Submitted by Eric Peters, CIO of One River Asset Management
"One man’s debt is another man’s asset,” said the CIO, lifting his palms evenly, bringing them into perfect balance. “The weight of one is perfectly offset by that of the other.” So in theory, it should not matter how large either grows. “But debt creates asymmetric behavior between borrower and lender,” he explained. “When the economy comes under stress, borrowers are forced to retrench, and lenders must then choose whether to fill the economic void left by that adjustment.” By repairing their balance sheets, the borrowers do additional economic damage.
"Lenders tend to wait and see how things shake out before stepping in,” continued the CIO. Central banks provide stimulus to lure them back. “Therefore, the higher the debt level in an economy, the more susceptible it becomes to catastrophic failure and the less responsive it is to stimulus.” So central bankers must work harder. “But by doing so, they slow the necessary adjustments in parts of the economy where balance sheets are unsustainable. And this incentivizes leveraging up in places where balance sheets are strong – creating new excess.”
"In a global financial system, these dynamics spill across borders,” he said. 10yr German bunds yield -0.34%. Greeks pay +1.28% to borrow for 10yrs (40bps less than the US). Tesla market capitalization is $102bln. “This is good for the short-term performance of asset prices and economic growth, but down the line, it makes the financial system more prone to catastrophe.” And less responsive to stimulus.
"In each downturn, central bankers must step in more and more aggressively. The process is reflexive and ultimately leads to a Minsky extreme."
"Financial markets have capitulated to the secular stagnation narrative,” said the CIO, high atop his prodigious pile. “And in so doing, they have tethered themselves to the wrong inevitabilities – to low interest rates forever, to asymmetric central bank reaction functions, to a negative bond-equity correlation,” he added, peering into the distance. "And now a financial system which is structurally intolerant of inflation faces a political-economy regime change which makes inflation an imperative."
Seeking to escape the 1970s inflation, policymakers inadvertently engineered an equally powerful deflation machine. The 2001 ascension of China into the WTO global trading system - combined with decades of Moore’s Law compounding our computational speeds - amplified the machine’s deflationary force.
"From the S&P 500 peak in 1972 to the 1974 trough, a 60:40 stock bond portfolio lost 60% of its nominal value.” In real terms, it lost 70%. There was no V-shaped recovery that quickly returned portfolios new highs.
"Are we on the cusp of economic regime change and wealth destruction not seen since those dramatic years in the 1970s?" he asked. In the distance, Britain’s politicians readied their plans for an impressive fiscal stimulus. The Americans fought over how to best expand their current 4.5% deficit (with unemployment at levels last seen in the late-1960s and with the economy running above capacity). Will Republicans introduce new tax cuts and infrastructure spending? Or will Democrats expand entitlements on a scale not seen since the 1960s Great Society programs? Or launch a Green New Deal? Both?
"It does not take a wild imagination to see where this comes from – a shift in regime with government spending directly financed by central banks, secure in the belief that their deflationary machine will grant them license," he said. "Today the climate is deflationary to be sure. But the machine is being dismantled. The instability inherent in one extremity can easily swing to the opposite. And such a shift is not merely possible, or even likely, it is inevitable."