Having taken my family holiday in July, I had actually been hoping that August would see a pick-up in volatility and offer some trading opportunities. However, with trading ranges compressed and the post Brexit rally stalling but not reversing (yet?), I was left with two choices; either head back to the beach or catch up on some fundamental research. The latter won out to my great disappointment!
Frankly, we’re not sure whether the summer slumber will break during the final two weeks of the holiday season or not, but we can identify a number of interesting events in the next month, as well as noting the US presidential election and Italian referendum during Q4. With global central bank actions distorting financial markets in a way that has never been seen before in history, any hint of anxiety over the efficacy of current policies could prove, in hindsight, to be a pivotal moment. In this regard, Janet Yellen’s speech at Jackson hole on 26th August and the Bank of Japan and FOMC meetings on 21st September are of particular interest. Sandwiched between these dates, the next US employment report on 2nd September, the G20 meeting on 4th September and the ECB on 8th September could easily cause a few ripples.
We will no doubt tackle the outcome of these events as they arise, but this week we thought we would share some thoughts garnered or fleshed out from some of the recent work we have been doing.
We continue to be depressed by the current economic thinking. Seven years into the slowest post WWII recovery on record, John Williams of the San Francisco Fed published a paper last weekend calling for a rethink on central bank policies (see link below). Although he stated that monetary policy could no longer work alone and calling for a fiscal response, he also raised the spectre of a higher inflation target or even nominal GDP targeting.
Here is the introduction to the paper:
“Central banks and governments around the world must be able to adapt policy to changing economic circumstances. The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest. While price level or nominal GDP targeting by monetary authorities are options, fiscal and other policies must also take on some of the burden to help sustain economic growth and stability.”
Alongside these calls for more from monetary policymakers, there are growing calls for more action from Governments to stimulate and reform through fiscal policies. Now, we would very much welcome true reforms that boost the supply side of the economy, however, all too often fiscal policy is short hand for “borrow and spend” or even “borrow to cover promised expenditures”. All too often, both monetary and fiscal policies sound eminently sensible on paper and in the short term, but the evidence more than suggests that the secular stagnation threat is both real and growing and that suggested policies will be ineffective and may actually make matters worse.
One of our favourite weekly reads is John Hussman who rightly points out that “The true wealth of a nation is embodied in its accumulated stock of productive capital, infrastructure, unused resources, and knowledge. The use of this productive capital to generate “value added” – goods and services that have a greater value than the inputs used to produce them – is how new income, productive capital and wealth will emerge”. Furthermore, Mr Hussman rightly points out that securities issued (equities, bonds etc) are simply entitlements to the cash flows generated by the true wealth of a nation, or viewed differently, rising values of quoted equities and bonds do not create wealth, they simply bring forward future returns from those securities to the present.
So, how do we measure the true wealth of a nation? Traditionally, GDP adjusted for the rate of inflation has been used. We need to understand that real GDP growth comes from growth in both the population and productivity. So perhaps a better measure of how well economies are doing is to measure real GDP per capita, which should be in line with accumulated gains in productivity. Chart 1 below shows this for the US.
Chart 1 – US GDP per capita and productivity (1960 = 100)
We would also hope to see household incomes rise in line with GDP per capita and productivity, and from the end of WWII to about 1980, this was the case. However, something changed in about 1980 as can be seen in chart 2 below, and since then the median household income has barely risen at all whilst GDP per capita (not shown in chart 2) and productivity have risen by about 80% and 90% respectively.
Chart 2 – US Productivity and Real Median Household Income
As indicated on the chart above, the gains from technology and financialisation (and add to this globalisation) since about 1980 have accrued to those with higher education, ownership of assets and access to cheap credit. We can corroborate this when we look at income analysis for the top 5% versus the median (for men only I’m afraid) since 1973 as seen in chart 3.
Chart 3 – The growing income gap among men at the top and the middle of the earnings distribution
Perhaps another way to illustrate this; not only have the majority of economic benefits accrued to the top few per cent of the population, but the share of income accruing to all employees as a per cent of Gross Domestic income has collapsed since 1970 as seen in chart 4 below.
Chart 4 – Share of employees income relative to the size of the economy
So, according to our analysis that we have shown many times in the past, the current economic recovery is the weakest by far in post WWII history. Real growth is driven by productivity, which is barely growing now (see our commentary from two weeks ago LINK HERE). But the good news ends there, as the vast majority of households are no better off than they were 30 or so years ago. Pretty much all the broad economic gains in the last 30 years or so have accrued to a small group of people at the top of the income and wealth (and most likely education) bracket.
We have some thoughts on why the above situation exists, and will outline them in more detail in coming weeks. The reality is that for nearly three decades, central bankers have pursued policies that focus more on the performance of asset prices, arguably at the cost of long term economic performance. With the new monetary policy proposals mostly about trying to keep real interest rates low, and trying to stave off economic downturns (as measured by real GDP as opposed to say real GDP per capita or real median household income) and financial bear markets, we basically see no major change in central bank thinking. On the fiscal side, for politicians it’s all about winning votes. Here, past promises made will ensure dramatically higher mandatory spending in years to come, and all else being equal, higher budget deficits, before taking into consideration new fiscal expansion and the potential short term costs of long term reforms. In short, there is little room for fiscal largesse although well thought out public investment and supply side reforms would certainly not upset the markets
From an economic standpoint, our fear is that policymakers will continue to do more of what is not working. Monetary policy is currently distorting financial markets in ways never seen before, and with long term consequences that are highly likely to be much greater than the current cohort of central bankers will publicly admit. But in the short term, the markets are buying into ever greater monetary stimulus plans, and reaching for yield as far as the eye can see.
As we have tried to outline above, the real value of a nation does not lie in stock and bond prices but the accumulated stock of productive capital, infrastructure, unused resources, and knowledge. It is the cash flow derived from our true wealth that equity and bond buyers are gaining access to, and the higher the price is today, the lower the future return will be. Somewhat paradoxically, it can easily be argued that monetary and fiscal policies are now harming our productive capital, and with the current reach for yield everywhere, the gaping divide between financial prices of securities and the underlying cash flows derived from the productive capital is rapidly getting worse.
If this thesis is correct, then central bankers are simply creating a financial bubble that requires more and more stimulus to keep going. Unfortunately for them, if they stop, the risk of a financial event is very large. If they keep going, then they may struggle to actually keep adding to the punch bowl. With the negative interest rate policy now being openly questioned, and the Bank of England, Bank of Japan and ECB are beginning to struggle in finding enough assets to buy, they are close to reaching the limits of the extraordinary policies they claim to have cleverly designed and implemented.
So with policies neither helping core economic growth, nor being so easy to implement, policy makers are calling for a grand rethink on economic policymaking, both monetary and fiscal. However, if there was an easy answer would they not have tried this already? We do fear that the current debate is not really heading In the right direction, and any resulting policy changes will have little impact on the real economy and likely just try and sustain current asset inflation, which as noted above, is actually becoming harder anyway.
This note has already become too long for a late August weekend, and so we will sign off here for now. We will be monitoring the upcoming events for both short term policy and market implications as well as long term rethink on our economic framework. We will also outline in coming weeks some of our thoughts on what policies would actually help the real economy, although we doubt that current policymakers are anywhere close to thinking the same as us.
Stewart Richardson
Chief Investment Officer
