Knut’s Lessons for Us
Is the peak in (for inflation)? And is the trough in (for share prices)? And are these questions related? And if so, what should central banks do about it, and how should the rest of us protect ourselves?
After Tuesday’s ructions, the peak for US headline inflation remains intact; its highest level to date was for June. Meanwhile, the low that the S&P 500 set that month also remains intact, despite the furious response to the August CPI data:
History suggests that once inflation has peaked, equities can indeed be expected to rally. But you wouldn’t want to bet too much on it. Exhaustive research by Ann Larson of Sanford C. Bernstein shows that since the end of World War II, the S&P has averaged a fall of 5% in the 12 months before inflation peaks, and a 17% gain in the 12 months after the peak. But as this chart demonstrates, there was a huge range; an inflation peak doesn’t come close to guaranteeing equity gains:
Looking at bear markets in Europe, Asia and the US, and pushing the analysis back to 1937, Larson came up with three reasons why the bottom for this bear market is probably not in:
• The current macro regime is unprecedented. Since the Asia Financial Crisis of 1997, no bear market has coincided with such high inflation globally. All major global synchronized crises ended with moderate inflation and low growth; that hasn’t been reached yet.
• The correlation of major global markets with the US has been rising, and this typically happens during major market selloffs.
• Jerome Powell’s speech at Jackson Hole made clear the Federal Reserve’s resolve to fight inflation (and this was presumably reinforced by the August inflation data). A key reason for markets to rally in recent times has been the hope for imminent policy support, and that looks unrealistic.
That leads us to the most critical question: how central banks will react. Jean Boivin (whose name you will find with former Fed chairman Ben Bernanke’s as co-authors of much influential research on monetary policy) and Alex Brazier offer a fascinating blog post for BlackRock in which they draw an analogy between the economy and a bear. In 2006, a baby polar bear called Knut was rejected by his mother at the Berlin Zoo. The zoo nursed him to health, over the protests of other zoo directors who said they should have the courage to let him die. Now, as central banks contemplate inflicting more pain through higher rates to keep inflation in check, they are behaving like those who would have allowed Knut to perish, argue Boivin and Brazier:
Implicitly, central banks seem to believe that pain is trumped by the risk of inflation expectations de-anchoring – and that justifies aggressive rate hikes to “kill the bear.” Indeed, it would be justified if inflation expectations were unanchored. And it’s true that no one really has a good handle on how inflation expectations work: They’re anchored until they’re not. But contrary to when Paul Volcker took office as Fed chair in 1979, they remain anchored now. Unlike Volcker, they still have a stock of credibility to draw on.
That last sentence is contentious, but central banks undeniably retain more respect than they did when Volcker arrived in 1979. The post’s point is that this is a difficult decision that requires public debate (much as Knut’s fate did). And the writers also hammer home that the main central banks pressing ahead with tighter money are all either guilty of logical contradictions or unrealistic expectations:
They each swerve that debate in different ways. The ECB argues for “robust control” – avoiding inflation expectations de-anchoring at all costs, irrespective of how likely this outcome is. By that logic, you would stay in your house for fear of being hit by a car if you go out. The Fed argues it can bring inflation quickly back down to 2% without a recession. Wishful thinking, by our estimates. In the UK, this manifests itself with authorities working at cross-purposes: the Bank of England sees a deep recession as necessary to bring inflation down, while the government is trying to spend its way out of it.
Key to their personal motivations, according to Boivin and Brazier, is to avoid the worst possible outcome, which is to be the next Arthur Burns — the Fed chairman who has become history’s scapegoat for the inflation of the 1970s. Politicians feel no such pressure to keep interest rates high.
That disjunction could end with the inverse of the policy response to the Global Financial Crisis of 2008. Back then, governments opted for fiscal austerity, which central banks enabled by making money as cheap as they possibly could. This time around, the central banks will be trying to take from us, via higher rates, while elected politicians try to give back through fiscal policy.
The net impact of the loose monetary/tight fiscal policy of the last decade was, as Dario Perkins of TS Lombard points out, to drive bond yields to historic levels. And when I say historic, I mean he has a chart to show that long-term bond yields dropped to their lowest since 1314:
Perkins also suggests that central banks will need to go to greater lengths, and spend much time contemplating the morals of what they do, before pressing on with much higher rates. The key is that “independent” central banks are now committing themselves to a course of action that elected politicians will hate, and this will raise constitutional issues:
Weirdly (not weirdly, obviously), politicians – who will want to be reelected at some point – do not share their central bankers’ tolerance for a recession. They see inflation very differently, as a “cost-of-living crisis.” And their natural reflex is to ease fiscal policy to try to cushion the blow. European governments are set to launch another massive support program through a combination of direct income transfers and “price caps” on energy bills: In effect, they will be boosting demand and simultaneously curbing production.
This sets up what Perkins calls a “tug-of-war” between fiscal and monetary policy. “Central banks want to squeeze demand, but governments want to support incomes. Central banks believe a recession is largely inevitable, but the politicians are desperate to avoid one.” He warns central banks to be careful before they finish executing a 180-degree turn in the fiscal-monetary policy mix. This dynamic makes financial markets even more treacherous than usual.
There is a counter-argument that derives from a mistake made by — of all people — Paul Volcker. He rightly gets credit in history for beating inflation. Much less remembered is that after embarking on his fight against rising prices in 1979, Volcker reversed course in 1980 under huge political pressure. This may have forced them to rise even more aggressively, and create even more pain, when the Fed started hiking again in 1981 before victory was declared in 1982. Frederic Mishkin, a former Fed governor and professor at Columbia Business School, writes in a fascinating piece for the Financial Times that Volcker was obliged to hike rates to nearly 20% to restore credibility: “The ensuing recession that started in July 1981 became the most severe downturn since the second world war…”
Mishkin concludes that the Burns-like decision to reverse policy too soon led to higher interest rates and a larger cost to the economy than if the Volcker Fed had stuck to its guns. To return to the Knut analogy, he is suggesting that the Fed shouldn’t allow any sentimental pleadings to dissuade it from letting the bear die. If the Fed fails, it will end up needing to slay an angry and fully-grown bear instead. (The real Knut tragically drowned in his enclosure at age four in an accident triggered by an autoimmune disease).
How should you have invested in 1981 and 1982? More was at stake than avoiding a loss. The stock market low that Volcker created in August 1982 proved to be arguably the greatest buying opportunity in history. For the 18 years from then until the top of the dot.com bubble in 2000, the S&P 500 rose almost 1,400%, equivalent to 16.6% per annum, without including dividends. Was it possible to spot that opportunity in real time?
This chart from Larson of Sanford C. Bernstein shows that the great buying opportunity didn’t arrive until the recession was over and a recovery was under way. Inflation had peaked 10 months earlier, and long-term yields had only just started to tumble. After this particularly extreme episode in monetary policy, investors waited to make sure all was clear before venturing back into stocks — and this doubtless contributed to the explosive rally that followed.
At present, the inflation peak is at best only two months into the past, and the economy has not entered recession. The analogy with 1982 suggests that we may have to wait longer for the bottom in stocks. The upshot for investors: You’d better believe that central banks really have made up their minds to kill Knut. But you also need to keep an eye for political pressures that force them to relent. Not easy.
The chatter dominating the cryptocurrency markets right now — so much so that Google has launched its own countdown to the event — is centered on one thing: the Merge. It might make crypto much more useful, whatever effect it has on the currencies’ value as investments. But what is it? Read on. Isabelle Lee breaks it all down here.
Ether, the world’s second-most-valuable cryptocurrency after Bitcoin, runs on its native blockchain called Ethereum. If all goes to plan, Ethereum will start its much-anticipated upgrade a little before this newsletter arrives in your inbox. Proponents describe the upgrade as a configuration that could shake up the whole crypto universe. My colleagues Olga Kharif and David Pan wrote at length about it here.
The Merge will lower Ethereum’s energy consumption by an estimated 99% at a time when critics have been slamming digital assets for the electricity it takes to churn them out. Multiple studies have found that cryptocurrencies’ energy usage was equivalent to the power needed to light entire countries like Finland. Why that much?
For the uninitiated, Ethereum runs on a system called “proof of work,” in which a decentralized network of computers races to solve mathematical puzzles to compete for the right to order transactions and add blocks of data to a digital ledger called a blockchain. Owners of the computers, called miners, ensure the ledger cannot be altered. As a reward, they are given some Ether. (Bitcoin, the world’s largest crypto by market cap, pioneered and uses a similar system.) The whole process is quite energy-intensive.
With the Merge, Ethereum is switching to a system called “proof of stake.” Instead of relying on miners, the process will now rely on “validators,” who — in return for putting up, or “staking,” a certain amount of Ether in special wallets — will become eligible to order blocks of transactions. Any individual, and any company, can offer their services for this task if they’re prepared to commit 32 Ether (currently about $50,000). If a block is accepted by a committee, whose members are called attestors, a validator is awarded Ether. This process takes much less computing power and will significantly reduce the blockchain’s carbon footprint, with the staked Ether coins acting as collateral that can be taken away. To grossly oversimplify, staking is depositing or locking up one’s coin for a period of time, and receiving interest in return. It’s a culmination of all the upgrades made to the Ethereum block until now. Here’s a nifty timeline from Marion Laboure, senior economist at Deutsche Bank:
Too technical? All you need to know is two things: First, the transformation could change the way Ethereum as we know it works, from upending miners’ business models to shaking up institutional investors’ ESG rankings. Second, the switch may entice more investors to enter the crypto space. Here’s more from Laboure:
If the proof-of-stake system in fact proves to be a greener alternative, then regulators might increasingly force the proof-of-work cryptocurrencies to cut down energy usage. The Ethereum Merge is not expected to improve Ethereum’s transaction speeds or lower its gas fees; future updates are expected to bring about those improvements. For now, it is likely that institutional investors who participate as stakers — as a result of the Ethereum Merge — may see the cryptocurrency as an alternative bond or commodity, due to its attractive yields.
For investors, Ether post-Merge will resemble more of a traditional financial asset that pays interest (that could be in double figures!), like a bond or a certificate of deposit, which could entice hedge funds, asset managers and wealthy individuals. (It also could raise thorny regulatory issues, but that’s another question.)
Apart from working toward a more sustainable, eco-friendly Ethereum, the Merge will also allow for further scalability upgrades that weren’t possible under proof-of-work. Here’s Jaime Baeza, chief executive officer at of ANB Investments, a hedge fund focused on digital assets:
The Merge will definitely have an impact on the entire crypto industry, and makes a crucial decision about its future path. Post-merge-feasible upgrades are likely to increase Ethereum’s transactions per second from 15 to 100,000 – catapulting the cryptocurrency/blockchain into the orbit of world-scale financial transaction providers such as Visa and Mastercard.
If everything works out, then, this could be a huge step in establishing crypto’s reputation as a genuinely worthwhile utility that doesn’t rely largely on investors’ hopes that its price will rise. Chatter about the Merge has weakened the correlation between the tech-heavy Nasdaq 100 following the announcement of the expected date of the Merge:
Deutsche Bank’s Laboure says attractive yields could position Ether as an alternative to bonds or commodities for institutional investors; approximately 40% of Ethereum transactions originate from large institutional transactions, compared to 30% for Bitcoin. Stakers “can expect yields of 10-15% annually, without factoring in potential capital gains from positive movements in Ether’s price.” Those are mightily attractive yields which, as often in finance, betoken much higher risk. Ether’s price has declined for a third day at the time of writing, dropping about 0.5% to $1,599, though it has massively outperformed Bitcoin over the last year. Both coins, however, have more than halved in 2022, bogged down by the “crypto winter.”
By the time you read this, the Merge is likely under way. Soon we’ll know if there are willing volunteers to be validators, and whether the change prompts more people to use the technology. While some analysts expect volatility, the upgrade is undeniably a technological breakthrough — albeit with tail risks.
I left out lots of good songs to listen to when dealing with a disappointment. Try Part of the Process by Morcheeba, Oh Happy Day by the Edwin Hawkins Singers, Sometimes I’m Happy by Billie Holiday, Happy Talk by Captain Sensible (which, amazingly, 40 years ago reached number one in the UK), Enjoy Yourself by the Specials, and maybe The Dog Days Are Over by Florence and the Machine. For a total inverse, try Gloomy Sunday by the eternal Billie Holiday. As dark as it gets.
More From Other Writers at Bloomberg Opinion:
• Tyler Cowen: Inflation? The Workforce Is the Bigger Problem
• Conor Sen: Homebuyers Might as Well Take the Plunge
• Liam Denning: Anti-ESG Champion Misses the Mark
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”
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