suspect a lot of people are going to get tired of watching their neighbors get rich in the middle of a prolonged recession.
Casey: I think Paul [Courtney] is totally correct. And we have timelines for this already set in stone – namely whenever the verdict comes out for [Derek] Chauvin in the death of George Floyd. But there’s also the possibility of different actors engaging in civil unrest: those against current lockdown measures. If some variant of Covid pops up and new lockdowns are enforced, will parents stand by while kids miss more school? Will loved ones continue to virtually grieve in lieu of attending a funeral? Will people stand by while friends and family are hospitalized with no hope of seeing them and advocating for them in the health care system?
WindRock: Let’s talk about the long-term effects from the lockdowns. What do you guys see as the biggest negative impact, and what could potentially benefit?
Dirlam: The biggest impact is just small businesses going under since they lacked the resources to weather the lockdowns. We had a record number of bankruptcies this past year, and record number of IPO’s. In 2020, you had all of this record corporate and high- yield bond issuance. To me those things say it all. Main Street was left behind, and Wall Street wins again. So, I think unfortunately small businesses are structurally impaired and won’t come back from this.
Mauldin: I agree, the most important economic impact will be for small business. It’s one thing to lock the door and close your small business. But you just can’t take the key, open the door, and go back to business. You’ve got to have inventory, you’ve got to have cash flow, you’ve got to have employees, and you’ve got to have capital. We will have lost thousands upon thousands of small businesses by the time we get through this. That’s a lot of workers, that’s a lot of small businesses, and they just can’t all turn back on when we reach herd immunity.
Commercial real estate is going to get repriced. We’re not going to need as much office space. I think the apartment sector will be less affected except for some urban areas – like New York City – where you have people moving to the suburbs. Just look at the U-Haul numbers. The number of people moving to Arizona, Texas, Florida, Tennessee, etc. is staggering. That’s going to affect housing from the states they’re moving out of, but it’s also going to create housing demand for the states I just mentioned. So, there’s going to be opportunities in real estate in the states that are absorbing the population.
That includes areas where it’s easy to do business or where you want to retire to. As you know, I retired to Puerto Rico, and everywhere I turn around, there’s another opportunity somewhere. We’re actually going to think about how to create a Puerto Rico fund.
Casey: I absolutely agree that small business and commercial real estate – in particular, office space in urban areas with progressive regimes like New York, LA, and Chicago – are the biggest losers. Frankly, I am shocked at how many small businesses have actually reopened, but I fear it’s a swan song for many of them. I personally know of a number of local restaurants, etc. that simply are not paying their rent. At some point, the courts will allow landlords to press their rights.
And let’s not forget that many of the negative effects from the lockdowns have yet to be witnessed: the undiagnosed cancers, the untreated depressions, and increased alcoholism to name but a few. Not to mention the delayed marriages and births, educational setbacks, etc. There’s economic, health, and social carnage everywhere.
WindRock: Given government spending last year, the deficit exploded. It was up $900 billion from 2019 for a total of $2.3 trillion – and that’s with a fiscal year cut off of September 30, 2020. Where do you see debt realistically going in the future? And would you agree that Federal Reserve has no choice but to continue financing them? I mean, the Fed almost doubled its balance sheet in the last year by basically printing over three and a half trillion dollars.
Dirlam: Absolutely. I’ve seen enough headlines or watched enough press conferences of [Chair of the Federal Reserve] Powell and others; and they’re pretty much as outspoken as they can be about begging the government to spend more money because they [the Federal Reserve] can buy the debt. Maybe that’s why interest rates are climbing. But we think they also have to do it because, at their Jackson Hole meeting, they said they’re willing to tolerate higher inflation which will crush the real return of Treasuries. So typical buyers of Treasuries, while still considering it “money good”, will realize they’re not earning anything on them and they’ll have to find something else to meet return needs. I think the Fed is going to have to be the marginal buyer there to keep rates contained. So, it will be more QE [quantitative easing], and it seems like the market is generally okay with that right now.
Mauldin: The national debt will be $40 trillion by 2025, at least, and – because there’s just no impetus for reining in the deficit – we’ll probably be at $50 trillion plus by the end of this decade. Debt is spending brought forward. It has to be repaid. It clearly has an effect on growth in the future. It’s going to slow down growth, and growth is really the only way out of this, but if you slow down growth, you take out one of the major solutions to your debt problem. At some point, I think sometime in the mid to late 2020s, we have to start figuring out what we’re going to do about debt: how we’re going to restructure it and who’s going to pay it. You just can’t make it go away because it’s an asset on someone’s balance sheet. It’s not an easy reckoning.
Casey: I think John is right about where debt is headed. And a few things could easily accelerate that scenario. Most plausible scenario for that to happen: interest rates increase significantly. Higher rates mean larger government [interest] expenses which means deficits increase which means more debt. This thing can easily turn into a death spiral.
And we know what they will do both then and now – print more money. But printing money to suppress interest rates and pay off debt is like basic rocket science; and by that I don’t mean it’s complicated. I mean that printing more money to reduce interest rates – which are also a function of a creditor’s, that being the U.S. government’s, solvency – also increases rates at some level. For rockets, it’s like adding more fuel, in so doing, you’re also adding more weight, which reduces the benefit of adding more fuel. There’s a law of diminishing returns.
Courtney: There will be an overwhelming urge for politicians to spend money that they do have from taxation. Especially with the situation of still high unemployment, very high underemployment, and a significant number of people on some form of government welfare. That’s the only thing I know for sure. Exactly what happens with inflation, exactly what happens with bond yields – well, I think a lot of those types of predictions are really challenging to get right. What we’re trying to focus on is just that overall theme that government spending is going to continue in excess of tax receipts. Which leads policymakers to MMT [Modern Monetary Theory]. MMT is an awful idea whose time has come.
WindRock: How do you envision MMT looking much different from what we’re already doing?
Courtney: We are effectively there now, but I do think just behavior-wise there’s room for it to become more structured and potentially codified in law. That is the key to generating persistent inflation. It needs to become ongoing.
WindRock: Whether or not they go down that path, just given what they already have done, if you look at year-over-year money supply growth over the last 13 months, it’s just off the charts. How concerned are you guys about inflation? And if we get inflation, where do you guys sit on this whole deflation, inflation debate – that is, do we experience deflation first given any economic downturn, or do we jump right to inflation?
Courtney: I don’t care if they’re conservative or liberal, politicians will all do exactly the same thing: spend money they don’t have. Unless Paul Volker [former Federal Reserve chairman] comes back from the grave, there is no way that they do not address any economic hardships, slowdown in the economy, or any stock market decline with anything other than additional spending. As it relates to deflation or inflation, eventually they will outspend some of these deflationary forces. We may get a hot minute of deflation first, which would be the natural order of things if it wasn’t for the central bank, but we know what the response to any deflationary impulse will be: print more money to fund spending. It doesn’t matter how you get there; we end up with higher inflation. And if you look at other measures of inflation, you can argue it’s already here at about 8% to 12%. There’s absolutely no way around it, inflation is going to increase. That doesn’t mean you throw caution to the wind and go all-in on inflation hedges, but I think reminding ourselves of the end game is helpful as we manage risk. Investors should be very judicious with cash and they should raise the hurdle rate for investing in long-term bonds.
Casey: Agreed. As it relates to deflation, I also agree. A “hot minute” is exactly what we got in 2008. The last time we had any significant deflation – as measured in duration and magnitude – in this country was during the Great Depression. The Fed will never let that happen again for three reasons.
First, they are scared to death – incorrectly so – of deflation. They believe, as Milton Friedman incorrectly advocated, that deflation was the cause of the Great Depression. So, they will fight it tooth and nail. Second, deflation hurts debtors since they’re paying back money which is worth more than when they borrowed it. The U.S. government is the largest debtor in the world. It doesn’t want deflation. It cannot afford deflation. Third, with absolutely no link to gold, the Fed is unencumbered in their abilities to act as they wish.
As already mentioned, the Fed has made this very clear. They want long-term inflation at 2%. To “achieve” that, they will let inflation exist above 2% for some time. I still don’t understand why and there’s not justification for it. The Fed is charged with maintaining “price stability”, so I don’t know how that is consistent. In 40 years, the Fed went from fighting inflation to listing it as a policy goal. I don’t know who does the public relations for inflation, but I want to hire that agency.
Dirlam: Today rates are at 0% and the Fed continues to expand the balance sheet with roughly $120 billion in QE per month. Yet, I think they believe that they have the capacity to do more. If you just look at what they sort of did in March and April by buying $125 billion of securities a day. They can step it up as all of the plumbing is in place – especially for them to buy other assets like ETFs, etc.
Courtney: They do think they have more capacity – the Fed’s balance sheet relative to GDP is sitting at about 35%. It’s less than the People’s Bank of China, it’s less than the ECB [European Central Bank], and substantially less than the Bank of Japan.
Casey: It makes you wonder why they’re collecting taxes at all, let’s just print money.
Courtney: That’s exactly the point. That idea is going mainstream. That’s where we’re headed.
WindRock: Do you think central banks will adopt blockchain technology – basically issue their own so- called FedCoin? Do you guys think we’ll get to this point where they actually try to do something like this? What is the motivation – is it because they can inject money more quickly and with greater dispersion.
Dirlam: I think that’s it. Remember, they’re trying to get something that’s higher than a 2% inflation rate for a sustained period of time. They’re not worried about hyperinflation or anything approaching that – it’s not even on their radar. They feel as though they can’t print too much. So, it’s a possibility.
Casey: I’ve always thought they’d be reluctant to institute a so-called FedCoin. If they do so, it destroys their ability to use fractional reserve banking because you can’t have a block in the blockchain in two places at once. If this happens, then I think it evaporates their whole ability to have plausible deniability in being culpable for inflation. Now it seems much more direct, much more correlated. Remember in the 1970’s when they were able to blame the oil crisis, greedy businesses, etc.? A FedCoin destroys that position. But, if they view the benefits as outweighing this negative, they may do it.
WindRock: What are your thoughts on the kind of returns investors should expect going forward? Also, where do you see interest rates headed?
Courtney: Without intervention [by the Fed], interest rates would increase as investors rationally responded to the guaranteed erosion of purchasing power that they will be experiencing in a lot of fixed income securities. And the intervention is just going to increase. At some point, the central bank will just come into the bond markets and essentially nationalize them. When does that happen? We don’t know exactly. I think we’ll probably find out later this year if rates rise on the long end. You’ll probably find out that the Fed is soaking up more and more [Treasury] issuance as is the case in Japan. It might take a year or two but I think that’s where it’s headed.
Dirlam: On the equity side, the S&P500 one-year forward PE [price-to-earnings ratio] is about 23 times, the tech level bubble was 26 times. In a sort of “normal world”, you would look at that valuation along with earnings expectations of like 30%-plus this year and say: “jeez, equity seem to be really overvalued – we should probably be pretty light on that.” But given the dynamics of fiscal policy, we think you need to own equities closer to your allocation targets. There really hasn’t been a material decline in the equity markets when QE has been going on. That old adage of “don’t fight the Fed” we think is appropriate right now even though valuations and prices seem to be way ahead of fundamentals.
Casey: Is the question concerning real returns [meaning after deducting inflation]? You can make a number of arguments why they could be negative for some time. Simply start with mean reversion with or without adding in a potential recession. Perhaps of greater significance for investors is not what returns are for any given asset class, but how correlated they are. Just because something didn’t move in lockstep with something else, and therefore was considered “uncorrelated”, does not mean that will be the situation going forward. I’m primarily talking about stocks and bonds. Bonds saved most investors’ portfolios after the 2008 crisis. I suspect next time they both move together to the downside.
As far as interest rates, the Fed will do everything it can to keep them low. It cannot risk higher rates. They will print to control them until that no longer works. To Paul’s point, they only way they can really try to control this in the long-term is to effectively nationalize those markets by being the sole buyer of Treasuries. If they do that, they will destroy the dollar.
WindRock: It seems like every publication I read is talking about the U.S. dollar declining, having declined, and continuing to decline. Do you guys share that opinion? If so, what are the investment repercussions in your minds?
Courtney: Things that can’t be printed will go up in value. I’m being somewhat facetious but I genuinely mean that. I think the dollar is really hard to call. I do think that twin deficits [the trade and fiscal deficits] are a major headwind.
This has been our working model for a while: the dollar will generally track the combined deficit situation of the U.S. with lag. That’s been the case. But I don’t have a strong conviction that the policy makers in the U.S. will be able to destroy the purchasing power of the U.S. dollar faster than policy makers in Europe or Japan. I am very confident that they will destroy the purchasing power of the dollar. I don’t know if it’s a productive conversation to talk about the relative value of the dollar versus the euro or the yen. But regardless, inflation is here and you need a good reason to hold cash balances. Not to say you should have zero cash balances, but you should also consider other hedges rather than just cash.
WindRock: Where do you guys see the greatest risks and the greatest opportunities in the financial markets right now?
Courtney: The coronavirus has accelerated the disruptive trends that have been in place for at least the last five years. I think some of what’s happening in the blockchain space is incredibly interesting – especially in finance. The DeFi movement has recently gained a lot of traction [Decentralized Finance executes financial transactions without intermediaries.]. We’re super excited about a lot of these disruptive trends, maybe as exciting as anything I’ve seen in my career. I think accessing this space through the private markets is the way to go; look at blockchain venture capital.
Dirlam: The biggest risk is in real estate right now. I think that there’s so much change going on with corporations moving and also allowing flexible, work from home options. The commercial real estate footprint is overall declining. Leases are getting renegotiated. These commercial effects impact residential because they may not be coming in to the office as much. Apartment rent supply in Manhattan is at 19 months which is more than double the ten-year average. Rent prices are down back to levels ten years ago. I really think that’s a big issue.
Casey: I think inflation presents the greatest risk and the greatest opportunity. We know what it does to bonds: it devastates them. We know what it does to equities: it prevents any price appreciation in real terms – stocks basically held their own in the 1970’s. So, how to play any inflation resurrection? There are a number of ways. First, and perhaps most obvious, alternative currencies which are not experiencing the same inflationary pressures. By that I mean precious metals and cryptocurrencies.
Second, any businesses which have costs in an inflationary currency with revenues tied to a stable, or at least a less inflationary, currency profit from the currency valuation discrepancies, and should appreciate dramatically. Primarily, this involves commodity producers. Think of a Russian energy company during a ruble crisis or a Brazilian soybean producer when the real falls.
Finally, assets utilizing extensive financial leverage, especially with long-term, fixed rates, should also perform well. Since inflation helps borrowers to the detriment of lenders, industries with large debt levels such as real estate benefit. Especially true if they have short-term leases with tenants that renew at the new, inflation-adjusted rents. Additionally, as inflation may increase interest rates which deters or limits future borrowing, such industries may experience less future competition, as financing may be cost prohibitive. But keep in mind that not all real estate is created equal. We particularly like build-to-rent residential communities in the Sun Belt.
Regardless, investors should keep two things in mind when seeking out inflation-protection assets. First, the time to buy them is before they’ve been bid up in price. So, for most of these investments, the time is now. Second, because we do not know when or by what magnitude inflation returns, investors should focus on investments which will perform well regardless as to the impact of inflation.
Mauldin: Well, people often call me bearish, and I find myself amused at that. If you looked at my portfolio, you’d find me almost fully invested. I’m not as aggressive as some, I will admit, but my boring portfolio is, in part, made up of large hedge funds, private fixed income, trading strategies – things that I think are going to give me high single digits averaged over four or five years. I also have my speculative part of my portfolio, which I think has the opportunity to give me multiples over time. I’m very optimistic about the future.
But if you’re dependent upon passive index fund investing, you are making a very, very large mistake. If you think passive index funds are going to do in the next 10 years what they’ve done for the past 10, you’re wrong. If you go to the previous 10 years to the aughts [2000-2009], the S&P returned 0% – literally. Then it had 10 years where it’s been lights out, but we’re back to euphoric levels. The last time we were here was 1999, early 2000, and the next decade gave you 0% returns. I don’t know why we should expect something massively different this time. The old line, “past performance is not indicative of future results,” has never been more appropriate than it is today.
Think of it like this, a third of the companies in the Russell 2000 have no income. Now, some of those are good companies and they’re making no money because products are in development or they’re growing rapidly, but some of them are making zero income because that’s just what they do. Investing in these companies just because they’re part of some big ETF with arbitrarily created rules – like market cap size – is a bad idea.
Now, were there opportunities to make money in the aughts? Absolutely. Did active management work?
Absolutely. Absolute returns were the key to having a successful portfolio back then. Dividend portfolios, just plain-old rising dividend portfolios did extremely well.
This is the time to find a good investment advisor, unless you’re one of the 2% of people that are investment junkies and can do that yourself. Otherwise, get a good investment advisor, and make sure that they’re active, look at their portfolios, and look at how they go about structuring things. Don’t let somebody tell you: “Look what it’s done for the last 10 years. Let’s have this passive portfolio of ETFs and mutual funds.” If so, just pick up your notepad and walk away. Go find an investment advisor that understands absolute returns.
This is going to be the year, and I think it’s going to become the decade, of active management.
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.
The roundtable discussion was moderated by WindRock Wealth Managementwith the following participants:
John Mauldin
Mauldin Economics
Paul Courtney
SpringTide Partners
Aaron Dirlam
SpringTide Partners
Christopher Casey
WindRock Wealth Management
What Stops the Stock Market Rally?
August, 2020
In terms of magnitude and shortness of time, the stock market rally since its March lows has been unparalleled. Yet it is especially notable given negative economic reality (an annualized second quarter GDP plunge of 32.9%) and diminished company earnings (S&P500 earnings down 50%).1 Will this rally continue? If not, what stops the stock market rally?
Numerous threats exist: continued economic deterioration (a case can be made a recession hit before the lockdowns) and bankruptcies, trade and geopolitical strife with China, civil unrest and mass unemployment, renewed lockdowns due to a Covid resurgence, the loss of hope for a timely vaccine, and a negative economic viewpoint of a very possible Biden presidency.
Either mitigating or masking these risks stands the Federal Reserve’s unprecedented actions since March. Although it intervened with numerous programs and purchased a multitude of assets, its actions can be neatly summarized as having massively increased the money supply. Measured in M2 (a commonly cited definition of money) year-over-year growth since the end of the last recession, the money supply has exploded.
Monetary expansion is singularly responsible for the stock market rally. As such, to ask what stops the stock market rally is to question what stops the Federal Reserve.
Chairman Powell is unlikely to voluntarily withdraw monetary stimuli. He learned that lesson (it is no coincidence that the late 2018 stock market decline occurred after a long-term slowdown in monetary growth).
So short of this development, what external factors may prevent the Federal Reserve from pursuing its current monetary course? Theoretically, why is it that central banks cannot forever increasingly print money to ensure ever higher equity prices?
Murray Rothbard, the Austrian school economist and monetary expert, addressed this issue:3
. . . the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit. It is only when the bank credit expansion must finally stop, either because the banks are getting into a shaky condition or because the public begins to balk at the continuing inflation, that retribution finally catches up with the boom. As soon as the credit expansion stops, then the piper must be paid . . .
The “shaky condition” of banks may derive from low absolute interest rate spreads and unsustainable financial leverage alongside increasing bad loans. It will develop with sustained negative real rates (as it has in other parts of the world).
Assuming a banking crisis is averted, what about inflation? Few under 50-years old can remember, let alone experienced, an inflationary environment as a consumer, but could one be starting now? According to the August 14th issue of Barron’s magazine:4
A trifecta of inflation numbers came in hotter than expected this past week, with consumer prices, producer prices, and import prices for July all rising at faster paces than economists anticipated. Notably, consumer prices – excluding the more volatile food and energy categories – rose at the quickest clip since 1991.
It may not be starting now, but it could be. And unlike the 1970’s, the Federal Reserve will be unable to deflect blame at greedy business owners or higher oil prices. What they once could play off as coincidence will now reek of causality. And if they stop inflating, then any rally could turn to rout.
Endnotes:
S&P500 Down Jones (95% of companies reporting)
Federal Reserve Bank of St. Louis
Rothbard, Murray N. Economic Depressions: Their Cause & Cure. Ludwig von Mises Institute. 2009.
‘Stagflation’ Looms Over This Market. Why Some Analysts are Worried. Bellfuss, Lisa. Barron’s. 14 August 2020
