I left off on Friday blaming the atrocious behaviour of our political and business elite on the state of ‘money’. It’s a simple formula, erode the value of a currency and you erode the morals of a society.
The people who get their hands on a greater quantity (but of much less quality) of this money think they are morally and intellectually superior. Rules that apply to other, lesser beings don’t apply to them.
Hence their behaviour.
The weird thing about 21st century currency devaluation is that it’s not accompanied by inflation. At least, not in the traditional sense of high and rising consumer price inflation. We’re told that barely exists.
But there has been rampant asset price inflation. Because as interest rates decline, bond yields fall and that increases the future value of income producing assets. One unit of currency therefore buys you much less of one unit of income producing assets.
To show the effect of this ‘inflation’ is simple. You just denominate a share index by an ounce of gold, rather than a unit of fiat currency.
Let’s have a look at the ASX 200. The value (or, more accurately, price) you get each day is in Aussie dollars. The chart below shows the ASX 200 denominated in gold. The data only goes back to 2009, but that will do.
As you can see, over the past 11 years, the ASX 200 has nearly halved.
In other words, the post GFC recovery in the market has been nothing more than a result of lower interest rates. Put more accurately, it’s the result of deflationary forces pushing bond prices lower. Falling bond prices mean high share prices via their impact on discount rates.
A simple example is in order:
Say you want to capitalise $100 of earnings using a 10% discount rate. 100 divided by 10% = $1,000.
If interest rates fall to 5%, it looks like this: $100 divided by 5% = $2,000.
So earnings can stay the same, but the asset price can double from a halving of interest rates.
The chart above seems like a much truer reflection of the Aussie economy over the past 10 years, doesn’t it?
Real economic wealth (as reflected in the stock market) has declined markedly.
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What about in the US?
Here things are a little different.
Have a look at the chart…
Economically, you can see that the US peaked in the late 90s/early 2000s. It’s been all downhill from there. There was a recovery starting in 2012, as tech finally made a resurgence, but it topped out in 2018.
The trend looks to have turned down again.
Whichever way you cut it, in the 21st century asset prices have relied on monetary stimulus. Real economic wealth creation is increasingly hard to come by.
I wonder why?
Could it be the increasing involvement of government in our economy and lives?
Surely not! They are here to make things better.
I know you don’t believe that, dear reader. And if you do, have a look at the charts above again.
This brings up another point, one that I think is hugely important to understand for the next few years.
There is a widespread view that the Fed’s QE is the same as ‘printing money’, that it creates liquidity and pumps stocks prices up.
This is wrong.
QE creates bank reserves, not cash. When a bank sells a Treasury bond to the Fed, the Fed credits the banks account at the Fed. These are bank reserves, not cash that the bank can go out and buy something else with.
So why do stock prices rise with QE?
Firstly, think of why central banks do QE…
It’s not because things are going well, is it?
No, QE happens because the economy is slowing. When the economy slows, bond yields decline to reflect a slowing/deflationary/recessionary economy. QE doesn’t cause bond yields to decline…a bad economy does!
And as I just explained, when bond yields fall, asset values (assuming earnings don’t fall too much) move higher.
This raises the question, if the economy is in recession, why haven’t earnings tanked?
Well, that’s because most developed economies are running massive fiscal deficits and propping up household incomes. Given consumption accounts for nearly 70% of economic growth in the West, this support makes a huge difference.
The other reason why stock prices rise with QE?
Belief is the most important element of financial markets. You never hear it put this way though. It’s referred to as ‘sentiment’.
Because there is a common belief that QE creates liquidity and makes stocks go up…guess what, QE creates liquidity and makes stocks go up!
Everyone knows that everyone knows that QE is bullish for stocks. It’s a self-fulfilling prophecy.
Where it will break down though is via the inflation narrative.
The next logical step for such ‘massive’ QE (which is apparently ‘money printing’) is that it will lead to inflation. Or so the thinking goes.
But it’s wrong. QE is a result of deflationary forces. In this case, the unnecessary shutdown of the global economy due to COVID. With loads of spare capacity in the economy, how is inflation going to eventuate?
Come back in two to three years, and it might be a different story. But for now, deflation remains the biggest risk.
Editor, The Rum Rebellion