Understanding the timeline of Western economic developments that shaped investment returns from 1945 is highly illuminating.
Providing a much clearer picture of how to invest going forward.
To read PDF version click here
How did we get to where we are?
To track how it all fits together we would need to go back to 1945 and follow the incremental stages forward. But to understand where it goes next we can really just jump in from 2008 with a bit of backstory.
The Western world by 2008 had for more than 25 years, been supporting economic growth (GDP) by massively increasing debt levels, with country and individual debts rising to over 100% of GDP.
In 2008 this debt binge blew up in ‘The Great Financial Crisis’.
The big rethink post 2008
GDP is the gross domestic product of a nation; the total earnings from goods and services produced and sold. It’s like the nation’s wages. GDP is influenced up or down by 3 main elements:
Productivity, population growth and debt.
Governments and Central Banks realised two things in 2008/9,
1) The interest cost of servicing debts had to be lower than the growth rate of GDP or economies would shrink.
In 2008 GDP was 2% and debt servicing costs around 6%. With debt to GDP @ 100% that’s 4% negative economic growth annually.
This is exactly the same as a single person’s interest servicing costs on their loans. If increasing more than their income every year they get incrementally poorer.
2) The way to have GDP growth and debt costs stop being a net negative:
- Use central bank balance sheets for adding new debts
- Keep interest rates below GDP growth if possible (certainly below the inflation rate)
- Use QE to push down interest rates.
Central Banks Post 2008 and Quantitative Easing (QE)
QE was therefore created to put future debts on the Central Banks’ balance sheet and provide yield curve control.
This meant in practical terms central banks issued bonds into the market (Treasuries in US, Gilts in the U.K., Bunds in Germany) and bought them back themselves. So monetising debt but an asset still exists so not directly. It’s a way of printing additional money and pumping it into the system.
The outcome being the financial system had plentiful new liquidity and this supported better growth ongoing.
Why was this not inflationary?
The simple answer is it was. But only to certain parts of the economy and those parts were not of concern to Central Banks.
Inflation is fundamentally caused by a mismatch between supply and demand. The price of something goes up if more demand encounters restricted supply. Deflation happens when more supply hits less demand.
The great inflation surge of the 1970’s was exactly this phenomenon.
- Huge demographic uptick as the baby boomer generation entered the workforce and started buying houses, cars, having children etc.
- Artificial oil restrictions.
- Artificial labour relations problems due to strength of Unions.
- Primitive supply chains and global trade.
There has to be a change to the supply demand balance initially for inflation to spike.
All the above were changes to either supply or demand.
But it’s vital to know that inflation is not a continuous state. Imbalances will correct over time in free markets. For inflation to remain persistently high prices must keep going up each year.
If you have prices go up 10% in year 1 but stay the same in year 2, The inflation rate is then zero.
So, QE did cause inflation in assets such as equities, houses, art, classic cars etc; rare desirable items with finite supply and increased liquidity producing more demand?
A key metric that predicts asset price movements is whether liquidity is rising. Liquidity really just measures all types of money in the system. More is good as increased economic activity creates growth and profit. The relationship between liquidity and asset prices can be observed over recent times to be highly correlated.
If we look at asset price appreciation in relation to the increased money in the system due to QE then it’s over 90% correlated. In essence the rise in values of most assets just broadly mirrored the rise in overall liquidity.
This partly explains why the wealth divide between those that ‘have assets’ and those who don’t has widened so rapidly.
Interestingly the two asset classes which have risen in value much more than overall liquidity levels (this can also be seen as currency debasement) are
Technology stocks: because the majority of profit growth has been in these companies.
Crypto: Bitcoin being seen as digital gold by enough people and because it’s a fixed supply of 21 million not vulnerable to debasement.
The market struggles in 2022 were significantly worsened by the historically high withdrawal of liquidity. Central Banks took back a lot of the funding they pumped in with pandemic assistance. You can see from the figures below that money supply increases by around 6% pa on average, then the explosion in ‘20 and ‘21. The ‘22 number is negative, that’s never happened before.
Why the big inflation spike in 2022?
This was caused (as all inflation spikes are), by mismatches between supply and demand.
They were pandemic related and then war related but not one is still rising. We can run through a ton of examples, but all are normalising now.
Inflation by the end of 23 will be much lower. *see separate inflation report*
Wages and employment
The post pandemic rise in wages especially in the service sector has been inflationary. The recent figures suggest the mismatch between labour supply and demand is mostly normalised with wages to April ‘23 increasing by an annualised 1.2% pa.
Where are we now?
* Inflation is falling everywhere.
* Interest rate rises are either at an end (US) or coming to an end (EU)
* Energy costs are back to pre-war levels or below
* Company profits are still positive
* Likelihood of economic slowdowns as higher interest rates and lower lending (banking crisis) bite into economic activity.
* Economies are being reorganised post pandemic to ‘friendshore’ supply chains especially with China concerns in the US. This will be inflationary.
* ESG is inflationary.
* The world is now more obviously bipolar. The two axes of power being the US and China.
China will in the next decade become the world’s largest economy. It wants its stature reflected by influence with the US trying to stymie that. Look for the Chinese to continue exploiting disruptions to increase power and influence as it has recently with Russia, Saudi Arabia, Europe and Iran.
But also, China is not Russia. It’s a trading nation and needs the world’s biggest markets open to it. It won’t want to fight physical wars. It will concentrate on leveraging its power, access and trade to disrupt and reorder.
Where are we going?
In answering this question, we need to know
1 What interest rates will be?
2 What will inflation be?
3 What will growth be?
But there is a new factor emerging which is going to completely change the outlook for productivity, employment, inflation and growth going forward.
It’s a game changing, deflation creating, productivity boosting bomb.
AI (Artificial Intelligence)
AI has been unleashed and it’s already having profound effects in a relatively short time.
Just in the last week as examples,
B.T announced it will have 40% fewer employees by 2030. AI can do those jobs
IBM announced it has stopped hiring in 30% of its operations. AI can do those jobs
This will happen everywhere.
The knowledge economy
The higher paid workers are those with knowledge. They are paid for years of intensive specific study to perform what they’ve learned. So, doctors, lawyers, accountants, architects, designers, computer programmers etc.
AI is knowledge at super scale. It’s the most knowledgeable on any subject because it has instant access to all the accumulated knowledge. It’s happy to help anyone and it’s free. It works 24 hours, 7 days a week for no pay.
If you are sceptical, the following quote from the CEO of Octopus, a U.K. company, is the tip of the AI iceberg.
A productivity boom, a deflation bomb, an employment hurricane
If we look at AI alone, the reality is it’s only one of a number of transformative technologies getting ready for prime time.
The effects on economies are going to be profound…
PRODUCTIVITY- AI is going to create a productivity boom. GDP will rise. Profits will rise. Companies producing the most usable AI tools will grow very rapidly.
DEFLATION- It will be the most deflationary single change the western world has possibly ever seen. It will reduce costs across most sectors by large chunks. Forget current inflation worries.
EMPLOYMENT- It will transform the knowledge economy. If whatever isn’t better than the AI alternative, then it will be replaced by AI.
Back to the 70s
It is ironic (don’t you think) that given the ‘Cambrian explosion’ we are about to see in technology advancements that 2022 felt like we revisited the 1970’s.
Raging inflation, strikes, transport shutdowns and a Russian created crisis.
As much as anyone who said ‘transitory’ about what was taking place got pilloried, it was/is transitory. 2022 was a very weird year which followed two equally weird and surreal years.
What do we do now?
We invest going forward being confident of the likelihood of the following
- Inflation will not continue as the same issue
- Central banks will reduce rates because inflation craters and employment is weaker.
- Technology innovations will be transformational and deflationary
- For economies not to shrink rates still need to be the same or lower than GDP growth. We are still over 100% borrowed to GDP.
- QE (or something similar with a new name) will be used to keep rates lower (yield curve control) and subdue the debt to GDP ratio. So, more liquidity which is good for asset prices.
- Ideally for economies, interest rates continue to be lower than inflation. If a 2% differential exists, total debts can then increase 2% per annum at no extra servicing cost.
Essentially we go back to the 2019 playbook (before the pandemic) but with AI as new.
Nvidia which is the leading designer of the most advanced micro chips needed to power Ai compute is up 113% YTD.
What worked best as investments?
Assets with consistent above average profits and growth trajectories
So that’s what we focus on moving forward.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog, and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.