Our weekly commentaries provide Euro Pacific Capital's latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital.
The Year of Living DangerouslyWednesday January 12, 2022
2021 is now in the rear-view mirror and I believe that future financial historians may regard it as the year of peak speculation. While the history of American markets is littered with periods of irrational exuberance, none of those episodes can really match the current market for outright delusion and the blatant disregard for basic investment discipline.
Where to begin? It was the year that brought us “meme stocks,” companies whose share prices skyrocketed precisely because their business prospects were inarguably bleak. It was the year that launched thousands of new crypto currencies, more than quintupling the market capitalization of these new “assets,” (from $578 billion in November 2020 to more than $3 trillion a year later). Although few people can explain, or understand, the utility and features of these new currencies, the Bloomberg Galaxy Crypto Index nevertheless rose by more than 160% over the course of the year.
It was the year that brought us non-fungible tokens, otherwise known as NFTs, virtual assets that don’t exist in the real world but are discussed as if they were precious artifacts brought back from the future. According to data from DappRadar, NFTs sales in the third quarter alone were $10.7 billion, eight times the pace in the second quarter of the year. In 2021, people frequently paid thousands of dollars for virtual sneakers, and someone paid $450,000 to acquire a virtual piece of property in the “Snoopverse,” a digital world created by rapper Snoop Dogg.
It was a year that saw more than 1,000 companies (a record) offer initial public offerings (IPOs) on U.S. stock exchanges, more than four times the volume averaged over the last decade. These newly public companies raised a record $315 billion from investors. Never before has that total surpassed $200 billion. Even more unusual was that more than half of those IPOs were special purpose acquisition companies, or SPACs, black box investments that are simply stock ticker symbols in search of unproven businesses. Investors didn’t even know what they were buying, but they just bought anyway.
It was the year of record share buybacks, in which US companies bought nearly one quarter trillion dollars of their own stock in just the third quarter. It was a year of record mergers and acquisition activity, with global deal flow topping $5 trillion for the first time.
But apart from gains made in these esoteric asset classes, the most important area of peak speculation may have been in the broader stock market. The S&P 500 added 26.9% in 2021, which is more than double the average return over the past 10 years. While excellent, the results were by no means a record (there have been 11 years since the Great Depression in which the S&P delivered better returns); it is very unusual for stocks to do so well when they are not rebounding from significant previous declines.
The decree of the speculative mania can be seen in the ever-expanding price to earnings ratio that stocks currently enjoy. Most investors agree that the best way to judge relative stock valuations is to look at Cyclically Adjusted Price to Earnings (CAPE) ratio, which measures the average of adjusted earnings over a period of 10 years. This figure generally filters out short-term earnings and volatility to give a more reliable picture. The mean CAPE ratio for stocks (which goes back well over 100 years) is 16.9 (through 1/2021). The ratio currently stands at 38.87, as of 1/10/22. In the history of the market there has only been one period, the eighteen months between December of 1998 and September of 2000 (a period now referred to as the dotcom bubble), when CAPE ratios were higher than they are now. We know how that ended. But the extreme valuations of the dotcom bubble were achieved on top of a booming economy and historically high consumer confidence. That optimism is nowhere in view today.
After the dotcom bubble burst, the S&P 500 lost nearly half of its value and CAPE ratios contracted by almost 50%, from 43.5 in April of 2000 to 21.9 in October of 2002. Those declines paved the way for above trend gains from 2003-2007. When the Great Recession hit in 2007, stocks declined by 56% (between October 2007 and March 2009) and CAPE ratios declined by more than 50%, from 27.9 in May of 2007 to 13.3 in March 2009. These declines were also followed by an historic bounce back.
But the great results in 2021 were different in nature. In 2020, during one of the largest economic contractions in U.S. history, in many ways worse than the dotcom implosion and the Financial Crisis of 2008, stocks rose 16%. So, in 2021 there were no losses to recoup. It was all gravy on top of gravy. By the end of 2021, stocks had risen more than 40% from pre-Covid levels.
But peak speculation was not confined to Wall Street. The good times extended to Main Street, where, in November 2021, U.S. home prices had increased 18% annually, the largest increase since the end of WW II, and 4 percentage points faster than in any year during the real estate bubble of 2004-2007.
So, it was a great year to own just about everything. The question is, what is so extraordinarily good about an economy that justifies these broad increases? The answer, of course, is nothing. While GDP growth averaged more than 6% in the first half of 2021 (which is not particularly impressive given the 3.5% contraction in 2020), economists were surprised by the sharp deceleration to 2.2% annualized in the third quarter. They have also been surprised by the failure of workers to rejoin the labor force.
A study published in Fortune magazine in October 2021 found that among Fortune 1000 companies, 73% of CEOs anticipate the work shortage will disrupt their businesses over the next 12 months. The exodus of workers has been dubbed “the great resignation.”
Increases in asset prices in the current environment should be seen as strictly a monetary, not an economic, phenomenon. Since the beginning of the pandemic, the Federal Reserve has added more than $5 trillion in newly created dollars into the economy. And while the Fed has been engaging in this type of monetary magic for more than a century, its efforts of the past two years have dwarfed prior episodes. In 2020 alone, the Federal Reserve added more than $3 trillion to its balance sheet, almost double the record previously set during the Great Recession. And while the balance sheet expanded by “only” $1.7 trillion in 2021 (still more than any other year in history, besides 2020, and a record for a year not in recession), Keynesian theory holds that monetary expansions should happen only in recession, and contraction should occur in periods of growth. Keynes warned that monetary expansion during periods of growth would be doubly distortive. And that’s exactly what happened.
But unlike prior episodes of Fed activism, money creation in 2021 did not just push up asset prices. Last year, inflation (as measured by the CPI), came in at 6.8%, the biggest gain since 1982. (If we measured the price increases using the same methods used back in 1982, it’s likely inflation could be closer to 15%).
In the last few months, the Fed has finally had to admit that the inflation it had been describing as “transient” for more than a year was, in fact, far more persistent. As a result, it has promised that it will act decisively to bring inflation under control. But few economists and investors appreciate just how difficult and destructive that process would be given how deeply dependent the economy, financial markets, and the Federal Government are on ultra-low interest rates.
In order to slow, and ultimately reverse, inflationary pressure, the economic textbooks say that the Fed should deliver interest rates ABOVE the rate of inflation. Such a rate would discourage borrowing and lending, encourage savings, reduce demand, and bring down inflation. That’s what Paul Volcker did in 1980, when he raised the Fed Funds rate to nearly 20%, when inflation was running at 13.5%. Could anyone imagine what our economy would look like with 7% interest rates, let alone 10% or higher? At 7% Fed Funds rate, corporate bond and home mortgage rates would be at least 8%, if not higher. Clearly, rates like that would sharply impact stock and home prices. An overly inflated stock market would fall, perhaps steeply, and home prices would drop as financing costs increased from current low levels. Such asset price declines could push the economy into a depression that the Fed would have to fight with stimulative monetary policy.
Even worse might be the impact on the Federal budget. Even if just half of the $30 trillion National Debt had to be refinanced at 7% over the course of a year, the costs would add $900 billion in extra annual interest every year to the Federal budget. That’s almost as large as the $1.2 trillion infrastructure bill that was passed in 2021, the cost of which will be spread over many years. Financing just the extra interest might require sizable cuts to entitlements and large middle class tax increases, even as the economy may be mired in deep recession. No one at the Fed will be willing to deliver that kind of tough love.
Instead, they are hoping that one percent interest rates, arrived at the end of this year, will do the trick. I would argue that that is wishful thinking in the extreme. In fact, a 1% Fed Funds rate, when inflation was much lower than it is now, was the highly accommodative rate the Fed used to stimulate the economy after the 2008 Financial Crisis. How can that same rate now be considered tight enough to fight off the highest inflation in 30 years? Yet even the possibility of such a minimal reduction in stimulus is enough to spook Wall Street.
On Wednesday, the release of the Fed minutes from its December meeting revealed to investors that the Central Bank is preparing fully to end its quantitative easing bond purchases, and possibly deliver its first quarter point rate increase by March of this year. It also raised the possibility of raising rates as much as four times (for a total of 1% percent) this calendar year, and even possibly conducting active operations to reduce the size of its $8.8 trillion dollar balance sheet. This news helped push the Dow Jones average down 600 points.
But such moves by the Fed, if it is even able to implement them, will be a fraction of what would be needed to bring inflation back down to the Fed’s 2% target. And what exactly will the Fed do if its loose policies start to take a bite out of the stock market or the economy as they did in late 2018? At that point, the Fed’s commitment to interest rate normalization and balance sheet reduction, which had pushed yields on 10-year Treasury notes above 2.5% for the first time since 2011, ran smack into the reality of a bear market in stocks and a slowing economy. After less than six weeks of a market sell-off, the Fed caved completely. As it always has over the past 40 years, the bankers at the Fed, who are really just politicians in disguise, chose short-term expediency over long-term health. By January 2019, all of the Fed’s carefully telegraphed plans of monetary discipline had been totally abandoned.
Three years later, after the hollowing out of the Covid economy and the massive stimulus needed to keep it inflated, the Fed faces a far higher mountain, with far greater cliffs. My guess is it will fold like a lawn chair at the first sign of real trouble.
At that point, investors should finally realize that the Fed is powerless to control inflation. If another recession comes along, the size of the stimulus needed to combat it will rise exponentially. The current $8.8 trillion dollar balance sheet may become $20 trillion, with no end in sight. If investors had any sense at that point, they might consider abandoning the dollar, and refuse to buy Treasury debt that pays 5% or more below the rate of inflation. If we are seeing 7% inflation with a rising dollar, imagine how high it could be if the dollar were falling, particularly as we continue down the road of record trade deficits. (The shrinking labor force means that we import an even larger percentage of the goods we consume, making us even more vulnerable to rising import costs).
In other words, the Fed has painted itself into a corner, and the room for maneuver is getting smaller and smaller, even as the stakes are getting higher and higher.
In the meantime, those lucky enough to own assets are enjoying one more spin on the merry-go-round. Only about a week into 2022, shares of Gamestop, the posterchild of the meme stock craze, soared when the company announced that it was jumping into the NFT business. Meme stocks and NFTs in one convenient ticker. All the pretty horses!
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