Thursday, September 17, 2020

This Week's Message: History's Rhymes

In our effort to keep you informed as to what we're thinking in the here and now we're forever highlighting herein the at-the-moment trends and developments that instruct our entries into, exits out of, and hedges on various asset classes and securities. Underneath it all of course is the broad macro picture, global general conditions, if you will, that command our attention (analyzing, interpreting, testing, hypothesizing) on virtually a 24/7 basis. 

Yes, no doubt, we live in times that are indeed unique to you and me. However, as history has a way of rhyming, it turns out that times like the present have in fact played out in the past. Which of course makes the intense, ongoing study of history a mandatory function for a firm like ours -- as it aids us in gauging the go-forward probabilities with regard to inflation, deflation, interest rates, currencies, commodities, stocks, bonds, etc.

The raging conversation among deep macro thinkers these days is around the efficacy of monetary policy, and of fiscal policy, and what it all means in the inflation vs deflation debate.

The chart below will give you a sense of the modern-history uniqueness of the situation we find ourselves in. Grey shaded areas denote past recessions, the blue line represents corporate debt to GDP, the red line represents interest rates (3-month TBill):

Notice how debt tends to decline when things get tough, but each short-term cycle resolves with a higher level relative to where it began. I.e., existing debt at the beginning of each new expansion is higher than it was at the beginning of the last. And note how interest rates are now nearly as low as they can go, without going negative.

Now let's stretch out the graph and capture the past 100 years:

Now notice when in history (the Great Depression and the Great Recession) interest rates (orange) were at present lows. And, alas, notice where total debt to GDP (blue) rested during those rare occurrences.

At this point you may have a greater appreciation for my thesis that the Fed's new approach to potential inflation -- let it run hotter -- is, contrary to popular opinion, not about their desire to inspire inflation via "forward guidance", but to give themselves the wherewithal to not address it with higher interest rates if/when it ultimately exceeds the point where their old commitment would've had them doing so. 

I.e., imagine the Fed hiking rates amid history's greatest debt bubble when their decades long practice of bailing out otherwise failed institutions, not to mention rescuing egregiously careless hedge funds and private equity firms (this go round), coupled with financial repression, leaves them with virtually no choice but to in fact inflate the debt away via the printing press. 

Oh, and imagine what would happen to the price of stocks when the discount models that justify their valuations have to factor in an interest rate above zero! Although, inflation (particularly in a massive debt environment) by itself -- without regard to Fed rate policy -- could easily do the trick.

In the meantime, the overwhelming consensus has it that fiscal stimulus (government borrowing and spending) is paramount if we've any chance of making our way out of this recession anytime soon, and in a healthy, sustainable manner. The theses of those in the inflation-is-coming camp see this as the ultimate ingredient, as, clearly, we've learned that the Fed simply printing money bank reserves by itself sparks no inflationary impulse, other than in asset markets (stocks in particular). A trillion or three of government injections into the economy, however, amid zero Fed restraint (the opposite in fact) and global supply constraints (Covid, trade disputes, onshoring, etc.), and -- while there remain some very smart skeptics -- it's not hard to at last begin sympathizing with the inflationistas.

Now, for us, being tasked with the smart allocation of our clients' monies, it all comes down to risk and opportunity. Suffice to say, that, while I've barely scratched the surface of the inflation debate for you herein this morning, we need to remain uber cognizant not only of the prevailing setup, with its attendant risks and opportunities, but of the rhyming of history -- which, per the 2nd graph above, has us (with 41% of our core allocation presently targeted to cash, currencies and commodities, and our top equity holdings being staples, utilities, healthcare and materials, and, not to mention hedging with puts) erring on the side of caution these days.

Thanks for reading!

P.s. For a deeper dive into the times when history rhymed with today, the source of the above charts, Lynn Alden's enlightening essay titled A Century of Fiscal and Monetary Policy: Inflation vs Deflation, is a great read!

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