Portfolio values are down, the cost of living is up and every month when you open your statement you find yourself in a state of depression. How is this going to play out, and will things ever get better? We spend a lot of time trying to work out what is happening in the world; no-one really knows, but there are certain data sets that we look at to try and understand where we are in economic, business and market cycles.
In a very simple explanation, the relationship between economic growth, inflation and interest rates is a balancing act. As growth increases and there is a greater demand for goods and services, the demand pushes inflation up, and as that happens, the central bank will increase interest rates to make it more expensive to borrow money. As it gets more expensive to borrow money the economy slows down, demand reduces and gradually interest rates would be lowered to stimulate the economy again. As I said – that is the simple explanation. It is never that clear cut, and today we find ourselves in a situation where inflation is high, growth is slowing, and interest rates have only just started moving up. We have a war in Ukraine, a Covid lockdown in China and rising oil prices due to supply constraints not demand. We haven’t been spending on increased capacity for future demands of commodities (think oil) and now there is pressure to the upside.
In a chess game there comes a point where the losing player has limited options to move their king out of danger. Ultimately they need to force a draw, or face Checkmate. Central banks are facing dwindling economic options. One might suggest that the Bank of Japan and the European Central Bank are already been put in checkmate, and the Federal Reserve and Bank of England see their possible choices going to zero. Without going into technical detail, as a result of the long term debt cycle, economies have taken on more and more debt as a percentage of GDP and lowered their interest rates over decades to a point of zero or slightly negative rates. Checkmate in this context happens when central banks encounter inflation above their target rate, but still can’t stop printing money due to critical liquidity problems developing in their financial markets.
The saying that history doesn’t repeat itself, but it rhymes is very true in this instance. It is difficult to see how things will go back to how they were in the past. Demographics are changing, technology is developing, climate change is forcing us to look at things differently. So where to from here? Will your portfolio ever look comfortably secure again?
If we look back at the 1920’s, 1930’s and 1940’s in the United States, and compare what has happened in the 2000’s, the 2010’s and the 2020’s (so far) it paints an interesting picture.
The 1920’s and the 2000’s were both decades of excess in the US, driven by easy monetary policy. The 1920’s ended with the 1929 stock market crash and the 2000’s ended in the 2008 subprime mortgage crisis or Global Financial Crisis. In both instances, interest rates went to zero for the first time in generations.
The 1930’s and 2010’s were periods of economic stagnation, disinflation and bank recapitalisation after the respective crises. In both decades the banks were recapitalised, but the consumer for the most part were not bailed out; populism began to increase around the world as people felt great discontent about their economies.
The 1940’s was a period of “wartime finance”. The government applied massive fiscal stimulus and drove debt to GDP to a ratio of about 130%. Broad money supply expanded, and price inflation followed, albeit it with a lag. The gap between the short term interest rate and the official inflation rate was around 6%. Does any of this sound familiar? In the 2020’s (so far) we have had a pandemic and lockdown and the US government amongst others, has applied massive fiscal stimulus – inflation is upon us and the gap between the short term interest rates and official inflation rate is close to 6%.
There are a number of differences between the 1940’s and the 2020’s in the United States. In the 1940’s the US was a rising super power, was taking an increasing share in global GDP and ran a structural trade surplus. The opposite is true in the 2020’s. The second difference is productivity – in the 1940’s stimulus was directed to industrial manufacturing, hiring soldiers, educating returning soldiers and placing them in the post war economy. Although it was inflationary, it came with a lot of productivity growth. In 2020 and 2021 the stimulus was keeping businesses solvent, but productivity was reduced by the lockdowns. Many people were helped by the stimulus checks, but in many cases it went to the bottom line of wealthy business owners with no increase in production capacity. The third difference was the demographic profile of the US. The younger population responded to the austerity that was ushered in as normal monetary and fiscal policy returned and they started to enjoy the benefits of the productivity boom. Now the demographic is heavily skewed to the older generations where governments are obliged to support senior citizens in their retirement and healthcare. It seems doubtful that this government will be able to practice fiscal austerity under the circumstances.
The Federal Reserve has a dual mandate (as do most central banks in one form or another) to maximise growth (employment) while maintaining price stability. Their quandary at the moment is that inflation is at four decade highs, and unemployment is at five decade lows! This is a balancing act that is very difficult to hold steady. By raising interest rates to curb inflation, the chances are that the high interest rates will draw the US (and global) economy into a recession. Technically a recession is declared retrospectively as two consecutive quarters of negative economic growth. The US experienced negative real GDP growth in the first quarter of this year, and indications are that there won’t be any real growth in the second quarter – so we are teetering on the edge of recession! A harsher definition would be a year on year slowdown in growth, we’re not there yet.
So can the Federal Reserve continue to raise interest rates to curb inflation? With their mandate to maintain price stability it is difficult to see that they will hike rates to eight or nine percent to meet the inflation numbers – it will cripple business and individuals. The 10 year bond yield in the US has already risen to over 3% in anticipation of a higher fed fund rate, and has dropped below the 3% mark again. This is a very complicated situation and it is difficult to see how it will play out. Towards the end of the 1940’s and also in Japan in the 1990’s the central banks manipulated the yield curve and capped long dated interest rates. This resulted in savers losing money as inflation eroded their long term wealth, but the debt became more manageable and eventually they were able to normalise the fixed interest markets.
At the end of the day, we still don’t know how markets will be impacted. I hope this gives you a sense that we do in fact look at the data and try to formulate a plan which is forward looking. Without committing to a time frame, I am tending towards a retracement in interest rates as fears of recession increase. I think the Federal Reserve may try to stimulate the economy again and if that plays out, then I think growth stocks and the equity market in general will do quite well. The disclaimer is that we may still have some months of pain ahead of us – and it may be 2023 before we see this scenario play out. It is also my base case at the moment. Data points could change the view dramatically and quickly. The end of the war in Ukraine would have a positive influence on energy and thus economic growth. An escalation of the war would be negative. So please don’t hold me to this view – it is a dynamic world. But hold onto your hats, it is going to be volatile, and in the words of John Lennon: It will all be alright in the end, and if it isn’t alright, it’s not the end.
Inflation and Debt! Checkmate for the Fed?
Portfolio values are down, the cost of living is up and every month when you open your statement you find yourself in a state of depression. How is this going to play out, and will things ever get better? We spend a lot of time trying to work out what is happening in the world; no-one really knows, but there are certain data sets that we look at to try and understand where we are in economic, business and market cycles.
In a very simple explanation, the relationship between economic growth, inflation and interest rates is a balancing act. As growth increases and there is a greater demand for goods and services, the demand pushes inflation up, and as that happens, the central bank will increase interest rates to make it more expensive to borrow money. As it gets more expensive to borrow money the economy slows down, demand reduces and gradually interest rates would be lowered to stimulate the economy again. As I said – that is the simple explanation. It is never that clear cut, and today we find ourselves in a situation where inflation is high, growth is slowing, and interest rates have only just started moving up. We have a war in Ukraine, a Covid lockdown in China and rising oil prices due to supply constraints not demand. We haven’t been spending on increased capacity for future demands of commodities (think oil) and now there is pressure to the upside.
In a chess game there comes a point where the losing player has limited options to move their king out of danger. Ultimately they need to force a draw, or face Checkmate. Central banks are facing dwindling economic options. One might suggest that the Bank of Japan and the European Central Bank are already been put in checkmate, and the Federal Reserve and Bank of England see their possible choices going to zero. Without going into technical detail, as a result of the long term debt cycle, economies have taken on more and more debt as a percentage of GDP and lowered their interest rates over decades to a point of zero or slightly negative rates. Checkmate in this context happens when central banks encounter inflation above their target rate, but still can’t stop printing money due to critical liquidity problems developing in their financial markets.
The saying that history doesn’t repeat itself, but it rhymes is very true in this instance. It is difficult to see how things will go back to how they were in the past. Demographics are changing, technology is developing, climate change is forcing us to look at things differently. So where to from here? Will your portfolio ever look comfortably secure again?
If we look back at the 1920’s, 1930’s and 1940’s in the United States, and compare what has happened in the 2000’s, the 2010’s and the 2020’s (so far) it paints an interesting picture.
The 1920’s and the 2000’s were both decades of excess in the US, driven by easy monetary policy. The 1920’s ended with the 1929 stock market crash and the 2000’s ended in the 2008 subprime mortgage crisis or Global Financial Crisis. In both instances, interest rates went to zero for the first time in generations.
The 1930’s and 2010’s were periods of economic stagnation, disinflation and bank recapitalisation after the respective crises. In both decades the banks were recapitalised, but the consumer for the most part were not bailed out; populism began to increase around the world as people felt great discontent about their economies.
The 1940’s was a period of “wartime finance”. The government applied massive fiscal stimulus and drove debt to GDP to a ratio of about 130%. Broad money supply expanded, and price inflation followed, albeit it with a lag. The gap between the short term interest rate and the official inflation rate was around 6%. Does any of this sound familiar? In the 2020’s (so far) we have had a pandemic and lockdown and the US government amongst others, has applied massive fiscal stimulus – inflation is upon us and the gap between the short term interest rates and official inflation rate is close to 6%.
There are a number of differences between the 1940’s and the 2020’s in the United States. In the 1940’s the US was a rising super power, was taking an increasing share in global GDP and ran a structural trade surplus. The opposite is true in the 2020’s. The second difference is productivity – in the 1940’s stimulus was directed to industrial manufacturing, hiring soldiers, educating returning soldiers and placing them in the post war economy. Although it was inflationary, it came with a lot of productivity growth. In 2020 and 2021 the stimulus was keeping businesses solvent, but productivity was reduced by the lockdowns. Many people were helped by the stimulus checks, but in many cases it went to the bottom line of wealthy business owners with no increase in production capacity. The third difference was the demographic profile of the US. The younger population responded to the austerity that was ushered in as normal monetary and fiscal policy returned and they started to enjoy the benefits of the productivity boom. Now the demographic is heavily skewed to the older generations where governments are obliged to support senior citizens in their retirement and healthcare. It seems doubtful that this government will be able to practice fiscal austerity under the circumstances.
The Federal Reserve has a dual mandate (as do most central banks in one form or another) to maximise growth (employment) while maintaining price stability. Their quandary at the moment is that inflation is at four decade highs, and unemployment is at five decade lows! This is a balancing act that is very difficult to hold steady. By raising interest rates to curb inflation, the chances are that the high interest rates will draw the US (and global) economy into a recession. Technically a recession is declared retrospectively as two consecutive quarters of negative economic growth. The US experienced negative real GDP growth in the first quarter of this year, and indications are that there won’t be any real growth in the second quarter – so we are teetering on the edge of recession! A harsher definition would be a year on year slowdown in growth, we’re not there yet.
So can the Federal Reserve continue to raise interest rates to curb inflation? With their mandate to maintain price stability it is difficult to see that they will hike rates to eight or nine percent to meet the inflation numbers – it will cripple business and individuals. The 10 year bond yield in the US has already risen to over 3% in anticipation of a higher fed fund rate, and has dropped below the 3% mark again. This is a very complicated situation and it is difficult to see how it will play out. Towards the end of the 1940’s and also in Japan in the 1990’s the central banks manipulated the yield curve and capped long dated interest rates. This resulted in savers losing money as inflation eroded their long term wealth, but the debt became more manageable and eventually they were able to normalise the fixed interest markets.
At the end of the day, we still don’t know how markets will be impacted. I hope this gives you a sense that we do in fact look at the data and try to formulate a plan which is forward looking. Without committing to a time frame, I am tending towards a retracement in interest rates as fears of recession increase. I think the Federal Reserve may try to stimulate the economy again and if that plays out, then I think growth stocks and the equity market in general will do quite well. The disclaimer is that we may still have some months of pain ahead of us – and it may be 2023 before we see this scenario play out. It is also my base case at the moment. Data points could change the view dramatically and quickly. The end of the war in Ukraine would have a positive influence on energy and thus economic growth. An escalation of the war would be negative. So please don’t hold me to this view – it is a dynamic world. But hold onto your hats, it is going to be volatile, and in the words of John Lennon: It will all be alright in the end, and if it isn’t alright, it’s not the end.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.