NAKED EMPERORS
Ukraine War fallout fanned the flames of accelerating inflation caused by predictably disastrous, but widely popular, covid policies – draconian lockdowns and wildly excessive stimulus.
The result: the highest inflation for at least 40 years across advanced economies, not to mention sky-rocketing debts and catastrophic long-term damage to health, education and society. The bills for extremely narrow policy focus will last generations.
For central banks which had repeatedly assured us inflation was transitory, this was a humiliation. Their models, optimised for the outgoing era of relative calm and deflationary tailwinds, could not account for negative supply shocks or a real time experiment with Modern Monetary Theory. Both will be staples of the new era.
Operation Stable Door – central bankers’ belated attempt to put the inflationary horse back in its loose box – may or may not succeed in the short term. But it’s irrelevant because, in the long run, central banks do not control the level of inflation. Covid and Ukraine are the one-two combo which revealed their Potemkin pretentions.
GORED UNICORNS, MAIMED MONKEYS
This was bad news for market darlings and for many popular portfolio strategies based on the belief inflation was dead. Magical thinking drives asset bubbles, and we have been in the record-breaking ‘everything bubble’. Low rates, inflation and volatility increase the present value of distant returns.
Unsurprisingly, 5,000-year lows in rates created a frenzy. Trillions of dollars of bonds offered negative yields, guaranteeing losses for investors in these ‘safe’ assets. Fast-growing profitless tech unicorn multiples charged higher, fed by sackfuls of nearly free cash. Non-fungible token digital images of Bored Apes were changing hands for millions of dollars. Dozens of new cryptocurrencies launched daily.
But sharply higher inflation, rates and volatility marked reality’s revenge, goring the unicorns, maiming the monkeys and sending almost all asset markets south. The 60:40 and risk parity strategies had their worst year for over half a century. Diversification using only conventional assets floundered as investors discovered it was all one big liquidity-fuelled trade.
Crypto assets and the UK pension industry’s leveraged liability-driven investment (LDI) strategies were two prominent victims of evaporating liquidity. As the monetary tide retreats further, more investment bubbles will burst. Many private market valuations remain magical. If you pay magical prices, don’t expect a fairy-tale ending.
NO MONEY MO PROBLEMS
When it comes to paying the bills, there’s a problem: the issue for politicians is never finding projects to spend money on; it’s finding money to spend on projects.
In his posthumous hit ‘Mo Money Mo Problems’, The Notorious B.I.G. lamented that extra cash couldn’t solve his difficulties.
The central fact of the new era is this: money is no longer free. Governments thus have an even bigger issue: no (spare) money, even mo problems.
By peacetime standards, advanced economies were already historically indebted. Covid added to the tab. And herding in the corner of the room are the elephants. Mass ageing brings dramatically higher spending on pensions, health and social care, alongside relatively scarcer labour and capital. Climate change requires colossal expenditure on adaptation – cast your mind back to the melted runways and buckled railway tracks as Europe frazzled in 40°C heat last year. And debt service ratios in many countries are already at or near all-time highs, despite rates plumbing multi-millennia lows.
Central banks and, more importantly, fiat currencies are precariously placed.
Remember that central banks were created not to control inflation but to manage government debt – the Bank of England was founded in 1694 to help fund upgrades to the navy after a drubbing by the French – and this remains their essential function.
And they are not politically insensitive. As structural inflation pressures become more obvious and economic pain grows, the pressure to tolerate higher levels of inflation will, too.
The eurozone, a child of the deflationary era, is especially vulnerable, with its many fault lines: keeping the bloc together and fighting inflation may be mutually exclusive.
“When it comes to paying the bills, there’s a problem: the issue for politicians is never finding projects to spend money on; it’s finding money to spend on projects.”
The chorus of ‘3% is the new 2%’ for central bank inflation targets is already finding its voice – the International Monetary Fund is flying kites.8 This is a tacit admission that long-term price levels are set not by central banks but by structural forces, and that financial repression – keeping inflation above the rate of interest in order to erode outstanding debts – is increasingly likely. Financial repression will be required not only to prevent property markets collapsing and pay off the elephants, but also to incentivise the major investments in supply required in this new era of shortages.
In short, fiat currencies will pay the price for our addiction to debt.
8 Blanchard (Nov 2022), Financial Times