Monetary policymakers are confused. After years of monetary experiments at a scale never seen before, inflation is still absent. Why?
This event has been so dramatic that the politicians are starting to overlook the danger of inflation. They are now searching for the holy grail of monetary policy, in the form of Modern Monetary Theory (MMT). This tool in the hands of politicians, after decades of not having to deal with inflation, feels like we are at the early stages of the Weimar Republic. A contemporary form of print your own budget deficit.
Graph 1 - Web search interest for "Modern Monetary Theory"
But, why does the MMT seem so plausible now?
Arguably, the prolonged low inflation environment has increased the plausibility of MMT. The absence of inflation has allowed policymakers to use the printing machines as never before. They have become so addicted to it, that new monetary theories are springing-up like mushrooms.
More important is to understand the root causes of low inflation. Although it might be an oversimplification, I've identified three main drivers for it.
i) The 2007 crisis caused deflationary pressures in assets
Before the subprime crisis, there was a huge general overvaluation in the markets, then, the collapse in asset prices left a void behind. The US and China were quick to approve stimulus packages, that led to a boom-and-bust cycle in the commodity sector. During the initial phases of the stimulus, commodities roared, but as the prices reached a bubble phase and incentivized more suppliers to get in, the market prices crashed.
Graph 2 - iShares S&P GSCI Commodity-Indexed Trust (2006 to present
(Source: Yahoo Finance)
ii) Industry accelerated the shift to Asia
The financial crisis made several companies rethink its supply-chain, and mostly, it accelerated the move, from the west to Asia, due to lower costs. That trend has contributed to the US trade deficit, but it has allowed for consumer prices to be kept low.
However, explaining the current low-inflation scenario with the lower production costs in Asia, and the deflationary pressures in financial assets, seems short. After all, there has been an economic recovery, and the asset prices, across the board, have recovered and hit new highs. There must be at least one missing component.
iii) New economy productivity spurt
For those acquainted with Alan Greenspan's tenure at the Fed, the term "new economy" should be familiar. Just before the dotcom bubble, Greenspan defended his monetary policy, from economic warning signs, by referring to the "new economy" improving productivity. Later, he was heavily criticized by having embarked on a "this time is different" narrative.
However, I dare to say that the fad, of the late 90s, has become serious 20 years later. One example is the cloud sector. By centralizing hardware and developing automation software for several routines, cloud companies are increasing productivity and savings at a fast pace. Additionally, most of the dollars, being spent on the cloud, might not even make it to the GDP figures. Instead of investing in expensive hardware, companies might just spend a fraction of that sum renting a server overseas (i.e., replacing Capex for SaaS expenses).
Another way to look at that is by looking at the current array of free apps. Ten years ago, everyone had access to free e-mail accounts. But, now, they come bundled with free apps, like free GPS, free online storage space, free video streaming services, free photo editing features, popular chat tools, free payment services, you name it.
Finally, at a production level, automation has been steadily rising. Robots are getting more precise and more autonomous. For instance, a chatbot might initiate and sort the early stages of a customer request. Amazon is using robots as auxiliary tools for employees in warehouses and sorting centers.
It is important to note that a significant part of these services won't be measured correctly by traditional statistics. And, for policymakers, that have become so data-dependent, it seems to me that incorrect data is driving their decisions, which don't seem to be working.
Updating the investment narrative for 2020 and onwards
The drag from the subprime crisis, the industrial relocation to low-cost geographies and the new economy productivity are offsetting the impact of the decade-long monetary experiment. That scenario has induced low-interest rates and has been friendly for the equity markets. However, that should be seen, in conjunction, with the current investment glut environment. Right now, cash is flowing to the bond market, bringing yields down. Corporate credit is at all-time highs, while inflation figures reinforce the idea that yields won't go up.
It all adds up to a bubble, and the thing about bubbles is that they unwind at any time. However, keep in mind that they also tend to stick around for long periods, even after some professionals have gone on TV denouncing them.
If 2017 was the year of muted volatility, 2018 and 2019 have been part of a period of increasing instability. That has been a pattern in previous bubbles. During a long period, stock prices rise slowly but steadily, with low volatility. When market participants become wary that the bull market might be overdone, every event serves as an excuse for a pullback, thus generating episodes of increasing volatility. As each pullback is followed by new highs, and the bull market proves resilient, investors start to feel confident, and a buy-the-dip mentality becomes prevalent. Asset prices might even accelerate just before heading into a Minsky moment.
Graph 3 - The S&P 500 run-up to the 2007 crisis
(Source: Yahoo Finance)
I believe that we are reaching that point. Each pullback has been followed by new highs. Investors have feared a recession for a long time. The fact that it hasn't materialized yet is providing an invincibility aura to this bull-market.
Let us make a final recap. We have one significant factor (the productivity spurt) that is not being correctly measured by the policymakers. In my opinion, that is leading to a dangerous dovish tilt, which is supporting the markets.
The consequences are straightforward. A rate cut should help the market (SPY) to have, at least, one more leg up. However, as the stock market rises, we should expect some event in the markets where the monetary policy has, likely, led to a high proportion of malinvestment. A pick-up in default rates in the high-yield corporate credit market comes to mind (HYD) (JNK). Another possibility is a full-fledged debt crisis in the US. In other words, it would be a US dollar depreciation, which would be, tremendously, inflationary. Therefore, in one case we have a credit market turmoil that will drive policymakers to ease, on the other, we have an inflationary outburst.
In any scenario, expect the valuations to dissipate in most fixed-income and equities. In that scenario, commodities with solid demand (that won't be affected by the crisis) and fixed supply will be our best friends. The first one that comes to mind is Gold (GLD).
Disclosure: I am/we are long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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