Schvets: Lowflation here forever now

There are not many asset strategists that are worth the time of day. Macquarie’s excellent Viktor Shvets is an exception. I agree with just about everything that he writes below.

It can’t happen here–Why not?

Is US really different to Japan or Eurozone?

One of the most consistent macro themes over the last two decades was that disinflation and deficient demand that afflicted Japan since the early ’90s or Eurozone since’08, cannot occur in the US. There are five arguments against Japanification of the US:

1.Radically different demographics;

2.Significant differences in debt overhang;

3.Differences in productivity trends;

4.Role of private vs public sectors; and

5.Labour flexibility and innovation impulse.

While each argument contains a grain of truth, they are insufficient to negate experience of Japan or Eurozone. On the contrary, similarities are far greater.

1.At the peak of deflation in the’90s-early’00s, Japan’s demographics were similar to where theUS is today and by 2030, US is likely to approach Japan’s demographics a decade ago. The same applies to Eurozone. US will still enjoy better demographics, but differences are narrowing rapidly, and hence,it is unlikely to be a dealbreaker.

2.While massive debt overhang that Japan endured in the’90s was unusual; now it is common. In 1990, Japan’s debt to GDP was ~4x while the US was at ~2x. Today, Japan’s debt burden is ~6xGDP while the US is touching 4x (~6x if adding unfunded liabilities), with public sector in the US at ~130%of GDPvs Japan’s state debt below 100% in late ’90s. Eurozone’s debt is now only slightly ahead of the US, and lower in the public sector.

3.US and Eurozone are essentially mirroring Japan’s expansion of base money through’90s-early’00s, with a pace stronger than Japan was then prepared to accept. Hence, collapse in the US velocity of money has occurred at a greater speed than in Japan or Eurozone.

4.The gap in role of the state is narrowing, with the US raising its public spending at a far stronger clip. While it can be construed as both positive and negative, this argument for slower growth (state dominance) is no longer relevant.

5.While US remains the innovation leader, Japan and EU have a greater share of patents while their R&Dis approximating or exceeding US and labour flexibility is eroding.

6.Productivity (TFP) trends in the US are no longer exceptional. Over the last decade, US TFP has slowed to ~0.3-0.4% (belowGermanyandJapan).

There do not appear to be strong reasons why US will not follow Japan unless there is a fundamental shift in the nature of the economy, and even then, it is not clear what that change might be. If deficits were the answer, Japan has done more of that than anyone eelse. One might argue that Krugman’s retort about the need to be ‘credibly irresponsible’ is more attuned with the US than Japan of’90s, but since ’12, Eurozone has been just as ‘irresponsible’. Fiscal-monetary fusion could be helpful but Japan has been doing it for two decades, with BoJ now sitting on 52% of JGBs. It seems that what we describe as a Fujiwara effect (merger of Information Age and financialization) is so powerful, the best fiscal, monetary and social policies can do is to soften disinflationary backdrop, implying that over the LT, rates are unlikely to rise, and the bondmarket is far from ‘dead’. At the same time, concern that USD is debased will be just as wrong as earlier angst about collapsing Yen. Equities are harder, but as long as CBs have ability to corral vols, CoE will remain contained and more likely fall over time. How does it all end? ?It does not, as the world adapts.

Policy errors committed in real time

Tightening when liquidity & cyclicality retreat?

May signalled continuing fall in liquidity and peaking of cyclicality

•As T.S. Eliot once said–‘if we all were judged according to the consequences of our words and deeds, beyond the intention, and beyond our limited understanding of ourselves and others, we should all be condemned’; or it is only human to fail, and CBs are nothing but human institutions.

•Today, there are widening cross-currents of views emerging from both current and former Fed governors as well as other key CBs (witness Kevin Warsh opinion piece in WSJ on June 7). As we have been anticipating, the height of anxiety will likely occur over the next three months (as economies recover and inflation accelerates) and also in mid-2022 (as we started adjusting to return of disinflation). Today, the overwhelming concern is the pace of normalization of demand and supply, and the extent to which inflation will move up and its stickiness. An increasing number of CBs are now lining up on a more contractionary end of the curve (i.e., BoC, BoE, RBNZ, PBoC) and it appears preordained that these will be joined by the Fed. Discussion of tapering and tightening, and whether CBs are already behind the curve and how painful the ultimate tightening will have to be if no action is taken now, will get louder.

•It is unfortunate that rising demands for action and dire predictions are coinciding with a broadly based decline in public sector liquidity, supply USD, credit impulse and M2. No matter how one cuts these numbers, the peak of liquidity has already passed two months ago while cyclical upswing is nearing its peak as does fiscal impulse. CBs and economists seem to believe that the level of accommodation is more important than the delta; unfortunately, the opposite is true: the pace of change determines almost everything, from asset prices and their impact on consumer and business behaviour, volatilities and ultimately risk premia, and hence availability of credit.

•May has seen a further erosion of public sector liquidity, with the pace of G4 (US, UK, Eurozone and Japan) CB assets decreasing to less than 25%,compared with a 56% clip in Feb’21. On the current trajectory, public sector liquidity expansion will halve yet again over the next six months. At the same time, slower pace of US monetary base, is contracting supply of USD, with the pace dropping from 20-25% earlier in the year to below 10%. Credit impulse is also receding, in the case of China it is already turning negative (vs growth of~8-10% late last year), and it is also diminishing in Eurozone, with private sector lending decreasing to ~2% from 3.5% in Jan’21. The broader gauges of money supply (such as M2) are also signalling declining liquidity, with G4 M2 supply dropping to ~16-17% from 22-23% two months ago.

• What does it mean? In our view, chances of serious policy errors are rising, with maelstrom of noise forcing CBs into tapering and tightening at exactly the wrong time, as liquidity and cyclicality turn down. In extreme, it could lead to a massive spike in vols, and derating of everything, in particular more marginal areas (e.g., HY). What can investors do? Buying vols is a good option. For equity investors adding quality and staples could also offer some protection. Policy errors will be reversed, but not before some damage is inflicted.

Investors have passed the peak of monetary & reflationary pulse

• The easing of inflationary expectations (at least as reflected in break-even and nominal rates) has over the last several weeks shifted the sectoral dynamics in favour of growth and quality. From the peak of value rally in mid-May, growth outperformed value in global portfolios by ~4%-5% and was flat against value in EMs while quality has outperformed value by ~3%-4% in global and ~2% in EMs. YTD, value is still up vs growth by ~6%-7% in global and EMs and has thus far outperformed quality by ~3%-4% in global and ~2% in EMs.

•The overwhelming market noise of out-of-control inflation (something we have consistently disagreed with) has subsided somewhat, and while the Fed will continue to be tested, the high point of monetary accommodation has passed. We are also at the peak of fiscal accommodation, which will soon start to erode, while cyclical recovery is largely behind us, with China having already peaked in 1Q’21 with the US peaking in 2-3Q’21. It is likely that investors have already witnessed the high of US CPI and China’s PPI. The question is not so much about runaway inflation anymore but its stickiness and the extent to which it will recede into late’21 and 1H’22. We maintain that fusion of the Information Age and deep financialization favours a return to a disinflationary climate. These are stronger forces than deglobalization and the cost of ESG and social policies. But we maintain that the next decade (unlike the last 20years) is likely to be more volatile, with wider swings between inflation and disinflation within disinflationary LT channel. This will yield intermittent trading opportunities but with growth and pricing power still being highly valued.

•Periods of low but rising inflation tend to temporarily return pricing power to sectors that have been losingit for years (as with COVID recovery), favouring value and cyclicality (i.e., energy, financials,etc). High and rising inflation and/or stagflation are generally bad for most asset classes (i.e., everything corrects, apart from gold and other niches). However, contained and/or falling inflation favour sectors with stronger secular drivers, pricing power and growth potential, with investors focusing on various styles of growth and thematic (àla the last 20 years). The next decade will be more complex, as we migrate from digits and information to real life (i.e., alternative energy and transport,robotics and automation,etc). It will be a more capital intensive era, requiring different & more complex skills than data manipulation. Thus, composition of thematics will change (to ‘atom’ rather than ‘digit’ manipulators), but the core (i.e., secular strength) will still dominate. Ultimately, disinflation wins even if CPI is high and sticky, as it collapses asset prices, and deflates economies.

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