The writer is founder of the hedge fund advisory Totem Macro and former head of emerging markets at Bridgewater Associates
We’re at the sort of inflection that only strikes once or twice a century. That’s what makes it tricky.
Most people alive today grew up alongside a simply historic rise in financial wealth. We know nothing but relentless asset appreciation, propelled by disinflation and falling rates. Liquidity outpaced the economy. So did asset prices. But violent financial and geopolitical regime change is upending that status quo and the bubbly valuations that hinge on it.
Disinflationary, liquidity-dependent assets are of course the opposite of what you want under opposite macro conditions. But after 40 years of hyperfinancialisation and the recent orgy of money-funded speculation, these assets are most of global market capitalisation.
What good is financial wealth, if not to ultimately spend it? The period of building “paper claims on real things” is over, and these claims are being called in. So assets deflate and “real things” inflate. Aggregate measures like market cap-to-GDP and wealth-to-income are down, but barely off extremes. In this new era, a lot of the “financial wealth” we built will prove illusory.
These arcs of history are bigger than any man, but Richard Nixon’s gold and China policies set the parameters of the world we’re now leaving. More money was printed since the US abandoned the gold standard than during any other peacetime period. We spent more than we made. But globalisation simultaneously supplied us with output from the world’s cheap labour, and a privileged ability to import the world’s savings.
Global integration kept prices down and the dollar supported, funding twin imbalances by supplying ample buyers for US paper, which of course only went up in that regime just like all assets. This was turbocharged by a unique global peace under a unipolar dollar standard. The point is that it was a virtuous cycle, and it was a fluke.
We bookended secular US exceptionalism with cyclical US exceptionalism. The old-economy boom gave way to a new-economy bubble. Winners naturally rotate across cycles, and that rotation was overdue before the Covid-19 pandemic. Then our great leaders seized the excuse to take printing-and-spending to an unsustainable extreme. So what’s now happening is the inevitable cyclical baton-pass, secular regime change and a monetary contraction of untested size (always bad) — all from bubble levels.
There is no immaculate disinflationary force to counteract the demand shock this time. This isn’t a supply crunch — volumes of almost everything are at highs. But immaculate disinflation is what is priced in. Markets expect inflation and interest rates to converge at around 3 per cent, with negative real rates the entire time. Seasoned watchers of emerging markets know a Brazilian policy mix gets you a Brazilian growth/inflation mix.
The economy is overheating, external dependencies are growing, real rates are negative and policymakers are just waking up. Next step, your currency falls and inflation persists until you give your foreign creditors the positive real returns they demand, crushing the economy at the same time. What EM investors have never seen is how this macro volatility looks on overleveraged DM balance sheets. Volatility and leverage are antithetical concepts. So, inflation must remain above interest rates to first eat through the debt. The base case must therefore be a repeat of the inadequate tightenings and chronic inflation of the 1970s.
There are countless strategies, but only two ways to make money in the markets. You can bet that something’s going to happen that’s not priced in, earning alpha. Or you can position yourself along the spectrum of “zero-to-max risk” and earn the prevailing rate. This gets you returns on cash or a positive risk premium, beta. Cash pays below inflation, while risk premiums are historically small.
Assets quite simply extrapolate what were always fundamentally unsustainable cyclical and secular conditions. So you’ll need to get real returns from alpha. The “thing that’s not priced in” is that both inflation and interest rates will be much higher, for much longer, than the markets are willing to price. Both are, independently, a death knell for assets, at least in real terms. Higher rates won’t bring down inflation if they remain below nominal growth, because in that world cash flows are rising faster than the cost of acquiring and servicing them. But the end of abundant liquidity can certainly crush assets trading at many multiples of sales.