Monthly Archives: December 2015

Most Popular Articles of 2015

December 22, 2015

top 10

As 2015 draws to a close, I wanted to thank all the readers who have supported The Money Enigma in its first year and highlight some of the articles that readers found most interesting in 2015.

#10: The Value of Money: Is Economics Missing a Variable?

Just slipping into the Top 10 list is an article regarding the “value of money”. If money has value and if the value of money is an important factor in the determination of prices in money terms, then why doesn’t economics officially recognize the value of money as a variable in its equations?

#9: Monetary Base Expansion: The Seven Stages of Addiction

Is printing money our great modern addiction? In this article it is argued that there are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.

#8: What Determines the Price of Gold?

Does 2015 represent the low point for the gold price? While there are many theories regarding the price of gold, the view of The Money Enigma is that there is one key driver of major bull and bear markets in gold: long-term economic confidence. Bull markets in gold tend to begin when people are too optimistic about the long-term economic future of society.

#7: The Case for Unwinding QE

While the near-term costs of reducing the monetary base may seem to outweigh the benefits, there is a terrible risk associated with the path of inaction.

#6: What Factors Influence the Value of Fiat Money?

What determines the value of money? Why does the value of money fluctuate and tend to fall over long periods of time? And why does the value of a fiat currency sometimes fall precipitously? The view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. Over long periods of time, an increase in the monetary base relative to real output will reduce the value of the proportional claim and lead to rising prices across the economy. Over short periods of time, it’s all about changes in expectations…

#5: Does “Too Much Money” Cause Inflation?

Does printing money cause inflation? And if it does, why didn’t QE trigger inflation? This popular article tackles these complex issues and argues that it is not “too much money” per se that causes inflation, but the expectation of “too much money” relative to future output that matters.

#4: Why Does Money Exist? Why Does Money Have Value?

One reader commented that this post “should be studied line by line”. Frankly, I couldn’t agree more.

#3: Government Debt and Inflation

Government debt has a critical role to play in the determination of the price level. More specifically, the market’s assessment of the sustainability of government debt and deficits has a direct impact on the value of the fiat money issued by that society and, consequently, the rate of inflation.

#2: The Risk of Hyperinflation in the United States

This very popular article asks a simple question: “Is there a risk of hyperinflation in the United States?” Ultimately, fiat money is only as good as the society that issues it…

#1: A New Economic Theory of Price Determination

The most popular article of 2015 challenges the fundamentals upon which modern economics is built. The most important article of the year and a must read for those that care about the science of economics…

Gold and Interest Rates: Interview with Malcolm Palle

Earlier this week, I spoke to Malcolm Palle at www.miningmaven.co.uk about the outlook for gold in a rising interest rate environment.

As discussed in one of my recent posts, “Can the Gold Price Rise as the Fed Raises Interest Rates”, I believe that the first rate rise by the Fed could mark the low point for the gold price and the beginning of a new bull market in gold.

Malcolm and I discuss the rationale for this view in the Mining Maven interview which you can listen to below.

Five Myths and Misconceptions of Modern Economics

December 15, 2015

top 5

 

Myth #1: Supply and Demand Determines the Price of a Good

The first misconception of modern economics is that supply and demand for one good determines the price of a good. The view of the Money Enigma is that the price of one good in terms of a second measurement good is determined by both supply and demand for the first good and supply and demand for the second measurement good.

Price Determination Theory

Consider the following example. Imagine that we live in a barter economy with two goods: apples and bananas. Does the price of apples in banana terms depend on (a) supply and demand for apples, or (b) supply and demand for bananas?

The answer is (c), “both”.

Think about it this way. What would happen to the price of apples in banana terms if there was a sudden shortage of bananas?

All else remaining equal, if there was a sudden shortage of bananas, then bananas would become more valuable. Therefore, it would require fewer bananas to acquire one apple and the price of apples in banana terms would fall. Although there has been “no change” in the market value of apples in an absolute sense, the price of apples falls because the measurement good is now more valuable.

In other words, the price of apples in banana terms depends upon both supply and demand for apples and supply and demand for bananas!

The myth that the price of a good is determined solely by supply and demand for that good has sustained itself for a long period of time because it is based on a half-truth. Supply and demand for a good does determine the market value of that good. But the price of one good, in terms of another, depends upon the market value of both goods being exchanged. What determines the market value of the second good? Another set of supply and demand!

The traditional representation of the supply and demand paradigm, with price on the y-axis, obscures the true nature of price determination. At the most basic level, a “price” is nothing more than a ratio of two quantities exchanged. This ratio of exchange is determined by the relative market value of the two goods being exchanged.

By definition, we can not measure a relative relationship between two goods unless both goods possess the property being measured, i.e. the property of “market value”. Both goods must possess the property of market value and, therefore, there must be two independent market processes at work.

Price as Ratio of Two Market Values

More specifically, supply and demand for the first good determines the market value of the first good. Supply and demand for the second measurement good determines the market value of the measurement good. The price of the first good in terms of the measurement good is a relative expression of the market value of both goods and, therefore, is determined by supply and demand for both goods.

Price Determination Theory

The theory that every price is determined by two sets of supply and demand is explored in many recent posts including “A New Economic Theory of Price Determination” and the popular “Is The Price of Apples Determined by Supply and Demand for Bananas?”

Myth #2: Supply and Demand for Money Determines the Interest Rate

The failure of economics to develop a comprehensive model of microeconomic price determination left the door open for another economic myth to be created. In the early 20th century, Alfred Marshall described the simple notion that supply and demand for a good determines the price of that good. However, if this is the case, then what does supply and demand for money determine?

This apparent hole in Marshall’s price determination theory was filled by John Maynard Keynes who argued that supply and demand for money determines the interest rate: a misleading and dangerously simplistic idea sits at the heart of modern macroeconomic theory.

This second economic myth has sustained itself for nearly a century because, at least superficially, it seems quite credible. For example, if I ask to borrow money from you, then what is the “price” of that money? One might argue that the price of that “money” is the interest rate that you charge me.

The problem with this example is that it confuses the “price of money” and the “cost of credit”. When someone borrows money from another person, then that act creates a credit instrument and the cost of that credit is the interest rate. We could call the interest rate the “price of credit”, but really it isn’t a price at all. Why? Technically a “price” is a ratio of exchange, i.e. a quantity of one good for a quantity of another.

The “price of money” is a ratio of exchange, not an interest rate. Technically, money doesn’t have just one price. Rather, money has many prices, depending upon which measurement good you are using to measure the value of money. For example, we can measure the price of money in terms of apples, or bananas, or in terms of a basket of goods. In each case, the “price of money” is a ratio of exchange reflecting how many units of a good must be exchanged for each unit of money.

Moreover, the price of money is determined by two sets of supply and demand. For example, the price of money in apple terms is determined by both supply and demand for money (i.e. supply and demand for the monetary base) and supply and demand for apples. Conversely, the price of apples in money terms is determined by both supply and demand for apples and supply and demand for money.

Price Determined by Two Sets Supply and Demand

As discussed in the earlier section on price determination, every price is a relative measurement of the market value of two goods. In order for money to be accepted in exchange, it must possess market value. The market value of money is determined by supply and demand for money, or more specifically, supply and demand for the monetary base.

In summary, supply and demand for money determines the market value of money, not the interest rate. The market value of money plays a key role in determining the price of all goods in money terms: all else remaining equal, as the value of money falls, the price of all goods in money terms rises. In contrast, supply and demand for credit (the act of borrowing and lending money) determines the interest rate.

The theory that supply and demand for money determines the market value of money, not the interest rate, is discussed further in “Supply and Demand for Money: Where Keynes Went Wrong”. The notion that money possesses the property of market value and that the value of money plays a role in price determination is discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

Myth #3: Inflation is Caused by “Too Much Demand”

Both of the misconceptions described earlier have led, at least indirectly, to the creation of a third economic myth: inflation is caused by an overheating economy.

The idea that the primary inflationary risk faced by the economy is an excess of aggregate demand is a fundamentally Keynesian view and one that draws primarily on the experience of the Great Depression. In essence, Keynesians believe that if too little demand created deflation in the 1930s, then too much demand must be the primary cause of inflation.

Surprisingly, economists still cling to this notion despite the fact that the empirical evidence for this contention is poor. Anecdotally, some of the strongest economic periods in the last century, for example the 1990s, were characterized by low and falling levels of inflation. In contrast, some of the weakest economic periods, such as the 1970s, were dominated by high levels of inflation.

From a theoretical perspective, the problem for Keynesian economists comes back to misconception #2, namely that supply and demand determines the interest rate. In the Keynesian view, the risk to inflation is that the Fed lowers the interest rate too far and this leads to an overheating economy and prices rise.

In contrast, the view of The Money Enigma is that supply and demand for money determines the market value of money. The real risk associated with creating too much money is that it leads to a fall in the market value of money. As the value of money falls, prices in money terms rise.

Ratio Theory of the Price Level

Ratio Theory of the Price Level states that the price level is a relative measure of the value of the basket of goods in terms of the value of money. In the short term, it is debatable as to whether it is the numerator or the denominator in the equation above that matters more.

However, if we step back and think about what drives prices higher over long periods of time, it is very hard to imagine how “too much demand” could be the driving force. After all, basic microeconomic theory tells us that “too much demand” today will generally be met by an increase in supply at some point in the near future. Therefore, any rise in the value of the basket of goods, as measured in absolute terms, is likely to be temporary in nature.

Rather, the view of The Money Enigma is that the primary driver of inflation over long periods of time is not “too much demand” but rather a decline in the value of money. If the central banks grows the monetary base at a rate exceeding the growth in real output, then the value of money will decline and prices, as expressed in money terms, will rise.

The relationship between too much demand and inflation is discussed at length in a recent post titled “Does Excess Demand Cause Inflation?” The idea that it is the value of money, not excess demand, that drives inflation over long periods of time is described in another post titled “Why Do Prices Rise Over Time?”

Myth #4: Inflation is Caused by “Too Much Money”

In the last section, it was argued that, over long periods of time, the primary cause of inflation is growth in the monetary base that exceeds growth in real output. However, over short periods of time, the view of The Money Enigma is that inflation is not caused by “too much money” per se, but rather “expectations of too much money”.

This may seem like a subtle distinction, but it is a very important one in practice. For example, it can explain why the quantity theory of money works in the long run, but not in the short run.

The view of The Money Enigma is that money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society. Therefore, the value of money, and consequently the price level, depends primarily upon long-term expectations regarding the future levels of real output and the monetary base.

If people are optimistic about the long-term economic future of society, then they might reasonably expect solid real output growth and restrained levels of growth in the monetary base. This combination of expectations supports the value of money today and keeps a lid on prices as expressed in money terms.

However, if people suddenly become more pessimistic about the long-term future, then they might reasonably expect real output growth to stagnate while monetary base growth keeps climbing. In this scenario, the value of money can decline sharply.

In other words, it is not the amount of money that is created today that drives the value of money, but rather expectations regarding future levels of money creation.

This phenomenon can help to explain why the massive monetary base expansion that has been experienced over the past seven years has not led to a significant decline in the value of money and a commensurate rise in prices. In essence, most market participants still believe that the monetary base expansion by the Fed is “temporary” in nature, i.e. quantitative easing will be reversed eventually. The current risk for markets is that the Fed stalls on the process of monetary policy normalization and fails to reduce the monetary base. In this case, the value of money could decline sharply and inflation could surge.

For those that are interested, the relationship between and inflation is discussed in several posts including “Does Too Much Money Cause Inflation?” and “A New Perspective on the Quantity Theory of Money”.

Myth #5: Government Debt Doesn’t Matter

One of the most popular misconceptions among economists and policy makers today is that the accumulation of government debt has little to no impact on the value of money and inflation. Indeed, the popular view among some noted economists is that higher fiscal deficits are the best solution to any economic slowdown, even at a time when government debt as a percentage of GDP keeps climbing to new post-War highs.

In contrast, the view of The Money Enigma is that the excessive accumulation of government debt has a critical role to play in the determination of the value of money and, consequently, the rate of inflation.

The key to understanding the relationship between government debt and inflation is the notion that money is the equity of society.

In essence, the view of The Money Enigma is that society faces very similar financing options to a typical corporation. When a company needs more funds, it can either issue debt, a fixed claim against its future cash flows, or it can issue equity, a proportional claim against its future cash flows. If a company issues too much debt, then this can begin to have a negative impact of the value of its equity, particularly if the company’s cash flow growth doesn’t match original projections.

Similarly, when a society needs more funds to finance government deficits, it can either issue debt (government debt) or it can issue equity (expand the monetary base). Money, the equity of society, represents a proportional claim against the future output of society.

Just as a corporation can get itself in trouble with debt and devalue its equity, so society can take on “too much debt” which, in turn, leads to a debasement of money. In essence, once it is perceived that a government has issued too much debt, then people begin to expect that (a) output growth will slow in the future, and (b) base money creation will accelerate in the future. This combination of expectations will damage the value of a proportional claim on the future output of society, i.e. it will lead to a fall in the value of money and a rise in prices.

Value of Fiat Money

Ultimately, fiat money is only as good as the society that issues it. As a society approaches bankruptcy, the value of the money issued by that society becomes worthless. Nowhere is this concept more evident than in extreme cases of hyperinflation such as occurred in Zimbabwe in the 2000s.

The relationship between government debt and inflation is one of the most complicated subjects discussed by The Money Enigma. Readers who are interested can read more about this topic in “Government Debt and Inflation” and “Does the National Debt Impact the Value of the Dollar?”

Author: Gervaise Heddle

Can the Gold Price Rise as the Fed Raises Interest Rates?

  • What is the relationship between the gold price and interest rates? Can the gold price rise in the face of rising nominal interest rates? And is it possible for the next bull market in gold to begin as the Fed normalizes monetary policy in 2016?
  • The conventional view is that gold prices fall as real interest rates rise. Therefore, most market commentators believe that the gold price will remain under pressure as the Fed raises interest rates in 2016.
  • In contrast, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed could mark the start of the next bull market in gold.
  • First, markets are discounting mechanisms. Markets have long-expected the first interest rise by the Fed and, after much delay, it would seem that the moment is finally upon us. Various speculators have taken a negative position on gold in anticipation of the event and these positions may be unwound in the months ahead as gold speculators “sell the rumor and buy the fact”.
  • Second, the view of the Money Enigma is that the primary driver of the gold price (in USD terms) is confidence in the long-term future of the United States, not the level of real interest rates. More specifically, the gold price tends to peak when people are most pessimistic, and the gold price tends to bottom when people are most optimistic about the long-term economic future of society. Today, most market participants are extremely optimistic about the future of the United States, but this confidence will be challenged as the Fed begins to unwind nine years of highly accommodative monetary policy.
  • The third and related reason is that the process of policy normalization by the Fed may trigger a sudden rise in the rate of inflation. The view of The Money Enigma is that the value of fiat money is driven by confidence. Fed policy over the past twenty years has enabled a bubble of overconfidence to develop regarding the long-term prospects of the United States. If the Fed begins the process of policy normalization and is forced to stall or defer this process due to unfavorable market and/or economic conditions, then confidence in the United States may be damaged and the markets could be caught off guard by a sudden surge in inflation.

December 8, 2015

gold bull bear

Is There a Light at the End of the Bear Tunnel?

Gold has been in a bear market for nearly five years. Since gold peaked in August 2011, the gold price in USD terms has nearly halved.

Interestingly, this collapse in gold and gold equities has occurred during a period in which both fiscal and monetary policy can only be described as highly accommodative.

On the fiscal side, most developed countries, including the United States, continue to record budget deficits and government debt levels as a percentage of GDP continue to climb. On the monetary side, the Federal Reserve has, at least for now, stopped additional rounds of quantitative easing, but globally both Japan and Europe continue to expand the monetary base. Moreover, none of the major central banks have begun to unwind their bloated balance sheets.

Perhaps more surprisingly, gold has just suffered one of its worst bear markets in history before a single major central bank has their benchmark interest rate even once. In most developed countries, short-term interest rates have been stuck at zero for much of the past five years. Yet gold, which supposedly is a beneficiary of a negative real interest rate environment, has been pummelled.

Clearly, all of this creates a concern for gold investors. If the gold price can’t rally in an environment of monetary excess, then how will the gold price manage to climb in an environment where the major central banks are raising interest rates?

While the concern is a legitimate one, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed is likely to mark the end of the current bear market in gold and the start of a period of great economic uncertainty that will ultimately drive gold prices much higher.

The theme “the Fed is going to raise interest rates” has been hanging over the gold price now for at least a couple of years. At the beginning of 2014, many experts were certain that the Fed would raise interest rates by the end of 2014. It didn’t happen. But that didn’t stop investors from unwinding their positions in gold.

As the calendar flipped over into 2015, many experts were once again absolutely positively certain that the Fed would raise interest rates no later than June 2015 or, at the very latest, September 2015. Again, it didn’t happen. But once again, that didn’t stop an accumulation of negative sentiment against gold.

Indeed, one of the key problems for the gold price over the past couple of years is that everybody knew that the Fed would have to do something eventually. The Fed can’t just leave interest rates at zero indefinitely. Moreover, consensus is that easy money is good for gold and, therefore, rising interest rates must be bad for gold.

In this groupthink environment, it is a brave junior trader that decides to go long an asset that is an “obvious loser” on the Fed-tightening theme.

So, why might this change when the Fed does begin to raise interest rates?

Until the Fed actually raises interest rates, the question is largely one of “when” will the Fed raise interest rates? But as the Fed begins the process of tightening, the question will become more about the “pace” of tightening. For example, will the Fed raise interest rates by 25bp at each meeting or only every second meeting?

This may seem like a subtle change, but it’s an important one for investor sentiment. Arguably, it is much easier for the Fed to disappoint the markets on the pace of tightening once the process starts. For example, imagine that the Fed does tighten interest rates three times but then the US economy hits a “soft patch”. Suddenly, the Fed is on the back foot and stalls the tightening process. This stalling of the normalization process could easily create a much more positive trading environment for gold.

However, the real upside for gold comes at a slightly later point. At some stage, the Fed will need to decide what is “normal”, i.e. what is the end point of monetary policy normalization.

While many people don’t appreciate it, current monetary policy settings are exceptionally loose by historical standards. Since the 2008 crisis, the Fed has quintupled the size of the monetary base. The Fed has overtly manipulated markets to ensure that both short-term and long-term interest rates are well below historical norms.

If the Fed is genuine about “normalizing” monetary policy, i.e. if it raises interest rates back to historical norms and cuts the size of the monetary base down to roughly one-quarter of what it is today, then it will be a tough environment for gold.

The problem with this scenario is that is likely to involve a cost to financial markets and the real economy that is too great for Fed officials to bear. Indeed, the view of The Money Enigma is that the Fed will find that the economic and political costs associated with a genuine “normalization” of monetary policy are too high and the Fed will stop well short of this goal.

At the point the markets realize that the Fed will not deliver on its obligation to deliver monetary policy discipline, the price of gold is likely to surge higher. More specifically, the value of the US Dollar and other associated major fiat currencies will be undermined and investors will search for good alternatives to fiat, most notably, gold and silver.

In summary, the first rate rise by the Fed has been hanging over gold for the past three years. As the Fed does begin to raise rates, investors will begin to focus not on the start of the normalization process, but on the end of the process. Starting the process of policy normalization is easy for the Fed. Finishing it will prove much harder.

What Drives Bull and Bear Markets in Gold?

While a shift in investor sentiment may help the gold price in the short-term, the real question for long-term investors in the precious metals space is when will the bear market in gold end and the next bull market begin?

In order to answer this question, we need to establish a theory that can successfully explain what drives the major cycles in the gold price.

Many gold market commentators focus on the relationship between real interest rates and gold. The theory is that as the real rate of return on yielding assets rises, an asset with no yield, i.e. gold, becomes less attractive and, therefore, people will sell gold.

The empirical support for this theory is mixed. While it is true that there have been periods where negative real interest rates have been accompanied by rising gold prices, most notably the 1970s, this same price action is not be observed across all time periods.

From a theoretical perspective, it far from clear that real interest rates are the key driver of gold prices. Intuitively, there is a much better case to be made that the gold bull market in the 1970s had more to do with the declining fortunes of fiat currencies than it did with negative real interest rates per se.

So, if real interest rates are not the primary driver of bull and bear markets in gold, then what does drive the price of gold? This is a subject that was addressed at length in a recent Money Enigma post titled “What Determines the Price of Gold?”

In essence, the view of The Money Enigma is that the gold price is driven by confidence in the long-term economic future of society. As people become more optimistic about the long-term economic future of society, the gold price falls. As people become more pessimistic about the long-term outlook, the gold price rises. In this sense, the gold price can be considered to be a barometer of pessimism regarding the long-term future of the United States.

Why is the price of gold inversely related to confidence in the long-term economic future of society? Well, in simple terms, gold is an anti-fiat asset. When the value of fiat money is stable, gold tends to lose its attractiveness as an alternative form of money. However, when the major fiat currencies come under pressure, gold offers an attractive alternative. In this sense, gold is not a commodity, but rather an anti-fiat currency.

In turn, the value of any fiat currency is primarily determined by expectations regarding the long-term economic future of the society that issues that currency. In simple terms, fiat money is only as good as the society that issues it. In more technical terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. If people become more concerned about the long-term economic prospects of society, then the value of the fiat currency issued by that society declines. In this scenario, an anti-fiat asset such as gold becomes a more attractive alternative.

If we extend this theory to bull and bear market cycles in gold, then we can say that bear markets in gold tend to begin when people are overly pessimistic about the long-term future of society. Conversely, bull markets in gold begin when too many people in the crowd are wearing rose-colored glasses.

Arguably, the markets were quite pessimistic on the long-term economic outlook for the United States in August 2011 when S&P downgraded the credit rating of the US. Perhaps not surprisingly, this low point in confidence marked a peak for gold.

However, the key question for gold investors today is whether markets are too optimistic regarding the long-term future of the United States.

Over the few years, it is likely that any attempts by the Fed to normalize monetary policy will disrupt both financial markets and the real economy. More specifically, low short-term interest rates and quantitative easing have pushed down the required cost of capital for business. As the Fed attempts to unwind these policies, the required cost of capital will rise and this will put enormous pressure on asset prices and reduce the incentive to invest. [See “Has the Fed Created the Conditions for a Market Crash?”]

There is a very real possibility that the Fed’s actions over the next couple of years will pour a bucket of cold water over the markets and that this will lead to a loss of confidence in the long-term economic future of the United States. Such a loss in confidence would lead to a significant rise in the price of gold, even in an environment of rising interest rates.

In summary, the Fed’s actions are likely to hurt confidence and this should lead to a rise in the price of gold. However, even if this theory of gold and economic confidence is wrong, there is still one phenomenon that could surprise markets in 2016 and drive the price of gold to much higher levels: inflation.

The Outlook for Inflation

The consensus view today is that rising real interest rates are negative for gold and, therefore, the gold price will remain under pressure as the Fed raises interest rates.

Even if we accept the theory behind this view, i.e. the relationship between real interest rates and the gold price, the problem with this outlook in practice it assumes that inflation will not accelerate over the course of the next few years. While the Fed is likely to raise nominal interest rates over the next 18 months, there is a real risk that the Fed will find itself behind the curve as the rate of inflation accelerates.

Most market commentators think that the risk of acceleration in the rate of inflation is low because inflation can only be produced by an “overheating” economy and that the Fed will “put on the brakes” well before this occurs. Frankly, this represents a very one-sided and dangerously simplistic view of the price determination process.

What these commentators fail to remember is that the price level depends upon two key factors: the value of goods and the value of money. More specifically, the price level can rise for one of two reasons; either (a) the value of goods rises, i.e. the economy overheats, or (b) the value of money falls.

Most market commentators pay little or no attention to this second factor or what drives it, despite the fact that it is the value of money, not the value of goods, that is the primary driver of inflation over long periods of time. [See “Why Do Prices Rise Over Time?”]

The view of The Money Enigma is that the next few years could represent a turning point for the major fiat currencies.

Long-term confidence in the future of the major Western economies has provided tremendous support to their respective currencies, despite the borderline reckless behavior of both fiscal and monetary policy makers. But as these policy makers attempt to normalize policy, it is likely that the structural cracks in the economic story will begin to appear. As these cracks appear, market faith in the major fiat currencies will be tested, the value of the fiat currencies will decline, and prices, as expressed in fiat money terms, will rise.

A sudden surge in the rate of inflation in 2016 would provide the key catalyst that is required to end the bear market in precious metals and commodities more generally. Unfortunately, it would also lead to a serious decline in equity and bond markets, damage the market’s confidence in the Fed and add further pressure to those struggling to make ends meet.

Interview with MiningMaven

I recently had the privilege to be interviewed by Malcolm Palle who is co-founder of www.miningmaven.co.uk. MiningMaven does an excellent job of covering the small-cap mining space in the UK and Malcolm regularly interviews the leading CEOs in that industry.

During the interview, Malcolm and I discussed one of my recent posts “Confidence Game Creates a Dilemma for the Fed”, the outlook for interest rates and gold prices. You can listen to the whole interview by clicking on the image below.

 

Should Investors Hope for a Strong or Weak Economy in 2016?

The Money Enigma – December 1, 2015

strong or weak

  • There is a widely held view among equity investors that the S&P500 can hold its ground and possibly manage small gains in 2016 provided that the US economy continues to recover. While nearly all market strategists recognize that rising interest rates will create a “headwind” for the market in 2016, most of those strategists will argue that the stock market can hold its own provided that the economy remains robust.
  • The view of The Money Enigma is that this optimistic assessment ignores the fundamental principles of equity valuation. The value of any business is far more sensitive to its required cost of capital than to any near-term earnings potential. Therefore, as the Fed “normalizes” monetary policy and, in effect, raises the required cost of capital for all businesses, the negative impact on stock prices will far outweigh any positive benefit associated with a stronger economy.
  • Does this mean that equity investors should hope for a weak economy in 2016? It is certainly true that a weak economy in 2016 may delay the process of monetary policy normalization and thereby provide continued support to the global equity markets. However, a weak economy creates its own set of risks.
  • While many investors will worry about the impact of a weak economy on near-term earnings, the real issue that investors should focus on is how a weaker economy might impact long-term expectations regarding the future economic prosperity of the United States.
  • There are two reasons that equity investors should worry about how a recession might impact expectations regarding the long-term future of the United States. First, stock valuations are highly sensitive to expectations regarding long-term earnings growth. Second, and less obviously, the inflation rate is highly sensitive to expectations regarding the future of the United States.
  • If a weaker economy in 2016 damages long-term economic confidence, then this could precipitate a marked fall in the value of the US Dollar and a sudden rise in prices. A sudden surge in the rate of inflation combined with increased uncertainty around long-term earnings growth would spell disaster for the US equity market, particularly given the current state of elevated equity valuations and positive sentiment.

A Strong Economy is Good for Stocks, Right?

Conventional wisdom used to be that a strong economy is good for stocks and a weak economy is bad for stocks. But it seems that times have changed. The equity market treads water on good economic news and surges on bad economic news. So, what type of economy should equity investors hope for in 2016?

In order to answer this question, it helps to go back to fundamentals. More specifically, it helps to think about what makes a business valuable: the sum of its discounted future cash flows.

There are a couple of basic arguments to support the notion that a strong economy is good for stocks. First, a strong economy supports near-term earnings. This factor is particularly important for companies that have been struggling to generate profits and pay down high levels of debt.

Second, a more importantly, a strong economy tends to reinforce and promote optimistic expectations regarding the long-term future of the economy.

While most Wall Street analysts are obsessed by near-term earnings, the fact of the matter is that the stock market’s valuation is, at least theoretically, far more sensitive to expectations regarding its long-term earnings potential than its earnings in the next quarter. At the margin, a strong economy will tend to make investors more optimistic about the long-term earnings potential of the market and provide support to stocks. This rise in long-term confidence tends to be far more important to the market as a whole than any actual improvement in near-term term earnings.

The problem with our analysis so far is that ignores another simple but critical idea: the value of a business is determined by the sum of its discounted future cash flows. While a strong economy may promote confidence regarding future cash flows, we also need to consider how a strong economy may impact the discount rate that is applied to those future cash flows.

In today’s world of hyperactive monetary policy, markets tend to believe that a strong economy is bad for stocks and a weak economy is good for stocks. Why? Well, in simple terms, a strong economy encourages the Fed to tighten monetary policy, thereby raising the risk-free rate and consequently the required cost of capital for all businesses. In contrast, a weak economy encourage speculation that the Fed will maintain the current level of very low long-term interest rates, thereby pegging the long-term cost of capital at a low level.

It should be noted that this wasn’t always the case. Indeed, it is worth thinking about what has changed over the past thirty years.

In simple terms, prior to the current period of Fed hyperactivity that began with the introduction of QE1 in 2008, it can be argued that Fed policy had relatively minimal impact on the real long-term risk free rate and, therefore, a fairly small impact on the long-term cost of risk capital.

Prior to 2008, the Fed focused most of its efforts on controlling short-term interest rates. This manipulation of short-term interest rates did have a significant impact on bank lending activity and it certainly had some impact on the shape of the yield curve, but arguably the Fed’s interference in the long-term interest rate market was fairly minimal.

Why does this matter to equities? It matters because it is the long-term cost of risk capital that drives stock valuations and, one can argue, that prior to 2008, the Fed had very little direct involvement in setting this benchmark.

However, in 2008/2009, the Fed decided that the manipulation of short-term interest rates wasn’t enough. Therefore, the Fed started to explicitly manage long-term interest rates by creating money and buying long-term government securities, a policy known as “quantitative easing”.

Suddenly, the Fed plays a critical role in the determination of stock valuations and, therefore, a critical role in driving stock market direction. Whereas pre-2008 Fed policy was analyzed largely for the impact it would have on future cash flows, i.e. would Fed policy stall the economy, post-2008 we can see that Fed policy has a critical impact on both future cash flows and the long-term interest rate used to discount those future cash flows.

This combination of factors has created much confusion in the equity markets. In particular, it has led to confusion regarding whether a strong economy is good for stocks.

Long-Term Cost of Capital Trumps Near-Term Earnings

As mentioned at the beginning of this week’s article, there is a view among many Wall Street equity market strategists that the equity markets will be OK in 2016 provided that the US economy continues to recover. Their view is that improving earnings will offset any normalization of monetary policy by the Fed in 2016.

The view of The Money Enigma is that this perspective either demonstrates a lack of understanding regarding the key drivers of stock valuations or that these strategists are making rather optimistic assumptions about the path and timing of monetary policy normalization.

The key problem for the US equity market is that the long-term cost of capital used to discount future earnings is far more important than any improvement in near-term earnings. If the Fed begins to normalize monetary policy and the long-term interest rate rises, then this will have a profoundly negative impact on stock valuations.

Moreover, we know from a mathematical perspective that this negative impact will far outweigh any positive impact on valuations from an improvement in near-term earnings associated with a stronger economy. Stocks are long-duration assets and their valuation is far more sensitive to changes in the long-term discount rate than any change in near-term earnings.

Therefore, if a stronger economy does encourage the Fed to normalize monetary policy, then this will have a profoundly negative impact on stock valuations and overwhelm any improvement in near-term earnings.

However, a strong economy isn’t necessarily bad news if the Fed raises short-term interest rates but is careful to keep a lid on long-term interest rates. In other words, if the Fed raises the Fed Funds rate but uses its balance sheet to keep long-term interest rates at current low levels, then the equity market may be able to eek out another year of gains as earnings growth continues and the Fed continues to overly manipulate the long-term cost of risk capital.

For equity investors, this is probably the best near-term outcome. However, this “let’s pretend to normalize policy” path by the Fed does pose long-term risks. As discussed in previous posts including “The Case for Unwinding QE”, the Fed must eventually normalize the size of the monetary base (the Fed balance sheet) or it risks triggering a sharp devaluation in the US Dollar and resurgence in inflation.

In summary, a strong economy in 2016 will probably force the Fed to do something. Whether this action by the Fed will hurt the equity markets will depend on largely how aggressive the Fed is and, more importantly, whether it genuinely begins the normalization process or merely pretends to, i.e. raises short-term interest rates but continues to manipulate long-term interest rates.

Is a Weak Economy is Better for Stocks?

If a strong economy is likely to produce an adverse outcome for stocks, then should equity investors be praying for a weak US economy in 2016?

In the previous section we argued that a strong economy was bad for stocks because the negative impact of a rising cost of capital would overwhelm any positive impact from stronger near-term earnings. Therefore, if we simply reverse the logic, a weak economy should be good for stocks, right? Although there may be a hit to near-term earnings, this weakness will be mostly offset by hopes for a further reduction in the long-term risk free rate, i.e. more QE!

Superficially, this argument is fair. Indeed, it may be the case that this is exactly how events unfold. A weak US economy in 2016 puts the Fed on hold, thereby supporting the equity market at its current lofty valuation level.

The problem with this rather simplistic analysis is that doesn’t consider how a weak economy in 2016 might impact long-term expectations regarding the future of the US economy and the long-term earnings growth potential of corporate America.

While a strong economy in 2016 is unlikely to improve already optimistic expectations regarding the long-term future of the United States, a weak economy in 2016 could damage investor expectations regarding the long-term health of America.

In general, a weak economy should not represent sufficient cause in and of itself for a major rethink by investors regarding the long-term economic prospects of society. But the view of The Money Enigma is that a major recession in 2016 could trigger such a review. Why? Well, if a recession did begin in 2016, then it would be the first time that a recession has begun without any attempt by the Fed to raise interest rates or normalize monetary policy. In other words, investors may begin to feel that the Fed has missed the boat and they may begin to question the underlying structural health of the United States.

If a weak economy in 2016 damage optimism regarding the long-term economic future of the United States, then this could hurt equity prices in two ways.

First, and most obviously, if investors begin to believe that the economy will grow at a slower rate than previously expected over the next 10-20 years, then investors will be forced to lower their expectations regarding the long-term earnings growth rate for the market.

Historically, companies in the S&P 500 have grown their earnings per share at a rate of about 6% per year. However, if investors become more pessimistic about the long-term prospects of the economy, then they may need to lower this expected earnings growth rate, particularly given the current elevated level of corporate profit margins (see John Hussman’s work for more details on this point).

In theory, this lowering of long-term earnings growth expectations will have a much greater negative effect on stock prices than any near-term weakness in earnings that would ordinarily occur in a recession.

The second factor that could have a major negative impact on stock prices is more complex. In essence, the view of The Money Enigma is that the value of fiat money is inversely correlated to optimism regarding the long-term future of society. Therefore, if investor optimism regarding the long-term future of the United States is damaged, then the value of the US Dollar will fall and prices, as expressed in US Dollar terms, will rise.

In other words, a weak economy in 2016 could be the trigger for a sudden increase in the rate of inflation. Such an outcome could be devastating for equity markets that are priced to achieve low nominal expected returns, at least by historical standards. Moreover, a sudden increase in the rate of inflation in 2016 would definitely catch the Fed off guard and hurt the confidence of both bond and equity market investors.

Inflation and Long-Term Expectations

The consensus view among economists is that inflation in the US will only occur if the economy is strong. Moreover, most economists believe that a weak economy poses a greater risk of deflation than inflation. This quintessentially Keynesian view of inflation is terribly flawed and represents one of the great economic myths of our time.

The simple fact of the matter is that historical evidence indicates that episodes of high inflation (10%+ inflation) are more commonly associated with weak economic conditions than strong economic conditions as discussed in a recent post titled “Does Excess Demand Cause Inflation?”

The theoretical foundations for this phenomenon are complex but, in essence, the problem with the traditional Keynesian view of the world is that it only considers one part of the picture. Keynesian economics focuses on the impact of a recession on the market value of goods. But it forgets on key thing: every price is a relative measurement of two values. More specifically, every price in money terms is a relative expression of both the value of goods and the value of money. If a recession triggers a fall in the value of money and if that fall in the value of money is greater than the fall in the value of goods, then prices as expressed in money terms will rise!

Ratio Theory of the Price Level

The view of The Money Enigma is that the price level is a function of two values: the market value of goods and the market value of money (see “Ratio Theory of the Price Level”). The key to representing the price level in this way is isolating both variables by measuring each in terms of a “standard unit” of market value, an idea is discussed at length in “The Value of Money: Is Economics Missing a Variable?”

While economic weakness will almost certainly have a negative impact on the market value of goods (the numerator in our price level equation above), the view of The Money Enigma is that economic weakness can also impact the value of money (the denominator in our equation).

More specifically, the problem with recessions in fiat money regimes is that they can trigger a sudden collapse in the value of money. Why? Well, in simple terms, fiat money is only as good the society that issues it. More specifically, the value of fiat money is primarily determined by long-term expectations regarding the future economic prosperity of society. If that confidence is suddenly undermined, then the value of money can fall precipitously.

Prolonged economic recessions have a nasty habit of highlighting the key structural weaknesses of an economy. If next year turns out to be a much more difficult year for the US economy, then this could remind investors that the United States faces several long-term structural challenges, most notably its continued reliance on rising government debt and persistent deficits.

If economic weakness in 2016 does trigger a collapse in long-term economic confidence, then the results could be devastating for both the US Dollar and US equity markets. More specifically, a slump in long-term confidence could lead to a sudden jump in the rate of inflation and a decline in long-term earnings growth expectations. This combination would spell disaster for a stock market that is priced for perfection.

In summary, the best hope for equity investors in 2016 is that things continue much as they have done in 2015: the US economy muddles along and the Fed remains on hold. The problem is that the clock is ticking on this “new normal”: the Fed must normalize monetary policy eventually and, as it does, the US economy must demonstrate that it can grow without the Fed acting as life support.