What Coronavirus? Says the Market - My take on why central banks can still dictate the market and for how? long

‘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.

 

Disclaimer: risks such as political checks on central bank powers, financial stability concerns, and any end of the world scenarios are all possible, but are excluded for the sake of this thought exercise.

Is Marie Kondo bad for the economy? A Thought Exercise on Global Demand

U.S. consumers spend, and the global economy depends on it. Though the 320 mn U.S. population is only about 4% of the global population, U.S. consumption represents 10.6% of global GDP, and this figure’s impact is understated since the rest of the world’s investments, exports, and consumption associated with U.S. consumption is excluded. So, if ‘Tidying Up with Marie Kondo,’ the new Netflix show that helps people combat hoarding embrace minimalism, becomes the new norm, does it mean the economy will suffer?

I believe the answer is no, but it requires advanced economies to sort out housing and emerging markets to figure out politics. With 7 bn in global population, there is no shortage of people who want to live the good life. Regardless of the different views on materialism and frugality and the different stages on Maslow’s hierarchy of needs, people want modern shelter, appliances, technology, and conveniences. However, the first problem is that increasingly those who have the means don’t need or want to spend. The second problem is that those who truly need don’t have the means to spend.

Let’s take Japan, the third largest economy in the world, for example. Japan’s elderly owns most of the wealth, but the lack of desires, retirement insecurities, or concerns for their kids’ future keep them from living it up. The problem underneath is Japan’s bad demographics. The country’s bad demographics, characterized by the rapidly aging population and low fertility rates, threaten the stability of the stability of the retirement system and the vibrancy of the economy and its future prospects.

As for what explains the bad demographics, I believe housing played a big role. Japan’s massive housing bubble made having children expensive, unreachable, and undesirable. Buying a home or paying rent is an option for a young individual, but having a stable home becomes more of a necessity for a couple looking to raise a family. As a result, when Japan’s housing price outpaced wage gains, it became rational for people to have fewer kids or forgo having kids.

Increasingly, this trend may play out in U.S. as well. The combination of the knowledge economy’s cluster effect and global wealth investing in U.S. cities have driven up housing prices in metropolitan cities. For instance, the tech jobs in San Francisco, the finance jobs in New York, and the biotech jobs in Boston draw young talents to these cities. This results in a cluster effect where the talent influx creates a bigger ecosystem for these jobs, which draws even more people to these cities. In addition to the increase in demand from the population growth, investors also add to those who wish to own a piece of these growing cities.

In the end, the high home prices reduce these residents’ disposable income in the short-run and may reduce their willingness to have children in the long-run. While wage gains and home prices ebb and flow, these advanced economies’ demand becomes permanently impacted once demographic takes a dip. As a result, housing plays a big role on why advanced economies may decide to spend less than they are able to.

As for the second problem, emerging markets’ messy politics often prevent them from achieving their full potential. China is a poster boy on how politics matter. Since Deng opened up China with a single-minded focus on pursuing growth, China has been on a tear. In the past decades, China has lifted close to 800 mn of its 1.3 bn population out of poverty. Growth inducing policies allowed people to get jobs and buy things to improve their quality of life. However, things may be starting to slow in China.

Automobile sales contracted for the first time in 20 years and smartphone sales have been falling for over a year now. This doesn’t mean that China is running into a wall or a crisis, but it does mean that it is important for other emerging market to take over the baton for demand. The difficulty is that there are few countries can match China’s size and trajectory for growth. Messy politics have kept other large emerging markets such as Brazil, India, and Indonesia from achieving their full growth potential. Politics matter because bad policies prevent technology and organizations from maximize productivity and full utilizations of their land, labor, and capital.

China Automobile Sales (mn of units)  

China Smartphone Shipments (mn of units)

As I see it, there are five ways to tackle the two problems so that Marie Kondo doesn’t become the new scape goat for a global economic slowdown.

1. Transfer money from the haves to the haves-nots in the advanced economies and emerging markets for them to spend.
2. Lend money to the haves-nots in the advanced economies and the emerging markets for them to spend.
3. Encourage investments in financial securities and discourage investments in real estate.
4. Loosen building and zoning laws and adopt accelerated building techniques to meet housing demand.
5. Influence emerging markets to pursue better growth policies and achieve more global economic coordination for mutual gains.

However, not all of these solutions are feasible, practical, or advised. First, transferring money is not productive and will be lobbied hard against. Second, lending money to those who can’t payback results in high non-performing loans at best and another economic crisis at worst. Third, channeling wealth from real estate is possible, but the current homeowners will become unhappy voters. Fourth, turning every desirable metropolitan city into dense concrete jungles of stacked modular apartments works on paper, but not in practice. This leaves the last option, which is also the best out of all the potential solutions.

The difficulty here lies in the world’s current state of political economy. As politicians around the world see global economy as a zero-sum game (maybe globalization or the winner-takes-all development has indeed turned it into a zero-sum game), this also makes the last option unlikely. 

So, what will happen and will Marie Kondo become the scapegoat? I don’t think so, but may be it is not impossible.