Risk is higher. Markets are more unpredictable, and valuations more volatile. So, when anyone says “this time it’s different” it usually makes good sense to stop listening. However, these days the markets have given us more frequent and intense volatility. The NASDAQ is down almost 30% so far this year, and shocks from the pandemic, the Ukrainian war, massive central bank interest-rate maneuvers, and China’s zero-covid policy, are all ongoing inputs for turmoil that will continue for some time. Persistent uncertainty creates higher costs of capital and less affordability, weakening business investment, slowing GDP growth, and reducing investment returns. Hyperbolic “this time it’s different” statements are turning out to be true. This time days look darker, uncertainty greater, economic growth lower, vulnerability to additional shocks higher, and investors fear many more dark days to come. More frequent and intense volatility will not be calmed anytime soon. It really may be different this time.
While most of Europe and the United States suffer sweltering heat, darkening economic skies and bitter winter of discontent are looming. Threats to the world economy are chilling. Rising interest rates are slowing activity for discretionary spending while rising prices for nondiscretionary spending are also slowing economic activity. It would be miraculous if the compounding of both effects would not lead to a recession in both Europe and the US. China’s growth has stalled. The Ukraine conflict will resolve itself to the West’s dramatic disadvantage and the West seems to be willing to let it happen – much to each economy’s long-term disadvantage. Don’t count on anything miraculous.
The Fed’s latest projection was for annual inflation to fall from over 5% at the end of 2022 to about 2.5% by the end of 2023. At this point, we’re not taking the Fed’s projections seriously, and for good reason. They were spectacularly wrong when a depth of understanding and insight into critical future events was essential. In other words, the understanding of how the economy works, the Fed’s ability to predict the effects of economic shocks, and its policy actions have gotten no better over the last 50 years. More specifically, price stability doesn’t seem to be coming anytime soon because people simply don’t think it will. If we look at the combination of rising wages and inflation expectations for both consumers and businesses, it is these expectations that drive inflationary pressures more than central bank policy. Inflation levels will be stickier than first theorized by the Fed, and the time to resolution is likely longer. Expect more “surprises” that will be no surprise.
The average prices of food and fuel rose more than 16% in February from a year earlier and are expected to rise further by the war in Ukraine. Consumers are paying much more for meat, bread, milk, shelter, gas, and utilities. Only a small amount of food consumed in the U.S. is imported, and most of that is from Mexico and Canada. But Russia provides 15% of the world’s fertilizer and other agricultural chemicals that are now in short supply as planting season approaches. Wheat futures are up 29% since Feb. 25 and corn is up 15%. There is no shortage of wheat in the U.S., but global supply was the tightest in 14 years before the conflict, and dramatic shortages and price spikes are expected. What data is the Fed looking at, and how is it assessing inflationary risks? It’s hard to feel confident that the right hands are on the wheel because the combination of extraordinary factors, such as extremely tight labor markets and wage inflation (at over 6% annually and accelerating) showed inflation was already a significant risk. Yet interest rates were left unaltered. This is even before the crisis in Ukraine. The Fed should do whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point, and a rapid reduction of its balance sheet. It also means recognizing that unemployment is likely to rise over the next couple of years. Paul Volcker would not have had to take extraordinary steps, driving the economy into a recession to crush runaway inflation, if his predecessors had not lost their focus on inflation. To avoid stagflation and the associated loss of public confidence in our economy today, the Fed has to do more than merely adjust its policy dials — it will have to head in a dramatically different direction.
Transformation, Valuation, Employment, and Deflation
Disruption to some of the world’s most important industries, deflationary pressure caused by scaling lower-cost businesses, and sustained low interest rates challenge traditional valuation models. Technological platforms, from blockchain-based businesses to energy storage to DNA sequencing, enable unprecedented disruption to business and economic models.
Interest rates will remain low, equity values will remain high, innovation will drive deflationary pressure, and volatility will be intense and frequent. A new approach is required to understand dynamic global competition and sustainable value.
Central bank independence and fiscal responsibility matter, even though the Western world is acting as if these rules no longer apply. Well, perhaps. But the world has given us three examples where the consequences are extreme when these basic foundations of economic policy are ignored or violated.
Separating signal versus noise is challenging these days because today’s signal is more muddled than ever. One of the more unusual circumstances, which I covered in more detail in the article “Important and Unknowable” is that the immediate past is telling us extraordinarily little about the near future. That is unusual because we can typically…
Economic predictions have always been highly variable and uncertain, and, for some reason, relied upon as if the future were a magical algorithm. Essentially, economists would make one fundamental mistake. They thought they were practicing a science. Data could be collected, inputted, and a predictive algorithm could be generated. Even Nobel Prize winners like Paul Samuelson believed that with enough data we could come to understand the economy and how it functioned.
This is nonsense. As Daniel Kahneman and Amos Tversky have shown us, human behavior and irrationality, combined with unpredictability and randomness (thank you Naseem Taleb) make this even a questionable social science. Using existing analysis and algorithms to reliably forecast is a fool’s errand, essential for someone’s tenure, and maybe even a Nobel Prize, but doesn’t add much that is useful. Some of the more laughable Nobel Prizes have been given to people who determined that markets were efficient. They are not. Economies can be predicted with useful data input. They cannot. A couple of inputs about inflation and the unemployment rate, and we know how to manage an economy. We can’t. That last one is the Philip’s Curve – true for a limited time and then it goes spectacularly wrong – a lot like most risk and market prediction models.
The world economy is struggling to escape the Covid-19 economic shock. During the worst of this pandemic, the world’s developed economies provided an enormous fiscal stimulus on a scale not seen since the second world war.
Now, however, the US is proposing to more than double its already generous fiscal stimulus. Is this a good idea or excessively risky?
Go Big, But Where?
For its proponents, the idea of “going big” is designed to be a transformative political moment. But too much appears allocated inefficiently, and it may simply be irresponsible.
An easy money era produced only anemic growth. But the scale and direction of additional stimulus look more like irresponsible fiscal policy leading to significant overheating and the waste of resources. While there is a strong case for a more aggressive approach to fiscal policy, that policy still needs to be grounded in economic realities and reasonable priorities. These are not.
“I believe that the present, accurately seized, foretells the future.” V.S. Naipaul There is a lot of uncertainty today in the markets, but there has always been uncertainty in the markets. We have never had certainty regarding the economy or the future. The most reasonable exercise, as V.S. Naipaul reminds us, is simply to understand the present. So what’s going on? The economy is accelerating. Inflation isn’t a problem. The Fed is going to keep interest rates as close to zero as possible for the foreseeable. These components are driving valuations higher, and in some cases, approaching stratospheric levels. Some concern is warranted in certain sectors, but overall, things seem to be relatively steady and not too overblown. Earnings appear likely to grow, and in many cases, quite rapidly, for the next couple of years – assuming something unforeseeable does not occur (but this probability is not zero). Bitcoin has a few interesting characteristics worth understanding. It is a decentralized, permissionless, peer-to-peer network of computers that’s permanent and unhackable .An investment in Bitcoin is, in reality, a part of the peer-to-peer computer network (essentially, a slot on the database), and almost all of those slots have been allocated. Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated. Price is a function of supply and demand (see Economics 101).Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin. Bitcoin supply grew 2.5% in 2020; it will grow 2.0% in 2021.The question for Bitcoin valuation is simple: Is demand growing faster or slower than 2.0% annually?