November 17th, 2021
Come before those battles lost and won.
This life is shining more forever in the sun … now let us check our heads
– Red Hot Chili Peppers, “ Road Trippin’ ” 1999
After a twenty-month lockdown in British Columbia, we are back on the road visiting clients. The Red Hot Chili Peppers’s fully acoustic song seemed a fitting soundtrack for our first foray back into the in-person business world. Runner ups included “Day Tripper”, “Born To Run” and, if your musical tastes lean more middlebrow like mine, “Back In Black” from AC/DC (send in your playlists).
Thankfully, clients were eager to engage. But a long pandemic exile had shaken up the time continuum. Having been shielded from regular human interaction for so long, some fundamental life skills had noticeably withered. Travel routines and hacks were rusty from disuse. Any savoir faire once held by this author had clearly atrophied. Conventions have changed too. How best to greet someone today? No one knows. But, in practice, it typically goes like this: approach the other person, circle warily before attempting a touchless handshake and finally settle for a clumsy elbow bump.
For those yet to disconnect from the Matrix and step into the light, be aware that new rules now apply. It’s a social minefield out there. And while most recognize that the pandemic has thrust a new reality on us, exiting the lockdown time machine is bumping most back to earth. Admittedly, this is an awkward place. Even though the world may be on the verge of breaking through to some other side, there is also another sense: that we are caught in a liminal space between the before and after.
To say it has been a strange few years is an understatement. And it continues to be strange. The economy is ripping yet consumer confidence is hitting new lows. Predictions of stagflation have surfaced. Jack Dorsey goes further and tells us hyperinflation is coming. Billionaires are taking vacations in space. And now Mark Zuckerberg, evidently eager to move on from congressional oversight, has shifted his focus to creating a parallel virtual world called the metaverse (most people haven’t the foggiest idea what that might look like, but my ten-year-old son seemed to capture it best: “the headset and avatars look cool but it would suck if the power went out”).
Needless to say, our clients were spring-loaded with questions. Below, we provide answers to the most common ones.
Will inflation be transitory or more sticky?
This was the biggest concern on client minds. And, indeed, it is the key macro battleground among global asset allocators. Central bankers have claimed that currently high inflation can revert serenely back to its previous course. Quite the gamble. Actually, we are somewhat sympathetic with their perspective. Much of the recent inflation is pandemic-driven. We have just witnessed the largest demand surge since World War II, caused by post-Covid reopening, and the largest supply collapse the world has ever seen, caused by Covid lockdowns. Base effects and bottlenecks are contributing to a surge in prices. Yet the world economy is rebalancing quickly as the recovery process broadens out and various sub-sectors adjust. Inflation should start to moderate somewhat in 2022 (see our recent podcast discussing supply chains).
But team transitory only focuses on the supply side. They are entirely missing the other main cause of rising prices — excess aggregate demand. Here, the kindling needed to light a blaze in global demand can be seen almost everywhere. This can be viewed through a consumer, corporate and government lens. Household balance sheets in the major economies are in very decent shape, capital spending is booming and governments have completely abandoned austerity (see “Global Inflation: Has The Force Awakened” for further insight).
All of this suggests inflation will be far more sticky than central banker forecasts. In fact, while global central banks consistently overestimated inflation in the post-2008 period, we will now see the opposite: policymakers, conditioned by years of inflationary false alarms, will now likely underestimate price pressures in the next decade. Real yields will stay deeply negative for years.
Last week’s 6.2% jump in US consumer prices supports this view. Not only was it a 30-year high, but, more tellingly, the data showed a broadening of inflationary pressures – away from categories confined to the economy’s reopening and a more general rise in prices. The same story can be seen across the globe.
What are your thoughts on cryptocurrency?
Ah, crypto — today’s most hotly contested topic. Earlier this year, we wrote a report on the subject. Not much has changed since then. On the surface, many of the arguments for crypto are appealing and excitingly subversive, making people feel like they have taken the red pill and seen the truth. In fact, the crypto boom has tapped into many of our modern discontents — a mistrust of policymakers, disruptive technology, rising populism and a deep concern over government largesse.
Crypto claims to solve all these issues, along with almost all of humanity’s other pressing concerns. And, the market is now worth more than $3 trillion (fun fact: Shiba Inu, the second most important dog-based cryptocurrency, has a similar market capitalization as gold major, Barrick Gold).
This is a big topic (one client meeting ran 45 minutes longer due to a lively discussion). Where to start? First, the great irony is that, while crypto has promised to be an independent, decentralized currency, it is steadily moving further away from that ideal. Crypto architects have spawned an entire ecosystem, including tokens, ETFs, listed securities and exchanges to trade cryptocurrencies. This is looking more and more traditional and centralized by the day.
It is also becoming clear that crypto will be heavily regulated. If this author has learned anything after two decades in finance, it is this: policymakers are control freaks. Eventually, they will demand their slice of the spoils (raising taxes) or regulate something (increasing costs for the private sector). All this matters because, if enacted, regulations add risks and potential costs for those who transact against the law. And, increased regulations would systematically remove the original benefits the cryptocurrencies claim to bring. Less anonymity, more intermediaries and greater surveillance was not part of the plan. This signals that the state, not crypto, is winning in terms of control of the monetary system.
But our biggest problem with crypto is that it shares so many similarities with previous financial bubbles. The high temperature of the conversation gives away what’s behind it: bubbles all feed on captivating stories, excess liquidity and magical thinking. People are not buying crypto to use it as a currency. They are buying it in hopes that it will gain in price. Many will counter and say that Bitcoin is the new digital gold — an inflation hedge. Yet if Bitcoin correlates to anything, it is broadly to speculative appetite.
Of course, timing a crypto crash is difficult (even though there have been 7 major declines in the last decade). Historically, an improving global economy with tighter monetary policy usually does the trick to prick financial bubbles.
Is China heading for a crash? Is the country “investable” anymore?
This was the most divisive investment topic. Some would rather not touch the subject at all. But China is the second largest economy in the world (soon to be the largest). A view on China is crucial to getting global investing right.
The reality is that the rest of the world remains tightly linked with China. The country will continue to be the fastest growing market for nearly everything for the foreseeable future. China’s retail sales are larger than America’s, and China is the largest market for nearly all consumer goods, from autos to personal electronics and luxury goods. Foreign business will not abandon the Chinese market any time soon.
In fact, in an era that is increasingly defined by geopolitical competition and a push towards economic “decoupling”, Western business has never been closer to the Chinese economy. “There’s no point in talking about decoupling … we have no interest in a cold war with China. It’s too big of an economy — we want access to their economy, they want access to our economy,” US commerce secretary Gina Raimondo stated baldly.
Still, China’s heavy-handed policy interventions this year have decimated the local stock market. The economy has slowed substantially on austerity measures over the last year. Big Tech stocks are still down 50% from their highs earlier this year. The rout has also led to indiscriminate liquidation across all equity sectors (most of which are not in the crosshairs of China’s regulatory crackdown).
Yet we are now approaching a key inflection point. Regulators are adopting a far more constructive tone, aiming to restore confidence in domestic capital markets. A decisive turnaround in China’s fiscal and monetary policy is imminent. Historically, this has always been the time to start accumulating Chinese assets. In fact, the wider emerging market equity complex, having just hit a 20-year low versus US stocks, is primed for a long period of outperformance. China’s policy will be one of the catalysts to spark a change in trend. (For a longer discussion on China, see our Special Report written from Beijing right before the pandemic hit. We will be back in the country again soon).
Are you worried about the Federal Reserve’s recent taper announcement?
Quantitative easing is set to wind down by the middle of 2022 in America. We are not deeply concerned. First, Fed Chair Jay Powell’s announcement earlier this month was, without hyperbole, the most well-signaled policy announcement in history. Forward guidance has been taken to new heights.
Of course, the concern is that tapering will cause a market tantrum, as it did in 2013. But today’s economic and investment climate is entirely different. Economic growth is ripping. The Fed’s own forecast for GDP this year is at 7%, to be followed by 3.3% in 2022. The timeline for policy normalization is being accelerated simply because the economy is making rapid progress towards the Fed’s goals. This is all more evidence that we are quietly moving away from an era of secular stagnation.
Market valuations and positioning are also far different than 2013. Back then, the US dollar had just concluded a decade-long bear market. The currency was under-loved, under-owned, and primed for a multi-year rally. The taper was just a catalyst. Emerging markets suffered most and the US dollar’s surge also contributed to a collapse in commodity prices, generating a double blow to the resource-rich EM nations.
A repeat of the above is highly unlikely. Today, strong underlying forces favor a weaker US currency. Similarly, in 2013 commodity prices had just finished their “super cycle” and were vulnerable to a multi-year correction. Today, commodities, although significantly higher than last year’s Covid low, remain deeply depressed compared to historical trends. In 2013, global asset allocators also remained wildly optimistic on EM prospects, with EM bourses trading at similar multiples as developed markets. Capital inflows were strong. Today, EM equities trade at a massive discount to Western markets and remain deeply out of favour. The EM rate hiking cycle, that has been with us for the last year, is also closer to the end than the beginning.
But the last difference is the most important one: monetary policy is no longer the only game in town. Fiscal policy is a far more important driver of growth now. Investors may debate the size and efficacy of government spending. The US’s spending plans are now getting watered down. But investors should not lose sight of the ongoing regime shift (Biden did manage to sign a $1.2 trillion infrastructure bill on Monday — something neither Trump or Obama were able to do). With more accommodative fiscal policy, the missing policy lever from the post-2008 slow-growth recovery, will result in higher growth for several years. Monetary policy normalization becomes far easier to engineer in this environment.
The TSX is soaring this year. Can it continue?
As we write, the Canadian stock market is up by more than 27% this year. Last year’s peak-to-trough decline was 37%. All of this is unsurprising. Canada is a highly cyclical economy, moving in a “high beta” fashion to the gyrations of the world economy.
The question, then, for the globally-minded investor should be about Canada’s performance relative to other cyclical economies and even sectors. Here, several macro headwinds remain for our country. Most conspicuously, Canada still carries the weight of substantial credit imbalances. Total household debt has far outpaced disposable income and wages. And contrary to the successful private sector deleveraging episodes that occurred in the US and Eurozone since 2008, Canada had no such reckoning.
Another longer-running macro issue still exists. At its core, Canada has been far too complacent in strengthening its international competitiveness. Our country relied on currency depreciation throughout the 1990s, then the commodity super-cycle boom in the 2000s, and, most recently, the housing and credit excesses of the 2010s for growth. A key issue is that Canadian businesses have persistently under-invested in productivity enhancing processes. Looking ahead, productivity improvements take time. What chance will Canada outperform its more competitive global peers over the coming years? Adding it all up, Canada is destined for middling performance. Better opportunities exist in other cyclically oriented regions with better macro prospects and lower valuations.
Can the global recovery continue? Or is stagflation in our future?
In one client presentation on the road, we discussed seven reasons why this cycle would be unlike any in the last four decades — and far different than the post-2008 rebound. Consider that the last decade was characterized by slow growth, disinflation and skittish investor sentiment. Secular stagnation, muddle-through and a “new normal” were the dominant narratives. A series of deflationary shocks supported the view, most notably America and the Eurozone’s multi-year household debt deleveraging. Related to the above inflation question, the central issue was a deficiency of aggregate demand.
This is clearly a very different recovery than the one after 2008. Many are still misreading this, mistaking the coronavirus crisis for another 1999 or 2008. It is not. This is because the terrain upon which the virus landed is far different. No major global imbalances existed in early 2020. In fact, most imbalances had largely been worked out in the post-2008 crisis period. That meant, should the threat of the virus recede (as we are working through now), the cyclical rebound would be immediate and explosive.
What’s more, it is now obvious that the world is undergoing a massive shift in the way business is conducted. What is less obvious is that the pandemic has offered a rare opportunity to kickstart sluggish economies. Yes, the supply chain is currently a snarled mess. But it’s also an enormous opportunity for durable productivity gains. A crucial missing element of both the recoveries in the early 2000s and after 2008 has been meaningful capital spending. Yet the US is now seeing the strongest capex cycle since the 1940s. Measures from other countries and regions show similar dynamics.
On the consumer side, another missing feature of previous recoveries has now appeared: wage gains. In fact, wage growth has been the highest at the lower end of the income scale. This is where the marginal propensity to consume is higher and will trigger a sustainable pickup in velocity. Global consumers also have far more robust balance sheets, with more savings to be spent earlier in the cycle.
Finally, on the government side, the pandemic has been a moment of revolutionary break. Stimulus arrived fast and furiously. And, a consensus amongst policymakers has emerged: the risks of doing too little greatly exceed the risks of doing too much. Deficit shaming and austerity are now dead.
All of this adds up to an economic cycle that is not only likely to last for several more years, but will also see higher GDP growth than the last decade. With this backdrop, the case for a stagflationary outcome in the next few years is not strong simply because demand is there to offset the impact of rising prices.
Enough data points support a robust economic cycle. Yet most investors end up anchoring on the prior regime, assuming that the low growth era of 2009 – 2020 and the associated investment leadership (US growth stocks, bonds, etc.), will remain in place. This includes the long-duration growth tech stocks that have become today’s darlings. But investors need to position for an investment regime change. That means broadly staying with a reflationary bias and cyclical-orientation in portfolios. Markets are nowhere close to pricing any of this in.
Will any future client meetings be held in the metaverse?
Anything is possible. Just don’t blame us when the power goes out.