The London Brief - April 23rd, 2022

The London Brief

April 23rd, 2022

Given the hawkish commentary from Jerome Powell that a 50 basis point rate hike is coming and the subsequent decline in markets, it seems like a good time for a short brief about inflation and likely percentage impact on markets. The Economist’s survey on central banks and the Hoover Institution’s GoodFellows, “Soft Landing: Larry Summers on the Economy” were useful sources of information. I also have some thoughts on the dollar after listening to a Ray Dalio Youtube video promoting his book about the New World Order.

Rates and Stock Market Impact

According to the Economist, central banks grew their assets by $10 trillion during the COVID period. The Bank of Japan owns 44% of JGBs, the ECB owns 40% of Dutch, Finnish and German bonds, the Bank of England owns 30% of gilts and the Federal Reserve owns 40% of U.S. Treasuries. Because quantitative easing swaps long term bonds with shorter duration central bank reserves, the duration of government bonds has been artificially shortened. For instance, England has four years duration down from eleven years.

In February 2021, when prices were still quiet, Summers warned that Biden’s $1.9 trillion COVID relief bill might “set off inflationary pressures of a kind we have not seen in a generation.” The Fed disagreed (along with 28 or so ‘Fed watchers’ who are paid by the investment community for their views). Now Summers thinks the market’s view of rates topping out at 3% is too low. While he doesn’t give a number for where the Fed will ultimately have to go to get inflation under control, he doesn’t think the real rate will be like the 1980s where the nominal rate was 9% and the real rate was 5%. During that time, the Fed lacked credibility and there were deep structural forces that created the need for an “anti-inflation crusade”. He agrees with the market that real rates are likely to be much lower than before, but that the Fed will end up going north of 3%. The removal of tariffs may also be helpful; according to the Petersen Institute, they believe the elimination of tariffs would decrease CPI by 1.5%.

One point of note is that never has inflation averaged over 4% and unemployment under 4% and there has not been a recession in the following two years. Even Powell says that a soft landing is hard to pull off. The “immaculate disinflation” crew at the Fed’s rate-setting committee says that inflation is expected to come down to 2.3% in 2024 with short-term rates hitting only 2.8%. This means barely positive real rates will fizzle out inflation. Larry Summers says this is improbable. If the economy slows in 2023 but inflation is still above the 2%, most Fed watchers believe the Fed will choose credibility and continue to hike until its credibility is unquestioned. Otherwise, when inflation flares again, the Fed will have to go much further to reinstate its credibility. I agree with these views.

In terms of the impact on stocks, generally recessions mean stocks fall. With the S&P registering only a 7% negative move year to date, an argument can be made that the market is too sanguine. I looked at data going back to 1973 and I think the mega bears point out that the stock market has generally traded around 13x-15 earnings. However, if you look at the periods of low multiples, they were usually accompanied by some bank having problems whether it was the Latin American crisis of the 1980s and the European bank crisis of 2011-2012. If we look at data from 1995 onward, which is probably a fairer representation of the current world order, the median multiple has been 19.1x earnings and the average has been around 20.3x. If we exclude 2011-2012 and the European banking crisis those numbers lift to 19.3x to 20.8x. The 2001-2002 period, which was a period of rapid interest rates hikes as Greenspan attempted to take away the punch bowl saw the S&P go from a 27.1x multiple to 19.2x. However, the 2001-2002 period saw GDP growth of 1.0%-1.5% versus 3.0% currently. Given Summers views and the need for Fed credibility, I don’t think it’s unreasonable to see us visiting these types of low GDP growth figures in 2023. In this case over the next year or so we could see a further decline in the S&P of 7%-11% to the 19x-20x earnings multiple. Because I don’t see a bank crisis, I don’t think we’ll see a larger correction. Still, 7%-11% won’t seem fun and the Nasdaq, which trades at 51x earnings today may still have a lot more to fall.

The Dollar and the New World Order

Ray Dalio’s video seems to imply that the U.S. World Order may be taken over the by the China World Order. He has tracked many countries over a 500-year period using a number of ‘health indicators’. These include strong education but with a focus on character, common purpose, civility and working for something great; technology, competitiveness as productivity goes up, output, share of world trade, military power, strong income growth that finances education, R&D and infrastructure; capitalism and entrepreneurs; and financial markets including stocks, bonds and lending markets. Ultimately the strength of these indicators determines who holds the reserve currency. Based on his indicators, the U.S. is in decline (although I think you have to buy his book to see exactly where). It also seems to suggest China is on the up and may assume the reserve currency mantle. Dalio has noted in the past that China is 4.5x the American population and if the population ends up with half its GDP, then it would be twice the economy’s size. Per capita income is up 26x since he has been going to China. With U.S. inflation around 7% and rates so low, there will be a competition for currencies and alternatives. Fiat currencies have low rates, but China has been growing its reserve currency status, as it’s made it a little more attractive on rates. China is the largest trading country; has the highest percentage of world trade; and is growing as a reserve currency. The world is also awash in too much dollar debt. This makes the dollar riskier.

In contrast, Summers believes the more important element is to look at the ability to service the debt rather than the absolute number itself. When you are financing at 9%, a 60% debt to GDP may be the right level. But with markets implying 3%, there certainly isn’t an issue today. Additionally, while deficit spending is 5% of GDP, the growth of debt/GDP is only about 2% once you factor in growth. Again, this isn’t a signal of fiscal crisis. This doesn’t give the government room to misspend, but he’s sanguine about the cacophony of voices saying the U.S. balance sheet is about to collapse.

Another point he makes is that saving in RMB is not a great option as most people do not perceive it as a safe haven. In fact, as the Fed has lifted rates, China has shown a foreign capital outflow. This forced the PBOC to intervene in the FX market at 6.4098 (this didn’t work completely and RMB closed around 6.5). China has lax accounting standards where property companies like Evergrande were given clean bills of health by Chinese rating agencies before suddenly defaulting. Then when Evergrande defaulted, China mandated that Chinese retail holders were paid off, while assumedly foreign bondholders would get the shaft. Arbitrary rules against Chinese tech companies have seen a foreign exodus from its stock markets. Additionally, the Fed’s mandates are prices and unemployment. The PBOC has a much wider mandate including telling banks how much to lend. It has targeted lending to specific sectors via subsidized lending programs. This allows overextended state-owned firms not to have worsening debt problems, but it encumbers the PBOC’s balance sheet potentially. It’s loaned about $234 billion to support rural development, small and medium firms and poverty alleviation. Probably the most glaring observation is that one reason why China has strict capital controls is that many Chinese would like to take their money out of China into states that believe in rule of law. In fact, one factor that Dalio does not choose as an indicator, which perhaps he should, is adherence to the rule of law, and I think this is where the China World Order falls down.

The crypto world could potentially be an alternative, but it needs to interface with the real world. A Latin American experiment in El Salvador does not seem to be working. Additionally, it’s unlikely any substantive government will facilitate a loss of fiat power. El Salvador, for instance, is mostly a dollar-based economy. It’s unlikely China will cede its monetary power to Bitcoin.

Summers view on the dollar is that if it loses supremacy, it will be a symptom rather than a cause. He’s not complacent about the centrality of the power of the U.S., but we’re still a long way from the dollar losing its status.

Cobham, Surrey

April 24th, 2022