When the coronavirus struck at the beginning of the year, markets tanked. But when the US Federal Reserve (Fed) cut rates to zero and launched a massive quantitative easing program in mid-March, markets reversed. With central banks and governments adding new stimulus measures almost on a daily basis, asset prices have by now recovered half or more of their previous losses.
Despite massive state intervention, economic fundamentals are rapidly deteriorating. Millions of people have lost their jobs and many companies are close to default. Financial markets and the real economy have never been more at odds with each other. The big question for everyone is, will governments succeed in rescuing the economy, or will they just further distort markets and eventually cause the largest crash of our lifetime?
For a better understanding, let’s take a closer look at how stimulus measures affect economic growth, inflation and asset prices.
V-shaped recovery or deep recession/depression?
Western economies were already in a downward trend, starting in the second half of last year. Recent lockdowns enacted by governments have caused additional havoc. While it was easy to shut down businesses, reopening them will be quite a different challenge. Some companies will succeed, others will reopen and then default, and the rest will just remain closed forever.
Demand is already down and we can’t expect a quick recovery. Not all of those, who got laid off in recent months, will be reemployed quickly. Others, who still have a job, will be victims of the next wave of restructurings. Even though public welfare systems in the West soften the effect of unemployment, total income will fall and so will demand, as many households already have a high level of debt. Changing consumer behavior further worsens the situation. People, who are unclear about the future, tend to spend less and save more. And health concerns will restrain them from going out to restaurants, bars and entertainment venues or travel as before. Companies are already bracing for a large slump in demand by slashing costs and reducing output.
To deal with the crisis, authorities have launched massive support measures. Instead of reducing regulation and finding creative ways to foster entrepreneurial behavior, governments are just pumping huge amounts of money into the economy.
Company bailouts are high on the agenda. As governments can’t provide sufficient support to every enterprise, they are now picking winners and losers. Based on what happened during the last crisis, big business is likely to survive, while many small and medium-sized companies are bound to fail.
A lot of money also goes to massive public spending programs, e.g. for infrastructure, health, education, or the environment. Apart from the fact, that such programs involve a lot of waste and corruption, existing regulations and slow bureaucratic processes ensure, that major effects will probably not be felt this year.
Another option for governments is to unleash helicopter money, by distributing free money among the population. Hong Kong was first to enact such a measure and since then, many other countries have followed. But so far, the allocated amounts have been insufficient to generate a major surge in demand. Even if governments increase helicopter money by a factor of 20 or 50, it is highly questionable that they will achieve their objective. If the money is used to pay back loans, save more or buy foreign goods and services, the domestic output effect will be just a fraction of the original money spent.
All government spending programs have one thing in common, they need to be financed. If governments increase taxes, they reduce existing private demand and the overall effect will eventually be close to zero. If they borrow from commercial banks or rely on central bank debt monetization, the additional money in circulation will cause inflation to soar. Overall public spending programs without accompanying major reforms will not achieve their objectives, but rather cause more market interference, thereby preventing a swift recovery in the future.
Some analysts still dream of a V-shaped recovery, but we think this is highly unlikely. Government intervention can prevent a depression this year, but a recession is almost assured.
Deflation or inflation?
There is a fierce controversy among academics and analysts about the effects of the money tsunami, that has been unleashed by central bankers and politicians. Some expect deflationary pressures to prevail and prices to fall, why others warn about an impending surge in prices leading to hyperinflation.
In our opinion it is misleading to just look at inflation in general. Price changes for various items can vary considerably and this will affect investors, businessmen and consumers in very different ways. Therefore, we need to distinguish at least between inflation concerning assets (e.g. stocks, bonds, real estate), production goods (e.g. commodities, materials, tools, machinery) as well as consumer goods and services (e.g. food, hygiene products, electrical appliances; but also, health care, education services and housing cost).
To understand, whether and to what extend authorities can control prices, we need to take a closer look at the main factors causing inflation/deflation:
1. Amount of money
Excessive money printing by central banks should have an inflationary effect. On the other hand, not only central banks, but also commercial banks create money (it is still a widely held believe even among some academics, that commercial banks use customer’s deposit to issue loans. This is incorrect, as in our ‘reserve banking’ system financial institutions simply create money by expanding their balance sheet). Commercial banks are currently not very keen on providing new loans, except if the government provides a guarantee. The amount of money created by them will therefore decline, which has a deflationary effect. The net effect is unclear. The more authorities can control lending by commercial banks, the more they can control the amount of money.
2.Use of money
Since the Great Financial Crisis in 2007-09, central banks have expanded their balance sheets in a big way. Most of the newly created money stayed in the extended financial sector, and only a smaller part seeped into the real economy. This is the reason, why prices of stocks, bonds, and real estate went up considerably, while consumer prices were less affected (even though official statistics understate the true extent of consumer price inflation).
By defining how and where newly created money enters the economy, authorities can manipulate prices in those sectors, that the new money reaches first. However, authorities are usually not able to control secondary and tertiary effects.
People who get laid off or must accept a salary cut, tend to reduce their savings. On the other hand, people who keep their jobs but are unsure about the future, often decide to save more.
Whereas most academics only talk about ‘savings’ in general, it is also important to evaluate, how people are saving or dissaving. If the government gives you 10,000 EUR of new money created ex nihilo, and you put it under your mattress, there is no inflationary impact, as long as you keep it there. At least some inflationary effect occurs, if the money is put into a bank savings account. But the extent depends on how the bank uses the deposit. There is an immediate price effect, if people save money by purchasing bonds or stocks, as it affects the underlying value of the assets bought.
In free markets authorities only have a limited influence on the size and kind of savings. To increase this influence would require implementing draconian control measures. It has been done in some countries before, so we can’t rule it out for the future.
4. Supply and demand of goods and services
Prices change, when there is a mismatch between supply and demand. In the current crisis we have seen, that a steep increase in demand for masks and disinfectants, has led to a dramatic surge in their respective prices. Equally, lower supply of food and other essential goods, coupled with constant demand, has caused prices to rise. With regard to oil, collapsing demand in the face of stable supply, has led to rapidly falling prices (oil futures have even traded at negative prices below USD -40). These examples show, that the current crisis affects the prices of goods in different ways.
Authorities have only very limited influence on supply-demand related price changes, except if they resort to price controls. However, such controls are often not effective and usually lead to undesired consequences, such as a reduction in supply.
5. Production costs
Lower volumes and new corona-related government regulations (e.g. to ensure social distancing) will increase production costs. Repatriation of production that was previously carried out in low cost countries, will also increase costs. Some of the additional cost will be absorbed by producers, wholesalers or retailers, but the rest will be passed on to the consumer. Apart from direct intervention, authorities have little power to influence this.
6. Foreign impact
The USA (still) has the global reserve currency. As there is huge demand for USD in the Eurodollar system outside of the USA, money printing by the Fed does not have any impact on domestic inflation, as long as the money is parked abroad. Other countries don’t have this privilege. For them, and also for the USA, prices of imports matter. If they go up in local currency, inflation will soar. The reverse applies, if import prices go down. The situation will vary substantially between countries and specific products. Domestic central banks have only limited power to control the exchange rate and for local authorities in Eurozone countries, there is hardly any influence.
7. Trust in fiat currencies
The USD, EUR, AUD, CAD, or GBP are all fiat currencies. They are legal tender issued by the state or rather its central bank. As they are not backed by any physical commodity, they rely only on trust. In Germany’s Weimar Republic, Venezuela and Zimbabwe this trust was lost, and as a consequence hyperinflation ensued. Currently Western currencies still enjoy a comparatively high level of trust. But the more money is created ex nihilo by central banks, the more this trust is going to wane. Authorities will be powerless, as they can’t control trust.
The above short scrutiny shows, how complex the topic of inflation is. Whether deflation or inflation prevails, does not only depend on the actions taken by the government and its central bank. Commercial banks, businesses, individuals and foreign countries also play a major role. Absent dictatorial interference with private decision making, those other players are powerful enough to offset or reverse any government initiative.
In the short-term, we expect prices for essential consumer items to go up, as declining supply meets stable demand. Prices for non-essential consumer products and many production goods will likely go down, as demand is slashed. Further below we will explain, why we anticipate asset prices to decline, if the economy deteriorates further despite intervention by the authorities. This would mean having (asset) deflation and (consumer) inflation at the same time, the worst outcome for the average citizen. In the long-term, a lot depends on how far central banks are willing to go. If they discard all restraints and start creating money without limits, (hyper)inflation for goods and services will follow and even asset prices will take off (at least in nominal terms), despite poor economic fundamentals. Contrary to others we don’t claim to have a crystal ball and therefore could be wrong. Nevertheless, in our opinion it makes sense, not to rule out and prepare for hyperinflation as one possible scenario.
Boom or bust in stock and bond prices?
In the current situation, prices for stocks, bonds and real estate should be in free fall. Those for stocks and bonds really plummeted at the beginning of the crisis, but then central banks responded with massive monetary expansion. As they can create an unlimited amount of new money ex nihilo, many investors believe that central banks will bail them out, every time markets drop. “Don’t fight the FED / ECB” is a common saying.
All major central banks are already purchasing government debt titles, corporate bonds and asset backed securities. The respective market is huge. At the end of 2019 it amounted to over USD 40 trillion in the USA alone, about 2 times national GDP. In comparison, the Fed’s balance sheet currently ‘only’ amounts to USD 6.7 trillion.
Up to now, the Bank of Japan (BOJ) and the Swiss National Bank (SNB) are buying stocks, either directly (SNB) or indirectly via ETFs (BOJ). But given the current situation we wouldn’t be surprised, if the ECB and the FED were to join the bandwagon. Total stock market capitalization is also huge. For instance, in the USA it was almost USD 37 trillion at the end of last year.
To bail out both, the bond and the stock market, central banks would have to increase their balance sheets well above the level of national GDP. As the BOJ’s balance is already larger than Japan’s GDP, this is possible. But how far can central banks go, without completely destroying trust in the value of their currencies? Will central banks become insolvent, if the value of their purchased bonds and stocks plummet by 50% or more, because the issuing companies go bankrupt? And will the population eventually accept, that the central bank owns 20%, 60% or 90% of all listed companies?
Central banks will certainly fight ferociously to prevent a further decline in asset prices. But we think they will hesitate going “full in” to keep all stock and bond prices at their current levels, if the economy deteriorates further, as we expect. The Japanese Nikkei 225 provides a good example, that authorities can’t achieve everything they want. The index peaked at close to 39,000 at the end of 1989, but is currently trading below 20,000 despite massive central bank and government intervention. This means, that more than three decades later, it is almost 50% below its historical peak, even without adjusting for consumer inflation during the same period.
There is another aspect to consider. Even if authorities are willing and able to stop a decline in stock and bond prices, they might not necessarily support a strong price rally in the future, similar to what we have experienced over the last decade. If they decide to keep prices at current levels, the return of securities over the coming years will be near zero in nominal terms, and negative adjusted for consumer inflation.
History has shown, that authorities ultimately never succeed in manipulating markets. They can postpone a crisis, but they can’t suppress market forces indefinitely. However, they have the power to put an end to individual decision making and create a centrally planned economy. As free markets are more and more under threat, we consider the following scenarios possible:
- Crash: Authorities fail in their attempt to control markets. In this case, GDP as well as asset prices crash. If the crisis is used to implement far-reaching reforms, a strong rebound in the future is possible. Otherwise it will be stagnation at a much lower output level
- Recession and stagnation: Authorities print enough money to prevent a collapse in asset prices, but fail to rescue the real economy. Absent radical reforms, the economy languishes for years, while asset prices are artificially propped up by central bank and government activities
- Control economy: To prevent a crash in asset prices, authorities buy the majority of shares and bonds of listed companies, thereby nationalizing most industries. To stop the economy from deteriorating further, broad price and production controls are implemented. This can lead to the country being run “Soviet style’ by a small number of politicians and unelected officials with unlimited power. We all know what that means
Let’s hope for the first scenario. It will for sure cause a lot of hardship in the short-term, but if offers hope for a fast recovery in the future. Other options just prolong our suffering and might even result in completely abandoning free markets. As the saying goes: Better an end with pain than pain without end. Unfortunately, selfish politicians are more likely to opt for the latter option.
Nobody, including analysts and financial advisors who are backed by state-of-the-art data and AI driven models, can be sure about what is really going to happen. Investors must therefore build a portfolio, that can deal with a large number of defaults or government bailouts, lasting deflation or hyperinflation, crashing or soaring prices of securities, and everything in between.
For professionals this means working with options, futures and other financial instruments. For the average investor this is hardly a choice. In upcoming blogs, we will discuss portfolio allocations, that require neither deep financial knowledge nor round-the-clock checking of financial data. The return will certainly be lower, than what some of the top professionals will achieve. But for the average citizen, ‘return of assets’ is more important than ‘return on assets’ in the current turbulent times. Many average professional investors, who thought that they have figured it all out, are likely to learn this the hard way in the not too distant future.
Disclaimer: The above is for informational purposes only. It is not an offer or advice to buy or sell any products or services. LBB and its owner do not provide investment, tax, legal, or accounting advice. Neither the company nor the author is responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods or services mentioned in this article.
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