Back in 2008-2009, the Fed instituted the unprecedented policy of the purchase of treasuries and agency mortgage securities as well as opening up lines to banks which used all manor of assets as collateral. What became known as QE was called “money printing” by some and a number of analysts and market watchers predicted a bout of inflation post crisis that would have adverse effects on the public and their savings.

But this never came to pass, why? One reason, which was pointed out eloquently and in detail in this post by blogger Lyn Alden was that the original QE was essentially a system wide bank recapitalization. First, the Fed stepped in to purchase treasuries and provide collateral backed liquidity to banks. Banks were able to use assets like agency mortgage securities as collateral, which eased the losses from these types of securities on their balance sheet.

The other element of the bank recapitalization was the Troubled Asset Relief Program or TARP, which enabled the Treasury to take the worst of the mortgage and securitized assets off the balance sheets of the banks through direct purchases but with the caveat through the Emergency Economic Stabilization Act (EESA) that the banks also had to issue the Treasury warrants for non-voting shares. These warrants could be converted to stock of the banks at a later time.

Despite all the hoopla and politicization of these events, the programs were the right call and actually quite ingenious. In the case of TARP and the EESA, the Treasury was able to take the worst assets off the bank’s balance sheets and if they produced losses for the Treasury, it could make these up by exercising and selling the warrants of the newly solvent banks for a profit. It’s underreported and often forgotten in the public domain, that the TARP program has actually earned the Treasury a profit of $110 billion as of December 2020. In addition, in absence of these programs and central bank intervention, it’s very likely we could have seen bank collapses and a worldwide depression very similar to that of the 1930’s. In this case the Fed learned its lessons of the last banking crisis in terms of shoring up confidence in banks and the solvency of the system through government support.

This Time is Different

As Ms. Alden points out though, the current combination of fiscal stimulus and Fed QE brought on by the response to the pandemic is stimulative to the broad money supply. The actions of both the Treasury and the Fed during the last crisis were actually anti-deflationary, not pro-inflationary since the stimulus was held mostly within the banks and not transmitted out to the general public in the form of greater lending to the general population. In fact, the banks still pulled back heavily in terms of lending, it was just a pull back in the bad type of lending that shouldn’t have been going on anyway. Home loans post crisis and since then have essentially had to conform to the standards of Fannie Mae and Freddie Mac, meaning they have at least 20% equity for primary home borrowers and have documented income, among other factors.

M2 is the classification of the broad money supply which includes savings deposits and money market funds outside of the currency in circulation and the checking deposits. You can see from the below the difference in M2 recently compared to any bump during the crisis where the pro-inflationary changes were contained.

The famous monetarist Milton Friedman famously proclaimed: “Inflation is always and everywhere a monetary phenomenon.” This is true in the sense of more paper fiat money being produced to chase fewer goods and services, yet the effect of a greater broad money doesn’t mean we are in a static environment of money demand either. At the same time that these pro-inflationary forces are in effect, there are also deflationary forces in effect acting against the pro-inflationary elements.

The term QE was coined in 1995 to describe unconventional Japanese efforts to stimulate the economy through asset purchases. Friedman himself advocated for this type of stimulus to kick start the Japanese economy. Yet even after the “three arrows” attempt under Prime Minister Shinzo Abe to stimulate the economy met with limited success, many have been starting to ask whether low inflation was here to stay and whether central banks have any relevance anymore. This is why it’s important to understand some of the deflationary factors which can affect the demand for money. I will again borrow and paraphrase the summary from Ms. Alden as it was succinctly displayed:

• High private debt levels are deflationary, since it makes consumers and businesses financially restrained and risk-adverse. This was also at play post crisis, as high private debt levels started to reverse as people paid them down to manage their own personal solvency.
• Slowing population growth and aging demographics are deflationary, since resource demand slows. This is the case in both Japan and Europe and without immigration or a jump in the birth rates, will start to take hold in the US as well.
• Technology is deflationary, since it makes some things cheaper and better.
• Wealth concentration into fewer hands is deflationary, since money coalesces rather than circulates. We can see this in the decreased velocity of money, or number of times it changes hands in a given period.
• Commodity oversupply is deflationary, since it cheapens the building blocks we use for everything else.
• Outsourcing is deflationary, since it lowers labor costs of goods and puts downward pressure on domestic wages.

Out of these 6 factors, at the current moment the US is experiencing 5 (private debt levels have come down since the crisis, see below).

The question now going forward is whether the downward pull of these deflationary factors will offset the inflationary push of broad money supply increases. Many of these are difficult to measure precisely but we can partially strip out the population effect by looking at M2 money growth per capita and when we do that we can see that broad money growth per capita is at the highest levels it’s been since the 70’s.

The Response

This just points to a common misconception among much of the press and market participants: that the Fed can control nominal interest rates. The Fed can only affect rates in the short term and not the nominal level. Long term supply and demand for money determine both the real as well as nominal rate, the Fed can affect the difference between the two in the short term and even that is up for debate. As an institution the Fed has already began to chip away at its hawkish position towards inflation and stated that it is willing to tolerate inflation above the 2% target for some period to get overall annual inflation back towards its target of 2% and avoid deflation.

Although the 2% mark is a worthy goal because as countries get wealthier their demand for money increases, it leaves open the door to prolonged periods of inflation that the Fed may find it does not have the ability to easily control once it is out of the box. Their ability to be able to temper inflation in the future rests on the assumption that the public and markets will not change their inflation expectations. If we see a prolonged period of above average inflation, workers and investors will demand their wages and move their money accordingly and the genie is out of the bottle. The only way the Fed would be able to push back would be a painful and harmful raise in rates that would likely plunge the country into recession and put millions out of work. A difficult prospect given the closer coordination of the Fed and central government since the crisis.

This politicization of the Fed and the fear of tanking the economy, along with further calls for government intervention, is what led to the inflationary spiral and government overreach of the 70’s. If you look back on the commentary of Fed governors at that time, they often spoke to committing to low inflation but the reality always turned out different. Now that the Fed has an inflation and employment mandate, a bout of inflation may put these interests at opposing sides and the Fed may not find it politically expedient to raise rates to the level required to strangle inflation in its crib.

How to Hedge

Market participants have likely weighed the risk that this could happen (not called it outright as some are trying to do) and are subsequently hedging accordingly.

The easiest initial call is the weakness of the dollar. As fiscal spending increases and the Fed tries to stimulate the economy with zero rates, they hope to eventually see consumption increase. This puts downward pressure on the dollar as the demand for all goods, including imports, increase. This produces a fall in the value of dollar assets versus other currencies and assets denominated in those currencies become more attractive for investors. This could then subsequently mean a gradual rotation away from the higher priced tech stocks which have been propelling returns for the past few years, especially if earnings in the coming year don’t meet lofty expectations.

Besides developed market assets, emerging markets tend to benefit from the weaker dollar, especially when the are commodity producers exporting to foreign markets. Initially, issuers take advantage of the low rates, binging on dollar denominated debt. This is already starting to happen as we saw Peru issue a 100 year bond yielding 3.3%. A bout of dollar inflation would even help these borrowers for a time being as it lowers the cost of servicing their debt alongside the increasing dollar value of their commodity exports.

As I pointed out in my last post as well, cyclicals as well as value stocks also tend to do well faced with the bursting of a tech bubble as well as the prospect of a weaker dollar all alongside the potential for higher inflation. This is why many asset managers have spent the better part of the 4th quarter advising clients that now is the time to start taking commodities positions based on the convergence of factors I discussed.

Although it will be difficult to catch the timing of this shift, all signs point to it coming which means a portion of your portfolio should at least be devoted to emerging market, value, foreign and cyclical stocks. The hype is on tech now, and by all means you should be along for the ride, but hedging given the macroeconomic environment would enable investors to take advantage of the super cycle headwinds taking shape.

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