Jasper: Thanks for taking the time to speak to me today. Why don’t we jump straight into it? Could you give us a quick summary of where we are and how we have got to this point?
Supun: My pleasure. Sure. For me the origin of our current position started back in 2007/08. The US faced a crash in the housing market that had repercussions on a global scale. Central banks across the world rushed to cut interest rates and purchase bonds, otherwise known as Quantitative Easing or QE, to add liquidity or money to the system. There was concern that this money printing would cause inflation, but it did not happen. A few years later we also had the European sovereign crisis and “Abenomics”. Both of which resulted in further purchases of bonds and in the suppression of interest rates. In both Europe and Japan policy rates went below 0.
Jasper: Sorry, what is Abenomics?
Supun: This was the name given to the policy of Shinzo Abe, former Prime minister of Japan, to stimulate reflation and growth. It involved cutting rates, bond purchases, and fiscal policy.
Jasper: Thank you, please continue.
Supun: With rates being held down across the world, money started to flow into assets driving prices higher. The idea of this was that asset owners would become wealthier and spend more thus stimulating demand through a waterfall effect. Trickle down economics as it became known.
Jasper: Is this why tech performed so well, and people piled into stocks?
Supun: I think that is partly true. Money certainly has been forced to look for a home. With rates so low, investors have had to travel further down the risk spectrum to obtain returns. There have been increases of inflows into Venture capital investing, Private Equity, as well as Private capital markets. That isn’t to say that all the performance in asset prices has been because of people chasing returns. Some of the companies that have reached very high valuations are genuinely successful.
Jasper: I guess cryptocurrencies are also an extension of this?
Supun: I would agree with that. When policy makers derive ideas, they only really have the end objective in mind. They don’t seem to apply much thought to the incentives that policies create amongst people. Oftentimes, the incentives are not necessarily in line with the end goal. But we will come to this again later. With the amount of money printing that had occurred, people started to create alternative stores of wealth that were beyond government control. Conceptually, I can understand this.
Jasper: but it is crashing now.
Supun: Yes, it is. The principles that started bitcoin began to expand and momentum began to take hold. Speculation began to increase, and we had all sorts of ideas coming to existence. It was a typical bubble mania. We are seeing that deflate somewhat now.
Jasper: You have said that we did not have inflation to deal with despite all the money printing since 2007/08. When did it start then? What triggered it?
Supun: That’s a good question. It is always hard to say exactly what caused it, but I do think it was the combination of a few things. Firstly, governments responded to COVID with rate cuts but also started to use fiscal policy too. Stimulus cheques and furlough payments were given to people to tie them over till lockdowns abated. A lot of this money was put into speculating in the stock market, but a portion was also saved. There were no holidays and lower transportation costs which resulted in higher disposable income. At the same time, supply chains were blocked up. Once economies started to open, pent up demand for goods and services met restricted supply chains. As a result, prices started to rise.
Jasper: but this is only temporary, why has inflation continued to move higher?
Supun: This is exactly what G10 central bankers were thinking. The word “transitory” was used to describe inflation. Emerging market (EM) central banks took a very different approach and started tightening policy. The FED finally pivoted to saying inflation maybe more structural at the end of 2021. They and other G10 banks have been trying to get in front of inflation ever since.
Jasper: So, EM central banks have done a good job?
Supun: Good is a relative term. They certainly have the problems inflation can cause more deeply etched in their memories than developed market (DM) banks. They have hiked very aggressively, but still seem to be playing catch up to inflation. It makes you wonder how far DM central banks are behind the curve.
Jasper: that does sound concerning. What about the Russia/Ukraine conflict? Many are blaming that as the root cause of the inflation that we are seeing.
Supun: It certainly didn’t help. I think we can all agree on that. Having one of the largest producers of oil and gas removed from the market is certainly going to result in higher energy prices all else equal. However, issues in the energy market have been a long time in the making. Capex has been low in the industry, and this is mainly due to the push to green energy. Again, this is an example of the incentives of policy and the end goal not necessarily being aligned. Oil companies have been divesting assets and not exploring as they receive no support for doing so. This just makes shortages more acute.
Jasper: This doesn’t sound like it has been thought out too well.
Supun: You mean the war?
Jasper: No, the transition to green energy.
Supun: I agree. No one thought about the bit in the middle.
Jasper: do you have a view on what happens in the war?
Supun: sadly no. My bias is for things to get worse before they get better unfortunately. I don’t want to get into what worse means here. The situation seems all but forgotten in markets on a day-to-day basis, but I think it is a very serious underlying risk.
Jasper: But it is only oil and gas that seems to be having this problem. The economy is much broader than that.
Supun: Yes, but energy is such a large input into so many things. It is used to create many intermediate products that go into other things. If the price of it goes up, then it just means the price of all that follows also must increase. This means consumers pay more where the cost can be passed on, or margins fall where they cannot.
Jasper: but what about service inflation?
Supun: Unemployment is at lows. We still have excess vacancies as well. We would need for these to clear before we can start talking about recession. Forward looking indicators have started to look down, however. There has been a shortage of workers since lockdowns ended which has resulted in wages increasing. Governments have also mandated increases in minimum wages. I think we have all been surprised with how well data has held up. With the yield curve inverting in the US, talk of a recession has been increasing. Statistically, the probability of a recession in the next 12 months has increased, but it tells us nothing else. Housing stocks have started to head lower as have trucking stocks. A slowdown is coming, but the shape it takes and the responses to it are debatable at this point.
Jasper: It seems the market would welcome a recession?
Supun: Yes, I would agree with that. Intellectually it is a much easier world for people to navigate. It just means lower rates and higher stocks. Basically, a return to the world that we have been used to for the past 15 years or so. It is what the market is biased towards. To me though, the past 15 years have been the anomaly.
Jasper: What do you mean?
Supun: Financial markets are meant to be volatile, erratic and unpredictable to a degree. I feel with central bank intervention we have been led to believe markets can and should only go up. If there are ever any occasions where they head lower, it is okay, the central banks are there to help us. The worst part for me is that price information becomes distorted. Economics is the study of the allocation of scarce resources that have alternative uses. Prices therefore play a major component in telling people where they should put money. This mechanism has been lost at worst or enormously corrupted at best.
Jasper: I think I get what you mean. Central bank intervention led to capital allocation that may not have happened otherwise. Prices of crypto etc. going up meant people chased and as a result money was not allocated to other areas that may have been economically more beneficial. At the same time, the lack of defaults meant that companies that perhaps should have gone bankrupt did not as low rates allowed funding to be rolled over. This meant more money was put into these areas which probably would not have happened had there been no backstop.
Supun: I think that is very well put.
Jasper: Thanks. So now that we have gone through why we are where we are, what can be done about it? Where do we go from here?
Supun: The first couple of things thing that are already happening and will continue to do so, are the increasing of rates and the reduction of asset purchases by central banks. The question is how far do we go before this begins to take effect? The market is conditioned to want to receive rates. That is the next macro trade. But we maybe moving into a world where inflation remains sticky for a long period of time even though rates are increased. In this case we are not going to see rates come down anytime soon. There is no guarantee that even if growth falls inflation will come down with it.
Jasper: Does this mean that monetary policy is useless?
Supun: Not useless. To have any meaningful impact, the first thing that needs to happen is to get rid of forward guidance, dot plots and all the other things that were introduced post 2007.
Jasper: what is this?
Supun: Central banks have tried to make sure that their communication is not misunderstood. They have tried to show where things are headed so as not to surprise the market. However, we spend copious hours discussing the change of a word or phrase in a statement to get behind what is being said.
Jasper: That makes no sense. You guys are smart enough to figure things out for yourselves. Why do you need to be told what will happen?
Supun: I concur. What is even worse is that it ties the hands of the central bank and prevents them from being nimble in the face of changing circumstances. I believe we are all smart enough and too well paid to be spoon fed. It never used to be like this. I think if the FED stopped guidance and went dark, they could hike 150bps in 1 meeting and that would probably get rid of sticky inflation. At least the market would know they were being serious. Right now, they cannot go more than a set speed as it would upset asset prices which means they never can really get in front of the inflation problem.
Jasper: But if they did what you said, they might start an asset price sell off that could have bigger ramifications.
Supun: Maybe. But for me it is imperative to get in front of inflation. This is the biggest problem now. We are already in the uncomfortable position of trying to deal with what is effectively supply-side inflation with monetary policy. We are hoping to slow demand down enough that prices start to fall, but not too much that unemployment begins to move materially higher. There is a very small window to get this right. But play a game with me for a moment.
Jasper: go on
Supun: Suppose banks were to start easing before inflation was really under control. We can debate what under control means, but let’s say at or below 2% as is the mantra in the Western world. Then we would simply start to get inflation again as asset prices go up, mainly commodities as policy returns to being more stimulative too soon.
Jasper: that makes sense. So, is this only tool in the box?
Supun: from a central bank perspective yes. But governments can do other things which may end up making things worse. This is what scares me more. We have already seen the Bank of England have a windfall tax on energy company profits to pay for the cost of living in the UK. A similar idea is being posited in the US. I wonder what the motivation is for oil companies to keep producing oil if they are not able to make as much money. We may also see fiscal stimulus as governments drop money into bank accounts. COVID was a precursor to this. However, this would just create more inflation rather than tackle the problem.
Another possibility is that we have price restrictions. Both price restrictions and windfall taxes can result in supply falling at a time when we can least afford it. In the latter case, any increase in the cost of production may not be able to be passed onto the consumer. You only need to go back through history to see the impact of price and supply restrictions. During communist Russia, both price and quantity were decided by the central government. There were occasions where people starved even though there was enough food as price restrictions disincentivized farmers from producing wheat. I am not saying this is where we are headed, but it is something to bear in mind.
Jasper: That is a very sobering thought. It has been very insightful talking to you. Do you have any closing comments?
Supun: I think it is even more important now to think about the unintended consequences of central bank and government action. There is no doubt that they will try to do something to address the situation that we are in. Given we have mid-terms in the US, presidential elections in Brazil, and other geo-political events, inflation is a politically charged topic. When officials come out and say they plan on setting out on a course of action, think about what incentives are being offered and to whom. The end goal is not where the money will be made but more on the enfranchised and disenfranchised people along the way.
Jasper: Thank you Supun.
Supun: No problem. I did have one request for you though.
Supun: Our readers are probably wondering who you are. Do you at least have a picture you can share with us?
Jasper: Sure! Here you go.
Jasper is our beloved Spaniel a source of inspiration for a lot of things in my life.
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Supun Ekanayake is a Partner at Quay Partners Investments (UK) LLP and has over 15 years’ experience trading across asset classes.