23 Apr 2020
The End of Smith – by Richard Croft
I am sure everybody has noticed the extraordinary phenomenon of the last few weeks, where the stock markets have put in a record performance (the S&P recorded its best ever week in both absolute and percentage terms last week) whilst the IMF, Central Banks and Governments warn of the most severe economic downturn in several generations. In fact, in terms of short-term damage to the global economy, apparently this downturn is akin to the economic tsunami that was caused when the somewhat ludicrous tulip bulb bubble (there really was one of those) burst in February 1637. So, this is not a once in a lifetime or even once in a century event, but more once in a half millennial economic event.
I wrote parts of the original draft of this article in January as even then it was difficult not to notice the impact on markets (real estate, equities and bonds) of excessive liquidity. This was at the time that US markets had gained over 30% in a year but the economy had grown at about 2.5%, when despite an alleged booming economy and records every day being broken on Nasdaq, the Dow and the S&P, monetary policy was being eased and interest rates lowered. To anybody who was paying attention and / or who had any interest or knowledge of economics, this was indeed a strange juxtaposition of events. Like me, I would suggest most people probably shook their heads and ignored it because if you thought about it for too long, it was headache inducing. I did, however, have a dawning realisation that the economics we were taught at school (and are currently still lectured on by the various economic forecasting groups around the world) is, on the balance of probabilities, defunct. Mass quantitative easing, eye watering amounts of fiscal stimulus and the strange but likely increasing phenomenon of debt not necessarily being a liability (more on that later), have altered and then changed the rules of the “economic game”.
I appreciate that that is a big bold statement and unfortunately, as you all get to the end of this article, you will realise that I am unable to divine the future or provide any meaningful guidance to what the final impact of all of this will be. I do, however, have a few theories. I do think that we are entering a new economic age when the rule book that was originally written by Adam Smith (and initially showcased to the world in his seminal snappily titled work “An inquiry into the Nature and Causes of the Wealth of Nations”) is now defunct. In fact, you can now, in my opinion, safely ignore the works of Friedman, Keynes, Von Hayek amongst others and accept that a new economic rulebook exists. The issue, of course, is that nobody has actually written it and the relationship between capital, labour, inflation, investment returns and money flows is being redefined in the present tense. If you can ignore the economic carnage around you (which is a bit like saying if you can ignore the atomic explosion that happened a couple of miles away), we live in the most fascinating of times.
So, what has led me to that conclusion that Economics, as we currently accept it, is in fact a false science? Actually, I began to think this in about 2012, post the global financial crisis, as anybody who was unfortunate enough to get me on the subject will know. The experiment of quantitative easing produced some startling results. On August 29 2011, gold hit a peak value of $1,859.50 an ounce (having nearly doubled over a two year period) and by November 16th 2015, it had fallen to €1,056.20 an ounce. So, what accounted for the rise and fall of gold during that period? Simply, gold was being used as an inflation hedge. The presumption (aided and abetted by accepted economic theory) was that a massive influx of liquidity into both markets and the economy would lead to hyperinflation. Of course, as we now know, it didn’t. In point of fact, the biggest issues facing the central bankers and Governments by the mid-point of the decade were around deflation and stagnation.
The accepted economic theory that a substantial increase in money supply would lead to inflation and mass devaluation of currencies has been the bedrock of many investors’ decisions over the last ten years. An extreme example of this was the hyperinflation in the Weimar Republic in 1923 caused by excessive increases in the money supply – cash became so worthless that, allegorically at least, a wheel barrow of cash was needed to buy coffee (and people would steal the wheelbarrow but not the cash). More recently, the despotic regimes of both Venezuela and Zimbabwe have seen hyperinflation through massive increases in money supply. Using an appropriate viral testing term, those examples are, I think, false positives. In the global economy (and I hate writing this), Zimbabwe and Venezuela (despite its massive oil reserves) brutally don’t count. Neither country (due to sanctions) was, nor is, really connected to the global economy – so the impact of creating substantial new money supply in their small economies played out as predicted by economic theory. The Weimar Republic example was 97 years ago, which might as well be in another galaxy as well as another century.
In modern global economic terms, however, the picture is now very different. The first and most important reason is that ethereal term “the market”, the central plank of all economic thinking. The concept of the “market” (using economics 101) is that it is defined by the laws of supply and demand. That is, of course, true and the accepted thinking is, that if you have more demand than supply then prices will go up. Again, that is irrefutable but what is missing from this thinking is an understanding of how efficient the “market” has become and let me assure everybody, it has become very efficient. In fact, a bit like the rise of the machines in the Terminator series of films, the market might have become too efficient and too powerful. It is this supposition that makes me think the economic rule book really has been torn up. Until we accept that market efficiency has substantially impacted the way inflation works, however, investors and economists will continue to make decisions and provide advice on what I think is a false supposition.
When Milton Friedman was fathering monetarism (the economic theory that expansion of monetary supply is inherently inflationary), he did not know what we know today. He was correct for his time in history but until the very end of his life (he died in 2006 aged 94), the internet did not exist, global markets were a lot smaller and communication could take days. What he would make of the internet age, the speed of communication, the size of the global economy and the resultant increase in market efficiency, I do not know but I would suggest that like all brilliant men (and he was brilliant), he would have quoted from Keynes and said “When the facts change, I change my mind. What do you do Sir?” The facts have changed and as a result, market efficiency has changed the way that QE and fiscal stimulus impact inflation.
There have been several examples of market efficiency impacting inflation over the last ten years, but the oil market is perhaps the most striking. In the 1950’s, 60’s and 70’s, the concept of peak oil was very real. This was the thought that oil was an entirely finite product and human consumption of it would effectively become infinite. That concept defined the way that oil was produced and marketed. OPEC was formed in 1960 with the aim of managing supply and effectively controlling the price of oil. It has worked to varying degrees but since 2010, its efforts have become less successful because of market efficiencies. In July 2011, Brent Crude reached a value of $126 a barrel and several forecasters suggested $200 was possible. In fact, $100 plus oil had an impact that many in the industry did not foresee, in that it affected both supply and demand.
On the supply side, $100 plus oil meant that it became viable to extract oil from wells that would have been otherwise uneconomic and led to a boom in alternative extraction methods such as fracking, leading to the shale oil boom. Simultaneously, the price of oil had an impact on demand. The relative expense of oil sped up the research into cleaner energies and energy efficiencies, to reduce our reliance on a product that was becoming too expensive. From the design of planes (whose primary selling point became their fuel efficiency) to the rise of the electric vehicle, demand was being re-configured. The result was that pre-Covid, Brent Crude had stabilised at a value of c. $60 a barrel, a level considered affordable by the market. Today, the price of Brent is about $27 a barrel whilst West Texas Intermediate (the other primary form of crude) is sub $19 a barrel as a result of a huge fall in demand. The point being that even raw materials are impacted by market efficiency and since 2011, oil has actually suffered deflation despite records amount of liquidity.
If you then translate that efficiency into produced or manufactured goods or services, then even with rampant demand, inflation is capped by the efficiency of the market as supply can quickly be generated to match demand. It is this phenomenon that means that even with a massive influx of money supply, market dynamics are such that supply will almost always match demand so on the whole, inflation will be capped. The reality is that we have over the last hundred years or so, created not just fiat currencies but a fiat economy. This trend has accelerated since the global financial crisis and has created the extraordinary situation that debt is not necessarily a liability.
I am sure many people will have read that last sentence and think that I might have gone mad but let me explain why such an outlandish statement may in fact contain some truth. I should stress that if you personally owe money or a corporate is levered then debt remains a liability but with Sovereign debt (which allows fiscal stimulus and QE), that truth might not actually be a truth. For countries such as Switzerland, Germany and Denmark, almost all of their current bond issuance comes with a negative yield. In Switzerland’s case, the average yield across its entire maturity range is minus 22.6 basis points as of 17th April 2020. Germany (previously the most fiscally conservative major economic power) is offering two-year bonds at minus 70 basis points (as of 17th April 2020) and even 30 year maturity bonds are currently issued at a negative yield of 7 basis points. That means that Germany and Switzerland (amongst a number of other nations) are paid to issue debt. I have no idea what Friedman would have made of that, but I am pretty certain it would have taxed even his brain.
So what does this mean for investments and specifically real estate, as I am, after all, writing to an audience for which the real estate consideration is key? The likelihood is that the lack of inflation in the real world and in the real economy will translate into asset inflation. Even if the economy in the real world is suffering, the investment world will be somewhat insulated by the record amounts of QE and stimulus as all that liquidity needs a home. This strange decoupling has led to stock market out performance whilst the real economy burns (visions of Nero with a fiddle spring to mind). Whilst it is entirely possible and indeed probable that the stock market has another leg down, the current performance highlights that, as soon as Covid19 is under control, there will be substantial asset inflation across most investment classes. Ray Dalio, the hedge fund billionaire, has famously proclaimed that “cash is trash” (easy to say as a billionaire). His point is predicated on the fact that a combination of ZIRP (zero interest rate policies) and certain fixed income products (specifically sovereign debt) offering negative returns, causes investors to chase risk assets in search of income.
As we look forward, it seems likely that real estate will outperform most asset classes because it is considered an inflation hedge. The irony of this is that the real world is not likely to see much inflation and inflation will be limited to assets. The fiat economy is allowing Governments to run up record levels of debt though mostly from their own central banks and substantially increase money supply. In reality, that money supply is just replacing the lost value of investments and then likely propelling those values further as interest rates will be pegged to zero for a considerable period. Sovereign debt will weigh as an interest rate anchor further enhancing the performance prospects of real estate as an asset class.
Smith, Keynes and Friedman are probably all turning in their graves and would no doubt be perplexed as to what mass liquidity has done to the Economy and Markets. Keynes’s oft repeated quote “that markets can remain irrational longer than you can remain solvent” has never felt truer. The good news is that real estate probably will be the right side of the trade.