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Insights on the changing behavior of the financial markets by Michael Drury

June 11, 2021

This week, we would like to lay out the fundamentals of why we think the world’s key economic players have shifted away from solving the problem of inflation to a far greater concern about equality – underpinning the changing behavior of the financial markets that we assess (and pretty much everywhere else as well). Perhaps the simplest way to express our view in terms that conform to the old establishment is to observe that inflation expectations have become unanchored. More precisely, we feel that inflation expectations are increasingly irrelevant as a driver for key economic decision makers. This all fits with our broader view that both central banks and national governments are behind the curve on providing the answers their constituent’s desire. We believe that multi-national corporations are at one end of the spectrum seeking better answers for themselves as they game the system by rule hopping across borders for more desirable taxes, regulation, enforcement, resources, labor, customers, etc. At the other end of the spectrum are consumers looking for new solution via the sharing economy, social media, decentralized finance and reshaped political parties. Bottom line, entrepreneurs — both corporate and individual — are driving change, not existing institutions built to solve older problems.

Our deep interest in historical narratives makes us devotees of generational cycles, as discussed in The Fourth Turning, where the core argument is that children born in the two decades surrounding 1870, 1910, 1950 and 1990 carried disproportionate influence over their life cycles in reaction to seminal events. As such, the current shift in public sentiment to focus on equality is reminiscent of the early 1900s, as policy reacted to the outcomes of earlier laissez-faire economics, the rise of the robber barons and the gilded age of the 1890s. At that time, with a gold standard and recessions routinely occupying 18 months of regular 3-year manufacturing cycles, neither limiting inflation nor preserving jobs were top of mind. Rather, a drive to rein in business concentration – as scale limited competition and opportunity — started with the Sherman Anti-Trust Act of 1890 and a barrage of reinforcing legislation, like the Clayton and Federal Trade Commission Acts in 1914. The call for fairness was so widely accepted that four constitutional amendments passed between 1913 to 1920, all promoting greater equality: the income tax and the direct election of Senators in 1913; then, prohibition and women’s right to vote in 1919 and 1920. One of suffragettes’ major goals in prohibition was to eliminate men’s bar-room deal-making from politics. Even the Federal Reserve Act (1913) reflected the quest for a greater dispersion of power, as it effectively replaced JP Morgan as the key arbiter of financial stability, as he had been in 1895 and 1907.

The children of that equalitarian age — the Greatest Generation — were the first to be protected by child labor laws and to benefit from mandatory education. They were mostly too young to fight in WW1, grew up during the Roaring 20s, suffered most during the Great Depression, and served in WW2. Unlike their parents, government played a heavy role in their development. Their major economic concern was the poverty caused by unemployment after the onset of the Great Depression. Thus, the New Deal and subsequent programs developed over the long arc of Democrat political control from FDR to Carter were designed to support income. The GI Bill paid mortgages and tuition and helped to start companies; social security was steadily expanded to ease fear of retirement; Medicare and similar programs helped cover the cost of aging; Welfare programs aided the poor.

However, the war on poverty also brought both high inflation and recession (stagflation) in the 1970s, setting the stage for the Thatcher/Reagan/Volker era that shifted the global focus to controlling inflation, deregulation and expanding the global reach of democracy and capitalism – even if those meant jobs moved abroad. After Volker risked high unemployment and the double dip recession of 1980-82 to quell inflation, economic setbacks for Baby Boomers were more about financial crisis than job loss. The downturn of the late 1980s was based in Savings & Loans in the US and the Nikkei collapse in Japan. The Asian Crisis of 1997-8 was a byproduct of excess third world leverage and financial engineering. The post-Y2K stall was exacerbated by the popping of the NASDAQ bubble. Ahead of the Great Financial Crisis, the decades long descent in inflation and interest rates spurred overinvestment in housing, based on the faulty belief that everyone would benefit if more families could build wealth by becoming homeowners –as their value could never go down. With each crisis, central banks engineered ever lower interest rates to spur demand, leaving management of supply primarily to the private sector.

Now the generational baton is being passed from the aging Baby Boom to the rising Millennials – most of whom have never experienced a serious bout of inflation during their lifetime. However, they have watched increasing financial leverage result in very different outcomes in the distribution of income — and even more so for wealth. For them, unemployment and inflation are both problems that fiscal and monetary policy have solved in the past and can again in the future. The extreme use of fiscal policy post-COVID effectively severed the relationship between income and work, circumventing the immediate consequences of joblessness. However, the very uneven recovery in both the quantity and quality of employment, education, and wealth has created new issues that are widely viewed as more important than just aggregate unemployment rates or “transitory” inflation.

We have been watching a wide range of institutions – domestic and international – shift business and political strategies as they focus less on the benefits of low inflation and more on equality and fairness. Nowhere is this more important than in the interface between consumers and business. For many years, businesses promoted themselves as the guardians of low prices. Big Box stores used scale and imports to help limit inflation — or actually drive down prices — on many goods. Walmart famously shifted from Sam Walton’s Made in America promise to Every Day Low Prices. Recently, a new class of stores has popped up offering better quality – but at higher prices. They have thrived, because consumers were willing to pay for organic, cage free, low carbon, recyclable and other desired social traits that lifted the cost of production. Post-COVID we are witnessing price increases explained by the importance of paying entry level workers a living wage or to re-shore production previously made abroad. We doubt heuristic pricing will catch the full value of these social benefits when measuring those price increases effects on inflation. Indeed, the concern has shifted from inflation, which measures the value of what incomes can buy, to fairness — which is about who receives that income in the first place.

Existing political institutions are struggling to keep up with their constituencies shifting interests. Millennials have had less influence in that arena than in business, where they lead world changing technology firms. Obama did use internet fundraising to defeat establishment Hillary. Trump used social media to change his party so much that Rockefeller Republicans are now considered RINOs. Globally, the rise of China has altered the balance at many post-WW2 institutions from the World Bank to WHO. In Europe, the former centrist parties are being replaced from the right and left – while Brexit removed a major barrier in EU federalization of polices. This week’s G-7 reflects the reduced role of the US from world leader to consensus builder — for the idea of a global minimum tax to rein in primarily the technology firms — whose customers are mostly Millennials or younger. Will firms accept and pass the cost on knowing their clientele would approve – indeed select – those that pay more tax?

The importance of diversity, equality and inclusion is far more profound in the realm of philanthropy – which we view as private government, providing individually supported social services with tax advantaged funding. For Baby Boom donors, the primary question asked before they would commit their money to a project was whether the board of the non-profit was fully financially invested personally. Boards were stacked with corporate and government leaders whose business acumen and influence enhanced the effectiveness of the foundation’s investments. Increasingly, boards are being recast to reflect the populations they serve with non-financial board inputs valued for their importance in understanding how foundations can best fulfill their constituencies needs. Bottom line, Millennials are as interested in the methodology as in the outcome – even if it means higher cost.

The rapidly rising importance of issues like equality and climate change will directly impact financial investors because inflation has long been a policy tool to generate fresh funds that are then distributed via fiscal authorities to achieve set goals. Historically, this was associated with raising funds quickly to gear up for war. However, it has been used for many other reasons, like funding industrial policy to gain national comparative advantage or income redistribution for equality. Lax monetary policy sets the stage for higher prices generally — which acts as a tax. Markets then adjust, with winners and losers as the particular price of every good, service and asset reacts depending on the price elasticities for supply and demand – widening or narrowing margins and yields. Government influences the process through incentives and regulations – which most economists agree raise prices.

Critically, when the primary policy goal is low inflation itself, all other fiscal initiatives atrophy — as over the past four decades. Reining in fiscal authorities requires at least the appearance of an independent central bank with a mandate for stable prices. However, that independence is typically only protected by the will of the government itself and its mandate can be changed – like to maximize sustainable growth, as after the Great Depression; fiscal stability, as after the Great Financial Crisis; to fund the government, as in many third world nations; or to be eliminated, as under Andrew Jackson. In nations around the world, when fiscal policy is dominant, the central bank often becomes an enabler, rather than an independent voice of reason. They still jawbone, advising the markets of what they will do, but action – or the failure to act — speaks louder than words.

The Federal Reserve and ECB are currently jawboning about when they will even begin to discuss the timeline of future tightening. The Fed has made clear that they will have to see inflation above 2% on a sustainable basis for some time – and then argued that any inflation above 2% so far doesn’t count. Reality is that inflation has already met their 2% target whether on a 2-year or 5-year basis and is certain to go higher for the remainder of this year. Few analysts anywhere are talking about inflation back below a 2% trendline soon. Most have US growth above trend in 2022 (and beyond) with growth having already returned to the previous trend line by the end of 2021. History abounds with examples of inflation accelerating when the GDP gap has been closed.

History also tells us there is a long and variable lag between central bank actions and their effect – running about two years in the US. We believe the lag depends on the depth of financial markets, as the effect of interest rate movements can be absorbed in asset price movements – which generate changes in productive capacity — forestalling when price effects hit demand for currently produced goods and services. When we first visited China in 2005, their lack of asset markets (other than real estate) meant changes in monetary policy were rapidly reflected in final demand – especially since demand was growing so quickly. Over the past sixteen years, China financial markets have become far more sophisticated – slowing the communication of monetary policy. Thus, their recent tightening likely has little effect until 2022 – and even less if they remain alone in tightening globally.

When I came to Wall Street in 1982, my first mentor, Gary Shilling, had just finished his prophetic book Is Inflation Ending? Are you Ready? Few believed Volker’s success would be so great. In 1932, FDR was considered a traitor to his class. Few expected Republican’s dominance of Washington since the Civil War would end for 48 years. We believe we are at a sea- change in global policy focus just as in 1900, 1932, and 1980. Maybe the turning point was 2008, when President Obama ignored the GFC and pushed universal health care. Even with total control, Republicans could never reverse it due to issues of fairness – like for pre-existing conditions. Currently inflation is not a problem – nor unemployment generally either. Rather the focus is on specific types of jobs, participation rates, access to day care and education — and how to even out the existing inequalities that have been exacerbated over the past year. Bottom line, inflation will rise — because stopping it is no longer the top policy concern.

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