• Growth.

• • Likely to slow from the high pace of recovery.
    • + Base effects.
    • + Diminishing marginal returns to policy. Also, the need to reset policy to mitigate future crises.
    • + Substitution from efficiency to robustness.
    • + energy transition may cause loss in efficiency.
    • – Innovation in artificial intelligence, energy efficiency, supply chain optimization post re-shoring.
    • – continued loose fiscal and monetary policy.
    • – redistributive fiscal policy and progressive tax codes.
  • Expect oscillations. Amplitude of oscillations may exceed trend growth.
    • + Fiscal and monetary policy approaching extremes. Changes in policy may have big impact.
    • + Inequality. Social compact stressed. Risk of social instability is high.
    • + Climate volatility impact on inflation and policy.
    • + Medium term impact of COVID lockdowns still not well known.

For many years global growth rates have been maintained at beyond natural rates through unconventional monetary policy. These policies are reaching their limits. One serious constraint to further monetary stimulus is inflation which has recently risen above targets and forecasts.

Fiscal policy has recently been drafted to help where monetary policy may become less effective. Fiscal policy has in the past faced political hurdles but these have been cleared by the global COVID pandemic. Fiscal policy is a relatively new factor and may be able to drive growth rates further before it faces its limitations. A budget neutral redistributive tax code is also supportive for growth.

One moderating factor in growth rates is the substitution of robustness for efficiency. This was witnessed in the banking and financial sector after the financial crisis of 2008 and is a growing theme with multiple contributory factors including the desire for national self-sufficiency.

• Inflation. Inflation is partly transitory and partly persistent. It is likely that inflation will subside but not to pre 2019 levels.
  • Partly transitory.
    • Base effects from 2020 lockdowns.
    • Recovery from re-opening of economy.
    • Supply bottlenecks ease.
    • Innovation.
  • Partly persistent.
    • Substitution between efficiency and robustness.
    • Less globalised supply chains.
    • Redistributive fiscal policy.
    • Net fiscal deficits.
    • EM demographics.

After over three decades of modest inflation, prices are rising quickly once again. Much of it has to do with supply chain bottlenecks exacerbated by the COVID lockdowns and fiscal stimulus. If these were the only factors then the central banks would be right in thinking that they were transitory. There are reasons to expect some significant portion of inflation to be persistent.

Fiscal deficits added to monetary stimulus are inflationary. If fiscal discipline was reinstated quickly then this factor might be discounted.

The efficiency versus robustness trade-off is just beginning. The Balkanization of the world economy is driving this need for more robust supply chains. As supply chains are designed for more redundancy and self-sufficiency, cost efficiency falls.

One of the most significant factors in keeping inflation in check was cheap Chinese labour. The last couple of decades have seen Chinese wages rising, and the labour force growth slowing. India still has a young and growing labour force but cannot compensate for a maturing Chinese population. A China plus One production strategy has been adopted by many multinationals for almost a decade now.

Inflation is a failure of human ingenuity, and humans have yet to be beat. Innovation and collaboration have been hallmarks of the species. Advances in robotics, energy efficiency and artificial intelligence may yet prolong the goldilocks environment of growth and moderate price rises.

On balance, it seems that rising inflation has become a reality and is likely to be more persistent than central banks and investors hope.

• Policy
  • Fiscal policy gaining more acceptance globally. COVID has led to emergency fiscal deficits breaking the taboo.
  • Monetary policy may be limited by inflation.
    • Can central banks maintain low rates and asset purchases under rising inflation?
  • Coordination of monetary and fiscal policy to manage sovereign debt service.
  • Are asset markets also a policy tool?

Expansionary monetary policy balances downward pressure on interest rates and upward pressure on prices. Expansionary fiscal policy puts upward pressure on both rates and prices.

The popular acceptance of fiscal deficit policy has been telegraphed a long way ahead. COVID has provided the justification and acceleration of fiscal policy. Economic analgesics are difficult to wean off. On balance, fiscal deficits can be expected to grow or be more persistent. Even a budget neutral but incrementally progressive tax code will lean towards being inflationary though stimulative.

Monetary policy is expected to be coordinated with fiscal policy to maintain cheap funding for governments and the public sector. The complicating factor is inflation which could force central banks to tighten credit conditions more than they would like.

On balance there is a likely substitution of fiscal policy for monetary policy even as both policies remain expansionary. The result will be gentle pressure on short term interest rates and greater pressure on prices and longer term interest rates to rise.

• Socio-political factors.

• • Rivalry between US and China.
    • How much of this is driven by domestic politics?
    • What is the nature of the rivalry? Is it a struggle between philosophies such as communism and capitalism or is it a more prosaic economic and commercial rivalry?
    • Consequences for Europe, Africa, Middle East, Rest of Asia?

• • Central planning versus free market economics.
    • Efficiency of each under different assumptions of information completeness. This could, however, mitigate one of the failures of resource allocation under extreme inequality.

• • US policy.
    • Focus on domestic issues.
    • External policy through the lens of domestic dynamics.
    • Mid-term elections.

• • China policy.
    • Addressing market failures.
      • Free riders.
      • Rent extraction.
      • Monopoly.
      • Inequality.
      • Tragedy of the commons.
      • Other interventions to maintain balance and stability. Here also is an example of a repositioning from efficiency to robustness.
    • Execution risks. To what extent does the means confound the ends?
    • Is there a fundamental departure from market economics?

China is at an inflexion point. The actions of government and regulators could be indicative of a change in paradigm either in favour of more inclusive market economics with its market failures addressed and mitigated, or towards a more oppressive regime of central authority. At the operating level, the policies look the same.

For those who see China as an enlightened communist/market economy, the encouraging signs are that policies seem to be targeting established market failures. The implementation and signalling by the regulators have been awkward and clumsy. There are sufficient elements of excessive control in the new regulations that could support the more cynical view that China is turning away from free market economics. More time and signal are needed before the question is settled.

• • Inequality.
    • Inequality leads to more concentrated resource allocation decision making which is informationally inefficient.
    • Inequality impairs the explanatory and predictive power of our economic, social and political models and can lead to policy errors.
    • Inequality leads to aggregate over-saving and under-consumption reducing growth rates for a given endowment of factors and money supply.
    • – scope for inequality is required to encourage effort and enterprise.
    • – patience for trickle-down economics is a function of the age distribution of the population.

Economists and investors are only just recognising the ills of inequality as regards aggregate over-saving and demand deficiency (see The Saving Glut of the Rich, Mian, Straub and Sufi 2021). A more subtle problem plagues unequal societies in the form of unequal economic voices in the market place of capital allocation and consumption decisions. This can lead to the information processing efficiency of the market economy tending towards that of the centrally planned economy.

• The environment.
  • Climate and weather volatility. Amplitude of oscillations may exceed trend parameters.
    • Impact on agriculture.
    • Impact on shelter.
    • Water and food security.
    • Inflation and interest rates.

1. Education has to provide all an equal start.
2. Data protection addresses the question of who owns their own data, people or platforms.
3. Monopolies have to be regulated so that price falls between marginal and average costs. This is the compromise forgotten by Western democracies.
4. I expect wealth inequality will be addressed soon. To the detriment of luxury companies. Also expect wealth taxes.

Most investment professionals will tell you market timing is impossible. Now I am saying that not only is it impossible, it is important as well. 

Simplistically, the last time we saw stock valuations this high (S&P500 at 26X) was in 1999. If you invested then in the S&P500, and held on for 12 years, until valuations normalized, your annualized return would have been 0.55%, for a total period return of 6.81%. If you invested in 1994, by 1999, you would have made 225%, or 22% per annum. Market timing might not work on a yearly time frame, but it is important on a decade level time frame. Value investing and fundamentals may be out of fashion at the moment, but current valuations and in particular their departure from reality are cause for concern. The tactical and nimble investor may decide to go risk-on and hope to get out before the market turns. Buy and hold by all means, but keep an eye on price action.

S&P500 Price Earnings Ratio: Sticker shock. 

Asset Returns 1999 to 2011: Investing at a top. 

Asset Returns 1994 to 1999: Investing just before turbo boost. 

*data source: Bloomberg.

The picture of free markets and decentralized decision making is somewhat misleading. Companies are not democracies but highly organized and often hierarchical structures. Companies interact with one another and with their customers in a free market. Today’s capitalist economies look more like collections or coalitions of centralized control communicating with one another in a free market environment.

If the central planner has perfect information, then their resource allocation and investment decisions are optimal. When information is imperfect, decentralization is better. The optimal firm can be thought of as a collection of resources within which information is perfect.

The maximum efficient size of a firm is therefore determined by how close to information perfection it is. In the past, information was highly imperfect imposing limits to efficient firm size. As the quantity of information and the ability to understand and manage this information has increased, the maximum efficient size of the firm has also increased.

One practical implication of this hypothesis is that as we generate, store and process information more effectively, as has been the case in recent history, firms are getting larger before they hit the limits of their growth. This is especially apparent in the tech industry where information is the main commodity. Other industries who recognize this can also grow beyond their historical limits.

Another implication is that a firm should focus on its information efficiency as it grows headcount. It should focus on how it obtains or generates information and processes it as it expands.

You will hear a lot of talk about inflation in the financial media. Here are some thoughts about it. I don’t think inflation will rise or if it does that it will be protracted. But I am keeping my interest rate sensitivity low and keeping a keen eye on inflation data. Asset markets have either recovered most of their declines or are even higher than they were before the COVID lockdowns. Given that many countries and industries will not recover their level of economic output until 2022 or 2023, this seems strange.

1. Central banks have been supporting markets, not just the economy. Central banks are not only buying their own debt, they are buying private debt as well.
2. Governments have implemented emergency spending, sending checks to people. Significant portions of this money are being saved which leads to investment in stocks and bonds.
3. Some industries like tech, stay-at-home industries like e-commerce, Cloud and media streaming, logistics and industrial real estate are flourishing. Some are rebounding such as the auto industry and banks. Retail and hospitality and other old economy industries continue to languish.

Item 3 gives us hope that human ingenuity will overcome whatever nature throws our way. This is true to a great extent.

Items 1 and 2 are very important to asset values. Governments can continue to pursue such policies with one caveat. Inflation must not rise out of hand. If it does, central banks will have to raise rates or stop buying bonds. Governments will have to be more fiscally prudent. Either of these will throw the current trend of rising asset prices into reverse.

Inflation snippets:

• Human ingenuity leads to lower inflation. A bet on higher inflation is a bet against human ingenuity, a risky bet.
• Efficiency X Robustness = Constant. Efficiency is disinflationary and robustness is inflationary. De-globalization (whether in the form of trade wars, re-shoring, self-sufficiency,) decreases efficiency and increases robustness.
• Monetary policy cannot influence the real rate of interest. This is determined by the efficiency of the economy. This is the natural real rate of interest.
• Cutting rates can weaken inflation. Cutting interest rates leads to immediately lower real interest rates. However, real interest rates then return to their natural rate. For this to happen, inflation must fall. Conversely, raising interest rates can increase inflation.
• QE is relatively disinflationary. QE is printing money pro rata to assets which is a net relative transfer from poor to rich, increasing the savings rate and decreasing the propensity to consume. This depresses inflation and interest rates.
• Where the national debt is high relative to GDP, countries need low interest rates to maintain manageable debt service. Central banks may take into account national debt service in monetary policy. If so, central banks will maintain low interest rates for the foreseeable future.
• US bond issuers tend to focus on funding up to 5 years, with 10 year and longer maturity issuance tapering off. It is important that the Fed keeps interest rates low up to 5 to 7 years. Maturities beyond that are less important.
• There is an excess of money supply for assets. This has resulted in asset inflation. There is a shortage of money supply for goods and services. This has resulted in low inflation. The Fed cannot differentiate between money for assets and money for goods and services; this is a distinction made by consumers and investors.
• Fiscal policy is marginally inflationary. If fiscal policy involves the net transfer of wealth from rich to poor, it will increase the propensity to consume, encouraging higher inflation. If policy is financed with increased progressive taxation, it could lower aggregate savings leading to weaker demand for assets.
• 24% of the US consumer price index basket is shelter: owners’ equivalent rent. This quantity is flatlining even as other items are rising.
• Governments who have borrowed heavily should welcome inflation to erode the real value of their debts. Goods and services inflation is political risky, but asset inflation is mostly welcome by the people.
• Investors try to hedge against inflation by a) investing in commodities, b) investing in TIPS (inflation linked bonds), c) investing in stocks (tomorrow’s output bought today), d) shorting long maturity bonds while buying short-dated bonds or e) buying floating rate debt.