It's The Dollar, Stupid!
We think the markets have it fundamentally wrong. US investors are anticipating a cyclical shift towards economic expansion via new tax incentives, business de-regulation and Keynesian government spending that promise to increase output, demand and asset prices. However, there is a far more influential driver of future asset prices – a structural shift that has begun but has yet to be acknowledged by economic and political authorities, and, judging by financial asset markets, by most investors. We expect weak equity markets and a strong treasury market beginning in 2017.
It’s the Dollar, Stupid.
The financial model used by advanced economies since 1971 is quickly losing its ability to support economic growth and rising asset prices.1 Western economic policy, which had previously relied heavily on credit creation from 1971 to 2008, was replaced in 2009 by monetary policy that relied heavily on base money creation through asset purchases. The structural shift in central bank focus from credit to monetary creation marked a paradigm shift in the decades-long finance-based economic model – from the leveraging phase to the de-leveraging phase.
The Fed shifted to relying on a communications policy in 2013, which focused on renewing the broad perception that by “normalizing” US interest rates the economy would again begin to react to credit incentives it could manage. It also emphasized the need for fiscal stimulus, which would ostensibly create demand and stimulate production growth. Last month the Fed hiked overnight rates for the second time in two years and the markets expect it to hike rate three times in 2017.
Fed rate hikes tighten credit conditions in the US and, given the continued execution of QE by other major global central banks, increase the exchange value of the dollar. A stronger dollar theoretically increases other economies’ exports into the US, provided that US consumers and businesses are able to maintain the same level of demand for foreign goods and services. This is an open question.
Donald Trump’s election raised hope that new tax incentives, business de-regulation and Keynesian government spending will create sufficient demand. The dollar and US financial markets have reacted in sympathy with stock prices rising and bond prices falling…despite the Fed’s renewed credit tightening. A strong dollar would tend to attract global wealth to the US, wealth that theoretically could find its way into US risk assets including US equities. Thus, US equity strength since the election reflects a strong dollar, which is based on the combination of Fed rate hikes and renewed hope for US government stimulus.
This is not the first time the Fed has had to actively increase the exchange value of the dollar. Paul Volcker’s Fed had to hike overnight rates to 20% in 1980-81 so the dollar would be reaffirmed as a store of global value for US trading partners, including OPEC. We believe the Fed is doing the same today, in spite of its de-stimulative impact, because it wants to attract global capital to US banks and asset markets. Doing so would ensure USD hegemony, which would be necessary if/when global leverage leads to hyperinflation and multilateral trade and currency wars. Once substantial wealth is held in dollars and dollar-denominated assets, the US political dimension and the Fed, through the BIS and IMF, would be able to control the terms of a global monetary reset, which in turn would de-leverage balance sheets across currencies and economies in a controlled manner; in effect, a pre-packaged bankruptcy in real terms.
Nothing has changed structurally (or cyclically) since the US election. Global central banks are de-leveraging their banks through QE, with the exception of the Fed, which already did. Commercial bank liquidity and solvency is a precondition for a global monetary reset. The table is being set for more, not less, central bank intervention in the form of monetary inflation, and more intervention from the political dimension, which would choose which non-bank creditors (and debtors) will experience credit deflation.
The markets have it wrong
We believe fiscal measures like those being speculated about now in the US, even if successfully executed, would fail to generate meaningful new production and demand within the US and global economies. Financial markets are vulnerable to a reversal of their recent trends.
We cannot place specific figures or exact times when benchmark equity and fixed-income indexes will reverse current trends; however, we are increasingly confident that US and global economies have begun to experience necessary structural changes that directly impact: 1) incentives to produce and consume, 2) the fundamental manner in which the political dimension approaches monetary and fiscal policies, and 3) the way in which investors think about assets, liabilities, economics and capital markets.
The secular US fixed income bull market, which began in 1981 when the Fed embarked on what would become a forty five-year credit easing regime that benefitted, treasury, mortgage, corporate, municipal, small enterprise and consumer borrowers, and would eventually spread globally to other advanced and emerging bond markets; which allowed the US government to deficit-spend (eventually without the expectation of recourse) its way to unrivaled military might that defeated and then contained potential hostile threats abroad; which provided primary funding for bank and shadow bank lending that gave the US dollar and financial markets status as the ultimate sanctuary of global wealth; which provided a platform on which global bank and non-bank counterparties could swap contingent liabilities amounting to many times the size of underlying cash markets without fear of regulatory interference; and which provided speculators across other asset markets (including real estate) to continually sponsor unsustainable valuations, no longer produces capital or serves an economic purpose, and is almost over.
The secular US equity bull market, which not coincidentally also began in 1981 and served as the principal funding mechanism for great advances in digital technologies, communications, finance, logistics, health care, energy, retail, and other industries; which helped raise and maintain competitive trade advantages for the US and its allies; which expanded capital expenditures, productive output and consumer demand; which helped collateralize expansive public and private credit issuance and debt assumption, in turn creating a positive feedback loop that further increased nominal production, consumption and asset prices, and which created nominal wealth for US and non-US asset holders, is also in its evanescence.
Stock and bond markets in advanced, financially-oriented economies, have devolved more into political imperatives necessary to maintain social services and the perception of wealth, rather than serving as the traditional means to build and price wealth and capital. They no longer serve societies or global trade.
In over-leveraged economies, stock and bond markets become co-dependent. To sustain market prices, debt and equity require nominal output growth. To sustain market values, they require real output growth. The only way to increase nominal output growth and raise nominal equity prices in a highly leveraged economy with leveraged currency is to raise the quantity of credit, which must eventually reduce real output and asset values. The question before us is whether “eventually” is occurring now.
The primary reason we think stocks are peaking is scale. Aggregate market caps, valuations, revenues and earnings of public companies cannot be sustained by the level of real production in the underlying US and global economy. We think bonds are on the eve of reconciliation for the same basic reason: the scale of systemic leverage has already begun to reduce incentives to expand credit for capital formation, which, in turn, promotes debt deflation.
We expect debt deflation coincident with central bank monetary inflation, which would offset the deflation…on paper (like feet in the oven, head in the freezer producing a reasonable average). Before this occurs, we expect a financial or economic event that focuses public attention on the leverage problem.
The incentive to invest in the stock market is to build wealth, which is accomplished by generating positive real (inflation-adjusted) returns. This presents a problem looking forward. Many of the companies the market rewards most in terms of market cap drive goods and service prices lower by innovating and connecting buyers and sellers (e.g. Amazon, Facebook).
Against this backdrop, the Fed’s economic mandate from Congress is to work towards stable prices and full employment. To do so, it has a specific annual inflation target of 2%. If the Fed is successful in this target, then it will reduce the purchasing power of US dollars by more than 64% over the next 25 years:
As the table above makes clear, through its specific economic mandates and acceptance of the Fed’s 2% inflation target, the US Congress effectively promotes a decline in the value of ongoing savings earned and amassed by American labor. For investors, the policy also acts as a hurdle over which investor returns must rise to create positive real returns (i.e., wealth).
On one hand, commercial competition is naturally driving prices lower, making goods and services more economical for producers and consumers, and equity markets are inflating the asset values of businesses that deflate prices. On the other hand, the Fed is trying to drive goods, services and asset prices higher, which would drive the purchasing power value of savings lower.
Since 1998, asset prices (portrayed by the Wilshire 5000 on the graph above) have been supported in great part by Fed liquidity and debt-driven buybacks while US economic activity, (portrayed by monetary velocity), has been in secular decline. It is tough to sustain 2% inflation for very long through financial maneuverings when domestic economic activity continues to weaken. Any further inflation the Fed might help create (as it hikes rates!?) will not be demand driven, but rather the result of more financial leverage.
It can’t persist much longer
The current excitement among US equity and credit investors over the promise of a best-case stimulative mix of deregulation, tax cuts, and Keynesian government spending has created a very optimistic market tone. The Fed has further intimated December’s rate hike was the start of a new regime of interest rate normalization. Together, these dynamics have caused treasury yields across the curve to rise. Rising treasury yields in past business cycles have further signaled economic recovery, which has seemed to confirm to most investors that economic and equity market optimism are warranted. We disagree.
Any fear of demand-driven goods and service inflation is un-warranted given 1) the already-leveraged nature of public and private sector balance sheets, 2) the need to perpetuate the relative strength of the dollar, and 3) the expectation of further Fed rate hikes. Even a successful multi-trillion dollar US government spending program that provides a few jobs and necessary American capital improvements could not provide sufficient consumer demand to overcome US and global balance sheet leverage and the attendant necessity to maintain US dollar strength to sustain the current monetary system.
The graph below plots the secular decline in long-duration treasuries against the year-over-year rate of US goods and service inflation. (The gap in 30-year treasuries is due to the elimination of Long Bond issuance from August 2001 to February 2006.) We believe the rise at the extreme right of the graph representing their most recent trends is not indicative of the next big move for long-duration treasuries.
Given the need to maintain the US dollar as the fulcrum of the US monetary system, the most influential input for future treasury yields has become global output, which is in secular decline. This trend is logical, established and seems to be accelerating. It is logical because the secular post-War decline in global output growth was only interrupted by the emergence over the least twenty years of large new economies like the BRICs. The continuation of that secular downward trend would make sense once those emerging economies are established. The graphs below confirm that balance sheet leverage within emerging economies have surpassed those in developed economies and that, not surprisingly, global output growth is truly struggling. As a result, we expect one last spasm that takes long-term treasury yields to new lows.
Relevant Economics for Equity Investors
Investors will soon be forced to better understand the macro world around them. The perception of the deflation/inflation metric should determine near term and secular debt and equity market directions.
Prices are determined by supply/demand equilibriums – where the supply of goods, services, labor and assets meets the demand for each. This is theoretically true in classical economics. However, in the current flexible exchange rate monetary system administered by banking systems and the political dimension (i.e., a fiat regime), both supply and demand are determined by the prevailing quantity of credit available to producers of supply and the quantity of credit available to consumers who create demand. (Credit is simply a claim on base money, which is created by central banks.)
The most insipid structural problem threatening economic vitality and equity market returns is public and private sector leverage. High and rising debt-to-GDP ratios, which threaten economic liquidity, and high and rising debt-to-base money ratios, which threaten balance sheet solvency, must eventually be reconciled. Aging demographics within the world’s largest economies is accelerating the timing of the necessary reconciliation, which must occur through debt deflation, monetary inflation, or both.
Thus, investors seeking to create wealth by investing in broad equity markets face a fundamental structural problem caused by the irreconcilability of 1) naturally occurring commercial deflation, 2) economies and political systems that rely on inflation, and 3) the crowding out of consumption and investment by necessary debt service.
Consider the 2% inflation target established by the Fed and accepted by most political economists. See table, page 4.) The target ostensibly limits the annual loss of purchasing power to 2%, and therefore it is generally thought that having such a target is in the best interest of American workers. Such an argument is inaccurate, naïve and disingenuous. As the graph on the previous page shows, the Fed was unable to cap goods and service inflation when energy prices spiked from limited supply in the 1970s, and unable to cap inflation at 2% throughout the credit-led secular bull market in corporate and property equity in the 1980s, 1990s and 2000s.
Goods and service inflation more recently has struggled to rise to 1.7%, where it stands today. A 2% inflation target has shifted from a target to preserve the purchasing power of the dollar to a target to ruin it. Nowhere in the public discussion has this been mentioned. As discussed above, we think the Fed’s “fear of inflation”, which is ostensibly driving the new rate hike regime, is a necessary public narrative that will let the Fed pursue its true objective – a stronger dollar and deflation amid a contracting real economy.
Even if US domestic economic activity were to somehow reverse its secular downtrend enough to warrant current equity valuations, it is difficult to conceive how much more asset prices could rise – especially in real terms. Simple math, anachronistic economic policies and poor demographics pose insurmountable barriers for creating wealth through public share ownership. (We further discussed the current negative implications of over-valuation and the negatively convex nature of equity markets in The Grift.)
Can the Establishment really be that wrong?
In classic economics, both employment and inflation are derived from production. Political economists, a moniker that defines the academic discipline from which the great majority of contemporary economists spring, argue that a fully-employed labor force suggests that rising labor inflation will lead to rising goods and service inflation. Thus, the Fed is trying to raise rates currently, citing the second Fed mandate – full employment – which threatens stable prices. The ultimate policy goal is to protect the US (and global) economy from shrinking.
According to logic and classic economics, there is nothing wrong with a shrinking economy. Why? Because an economy should shrink commensurate with a rise in leisure time. Seriously. An economy is theoretically supposed to serve its factors of production. The more economical it is, the more leisure time it produces for its participants. (We suspect economies are called “economies” because they were formed naturally as systems that actually economized.)
In such an economy, only theoretical today, deflation would be a good thing because it would increase the purchasing power value of savings produced from past labor. In fact, an increase in deflation (i.e., an increase in declining prices) would actually raise real (inflation-adjusted) GDP because the gain in the dollar’s purchasing power from deflation would offset the declining volume of goods and services (nominal GDP). (We suspect this fundamental economic truth is the reason Congress’s mandate to the Fed includes only stable prices and employment, and not economic growth.)
The graph below shows the decline in the American work force since 2000. It should not strike you as alarming, given 1) all the great new innovations and technologies replacing human capital and 2) the expansion of global human capital from emerging economies. Tell us again, we ask sarcastically, what “full employment” is?
Market cap-weighted indexes notwithstanding, it may be worthwhile here to ask yourself again why an increase in the majority of US equity shares is generally perceived as a given as the US economy becomes more efficient.
Why it is all about the Dollar Now?
In today’s global monetary system, currencies are tranched liabilities of: 1) commercial banks that create deposits through the lending process; 2) central banks on the hook to collateralize member commercial banks that create deposits and credit without commensurate reserves or circulated currency (base money), and; 3) treasury ministries that ask constituent factors of production to have faith that its taxing authority and, as has been demonstrated throughout history, its ability to wage war to loot enough resources outside its taxing domain to protect its currency’s purchasing power value.
As liabilities without directly-linked offsetting assets, the purchasing power value of currencies are always susceptible to dilution. Dilution comes in the form of credit issued by banks (and, potentially, non-bank lenders) that is either not collateralized by assets or collateralized by assets that themselves are liabilities (like Treasury notes). The wider the gap separating the amount of un-collateralized credit denominated in a currency from that currency’s base money (bank reserves and currency in float) – the ratio that determines monetary leverage – the greater the amount of future monetary de-leveraging will have to occur. (De-leveraging must ultimately occur so that debtors can service or repay their obligations and so producers have incentive to continue to supply goods and services in exchange for that currency.)
We expect global monetary authorities to protect the dollar as long as they can and we expect them to fail. Stocks and bonds will react violently; stocks and weak credits falling, treasuries prices rising (at first). That failure will lead to hyperinflation – not driven by demand, but rather by central bank money printing. A new global monetary understanding will then emerge.
We expect weak equities and a strong treasury market in 2017, as they begin to discount this fundamental structural shift.