#230. The rule of three

WHY MARKETS WILL GET FOOLED AGAIN

In the autumn of 2008, as the full seriousness of the global financial crisis (GFC) became apparent to investors, markets fell with dizzying speed.

Something very similar happened in the first quarter of 2020, when it became clear that the coronavirus pandemic had severe implications for the economy.

Perhaps the single most striking aspect of the current situation is that markets haven’t – yet, anyway – gone into a tail-spin.

This might seem surprising, given the take-off in inflation, pressures on the supply of energy and other commodities, and a pretty general recognition that the interest rate cycle has turned.

There are, to be sure, what we might call ‘pockets of concern’, of which the obvious examples are the “tech” sector in America, and the value of GBP. These exceptions aside, though, market responses to the current crisis have been restrained, whilst property price bubbles haven’t burst.

As you may know, this site does not provide investment advice, and must not be used for this purpose.

But we’re entitled to look at the general behaviour of markets as a barometer of sentiment ‘at the sharp-end’ of opinion. Thus far, it’s fair to say that markets have behaved like the dog that didn’t bark “in the night-time” in the famous Sherlock Holmes story about stolen racehorse Silver Blaze.

As you may also know, the view here is that surging inflation signifies a fundamental tipping-point, a moment at which the reversal of prior growth in material prosperity moves from unconventional theory to inescapable fact.

If that is indeed the case, the outlook for the financial system is grim, because the entirety of the system is predicated on the presumption of ‘perpetual growth’.

“Won’t get fooled again”?

Why, then, are markets exhibiting comparative insouciance in the face of seemingly-grave economic trends?

There are, in essence, two main explanations for this relative calm. One of these can be labelled “won’t get fooled again”. The other is a belief that all of the bad news is already priced in to the markets.

The “won’t get fooled again” explanation is that investors lost huge amounts of money in the third quarter of 2008, and again in the first quarter of 2020, only to find out that the World hadn’t, after all, come to an end.

Investors seem determined not to fall for this ‘end of the World’ stuff for a third time.

Given that we should never underestimate the role of psychology in the markets, this is a persuasive argument.

The “already priced-in” explanation is slightly more complicated. For starters, falls in the NASDAQ and in GBP can be portrayed as isolated cases.

The prices of American “tech” stocks had, the argument runs, been inflated to absurd extremes, so what we’re seeing now is nothing more than a long overdue correction towards reality. There’s a precedent here, of course, making a ‘dotcom2’ bust a plausible thesis.  

An equally persuasive case can be made that Sterling, like “tech”, is a special case. It’s hard to deny that the British economy has very glaring weaknesses, and the market judgement seems to be that these weaknesses are not replicated, to anything like the same extent, in other Western countries.

This isn’t the place for an assessment of the British economy, but the broad view taken here is that, whilst the UK situation, as measured by SEEDS, is indeed pretty dire, other economies have broadly equivalent problems of their own.

The real question-mark is whether the UK has what it takes to navigate the coming storm.

More generally, the market view seems to be that inflation, whilst clearly not the “transitory” phenomenon claimed until recently by the Fed, can nevertheless be prevented from running wild.

With the coronavirus crisis behind us, it is argued, ruptured supply-chains can now return to normality, and the monetary largesse poured into the economy to counteract “lock-downs” is draining from the system.

Where the war in Ukraine is concerned, there are two ways in which a calm market response can be explained. The first is that, after a period of adjustment, energy and other commodities previously sourced from Russia and Ukraine can be obtained from elsewhere.

A second, more cynical view is that we can already see the outline shape of a conclusion to the conflict. As war cools towards stalemate and settlement – and as the approach of winter demand peaks starts to concentrate minds – the trade freeze might begin to thaw, with Western policy turning out to be no more resolute over Russia than it was in Afghanistan.

Arguing along these lines, whilst rates might indeed rise to perhaps 3% or even 4%, we’re not heading into a re-run of the double-digit rates experienced in the late 1970s and the early 1980s.               

A darker perspective

If you’ve been visiting this site for any length of time, you’ll know that the interpretation of the economy set out here differs starkly from the orthodox view which continues to inform decision-making in government, business and finance. The surplus energy interpretation is summarised briefly here, and in greater detail here.

Once we understand that the economy is an energy system, and not a financial one, it readily becomes apparent that material prosperity is a function of the supply, value and cost of energy.

Within this matrix, the most important determinant is cost, referenced here as the Energy Cost of Energy.

ECoE refers to that proportion of accessed energy which is consumed in the access process, and is not, therefore, available for any other economic purpose.

Largely because of depletion, the ECoEs of oil, natural gas and coal have been rising relentlessly, pushing overall trend ECoE to ever higher levels.

This has pushed prior growth in prosperity into reverse, because prosperity is a function of the surplus (ex-ECoE) energy available to the economy.

As ECoEs rise, surplus energy shrinks, and prosperity contracts.

Important though they undoubtedly are, renewable energy sources (REs), such as wind and solar power, can’t push overall ECoEs back down to levels at which growth is possible. The average person in the West has been getting less prosperous over an extended period and, latterly, the same thing has started to happen in EM economies which, by virtue of their lesser complexity, have higher thresholds of ECoE-tolerance.

Energy transition, though undoubtedly imperative on economic as well as on environmental grounds, cannot stem – still less reverse – this prosperity-sapping trend.

The connections between ECoE and prosperity per capita in America, Britain and China are illustrated in fig. 1. Prosperity per capita turned down in the United States from 2000 and in Britain from 2004, and China is now decelerating rapidly towards its own inflexion-point.

Fig. 1

Meanwhile, the real costs of essentials are rising, primarily because the supply of so many necessities is highly energy-intensive. Examples include food, water, housing, infrastructure, the transport of people and products and, of course, energy used in businesses and in the home.

Accordingly, the scope for the consumption of discretionary (non-essential) goods and services is being squeezed. The SEEDS metric PXE – prosperity excluding essentials – is in decline even in countries (such as China) where top-line prosperity has yet to inflect (fig. 2).

Fig. 2

Depending on how we define “essential”, upwards of 50% of Western economies ranks as discretionary, a proportion reflected in activity, employment and profitability.

One implication of falling PXE is a decline in the value of those discretionary sectors which account for more than half of all the businesses whose shares are traded on the markets.

Another implication is that, as the gap between prosperity and essentials narrows, the affordability of mortgages (and of rents) declines, with adverse implications for property.

These negative tendencies in stocks and property can only be exacerbated by rises in nominal interest rates, even if real rates remain negative because inflation is rising more rapidly than nominal rates.

Denial nears denouement    

None of this is accepted by an orthodox school of thought which depicts the economy entirely in monetary terms, thereby dismissing the possibility of material constraints, and assuring us of the possibility of ‘infinite growth on a finite planet’.

Accordingly, policymakers have tried to counter energy downside with financial stimulus.

As you can see in fig. 3, this has seen liabilities – such as debts and other financial commitments – rise much more rapidly than prosperity. (It should be noted that the financial “assets” shown in fig. 3 are the systemic counterparts of the liabilities of the government, household and corporate sectors).

Fig. 3

Meanwhile, this process has created cosmetic “growth” in metrics such as GDP, because these metrics measure monetary activity rather than material prosperity.

With this understood, it becomes apparent that there has been a relentless widening in the gap between the ‘financial’ or proxy economy of money and credit and the ‘real’ or material economy of goods and services.

This creates an ultimately irresistible force tending towards the restoration of equilibrium between the two economies of money and energy.

Inflation is a logical concomitant of this process, because prices are the point of intersection between the monetary (financial demand) and the material (physical supply). This relationship is illustrated in fig. 4.

Fig. 4

The necessary conclusion of this dynamic is that a large proportion of the monetary claims embedded in the financial system cannot possibly be honoured ‘for value’ by a faltering underlying economy of material prosperity.

The process of excess claims destruction can take place either (a) through an inflationary degradation in the purchasing power of money, or (b) through a process of failure and default driven by a determination to use rate rises to prevent ever-worsening rates of inflation.

In practical terms, what this means is that we face a choice between untamed inflation or a ‘hard default’ slump, both in forward commitments and in asset prices, which are the corollary of the liabilities side of the value equation.

Perhaps the single most disturbing aspect of the present situation is rigid adherence to the fallacy that fiscal and monetary policy can deliver ‘growth in perpetuity’ despite worsening resource (and environmental) limits to expansion.

When governments (and others) assure us that we can “grow out of” current pressures on living standards, and that we can promote policies of “sustainable growth”, they are – perhaps in all good faith – making promises that the material economy simply cannot honour.