The Four Ds

By Kevin Muir of the Macro Tourist

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Today’s post will be a little bit of a rant, but I am hopeful that even amongst my complaining, there will be a lesson in here.

Much attention is paid to the supposed four D’s of investing in today’s environment.

Yeah, I get it. These are definitely valid themes to consider when designing your portfolio. And don’t mistake my push back – I don’t have any problem with the assertion that debt, deflation, and demographics, are the most important factors affecting the current financial environment. My issues lie with the part on the right hand side of the equal sign.

Recently ZeroHedge wrote a terrific piece that highlighted the always insightful David Rosenberg’s commentary about the “single most important thing for the market over the next decade.” I am stealing a few charts from the presentation, but I recommend you read the whole thing.

Rosy correctly identifies the tidal wave of changes that are about to be unleashed with the Baby Boomer generation entering their golden years.

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And he notes that the public has saved precious little to fund this retirement.

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Which brings Rosy to his conclusion that deflation, or at least low inflation combined with low interest rates, is a trend that will not be displaced anytime soon.

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Rosenberg is by no means alone in this analysis. Many strategists have looked at the massively over indebted financial system, added in the over capacity built by China during the past decade, topped it off with the slowing population growth in developed markets, and concluded that these three D’s – debt, deflation, and demographics equals a destiny of lower rates for longer, with little inflation.

Yet I am not as sure that this conclusion is quite as obvious as many of these strategists assert. Yes, there is no doubt that these will be meaningful factors affecting the financial system in coming years and decades. But how can they be so confident about the outcome?

By claiming a “lower for longer” result, aren’t they assuming that both monetary and fiscal policy are impotent? Aren’t they concluding that regardless of where the Federal Reserve sets monetary policy, or how much the US government spends and borrows, officials are powerless to change this destiny?

I don’t buy it. I don’t think governments and Central Banks are irrelevant by any means. And in fact, I would argue that their response to these three D’s are what will determine the destiny, not the other way round.

To argue the opposite would imply that Volcker’s response to inflation in the 1970’s was not the reason for the dramatic decline in inflation, but instead just a strange coincidence. Or that Greenspan’s easy money didn’t create the DotCom bubble.

I know what you are saying – but that was different then, monetary policy was still effective. In today’s environment, monetary policy has not worked. As credit is pushed into the system, it sits fallow, and does not create any inflation or growth. The Fed is pushing on a string.

Yeah, yeah, I get it. There can be no denying that monetary policy effectiveness has diminished over the past half century, but do you really think there is no way a Central Bank can create inflation anymore? Really? So regardless of how much QE a Central Bank commits to, it’s all moot? What about if a Central Bank decides overnight to ramp the money supply by doubling their balance sheet through a massive purchase of gold? Don’t think that would affect inflation? And if you don’t like gold, what about oil? Or even stocks? Central Banks printing dollars to buy assets is inflationary. Full stop. It creates different types of inflation, but there is no denying that Central Banks have the power to debase their currency. To think otherwise is just naïve.

Now you might argue Central Bankers lack the political will to administer these sorts of policies, and that would be a credible line of reasoning, but I would counter that the same sort of defeatist attitude towards the inability to reign in inflation existed in the 1970’s before Volcker. Yet one man’s determination to stamp out inflation changed the course of financial history forever. What makes the Four D’s disciples so sure there isn’t a reverse Volcker waiting in the wings? Volcker’s policies were revolutionary. Why can’t we have the same sort of dramatic change, just this time in the opposite direction?

And what about government fiscal policy? Sure there are plenty of conservative politicians obsessed with cutting deficits and trying to balance the budget. The rise of the Tea Party and the German insistence on Greece and other struggling European countries instituting austerity programs into the credit crisis of 2011 are obvious examples. But that trend is slowly changing.

What would happen if governments just said “screw it” and spent? What if the demographic time bomb was paid for with governments borrowing more dollars (financed by an accommodative Central Bank)? What if governments wrote off all the student debt weighing down the young generation? Would inflation, and lower for longer rates, still be all these strategists base case forecast?

I think all these pundits that believe the three D’s equals the fourth D – destiny, are vastly underestimating governments ability to create inflation.

There is no doubt that these three D’s put governments in quite a pickle. And although I believe the high probability bet is that eventually governments will resort to the technique employed for the past thousands of years – to print their way out of problems, I don’t have anywhere near the confidence that these other strategists profess. Even with history on my side, I can’t bring myself to say “this will for sure be the outcome.” I might be wrong. Maybe society will hunker down and conduct responsible monetary and fiscal policy. Anything can happen, and a good trader learns to never say never.

But I can’t for the life of me understand why so many strategists take these economic conditions of debt, deflation, and demographics, and somehow make conclusions about the inevitability of an outcome. All I am certain of is that these influences will be the inputs that determine the reaction function by the various players. The important moves have yet to be made.

I look around and see Central Bankers experimenting with ever more bold policies, and governments increasingly willing to run deficits. If anything, I think the three D’s are the necessary precondition to allow the unorthodox policies that will ultimately create inflation, but hey – what do I know? I must not get it. After all, all these other strategists are so confident that they know the answer even before they see the actions of those that set the rules. Their conclusion, and their certainty regarding our economy’s destiny, is baffling to me.

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