The spectre of stagflation

George Frith is part of Superscript’s digital asset team and specialises in the digital asset ecosystem, covering everything crypto and web3. He previously spent six years underwriting property business for a well-known Lloyd’s syndicate, developing new product offerings and gaining a strong understanding of risk management principles.

Since the US Federal Reserve wheeled out the word ‘transitory’ when discussing the impacts of their self-titled ‘bazooka’ response to the Covid-19 Global pandemic in early 2020, commentators, podcasters and Fintwit personalities have been fiercely debating the implications of such unprecedented fiscal and monetary policies.

The Federal Reserve alone went from a balance sheet of $4trn to $9trn, which is over double its pre-pandemic state. To put this into some perspective, if someone gave you a dollar a second, it would take you 31,688 years to reach $1tn dollars. We’ve become used to talking about these enormous numbers as if they were merely pocket change when in fact the sums of capital we throw around ad-nauseam are in fact unprecedented in their size and scale.

The age of cheap capital

In an age of generally easy monetary conditions since the global financial crash in 2008/9, global markets have become used to low interest rates and access to cheap capital. We’ve seen the exponential growth of the tech sector and (until recently) FAANG stocks, as well as a steady rise in the price of hard assets such as property, fine art, classic cars, rare wines and whiskies. Also during this period we’ve seen the birth and growth of the digital asset economy.

As we draw into the second quarter of 2022, according to many commentators those days are apparently behind us. I’d actually argue, looking at Knight Frank's Objects of Desire research (which tracks the preceding 12 month and 10 year weighted average of individual asset performance) some luxury items on the list will be okay.

One just needs to observe the Forbes data showing that the combined wealth of all U.S. billionaires increased by $2.071 trillion (70%) between March 2020 and October 2021, from approximately $2.947 trillion to $5.019 trillion to see that these assets are likely to hold up okay. Demand may wane a little but ultimately many of these assets are likely to be viewed as a superior store of value to fiat money, stocks or bonds. There are also some favourable tax implications for wealthy individuals in holding some of these assets, including borrowing against the asset for capital gains-free cash financing.

Central banks and quantitative tightening

In an effort to combat inflation, the FED and other central banks (not including Japan) are engaging in a cycle of interest rate rises and quantitative tightening (QT), the opposite of quantitative easing. In a nutshell this means liquidity is being withdrawn from the market at the same time as the cost of borrowing is increasing. According to some, this is the fastest tightening of monetary conditions ever and it’s starting to show. Since reaching their respective highs, the NASDAQ is down by over 30%, Bitcoin over 50% and the S&P 500 by 16%. To put this in perspective $35 trillion in global market value has been erased since the beginning of the year. That's 14% of all global wealth.

The central bank playbook when the economy gets overheated and inflation accelerating is to withdraw liquidity from the market when times are good. This was famously described by US Fed Chairman, William McChesney Martin, who said the job of the central bank is to “take away the punch bowl just when the party gets going”. The problem with today's macroeconomic backdrop is that for many people without their own financial assets, they simply weren’t invited to the party in the first place. For those that do own assets and are at the party, central banks have arrived so late they’ve turned up drunk, misread the room and proceeded to trash the place whilst everyone else is already nursing an early onset hangover.

Inflation is raging

The current environment is not one in which you’d expect central banks to be tightening monetary conditions further. However, the issue of the day is that with CPI year-on-year inflation raging at over 8% in the U.S and now 9% in the UK, central bankers don’t really have a choice.

As a side note, the inflation we are talking about is the Consumer Price Index (CPI) which is the traditional measure of the rise in the cost of living taken from an indexed basket of goods and services. The CPI rising to these sorts of levels disproportionately affects those with lower incomes because they spend a larger portion of their incomes on necessities such as food, energy and shelter.

In the post-global financial crash era, asset price inflation has been enormous, driven by easy monetary conditions or fiat currency debasement, depending on your school of thought. This has brought with it sky high property prices and stock valuations, enabling the most affluent to increase their paper wealth significantly over this period, increasing wealth inequality to levels not seen since the 1920s.

Politicians and central banks largely ignored this growing wealth gap because it is not immediately apparent given it does not show up in the CPI. Indeed, increased housing costs in the U.S are skewed by the owners' equivalent rent and rent of primary residence measures. In an era of generally cheap food and energy it was easy to just do nothing whilst supporting asset prices.

During 2021, as inflation was rising, we heard central bankers talking about a transitory rise in inflation followed by a return to more sustainable levels. For reference, the FED and BoE’s target rate of inflation is 2%. Central Banks also spoke of ‘base effects’, meaning a percentage change looks larger when you start from an incredibly low level. In this case caused by a mass shutdown of economic activity via the Covid-19 pandemic. Now the base effects have worn off and with inflation stubbornly high, the political pressure to get things under control means there’s no other option left in the toolbox but to raise rates in a forlorn attempt to curb the inflationary conditions we find ourselves in.

Now I would like to point out that raising rates in a supply-led inflationary cycle doesn’t make much sense to me. There’s nothing quite like an enormous rise in the cost of living to ensure a political party gets voted out. The Bank of England’s governor, Andrew Bailey, admitted there’s “not a lot” the bank can do about four-fifths of the inflationary impulse due to global macro conditions.The real question is what sort of regime will we be in 6 to 12 months time? There’s a large number of macro commentators that think “this time it’s different” whilst others are far too busy basking in the glory of finally being correct about an inflationary cycle. It’s debatable as to whether you’re really right if you’ve called for something for over 10 years and it’s only just happened. Then there’s the camp that still think the previously dominant deflationary factors of globalisation, technology and easy monetary conditions, will have their time again.

The Third Way – Stagflation

Stagflation is a central banker's worst nightmare and it’s been looming on the horizon since the early days of the pandemic. I remember Ray Dalio and his team at Bridgewater talking about the potential for a stagflationary period as early as May 2020. Now it appears it may well have arrived.

Stagflation can simply be thought of as high inflation coupled with low economic growth. At a time when economists are predicting a fall in living standards in the UK not seen since the 1970s, a stagflationary regime sounds more than plausible. The old maxim ‘nothing cures high prices like high prices’ is starting to play out. The U.S ISM purchasing managers index (a forward looking monthly indicator of U.S. economic activity based on a survey of purchasing managers) is beginning to show signs of stress dropping to 55.4 in April vs. an expected 57.6. A drop below 50 indicates economic contraction.

As the cost of living continues to rise, consumers are likely to reduce their discretionary spending and focus on necessities such as food and energy. This can be seen already in Target and Walmarts earnings misses, and means that growth is likely to slow. In fact it could be argued some of the weakness in digital asset markets has been caused by this tightening cycle given many of these assets are still largely a retail phenomenon. The marginal buyer is being squeezed so we are seeing a reduction of capital inflows into the market. Back in the corporate world, the cost of capital is steadily increasing too, meaning the affordability of borrowing to fund future growth is diminished.

Part of the reason tech stocks have been destroyed in the past few months is because they are viewed as long duration assets. If growth expectations do roll over in a big way, expect to see businesses starting to reduce staffing numbers. This may take a while to show up in the numbers because of how tight the labour market is after the ‘great resignation’, but it is still worth looking out for. Reducing staffing costs is one of the quickest ways corporations can reduce costs as their margins start to get squeezed from increased costs of production amidst falling demand.

How will central banks respond?

So what can central banks do to combat such a tough macroeconomic backdrop? It’s becoming clear they are unable to walk the tightrope of looking after the asset markets and most likely the real economy whilst keeping runaway inflation down. The FED’s ‘soft landing’ is likely to prove a pipe dream unless something drastically changes. The wealth destruction and cost of living squeeze is the worst for over 30 years. Many are calling this period analogous to the 1970s but I disagree and think it’s more like the 1940s. As Lynn Alden has repeatedly pointed out, unlike the 1970s, today the debt load is significantly higher.

In the U.S, in Q1 of this year, a record 229 million new credit card accounts were opened, suggesting consumers are turning to credit to maintain their living standards - when this eventually breaks, sadly it’s likely to turn ugly. Andrew Bailey, the governor of the Bank of England told MPs that the bank is powerless to stop the rising cost of living. He warned of an “apocalyptic” rise in the cost of food prices due to the war in Ukraine, and tellingly India has already banned wheat exports. These driving factors amongst others mean wheat prices are now up by over 60% compared to before the Ukraine conflict. Remember Andrew Bailey is the same talking head (earning £575,000 per year) that was telling working people not to ask for a pay rise earlier this year. Central banks are stuck between a rock and a hard place and I don’t envy their position.

Where do we go from here?

Ultimately, my view is that we will continue to see rate hikes because central banks have to be seen to be doing something to show they have a semblance of control over the situation. It’s a desperate attempt to maintain credibility and this will likely go on until the real economy rolls over and we clearly see we are entering a recession. I can't see how central banks can continue their tightening cycle without causing demand destruction, unemployment and even social unrest. We are already starting to see this in Sri Lanka where food prices have skyrocketed and there’s been mass social unrest in recent weeks.

We might find that we see the perverse situation of continued rate hikes (to combat inflation) while politicians and governments bring back fiscal stimulus programs. This might include direct transfer payments to lower to middle income households (which could be thought of as inflationary). We've already seen this in the UK with a £150 energy rebate for most households and in New Zealand this week the government announced $1bn for cost of living relief with $814m being directed to those earning under $70,000 for a total of $350 in three installments.

I wouldn’t be surprised if we were to see something similar in the U.S as we approach the midterm elections later this year. Could we be heading towards a world of universal basic income (UBI) and continued direct payments to support the ‘have nots’. I wouldn't bet against it. There’s an old saying attributed to Milton Friedman; ‘nothing is so permanent as a temporary government program.’ UK income tax was first introduced in the Napoleonic era as a ‘temporary measure’ to fund the war on the continent, try explaining that to HMRC when you receive your income tax bill.

A few months ago, when markets were still hovering around their all time highs, I heard a commentator describe markets as having their Wile E Coyote moment. It appears gravity has finally taken hold of risk assets and we are heading back towards terra firma and fast. How far and how hard we fall is ultimately down to a small band of unelected central bankers and their policy decisions over the coming months.

You may also like:

• Investment in distributed ledger technology
• How has growth created risks for fintechs in 2022?
• Insurance and crypto mining