Where are we heading to?

The world has severe and growing financial as well as economic problems. Unfortunately, we cannot find a way out through money printing. This article intends to make a quick review on the changes characterizing the current state of the world, the reactions we have seen in central banks and governments after the Covid-19 outbreak, and the main implications of all of that for the financial markets.

Towards a new economic consensus

Marko Papic, Chief Strategist of Clocktower Group, says we are moving towards a new global consensus. In the past 40 years, the global consensus revolved around fiscal prudence, supply side economics, globalization, free trade, privatization, and central bank independence. Such policies favored short-term pain to achieve long-term gain. Regardless of who won the elections, all of the main parties adapted to the same consensus and investors never felt at risk. But now we live in a very different political situation.

The USA and the UK, early adopters of the previous consensus, have steadily moved away from it to embrace a new one that cannot accept short-term pain. It is a populist setting whose short-term focus will bring very negative consequences. This deep recession has been countered with an extraordinary fiscal response and war-like government spending. Fiscal deficits and government contribution to GDP have ballooned everywhere. Politicians know that the median voter has encountered trouble in the current downturn, that he or she is now left-leaning and demands relief and stimulus policies. Therefore, the era of fiscal austerity is over, even in Germany. The new consensus also favors deglobalization and protectionism, and promotes less technocracy in central banks, which obviously become less independent.

Markets are broken and central banks lose credibility

Jim Bianco, President of Bianco Research, says that the market cannot look for signals in interest rates because they are no longer freely traded. The Federal Reserve has responded to the crisis with a very aggressive expansion in its balance sheet, creating money out of thin air to purchase a wide variety of securities, including government bonds, corporate bonds, and mortgage-backed securities. Since the Fed is not a price sensitive actor and has unlimited funds at its disposal, markets no longer show the signals that could be read when they were freely traded with investors making conscious decisions. The debt market has shown very little volatility because the Fed has fixed prices.

Financial markets are supposed to reflect the real economy or, at least, over time both converge. But now the US President, the Secretary of the Treasury, and monetary authorities believe it is the other way around. They think that the real economy reflects the stock market, so if the stock market goes up, the ‘wealth effect’ will create jobs, confidence, growth, and avoid having companies going out of business because the government won’t let them fail. As a result, there is a huge disconnect between financial markets and the real economy. Markets have become addicted to the central bank drug. It is this intervention that boosts wealth inequality because it mainly benefits richer people who own financial assets.

When governments and monetary authorities come up with ‘temporary and exceptional measures’ to fight against downturns, as it happened in the Great Financial Crisis when Quantitative Easing (QE) was launched (although Japan used similar measures to fight against deflation in the early 2000s and concluded that they were not effective), and more than one decade later we are still dealing with unlimited QE, proving that such measures have become totally standard and permanent, institutions lose credibility and that ends up having a dire impact on investors’ expectations.

Many journalists have talked about ‘the historical shift’ recently made by the Federal Reserve. In his speech in the Jackson Hole meeting, Chair Powell underlined that in the Fed’s dual mandate, employment now seems to be more important than inflation. He said that they will allow inflation to exceed the 2% target to compensate for periods when inflation has been below, thus establishing an average target. Other than that, there was nothing new in what he said. And there is indeed no shift at all, since the Fed has been unable to achieve the target inflation for many years and Chair Powell did not specify any new tools to pursue the new average target.

Negative nominal yields are a game changer in finance. When interest rates are kept at an artificially low level for a long time, distortions and significant problems arise. Over the last decade central banks have not allowed the market pricing mechanism to function. Since QE policies and asset purchases have broken markets, we can no longer read market signals or assess risks effectively, and this leads to malinvestment and to a faulty asset allocation.

A new geopolitical stance

We are in a multipolar world. The hegemony of the United States is likely to come to an end. In my opinion, the US choosing Donald J. Trump as President and the isolationist doctrine of his administration willing to step back from several multinational organizations and from the role of protector of the world order are an unquestionable proof of the US decay. The Trump administration is hardly ‘agreement-capable’. Europe knows it can no longer trust the White House because negotiating with Trump is like playing chess with a pigeon: the demented bird walks all over the chessboard, shits indiscriminately, knocks over pieces, declares victory, and runs away.

Many people see the growing conflict between China and the US as a new cold war because many of us grew up in that environment (USA vs. USSR). Nevertheless, we should avoid that perspective because we are dealing with a completely different world. History shows that in a multipolar world the US will be unable to align its allies under its trade discipline because they will be willing to benefit from trading with China and from the business that US firms leave on the table. 

China clearly understands that it needs to move up in the value chain and reduce its focus on manufacturing. Unlike big democratic countries, China has the capacity of planning for the long run because the party ruling the country is unlikely to change in the foreseeable future. Many people also forget that under the Qing empire, China was the one and only Asian superpower centuries ago. To enhance its growth and development, China is fostering world-class domestic champions and technological innovation. In 2019 China surpassed the US as the top source of international patent applications filed with the World Intellectual Property Organization (WIPO). China’s public support and financing for favored or state-owned enterprises has been criticized for creating an uneven playing field for foreign investors and competitors. As a result of that, China intends to open market access for foreign firms and make it easier for them to invest and do business, boost private sector participation, develop its financial markets, and strengthen protection for intellectual property.

China intends to pursue global dominance through economic and technological power, rather than by military power. It goes without saying that any global superpower needs a large and strong military force (and China is indeed likely to surpass the US in military spending over the next 2 decades), but China understands that it should not openly and violently wrestle with other superpowers. China is rapidly securing a greater margin for manoeuvre in diplomacy and has already passed the US in the number of diplomatic posts around the world. It is also expanding its influence in global climate and trade institutions, and other key rule-setting bodies. In fact, the US and China need each other and can get along if each country stays on its side of the Pacific. However, should the US decide to strengthen its presence in the South China Sea and openly support Taiwan, which is deemed as an inalienable objective and a ‘rebel province’ by Chinese people, then we could see a war in the Taiwan Strait sooner or later.

Russia knows that China is still dependent on natural resources and President Putin has smartly played his cards because he knows that as an ally of China, Russia can keep a privileged position in a new world order. Some observers even think that in the long term Europe could continue strengthening its commercial relationships with China and maybe end up joining the new world's superpower to create an Eurasian hegemon with a shared currency of their own that would allow them to cast a dark shadow on the US dollar. 

Inflation or deflation?

There is a heated debate among pundits on how prices will evolve in the foreseeable future. While some claim that deflation continues to be the main risk, other believe that central banks’ policies and fiscal stimulus are sowing the seeds of inflation. In this respect, we need to understand that the Consumer Price Index (CPI) is far from perfect as a measure of either inflation or the cost of living. The index is inherently flawed and does not take important factors such as house prices or taxes into account. Hence the impression that everyday prices rise much faster than what the government tells us with the CPI.

Over the last decades inflation has been trending downward due to structural vectors such as demography, globalization, and technology. However, the new consensus and the emergence of a higher contribution of government spending to GDP in a world that will be rewiring its supply chains will lead inflationary pressures to build up.

Central banks have been unable to reach inflation targets for a long time. Their balance sheet expansion and asset purchases cannot generate inflation measured by CPI as long as there is a sizable output gap (production capacity is much higher than existing demand). The increase in the money supply has not ultimately followed through because the banks cannot utilize the reserves. In a downturn they don’t want to make the loans for the risk of default or they must charge an elevated risk premium in an environment where borrowers aren’t willing to pay it. Therefore, there has been no secondary follow-through in terms of money supply growth, and the velocity of money has dropped for a long time. The only inflation central banks have created is asset price inflation, as we can see in the debt and stock markets, and in real estate.

There has also been a significant amount of fiscal relief, but it has mainly contributed to support jobs instead of generating new demand. A few countries are already experimenting with the idea of a Universal Basic Income because the lower echelons of society in terms of income have been the hardest hit in this crisis.

We can all agree that the economy has not yet recovered the activity and growth levels that we used to experience before the pandemic. With regard to inflation expectations, I agree with those who think that we are unlikely to see strong inflation figures during the rest of this year. However, as we enter 2021 prices could start showing upside pressures nurtured by growing prices in commodities and the many supply bottlenecks, supply chain disruptions, and cost inflation that the transition towards deglobalization will undoubtedly bring.

In 1994 Alan Greenspan, the former Chairman of the Fed, testified to the Congress and said that the price of gold is “especially sensitive to inflation concerns”, which, next to other indicators, “can give important clues about changing [inflation] expectations”. Central banks used several tools to influence the price of gold in the past, thus conditioning inflation expectations, but now that inflation is desperately sought, they are unlikely to take advantage of them. Given the outlook that arises from the Fed’s so-called new approach with low interest rates for longer, a weaker dollar, massive amounts of fiscal stimulus, and a higher demand for inflation hedges, the price of gold and other precious metals finds a very supportive context. However, if stock markets experience a sharp correction or interest rates go significantly higher, demand for gold could falter temporarily.

Future outlook for the markets

The S&P 500 has risen 13% since June 30th and went up every day in August except for 4 days. This index is has gone up above its 200-day average by more than at any time in the last decade. US stock markets are reaching new all-time highs in the middle of the worst recession in our lifetime. Companies selling shares in secondary offerings this year have surprisingly outperformed the Nasdaq Composite Index by almost 40%. And the market capitalization concentration of the 7 largest public corporations in the US is now $8 trillion, which is larger than most countries (e.g. Japan has an expected nominal GDP for 2020 of $5 trillion). The US technology sector is now worth more than the entire European stock market. This reminds me of the 80s when the real estate bubble in Japan caused the grounds under the Imperial Palace in Tokyo to be worth more than all of the real estate of California. Sounds nonsensical, right? This is because bubbles go beyond reason and can get as big as human stupidity (did you know that in the US more than 20 persons have been poisoned or died so far after consuming hand sanitizer, which contains ethanol?).

As soon as inflation goes up the bond market vigilantes will sell their debt holdings because inflation punishes their nominal returns, and this will raise interest rates. The debt market has not reached that stage yet because currently there are many different opinions and expectations in that market. But when that happens, not even the Fed with an unlimited capacity will be able to stop it. Needless to say that once interest rates go up, the consequences for debt holders will be scary. Interest rates cannot go up to the levels seen before the Great Financial Crisis because this would cause the majority of sovereign states to go bankrupt due to the debt overhang. However, starting from historic lows (sub-zero or near-zero levels), they could easily jump up to 150 basis points and cause substantial collapses in the valuation of debt securities as well as important headaches in debtors.

The bull market in bonds has lasted more than 30 years and central banks have progressively reduced the interest rate down to zero or even below. However, neither capitalism nor finance theory are prepared to work effectively under negative rates. How can future cash flows be valued more than present ones? In that environment, the normal order of things breaks down: highly indebted companies turn into zombies, the creative destruction of capitalism is not allowed to work, herds of unicorns appear, and investment discipline disappears. Stock markets boom. Inequality skyrockets. And since the lowest income population bears the worst consequences in a tough crisis, peaceful coexistence in urban centers is at risk because a substantial percentage of households have no savings and no longer can secure enough money to eat. If it weren’t for food banks and food giveaways, many people would be hungry.

Given the current valuations achieved by stock markets and the fact that investors are totally overlooking fundamentals, we will either experience several years ahead of very low returns or may want to continue stretching multipliers to the moon till the bubble bursts. Savvy investors have taken advantage of this amazing bull rally to earn outstanding returns, but there are many red lights and technical indicators showing that the 'buy till you drop' mania should soon fade away and lead to a correction. As pundits have acknowledged, many investors have unrealistic expectations on what monetary authorities can do. It's probably not their fault, since they have been accostumed to constant interventions with a strong drive and new tricks every time the bullish rally happened to falter during the past 13 years. On the other hand, growth in passive investing, which is not price sensitive, has fostered significant concentration of value in the companies that compose the main equity indexes. Surprisingly, in this environment investors do not pay much attention to market risks, but when something unexpected happens, the market corrects very fast as we saw with the worst collapse of equity indexes in history after the spread of Covid-19 worldwide.

Even though stimulus from the Federal Reserve isn't going away anytime soon (it will keep rates at zero for years and is likely to continue pumping out trillions of dollars into the economy through various lending programs and its merger with the US Treasury), credibility of central banks may be starting to falter. There are no magic solutions for the economic and financial conundrum the world is faced with, and printing money is certainly not one of them. Consequently, equity investors will be challenged because stock markets currently discount a perfect scenario that is totally unlikely to happen. Keep that in mind when making decisions on your hard earned savings.

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Carles Iborra has worked more than 15 years in the wealth management business and he is now launching his own investment research firm. Previously he worked for The Boston Consulting Group, helping large corporations to boost growth and improve profitability. He has significant experience in wealth management, financial markets, and strategic management.