While many draw comparisons to 1994’s Fed actions, rate rises, and the subsequent economic and market performance, UBS’ commodity team examines the five main drivers of that mid-90s disinflationary boom and how (or if) they are applicable in the US’ current new normal. Their findings “this may be a 1994 redux, but it ain’t no 1995 replay,” as they note, in fact, it’s a bear market waiting to happen. Every one of these processes is deflationary, not disinflationary. And they are self reinforcing. And deflation, in direct contrast to disinflation, is very bad for asset prices (with a serious equity and credit bear-market). So just as we have noted previously any taper will likely eventually lead to an ‘un-taper’ reflation effort (which will see gold once again strengthen) along with the exposure of the fallacy that the Fed really has become.
In commodity strategy we suspect that the US economy cannot hold up in the face of a higher cost of capital. That means we will likely see a serious equity and credit bear-market. We expect gold will base out and then start rallying. And then we will see a new attempt at Fed reflation.
In the past we explored the rising cost of capital that comes with Fed normalisation after years of easy money and building leverage. We highlighted how the current environment was similar to 1994 – a period that was very messy for bond markets, for emerging markets with current account deficits and for any crowded trades. But 1994 morphed into a US growth stock boom, and an emerging market bust over the mid- late 1990s. This note argues that the future will be very different from 1995-1998.
In commodity strategy – we work most of our analysis off mental models – flow diagrams that describe the key forces that drive sustainable and self-reinforcing trends in global macro.
The first chart shows the five principal forces that drove the mid-90s disinflationary boom.
The first element was globalisation. In 1989, 60% of the world’s countries were under free democracy. By 1998 that had risen to 90%. The fall of the Berlin Wall in 1989, combined with reform and democratisation in Asia was central to a 25% increase in the world’s workforce available to participate in global trade. The price of exports to the US fell in every year of the decade, raising US consumer spending power.
The second element is monetary policy. In the mid-1990s US monetary policy under Greenspan was both highly conservative in its anti-inflation approach, but incredibly loose in its attitude to credit growth. The relatively high cost of capital following the 1994 anti-inflation push set off a debilitating vicious circle in emerging markets, highlighted in the second chart – familiar to regular readers – it shows how the higher cost of capital in the US triggered capital outflows, tighter EM liquidity, deteriorating domestic lending, disinflation, rising real rates, more outflows and currency crises. All added to the falling price of commodities and goods exported to the US.
The second aspect of monetary policy combines with the third driver – financial liberalisation – to effect a complete disregard for the implications of powerful credit growth. We talk later about the fallout from that. But in the 1990s it meant that corporates and consumers could gear up, and spend and invest faster than the increase in their incomes and cash flows would warrant. And it meant assets – from houses to stocks – appreciated, further spurring consumer and corporate leveraging. Banks raised and broadened lending and increased their leverage.
The fourth driver was disinflation. The combined effect of anti-inflation policy, globalisation and emerging market inflation lowered nominal rates, and with it, it raised the discounted fair value of all assets; from land and housing, to cashflow from operations. And when a disparity showed up, an equity value not reflecting the low cost of debt to release it, the asset arbitrageurs would step in and accelerate the process. Assets rose in value. Consumers felt more confident.
The fifth driver was the social contract. All the benefits of rising assets, rising bank leverage, and rising confidence meant that governments came under minimal scrutiny as they began an unsustainable push to grow wealth and income transfers. A significant portion of those income transfers came to the officers of the court themselves.
The interconnecting arrows show that each element that contributed to the ’90s disinflationary boom reinforced each other element. It was one of the great self-reinforcing cycles. The circuit breaker was the combined Russian debt default and LTCM credit default. That was sufficient to break the US market, induce the Fed into an emergency 75 bp cut, and trigger an unwinding of short yen and anti- inflation positioning.
In the 18th and 19th centuries, it used to take 60 years for macro cycles to play out. It was the classic Kondratief wave. But with the rise of leverage, what took sixty years back then, now takes six.
So it’s worth revisiting the 90s boom…
…to ask whether the key drivers are getting ready to play out again.
First, globalisation. No. Globalisation appears complete. Barring North Korea, almost every country that can export and import goods and credit is doing exactly that. As a result, domestic wages in China have risen faster than productivity over recent years. Export prices from EM are no longer falling.
Second. Monetary policy is no longer anti-inflation. It is anti-deflation. The advantage of a clear anti-inflation policy is that, during a strong recovery, the rise in the cost of capital usually knocks out excessive speculation and companies that have too thin a return on the cost of capital. The result; Schumpeter’s creative destruction which leaves the economy in a more robust sustainable position. However, all that an anti-deflationary policy does is shuffle debt between holders and it leaves weak companies on a lifeline. It encourages more people and institutions to take on debt and to chase assets, rather than building self-sustaining cashflow businesses. The problem, then, is that antideflation policy, by promoting the accumulation of debt in weak hands and in businesses that struggle to make a return on the cost of capital, raises the likelihood of deflation in the future.
Third, financial liberalisation has turned 180 degrees. All new legislation we have seen in commodity strategy over the past five years has created direct and indirect incentives to banks to delever. In commodity strategy, we suspect that proposed legislation to regulate the world’s largest insurance companies has the potential to cause a notable deleveraging of high yield credit.
Fourth, wealth gains from disinflation have ended. When debt levels are sufficiently high, growth rates fall (yes, we think Reinhardt and Rogoff were dead right in principal, even if their sums weren’t). Inflation turns to disinflation then deflation. And when rates start to exceed potential nominal growth, debt spirals kick off. More on that later – the key point. We believe wealth from disinflation has maxed out.
Finally, the social contract has broken. A combination of demographics and excess debt leaves no scope for either promises of future income in transfer payments or public wages, or the continued provision of current services.
So this may be a 1994 redux, but it ain’t no 1995 replay.
So what is it?
In our view in commodity strategy, it’s a bear market waiting to happen. Every one of these processes is deflationary, not disinflationary. And they are self reinforcing. And deflation, in direct contrast to disinflation, is very bad for asset prices.