Photo credit: Eric Kilby
I have written extensively about why I think that we’re in a bear market rally. Maybe I’m wrong, but it is a thesis worth exploring. At present, it seems like the Fed has full control over all events. The Fed has become ubiquitous, solving every problem with the printing press. It’s like they can shape reality at will. And, I must say that it is a very interesting concept, especially because it is probably wrong (but it may last for a long time).
The weak spot for this whole Fed in god-like mode is the problems that it can’t solve by printing more money. Specifically, I’m thinking about inflation. In my opinion, the last decade was a gift from the heavens. Being able to deploy multi-year quantitative easing programs, without creating inflation, was likely a fortunate confluence of events. The delocalization of manufacturing to cheaper countries increased productivity from free software, and the bust in oil prices helped to keep goods and services prices low.
The nemesis of our time: tightening
I think that it is clear, for everyone, even for those that don’t expect it soon, that the worst-case scenario is the one where inflation makes a surprise appearance. If that were the case, the Fed would likely have to pivot its dovish tilt in favor of hawkish stance. That would be devastating for bonds and stocks. I compare this scenario to the 1970s. The returns for financial assets would be meager at best.
Increasing interest rates and decreasing monetary mass is the recipe for lower asset valuations. It is everything that didn’t happen during the last decade. So, what could be the catalyst? I see a couple of hypotheses that might be tested during the following months.
H0. International supply chains get disrupted and spark inflation
The trend toward more international commerce has been on the rise since the Second World War. It has brought huge benefits to consumer prices, allowing rich countries to outsource low-value-added products from emerging countries. The unwinding of this trend was already underway with the 2019 trade war, but the virus has made it even more pronounced. And, it might even exacerbate the tensions laid dormant with the Phase One agreement.
Reigniting the trade war, in the name of internal security, could be an irreversible step towards some sort of neo-mercantilism. And, avoiding to advance further into the political read, the economic effect would contain the production of low-value-added goods at home, and, therefore, higher consumer prices.
H1. Higher energy prices lead to inflation in several product categories
This one seems off, but the oil market has become a difficult beast to discern. Obviously, there seems to be a lot of under-utilized capacity, but years of poor returns in the oil space might lead to an abandonment of the industry. At some point, we could be surprised with news of lack of supply.
Additionally, note that I’ve mentioned energy prices, not oil prices. The adoption of electric vehicles might also create temporary imbalances between supply and demand. With old fossil fuel power plants on its way to being decommissioned, we might get imbalances and power shortages.
H2. H0 and H1 do not materialize, and the huge stimulus keeps the bull market going.
This one is the contrary case. Assuming that there are offsetting deflationary forces, the huge size of the stimulus keeps the bull market going. The interesting part is that investors were tremendously fast at discounting that scenario. In 2008, investors took its time to digest the impact of the QE, this time it took Bill Ackman just a couple of days.
H3. If H2 holds during the next year, any attempt to raise rates, and, or, unwinding the QE will likely cause a tantrum, in a 2018 remake.
The current bull market is, clearly, sustained in the monetary stimulus, and in investors’ psychological conditioning to QE. The 2007 crisis, and the monetary response, ended up being so bullish for markets that investors have no doubts about what to do. Unwinding it could cause buyers to evaporate, and the selling pressure could create a panic.
Yes, the monetary package is huge, and, historically, it has proven positive for financial assets. However, the ramifications of the possible historical processes, following the current events, are dazzling. For starters, investors have become conditioned to quantitative easing, responding unequivocally to stimulus packages. On the other hand, new trends are taking hold of the market. Reports tell us that Millennials and their Robin Hood accounts are on the way to take over the market. Kids with guns conditioned by the fact that the Fed intervention will save the day, and no recall of the days when quantitative easing wasn’t possible because of inflation, seem poised to go to the edge of the cliff, and then carry on. These kids are buying stocks when the likes of Warren Buffet and Carl Icahn are selling. We are talking about battle-hardened veterans, with track records that speak for themselves. Is it possible that a whole generation of Millennials is capable of over-performing the investment legends of the past?