Narratively Speaking
When dogma enters the brain all intellectual activity ceases – Robert Anton Wilson
Life is complicated. Because it is, our brains have evolved in ways to simplify it. The author of Thinking Fast And Slow, Daniel Kahneman, describes the brain as having two “systems.” System 1 is the fast thinking, intuitive, and emotional system. System 2 is the slower, more deliberative, logical system. His theory is that we operate, most of the time, in system 1. This is where narratives come into play.
Narratives are stories. They are useful in making complex concepts understandable. They can, however, lead to an incomplete analysis of critical data. With the recent melt-down in financial markets, I thought it might be useful to review and comment on some of the more popular narratives in the fields of finance and economics.
Current profitability doesn’t matter; it’s all about the future of (insert your favorite high flying, money losing company here). Goldman Sachs created an index called the Non-Profitable Tech Index, which tracks the value of a basket of technology stocks that have yet to turn a profit. In 2020, this index stood at 82. It peaked at about 425 in the first quarter of 2021 for a gain in value of these companies of over 400% in one year. At the end of the second quarter, this index had fallen back to 140. If you had the unfortunate timing to have purchased this group of stocks at the peak, you would now have lost about two-thirds of your investment.
Bitcoin is “digital gold.” As of June 30th, gold was down 1.28% for the year. Bitcoin lost 58.51%. Enough said.
Debt and deficits don’t matter (Modern Monetary Theory). We are currently feeling the effects of the massive money printing (approximately $6 trillion in the US) begun as a response to the COVID-19 pandemic. Creating an enormous increase in the money supply without commensurate productivity increases typically leads to only one outcome – inflation. This money creation, backed by debt (US treasuries), needs to be sold to willing buyers. Japan, Russia, and China have significantly curtailed their purchases of US treasuries leaving our Federal Reserve as the primary buyer. Japan embarked on a similar path more than a decade ago and now its central bank owns more than 50% of its own government’s bonds. When you lose the ability to borrow from others, you are left with being both the buyer and seller of your own debt, backed by more money creation to pay the interest on your own bonds, leading to yet more local inflation. Rinse, repeat…
“Green” energy will soon replace fossil fuels. Some in Congress have called for “zero net emissions” in the US by 2030. In order to accomplish this goal, and assuming it is to be met by wind, solar, and hydro power generation, the world will need batteries – a lot of them – to store the energy produced when and where it is generated. According to a June 20, 2022 column written for the Wall St. Journal by Bjorn Lomborg, a visiting fellow at Stanford’s Hoover Institution, the world’s existing battery capacity is currently enough to power the world’s electricity needs for approximately 75 seconds. It is projected that by 2030, that number will increase to around 11 minutes. As a point of reference, in a typical German winter, when solar capacity is at its minimum, there are at least 5 completely windless days, or the need to store more than 5,000 minutes of power. Only 4,989 more minutes to go.
The Federal Reserve can, and always will, rescue the stock market (the “Fed put”). As I’ve written previously, the “Fed” has created a difficult situation for itself. Its self-prescribed “dual mandate” of low inflation and high employment will be under its first real test in decades. The tools available to the Fed to battle inflation are blunt instruments at best. Influencing interest rates at the short end (Fed Funds Rate), and on the longer end of the spectrum (Quantitative Easing), are not particularly precise, in that they effect the economy as a whole, not specific segments. The last Fed chair to successfully battle inflation was Paul Volker in the late 1970’s. He raised interest rates high enough to reduce overall US demand by making debt expensive to take on. At that time the total US debt relative to GDP was 25%. Today, that number is over 100%. Raising interest rates high enough to curb inflation would undoubtedly bankrupt many heavily indebted companies, put pressure on US borrowings and budgets, and likely send the stock market into a further tailspin. A tepid response will likely allow inflation to run “hot” for longer. Damned if you do, damned if you don’t.
Bonds are the best hedge against stock market corrections. As of the end of the second quarter, US stocks (S&P 500) were down 20.6%. US bonds (US bond aggregate) were down 10.4%, so the typical “60/40 portfolio” (60% US stocks and 40% US bonds) was down 16.5%. Not much in the way of protection there. Long dated US Treasuries fared even worse, being down 18.5% (refer to “Debt and Deficits don’t matter”).
Historical market metrics like price earnings ratios are irrelevant in today’s markets. The trailing p/e ratio for the S&P 500 hit 37 in November 2020. It has fallen back to 19. Gravity still exists.
This inflationary spike is temporary, and we will soon return to our historically low levels of inflation. For the past 50 years, the world, and the US in particular, had largely side-stepped inflation by “exporting” it to other countries. Instead of having our own high-paid, high-skilled workers create products and services, we sent them off to other countries (China, Mexico, Canada, Japan), where they could be produced less expensively. Enter COVID-19 and the war in Ukraine. COVID exposed many countries to the reality that primary reliance on one supplier (China) for critical medical supplies was probably not their brightest idea. The invasion by Russia into Ukraine further exposed the vulnerability of relying on other countries for critical supplies (energy, commodities, raw materials, fertilizer, etc.). Many nations are rethinking their globalization strategy, and those that can will most likely “re-shore” much of their critical infrastructure within their own borders. This will move production from the most efficient producer to the most reliable one. “Just-in-time” inventories will be replaced by “just-in-case.”
The US dollar is, and always will be, the world’s reserve currency. A primary reason that has allowed the US to run massive deficits is the fact that much of the world’s trade is still transacted in US dollars (the genesis of this was The Bretton Woods Agreement signed by 44 allied countries in 1944). Oil and natural gas, gold, and most commodities are chiefly priced in US dollars. As a result, countries need to hold US dollars (typically in the form of US treasuries) to transact business. This has never sat well with China or Russia (or the European Union for that matter). The unintended consequence of banning oil purchases from Russia, and freezing their US dollar reserves has been to accelerate moves by both Russia and China in creating a monetary system not based on the US dollar. Russia is now insisting on payment in Rubles or gold for oil from most of its customers, but has agreed to take Yuan Renminbi (RMB) in exchange for oil from China. China has already launched a “digital RMB” and may soon require its customers to open a “digital wallet” in RMB to purchase goods. These moves have the potential to significantly reduce the overall attractiveness of the US dollar, and our ability to control it along with our financial future.
Narratives, like those above, serve a purpose in simplifying complex subjects. However, it is important, in most cases, to go beyond the “headline” and dig deeper into the underlying facts. We are all wired to use “System 1” to navigate in our daily lives, but we need to tap into “System 2” to prevent falling victim to an incomplete analysis of the risks and benefits of a particular decision. At Access, we constantly challenge ourselves by asking a simple question when contemplating a change in strategy – “And then what?”