‘Cognitive dissonance’ is the word the Guggenheim Partners Global CIO Minerd used when he described the disconnect
between the economics and financial markets right now.
For
a long time now, financial markets have been living on ‘QE’. The
program to buy up government debt using created
money 1) has lowered the cost of borrowing for the economy 2) pushed
investors to buy other financial assets as they are crowded out from
government securities. Whether one liked it or not, the result has been
clear. Central bank balance sheet expansion drives
up market prices. Many have made comments similar to Minerd over the
past 12 years and they were shrugged off. However, the coronavirus is
making comments like this relevant again.
China,
the world’s second largest economy at around 15% of global, has been
devastated by the coronavirus, but
the market still marches on. Many believe the disruption is temporary
and things will go back to normal (V-shape recovery) so there is nothing
to see.
Yet,
behind the sanguine outlook lies the more important assumption, which
is that central banks are always here
to save the day. Therefore, bad coronavirus news is actually good news
because it makes supportive central bank policies more likely. For
instance, if the gets worse in China, perhaps China’s People’s Bank of
China will cut interest rates to zero and do QE
for the first time. To take it a step further, if the virus spreads to
the US and it becomes a pandemic, then perhaps the Federal Reserve Bank
will cut rates to zero and do QE for the fourth time. We, as people who
may contract the virus and die, know that
these certainly are not good outcomes, but if China does QE and US does
QE4, you can bet the market will just rip up mechanically.
Given
this outlandish, but perhaps probable, scenario, it is a good time to
ask the big questions: why does QE
still work, when would it stop working, and how long can this
‘cognitive dissonance’ last? (working as in it drives up real asset
prices)
Why does it still work?
1)
Globalization,
Moore’s Law, aging demographics in the developed markets have kept
inflation low. This allows central banks to use their powers without
limits and push back.
Globalization
allows goods, services, labor, and capital to flow so that things can
be done as efficiently, if
not as cheaply, as possible. Moore’s Law predicts that chips’
processing power doubles about every two years, this makes technology
cheaper and more widely adopted. Aging demographics in the developed
markets are the richest group. If they aren’t spending
on goods to drive up prices, then who can move prices? In the end,
central bank can keep on creating money to buy government securities,
but as long as these factors are at full force, the consumer price
index will stay low. This
allows central banks to use their powers without limits and push back.
2)
High quality asset needs
There
is a lot of wealth in the world ($240 tn in 2014), but not enough high quality assets (something that
generates a return). Don’t blame
it on the rich either, this is an everyday person problem. The rich
actually can afford to buy risky assets since they have more than enough
already. It is the middle class who are saving for their
retirement/children’s education or relying on their insurance
to help them that need high quality assets the most. When central banks
are making prices go up, the ETFs, money managers, and insurance firms
will follow, often times no questions asked.
3)
Asset holders cooperating supports paper profits
Even
though trading is a zero-sum game, global investors have cooperated
with each other. Instead of rushing to
sell the asset to realize the paper profit at once, they understand
that they are in it together. By taking turns to sell, nearly all
existing investors can realize their profits over time.
4)
Wealth effect
The
paper profits are not real until realized, but the asset holders’
spending on goods and services are real.
The wealth effect, the increased spending from the financial asset
market wealth, does improve conditions. As the economy improves from the
spending, the high assets prices become a bit more justifiable.
How long can it last?
The short answer is when capitalism gets diluted, too many people get in on the QE secret, and when there are
better things to invest in.
Based on the four reasons mentioned above, central banks’ easing would stop working when inflation increases and
middle class savers get scared. Yet,
these scenarios may only be temporary. For instance, inflation will
pass as supply or demand adjusts, the market fear behind any asset
dump will fade, and consumer sentiment will bottom out at some point.
For things to really change, we may need to see fundamental changes in
capitalism, investor behaviors, and market structures.
1)
A
global shift away from capitalism may lead to more sustained inflation.
In other words, if the profit incentive goes away, it will take longer
for producers to find cheaper, faster, and better ways to produce
whatever that is in short supply. This will make it permanently more
difficult for the central bank to respond to support the market.
2)
A
spike in investor interest given the central bank support would drive
prices into a bubble. If too many people get in on the QE secret, major
stock
indices will be driven up like Bitcoin or TESLA. This will lead to a
bubble burst, before investors come back betting on central banks’
support. In the end, successive rounds of bubble burst will either lead
to central banks or investors walking away. At that
point, the stock market will still exist, but at levels much lower than
the bubble period.
3)
The
invention of a new market could drive interest and capital away from
the major stock markets today. In a world where lifestyle, culture, and
technology have changed so quickly over the past decades, who is to say
the middle class savers and wealthy’ investment preference wouldn’t’
change.
As
for these fundamental changes, things are already gradually happening.
First, the world is moving away from the raw form
of capitalism. There is now growing
scrutiny over businesses’ environmental, social, governance, moral, and
cultural standards. It is possible that all these forces contribute
to future inflation from a supply standpoint. As for the second point,
there may never be too many who get in on
the QE secret. It has already been mainstream for 12 years and
inequality makes it hard for everyone to participate in the market.
Third, while a new market seems unlikely, weirder things have happened.
Bitcoin's market cap is $130 bn because enough people said
so. The difficulty is for a new market to get to a sufficient size. In
2014, there was about $240 tn of wealth in the world (Marginal
Revolution). Today, global equity markets add up to $50 tn (BofA),
global debt markets is about $135 tn (150% of global GDP),
and US and China’s housing market is about $75 tn (Economist, Goldman
Sachs). Unless there is a credible new market that rivals major equity market, middle class savers' money will still flow there.
Ultimately,
for those wondering whether the ‘cognitive dissonance’ of the market
can last, watch how the market is treating the producers and
whether a new asset market
is on the horizon.
