Posted on 9th Aug 2020
I haven't done one of these in a while so figured today might be a good moment to pause and talk through the recent state of financial markets. 2020 has been a rollercoaster ride with a 35% equity sell-off and subsequent full recovery, a bond market rally that saw rates moving from 2% to 0.5% and never climbing back up, enormous dollar strength then weakness, the Fed buying sub investment grade corporate bonds. Gold is at an all-time high and crypto is moving there slowly.
So what is it that is going on here? Assuming that the shock effect of Covid-19 has played out, we are likely in for a period of economic stagnation and as I have recently remarked, rising inflation. The two of these together make for a stagflationary environment - a spectre that has long hung over the market and something many of us have been viewing as likely for years - which is notoriously difficult for central banks to cope with given that it creates a conflicting incentive for monetary easing to deal with slowing growth and a need to raise rates to tackle inflation.
Central banks will not be able to ease and tighten at the same time, but in our view the reasons for rates to remain low and perhaps go even lower are likely to overwhelm any reasons for rates to move up. For starters, the US debt bubble and fiscal deficits are increasing fast (was enormous stimulus during an economic boom really a good idea?) and raising rates will make them truly unsustainable. At what point do the markets lose faith in the "full faith and credit" of the United States government? Even before the latest bout of stimulus started, back in late 2018 during a period of relatively healthy economic expansion, markets balked at ~2% rates.
The other side of it is that we have huge bubbles everywhere from debt to stock markets, to housing. Since this debt is denominated in nominal terms, a little inflation (emphasis on little) would in fact be beneficial and I would expect central bankers to look at this much the same way. The tricky part for them will be to allow for some inflation without letting it get out of control, and I think therein lies the real risk (no pun intended).
If inflation does really boil over, the battle for investors will be to keep up with inflation and to allocate their money to assets that rise with prices. I suspect this may very well be the story of financial markets over the next few years. What to invest in? Stocks (hey, the Venezuelan stock market is up 85,000% since November 2018), commodities, precious metals, real assets and cryptocurrencies would not be a bad place to start. What to avoid? Bonds and credit.