Authored by Charles Gave of GK Research, a Gavekal Company [13],
Financial markets operate on a number of implied assumptions about growth, policy direction and other factors. Experience tells us that these assumptions often turn out to be erroneous. The goal of this paper is simply to test the rationality of the current set of assumptions.
Assumption #1: Central bankers know what they are doing. Comment: This is the victory of hope over experience. Most central bankers do not even understand what money is (at least in its deeper economic sense. See Blind Men Looking At Money [14]).
Assumption #2: Central banks are in the middle of a totally new monetary experiment. Comment: True. The problem with new-fangled approaches is that the protagonists by definition have little idea about the long-term consequences of their actions.
Assumption #3: Low or negative real rates favor economic growth, and by suppressing or manipulating the price of money the central bankers can achieve happy results. This is another way of saying they are competent central planners, and that a capitalist economy works better without a market-determined price of money. Comment: Negative real rates and competitive devaluations always lead to a collapse in the velocity of money and from there to a structural decline in the economic growth rate (see Obsessed With Negative Real Rates [15]). They also result in increased social inequality and from there to a breakdown of the prevailing social contract.
Assumption #4: An increase in the quantity of money leads pushes up asset prices (another way of saying that central banks are able to control or manipulate asset prices). Comment: The value of an asset is equal to a stream of income discounted by a risk-free interest rate. If the asset has a very short duration, the central bank can manipulate the discount rate to artificially inflate its value while the expected return does not change much. But if the asset has a very long duration, the market participants will know that the discount rate is manipulated and they will NOT know how much of those expected returns result from the manipulation of interest rates. The upshot is that they will not be able to compute the present value of those expected returns. The result of this market dissonance is that capital spending will shrink, productivity will crater and growth will decline.
Assumption #5: A rise in asset prices always leads to an economic recovery (wealth effect). Comment: True if the rise in asset prices is justified by an increase in the citizenry’s median income. Not true if it is a bubble engineered by the central bank to bail out the commercial banks, and if the median income goes down, as it is in the US today and everywhere in Southern Europe. This is certainly the most dangerous assumption of all because the market is vulnerable to the sudden realization that the central banks are in fact naked in their attempt to resist the tide impacting asset prices.
Assumption #6: An increase in the money supply accompanied by a rising budget deficit together with negative real interest rates will boost economic growth. Comment: This idea has become almost ubiquitous even though economic history shows it is a fallacy that has been consistently proven wrong.
Assumption #7: GDP is a good measure of economic growth. Comment: When the output of a market economy and a nonmarket economy are co-mingled the effect is to muddle apples and oranges (see GDP As A Concept: Misleading If Not Outright Criminal [16]). GDP targeting is as stupid as targeting the unemployment rate, which will lead to a collapse in the participation rate.
Assumption #8: Investors do not need to fully understand what is happening—they should just keep an eye on the actions of central banks and governments, and invest accordingly. Comment: This approach implies a belief that central banks and governments know what they are doing do (see point #1); secondly it assumes there cannot be unexpected—read negative—results. Just in case any of our readers really believe this, I happen to know of a New York bridge whose exclusive use I’m sure could be negotiated for a reasonable price.
Assumption #9: I do not believe in assumption #8, but since everybody else does, I have to invest accordingly and will be smart enough to get out in time. Comment: Congratulations, and good luck.
Assumption #10: Debt does not matter as long as the central bank keeps buying it by printing money, and this printing exercise will have no consequences. Comment: This authorizes government spending to grow without limit. This has hardly been conducive to economic growth in the past since the first action of every government with unlimited access to money will be to prevent the disruptive part of the creative destruction process, thus preventing any creation. This always leads to economic stagnation as predicted by Austrian economist Joseph Schumpeter.
Assumption #11: Competitive devaluations are reflationary. Comment: Unfortunately, the historical experience of beggar-thyneighbor devaluations is that they are always deflationary, especially in a world where international trade is no longer expanding.
Assumption #12: Central banks can generate inflation by printing money and control it afterwards. Comment: In the long run central banks struggle to control anything. Inflation over the long term depends more on the velocity of money than on what a central bank does. This is really a slightly more refined version of assumption #1 - and about as credible.
Conclusion
A modern economy is an incredibly complex entity that involves millions of transactions every day. The notion that this vast and largely self-governing system can be controlled through tools such as government spending and/or an increase in the quantity of money is - to say the least - bizarre. A flood is rarely a cure-all solution to a drought; it just creates new problems for an already suffering population.
From 2002 to 2007, we witnessed a massive attempt by central banks to manipulate interest rates and currency exchange rates. The consequences of this action came due in 2008-2009. Criminal psychologists have long known that villains frequently return to the scene of their crime—in the case of western policymakers, they seem to be looking to finish off a caper that went badly wrong at the first attempt. The end result for the broader community is unlikely to be pretty.
Investment conclusions
My bet is that this effort at control-engineering the economy will fail, but of course I cannot know this for sure, nor can I state precisely how and when the unwind will materialize. The solution is to generally move out on the risk-reward frontier and seek assets that will do well in either eventuality—such investments we sought to identify in our last Quarterly [17].
- Focus on economies that either i) have an undervalued currency (e.g., the US), or ii) are seeing an aggressive devaluation on the road towards a more fairly valued currency (e.g., Japan or the UK). Conversely, one should sell assets in currencies with little depreciation potential (e.g., Korea).
- It also makes sense to own shares in companies that are exposed to the ongoing transformation in China and that can leverage on the rising demand for consumer goods and services (e.g., high end European exporters, see Europe And The Chinese Consumer [18]).
- At the riskier end of the spectrum, we would recommend a mix of Japanese and UK exporters, good quality US blue chip companies and some strong brand-name European exporters that have a large exposure to emerging markets.
- We also have a strong preference for dim sum bonds since we know that transforming the renminbi into a credible, globally traded currency is a key priority for China’s leadership, and this simply won’t happen unless the RMB is strong. This is why dim sum bonds continue to deliver steady returns with very low volatility.