#212. Are we nearly there yet?

ASSET MARKETS AND THE LOOMING ‘SNAP-POINT’

Throughout the period since the global financial crisis (GFC) of 2008-09, capital markets have marched upwards, even as the economy itself has, at best, stagnated. After a sharp correction at the start of the coronavirus crisis, the prices of stocks and property, in particular, have kept hitting new highs, even as the much-vaunted “recovery” has petered out.

The casual observer might wonder, first, about why this great divergence between the economy and the markets has happened at all, and, second about, whether, or when, it will come to an end.

The aim here is to explain the former, and anticipate the latter.

Questions around the divergence between the economy and the markets have been accompanied by the suspicion that decision-makers may have wanted this to happen (in order further to enrich the wealthiest), and that they have ordered events accordingly.

We can start by stating that the fault of the policymakers has, very largely, been one of complicity rather than of design. Ultra-low interest rates weren’t adopted to boost asset prices, but to prop up a faltering economy. This said, the ‘great divergence’ could, and should, have been anticipated, and fiscal measures adopted to restrain it.

To be clear about this, there’s an equation which links economic adversity to rising markets. The weaker an economy becomes, the greater the likelihood that interest rates will be lower, for longer, than if the economy were performing well. Cheap money is favourable for markets, so there’s a mathematical linkage between economic weakness and market strength.

This, though a linear equation, isn’t an infinite one. A weak economy is good for asset prices, but there comes a point at which economic stagnation turns into deterioration, and at this point the equation snaps, and markets correct downwards, quite possibly very rapidly indeed.

Economic weakness that pushes people into taking on ever more debt is favourable for asset prices, until it reaches the moment at which borrowers can no longer support the debt that they already have, let alone take on yet more. We can call this the “snapping-point” at which the equation inverts, and market exuberance turns into fear.

The trick is to work out how, and when, this snapping-point is going to occur. 

At this moment, there are some very evident economic problems, which include uptrends in inflation, a squeeze on the availability of energy supplies (and of natural gas in particular), the fracturing of supply-lines across a gamut of goods and services, and the perception – at least in Beijing – that financial risk is becoming excessive.

Mention of Beijing should remind us that what we need to identify are broad trends rather than national events, even when these are taking place in a country as important as China. The Chinese authorities have their own reasons for cracking down on speculative investment, banning crypto-currencies, taming ‘big tech’ and tackling the problem of moral hazard.

Likewise, we shouldn’t generalize from events in the United Kingdom, since many of Britain’s problems are self-inflicted, and are specific to a weak, vulnerable and badly-managed economy. There’s more reason – because America is much bigger and a great deal more important – for concern about the seeming irrationality of US economic and financial policy, with its one-trick-pony addiction to stimulus.               

At present, the tendency is blame everything – including inflationary pressures, supply-chain disruption and financial stresses – on the after-effects of the coronavirus crisis. As an explanation, this ranks for credibility somewhere between “the dog ate my homework” and “I can’t buy a round of drinks because a spaceman from Mars stole all my money”.

After all, official figures indicate that global GDP fell by a less-than-catastrophic 3.3% last year. To believe that all of these economic problems only began in 2020 requires extreme myopia, and a very short memory.

Rather, and as regular readers know, the economy has been deteriorating over a very long period, which we can trace back to the identification of “secular stagnation” back in the 1990s.

In the final analysis, the size and complexity of the modern economy are products of the use of energy from oil, gas and coal. Now, though, the ECoEs (the Energy Costs of Energy) of fossil fuels are rising relentlessly, and the window of environmental tolerance of their use is closing.

This mightn’t have mattered if we had a fully adequate replacement source of energy available, and were willing to adapt the economy onto a new basis consistent with radically different sources of energy.

Neither is the case. Wind and solar power cannot provide a complete replacement for fossil fuel energy, and our unwillingness to adapt to very different energy conditions is exemplified by the insistence that battery-reliant EVs, rather than mains-powered trains and trams, must be the primary transport mode of the future.

Readers will be familiar with the reasons why like-for-like transition isn’t feasible. First, the expansion and maintenance of renewable energy sources (REs) is dependent on vast quantities of materials whose supply, in turn, depends on legacy energy from fossil fuels.

Second, the intermittency of wind and solar power requires batteries, a requirement which loads the material balance still further against seamless transition. Relatively low-cost additional energy sources become much more expensive when they transition to the role of base-load.

Third, REs are never going to yield the energy density to which we’ve become accustomed over two centuries of reliance on coal, oil and gas. The magic elixir of ‘technology’ isn’t going to fix this, not least because best practice in REs is already close to maxima dictated by the applicable laws of physics.

The bottom line is that the ECoEs of REs are unlikely ever to fall much below 10-12%, and even that might be an optimistic target. The modern economy was built on ECoEs of less than 2%, can’t really grow once ECoEs rise much above 6-7%, and is in deep trouble now that trend ECoE has risen above 9%. As ECoEs rise, the supply quantity (as well the economic value) of energy starts to deteriorate, a tendency already playing out in the availability of natural gas.

This much will be familiar to readers, who will also know that there can be no lasting financial ‘fix’ for an economy that, ultimately, isn’t financial at all, but is shaped by the supply and ECoE-cost of energy.

If we insist on throwing the financial system under the wheels of the ECoE juggernaut, we shouldn’t be surprised if it gets broken.

A critical issue now is the process by which this deterioration in economic fundamentals feeds through into the financial system in general, and into markets in particular.

To understand this, we need to recognize the role of essentials, defined here as the estimated total of household necessities and public services.

In absolute terms, the cost of these essentials is rising, because so many of them are energy-intensive, and thus exposed to the rising trajectory of ECoEs. Their proportionate burden will rise even more rapidly because, just as essentials are becoming more expensive, top-line prosperity is trending downwards.

Essentials are the leveraging factor that can turn comparatively gradual deterioration in prosperity and into something which is much more unpleasant.

This is particularly relevant to the markets. In equities, a large proportion of quoted companies are engaged in the supply of discretionary (non-essential) goods and services. Many of these stocks are priced by the markets on the basis of continuing growth, but energy-based analysis, as carried out here using the SEEDS economic model, makes it clear that discretionary prosperity is contracting, and that discretionary consumption has – thus far – been propped up by credit expansion alone.

More prosaically, a point is likely to be reached at which markets realize that pressures on household budgets – pressures reflected in energy and utility costs, in broader inflation and in the sheer scale of debt burdens – aren’t temporary or, in today’s buzz-word, “transitory”.

It will then become apparent that the rising cost of household expenses leaves consumers with less to spend on things like leisure and travel, cars and gadgets. It might also be recognized that decreasing discretionary prosperity leaves less resources available for the “streams of income” business model built on the continuity of subscriptions, stage payments and various forms of credit.

In practice, recognition of pressure on consumer discretionary resources may coincide with a realization that there are limits to the viability of perpetual stimulus. What SEEDS is telling us is that the affordability of everything from a foreign holiday and a day at the races to a new smartphone, a replacement car or an entertainment subscription is coming under worsening pressure. What orthodox data tells us is that consumers are still making these purchases, but are becoming ever more reliant on credit to finance them.

Here, then, is the “triple whammy” that is likely, sooner rather than later, to trouble the markets.

First, as discretionary purchasing power deteriorates, so does the outlook for any company supplying non-essential goods and services.

Second, these same pressures are putting the ‘stream of income’ business model at worsening risk.

Third, inflationary pressures – exacerbated by a non-“transitory” fracturing of supply lines – are taking us to the point where stimulus stops working and becomes dangerous, a point that might arise well before the authorities detect a need to raise rates.

These pressures are not, of course, unique to equity markets, but can be expected to extend to other asset classes, including property. Ultimately, what we’re witnessing is the compression of affordability in general, and discretionary affordability in particular, combined with arrival at the limits to the feasibility of stimulus.

Orthodox economics – with its insistence on a purely monetary ‘perpetual growth’ dynamic, unconstrained by resources – isn’t going to recognize any of this any time soon. Neither, for that matter, will governments, for whom predictions of anything but growth in perpetuity are anathema.

Don’t be too surprised, though, if markets tumble to what’s happening, long before reality penetrates the portals of economic orthodoxy or the corridors of power.