Comparing Historical Events

Dear Ladies and Gentlemen

I received a lot of feedback to my last weekly. I would like to come back to that feedback next week, for this week I have a „special“ by my friend Anton to share with you. Please enjoy the read:

„Rational Hope

There is a certain amount of consolation, or relief, in looking at the past, no matter how distant and turbulent it was, and concluding that tomorrow will, at least to some extent, look like yesterday. This line of thinking is a form of rational hope: the human world is somewhat cyclical, but this circular quality is in direct opposition with another aspect of our existence: entropy (which means change).

The backbone of all investment analysis is data. We often look at charts and tables to understand how various parts of the economy and financial markets have changed and how they may do so going forward. It is on this subtle but inevitable step of judgment – between the data that captures the past and our mental extrapolation into the future – that our discussion will focus.

Inflation Expectation

At the moment, inflation is at the forefront of investors‘ conversations. There is widespread expectation that, due to what the central banks and governments across the world have done in response to the COVID-19 pandemic, consumer price inflation is, more or less, „inevitable“.

Here are some recent headlines that further support the above chart: „Summers is right that inflation is coming, former Fed economist says„, „Inflation Is Coming For Your Wealth. Here is What Investors Can Do About It“ and „Inflation Is Coming. That Might Even Be a Problem.„. Even Martin Wolf from the Financial Times began an article arguing that inflation might not be around the corner and finished it with why investors should still be worried about it.

Why has this consensus formed? One answer can be found in the words of Joseph Gagnon, a senior fellow at the Peterson Institute of International Economics: „The stimulus is five times bigger than any conceivable need. […] We have never done this since World War II, and there was massive inflation. They put on price controls, but there was still inflation.“

In other words, previous events were extrapolated into the future. Gagnon is not alone, of course. As seen in the above chart, the majority of market participants expect these actions to lead to inflation because the past says so.
However, today was not yesterday, and tomorrow is not today. Here is how the world looked during the time of Gagnon’s example.

In the aftermath of WWII, the world economy was different: the US was the world’s major economic force, having won the war. Manufacturing was still a dominant sector in the economy for many countries. The monetary system was anchored in the Bretton Woods agreement, signed in 1944. The demographic makeup was very different, too, with only 2.5 billion people in 1950. The first hedge fund was established in 1949 by Alfred W. Jones, and there were no ESG products and no internet. The structure of money markets was different, with the first money market fund launched in 1971. Not to mention that societal values were different back then, and global trade was less interconnected.

Massive Changes

Today, all of these dynamics (and many more) have changed: developed economies are more service-orientated, with manufacturing representing a smaller contributor to their GDP (see two examples below). The dominant economic force is no longer the US alone but also China and the European Union. The monetary system is fiat with a tilt towards credit money. We have many more types of assets to invest in, and more people are playing in the markets. The world’s population grew from 2.5 billion to 7.8 billion in 2020. The hedge fund industry is now around $3.1 trillion. The structure of money markets is fundamentally different: the Federal Reserve (and other central banks) have shaped the channels of liquidity supply multiple times, more prominent following the GFC of 2008 and again during the COVID-19 pandemic in March 2020. With all of these changes, the mechanisms for transmitting monetary and fiscal policies have also changed. The past succumbed to entropy.

For successful investing, looking at data alone is not enough. If we make decisions based only on data, they will likely be wrong. Why? Because data are the traces of socio-economic activity. In other words, the numbers and their by-products (charts, tables and so on) are outputs of a broader environment, which is an open system with an „n“ number of factors that collide to provide a single data point.

Sure, 50% in 1950 meant the same thing as now. And so did a correlation of 0.8, for example. Nevertheless, these statistical figures need context. Often, however, we like to isolate certain factors and attribute them weight in the cause-effect dynamic to justify our judgment. For example, let us say that CPI inflation has reached 2.2%. We can view 2.2% as a weighted-average, where we divide each factor by its weight (importance) in deciding the direction of CPI inflation. We can make a mistake to attribute higher weights to factors that confirm how we see the world.

Money Supply

In the context of inflation, this can be money supply aggregates. We see the spike in M2 or M3 and link that growth in money supply to higher inflation. It is almost an automated mental process: because of A, then B must happen. This induction is further strengthened by comparing historical events without understanding that because it happened back then it may not happen now, for all the reasons we discussed above.

The argument that an increase in M2 or M3 leads to inflation is based on Fisher’s „butter argument„: if the total of goods produced in the economy is the surface of the bread when we put more butter (money) on the bread, we will have an increase in butter relative to the surface of the bread, i.e. inflation, unless the surface of the bread also expands so that it can absorb more butter.

Here is just one reason why the above chart may not lead to higher CPI inflation. As Ray Dalio explained, if you put money back into the economy by roughly the same amount that it was taken out / cancelled, then consumer inflation will not pop up. The equation is: – X (money destroyed by crisis) + X (money printed to replace them) = 0 CPI. Assuming this money gets directly in consumers‘ hands and they spend it on CPI-related goods, not on stocks etc.

The Past will not come back

Some things are indeed repetitive or cyclical: human nature. Our needs have remained the same as 100, 1000 and 10.000 years ago: shelter, food, rest and so on. Although our nature may offer some element of stable cyclicality, the changes in our environment and how we have adapted to them can make comparisons with past situations less relevant. Sometimes, we have to accept that the world around us is new, that the past is not coming back, and the future is simply uncertain.“

Thank you very much, Anton, for sharing your thoughts! Please, Ladies and Gentlemen, let Anton and myself know your views!

… but please do not forget (instead of hitting the reply button) to send your messages to smk@incrementum.li.

Many thanks, indeed!

Ladies and Gentlemen, I wish you a good start to the day, a wonderful weekend, and above all, good health!

Yours truly,

Stefan M. Kremeth