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Stephen Johnston

Stephen Johnston

Stephen has over 15 years experience as a fund manger - working for organizations such as the European Bank for Reconstruction and Development, Societe Generale…

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Some Thoughts Macro, Value and Austrian

"Everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone" - Frederic Bastiat

By virtue of more than a decade of low and often negative real interest rates, rapid monetary growth and emerging market currency pegs, the economies of the developed world have been skewed towards consumption rather than production. Unfortunately, consumption is the destruction of capital - by definition it represents the diversion of resources from productive purposes. Both the private and public sectors have been indulging in this protracted debt fuelled consumption spree. Savings rates have plunged and fiscal deficits have expanded.

To the increasing bafflement of the Keynesians, it has been requiring a larger and larger amount of debt to create each additional unit of GDP - on the order of $4 of incremental debt to less than $1 of incremental GDP. Why? Because on average, we are incurring debts that do not create offsetting cash generating assets. At some point this type of trend must result in default - whether outright or via the printing press.

Surprisingly or perhaps not surprisingly, the governments and central banks of the developed world (let's continue to call them non-profit maximizers or NPMs) seem intent on continuing this trend as they desperately force feed the markets consumption-oriented programs in place of stagnating private sector demand. An interesting fact is that for the last decade in the US, private sector job growth effectively has been absent and virtually all net job growth has been in government or state dependent sectors. We are facing political as well as monetary inflation.

There are many (invariably of the Keynesian stripe) who observe that money must be lent into existence and due to deleveraging in the private sector we face a deflationary environment. Of course that ignores that money can be simply spent into existence by the state - a powerful inflationary mechanism when the state represents well over 30% of the western economies and central banks have thrown off the last few vestiges of restraint and are willing to directly monetize fiscal deficits.

In our current world I would argue it's a relatively trivial matter to bypass private sector borrowers altogether and have government spending inject newly printed money into the economy. The presence of heavily leveraged and highly impaired asset classes - commercial and residential real estate and many banks to name a few - don't act as an offsetting deflationary force as Keynesians would have us believe. Inflation is not an aggregate phenomenon. After being released into the economy by the state, the newly created funds are simply avoiding past "bubble" sectors and flowing into new and less levered areas as is their wont. Banks may not be lending to homeowners but the state is spending and this money is most certainly turning up in the economy - commodities are just the most recent manifestation of that process and will not be the last.

The problem arises that all state spending requires that capital is first taken out of the hands of the private sector via taxes, borrowing or inflation, then deployed in typically loss-making (capital destroying) activities. The net result is that while government spending may appear to increase nominal GDP, this spending and the attendant deficits are setting the stage for much greater problems in the future. By preventing private sector savings from replenishing the pool of capital our governments are going further into debt to finance policies that at best can only serve to pull future consumption into the present - once again more consumption is not what the west requires at this moment.

So what of the seemingly relentless rally in the equity markets? Rather than indicating sound fundamentals a nascent recovery in the western economies, I believe we are simply witnessing the re-ignition of bank intermediated speculative finance funded by a wealth redistribution from savers to the financial sector. Of course the financial sector is a vocal proponent of this process for in the words of George Bernard Shaw "A government which robs Peter to pay Paul can always depend on the support of Paul"

To reiterate, what western economies need is more capital. There is no way to create capital other than through savings and hard work - a message to which western governments are reluctant to listen. Printing money seems alluringly easy at first, but it does not create capital, and worse, the inflation it creates ultimately causes long lasting harm to the production structure of the economy. To ask a rhetorical question, what possible outcome does the Federal Reserve expect by increasing the base money supply (M0) of the world's reserve currency 200% in 24 months - a stronger currency, low food and energy prices, a robust economy?

I believe that until the developed nations stop engaging in capital destroying activities and our capital base recovers, it will be difficult for sustained real growth to take place. A depleted and declining capital pool, combined with enormous expansion of the monetary base and negative real interest rates are creating the ideal conditions for an extended period of stagflation in the west. With this backdrop in mind, perhaps this is an appropriate time to engage in some "what if" analysis.

NPMs have allowed vast amounts mispriced risk to accumulate in the financial system and are eager to foster more in the form of higher nominal prices in real estate and equities. Even if we assume a small probability of the negative outcomes, given the magnitude of the consequences, investors should take the time to properly consider these risks.

For instance, imagine a world with more than 10% inflation, minimal real growth in the west, $12/bushel wheat and $175/barrel oil. How does your portfolio and standard of living fare in such a world?

  • Are you holding a long duration portfolio of fixed rate debt investments, particularly sovereign credits?
  • Are you dependent on consumption growth in the west for investment returns?
  • Are commodities an input cost rather than a profit centre for you?

If the answer to these questions is yes imagine if real growth were to decelerate in the west while commodity prices/inflation accelerated - stagflation. Sooner rather than later you should take a mental walk through your portfolio - be objective and ask yourself what investments benefit and what suffer in the world I outlined above and to what degree?

Kind Regards


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