Is Time Nearly Up on This ‘Conventional Wisdom’?
Monday, 19 April 2021
By Greg Canavan
[5 min read]
‘Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.’
Lacy Hunt, ‘First Quarter 2021 Review and Outlook’
I’m going to quote a bit from Lacy’s latest update in today’s Insider. I think it’s crucial that you understand the larger macroeconomic currents flowing through the financial system right now.
Lacy Hunt is one of the world’s best monetary economists. He knows intimately how the system works. As such, he knows the natural tendency of the global financial system is towards deflation/disinflation.
That’s because of the debt heavy nature of the system. And that in turn is because the only remedy to ‘fix’ problems is more debt. All this does is creates transitory reflationary booms that many mistake for recovery.
This is where we are right now. The amount of economists/commentators/experts who are calling for sustained inflation is nearly unanimous. It’s certainly ‘conventional wisdom’.
But Lacy provides five reasons why the recovery induced inflationary numbers will not be sustained:
- Inflation is a lagging indicator.
- Productivity grows strongly in the aftermath of deep recessions. Productivity growth is negative for inflation.
- The restoration of supply chains, badly disrupted by the pandemic, will be disinflationary.
- Accelerated technology developments will lower costs.
- ‘…eye popping economic growth numbers, based on GDP in present circumstances, greatly overstate the presumed significance of their result. This is where the fallacy of the broken glass comes into play. Many businesses failed in the recession of 2020, much more so than normal. As survivors and new firms take over their markets, this will be reflected in GDP, but the costs of the failures will not be deducted.’
Lacy then goes on to discuss the structural impediments to US and global economic growth, namely a huge debt overhang and deteriorating demographics.
‘While the huge debt financed programs were a response to the pandemic, the end result is that global nonfinancial debt increased to a record 282% of GDP in 2020. The 37% surge of debt relative to GDP was also a record. While this debt may be politically popular and socially necessary, it will weaken growth and inflation after a transitory spurt, which will lead to even more disappointing business conditions than existed prior to the pandemic.’
Lacy says adjusting for dodgy monetary data out of China, which vastly understates its debt-to-GDP ratio, the global number would likely be much higher. But focusing on regions that have more reliable data…
‘…the debt situation deteriorated at much faster pace in Europe and Japan than in the U.S. (Chart 2). In 2020, measured by the ratio of total debt to GDP, the Euro Area was 124.3% of GDP higher than in the U.S. while Japan exceeded it by 292.3%. The debt to GDP ratio in the Euro Area and Japan has consistently outpaced that of the U.S. This explains why U.S. GDP growth has consistently registered superior economic performance. In 1995, the U.S. economy was 4% greater than the Euro Area, but 98% larger than Japan. In 2020, the U.S. economy was 34% and 200% larger, respectively, than the Euro Area and Japan. The comparatively worse debt overhang in the Euro Area and Japan indicates the U.S. should continue to be the growth leader.’
As an aside, this is why you need to be careful about being too bearish on the US dollar. Sure, it will go through cyclical downturns. But a structural downturn, or long-term bear market, is difficult with the US outperforming its two largest competitors.
Still, too much debt growth is bad whichever way you look at it. Just because your competitors might be doing worse, doesn’t make things better. As Lacy points out, the use of debt to bail us out of trouble is becoming more and more prevalent:
‘The unique aspect about 2020 is that the debt surge occurred so quickly after the previous one. On average, the debt peaks occurred 46 years apart in the history of the United States, however, the 2020 peak exceeds the prior secular peak of 2008 by a mere 12 years. This shows the increasing over reliance on debt to solve economic problems. While the debt works transitorily, real per capita GDP, which is a measure of the standard of living, continues to lose momentum as the debt levels move higher.’
If you benefit from rising asset prices and own your home, your standard of living is probably pretty good. But if you don’t (and the younger generation generally don’t) then the deterioration in living standards is real.
Turning to monetary conditions, Lacy tells us that:
‘M2 increased 19.2% from 2019 to 2020, the fastest since the 26.4% gain in 1943. However, velocity neutralized this impact on nominal GDP by falling to 1.19, dropping below the previous record low set seven and a half decades ago. When money increases and velocity falls, the money is trapped in the financial markets and has only a minimally lasting impact on the real economy.’
In other words, QE ‘money printing’ only works if the ‘money’ (which is actually bank reserves) makes its way into the real economy via increased bank lending. But that is just not happening.
‘The depository institutions and their private sector customers play a major role in the transmission of monetary policy. It is often incorrectly assumed that ample availability of reserves will lead to increased lending. For loan volumes to rise the banks must be able to price the risk premium into their loan rates and their customers must be willing to pay those rates. The measure that captures this process is the loan to deposit ratio which is also considered a lagging indicator. In addition, the loan to deposit ratio is a key gauge of the profitability of the depository institutions, particularly so for the medium and smaller sized ones. The loan to deposit ratio suggests that a reversal in monetary policy is well into the future. This ratio has just slumped to a new low for the history of the series that starts in 1973 (Chart 4).’
Source: Fed Reverve Board
As I’ve said before, the monetary system is broken. All the stimulus thrown at the global economy this past 12 months doesn’t change that fact. All it does is give the impression that we’re on the road to recovery. Our elected politicians and unelected technocrats will absolutely not tell you that. In fact, I very much doubt they really understand it.
So, what can you do about it?
I’ll get into some solutions in Wednesday’s edition…stay tuned.
Continue below for the ‘Week Ahead’ update. Today, Murray shows you a scrap metal business that has just announced an upgrade to earning expectations.
[WATCH] Value Stocks Starting to Move
By Murray Dawes
There has been a lot of talk lately about the shift in investor appetites away from growth and towards value.
The main beneficiary has been the bank stocks, which have spiked since the crash last year.
But there are also trends developing in other sectors. For example, building material stocks such as CSR Ltd [ASX:CSR] and Fletcher Building Ltd [ASX:FBU] are seeing strong buying.
The stock I show you today is involved in scrap metal recycling.
They have been going sideways for a decade, but since the crash their share price has rallied from $5.50 to their current price of $16.70.
They announced today that their FY21 earnings before interest and tax would be in the vicinity of $300 million and their share price jumped 10% on the news.
They are starting to look a little overbought in the short term, but the trend is strong.
In the video above, I show you where the price should find strong support going forward and also show you what to look for as a sign that the trade isn’t working out.
Editor, Pivot Trader