Commentary on Political Economy

Sunday 28 November 2021



Investors need to pay attention to the capital cycle

Markets are fragile and set to be highly volatile in 2022

Ewan White illustration of Merryn Somerset Webb column ‘Investors need to pay attention to the capital cycle’
© Ewan White

The writer is editor-in-chief of MoneyWeek

Nothing says Christmas to a money journalist more than the arrival of the first 2022 outlook reports from the financial institutions. I can therefore tell you with complete certainty that it is nearly Christmas — and that, according to most of those who make a living in the equity markets, you will have no need to spend it worrying about equity markets. There is, they say, more good news than bad.

The last few weeks have been pretty volatile, they say, but economies are still growing nicely. Household savings are high, unemployment is low and both those things bode well for consumption in 2022, as does the shift in favour of fiscal policy by governments (they are all big spenders now).

Supply chain bottlenecks are also likely to ease in 2022, something that will both allow a gross domestic product-boosting inventory rebuild and ease inflation — which markets aren’t much worried about anyway. We are also, as one note from Invesco puts it, “living in one of the most noteworthy periods of change in history”, with the digitalisation of everything creating extraordinary new industries and medical advances yielding astonishing new ways of treating human diseases.

And Covid? By next year it may be that the expanded use of high efficacy antiviral pills will have pushed it some way down everyone’s list of things to worry about. Add all this up and global growth is likely to be over 4 per cent next year — well above the norm for the past decade. That, we are also told, is just the kind of background that is pleasantly supportive of share prices.

The analysts at Barclays note that this year has been characterised by nonstop earnings upgrades — companies just keep doing better than we expect them to. That, they say, is likely to keep happening, partly because of the good growth but also because Covid has “crushed competition” — the way in which the pandemic has “disproportionately hurt small and medium-sized businesses” means that there may have been a shift in the share of income going to larger (listed) firms from smaller (unlisted) ones. So there it is: markets are tough enough to shrug most stuff off. You can go and get on with your Christmas shopping. Nothing to worry about here.

A lot of this makes total sense. But there are a few problems with it nevertheless. It ignores policy risk. It ignores price. And it ignores the capital cycle.

Take policy risk first. It might be that inflation slows next year. But the truth is that no one is entirely certain quite how inflation really works. It is entirely possible that central banks have had a hand in keeping inflation low over the past 20 years. But it is just as likely — even more likely — that low inflation has more been an effect of the wave of globalisation and cheap labour that followed China’s entry into the World Trade Organization in 2001 and the expansion of the EU.

If that is true, the idea that central banks can sort it out with the odd 0.25 percentage point interest rate rise is laughable. It may be that they must either accept the inflation or actually raise rates properly above inflation rates to control things. That isn’t in anyone’s forecasts.

On to price. Markets are fragile when they are expensive, as they mostly are now — largely because not all market participants really believe everything they write in their outlooks.

We all know that future returns are a function of today’s price. And that’s fine when we can kid ourselves that earnings will soon rise so much that valuations will lower themselves without us having to lose any money. But it isn’t fine when confidence takes even the slightest of knocks.

That’s something we saw very clearly on Friday with the market panic over reports of a new variant of the Sars-Cov-2 virus. If global markets were cheap and resilient, the fact that we don’t know if the new variant is a bad one (more infectious and more lethal) or a good one (more infectious but milder) would have had no effect on markets. That they are neither had the FTSE 100 down 3 per cent before lunch.

Finally, consider the capital cycle. There is a must-have book for every stage of market madness. Right now it should be Capital Returns: Investing through the Capital Cycle, a collection of essays edited by Edward Chancellor. The idea here is simple: you should look at how much capital is flooding into a sector rather than focusing on price alone. The more capital there is, the more likely it is that sector will see oversupply and price collapse.

Right now it is easy to see those sectors in which capital seems both free and unlimited (renewable energy being the obvious example), and easy to see where it has been neither for some time (for instance, old energy and mining). This is a combination that should make investing feel both harder (the risks are high) and easier (there are obvious opportunities). 

So what should the 2022 outlooks really say? That markets are fragile and set to be very volatile. That there might well be good times ahead, but that many prices already discount 20 years of partying. And perhaps that investors should bias their holdings towards cheaper sectors and, in particular, towards the capital-starved ones that it turns out we need as much as we ever did.


Inflation always punishes America’s left

Biden’s lowest-cost remedy is to get tough on Covid

© Matt Kenyon

America’s inflation hawks are always prone to crying wolf. Since they spent the post-2008 years forecasting hyperinflation that never arrived, it was no surprise that so few people sat up when they issued the same warnings last year. Now the hawks are right but for the wrong reasons. The recent US inflation surge has little to do with the Federal Reserve’s easy money, as they claimed. Democrats should nevertheless resist letting their ingrained scepticism cloud their sense of self-preservation. Sustained inflation could ruin their chances of holding on to power.

Historically, inflation has done far greater damage to leftwing governments than to rightwing ones, even when the blame should be evenly divided. Republican Richard Nixon did as much as his Democrat predecessor, Lyndon Baines Johnson, to stoke inflation in 1972 when he bullied the Fed chair, Arthur Burns, to cut rates in the build-up to his re-election. It was Jimmy Carter, a Democrat, who sent inflation-slayer Paul Volcker to the Fed, which contributed to Carter’s 1980 defeat. The beneficiary, Republican Ronald Reagan, tried unsuccessfully to get Volcker to cut rates in the build-up to his 1984 re-election.

President Joe Biden’s reappointment of Jay Powell last week ought to reassure markets that he values the Fed’s independence. Powell withstood pressure from the Republicans’ Donald Trump to keep rates low before the pandemic.

Yet popular wisdom — typified by Angela Merkel’s admiration for the “Swabian housewife”, suggesting balanced household budgets should be the model for national ones — will usually punish the left. In today’s case, with inflation hitting 6.2 per cent last month, America’s highest in a generation, Biden’s Democrats bear a lot of the blame. They made two errors that have come back to haunt them. The first was to pass a $1.9tn stimulus in March for which almost no economist was arguing.

Since the US output gap — that between the economy’s actual and potential output — was around $400bn, the bill was huge overkill. It meant there would be too much money chasing too few goods, which is the most common driver of inflation. The bill was also politically short-sighted since it forced Democrats to pare down the size of their far smaller but more merited “build back better” investment legislation. History might view that stimulus as a seminal Democratic mistake.

Biden’s second error was to bet that Covid-19 would fade with the vaccine rollout. Had that been the case, US consumers would have rushed out to spend their stimulus cheques on all the in-person services that were mothballed in the pandemic. But coronavirus did not vanish — partly because of the arrival of the more virulent Delta strain, but chiefly because a large minority of Americans refused to get vaccinated, or respect social distancing. Covid’s persistence meant consumers spent their expanded accounts on goods rather than services, which squeezed dollars into a narrower subset of normal consumption. Pandemic-related hits to the global supply chain did not help. But the primary culprit was the surge in demand.

As is often the case, Democrats fell victim to wishful thinking. Biden cannot be blamed for the warped defence of “freedom” that has stoked so much anti-vaxxer resistance since he took office. Protesters wearing yellow stars to liken themselves to the Jewish victims of Nazism are an example of grotesquerie with which no US president can reason. But Biden could have been far tougher on the vaccine holdouts — and still ought to be. The White House could also do a better job of explaining why high inflation is something the left should fear far more than it does.

Inflation’s frontline victims are those on fixed wages trying to save for their retirement, as well as retirees. After years of income stagnation, the US middle class ought to be enjoying the benefits of a tight labour market. But in spite of the highest wage growth in decades, inflation is even higher, which means blue-collar Americans are not feeling the upside to the recovering economy. Higher food and energy prices hit those who live from pay cheque to pay cheque the hardest. Inflation is good for debtors, which include America’s billionaire class, whose consumption is mostly funded by borrowing against unrealised capital gains. Contrary to leftwing folklore, higher inflation increases inequality, as the IMF has shown. Price stability is thus progressive.

As Biden knows, US presidents have little power to influence inflation once it is out of the bag. The temptation is to float gimmicks to make it look as if he is acting. Biden’s move last week to release 50m barrels of oil from the strategic reserve was a triumph of optics over substance. The new supply would account for just over half a day of global consumption. Oil prices actually rose on the news. Keeping Powell in place was the right step, though the Fed chair has been stretching the word “transitory” (in relation to inflation) to breaking point.

Which leaves Covid. Here is something Biden should have done already. Obvious steps include creating a federal QR identity for the vaccinated and stopping the unvaccinated from flying. The quicker coronavirus recedes, the faster America’s service sector will return to normal. The alternative could be higher Fed funds rates than are otherwise priced in. Faced with a trade-off, Biden should embrace the vaccine culture wars with zeal.