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Investment Committee: End of the party

22 November 2020

Central bank policy in recent years has not only been creating a culture of dependency, they have broken the markets, argues Mike Hollings, Partner and CIO at LeifBridge, part of Shard Capital.

This article was first published in the November 2020 issue of Professional Paraplanner.

The very fabric of nature and the natural world we live in, at the macro level as well as the quantum level, is formed of and consists of opposites. Matter and antimatter, negative charge and positive charge, action and reaction, darkness and light, hot and cold, summer and winter. This is because the universe, like all of its content, is governed by balance. This is the Law of Polarity or perhaps more accurately the Law of Duality: nothing exists in nature without its opposite.

Why is this relevant? Because things work in balance for a reason. Over billions of years this is how the universe has evolved. Try and tamper with, or worse, control this natural order and the ultimate result is assuredly failure.

Why is this relevant to markets / economies? Because in an economic sense, over the last 25 years, that is exactly what central bankers and economists have tried to do. They have tried to tamper with and control normal (healthy) economic and markets cycles.

The simple fact is that most economists suffer from “physics envy”. They resent the fact that whilst scientists can, with great precision, calculate the trajectory and speed of planets and comets, economists are unable to precisely model the trajectory of economies. But given the hubris many possess this does not stop them from trying, with predictably dire consequences.

Over the last thirty years technological advances combined with globalisation have provided some very strong deflationary tailwinds for the global economy. Central bankers (actively encouraged by their political masters) sought to use these beneficial tailwinds to try and abolish business and economic cycles. They believed they had the intellect to effectively ensure that recessions were permanently avoided (the so called boom and bust cycle) and they used their own (conflicted) economic models to “prove” how that could be done.

The result was that every time market forces tried to clear excesses from the system (which would, yes, have involved a period of sub-par growth and maybe even a brief recession), they intervened actively (by cutting interest rates/printing money) to ensure this did not happen. So, what would have been a healthy re-setting of economic growth was indefinitely postponed. They ignored the fact that opposites exist for clear and beneficial reasons. Recessions actually strengthen the long-term growth of an economy by getting rid of excesses and building a platform for stronger long-term sustainable productivity.

What central bankers effectively thought would be a good idea was the economic equivalent of abolishing autumn and winter and running instead with only spring and summer. In what world did they think that would be a good idea? The answer obviously is in the purely theoretical and model driven world they seem to inhabit.

Balance

A critical component in any healthy economy is a stable balance between savers and consumers (another example of the beneficial effect of opposites).  If you favour one group over the other, you destabilise a key element of any capitalist system with very detrimental long-term social and economic consequences. The catastrophic effect of historically low interest rates on global pension systems is only just beginning to be felt and the social upheaval which continued underfunding of these pension systems will wreak on societies, in the years ahead, should not be underestimated.

“By ignoring asset price inflation because of a myopic focus on consumer price inflation, Central Banks have failed to notice a very key and ultimately fatal distinction between these two inflationary forces”

The irony is that whilst trying to contain the disinflationary forces which have been building over the last 20 years, all that Central Banks have achieved by cutting interest rates and perpetually bailing out markets has been to ultimately add to the very deflationary forces they were/are seeking to control. This is because debt is ultimately deflationary. Used as it has been for the last 20 years to finance consumption, (rather than investment), debt merely brings forward future consumption with no corresponding and balancing growth on the other side of the ledger with which to service and ultimately pay down the debt.

There is no realistic way the quantum of debt now burdening the global economy ever gets paid back in a conventional manner and all the while it just adds to deflationary pressures which Central Banks feel compelled to fight…which they will.

Low rates have also forced investors increasingly down the risk curve boosting a broad range of asset prices which, over time, increasingly detach from any objective real-world valuations.

Inflationary forces

By ignoring asset price inflation because of a myopic focus on consumer price inflation Central Banks have failed to notice a very key and ultimately fatal distinction between these two inflationary forces.

Asset Price Inflation is easily the more pernicious and dangerous type of inflation because, in the final analysis, it breeds dependency and, as Central Banks are belatedly finding out, once you create that emotional and financial dependency it is extremely hard to roll-back because consumer and investor psychology, and therefore spending and investment patterns, become increasingly reliant on continually increasing asset prices. The upshot from this is that a collective will therefore develop within central banks to ensure they do whatever it takes to preserve this state of affairs.

Consumer Price Inflation on the other hand generates the polar opposite effect, because higher consumer prices rein in consumption and stifle investment and lead inevitably to a greater portion of the population becoming poorer in real terms, with the political, economic and social consequences this entails. In this event a collective will develop within central banks to ensure that they do whatever it takes to most expeditiously end of this state of affairs.

“Monetary debasement is now the principal game in town. Everyone pretends they do not pursue these policies, but the truth is they have no option…It will get nasty…”

The latter type of inflation, we therefore collectively conclude, we prefer to live without, whereas the former type of inflation we come to believe we cannot live without.

The predictable result is that by continually bailing out markets, Central Banks have now effectively backed themselves into a corner from which there really is no easy way out.

1) There is no way they can step back from supporting markets…if they do markets will crash

2) There is no way they can raise (or hint at raising) interest rates…if they do markets will crash

Inevitable pain

We therefore find ourselves in a surreal world where the more central banks (and now governments through fiscal spending) do to preserve the “status quo” the worse they make things and the more painful the eventual bust is likely to be.

If we are “lucky” the bust will unwind as a period of high (or very high) inflation and this will help to re-set debt and asset price valuations in a less disorderly and potentially less socially disruptive way than a “traditional” asset price re-set, but of course this outcome is not guaranteed.

Monetary debasement is now the principal game in town. Everyone pretends they do not pursue these policies, but the truth is they have no option……It will get nasty…

Covid-19, and the desperate fiscal & monetary response to the pandemic, will most likely prove to be the last hurrah of a 25 year, Central Bank sponsored, bull market in bonds, equities, property, art and luxury items generally. Most likely politicians and central banks will keep the show going a bit longer but at what ultimate long-term cost?

To anyone under 30 reading this, I offer my apologies. My generation enjoyed the “party,” but politicians and central bankers have contrived to ensure that your generation suffers the “hangover”. I don’t think it is ethical; I don’t think it is moral…but I don’t make policy.

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