09 Mar, 2022

Inflation, high bond yields: The 2020s are eerily like the 1920s. Are investors in for a long haul?

“Policymakers have no endgame, markets do.”
In 2016, American investor Stanley Druckenmiller was speaking to a room of nearly 3,000 investors at the Sohn Investment Conference. His message was that policymakers have no “end game” for the ending years of ultra-easy monetary policy. “They stumble from one short-term fiscal or monetary stimulus to the next despite overwhelming evidence that they only produce a sugar high and grow unproductive debt that impedes long-term growth. Moreover, the continued decline of the global growth despite unprecedented stimulus in the past decade suggest we have borrowed so much from our future and for so long that chickens are now coming home to roost,” he said.

However, markets do have an end game. That’s what Sensex would say to the Dow Jones. While Druckenmiller didn’t explicitly give an investment recommendation, he did strongly hint at it.
I know I have thrown a brick at you with lots of economics. But hold on. This article originated from Druckenmiller’s premise. The issue: Can the Federal Reserve lose control, and if it does, what would the consequences be? This was before the massive spike in crude and other commodities due to the Russia-Ukraine war.

All these things point to a year that is not great for equities. So, what should investors do? The simple answer is asset allocation. To be more precise, it is a commodity that Indians have loved for years and continue to buy, no matter the price. We will come to that.

Micros of the macro

Macroeconomics is a fascinating topic. It is subject to the flaws and imperfections of human creations. My view was that the Fed is already behind the curve, and with the benefit of hindsight erred when it called inflation transitory. It was forced to backtrack very quickly. This spooked equity markets across the globe in January
2022. The interest-rate cycle and stock markets are intertwined, and I wanted to study this part.

The present crisis of 2022 has an eerie resemblance to the monetary policy in 1920, which resulted in a boom-and-bust cycle. In fact, between 1930 and 1932, the Dow Jones Index crashed 89%. This made me take a closer look at the macro conditions around that period and the result is this long piece.

A knowledgeable friend, Prashanth Krishna (founder, Portfolio Yoga), on the other hand, felt that if the Fed cannot manage the present crisis, that was as good as having a nuclear war. In which case, what you owned wouldn’t matter. It was meant to be a joke, but we hardly had to wait for a month before Vladimir Putin went ballistic on Ukraine, and the world talked about Russia raising its nuclear warheads.

Human constructs, especially in the field of macroeconomics, must sometimes make assumptions which are not true in the real world. Investors are not rational. However, we assume they are. Humans are also biased or inconsistent or both at times and hence any abstract conceptual framework will be subject to those weaknesses. Central banks are one of those constructs.

The Federal Reserve System (or simply, the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of events of financial panic (particularly the panic of 1907) led to the desire for central control of the monetary system to alleviate the pain of financial crises.

Crisis after crisis, the central bank has played an important role. While the idea is to play the role of a firefighter who inspects high-rises to avoid fire hazards, the central bank more often douses a fire (and in most situations, unlike firefighters, the Fed has itself played a role in lighting it) in one area and believes that it has controlled the fire. The fire returns with more fervour, affecting more floors. The central bank again temporarily tries to control it, and this process of whack-a-mole goes on.

More often, the bank uses interest rates like a fire hose to control the fire or the impending financial crisis. What it creates is a series of predictable patterns in stock markets, which have better explanations in physics or to some extent in technical analysis and maybe quants.

The base-level interest rates (the fire hose) are often decided randomly or arbitrarily by central banks that shape equity-market direction in the US, which further have impact on emerging markets, bond markets, and even commodity markets. The dotcom boom of 2000, the 1987 crisis, the 1920 crisis, and for that matter the current crisis of 2021 have the same pattern. In all these cases, the stock market has gone up for a year or two and had a sudden fall. In most cases, it took some time for the markets to recover.

From the looks of it, 2021 is eerily similar to the late 1920s. When I first saw this pattern, I just had one thought: “I just hope I’m wrong.” What bothered me was the fall after the bull run. The fall was uniform across crisis.

Indian markets are highly correlated to the US markets, especially during times of crisis. If the present stock-market movement is like the 1920s, then there is a high chance that the fall will be steep, and recovery will take a long time. So, if John Tuld (played by Jeremy Irons) from Margin Call wanted a clearer explanation, he would say, “Maybe you could tell me what is going on. And please, speak as you might to a young child. Or a golden retriever.”

Prashant Jain, or PJ (executive director and chief investment officer at HDFC AMC), was among the very few fund managers who was not lured by the US tech bubble in the late 1990s. He stayed away from the raging rally in technology stocks on the Nasdaq that drove returns of many Indian mutual fund schemes. As a result, his schemes underperformed significantly, drawing sharp criticism from investors and distributors. But, when the tech bubble burst in early 2000, most fund managers had to take severe hits on their portfolios, while Jain’s schemes were largely unaffected. This was probably the turning point in his career. He had the last laugh, and later reminisced, “Our funds underperformed 20%-30% that year … we kept on going back to our numbers to reassure ourselves. Ultimately, when the fall came, what we lost in one year, we gained in two months.”

Even back in the 2000s, Indian markets were not decoupled from the West and neither are they now. In fact, they are even more correlated, as we shall show later. The relationship between the Indian markets and the Dow Jones is aptly summed up by 1983 hit song by The Police, “Every breath you take, and every move you make…. Every bond you break, every step you take.… I’ll be watching you.”

The 1987 crash

In June 1987, another hedge-fund manager also known PJ, or Paul Tudor Jones, a market wizard, discussed his bearish outlook on the US stock market based on the exuberance in markets like fine art; a rapid rise in debt levels and bank leverage; stress in the oil patch and farm areas; and low corporate liquidity. Jones also used an “analogue model” (an overlay chart) that his research director Peter Borish had put together. The chart compared the stock markets of the 1920s and the 1980s and showed an “astonishingly robust” correlation.

As aside, on the Friday before the crash, Druckenmiller went to see George Soros, who showed him Jones’s charts. Druckenmiller avoided the worst by blowing out of his long position the morning of the crash. Meanwhile, Jones covered his short and went long bonds, expecting the Fed to ease financial conditions. That month he made 62%.

Eerily, the analogue of the Dow Jones Index from 2008-2022 looks very similar to 1916-1930. The Fed is now caught in the same situation. A very accommodative policy in 2010s, similar to what it did in the 1920s, which is now resulting in high inflation and bond yields rising. If it slams on the brakes too hard, it can risk a hard landing for the US stock market and economy.

Perception of control or actual control is one of the most powerful weapons in the Fed’s armoury. In their paper, The Economics of the Fed Put, Anna Cieslak and Annette Vissing-Jorgensen state, “Since the mid-1990s, negative stock returns come with downgrades to the Fed’s growth expectations and predict policy accommodations. Textual analysis of FOMC documents reveals that policymakers pay attention to the stock market. The primary mechanism is their concern with the consumption wealth effect, with a secondary role for the market predicting the economy. We find little evidence of the Fed overreacting to the market in an ex-post sense (reacting beyond the market’s effect on growth expectations). Although policymakers are aware that the Fed Put could induce risk-taking, moral hazard considerations appear not to significantly affect their decision-making ex-ante.”

The Fed Put has the seat-belt effect. It makes participants more risk-taking, as they know they have a fail-safe mechanism in the case of a catastrophe. But what happens if that fails. Who pays for the losses? As we have seen in 2008, losses are socialised, and profits are capitalised.

What Indian investors need to know

Global and Indian equity markets have a very high correlation, especially in times of stress. Therefore, if one expects India will decouple and go along its own trajectory, that would be an assumption not backed by history and data. Over the last 10-15 years, Indian and US markets have moved in tandem with an R2 of over 0.94.

Whatever the outcome and the action of the Fed is, we will follow the US market. If the Fed makes a few missteps, it will be a volatile regime, as investors and traders adjust to the Fed’s rate-hike cycle. So, what is the function of the central bank?

The then Fed chairman Alan Greenspan was ruminating about this in 1997. According to him, the Fed’s policy toolkit had only one bazooka – the power to change short-term interest rate, but conflicting goals. He wondered what the Japanese central bank should have done in the late 1980s, when it had sharp appreciation in equities and real estate, but flat consumer prices. He decided that one way could be to use interest rates to guide inflation and public rhetoric to guide asset prices. But as his famous “irrational exuberance” speech had shown, the impact of the second one was only temporary.

In 1996, Janet Yellen, Bill Clinton’s appointee to the Federal Reserve Board of Governors, in one of the meetings where the merits of inflation targeting were being discussed, asked Greenspan to define price stability. He defined it as a state in which “expected changes in the general price level do not alter business or household decisions”.

He could not put a number to that, but stated that if inflation was measured correctly, that number would be zero. In practice, however, they knew that inflation indices tend to overstate the true extent of price measures. So Yellen countered with a 2% number. The rest of the board fell in line, and Yellen’s 2% number stuck and became an objective. This led to the perception that if the Fed keeps inflation around 2% levels, it means it is in control. On the inflation target, this becomes its strike price. If inflation is below 2%, it can be accommodative. If above, it has to tighten monetary conditions. The base inflation number was actually pulled out of the hat without much logic. This sounds as if it came out of a Yes, Prime Minister episode, but then, facts are stranger than fiction. The Fed cannot control bubbles or busts, but its attempts to fix interest rates with random numbers only add to the fire.

In fact, Soros says that markets are not equilibrium bound but bubble prone. He strides in to take advantage of bubbles when they occur. However, the most important thing is to make a large bet when you are right and get out fast when you are wrong.

The Fed cannot prevent these events. It can try and prevent a hard landing, but at times these crises have been of the Fed’s own making. It douses fires instead of checking the electric wires in the staircase for every new building that comes up in the city.

John Tuld gives a number of examples, from the 17th century (which predates the Fed’s existence) to the 21st century. Let’s capture some of those events.

The Roaring Twenties

The Roaring Twenties were a decade of economic growth and widespread prosperity, driven by recovery from wartime devastation and deferred spending, a boom in construction, and the rapid growth of consumer goods such as automobiles and electricity in North America and Europe and other developed economies.

The US had successfully transitioned after the First World War to a peacetime economy. Europe, by contrast, had a more difficult post-war period and did not begin to prosper until after 1924. At first, the end of wartime production caused a brief but deep recession — the post-war recession of 1919-20. However, the US and Canada economies quickly rebounded, as returning soldiers re-entered the labour force and munitions factories were retooled to produce consumer goods.

Let us look at one of the most devastating events in the 20th century, after the formation of the Fed. The stock market collapsed by 89% over three years. The Fed, however, failed to act, and the markets took almost two decades to see that same high. Despite all the economic warning signs and the market breaks in March and May 1929, stocks resumed their advance in June and the gains continued almost unabated until early September 1929 (the Dow Jones average gained more than 20% between June and September). The market had been on a nine-year run that saw the Dow Jones increase in value tenfold, peaking at 381.17 on September 3, 1929.

Shortly before the crash, economist Irving Fisher famously proclaimed, “Stock prices have reached what looks like a permanently high plateau.” The market then recovered for several months, starting November 14, with the Dow gaining 18.59 points to close at 217.28, and reaching a secondary closing peak (bear-market rally) of 294.07 on April 17, 1930. The Dow then embarked on another, much longer, steady slide from April 1930 to July 8, 1932, when it closed at 41.22 — its lowest level of the 20th century — concluding an 89.2% loss for the index in less than three years.

“One ofthese clouds was an American wave of optimism, born of continued progress over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississippi Bubble.”
— Herbert Hoover, US president, in 1952

This crisis was again perhaps one of the making of the Fed’s easy-money policies. Austrian economists argue that the Great Depression was the inevitable outcome of the monetary policies of the Federal Reserve during the 1920s. The central bank’s policy was an “easy-credit policy”, which led to an unsustainable credit-driven boom.

The inflation of the money supply during this period led to an unsustainable boom in both asset prices (stocks and bonds) and capital goods. By the time the Federal Reserve belatedly tightened monetary policy in 1928, it was too late to avoid a significant economic contraction. Austrians argue that the government intervention after the crash of 1929 delayed the market’s adjustment and made the road to complete recovery more difficult.

However, across the pond, economist JM Keynes flourished during this period. Even though the world was not as interconnected as it is today, the ripple effects of the 1929 crash were felt across the globe.

In 1929, when the Wall Street Crash began, Keynes was as blindsided as anybody, but far quicker than many to react. A quantitative study undertaken by David Chambers, Elroy Dimson, and Justin Foo focused on Keynes’s management of the discretionary portfolio, which included the chest fund, over the quarter century from 1921 to 1946.

Basing their analysis on the annual investment reports of the King’s College endowment, the academics confirm Keynes’ reputation as a masterful stockmarket investor – over his 25-year tenure as investment manager, Keynes generated an annual return of 16%, compared to a 10.4% annual return for the benchmarked index. That meant beating the market by a significant margin over a period that included the crash of 1929, the Great Depression, and the Second World War.

In his 1936 The General Theory of Employment, Interest and Money, Keynes wrote, “Our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine . . . a building in the city of London amounts to little and sometimes to nothing.”

The great financial crisis of 2008

The seeds of this crisis were perhaps sown in 2000 when the dot-com bubble burst. The Fed cut rates to ensure the stock market or economy, or both had a soft landing. However, after recovery, the Fed chose not to hike rates. In December 2015, the Fed increased the key interest rate (from 0% to 0.25%) for the first time since June 2006.

This is because the global and the US markets were witnessing a Goldilocks scenario. Stable growth, low inflation, and booming markets. So why upset the apple cart?

In 2005, Raghuram Rajan, in a famous speech, ironically at an event in honour of Greenspan, presented a paper ominously titled, Has Financial Development Made the World Riskier? An article that later appeared in an International Monetary Fund magazine stated, “Rajan has written that he left Wyoming [the venue of the Greenspan bash] with some unease — not because of the criticism, but because ‘the critics seemed to be ignoring what was going on before their eyes’. Not too long after this event, his warning came true: The US market for subprime mortgage securities began to implode in 2007, leading to the global financial crisis.”

John Paulson, Michael Burry, Steve Eisman (of trading firm FrontPoint Partners) correctly bet on the collapse of the housing bubble. No one believed that housing prices could fall across the US because it had never happened before. If California was down, New York was up. But fall they did, and many people lost money. But many other people, like trend-following investors such as Soros, Druckenmiller, and John Henry, who were not as early as Paulson and Burry, still made a killing. As did Jim Simons’s hedge fund Medallion. And don’t forget the decade from 2010. It has been one of the most profitable years for the S&P 500, which saw a rise of almost 200%. Most active investors have found it tough to beat it.

Fed’s folly:the taper tantrum

The then Fed chair Ben Bernanke in May 2013 said the central bank would start tapering asset purchases at some future date. This caused bond investors to start selling their bonds and the yield on 10-year US Treasuries to rise from around 2% in May to around 3% in Dec 2013. The bond markets were throwing a tantrum in response to Bernanke’s comments. No actual sell-off of or taper of the Fed’s QE (quantitative easing) had happened at this point. Bernanke’s comments were referring to a future possibility. The extreme bond market reaction at the time to a mere possibility of less support in the future underscored the degree to which bond markets had become addicted to the Fed stimulus. And in fact, after Bernanke’s comments, the Fed did not actually slow its QE policy, but implemented QE3, which entailed bond purchases totalling another USD1.5 trillion by 2015.

The Fed was slowly pushing itself into a corner and stepping into a chakravyuh of its own making. The markets had taken control and were dictating Fed policy. In 2018, the Fed tried it again, and this time the equity markets threw a tantrum. The Fed did, however, start the taper. But an “unknown unknown” was lurking around the corner.

March 2020

Not one equity strategist warned their investors that a virus from bats would cross over to humans and cause a global pandemic that could be compared to the Spanish flu of 1918. The world wasn’t as interconnected then as it is now, in spite of which the havoc caused by this flu was enormous. No vaccine was ever made in time, and it took almost two to three years for the Spanish flu to disappear as mysteriously as it had appeared. Something similar happened this time. We got a working vaccine though. It has still taken two years for things to get back to some semblance of normality. Now, given the events of March 2020 and the market’s reaction, the Fed went back to its now familiar tactic to calm the markets and support the economy – QE4. Its balance sheet has now quadrupled. Like in 2008, it was necessary in 2020, too. Although I am not so sure about QE2 and QE3.

The conundrum the Fed is facing is that inflation is high, at about 7%, but the yield curve is flat. Sonali Basak writes in her newsletter Wallstreet: “The yield curve is flattening dramatically. The spread between two-year and 10-year US yields has fallen to levels not seen since the pandemic’s surge in 2020. It’s renewing worries about a recession.” Those are signs of stagflation or deflation.

If long-term rates are as low as short-term rates, it means the demand for long-term debt is low, or the expectation is that the Fed may hike rates now to control inflation. But then, it may have to cut back rates very quickly. That is a tough balancing act for the Fed.

There are three scenarios for the Fed:

1. The Fed is able to quickly control inflation by a series of rate hikes in 2022 and then get back to its accommodative policy stance soon.
2. The Fed hikes rates but inflation is not under control.
3. Fed hikes rate but is slower, as a result of which the bond market starts pricing yields higher and the Fed is forced to follow. This is a scenario where the Fed also loses a fair amount of credibility and control.

Bubbles, bubbles everywhere…

“Eventually, market expectations become so far removed from reality that people are forced to recognise a misconception is involved. A twilight period ensues, during which doubt grows but the prevailing trend is sustained by inertia.… A point is reached where the trend is reversed and becomes self-reinforcing in the opposite direction,” says Soros.

But my favourite Soros quote is, “All of economic history is one lie and deceit after another. Your job as a speculator is to get on when the lie is being propagated and then get off before it is discovered.”

As Keynes, Soros, Jones, Druckenmiller, (Warren) Buffett, Simons, Burry, Paulson, and many others who have invested and had great success in times of big market dislocations show, it can be huge opportunity if one is able to read the situation right. It can, however, also be very risky because in markets, history doesn’t repeat but it may rhyme or, like jazz, may improvise. As it did in 2000, 2008, and 2020. The tune that the Sensex seems to be humming is all thanks to Andrew Summers.

Giving the last words to Druckenmiller, this is as far as he was willing to go. “Let me throw this one at you,” he said. “My hint is what is the one asset you did not want to own when I started Duquesne in 1981? It’s traded for 5,000 years and for the first time has a positive carry in many parts of the globe as bankers are now experimenting with the absurd notion of negative interest rates. Some regard it was a metal. We regard it was a currency, and it remains our largest currency allocation.”

The answer is gold. During the great crash, gold prices moved from USD20 per ounce in 1930 to USD34 in 1940 or 5% annually. Against this, the Dow was down 2% annually. Over the last 10 years, gold has returned 1.51% against the Dow at 10% annually. But if we believe that there will be a trend reversal, then it is time to revisit your asset allocation seriously.

To sum up

In one of the scenes in Margin Call, Tuld tells one of the managing directors (played by Kevin Spacey) that these large dislocations have happened in the past. “It’s just money; it’s made up. Pieces of paper with pictures on it so we don’t have to kill each other just to get something to eat. It’s not wrong. And it’s certainly no different today than it’s ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937, 1974, 1987… Jesus, didn’t that f$#k up me up good… ’92, ’97, 2000, and whatever we want to call this. It’s all just the same thing over and over.”

According to Tuld, we can’t help ourselves. “You and I can’t control it, or stop it, or even slow it. Or even ever-so-slightly alter it. We just react. And we make a lot of money if we get it right. And we get left by the side of the road if we get it wrong.”

(Graphics by Sadhana Saxena)

(Originally published on Mar 9, 2022,12:34 AM IST)