Risk Update – November 2019

We suspect most of you have heard quite a lot lately about something along the lines of “monetary policy is running out of its potency, so it is time for the fiscal side to step up”. We certainly have.

The, deemed obvious, solutions run the gambit of traditional fiscal stimulus, to helicopter money, to something called Modern Monetary Theory (MMT), but in the end it all amounts to more or less the same thing: somehow additional government spending, whether financed by debt or otherwise, will set economies on their elusive sustainable paths.

We found the linked piece below from Beijing based finance professor, Michael Pettis, a useful and understandable thought piece on the topic of fiscal spending:

A broad paraphrasing of Mr Pettis’ note could be that the failure of past attempts to achieve the nirvana of sustainable growth were the result of flawed diagnoses of the problem. To overcome the core issue of demand-side constraints, the answer is to give money directly to the poor. In the perfect scenario, the poor will spend just the right amount of their new money and save just the right amount to fund the investment necessary to meet the increased demand from the additional consumption, such that it does not create inflation. The idea assumes there is spare capacity and no supply-side constraints.

Figure 1: Stairway to Heaven
Source: Creditwritedowns.com, Michael Pettis

That ‘answer’, along with the assumption that this time the ivory tower crowd will correctly diagnose the problem, are already hard enough to buy into. Even more unlikely, we would argue, is the assumption that “Government” will execute this free reign of unconstrained money distributing without any incompetence or corruption!

We were fed this story from a friendly visiting consensus economist recently as the obvious, sure-fire solution for what ails Europe at the moment. All they need to do is to free up the fiscal spending by taking away any concerns about the burden of debt. As he put it “everybody has unlimited fiscal capacity if the debt doesn’t cost anything”. We questioned his logic that giving unbounded and unconstrained spending capacity to elected governments in Greece, Italy, Spain, France, etc was likely to lead to long term sustainable economic growth. The Goldilock’s scenario of that spending flowing to just the right places, in just the right amounts, with perfect competence and honesty, struck us as a theoretical utopia too far removed from reality. We have a sneaky feeling that it will simply once again end up with the rich getting richer. As you have likely heard us say before, if (1) lower interest rates, (2) bigger Central Bank balance sheets, and (3) more government spending/debt were the answers to economic challenges around the world, we suspect the problem would have been solved by now!

Figure 2: 10yr Yields US Tsy, JGB, Gilt, Bund
Source: Bloomberg
Figure 3: Global Policy Rates
Source: Bloomberg and Nomura
Figure 4: Central Bank Assets Fed, BOJ, ECB
Source: Bloomberg
Figure 5: Global Debt to GDP
Source: Deutsche Bank
Figure 6: Percentage Change in Debt as Share of GDP
Source: IMF, Bank for International Settlements

Does anybody seriously think that the problems in economies today are that interest rates aren’t low enough? That Central Banks haven’t bought enough assets? That governments haven’t run sufficient fiscal deficits?

We might argue, that these solutions aren’t trying to fix underlying problems, but rather to sustain underlying problems. The mindset could be described as addressing a Ponzi scheme by funding another round of the Ponzi scheme, all the while arguing that this time, miraculously, the Ponzi scheme won’t need additional rounds of funding in the future! MMT Heaven indeed.

So, if the consensus is correct that we are heading down the path of MMT stimulus, then for that to be the correct solution, according to Mr Pettis, we must be in a world where there is no supply side constraint, ie no inflation and ample available labour. Oddly, we don’t really appear to be in that state.

We are, for example in Figure 7, at historical lows in unemployment rates….

Figure 7: US, Japan, Eurozone Unemployment
Source: Bloomberg

….and not really outside of historical norms in chosen price stability measures:

Figure 8: US, Japan, Eurozone CPI/HICP YoY
Source: Bloomberg

In fact, in the real world of living costs, many of the true essentials of day-to-day life have been inflating significantly. If only TVs, toys, and hand phones were our most critical annual purchasing requirements!

Figure 9: US Inflation by Components
Source: HowMuch.net

Begs the question, why do they want to keep driving up the cost of healthcare, education, and housing to offset the technology gains of TVs and computers? And why is it mission critical, at least according to Central Bankers, that the average of all of these moving parts must exceed 2% per annum lost purchasing power?

We are suspicious that it has something to do with this view of things:

Figure 10: Equity Index vs Price Index
Source: Bloomberg

Is it really the rate of increase of the white line above that they are concerned about? Or is it the sustained wealth transfer of asset inflation that they are focused upon? Again, we have our suspicions.

We wrote last month about the mathematics of compounding and the clear portfolio solution of adding convexity to improve compounded returns. We came to the conclusion that to optimize long term compounded returns one should own beta and efficient downside protection. Conveniently, our review of the current economic situation leads us to the very same conclusion. Own the thing the policy makers are trying to inflate, and own efficient protection in case/when they fail.

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