That’s probably not what you want to hear right now, and you probably disagree.
But if you’ll allow me, understanding how this might work could save or make you some money. It could help preserve your wealth through a difficult time, and mitigate losses during this rout.
Remember, investing is all about expectations. If they are beaten, certain things do well. If reality under-clubs and falls short of expectations, well… that’s what’s happening now.
But first, I must address the ground-shaking events of yesterday afternoon.
We need to reset our mental frameworks. The Powell Put may be dead, the era of central banks over, but it has been replaced. Arise, King Rishi.
Young and new to the job, he has changed the world already. 15% of UK GDP is being spent on loans, and he has given himself the power to do whatever it takes. Unlimited fiscal power.
Now. A quick thought experiment if you please.
There are 1 million people in an economy with £10 million of cash, £30 million of debt, and 10 million units of stuff.
Half those people get ill, and 100,000 lose their jobs – that’s 10%. So now there’s only 9 million units of stuff.
As a result, the lord of all these people decides to give them all some cash and loans to help them.
So now, there is £15 million of cash, £39 million pounds of debt, and only 9 million units of stuff.
The equation looks like this.
10 + 30 = 10x
15 + 39 = 9x
In the first instance, x = 4 right? The average value/cost of a unit of stuff is £4.
But now the equation has changed. The currency has been, to use the Tudor terminology, debased.
With 9x = 54, x now equals 6. the price of units of stuff has gone from four to six, a 50% increase.
This is a simplified explanation of inflation. More money chasing the same or less stuff means prices go up.
It didn’t come with the QEs of old, after 2008, because those programmes targeted liquidity in the financial system. Money was created to buy newly created bonds to give banks reserves, so they wouldn’t collapse. As a result, QE didn’t really enter the real economy, and affect prices.
That’s why tradable asset prices went up – houses and stocks – making the rich richer while austerity and low interest rates ensured those who didn’t already own assets didn’t see improvement either. Wages stagnated, and the wealth gap widened. Depressing, right?
But now, true, direct fiscal stimulus has arrived, at a time when goods (especially in the service and leisure sector) are becoming a scarcity.
Economists have spent a decade wondering where inflation has gone. Well, for my money they are about to find out.
I don’t mean to criticise Mr Sunak or the government here by the way. I mean, wow, what an impossible task. Events are unfolding so quickly. They have to balance the health crisis we face with the economic one which now looms. Criticism will come from all sides.
I watched him announce the fiscal measures which were to counter the economic fallout of the virus and I felt genuinely unwell, sick almost. Not because I felt they were wrong, sadly they may be necessary measures. And Rishi speaks well, and seems calm and competent. I couldn’t tell you if the measures are well-timed, go too far or fall short, and so I don’t wish to try and pass any judgement at all on the measures as a response to the current crisis.
I read Frances Coppola’s The Case For People’s Quantitative Easing (an argument in favour of helicopter money – QE for people not for banks) with some trepidation but found some of its arguments more convincing than expected. I don’t mind it being paired with traditional QE – keep the financial system up and running, but also make sure that ordinary people get some help too.
But whatever the rights and wrongs of the measures, the last 72 hours have seen the world change in a fundamental and enormous way.
The attitude towards fiat currency has changed. We have moved one step further away from the system of asset (gold) backed valuable currency. Currency which meant something, which had inherent stability. Which limited the whims of governments.
Always in times like these, the fear is that measures which seem temporary, turn out to be quite a boon for governments who then hang on to them. Emergency low rates and QE are the examples from last time. This time, unlimited power for governments to spend money is the one.
Like every power grab in history, this one has started with a crisis. The Night of the Long Knives in Nazi Germany allowed Hitler to consolidate power big time, or when Chancellor Palpatine uses the clone wars in Star Wars to get emergency powers. This time, the coronavirus.
And as always, the emergency powers are probably here to stay. Let’s hope that we don’t start having to give our health data to the government – facial recognition, curfews and the like don’t qualify for a “temporary” rollout. That’s how V for Vendetta begins…
Chicken and egg
Now, on to the matter of what came first, the chicken or the egg. Traditionally, or intuitively, it might be thought that a recession in the real economy causes stock prices to fall because investors don’t see economic improvement and so pay less for their share in the profits of companies.
That would make sense, right?
In 2008, the view is that the mortgage crisis and Lehmann collapse caused stocks to crash.
And so they did.
But I think it’s possible that the trend also works in reverse.
Obviously now the virus is doing most of the legwork on the recession front, which is why King Rishi announced his enormous fiscal package.
But what if I put it this way.
We all use mental accounting when we invest.
We bank gains in our head before we bank them in real life.
Do you remember that show, The Weakest Link? Questions go from person to person, the reward building each time until someone gets one wrong when it goes to zero, and contestants got voted off. Anne Robinson was paid to be mean. It was good TV.
The key was that contestants could choose to bank their gains, from four or five consecutive right answers, and thus avoid risking total loss of the pot. Those who didn’t bank a sizeable pot, and got a question wrong, were hunted like the witches of old by their teammates, then voted off as soon as possible.
Because seeing a 10% paper profit fall to a 10% paper loss makes us feel poorer, even though we weren’t withdrawing from our brokerage accounts then, and we aren’t now.
And we all do it, don’t we? We spend money that we think we have. Oh look, isn’t everything going great. Portfolio soaring, job looks stable – I’ll probably get a raise soon so I can probably treat myself to that weekend away, that nice dinner or that new pair of golf clubs.
But now, across the world people are feeling poorer.
Maybe they have sold, and crystallised lower gains or maybe even losses. Lower real or perceived wealth leads to lower spending.
Consumer confidence falling, after a prolonged trade war, and as a virus disrupts supply chains and the service and leisure sector… it’s a powerful combination.
The worst of the volatility is behind us. We won’t see multiple 10% days in a week again. Our imaginations ran away with us last week. Or should I say, they caught up with reality.
But now, investors have contemplated their worst-case scenarios and traded accordingly.
For volatility to increase again we would need this Black Swan to reproduce, having babies such as a powerful second wave of the disease, mutation, rioting, or some other surprise development.
I realise that saying there’s going to be a recession is hardly original thinking right now, but the point I’m making is that everyone thinks a recession will make stocks go down. But stocks have already gone down, and in fact they are contributing to the causes of the recession.
So, what I am wondering is this. Are we now in a dangerous feedback loop, where this crash will cause a recession which will lead to another crash?
Or is it the case that with the relationship inverted, news of a recession in the UK or abroad will have a much smaller dent on investor confidence?
I said at the top that investing is about expectations. A recession now matches our view of the world to come in the next few months, so maybe it’s not something investors need to fear so much.
If you’re looking for something to be scared of, look no further than the unlimited power now residing in the hands of our new Chancellor of the Exchequer.
For most people, a recession would be no shock, but the increase in inflation that will come once the virus crisis settles down will.
Make sure you’re not one of them.
Hoping you’re all keeping well and calm,
Investment Research Analyst, Southbank Investment Research