Delicate Equilibrium

The two charts are a just an illustration over time of  how  I best view  the principal driving forces behind the markets.

What matters here, are the proportions and their  respective empirical evolution.  It varies  countries from countries but since we all use the same monetary/economic system, the trip is the same (just at different speed..). GDP or Main Street is basically the productive private sector and as you can observe, the other parts are very small at the beginning and  tend to grow faster than GDP overtime.  GDP  is the  cornertsone of such expansion.

In SGG investment approach, I highlight two questions:

In a world awash in money, (Bain & Company 2012 shows that  for each USD 1.00 of GDP we have about USD 10.00 of financial assets (All financial assets of all sectors Includes financial holdings of direct owners, as well as financial assets controlled by and held on the balance sheet of banks and other financial intermediaries) what is the rate of return that financial asset will judge acceptable and for how long?  The second one would be:  Do Central Banks have such unlimited power without unintended consequences?

So… here we are!  12 years since the GFC and  “Capital Superabundance” could be viewed as too little GDP. QE & Co has become a permanent feature of GVT intervention through central banks. Asset price inflation is the  main component of their policies since much credit growth has been fueled by asset price inflation. GVT share to GDP is big and negative rates have lead to the volume explosion of derivatives. I highlight in previous posts the impact of the derivatives (in particular Equities  – market dealer Gamma impact) and somehow we have today a situation where the underlying assets have become the derivative of the derivative.  Overall credit quality has weakened a lot and  several sources indicate that zombies companies are 20% of all US Corporations. Since money is mostly debt….the coming insolvency phase could be quite  challenging for many investors.

COVID 19 has  just pushed the  delicate equilibrium further. Today, a Trillion Dolar  is almost pocket change. Between the have and have nots, political polarization is growing and could lead to other unpleasant events. So yes… politicians are worried and looking for solutions which shall not spook the markets.  It’s a process, money for Main Street has become the hot politician talk across the ideology spectrum.

I tend to believe that we will end up having inflation but it is a process.  GVTs can only intervene more with, in the cards, capital control,   taxes, regulation,  bank nationalization (EU?) , financial repression, yield curve control etc.. . The ultimate goal is capital remuneration lower than inflation for quite a long time. The deflationary forces are still very strong and I believe they will need to “express” themselves a bit more before the owners of capital  really embrace Money for Main Street. It is a tricky process to manage but COVID 19 may have been the trigger for faster adoption.  Among the investment community we can hear quite some diverse  and strong opinions :

Dump  long  term bonds is a must do thing now.

Inflation linked bonds only

Bitcoin $1 million  & other crypto  as the new digital gold,

Gold & Silver will go ballistic.

Currencies will die

Commodities and real assets should be susbtantially overweighted.

Private Equity & VCs versus traditional equities.

Maximum diversification as a hedge

etc..

I think that all of them hold some very valid points but there is no magic formula. However, there is a path which is managing how the parts relate to each others.  2020 has proven to be a year of many broken rules. What appears is that it is becoming harder  to keep the ball rolling for GVTs and Central bankers. The built in instabilities of the system require bigger and harder to manage  interventions each time.

(This is what Bain & Company projected in 2012 and it is quite acurate)

In good economic times and bad, the overarching objective for owners and managers of capital is to seek out the best possible risk-adjusted rate of return on the money they invest. That essential role for capital in a market economy powers a virtuous cycle: Money invested in tangible assets and research expands productive capacity, increases GDP and generates profits that can be plowed back into fueling further economic growth. In a world saturated with financial assets, however, that classic pattern of wealth creation is causing disturbances that will give rise to new risks.

Facing capital superabundance, investors are straining to find a sufficient supply of attractive productive assets to absorb it all. The sheer volume of liquidity being pumped into the markets by major central banks has sparked inflation fears. Stockpiled with financial assets, yield-hungry investors are venturing well beyond sustainable income-producing investments in pursuit of returns that for many could prove illusory. Given the ample spare capacity for production across the world, however, we expect that inflation will not show up in core prices in most markets but rather in asset bubbles, which have moved from being relatively isolated events to system-shaking crises claiming trillions of dollars in losses

Look for bubbles to remain a disruptive fixture of the low interest rate global economy through the balance of the decade, as investors move quickly when price signals indicate that an asset is primed to appreciate and pump in capital that further drives up its price.

What do we mean by “capital”?

Capital takes many forms, from the cash flow generated by the economy’s output of goods and services and the capital equipment used to produce them to the accumulated wealth held as financial assets. As the inverted capital pyramid below describes, real economic activity is the engine that makes possible the accumulation and replenishment of capital assets. The economy’s productive capacity, in turn, spins off financial assets the owners of capital aim to invest in, creating new forms of wealth. When supplemented by leverage and creative financial engineering by banks and other financial intermediaries, the crown of the capital pyramid encompasses all financial assets.

Here is an interesting reading for your year end (I just started.)  from Christopher Cole (Artemis Capital)