Caught Between a Rock and a Hard Place // VP #12

WTF is happening in the economy in layman's terms part three

This is part three of an undetermined part series where I attempt to explain WTF is going on in the economy in layman’s terms.

So, let’s recap.

In our first part of the series, I covered how the massive global government stimulus shoved into a shutdown economy created our current situation (low growth, high inflation, higher volatility).

This micro-cycle takes place within a larger macro (50-70 year cycle) which we’re closer to the end of than the beginning. This macro cycle, which I covered in part two, is characterized by massive debt loads, slowing growth, and heightened volatility.

Today, the economy sits at a crossroads. We have high inflation. A tight labor market. Volatile interest rates. And, a central bank trying to walk the tightrope between cooling the economy and downright crashing it.

There’s another element of our current set up that’s important to remember. Governments can always issue more debt. They cannot, sadly, create more people or increase productivity. So they’re heavily incentivized to use debt to boost economic growth.

Because their biggest fear is not inflation. No, no no…

It’s a deflation. Inflation gives you a period like the 1970s. Sure it was bad, but uncontrolled deflation gives you the Great Depression. And, nobody wants that.

That’s why the Fed and governments around the world will do everything they can to support asset prices (pension funds, 401ks, retirements, stocks, bonds, real estate, etc).

Think of all these assets as the collateral for the economy. This is what the Federal Reserve uses to support our national debt load.

If the value of the collateral falls, our debt to GDP ratio will skyrocket even further.

So debasement > deflation but the Fed will push as far as they can before they give the economy the medicine (QE and stimulus).

Ok, this set up leads us to the next 12-24 months. What’s likely to happen?

I see two broad paths forward. One represents the prized “soft landing” that the Fed would love to orchestrate. While the other brings with it a bumpy landing or a full-on hard landing.

Accelerative Oscillation

This is a concept that I heard through Julian Brigden, and I find it to be both compelling and concerning.

Accelerative oscillation refers to what happens when a system is subjected to a force that varies in strength and direction over time.

This force causes the system to move back and forth in a repeating pattern, but the pattern becomes faster and more intense as time goes on.

Think of a car going over a series of bumps and pot holes. The more consecutive bumps it experiences the higher the passengers get knocked up and down.

In this scenario, the system is the economy and the forces of different strength and direction are monetary policy, fiscal policy, supply chain, and other components of the economy.

Under this regime, we’ll see massive swings in interest rates up and down. Growth increasing rapidly then falling just as quick. Inflation yo-yoing up and down.

This is not a period where most investors do well. They get chopped up and ground out. I’d expect periods where every different part of the market experiences a massive rally and fall in a compressed period of time.

We’ll experience a radical increase in the volatility of the economic system. Governments will continue to increase their fiscal spending to satisfy new demands (green energy, defense, healthcare, onshoring, economic security) into an economy that is more fragile and reactive than we’re used to. This will drive quicker boom bust cycles in inflation, rates, and economic activity.

Julian shares one other poignant observation on how every period of low interest rates ended, “the two driving forces over the last 700 years that ended every single one of these real rate depressions or period of very low interest rates was a war and/or a pandemic.”

Pretty spot on if you ask me. Accelerative oscillation describes what a hard or bumpy landing would look like for the economy. The Federal Reserve and other global central banks become reactive instead of proactive. They’re perpetually behind the ball. This creates the yo-yoing of macro factors (interest rates, growth, price of dollar, etc).

Which leads me to the soft landing.

Economic Gravity

I’m referring to this second possibility as economic gravity, which refers to the inescapable growth-slowing effects of the massive debt load. The debt becomes too much for the economy to handle and deflation becomes the core risk instead of inflation.

In this scenario, slow growth and falling prices over the next 12 months rapidly cools inflation and the fed responds by stimulating. Like I said, the worst case scenario for the federal reserve is a deflationary bust, so they will always choose to issue more debt to avoid a bust, even if it leads to more inflation.

Bond yields already signal that the Fed has potentially gone too far in raising rates, risking a hard landing and bad recession.

Contrary to the accelerative oscillation regime, this view looks at the pandemic as a short-term deviation from the long-term trend of bond yields down, debt up, suppressed volatility and similar returns to the ten years pre-covid.

In this scenario, the most QE-sensitive investments do the best. Which, as much as people hate it, are the zero-profit tech stocks that Cathie Wood loves to buy and everyone loves to hate.

I tend to think economic gravity will win in the end, but we’re still experiencing the hangover from the pandemic. The labor market is still tight, inflation has not fully cooled, and the economy is humming along.

Inflation is still the main dragon to slay, which, in my opinion, means the Fed will continue to bring rates up to cool the economy attempting to skirt that line between hard and soft landing.

I think they go too far and we move into the accelerative oscillation period over the near-term (1-2 years). Then, as we try to navigate our way out, that inevitable economic gravity pulls us down.

I’ll finish with another quote I heard from Darius Dale, another macro voice I follow.

Understand that we’re probably not yet at the beginning of the next bull market. You need to have patience to get to the next bull market without blowing up a significant amount of your capital in what we think will be… a phase two downturn.

Stay vigilant.

-Jared