Blain’s Morning Porridge – 1st December 2022: Did the Fed just make a long term mistake? Is inflation a bad or good thing?
“Don’t stop thinking about tomorrow. Don’t stop, it’ll soon be here. It’ll be better than before. Yesterday’s gone.”
This Morning: Jerome Powell signalled a slow-down in interest rate hikes – and markets loved it. But did he just make a long-term mistake by not decisively signalling the end of the era of monetary and market distortion? There are lessons to be learnt, not least being the role of inflation in a buoyant economy.
But first: I won’t be the only boomer this morning thanking Christine McVie for the soundtrack of our youth – growing up to Fleetwood Mac was joyous. Rumours provided the ambiance to my first kiss. I won’t be alone being ear-wormed by Don’t Stop, Tell me Lies, You make loving fun, Songbird and a host of other great songs this morning. Thanks!
Back in the fantasy we call markets….
Fed Head Jerome Powell might just have made an unavoidable, but massive long-term mistake last night – for all the right immediate reasons.
The job of a central banker is never easy – walking a razor thin slack wire spanning disaster on any stumble or misspeak. His comments were fundamentally dovish and market supportive, confirming the Fed will er towards a slower path on interest rates, spiced with comments about “moderating” the pace of rate hikes, and “sufficiently” restrictive levels to avoid crashing the economy and all the commercial and social costs that would create. The market loved it. Of course it did.
Powell is an excellent central banker. He is engaged in “satisficing” – doing just enough to hope for the right outcome: correcting inflation without triggering a severe recession – a laudable goal, but confirming the role of central banks as compliant enablers rather than brake-men on the roller-coaster ride markets have become.
Why do I think easing rate hikes could be a long-term mistake? Because maybe we need some pain now to avoid greater pain tomorrow…
Markets remain fundamentally flawed by the last decade of monetary mistakes, leaving the global economy fundamentally distorted as a consequence! 14 years (Nov 2008) of aggressive monetary experimentation, overly low interest rates, ballooning global debt, quantitative easing, and the multiple distortions of macro and micro economic behaviours these caused, have not yet been worked out the system. The consequences are still being worked through in terms of investment and asset prices – and will continue to be until we re-establish market pricing free of distortion.
Back in 2008 the Fed started QE in the hope buying back mortgage bonds would a) stop markets crashing and bringing down the Western economies with them, b) avoid a deeper crash in the US housing market, c) stimulate new mortgage lending. It led to a buy-back binge of government debt around the globe in the expectation it would d) avoid the Global Financial Crisis of 2008 deepening and e) trigger growth by pumping money into the economy.
E never happened. Low interest rates did not stimulate growth, but changed behaviours in investment and fuelled speculation. We are now understanding the consequences of fiddling with rates. Yet, the consequences continue – and remain unaddressed.
We can either address these problems decisively, or leave them embedded in the economy in the hope they don’t cause further crisis – effectively living with economic cancer – and hope for a long-term easier cure. Effectively Powell signalled last night that we’re going to hope the imbalances of the last 15 years solve themselves if we keep rates low, hope for inflation to fall, and don’t rock the boat…
Hope is never a good strategy.
Powell was surely encouraged by recent signals of lower inflation in the US and, yesterday, in Europe. These point to the inflation threat moderating – but that’s missing the point. Inflation is an economic disease – it has profound effects in terms of savers, the degree to which high debt levels affect the economy, and triggering social unrest as wage demands soar, (especially when the demand for labour is so high), but it’s also a very effective economic stimulus.
Received wisdom is high inflation demands countering with punishing higher real interest rates to crush demand. Investors are left with either negative real returns, or to go and seek higher real returns by taking more risk.
A massive issue revealed through the 2010s was that 2% inflation targets (which were suspiciously too easy to achieve due to China exporting global deflation) were insufficient to trigger investment into higher return real economy investments, but directed investment into increasingly speculatively fuelled financial assets – hence the global stock rally despite pitifully low real growth and minimal productivity growth (because no one was investing in real assets: plant, machinery, jobs, etc.).The global economy was financialised by low real interest rates – borrowing money to buy financial assets on the basis they would yield more than risking it in the real economy.
It reached its ultimate madness in the speculative frenzy around disruptive tech stocks, hero-worship of tech-shysters, a car company worth multiple times other better auto makers, the myths around corypto-currencies and NFTs and a stock market that still assumes the only way is up. The biggest issue, and perhaps the least understood, is global debt: just how ultra-low interest rates have ballooned borrowing across governments, commerce and individuals. Very few of us are not leveraged up to the eyeballs… meaning higher rates will hurt. A lot.
Now there is an increasing realisation inflation may actually be a critical component of growth. It becomes an incentive to make real returns through real investments as opposed to stocks and bonds. (Think about it for a second – when everyone is borrowing more and more money, and using it all to buy shares and the debt of other companies, what is actually being produced and sold in that economy? Such an economy is definitionally inflationary as the only thing being produced is more debt!)
When inflation is low, investors are prepared to buy financial assets on the basis they are low risk in low rate environments, and borrow money to invest in the markets. When inflation is high, then financial assets become more risky (because they need to generate higher real returns.) Therefore, perversely, investing in the real economy to make real inflation beating returns becomes more attractive.
Maybe we neglected the signals of the 20-teens: economies with ultra-low inflation or deflation stagnated, like Japan or Europe. Deflation slows growth. A little inflation is like a sugar cube – a burst of energy, but too much is dangerous.. And persistent high inflation, and the associated wage spiral it inevitably creates, is great for debt… inflating it away. If house prices inflate by 6% per annum and my debt is 50% of the value of my house, then my debt will fall to around 30% of its value in 5 years time. My worry will be: will my income keep up with inflation?
Understanding exactly what’s going on is the critical rule across all investments: understand what you are buying. That’s particularly true of inflation and rates. At present, the market just goes with it, fixated on the current big theme of due diligence. I disagree. It’s the lack of common sense that dominates markets.
I love the story this morning that Singapore’s Temasek is “reviewing” its $275mm loss om FTX. That’s nearly 1% of its AUM (assets under management). The fund is defending its 8-month due diligence process on its investment, but it and a host of others including Canadian pension funds, Sequoia, Softbank and others were all taken it by an improbable-sounding, arrogant, shorts-wearing, dope-smoking slob who kept playing computer games through his pitches. Please explain what drove the investment decision?
I suspect all these institutional FTX losers were suffering institutional FOMO, a desperate desire to hitch on to what might by a credible emergence of new stuff they vaguely hoped they understood – the emergence of crypto infrastructure, and to look smart… Epic failures of common sense all round!
The current meltdown in Corypto-markets is a good example of mass stupidity and understanding what it is and what it was not. Not understanding has been my fundamental problem with Corypto-currencies. I actually got the concept, broadly understood the rules and how blockchains work, but could not see any probable utility in them which was legal, and therefore could not understand how to monetise them except through pure speculation on what they might be worth – which turned out to be what the next idiot would pay – or by outright knavery. Guess what – that was exactly what’s happened.
I am not immune to stupidity. Three times I have invested in various airship projects. I have lost my money three times. I like airships. Who doesn’t? But liking and making money out of anything are very different things.
That’s all micro stuff. The Macro matters.
Anyone entering the investment world today needs to understand exactly what the biggest issue facing markets today is – broadly that’s still the consequences of the ongoing monetary distortion and expectations central banks are there to prevent market dysfunction – which is why I worry about the Fed addressing the current inflationary market in such a conventional way: “we think inflation is moderating, so we will hold back on rates… and by doing so give markets a massive buy signal”.
That makes me worry. They are probably right on inflation, but the key is markets. Encouraging markets is not the same as encouraging growth. That link was broken by monetary experimentation from 2008. Central banks should be thinking about how to redirect financial asset flows into the real economic growth – and that maybe requires a very different market punishing regime, remining investors is not about the price of a stock, but what that stock does to create real incomes and real wealth across the economy!
Five Things To Read This Morning
Out of time, and back to the day job…
Strategist – Shard Capital