After a two-week hiatus dealing with successive health issues, I am back this week to ask what may be the most important strategic question facing investors, and indeed policymakers, over the coming months, quarters, and years. As a point of clarity, my description of ‘Regime Change’ is not geopolitical in nature, but rather the potential for what I refer to as the ‘Lacy Hunt Paradigm’ to fundamentally shift.
I label it as such due to Mr. Hunt having been the singular person whose writings and public interviews enabled me to more fully understand the underlying macroeconomic forces at play since the late 1990’s. It is his analytical framework which I will revisit today, and not the investment management decisions he and Hoisington have made- those are discrete topics, in my opinion, and the latter should not be conflated with the former.
In the interest of time and trying to keep it simple stupid (KISS), I will attempt to distill this paradigm into some high-level concepts. An overarching way to consider the paradigm is to consider it a ‘Debt Trap.’
The first two charts come from Hoisington’s Q3 2021 Economic Overview. The US reached a level of indebtedness in the late 1990’s which various studies suggest has introduced a drag on economic growth once countries reach a certain threshold range (80%+ of GDP). The first chart shows a cumulative gap opening up between Real Per Capita GDP growth prior to having reached the threshold of indebtedness (2.2% dating back to 1871 when associated data capture began) and subsequent growth. Also, please remember these metrics incorporate what I like to call the post-Boskin Commission phoney baloney inflation calculations- I would argue reality has been worse.
The idea is that there is a non-linear impact of piling more debt onto the economy once the threshold is reached.
We can see the deleterious impact of adding incremental debt in this next chart, which shows it for the US, Eurozone, and Japan since 2000. The US is not alone in this paradigm (China included), and actually for various reasons, has been less worse off than the other two economic powers. On a cyclical basis, whether it has been new rounds of quantitative easing (QE), deficit-financed tax cuts, or ‘stimmies’ like those which exploded during the pandemic, economies have enjoyed temporary boosts in GDP followed by having to deal with the ‘more debt’ - rinse and repeat. In fact, the duration of the ‘boosts’ has been getting shorter relative to the size of stimuli as the law of diminishing returns has asserted itself.
This backdrop is supposed to be one of structural disinflation, with this next chart from the Q2 2021 commentary offering one variable as to why:
With many analogies to the 1970’s becoming popular recently due to the multi-decade highs in consumer inflation, this is a very important chart, in my opinion. It shows the difference in monetary velocity between that period and the one since the US reached the debt trap threshold in the late 1990’s.
Well, if this paradigm remains the dominant regime, then how has consumer inflation increased so dramatically? That can actually be explained reasonably well within the paradigm, as an explosion in deficit-financed stimulus resulted in a huge increase in discretionary consumer income. Due to the pandemic, consumer behavior was then shifted to focus that ‘windfall’ on consumer goods, which…..happened to be experiencing pandemic-related supply chain problems. Higher demand + lower supply = many people failing Econ 101, apparently.
I wrote last fall and early this year that leading indicators had been suggesting that the inflation cycle may begin to decelerate, but those leading indicators turned back up to new highs as the invasion of Ukraine occurred, subsequent financial war was declared via sanctions, and then the recent widespread lockdowns in China emerged.
Whether it is neon for microchips, fertilizer, or nickel for batteries, the invasion and sanctions have further destroyed global supply chains, all while volatility in many commodity prices has exploded. Events in China have only further compounded this mess, chart courtesy of Macro Alf:
These events continue to be explainable within the Hunt Paradigm, as supply and demand curves continue to be altered. However, they are now disproportionately being impacted on the supply side, as various stimulus programs have lapsed and government deficits have fallen sharply.
How can or will the paradigm shift? I think about this a lot and wrote recently about looking toward Japan, which is now engaged in an attempt at unlimited yield curve control with the yen falling sharply. They’ve been engaged in the debt trap regime for even longer than the US, and expanded quantitative easing to include equity markets. The Europeans went to sharply negative interest rates and expanded QE to include large amounts of corporate bonds.
Neither has yet crossed the rubicon towards making central bank reserves legal tender, which would likely introduce Gresham’s Law. However, as we repeatedly witness, it is unwise to underestimate the stupidity and corruption of politicians. The next two charts come courtesy of Liz Ann Sonders:
Here we see a large gap opening up between consumer confidence and the parabolic spike in household net worth as a percentage of disposable personal income. Inflation now polls as the most important issue amongst US voters. The net worth component is extremely skewed towards a very small percentage of the population, while inflation is horribly regressive.
This chart shows how deeply negative earnings have turned, as the consumer inflation rate has outpaced nominal earnings. With inflation having shot to the top of the list of voter concerns, politicians have begun to respond in typical fashion. For example, cutting gas taxes is in the same neighborhood of economic ignorance as the Nixon price controls of the early 1970’s. Artificially boosting demand within the context of markets in tight supply or even shortages is likely to compound problems.
With the risks of things like global famine likely increasing significantly, who is to say that the supply chain mess will not sustain for far longer than many expect and possibly get even worse? Famine can drive mass human migration, and with anti-immigration politics already enveloping much of Europe, what happens if an anti-EU leader emerges and ascends to power in one or more member nations? What if Japan does cross the rubicon first and relatively soon? Will the Chinese just sit by with the yen plummeting?
While the Hunt Paradigm offers a clear analytical framework with which to understand the driving forces in the macro environment, the environment is hypercritical and vulnerable to a phase transition, or regime change. The two potential destinations from the current regime are either some combination of severe austerity and sovereign default, or politicians eventually overwhelming central bank independence and unleashing Gresham’s Law.
My base case has been that we would need to see at least one more large deflationary scare in order to usher in a paradigm shift. I am now more open to a potential path where global finanical war (and potenially a hot one eventually) and de-globalization result in a different path to regime change. Sustained multi-year supply chain problems, shortages, famine, and politicians’ moronic policies in response to such terrible human suffering could result in a shift in paradigm without a severe drop in consumer prices.
What would fiscal and monetary policy look like within the context of war, consumer inflation, and a recession/depression - a sort of stagflation on acid and meth? Hopefully, we do not have to find out, but to completely discount the possibility would be a bet against politicians’ stupidity and corruption.
Very interesting and thoughtful piece, thanks for sharing.