Don’t Short the ‘Everything Bubble’!
Updated: May 1, 2020
“For every complex problem there is an answer that is clear, simple and wrong” H.L. Mencken
The charts below all plot the Net Worth of US Households (blue) and US GDP (orange), both in nominal US dollars (so we are comparing apples with apples) and both indexed to start at 100 at the beginning of each chart. Net Worth includes things like cash deposits, property, bonds and equities (all net of associated liabilities). GDP is the aggregate income of the economy. Chart 1 shows the full data series from 1944 to 2019. Chart 2 shows the first half of the series to 1985 and Chart 3 shows the second half from 1985 to 2019.
Chart 1: Index of US Household Net Worth (Blue) vs US GDP (Orange) 1944 – 2019 (1944 = 100)
Chart 2: Index of US Household Net Worth (Blue) vs US GDP (Orange) 1944 – 1985 (1944 = 100)
Chart3: Index of US Household Net Worth (Blue) vs US GDP (Orange) 1985 – 2019 (1985 = 100)
Chart 2 shows that for the 40 years after WWII, US income and assets grew hand in hand, which is what one might expect (after all, the cash flows that support the value of financial assets must ultimately come from the real economy). Chart 3 shows us that after around 1985, asset prices and incomes started to go their separate ways, a process which accelerated in the late 90s.
The first major divergence around the millennium was the dotcom technology bubble, the bursting of which helped the S&P 500 to fall 50%. Aggressive rate cuts by the Federal Reserve turned the market and the economy around but succeeded in blowing an even bigger bubble in housing, which simultaneously blew-up the US banking system in the Global Financial Crisis of 2008/9. This time the S&P 500 fell 60%. Fast forward to today and we have the “everything bubble”. Central banks have forced the prices of every financial asset under the sun into the stratosphere with zero rates, negative rates, forward guidance and wave after wave of QE. From these lofty levels, it is only after matter of time before asset prices collapse again.
Clear, simple and wrong.
The divergence between the two lines neatly encapsulates the investing zeitgeist that has dominated the careers of all current practicing investment professionals; financialisation. Financialisation happens when leverage rises faster than the income that is required to service it. Its chief sponsor is the central bank who nurture it through its formative years and beyond by progressively lowering interest rates.
But here’s the rub: In a highly financialised economy, the blue line cannot be allowed to fall back to the close the gap, without the orange line itself heading lower in a self-reinforcing and non-cyclical manner. We can see this start to happen in the 2008 crisis until central banks rode to the rescue. It is the same dynamic that morphed into the Great Depression in the 1930s when central banks didn’t have the tools they have today. In a highly leveraged economy, assets collateralise the whole system. More assets equal more collateral, equals more debt, equals more “growth”. For example, if house prices double, is there twice as much housing? Patently not, but it does facilitate twice as much debt and spending. But if they then halve, we’ve got big problems.
The monetary response to the financial crisis centered around forcing asset prices higher to drag the economy back onto its feet. It worked. The problem is that if asset prices now fall it will be from an even more extreme position and the already spluttering economy will implode. The sensitivity of highly financialised economies to rising interest rates and falling assets prices is extreme.
But neither is it tenable for the gap to persist. The reasons are too numerous to list in full. The widening gyre in politics due to a growing sense of injustice and inequality is one. This is driven by the fact that the fortunes of the rich who own the assets follow the blue line, while those on a wage are joined at the hip to the orange. Society fragments and demands solutions from its political representatives. Another reason is that it impairs the working of the capitalist system, feeding businesses that should be starved, promoting malinvestment and distortions that sap productivity.
We need another solution to the problem. The orange and blue lines need to reacquaint themselves but the old-fashioned way of doing this i.e. bursting the bubble (blue line down) is going to take the orange line down with it. Therefore, the Occam’s razor solution is for the orange line to go up and go up at a faster rate than the blue line.
Making this happen might seem equally impossible until one considers that in a fiat money regime, there is technically no limit on the sovereign’s capacity to spend. They can (and will) print as much money as they need without limitation. They have already proved this in financial markets which have themselves become no more than political utilities. Asset prices aren’t going to fall that far or for that long, when you have a price insensitive, politically driven entity with unlimited “money” to buy them and an existential interest (retaining power) in them not falling. They just need to target this firepower at the orange line instead of the blue.
The next incarnation of policy will do this. Monetary financed deficit spending (most of which is pre-ordained due to future entitlement obligations) or Modern Monetary Theory if you prefer, will create the demand necessary to keep the orange line rising and the central banks will write the cheques with freshly minted money to fill the void. To the extent that this spending can be channeled into projects that deliver a return over the cost of the debt, some of the growth can be real. To the extent it exceeds the supply constraints of the economy it will result in inflation. But be under no illusion that the political momentum behind “debt-be-damned” policies is unstoppable. For what its worth, I think this will “work” to start with in that it will support growth. I mean “work” in the same sense as the post 2008 monetary policies have worked. i.e. delaying the inevitable.
Ultimately, un-repayable debt burdens must be inflated away. Both orange and blue lines above are in nominal dollars. Inflating nominal GDP can close the gap and de-lever the system even if there is minimal real growth. If wages and prices are both 50% higher (and financial asset prices stay roughly the same) people with jobs and no wealth will be no worse off (and the orange line will be 50% higher). It’s just fiddling with the numeraire. The eagle-eyed among you will have realised that this means that the real (inflation-adjusted) return on financial assets must, in aggregate, be negative, even as nominal prices are held steady. This pain will be felt most acutely in cash and fixed income assets as rates and yields are pinned below inflation.
The bubble in tech stocks got kicked upstairs to the housing bubble which got kicked upstairs to the banking system which got kicked upstairs to the government. The question is: To where do you kick a government debt bubble? The answer is: the currency.
Bubbles by their very definition are ephemeral and this absolutely is a bubble. Bubbles in the private sector are resolved by forced selling. Bubbles in the public sector (for countries that can print their own currency) are resolved by forced buying. Governments with the power to print will not go bust for lack of money. They can and will maintain the liquidity and solvency of the economies they oversee. However, they cannot do so while simultaneously maintaining the purchasing power of the currencies in which the assets and liabilities are denominated. The next major crash in markets will be up, not down.
As an investor, what you must do and the assets you need to own if the orange line is forced up to the blue is the exact opposite than if the blue is allowed to fall back to the orange. The fundamental lack of awareness of this reality across the investor class and the fact that it is they who are in the crosshairs, is simultaneously a tragic necessity and an incredible opportunity.
Long scarcity, short money.