HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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August 9, 2020

Internet Balkanisation & Risk of Inflation & Deflation

Cheap Shot or Prolonged War

Trump’s executive order regarding Chinese apps Tik Tok and WeChat are the latest skirmish in the ongoing ColdWarII between the US and China and is a move that takes the dispute to the heart of the battle for data and technology supremacy. There is a lot to unpack here. Most obvious is to question the extent to which this is a Trump pre-election gambit of deflection, or to what extent it can be considered the opening shot in a Sino American social media war. Given that the threat of China and its technological prowess is about the only area of bipartisan agreement in the US right now, I fear this is more the latter than the former.

One of the ironies here is that the US government is acting in an authoritarian manner which is at least the equal of China, in what is quite obviously a political move. Even the CIA is not indicating Tik Tok data has been compromised, while also vaguely conceding that it knows this data can be infiltrated. (Well, no shit Sherlock, they should know, as Edward Snowden demonstrated, they have done it themselves. It is the epitome of hypernormality, they know we know they lie. But I digress).

The Splinternet

The bigger picture is one of a fracturing internet. Where we like to think of the world wide web as being well, err, worldwide, it looks more like at least three distinct spheres of the internet which will become increasingly non-interoperable. The American version with its tech giants, while known in Europe is largely unknown in China already. Meanwhile Europe is separating itself from both the other spheres as it digs in behind its GDPR barricades, political obsessions and dysfunctions. The main battle is waging on the US China front, and for the time being it is unclear who has a lead in the key WMD tally. These include: semiconductor know how, AI and quantum computer capability, 5G (and beyond) networking capability and their spinoffs into driverless cars and robotic warfare etc.. However, in terms of popular adoption and observable innovation I would say China has the lead in most areas.

Intel Value Play

In practical terms I have started to look at Intel as a defensive counter. Intel has had a perfect storm of poor performance over the last few years, its value is less than it was in the early 2000s. This most recently culminated in it losing its place on the Apple iMac. Over recent years Intel has been eclipsed by Nvidia, Qualcomm and ARM (not to mention TSMC). However, I also think that Intel is considered an asset of national importance, and one that will ultimately be offered protection by the US government. While this view is insufficient to form a growth investment thesis yet, on a single figure PE and a near 3% dividend yield, it is not a bad bond proxy for the time being (admittedly a low bar).

Deflation or Inflation

I have had reason to reassess my thoughts on the risk of inflation in our post COVID world. To be clear I still believe the risk of inflation has increased year to date. However, I also think I have previously underestimated the disinflationary forces at work and the consequential risk of a sustained period of deflation. Counter intuitively I remain of the view that it is possible to hold both views concurrently. The risk of inflation however, has a profile of radical uncertainty while that of deflation a more normal (knowable) uncertainty, or risk profile. (See the Taleb Distribution for more details).

Paradigm Shifts

My starting perspective is that macroeconomic policy in my life time has so far had three eras of ideological dominance. We had the post-war Keynesian consensus superseded by Monetarism in the late 1970s and then amended to (what I would describe as) Central Bank Orthodoxy from the late 1990s (beginning when the Fed threw its protective blanket around the collapsed LTCM hedge fund). Each of these transitions (paradigms) had their own causes and effects, but once accepted and normalised allowed for sustained periods of “normal” risk assessment to take place by investors and other actors in financial markets.

Fat Tails

However, at the turning points the risk profiles become unkowable and are characterised by radical uncertainty (see King and Kay for details). The profile of radical uncertainty is not normal and sufficiently unusual that when you are in one these periods it is difficult, if not impossible to comprehend your situation. They are what Taleb and others call fat tail distributions where averages are meaningless and rare outcomes dwarf all others so completely that normality is upended. (Such as the risk profile of pandemics).

This Time It May Be Different

listened to a podcast interview with economist and fund manager Lacy Hunt, which is one of the most articulate synopses I have yet heard of the macro economic environment we are in currently, and how to think about the risk of it changing. Significantly Mr Hunt, along with his colleague Van Hoisington, has a 40 year track record in managing fixed income portfolios and one of successfully riding the wave of disinflation and bond market supremacy for all of this period. What he articulated was that he believed that Irving Fisher’s monetary theory of inflation would remain intact (technically that V, the velocity of money would fall) despite there being an observable and sudden massive increase in the money supply so far in 2020. However, as he concedes there is one very important caveat to this thesis, and that is the scenario in which the Fed’s liabilities are monetised (become currency), which he still believes to be unlikely.

Pay Your Insurance Premium

I would say that we are already in a hypernormal period where we have been forced to try and solve our over indebtedness by the use of more debt. As Lacy shows we have previously been here on a few occasions over the last 300 years, and before that earlier civilisations were ultimately crushed by debt and its inflationary consequence. The thing that is currently acting as the dam to inflation (and possibly hyperinflation and monetary collapse) is basically the degree to which monetisation of the Fed liabilities can be resisted. I think there are real signs that this particular edifice is now starting to show signs of fatigue (just like I hear that the Three Gorges Dam is supposedly about to break and wash away Wuhan with its vital COVID evidence). However, I must confess (as an amateur in matters to do with financial theory and macro economics), I might well be crying wolf. I, and others did this in 2009/10, the last time the gold price hit this type of level. For me the insurance against this dam bursting is worth it, and in practical terms I have not altered my baseline view that gold (and other real assets) should feature in any long term portfolio.

Post Scrip - Selection of quotes from Lacy Hunt and Van Hoisington latest newsletter.

Except for the very short run, the Federal Reserve’s lending operations for the corporate bond market are a negative for economic growth. The BOJ (Bank of Japan), ECB (European Central Bank) and the People’s Bank of China (PBOC) have all been buying corporate debt of failing entities for more than a decade with the BOJ doing so for more than 25 years. These operations have provided a fleeting lift to economic activity, but at the end of the day they resulted in misallocation of credit, poor economic growth and disinflation/deflation. By keeping failing players in the game, this prevents the process Joseph Schumpeter called “creative destruction” as well as “moral hazard”, thereby eliminating these critical factors that make free market economies successful. When central banks sustain failing businesses, resources are tied up in nonproductive firms and therefore unavailable for new firms that can contribute to economic growth.  

 The pandemic will eventually run its course and when that happens economies will register a noticeable improvement. However, the adverse consequences of an unsurpassed increase in new debt will remain for years to come as there currently exists a record domestic and global debt overhang from previous borrowing. Four great past economists – Eugen Bohm Bawerk, Irving Fisher, Charles Kindleberger and Hyman Minsky – all captured the two-edged nature of debt being an increase in current spending in exchange for a decline in future spending unless the debt generates an income stream to repay principal and interest. Using rigorous statistical techniques, contemporary economists such as Kenneth Rogoff, Carmen Reinhart, Alan Taylor, Anja Baum, Cristina Checherita-Westphal, Philipp Rother and others have documented the deleterious effects of high debt levels on economic growth. Included in this work is evidence that the detrimental effect of the debt on GDP per capita increases as the debt level rises. Significant research indicates that the adverse consequences start as low as a 67% gross debt to GDP ratio. In other words, the relationship between debt and economic growth is non-linear, just as is the law of diminishing returns.  

 Assuming a large percentage gain in economic activity in the second half of this year, the Fed, the World Bank and many economists project that there will still be a substantial gap between potential and real GDP. In economic theory, this is called a deflationary gap. At the end of the three worst recessions since the 1940s, the output gap was 4.8% in 1974, 7.9% in 1982 and 6.4% in 2009. The gap that existed after the recession of 2008-09 took nine years to close. This was the longest amount of time to eliminate a deflationary gap. Even when the gap was closing over the last decade, the inflation rate continued to trend downward, remaining near or below 2%. This indicates that there were even more unutilized/underutilized resources than was captured by the magnitude of the gap. Considering the depth of the decline in global GDP, the massive debt accumulation by all countries, the collapse in world trade and the synchronous nature of the contracting world economies the task of closing this output gap will be extremely difficult and time consuming. This situation could easily cause aggregate prices to fall, thus putting persistent downward pressure on inflation which will be reflected in declining longdated U.S. government bond yields. 

https://hoisingtonmgt.com/economic_overview.html )

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