The Great American Melt Up
I just finished reading Lords of Finance, a book which follows the lives of central bankers and their actions throughout the period from about 1910 to 1950. It specifically focuses on the period of the 1920’s and the aftermath of WWI on the powers involved (including Weimar Germany’s infamous hyper-inflationary period and England’s sharp deflationary period after going on back on the gold standard).
It also goes over the period following the 1929 crash and the fierce global credit contraction which ultimately resulted in a 40% reduction in bank credit worldwide. This created the hellaciously deflationary period known as the great depression.
I wanted to talk about what has happened recently in the US where it looks like things are going
The recent inflation talk
Many economists (including those at the Federal Reserve) are saying this is “transitory” and we will have a temporary inflationary period and it will drop back to 2% again. This is because of the all of the temporary supply chain imbalances, pent up demand and stimulus.
I’m going to try to lay out how we got here and why I think that even if the inflation is not transitory having high inflation for a while to burn off some of the debt is likely a much better outcome than the opposite: a deflationary credit contraction from where we currently are.
Furthermore, given my read of history I think an inflationary outcome to clear debt overhang is probably desirable compared to what happened during the great depression and the powers that be will do everything they possibly can to avoid a deep deflationary bust.
The Recent SP500 Returns in the US
I wonder if people realize just how abnormally high SP500 returns have been the last several years:
Maybe you aren’t aware but long term historical averages of returns in equities are around 7-8%, some people report it being a bit higher, and some people report it being a bit lower after inflation and counter that “real returns” are more like 4 or 5%.
Anyway, it’s a lot less than 20% returns that we have seen so frequently in recent years (and by the way we had little real economy inflation, though we had a lot of asset based inflation).
Something a little wild to note is that people who put money into an S&P 500 index fund in 2018 have had much more than a 50% return on their money. That’s a huge return for one of the most popular investments out there in a very short period of time.
If 2021 turns out the same way as 2020, we’re on track to book another 20% on the index this year.
Why are returns so good lately?
Well, I think it has a lot to do with monetary policy, and I think the -4% return in 2018 is a big clue about this. In the aftermath of the 2009 financial crisis (which was a deflationary banking crisis which resulted in credit contraction) central banks kept rates very low for a very long time.
Low rates cause people to seek higher returns in more risky assets. Bonds were paying little and were barely beating inflation (now they are negative payers in real terms, but I’ll get to that later) which caused people to move money into equities to seek a higher return. Additionally the central banks were buying bonds and putting them on their balance sheets (Quantitative Easing). This also kept bond yields low due to the increased demand for bonds this created.
Corporations were able to issue cheap debt and did so in very large quantities.
All of this was a totally natural response to a deflationary crisis, this ended up giving us a pretty good outcome. We did not spiral into a deep depression, just a long recession. The economy recovered and unemployment eventually reached a 50 year low.
Looking what let up to the 2018 correction
If we look at the dip in the markets in 2018 it gives us a clue about how responsive the markets have become to monetary policy. In 2018 the Federal reserve had started increasing interest rates again and was selling the bonds on their balance sheet. But all of a sudden towards the end of 2018 the market started to fall. At one point in 2018 (at the end of November I think), I remember my own portfolio (which is mostly index funds) being down almost 20% on the year.
Then late in December of 2018 Powell abruptly reversed course, started cutting rates again and the market recovered almost immediately. Then, in late 2019 they essentially started doing QE again (buying government debt and putting it on their balance sheet). The market rose steadily and ended the year up a whopping 31%.
The clue this gives is that the economy is overlevered and cannot tolerate higher interest rates. Specifically, it appears that corporations and governments cannot handle higher interest rates (because of their high debt loads).
The Covid Crash
The corona virus crash in March 2020 was a totally external event that caused a large market correction, but the central banks responded by cutting rates immediately and rapidly increasing their QE programs. This took interest rates very low. Given that we know there is some inverse relationship between bond yields and equity markets this ended with the equity markets 18% higher on the year (even after the nearly 30% correction in March).
Now (nearly June 2021) the 10 year treasury yield is at 1.58%. In July of 2020 it was at 0.58%. In July of 2019 it was at about 2%. In July 2018 they were 2.9%. The highest the 10 year bond got in the last 8 or 9 years was October 2018 when it 3.2% and the equity markets sold off hard and fast.
So what I’m saying is that all things being equal rates have to probably keep going lower or else the equity markets will crash. The only problem is that interest rates are very low and cannot go much lower…
But, what if all things are not equal? Well we could have some inflation to reduce the pressure of all of this debt building up. In fact I think this absolutely what we need to have happen so that proportional debt to GDP can go lower and rates can eventually normalize.
Oscilating between crashes and booms
It seems that anytime there is some shock that causes equity markets to fall sharply that an intervention happens fairly quickly. I’m not sure what to think about why this is, but it appears to be true. Is it really so bad if we have a bear market in equities for a couple of years? Anyway, these interventions seem to push the equity markets even higher every time and interest rates end up lower (permanently?).
I have to credit Travis Kimmel with this interesting observation of overlaying an oscillation on the S&P 500:
Structurally Deflationary Forces
There are quite a few deflationary forces impacting developed economies. Increasing automation, general technological advancements, weaving software and machine learning into just about everything, and finally the aging population is a deflationary force.
I can tell you first hand - I’m a programmer and my job is basically to automate other people’s jobs. My first job as a programmer I obsoleted the jobs of about 10 people doing clerical work, it took me one year to do that permanently. Technology is a strong deflationary force!
At the very least I create new software systems to automate something totally new which otherwise would have employed people to shuffle around paperwork or work in a call center.
My point here is that we had low CPI inflation for years in the aftermath of the 2009 crisis, even though we had very easy stimulative monetary policy (low rates). During this whole time after so much credit was destroyed it has been built back up again in the corporate sector & governments are more indebted than ever. And debt itself is deflationary, it pulls forward spending and then later you need to pay it back which causes you to pay more of you cash flow out as interest payments.
To counter this you probably have to take very aggressive inflationary fiscal actions like sending everyone in America checks for $1400. So maybe this is finally working.
The debt situation
I mentioned it a few times but let’s look at some charts to show the current debt load of the world.
Here is a more zoomed in view with the deficit spending comparison included
And here is corporate debt to GDP after covid
Inflation is (maybe) finally here, and that’s probably OK.
So going back to one of my opening statements: the great depression was so terrible that everyone with the power to avoid that outcome will probably do everything in their power to do so. So what if we create asset bubbles, and we have some inflation?
Maybe the world can sustain higher debt in it’s current structure, but I think evidence shows given that higher rates keep blowing up the stock market that it can’t. There has to be some release valve to clear the debt: either inflation to reduce it in real terms or defaults to reduce it in absolute terms. High inflation results in a little bit of temporary chaos but a deflationary default can result in a collapse of society.
A deflationary death spiral is arguably harder to recover from based on my read of history. Inflation causes economic issues and various inequalities but heavy deflation can result in mass starvation.
It was not the Weimar hyperinflation that led to the rise of Hitler in Germany, it was the deep deflationary bust after the boom years of the 20s. In fact Germany recovered from their brief hyperinflationary years fairly quickly. It was not easy to recover from the depression of the 30s.
And to be clear I’m not saying we could even get hyperinflation in America, at worst I would guess we could get some sustained 5% inflation given the strong deflationary headwinds we face. Let’s say we get 10% inflation that’s not even what we hit in the 70s.
The Melt Up
Given everything I just presented, it appears to me that everyone at the levers of power has a lot of incentive to create a bit of inflation and continue to bail out equity markets.
Part of the reason I think that equity markets keep getting bailed out is because everyone is all in on them. Governments (for the tax receipts), pension funds, retirees, savers, corporations - everyone is dependent on equity markets going up forever. It feels really great when the market goes up 30% in a year like it did in 2019, but if it drops 20% in a year that feels terrible and can touch off a spiral of deleveraging. These deflationary spirals are self re-inforcing and credit can contract really fast.
So rather than let a melt down happen and gather steam, we are going to see everyone in power united to spur a simmering melt up. It’s more palatable and you probably won’t end up with tent cities.
I’ll add one more thing: I see a lot of people talking about the “roaring 20s” right now. Maybe they are right, or maybe they started under Trump after the big tax cuts and deficit spending policies he enacted. Either way I think the party will keep going for a while.
Perhaps I’m wrong and something else happens over the next 5 years. I’m just laying out these thoughts here so I can come back and look at them later to see what happened vs how it feels it right now.