A change in the common knowledge in the markets - last weekend of November
For the last little while there's been this spectacular disconnect between the "real" economy and equity markets, unfortunately as currency debasement heats up even more we could see this gap close in a number of different ways. For example there's major problems in multiple real estate markets, Turkey just had some severe hyperinflation, supply chain costs are insane, international logistics is a mess, energy prices are through the roof in much of the world, multiple countries have tripped early warning indicators for banking crises, disruption with covid continues, and so on. Even black friday sales, perhaps an indicator of rampant consumerist behavior, are also down this year. All the while equities are, at least in nominal terms, trading almost at record highs.
But here's the problem sustained heavy inflation is terrible for everyone and especially the poor. On top of this sustained heavy inflation could destroy the equities markets, even an equities market that is this detached from fundamentals is unlikely to survive high inflation1.
The last few months I have noticed have been especially hard on many people with inflation getting to the point where it's impossible to notice as many people are starting to struggle with day to day expenses. CPI doesn't reflect this, which is entirely by design, but no about of intellectual dishonesty will convince people in poverty that inflation is low when they are having to forgo things due to prices inflating, only people who are wealthier are capable of falling for this. Last year when I wrote an article on if Quantitative Easing is inflationary I remember there being an entirely different sort of reaction from people, back then there were many more people still staunchly in the disinflationary camp and not a whole lot of people out there were realizing the potential for inflation that was around the corner. No joke I had a lot of people tell me that QE was deflationary, and maybe in some circumstances - unlike the ones we actually have at the moment - it could be2. But when inflation wasn't taking off fewer people were willing to accept that QE is an inflationary mechanism, but now that tapering looking increasingly unlikely to happen and people like the head of the ECB are saying they even though inflation is high they won't taper because it would hurt the economy, it's much easier to see how QE is actually inflationary after all. Put simply debt to GDP ratios are exceedingly high, never been this high ever before outside of wartime and if they keep growing they will be the highest ever seen. The only way out of this now is defaults or increased inflation as declining demographics make it exceedingly unlikely we will be able to grow the economy enough to get out of this debt problem. So I'll believe the tapering talk when I see it and not a day earlier.
It appears that the "inflation is transitory" narrative was itself transitory with a lot of people pivoting to progressively say that inflation is more likely. The next pivot for some is to backflip on the transitory part as well. This shift in narrative has been a spectacular one for me to witness since I've been paying extremely close attention to this space for a few years. It felt like this took an especially long time to then happen quickly.
Perhaps one of the most interesting things is recognizing just how few people actually look at the data directly, I'm talking about things like FRED, PMI reports, commodities, central bank reports, employment statistics, supply chains, BLS stats, etc. when building their worldview about what's happening on the markets. I like to get into the data and really dig into research so I have a bias in assuming that other people do this more than they actually do. As a result the narratives around inflation held far more power over people, especially those who do no research of their own, than I had assumed. In the face of unrelenting price level rises people start to really change their attitudes regardless of the narratives they here. This is because when prices change fast enough that they are in short term memory people are reminded of how their money is going less far on a regular basis. When you remember how much more you got just last month it's hard to ignore and this anecdotal data accompanied with a shift in group psychology makes it so much harder to buy into the deflationary narratives. Psychology plays a strong role in inflation.
The exceptionally loose fiscal policy we have seen combined with the insane amounts of greed in the markets has led me to fully expect to see a massive melt-up phase in equities. This is a phase driven by entirely by momentum, FOMO and the greater fool theory, people start to look at you weird if you mention fundamentals. Because bubbles can last as long as new money flows in and money is explicitly being created to prop up prices such a bubble can last a long time with absolutely no fundamentals to back it up. I don't know when this will end, the first potential trigger I thought could end it was the massive Evergrande credit problems and defaults or the Zillow implosion. But the markets mostly shrugged those off which laid the basis for an even stronger melt-up being possible since when especially bad news doesn't tank prices people become even more emboldened. This weekend has been the second time I've seen the potential for mass psychology to shift in a negative direction, but will this impact the markets? If the markets shrug this off too I think an insane melt up phase is likely to begin.
And that's where I think we are at now, the markets are exceptionally highly priced relative to traditional metrics with the exception of some value stocks but despite this many people out there think it can go higher still. A discussion of relative vs nominal gains is in order here, markets when looked at in nominal terms can go up even when the real value is going down, see this chart of the markets in Zimbabwe for a great example, first in the famous hyperinflationary era of 2007-2008:
After a certain point the market ceased to operate as hyperinflation killed it off and effectively there was a reset. After this a ne w market was created but it looks like this is same sort of scenario is happening again now:
You might look at these and think "oh wow returns are good" but Zimbabwe hasn't been doing so great lately. The currency has lost value again at such a rate that even with these positive nominal returns you might still be behind. After talking to a lot of people I've come to realize this thought is actually unthinkable for many people in the west, the assumption is so strong that nominal terms gains must be gains in real terms. The more freshly printed money enters into the markets the more markets priced in that money become a signal of inflation rather than growth.
I think if debt monetization and monetary creation keeps running hot we might have a sharp rise in nominal terms while the real value drops badly. This might be one of the most low commitment ways to call a market top and frankly this is a bit embarrassing, but I just don't have the confidence to call a top in nominal terms just yet. As mentioned earlier with enough monetary manipulation a nominal drop need not ever happen until the currency entirely collapses, I just hope we don't get there. For now the bubble still seems to be growing in real terms and as long as inflation doesn't get more out of control I think it will take some sort of event to change the common knowledge game and end this bubble. That event might be the Omicron variant, much like in earlier phases of the pandemic there's a huge amount of fear being pushed in the media about this. New variants don't change the economic fundamentals as much as they turn the emotions of greed into fear. Whether or not this fear is warranted is not something I don't want to get into, the impact on sentiment is likely to happen in any case. When there's articles with headlines like "Omicron poses very high global risk, world must prepare -WHO" I don't expect this to do anything good for sentiment. I wrote about how the "V shaped" recovery narrative was a lie and I think the reason this narrative was inaccurate is that the pandemic has lasted far longer than this narrative needed to be true. We are now almost two years later after "two weeks to flatten the curve" and people are now realizing that covid, much like influenza, isn't going away any time soon. I don't know what will happen when people finally accept that covid will be around a long time, as I think a lot of people were operating under the idea that it would come and go quickly and I think there's going to be a phase of disappointment in order.
I do think there will be a strong economic recovery at some point, but that will be something that happens after the root causes of these major financial and banking problems are actually resolved. Many of those problems actually have nothing to do with the pandemic at all and started long before 2020, and major events that happened before the pandemic like the 2019 repo crisis are still not entirely resolved. If these problems actually get fixed I'd be extremely positive on the longer term prospects. Covid will likely still be around in some form or another after we have that recovery, but hopefully by then we have much better treatments and like influenza we will move onto a new era where things are back under control and people can get on with living their lives again.
Unconventional monetary policy that has been involved in the direct purchasing of things on the open market have been a tremendously powerful force in suppressing free market price discovery mechanisms. Without this I just don't think we could be in a situation with news this bad on this many fronts while simultaneously having tops in various equity markets. When we have major indexes such as the Nikkei 225 more than half owned by the central bank we really should be having some serious conversations about whether or not we still have free markets at all. In many senses this sort of monetization has meant that the markets are getting less free over time. ↩
The idea is that bank reserves aren't really currency in the same way that regular currency is, you can't go to a store as an individual and spend bank reserves so in some senses they are just an accounting mechanism. BUT the thing is all modern money is mostly just accounting mechanisms backed only by ones and zeros stored in various databases in banks. If money were actually backed by something QE might actually be somewhat deflationary because it would take real money out of the economy which would then lower the velocity of money. But seeing as we don't really have any sound money anywhere and there's an increasingly large number of people calling for even less sound money we might need to come back to question some of those assumptions about how these monetary velocity arguments work. For example if you include these things like bank reserves in monetary aggregates it's likely going to show that monetary velocity is lower because that "money" isn't moving, but if it's not real money should it be counted in the monetary velocity calculations? I'm honestly not sure. Such is the annoyingly murky nature of much of modern money. ↩