#159. The perils of equilibria

‘INDICATIONS AND WARNINGS’

Putting together what might turn out to be the last article published here this year has been one of two main items on my agenda. (I’m hoping to slip a third, pre-Christmas article into the list but, should this not happen, please accept my premature good wishes for the season).

In back-to-front order, the second ‘agenda item’ is a much-updated guide to the principles of Surplus Energy Economics, and to the latest – SEEDS 20 Pro – version of the model. The Surplus Energy Economics Data System has now evolved into a very powerful analytical tool, and I plan to make even greater use of it to inform discussions here in the future.

You can download at the end of this discussion, or from the Resources, page a summarised statistical guide to selected EM economies, whose prospects are one of the issues discussed here.

Two disequilibria

The aim here is to set out two of the trends that I suspect are going to ‘go critical’ in the year ahead.

The first of the two narrative-shaping issues that I’m anticipating for 2020 is a marked slowdown in the emerging market (EM) economies.

We can say what we like about the advanced economies (AEs), where monetary adventurism seeks to disguise (since it cannot reverse) an economic stagnation that has morphed into a gradual (but perceptible) deterioration in prosperity.

But, all along, we’ve known that our trading partners in the EM countries have been “doing stuff” – churning out widgets, building infrastructure, ‘going for growth’, and doing a quite remarkable job of improving the economic lot of their citizens.

This positive trend is, in my analysis, starting to top-out and then go into reverse. Even ‘conventional’ numbers are now starting to reveal what SEEDS has been anticipating for quite some time. The cresting and impending reversal of the wave of prosperity growth in countries like China and India – and the consequent financial strains – are likely to inform much of the economic narrative going forward.

The implications of what I’ll “the EM crest” will be profound.

We will no longer be able to say that ‘the Western economies may be stagnating, but the emerging nations are driving the global economy forward’. Their less complex, less ECoE-sensitive economies now face the self-same issues that have plagued the West ever since the onset of ‘secular stagnation’ from the late 1990s.

The second critical issue is financial disequilibrium, and the ‘devil or the deep blue sea’ choice that it poses.

Here’s an example of what this ‘disequilibrium’ means. In nominal terms, the value of equities around the World increased by 139% in a decade (2008-18) in which nominal World GDP expanded by 33%. Applying inflation to both reduces the numbers, of course, but it leaves the relationship unchanged. What’s true of equities is also true, to a greater or lesser extent, of the prices of other assets, including bonds and property.

What matters here is the relationship between asset prices and incomes, with ‘incomes’ embracing everything from wages and pensions to dividends, corporate earnings and coupons from bonds.

This divergence is, of course, a direct result of monetary policy. But the effect has been to stretch the relationship to a point from which either surging inflation (by driving up nominal incomes), or a crash in asset prices, is a necessary element of a return to equilibrium.

We may have to choose between these, with inflation the price that might need to be paid to prevent a collapse in asset markets.

Our industrious friends

A critical issue in the near-term is likely to be the discrediting of the increasingly fallacious assumption that, whilst much of the “growth” (and, indeed, of the economic activity) reported in the West is cosmetic, emerging market (EM) economies really can go on, indefinitely,  producing more “stuff” each year, so a big part of the World remains genuinely more and more productive.

Westerners, the logic runs, might increasingly be making their living by using a ‘churn’ of newly-created money to sell each other ever-pricier assets and ever more low-value incremental services, but the citizens of Asia, in particular, remain diligent producers of everything from cars and smartphones to chips and components.

This, unfortunately, is a narrative whose validity is eroding rapidly. China’s pursuit of volume (driven by the imperative of providing employment to a growing urban workforce) has driven the country into a worsening financial morass, whilst a former Indian finance minister has warned of “the death of demand” in his country.

Figures amply demonstrate the development of these adverse trends, not just in China and India but in other members of the EM-14 group that is monitored by SEEDS.

On the principle that a picture is worth a thousand words, here are SEEDS charts showing that, whilst Western prosperity is already in established decline, something very similar is looming for the EM-14 economies. Of these, some – including Brazil, Mexico, South Africa and Turkey – have already started getting poorer, and many others are nearing the point of inflexion.

And, as the next pair of charts shows, you don’t need SEEDS interpretation to tell you that the divergence between GDP and debt in the EM countries doesn’t augur well.

What’s starting to happen to the EM economies has profound, global implications. Perhaps most significantly, the dawning recognition that the World’s economic ‘engine’ is no longer firing on all cylinders is likely to puncture complacency about global economic “growth”.

When this happens, a chain reaction is likely to set in. With the concept of ‘perpetual growth’ discredited, what happens to the valuations of companies whose shares are supposedly priced on their own ‘growth potential’?

More important still, what does this mean for a structure of debt (and broader obligations) predicated on the assumption that “growth” will enable borrowers to meet their obligations?

In short, removing ‘perpetual assured growth’ from the financial calculus will equate to whipping out the ace of diamonds from the bottom tier of a house of cards.

Timing and equilibrium

This brings me to my second theme, which is the relationship between assets and income.

Just like ratios of debt to prosperity – and, indeed, mainly because of cheap debt – this relationship has moved dramatically out of kilter.

The market values of paper assets put this imbalance into context.

Globally, data from SIFMA shows that the combined nominal value of stocks and bonds increased by 68% between 2008 and 2018, whilst recorded GDP – itself a highly questionable benchmark, given the effects of spending borrowed money – expanded by a nominal 33%.

Equities, which were valued at 79% of American GDP in 2008 after that year’s slump, rose to 148% by the end of 2018, the equivalent global percentages being 69% and 124%.

For the United States, a ‘normal’ ratio of stock market capitalisation to GDP has, historically, been around 100% (1:1), so the current ratio (about 1.5:1) is undoubtedly extreme.

Prices of other assets, such as residential and commercial property, have similarly outstripped growth in recorded GDP.

Whilst this isn’t the place to examine the mechanisms that have been in play, it’s clear that monetary policy has pushed asset prices upwards, driving a wedge between asset values and earnings.

This equation holds true right across the system, typified by the following relationships:

– The prices of bonds have outstripped increases in the coupons paid to their owners.

– Share values have risen much more sharply either than corporate earnings or dividends paid to stockholders.

– The wages of individuals have grown very much more slowly than the values of the houses (or other assets) that they either own or aspire to own.

This in turn means that people (a) have benefited if they were fortunate enough (which often means old enough) to have owned assets before this process began, but (b) have lost out if they were either less fortunate (and, in general, were too young) when monetary adventurism came into play.

The critical point going forward is the inevitability of a return to equilibrium, meaning that the relationship between incomes and asset values must revert back towards past norms.

You see, if equilibrium isn’t restored – if incomes don’t rise, and prices don’t fall – markets cease to function. Property markets run out of ‘first-time buyers’; equity markets run out of private or institutional new participants; and bond markets run out of people wishing to park some of their surplus incomes in such instruments.

To be sure, markets might be kept elevated artifically, even in a state of stasis, without new money being put into them from the earnings of first-time buyers and new investors. But the only way to replace these new income streams would be to print enough new money to cover the gap – and doing that would destroy fiat currencies.

This means either that incomes – be they wages, bond coupons or equity dividends – must rise, or that asset prices must fall.

In a World in which growth – even as it’s reckoned officially – is both subdued and weakening, the only way in which nominal incomes can rise is if inflation takes off, doing for wages (and the cost of living) what it’s already done for asset prices.

With inflation expectations currently low, you might conclude, from this, that asset prices must succumb to a ‘correction’, which is the polite word for a crash.

But that ‘ain’t necessarily so, Joe’. It’s abundantly clear that the authorities are going to do their level best to prevent a crash from happening. It seems increasingly apparent that, as Saxo Bank has argued so persuasively, the Fed’s number one priority now is the prevention of a stock market collapse.

Additionally, of course, and for reasons which presumably make political sense (because they make no economic or social sense whatsoever), many governments around the World favour high property prices.

The linkage here is that the only way in which the authorities can prevent an asset price slump is ‘more of the same’ – the injection of ever greater amounts of new money at ever lower cost. This is highly likely to prove inflationary, for reasons which we can discuss on a later occasion.

My conclusions on this are in two parts.

First, the authorities will indeed do ‘whatever it takes’ to stop an asset price collapse (and they might reckon, too, that the ‘soft default’ implicit in very high inflation is the only route down from the pinnacle of the debt mountain).

My second conclusion is that it won’t work. Investors, uncomfortably aware that only the Fed and ‘unconventional’ monetary policy stand between them and huge losses, might run for the exits.

They know, of course, that when everyone rushes in a panic for the door labelled ‘out’, that door has a habit of getting smaller.

There’s an irony here, and a critical connection.

The irony concerns the Fed, the President and the stock market. Opinions about Mr Trump tend to be very polarised, but even his admirers have expressed a lot of scepticism about his assertion that a strong stock market somehow demonstrates the vibrancy of the American economy.

So it would indeed be ironic if the Fed – in throwing everything and the kitchen sink into stopping a market crash – found itself acting on the very same precept.

The connection, of course, is that equity markets, just like bonds and other forms of debt, are entirely predicated on a belief in perpetual growth. If, as I suspect, trends in the EM economies are set to destroy this ‘growth belief’, we may experience what happens when passengers in the bus of inflated markets find out that the engine has just expired.

EM 14 December 7th 2019