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‘Drowning in a Bubble Bath’

Financial markets today face the risk of drowning in a bubble bath of stagflation, with wealth – in the form of asset prices – rather than wages, the financial patsy. After over a decade of boom in long duration equities and bonds, investors risk having no hedge for a 1970s redux.

From the Roaring ‘20’s to ‘70’s Redux

So much for the “Roaring ‘20’s”. We now have a stagflation situation, whereby inflation and stagnation previously thought to be mutually exclusive are now concurrently prevalent. The global economy faces a series of worsening supply shocks – still widely underestimated and predicted to be  “transitory” - for which investors are ill prepared and central banks impotent to resolve. 

Sorry, Sold Out

The current energy crisis – likely to worsen over the winter months - is the latest in a series of shortages from shipping to semiconductors to hit the global economy. Markets have become too used to downturns being only demand led, where the safety valve for economic activity and financial markets has been the quick fix of more central bank monetary stimulus. When industries are sold out - unable to respond to demand - this requires an alternative solution and a different investor mindset. 

More supply required, not less demand

Central bankers are prone to recognising any supply led inflation as “transitory”, believing that these disruptions are soon resolved by market forces. But in a supply shock - such as those witnessed with OPEC in 1973 and 1979 - central banks are unable to come to the rescue: they have no tools to manage supply bottlenecks.  What is required is more capacity: capital formation in often old economy industries where investments today are chronically held back by a glamour-seeking stock market and ESG constraints. 

China no longer exports deflation 

The Chinese economy is still particularly energy intensive: as the world’s largest manufacturer China now consumes 29% of all global power generated. Despite having limited indigenous energy resources aside from coal, China finds itself exporting manufactured energy to the rest of the world. This makes no sense. 

Given this predicament, it is logical for the Chinese government to pivot its economy away from the export of energy intensive products, particularly when Western consumers may penalise China for those products being manufactured using energy from coal. Hence the recent curtailing of production or outright export bans in the Aluminium, Nitrogen Fertiliser and Steel, all amongst the most energy intensive industries.

This policy has huge, still largely unappreciated implications given that in these industries China constitutes over half of global production and has for the last two decades been the key global swing producer, like that of OPEC+ in oil. If supply of nitrogen fertiliser outside of China cannot rise to fill the gap – and currently European capacity has recently been mothballed by sky high natural gas prices – then a prolonged period of higher fertiliser prices will result in elevated food prices, itself a recipe for global political turbulence. 

The Chinese focus on security of supply chains – from energy to food to semiconductors – will soon hit home in the West, with corporates compelled to build their own, more expensive local supply chains. What the global economy has become so reliant on out-sourcing to China – but China no longer wants to export - now offers windfall profits to previously beleaguered Western producers. 

Central banks can’t fix supply led downturns

Financial markets largely still believe either that inflation is “transitory” or that central banks will induce another deep “Volcker recession” that kills the cycle: they are ill prepared for the third scenario of the 1970s redux.

It is worth remembering that it took over a decade of stagflation in the 1970s for there to be sufficient political will for monetary policy to induce the highly controversial painful shock therapy of 1981-2, bringing inflation back under control. How confident should investors be that today’s central bankers have the stomach for this fight? 

Quality stocks and government bonds may not be safe havens

In a demand led deflationary recession “high quality” equities and government bonds usually prove “defensive” for investors in terms of capital preservation. It is, however, a dangerous assumption – perhaps the biggest consensual mistake - to position in these assets in a supply-led downturn. 

During the 1970s, only Gold (+32%), Oil (+32%), Farmland (+13%) and Housing (+10%) beat the US annual average inflation rate (CPI +8%) over the decade, whilst government bonds and previously high-flying growth stocks – the “buy and hold” “Nifty-Fifty” of the 1960s bull market, thought to be impervious to downturns - performed disastrously. The lesson from the ‘70’s is that investors don’t pay high prices for long duration assets in an era of high inflation. 

After more than a decade long boom in long duration equities and bonds, investors now risk having no hedge for a 1970s redux.   

“Drowning in a bubble bath”

In the investment classic “Paper Money” published in 1981, the author “Adam Smith” noted that the ‘70s decade saw the worst bear market on record:  the value of US stocks on the New York Stock Exchange fell by 42%, worsting even the decade including the Wall St. Crash (1929-39) when the value of NYSE stocks fell by a more modest 31%. 

Whereas the 1929 Crash was a typical deflationary bust - with much more devastating mass economic consequences - the pain of the 1970s bear market fell on wealth rather than wages. For most of the population, it was an “invisible crash...masked by the age of paper money… houses went up… jobs didn’t disappear”:

“If the first crash [1929] was a dramatic leap for a sixty-story building, the second [1970s] was like drowning in a bubble bath. The bubble-bath drowning sounds less scary, but you end up just as dead” 

Like the ‘70’s, the risk is that today’s financial patsy is wealth – in the form of asset prices - rather than wages. This will bring few political tears. Investors face the risk not of falling from a skyscraper - the familiar deflationary crash - instead the stagflationary death of drowning in a bubble bath.  

The end of Davos Man, usurped by 1970s Redux

There is now a strong possibility that the 13-year bull market in growth stocks – and the 40-year bull market in rates - is over. Chinese autarky means globalisation is on the wane. Central bankers – unable to fix supply side constraints and unwilling to kill the cycle – may now have lost control. Into this void will step greater government taxation, regulation and heightened geopolitical risk. 

Pricing power has now moved to those commodity companies previously thought to be at the bottom of the food chain, who will now reap supernormal profits,  precisely because for over a decade all the capital went elsewhere. It’s about supply, stupid, not demand. 

The capital cycle has now come full circle: Davos man is dead, usurped by a 1970s redux. How well are you hedged?



Barry Norris
Argonaut Capital
October 2021