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GlossaryThe Outlook and Ms. Eilish
September 26, 2021This is Part 2 of my answer to a subscriber who asked what the big picture “take-away” is, the outlook. If someone forwarded this to you, you can sign up here.
Over there, said Billie Eilish, wearing a baggy white T-shirt, shorts and hi-tops, waving toward a section in the crowd. In the VIP section, you guys doing all right?
Fu@# the VIPS! Boomed the crowd packed around me.
The anger came from some place deep (I’m paraphrasing, I didn’t record the precise words). This emotion may come from the fact that young people probably face slow, volatile, economic growth, a chaotic information landscape and see problems like global warming as both scary and without an obvious solution. Polling seems to confirm this sentiment. Given that, the biggest investment risk is less a shift in inflation and more a radical shift in the system—and not just in the US.
When it comes to investing, I follow a practice. Here are the steps:
a) Have a framework (covered in Part 1 last week) to make an investment decision,
b) Guess what future conditions will look like, including possible low probability events,
c) Know how different investments—stocks versus bonds—react to events,
d) Look at what an investment costs and how it’s priced relative to other assets—ideally you find a Mercedes priced like a Hyundai.
Today, I will cover “b,” the outlook, and in subsequent posts will cover the rest. Disclaimer: This is not investment advice. You can and will lose money on investments. I’ve lost money on plenty of investments.
The Outlook
We are in a pandemic, which will pass. What follows next will likely be a period of low growth that self-reinforcingly feeds political instability even as innovation continues to eliminate the middle-man. I come up with this by unpacking growth, inflation and the risk of a systematic break.
Growth
Growth, as I noted last week, measures spending. A pandemic creates volatile swings in spending. Spending on hotel rooms essentially drops to zero, while demand for face masks explodes. While we are in the pandemic it is tough to understand what exactly is going on with the economy because the dials on the dashboard keep swinging around so much, like a plane going through really bad weather.
Longer term, growth has three parts: income, borrowing and demographics.
a) Income goes up or down depending on the job you hold (brain surgeon versus butcher), overall employment and inventiveness, or productivity. Inventiveness is producing more with less, the tractor replacing a plow. Over the last decades, US productivity has grown at about 2% a year. This creates a speed limit on growth. The IT revolution is having a huge impact on inflation (more on this below) but does not appear to be as economically transformative as past inventions, like electricity.
b) Debt is spending tomorrow’s money today. Debt levels are now high in most major economies. It means that future has already been spent. The chart below by Rose puts the dollars of debt into perspective.
c) Demographics. In the next decade, the global population will grow in places like Nigeria, India and Pakistan and shrink in Europe, Japan and China. As an investor, you care about the growth of places with safe asset markets. On that count, the US, Canada and Australia have a structural advantage because they have systems that both attract and integrate immigrants well, even if their birth rates are similar to Europe.
In sum, growth probably isn’t going to be very fast, but will be slightly faster in places that attract immigrants and encourage industry disruption, absent a radical, unexpected shift in productivity.
Inflation
Inflation is the average price of the stuff you buy. It is currently high, like 4% or 5%, mostly because of pandemic-related supply-chain disruptions, like temporary port shutdowns. Inflation matters because your money buys less. When I was growing up, the grocery bill was around $100 plus. Now it is $200 plus. Same food, but my dollars buy less. You can find a more fulsome discussion of inflation in Deflationary Locusts.
I suspect inflation will fall as the pandemic supply chain blocks ease, population growth slows or in some cases shrinks and because much of today’s innovation is about eliminating the middle-man. Consider Amazon, which existed for almost a decade (94-03) without making a profit, systematically picking off the middle-man, financed with a soaring share price. The deflation Amazon created allowed the central bank to run easy policy, further boosting Amazon’s share price, what I referred to as our stock market addiction.
This process continues (Carvana to car dealerships, Upwork to accountants and graphic designers, etc). The big areas of the US that have not yet succumbed to this are education and medical. Covid may change this. If learning is partially on-line, maybe one great calculus teacher can replace thousands of mediocre ones? If so, that would reduce education costs and likely boost quality.
A System Breakdown
Low growth weakens confidence in the political system, which then fuels the angry burst evident at an otherwise upbeat and fun Eilish concert. Wealth gets destroyed when political systems fracture. Civil wars are more frequent when growth is low, the government is seen as unresponsive, rule of law is weak, antagonists are unable to negotiate and information channels are chaotic.
This seems to fit a number of countries, including the US, parts of Europe and China. For instance, in the US, inhabitants on the wealthy coasts have a political agenda at odds with those who live in rural areas, who are are over-represented in the Senate. This tension on everything from election integrity to abortion risks creating a Constitutional crisis. In authoritarian countries like China the slower the growth gets, the tighter their controls need to be, which also threatens the system.
Over time, the list of countries that have experienced such a break is long and is most evident in their currency, which typically becomes worthless when populist parties undertake irresponsible monetary and fiscal policies. Obviously, a scary thought. The chart below from Rose shows currencies in log scale against gold (as a reference point). The point: when the system breaks, wealth gets wiped out. The groceries don’t cost $200, they cost $20,000, which is a risk I consider in my asset allocation. More on that, later.
