Real Assets and Bread
The cheap cost of money is one reason why markets discount negative news and continue to rise despite any short-term negativity. Once we remove zero cost of money from the equation, the 50% global wealth, blowing off its top, calmly, the global real estate which is not a real asset, could create a new hard-to-comprehend risk.
The market discounts toxic paper, bad debt, poor valuations, and all negative news is primarily because of the cost of money. If the cost of money is kept low, the equity market could discount any negativity and show uncanny resilience. Interest rates are an important indicator to watch for signaling the change in the cost of money. Though near-zero interest rates are good for markets they are not sustainable. The Federal Reserve has so far been able to manage the yield curve on the short end. How far it can do it in the future is doubtful.
There’s another catch here. History may be important, but we don’t have a long market history. What we have seen is a long history of interest rates of nearly 10,000 years. This is why just looking back trying to learn from the great depression might be shortsighted. Deflation and inflation are known to have alternating cycles, more in line with rhyme and repetition.
Near-zero cost of money offers support to the residential and commercial real estate market. Interest rate control is an illusion and not a solution. Near-zero cost of money blows bubbles in different asset classes and is not the monetary tool to solve the long-term unemployment and economic problems. It is part of the problem, as capital savings are diverted to speculation. Printing a large number of dollars has the opposite effect of debasing a stable monetary system.
Bonds are a leading indicator compared to the USD Libor short-term rates. The blow-off phase seems to be behind in global bond prices. The inflection if it’s in place could affect all asset classes. For a change, it could make it worthwhile holding the dollar for a little while. Only commodities provide the real value against a debased monetary system. Above this, we have the fear and panic linked to the instability in the current monetary system. Gold adjusts well to the cost of money owing to its low cost of carrying. Unless the printing press slows down investors will attempt to solve their problem by using metals as the store of value.
Cycles of Cash
With interest rates at zero, the new rise in agro commodities might not be the regular 10-12 year cycle. Cash conservation becomes strategic, as the healthy disinflation era is challenged by rising food prices.
Economic cycles are driven by credit. There is a shift from paper to hard assets and vice versa.
There are three stages linked with the credit cycle viz. hyperinflation, disinflation, and finally deflation. Disinflation is a period of low inflation and low prices for food and essential goods. This leads to economic growth. While there is little literature available on the chronology of events, disinflation is the one preferred most by investors and market participants. Disinflation is generally perceived as beneficial. However, mass psychology extremes have been known to stretch the benefits to an extreme causing deflation. The most visible example of deflation is the 13-year slowdown of the Japanese economy. The deflation period is one of a decrease in the general price level over a period.
Deflation is the opposite of inflation. During deflation the purchasing power of money increases. Many still consider deflation as a problem of the modern economy because the phenomenon can spiral into a depression.
Hyperinflation, on the other hand, refers to a period when inflation goes “out of control,” as cash or currency rapidly loses its value. A monthly inflation rate of 20 percent or more is hyperinflation time. Although there is a great deal of debate about the root causes of hyperinflation, it becomes visible when there is an unchecked increase in the money supply or drastic debasement of fiat currencies and is often associated with wars, economic depressions, and political or social upheavals.
The worst case of hyperinflation happened in erstwhile Yugoslavia where inflation doubled every 16 hours. Hyperinflation destroys real money. So the talk of hyperinflation in India or the US is a clear misinterpretation. There is a crisis of confidence in hyperinflation. China between 1939 and 1945 is a classic example of the government printing money to pay civil war costs. By the end, the currency was flown in over the Himalayas to be destroyed. The chaos often ends with a civil conflict. And there are a lot of zeros in the currency and they keep adding. A majority of countries around the world have experienced this phenomenon. In recent times, itʼs happening in Zimbabwe. There is a crisis of confidence under Mugabe and the country is in civil strife witnessing the biggest modern-day exodus.
So all our good times rest on how sustainable this current disinflation is, the good inflation. According to a research paper by Marc Hofstetter, Universidad de los Andes, very little is known about the sustainability of disinflations. The paper dispels misconceptions about disinflation and points to food as an essential sustainer of prosperous times. One cannot blame the low sustainability of disinflations during the seventies on rising oil prices as Yale professors Boschen and Weiss state that world food prices are a significant predictor of inflation in OECD nations. And food inflation plays a bigger role in undermining positive disinflation than oil prices. The significance of oil shocks turns out to be weak. The paper also comments on exchange rate regimes saying that an increase in exchange rate flexibility reduces the sustainability of disinflations.
Disinflations that bring inflation down to low rates of 5 percent or lower (like we have today) are more likely to succeed in keeping those gains in place. Rogoff (2003) and Razin (2004) add the idea that globalization played an important role in the recent worldwide disinflation. Since the early nineties, an increasing number of developed and developing countries have adopted inflation-targeting regimes to conduct monetary policy, which is ineffective in determining the sustainability of disinflation. Politics also seemed to have little effect. The most interesting aspect was the linkage of whether US inflation had something to do with worldwide prosperity since the nineties. Boschen and Weiss found strong evidence that US inflation plays an important role in triggering inflation abroad and US monetary shocks have important consequences abroad ie a higher US inflation reduces the sustainability of disinflations abroad.
What all this means is that if food prices donʼt stop going up, the good times will come to an end. And there is nothing the central banker or the politician can do to sustain it. We see a lot of unsustainable greed at current levels. And highlighting the importance of cash before the crash cycle can never be overstated.
If the cost of money is kept low, we are in a process of creating fast and sequential bubbles. This would make bull markets fast and bear markets faster. We witnessed bubbles that shifted from blue-chip investments to dot.com. After the dot.com bust, the public purchased and leveraged housing. Cheap money pushes investors into poor decision making encouraging them into inter-market speculation. When the debt bubble bursts money may come out of bonds into other asset classes. Debt will begin to underperform other assets like commodities. The US municipal bond market is America’s Ireland, Greece, Spain, and Portugal all put together. The AAA ratings do not reflect the debt risk.
In the end, even if the stock markets may rise for another few years after any multi-month correction, investors should understand they have an extended risk and return profile and that real consistent gains of tomorrow will not come from the focus on returns, but a focus on risk containment. Cheap money after all is a risk, hard to grasp.
Long term is the neighbor's problem
This chart from the Foundation of Cycles is 10,000 years of interest rates. The last 500 years (longer than the history of stock markets) have witnessed falling interest rates. In this period, a lot of money has been printed and thrown from helicopters and occasionally have been put in the fireplace. The large cycle can only head to zero, which it has, in 2020. One doesn’t need to be a market technician to understand a ‘Head and Shoulders’ pattern as there is a conspicuous cycle of varying periodicities. Even if the potential right shoulder emerging here can supposedly be managed by some brilliant financial innovation, the case for statistical reversion doesn’t need a hard sell, unless you believe in the power of the global central banks to tame inflation. And if the reversion is going to happen, it may last for 150 years, during which everything should change; economics, science, climate, and society.
One should probably dismiss this as a nightmare, ultimately in the long term we are anyway dead and who cares about ESG, freedom, or children. We should continue to live our comfortable lifestyles as it’s impossible to become a vegan, drive a bicycle, or reduce our carbon stamp, let the neighbour handle the tragedy of commons.
[1] M. Pal, Cost of Money, mukulpal.com, January 2011
[2] M. Pal, Cash and Crash Cycles, mukulpal.com, October 2007
[3] History of Interest Rates, Foundation of Cycles