Time and risk

The financial world is about two interrelated things: time and risk. The moment a pension fund has an obligation over thirty years and there is no longer a bond than one with a ten-year maturity, that can theoretically be offset by a larger position in a ten-year loan. Suppose the yield on that loan was originally 5 percent and drops to zero percent. The duration (the weighted average life of the distributions) of a 30-year loan then increases from 15.4 years to 30 years, while that of a 10-year loan increases from 7.7 years to 10 years. Whereas previously two 10-year loans were sufficient to cover the risk of a 30-year bond, the fall in interest rates increases that to three 10-year loans. The fall in interest rates alone, therefore, means that more bonds have to be bought, creating a self-perpetuating downward spiral in which ‘safe’ government bonds become more and more expensive, with the result that savers and bond investors are deprived of all returns. 

Interest rates are too low

This drop-in interest rates to zero is the result of central banks keeping interest rates much lower than they need to be. In the ideal situation, the interest rate is more or less equal to the nominal growth rate of the economy. Those who can make just a little more return than the average (the nominal growth rate) can pay the interest on the debt. Such a situation automatically creates innovation. Old and uncompetitive companies lose out to new, innovative, and more profitable companies, if only because those old companies can no longer pay the interest. In the case of governments that are over-indebted, an ever-increasing portion of the budget goes to interest payments, eventually leading them into a debt trap. The job of the central bank is to keep interest rates in line with the nominal growth rate of the economy. There are periods when this has worked wonderfully, such as from the early 1980s to the beginning of this century. This ensures economic growth, falling unemployment and is also good for financial markets. This century, in particular, interest rates are much lower than the nominal growth rate. Borrowing money is interesting because the rate of return (the nominal growth rate) is much higher. More and more borrowing is done to buy existing assets and less and less to invest in innovation. The side effect is that existing poorly performing companies do not go bust thanks to the excessively low-interest rates, and therefore impede innovation by new competitors. This development is crippling for economic growth, but financial markets are decoupling themselves from the real economy through constantly rising valuations due to cheap credit. 

Monetary madness post-Corona

Post-Corona is a new world. In large parts of the developed world (United States, United Kingdom, and the Eurozone), the government dictates how much money is created. This flows into the real economy thanks to government guarantees. This form of blanket credit has minimized the chance of things going wrong somewhere because a company is over-financed. There is no longer any link between the amount of money and the growth of the economy. The creation of money has been nationalized, central banks are de facto part of the ministries of finance. It is not the private sector that determines how much money is needed, from now on the government determines it. Governments have a lot of debt, but it is easy to carry thanks to low-interest rates. Unfortunately, governments have an unlimited need for money, which may result in an unlimited growth of the money supply. The result is lower economic growth, higher prices, and a lower standard of living. The moment there is too much money in an economy, it is important to distinguish between real assets (stocks, commodities, real estate) and contracts (loans, bonds, savings accounts). Real assets are by definition limited and therefore retain their value. Contracts are infinite, as paper is patient. Savers are punished, but unprofitable companies are allowed to continue to exist and therefore put pressure on the returns of healthy companies. This stands in the way of innovation and productivity, which would ultimately benefit everyone. 

Consequences for investors

In this situation, it is important for central bankers and governments that the value of financial assets remains the same or rises, only then the debts that are covered by these financial assets are sustainable. The central bank’s put option is stronger than ever. Ultimately the assets with the longest duration benefit from this, and that is equities, especially growth stocks. After all, the value of a stock is determined by the present value of its future cash flows, and with low or even negative interest rates, cash flows in the distant future have become increasingly important. This new post-Corona monetary system has only just begun, with the risk of blowing bubbles again. If we draw a parallel with historical bubbles, we are only halfway there. This bull market does not stop until the economy goes into recession or stocks have become more expensive than bonds. A recession is unlikely because of the coming Keynesian investment wave, and the risk premium on equities is at about the highest point of this century. Inflation is rising, but in the long run, companies are perfectly capable of passing on that inflation, while for savers and bond investors inflation is the biggest enemy. Because of these developments, especially because of the accumulated debt, many fear a new systemic crisis. The likelihood of that is not so great. Any country with its own currency can and will always pay off its debts in full; the big question is only what the value of that repayment still is at that time. So the big outlet for this financial problem is through the value development of the currency. Now, the aforementioned Western central banks seem to be caught in a race to the bottom in this regard. The solution probably has to come from Asia, through a revaluation of the Chinese renminbi. Hedging the currency risk to a currency where monetary madness has struck is then unwise. For those who want to escape this wealth trap, a well-diversified equity portfolio is the best alternative.

Ageing is wrongly linked to deflation

Japan is a country with an ageing population. The working-age population (ages 15 to 64) has fallen from 87 million in 1994 to less than 74 million today. In 40 years, it will be down to 48 million. In nuance, that shrinking labour force did cause 13 per cent of the labour force to now consist of people over 65. It is quite normal in Japan for a person to continue working into old age. In parallel with this shrinking labour force, Japan experienced two lost decades of regular deflation. It is tempting to link these two issues together; after all, they are both typically Japanese problems. But the deflation was not caused by demographic factors, but by the bursting of a double bubble of unprecedented proportions. By the late 1980s, both the housing market and the stock market had risen sharply. The weight of Japanese stocks in the world index was approaching 50 per cent and a valuation of 200 times earnings for a Japanese bank was quite normal. Those banks financed plenty of real estates, with loans that were worth nothing when real estate prices came under pressure. It took until Shinzo Abe to address this problem, and Japan is still struggling to escape from the negative debt/deflation spiral.

The impact of the baby boom wave

After World War II, there was a birth wave in many parts of the world. This was especially true in 1946 and also 1947, but even in the twenty years that followed, significantly more children were born than in the period before and after. With the advent of contraception in the late 1960s and the breakdown of the pillarization movement, on the other hand, the number of children fell sharply. Assuming a retirement age of 65, the people from 1956 will retire this year. By stretching that retirement age a bit, we manage to postpone the problem, but not put it off. That means the number of baby boomers retiring will continue to rise over the next decade. Those people are also getting older thanks to better lifestyles and modern medicine. Between 2000 and 2015, the life expectancy of the world’s population increased by an average of five years. Those baby boomers also managed to save more for their retirement because of the power of the trade unions in the 1970s. All those pension savings depressed interest rates in the 1980s and 1990s. It is sometimes argued that the debt problem was created in the 1980s, but there was a savings bubble that made this possible. A worker who does not consume all income and defers some through savings allows prices to fall. After all, more is produced than consumed. Now that these people are retiring, the roles are reversed. They acutely stop producing and, because of favourable pension plans and increased life expectancy, will only consume for years to come. Less supply and more demand just make for rising prices.

No one exports more deflation

Since the 1970s, there has been a migration of companies to low-wage countries. Helped by container transport and improved global communications thanks to satellites, it became increasingly easy to produce stuff cheaper somewhere else. With Made in Japan, Made in Korea and Made in Taiwan, the emphasis in those years was on cheap and less on good. They exported products at prices that Western producers could not compete with, and that depressed inflation worldwide. In recent years, China has taken over that role. That country is now home to the world’s factories. Due to the sharp increase in urbanization in China, there was for many years a sufficient supply of cheap labour. Those times are over. Beijing no longer worries about whether there are enough jobs, it is now about an affordable house, cheap education or good healthcare. This means that China needs to produce more for its own people and no longer needs to rely so much on exports. And there are some countries like Vietnam, Indonesia and Nigeria that can partly take over China’s role, but the effect will be much weaker. There is also an ageing population in China, not because of the baby boom generation, but because of the one-child policy that has been in place for years. So this too will cause China to produce much less and consume more.

So it’s not surprising that deglobalization, big tech monopolies, the pendulum of capital-labour, the greater influence of government and central bank policies will lead to more inflation, but don’t count on being saved “like Japan” by a positive effect of demographics. On the contrary, demographic factors actually contribute to more inflation. It’s time for investors to design their portfolios accordingly.

Economy and Liquidity

Economy and liquidity (of central banks) are two communicating vessels. An economic downturn is compensated with central bank money and the moment the economy can stand on its own feet again, it is time to take money off the table. The big move by these three central banks is only possible because the economy is doing well. Central bankers are also beginning to worry for the first time about inflation and the impact of low-interest rates on financial stability. After all, until recently, inflation was a temporary phenomenon and central banks signalled that interest rates would remain low for much longer. Last week, Norway’s central bank became the first Western central bank to raise interest rates by a quarter of a percent, and Norway is not in a totally different position than many Western countries.  

Inflation is more stubborn than expected

Powell also had to admit last week that inflation was higher and more persistent than the Federal Reserve’s earlier forecasts. The Federal Open Market Committee (FOMC) is now also more uncertain about the outlook for inflation, given the wide dispersion in inflation forecasts from different members. Notable are the rapidly rising inflation expectations in the Eurozone. Based on a comparison of the German ten-year bond with a German inflation-linked bond, that inflation expectation is now above 1.6 percent. The last time inflation expectations in Germany were above 1.6 percent was in 2013. It is possible that the market fears the upcoming German coalition in which socialists and greens will spend more.  

Inflation in the pipeline

There is still a lot of inflation in the pipeline. Marine transportation costs have increased fivefold, as have European natural gas prices. Semiconductor shortages are getting bigger rather than smaller, a problem that probably won’t be solved until 2023. These are issues that a central bank would be hard-pressed to foresee. This year, the impact of weather on inflation rates appears to be very large, not to mention related to the climate crisis. The extreme drought in large parts of China and Brazil caused a shortage of water at hydropower plants, leading both countries to import massive amounts of liquefied gas, leaving nothing for Europe. In the United States, the drought is causing higher prices for agricultural commodities. Over the past forty years, each year of record drought has almost always been followed by years of normal or even above-average precipitation, but there are growing concerns that the impact of the climate crisis will create another “Dustbowl” in the United States. Central bankers do not include weather in their inflation forecasts. Moreover, food and energy are not part of core inflation. But food and energy are precisely two components where the price is often not the determinant of demand, but not of supply either. People still need to eat and the stove needs to burn. Rising energy prices and acute shortages also have a negative effect on economic growth, not the time for a central bank to raise interest rates. The dilemma for the central banker just gets bigger. 

Shortage of personnel

There is also a shortage of personnel. Although fewer people are working than before the corona crisis, it seems that many people no longer want to work. In part, this is probably the baby boomer generation who took advantage of the corona crisis to retire early. In part, fewer people are coming out of education because of the many delays caused by corona. It is also because of the strong growth in business activity, actually thanks to corona. The need for companies to adapt by innovating has worked. There are more vacancies outstanding than there are unemployed. At such a time, it is easier to demand higher wages, if only to compensate for rising prices.  

Impact of financial markets

The start of the tightening cycle will have little or no effect on rising inflation in the short term. The impact on the prices of various assets in the short term may be greater. For example, the Federal Reserve buys a large chunk of mortgage-backed securities each month, but the U.S. housing market really doesn’t need any more stimulus anyway. In Europe, too, low-interest rates have led to higher prices for financial assets, but it will take some time for this to turn around. The past shows that the first half of the tightening cycle is not so bad for the stock market at all. After all, it is a combination of good news: interest rates are still historically low, and the economy is picking up. Only in the second half of the tightening cycle do policies slow economic growth, and higher interest rates also hit valuations. The question is whether it will come to that, given the changed monetary objectives in which central bankers are embracing Keynes en masse, possibly resulting in inflation that will remain stubbornly high for a bit longer.

Also in the United States, the support program is being phased out

The federal funds rate and the discount rate remained unchanged. However, according to the Fed, sufficient progress has been made towards the goals of inflation and maximum employment. Therefore, it is justified to slowly end the support program that was rigged to help America through the corona crisis (“tapering”). In his explanation of the decision, Powell said that during the next meeting on November 2 and 3, the final decision to phase out the program could be taken, and the tapering could begin immediately. But of course only under the condition that the economy continues to recover and that corona does not cause any further obstacles. The Fed will then take its time until mid-2022 to completely phase out the support program. When the previous support program was phased out in 2014, the Fed took 10 months to do so. Whether interest rates will go up after that is an entirely different matter, according to Powell. The necessary uncertainty, therefore, persisted about when a possible interest rate increase would take place. Some guidance can be found in the “dot plot” with the individual expectations of the various central bankers. From this dot plot, it can be deduced that half of the policymakers expect a first interest rate increase in 2022, the other half does not see this happening until 2023.

New growth forecasts

In addition to the interest rate decision, the Fed also released new growth forecasts for the U.S. economy. The expectation for this year is slightly lower, going from 7.0 percent previously to 5.9 percent now. For 2022, the growth forecast was raised from 3.3 percent to 3.8 percent. Inflation expectations were also revised up. In June, the Fed was still expecting an inflation rate of 3.4 percent for this year, now this expectation was revised upward to 4.2 percent. In 2022, inflation will fall again to just above 2 percent.

German research institute assumes weaker recovery of the German economy

The Munich-based economic research institute IFO believes that the German economy will recover less strongly than previously assumed. Whereas in June it was still assumed that the German economy would grow by 3.3 percent this year, it is now only expected to grow by 2.5 percent. The German economy would like to recover more strongly, but is being held back by industry, which is facing a serious shortage of semifinished products. As is well known by now, semiconductors are the most frequently mentioned. However, the shortages are temporary, according to the IFO. Therefore, the German economy will grow more strongly in 2022 than previously assumed. The expectation was raised from 4.3 percent to 5.1 percent. Today’s release of the German purchasing managers’ index confirms IFO’s view of the current year. The composite index for services and industry fell from 62.6 to 58.5 in September. Economists’ expectations were at 61.5. The fact that the index shows a number above 50 means that the economy is still growing, but less vigorously than was assumed.

Since 1978, the Federal Reserve Bank of Kansas City has sponsored a symposium for central bankers. The first conferences were held in Vail and Denver, Colorado. Since 1982, the event has been held in Jackson Hole, Wyoming. Jackson Hole was chosen to entice Fed Chairman Paul Volcker – an avid sports fisherman – to attend as well. The meeting has been held every year since then at the Jackson Lake Lodge in Grand Teton National Park, a part of the United States that we seem to know primarily from the painter Bob Ross, an almost surreal world of snow-capped peaks, trees, and lakes. Furthermore, Jackson Hole is known for winter sports, especially powder snow. Unfortunately for central bankers, due to the corona crisis, the meeting has been virtual since last year.  

Monetary policy is made in Jackson Hole

The Jackson Hole meeting is an ideal place to release trial balloons, things that could later make a significant turn in monetary policy. One of the highlights each year is the Fed chairman’s speech, as several presidents have used this moment to announce new policies. This year, Jerome Powell gets to speak on Friday morning, August 28.  The central theme this year is when the Fed will tapering. Tapering is the gradual reduction and eventual cessation of monthly purchases.

Second Tapering

This is not the first time the Fed has been tapering. Central bank bond buying may fall under the heading of unconventional policy, but in practice, this unconventional policy has been used for more than a decade. The last time the Fed began tapering was in December 2013. Then the Fed reduced monthly purchases from $85 billion per month to $75 billion per month. That caused the 10-year U.S. interest rate to rise from 1.5 percent to 3 percent. Currently, the Fed buys 120 billion in bonds each month and the ten-year interest rate stands at 1.25 percent. In 2013, tapering caused a lot of turmoil. The Fed is trying to avoid that this time. The Fed’s latest minutes already indicated that most members of the Federal Open Market Committee (FOMC) favor starting tapering in 2021, provided the economy is strong enough. The minutes literally read, “most participants noted that, provided that the economy was to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year.”  

Tapering should not surprise

Various members of the Fed (San Francisco, Atlanta, Boston, Richmond, and Dallas) have also given speeches in recent weeks that should ensure that the actual announcement of tapering should no longer come as a shock to financial markets. Until recently, markets were still counting on tapering starting in the course of 2022. This has now been brought forward by a few months. US interest rates have not contracted in the meantime. This is also because the start of tapering seems to coincide with some slowdown in growth caused by the delta virus and shortages of chips and other components. But in financial markets, something may not be a problem for a long time until it is, and Jackson Hole has been a tipping point before.  

Fed reacts much later than usual

 

The 120 billion in monthly buybacks consists of 80 billion in government bonds (treasuries) and 40 billion in mortgage-backed securities (MBS). As a result, U.S. mortgage rates are at historic lows and house prices have risen sharply over the past twelve months. Stimulating the housing market is no longer necessary. Also, it is unprecedented in the past for the Fed to pursue such an extreme policy of stimulus when inflation is so high – it has been above 5 percent for two months now. But since last year’s Jackson Hole meeting, the U.S. central bank’s policy has changed. The Fed now aims for a long-term average inflation rate of 2 percent. That inflation has moved below 2 percent for so long that it is now allowed to rise above 2 percent for an extended period of time to return to trend. With inflation above 5 percent, things do move quickly. Accrued inflation has already compensated for the last five years, and soon the under-inflation of the last 15 years seems to have evened out. That is even before the start of unconventional policies in the United States. 

Interest rates are important for the valuation of financial assets

The U.S. interest rate has a major impact on the valuation of the stock market. With historically low-interest rates, even U.S. stocks look attractive in terms of valuation. The ten-year interest rate in the United States rose from 0.75 percent in December to 1.75 percent in March. Since then, the interest rate has fallen to 1.25 percent. It is unprecedented in U.S. history for government bond yields to be below 2 percent for so long. Even at 2.5 percent, the compensation that equities offer over and above the risk-free rate is still attractive. Consider further that today’s central bankers would rather be late than early.  Inflation has to rise, and it has to rise to a level that minimizes the chance of another flirtation with deflation. Furthermore, central bankers are also leaning more and more toward the Keynesian school and neoliberal monetarism seems to have fallen by the wayside. Moreover, central bankers have multiple goals, not only economic but also social. For example, the ECB is committed to the energy transition and Powell is striving for a job for every American, regardless of ethnic background.  

Financial stability puts a floor under the market

Another goal of central bankers today is to guard financial stability. This focus has to do with high debt levels. Financial turmoil can quickly create a new debt crisis through these debts. In fact, central bankers are telling stocks not to fall fast and this fact lays a floor under the market. Due to the extensive communication from the Fed about tapering and the unwarranted fear of a repeat of last time’s turmoil, it seems that this round of tapering will be much smoother than the last. That means that many investors will realize that interest rates could remain relatively low for an extended period of time, while inflation is above average. Not an attractive prospect for savers and bond investors. For years the inflow into bonds was greater than the money flowing into the stock market. This has changed this year. There is even talk of a rotation from bonds to equities, also seen by some as the great rotation. Such a rotation means that even without further monetary and economic impulses, the stock market can continue to rise. 

In 2014, the price of oil halved after a major transaction between the marginal buyer and the marginal seller. At the time, the marginal buyer was China and the marginal seller was Russia. In February of that year, the conflict between Russia and Ukraine began. Russia did not want to be too dependent on revenues from gas and oil exports to Western Europe in light of European sanctions. In May of that year, a deal worth $400 billion was signed with China. China took advantage of the situation and only had to pay half the market price. In the following months, the energy market adjusted to this new reality. For a long time, an oil price of $50 per barrel was a ceiling rather than a bottom.

Since the Great Financial Crisis, U.S. oil production has increased from about 5 million barrels per day in 2008 to a peak of 13 million barrels per day in 2019. That is higher production than Saudi Arabia or Russia. This was made possible by the Federal Reserve’s monetary policy, which lowered the cost of debt, and by innovations such as horizontal drilling and fracking. Those innovations were a direct result of the high price of oil before the Great Financial Crisis. Normally within OPEC, Saudi Arabia is the marginal seller, but the Saudis feared competition from U.S. shale farmers and pumped as much oil as possible to thwart U.S. oil farmers. Given rising U.S. production, they have not succeeded. Because of the reasonably steep learning curve, it turned out that the costs of the unconventional way of oil extraction could be lowered much further than expected. From now on, the United States was the marginal seller of oil, and the power of OPEC, Saudi Arabia and Russia broke down empty.

At the start of the corona crisis, OPEC + Russia reduced production by 10 million barrels per day. That was the largest reduction in oil production ever. In theory, a united cartel is capable of doubling the price of oil with a small reduction in production, but that unity sometimes wants to be lacking. Not this time. Meanwhile, oil production outside OPEC is under pressure. As part of the energy transition, more and more parties are demanding that oil companies stop investing in new production. Central bankers are warning commercial banks to stop lending money to oil companies because of the risk that not all oil will be pumped out of the ground anymore. Sustainable investors are demanding that oil companies use their cash flows to invest in alternative energy. The valuation of oil companies today is much lower than energy companies that have made the transition to alternative energy, a financial incentive for oil company executives to make the same transition. Otherwise, they will be stopped by a stray judge. Furthermore, last year’s extremely low oil price caused many long-term investment projects to be canceled. The best cure for a low oil price is still a low oil price.

Despite the higher oil price achieved by OPEC, production outside OPEC is now barely rising. Still, the production is 2 million barrels per day lower than at the peak of 2019 when the oil price was lower. In fact, it is likely that production will shrink in the coming years due to the lack of new investment. Meanwhile, oil demand is again rising toward 100 million barrels per day, equal to pre-Corona demand. A year from now, oil demand is likely to exceed global potential pumping capacity. That’s the first time in 160 years of oil market history. It is striking how much is being shouted about the energy transition when it is simply not visible in oil demand. Low investment outside the OPEC area will increase OPEC’s market share from 37 percent today to 52 percent in 2050. A cartel that gains more power can only mean one thing: rising prices. At the beginning of this century, production in non-OPEC countries also fell, with the result that OPEC’s increased power allowed it to quadruple the price of oil from $35 a barrel to eventually $145 a barrel. After all, OPEC oil’s biggest competitor is non-OPEC oil.

Due to the climate crisis and the energy transition, analysts seem convinced that the demand for oil will fall quickly. This is not or perhaps not yet visible in the statistics. If capacity limits are reached in a year’s time, a new oil crisis is even imminent. Even in the two oil crises of the 1970s, there was always sufficient production capacity. In the previous oil-bull market that started in 1999, oil prices rose from $11 to $145. When participants in the oil market realize how close demand has come to maximum supply, the slightest disruption can cause a rapid rise in oil prices. This could be Iranian-Yemeni missiles fired at Saudi oil installations, but a cold winter could also be enough to cause oil and gas prices to rise sharply. Then there will be no more marginal sellers, only marginal buyers.