When I started this newsletter in the fall of 2020, the idea of the world returning to normal and the rules that would govern the after times were very hard to imagine. Unprecedented actions by governments and central banks to provide economic relief have also given us stonks, an incredible crypto boom/bust cycle, and a wave of fresh concern that inflation and overheating asset values are threatening a major economic collapse.
So naturally I spent the bulk of my first week off in six months reading all I could about how the economic developments over the next 18-24 months will shape the majority of my productive investment and working years.
I've been hearing for over two decades that US entitlement programs will bankrupt the country if not fixed and most of what I've observed in my life has been a relative erosion of civic competency and the capacity of government to solve generationally hard problems. I don't have any great answers, but there are definitely some broader narratives I'm starting to pay more attention to.
💣 Deficits and Inflation
Lyn Alden's May 2021 investor note is a good summary of current concerns around inflation in the US and provided some useful historical context contrasting the 2020's with fiscal measures taken in the 1930s and 1940s to steer the US out of the Great Depression and mobilize for WWII.
The last time the US debt was this large a part of the economy and interest rates were this low was during the 1930s. In these scenarios, the central bank has two paths: 1/ hold rates low while printing money to effectively inflate away the debts or 2/ deflationary collapse. Ultimately, most policymakers elect to make the money printer go brrr rather than knowingly blow up the market.
A global economy with this much debt is fragile, and can't persist without constant cash flow
The Fed has been inching closer towards policies of direct fiscal intervention versus monetary policy - a tacit acknowledgement that once interest rates are at 0% (or close to it) the only place to go is figuring out how to give people money directly. In the 30's, this took the form of the WPA, and in the 40's it was manufacturing of war matériel.
It will be interesting to see if direct stimulus checks and leaving employment to the market will be sufficient intervention to grow the economy in the coming years, or if we truly need a sustained commitment to domestic infrastructure and manufacturing investment to overcome the surge in inflationary pressure.
💸 The Market Metagame
With more money in the system and interest rates at nearly 0, the easy answer to the question of "where does the money go" is simply "the stock market", but it's useful to think a little deeper about why.
Markets turn financial capital into physical capital. Finance bridges the fact that people need to borrow from the future to work on something today which will result in physical capital in the future which acts as the collateral for the loan or equity upfront
- Albert Wenger
Kris Abdelmessih wrote a long and wonky piece trying to make sense of the widening gap between asset prices and the core fundamentals-based performance of those assets, and what this can teach us about the psychology of buyers in today's markets.
A fundamentals-based valuation approach looks at the intrinsic value of a company/asset - essentially a conservative sum of future cash flows / whatever's left over if you shut a company down, liquidated all the assets, and paid off all the liabilities. But public markets contain multiple actors with multiple strategies and motivations. There are people today with irrational beliefs about Tesla that it's more than a car company just as you had people in 1998 that Amazon was going to do more than just sell books.
Those investors place a premium on the extrinsic value a company could create in the future - it's not represented in evaluating the company as it is. Abdelmessih splits extrinsic value into two concepts:
the imagination extrinsic - for what a company could become (think a drug company that gets FDA approval on a single pill that cures cancer)
the liquidity extrinsic - for the confidence in normal market operations that lead to relatively stable prices that make it easy to exit your position for cash
The liquidity extrinsic is kind of weird - the best way to think about it is you are fine owning a high-flying technology stock like Tesla because you know there are a ton of people that also want to own Tesla, and so your ability to sell your stock whenever you might need to is relatively easy (in normal times).
The core takeaway from the essay is to always be cognizant of who the marginal buyer is that is setting the market price (e.g. enabling liquidity of transaction to occur). Whoever sets the price is the person granting liquidity, and the motivations of the price setter are everything.
Faith in liquidity increases the demand for an asset since it is easily convertible back to the fiat your obligations are denominated in. If you did not trust liquidity, you would need to hold more fiat in reserve just in case. This would reduce your demand for assets.
In environments with high liquidity, fundamentals don't matter as much because the marginal buyer derives value from either liquidity or imagination extrinsic value (future market demand or asset potential) than they do for whatever cash flows the asset is capable of producing today.
When liquidity dries up, companies can't borrow against an increasingly uncertain future and need to produce their own cash flows. That's the environment when fundamentals matter.
The question now is with several rounds of stimulus and the conquering of COVID (at least here in the US), will we continue to see extrinsic value investors dominate the market?
🇺🇸 The Inflating of Fears
Peter Zeihan was out with a new note this week advocating that while inflation is coming, it will be uniquely manageable by the US.
Despite increasing the money supply by 20% to a shade under $20 trillion, the majority of the increase happened in the first month of COVID - his point being that the newly printed money supply has had its time to work its way through the system and if the stimulus was actually causing issues, it would be more pronounced by now. For context, Zeihan points out that the Chinese have expanded their money supply to $35 trillion, despite having an overall smaller economy and way less international trading of the yuan.
I'm not smart enough to really understand what this means, but the useful frame to hang on to here is possibly that the US has been able to accommodate stimulus better than the media portrays and perhaps the Chinese economy isn't doing as well as we think it is. 🤷♂️
That is not the same thing as saying inflation won't occur at all though, which Zeihan makes abundantly clear:
In the remainder of 2021 and throughout 2022 the United States will experience the highest levels of inflation since at least the 1970s. And if relations with the Chinese really do tank, the United States will be looking at World War II levels of price increases.
The double whammy of America's vaccination rate + the looming retirement of the Boomer generation makes the next year unique as one of the more abundant and cheap capital environments in human history. To Zeihan, the size and scope of investments the Biden administration wants to be making actually make sense given the interest rate environment and the ability for vaccinated people to go back to work to put those dollars to use.
Once Boomers start retiring en masse, investment dollars become consumption dollars and the cost of capital begins to climb. Putting it in terms of our earlier discussion of marginal buyers, fiat liquidity starts to matter more and you may see a retreat towards the fundamentals-based marginal buyer of assets.
This is just a partial subplot of Zeihan's broader thesis that globalization is fucked due to America's retreat from being the world's police force, which I'll dig into below...
🧠The Retreat of the Superpower
The best part of the Internet is discovering people smarter than you that have summarized weeks/months/years of knowledge into a concise blog post or newsletter. I have been meaning to read all of Zeihan's books, but Erik Torenberg has given me the benefit of a highly compressed summary on the worldview:
The Accidental Superpower is about how the US created the global world order and why it's ending
The Absent Superpower is about the shale revolution in the US and how it accelerates the American retreat from the world stage
Disunited Nations is about who flourishes in the coming disorder
The Zeihan thesis is that the US crafted a global order after WWII that optimized for security rather than economics to fight the Russians. Once the Cold War ended, it no longer made sense for the US to be the world's cop, but that process has been slow and the world writ large has not internalized the significance of this pull-back.
While the US retains global power and reach, it no longer has global interests. This will be a profound realization and perspective shift for nation states that have come of age in the last 60 years and everyone else without solid geographic borders and a steady supply of food and energy. What those powers do in response to a slightly less stable global order no one really knows, but will come to define the political problems for the next several decades.
🎧 The Real Cost of Inflation
Pseudonymous twitter investor Jesse Livermore was a recent guest on the Infinite Loops podcast and had one of the best explanations as to why inflation should matter to all of us:
So for example, let's suppose that the only way to get inflation under control is to... Or let's suppose that the only way to achieve the outcomes that we want from a policy perspective is to have this group over here take small losses every year, year after year. That is much easier than having a group over there take a big hit all at once.
So if we had to crash the stock market to be able to achieve some sort of economic balance at some future point where we're in a massive bubble, that's going to be a problem because that's what kind of costs that really shocks when it hits, that's like, Ooh, who wants to do that? But if it's just asking a retiree to take greater losses every year on his or her savings, that's easier. So what there's me a little bit is that I don't see that retiree having much of a constituency in this discussion. That person created value for the system. They did the work to earn the money. They want to spend it now
...
If you think about, let's say a 3% inflation rate against the 0% interest rate that you keep going and you take it out for 20 years of a retirees life, you're talking about a huge chunk of that wealth.I did the calculation with 2% for 20 years. It was like 30% right down. I mean, a 30% loss if I made you take it all at once on the stock market, or if someone made me take it on the stock market, that would be a big deal. Everyone would freak out. The fact that you spread it out over someone's life to me, that doesn't really change the fact that the loss is still the loss, but from a policy perspective, it's much easier to just gently every year have it just erode away like that
Whole episode is worth a listen for some blistering hot takes on crypto. There's also a transcript if you read faster than you listen.
And Finally
Until next time!
W