What is going to happen to the stock markets?
Updated: Feb 15
I am getting this question from a lot of people, clients, prospects, other advisors etc.
Forecasting the future is not easy, however, having learned a lot from Richard Koo and Ray Dalio, I would try to have an educated guess.
First, let set the table straight, we deal with Fiat money. Fiat currencies are produced by central banks and commercial banks’ credit expansion. It amounts to money creation from thin air, mainly to finance the Government spending. Issuing new fiat currencies sets into motion an economic boom, giving an illusion of prosperity. Consumption and investment expand, the economy enjoys higher corporate profits, increased employment, rising stock, housing prices, and generally all asset prices go up significantly.
Governments in particular take advantage of this new access to credit and run higher deficits, by borrowing more and sometimes reducing taxes further (Trump policies). Some leaders even become more popular getting closer to become some “little dictators” in democratic countries. Fiat money becomes the very elixir for the State to become “big, and truly deep”.
The other problem is that fiat money creates winners and losers, creates an unjust and unsocial distribution of income and wealth within society. It destroys the homogeneity of the society.
Is fiat money printing inflationary? Yes and No. Yes, for financial assets (S&P 500 had its best performance for the last 3 years period), not so much for goods and services, unless holders of cash stop hoarding and go on a buying spree. It is usually used to buy financial assets, so it inflates financial assets; this in return reduces discounts rates and results in higher saving rates for population and sometimes even for corporates.
Below, is the U.S. savings rates, and in 2020 - 2021 the savings rates were at the highest when U.S. Government had its biggest deficit; in fact, many people did not spend the “helicopter money” cheques, they saved it. As far as I understand it, U.S. families received three rounds of cheques or around $3,000 per round for a family of two with one child, more than $10,000 per family.
Some of the fiat money printing will be inflationary, however today’s inflation is not only the result of fiat money printing, but also of growing oil and gas prices (Oil companies made little investments in new drillings in 2020) and shortage of microprocessors. It is more of a supply and demand inflation.
However, if fiat money printing is abused, it would create hyperinflation – Turkey and Argentina are good examples.
The second important element when we try to figure out inflation is unemployment. I will refer again to United States. In fact, it is one of the elements close to heart for the Federal Reserve Bank (FED) when it decides its monetary policy. Low unemployment will result in wage increases to recruit more workers, increasing inflation, if there is no increase in productivity.
So far, the U.S. has not reached the 153 million workers peak from November 2019, and this gave the FED a bit of room to postpone interest rates increases.
Before starting the forecast, let’s state where we are. The US Government has run a huge deficit in the last 2 years, by helping companies through the COVID pandemic with grants, increased the spending on healthcare, and gave every American “helicopter money”. The debt to GDP ratio is now at 125%, an increase of 25% in two years, and total debt is $28 trillion. Inflation for last 12 months as measured by CPI was 7.5%. Employment is forecasted to get closer to 153 million this year, the maximum from November 2019.
The FED balance sheet is $8.935 trillion, of which $5.73 trillion are US Treasuries. It has grown by $1.449 in the last 12 months, and more than doubled from February 2020 when it was $4.16 trillion.
This money, tons of money are held in bank accounts of people and corporates in the U.S. or Overseas, plus foreign Central banks earning nothing at this moment. It costs nothing to hold this money, but there is no return on offer either. To give an example, Bank of America (BofA) received an additional $630 billion in deposits in the last two years made by people and corporates. Around $400 billion is held in cash overnight as it cannot be placed; this $400 billion represents 5% of the FED balance sheet. There are no attractive short duration fixed income securities for the bank to buy with them.
And here is the problem, if the FED increases interest rates, people and corporates owning this excess cash will look to earn some return. But there are not many other people and corporates, apart from the Government (which may start to cut expenditure too – we named this austerity previously) willing to borrow to pay a return. And even if they were, the people borrowing will return the money to other people and corporate bank accounts.
There is just too much fiat money around. And two things could happen, people starting an “extravaganza” shopping, borrowing, and spending every bit of money, which would result in double digits inflation and would take huge efforts from FED to stop it.
Most likely, we could repeat what happened in 2018, when with three FED increases, 10 years Treasuries reached 3.25% per annum, and FED balance went down by 10%. This time, we forecast that FED would not be able to increase interest rates that much, maybe two increases will suffice, and 10 years U.S. Treasuries would only reach 2.5% per annum at peak.
Money will slowly start to return to the FED, especially if foreign investors and other Central Banks keep their interest and buy more U.S. Treasuries with a return of 2% per annum (0% in real terms once inflation is considered). U.S. consumers, seeing the low return on cash, would increase their savings rate, worrying about retirement and cost of healthcare, and stop buying extravagant things, so inflation will return to 2% - 3% per annum, something acceptable. Some of these additional savings will end up in the stock market, which will help stock prices.
Once 10-year Treasuries will reach a peak around 2.5% per annum, we will then start to oscillate again as explained by Richard Koo in the QE Trap, or by Ray Dalio as “pushing on the string”.
However, this time, it will oscillate around a lower mean, maybe 2% per annum, instead of 2.5% per annum as in 2012 - 2019. And here is the word of caution, this approach cannot be repeated many more times from now, without a burst of the bubble (default).
As Ray Dalio says, China is challenging the status-quo, and would like to become a leader in the World with GDP double of the United States. If this happens the US Dollar and a few other currencies like GBP, EUR, Yen, or Swiss Francs could lose their “reserve” status, which is what stops a high inflation period now. It is the credibility given to the U.S. Dollar in particular which helps people to hoard it, which when lost, will cause people to react to fiat money similar as in Turkey or Argentina, where they would all want to spend on proper goods and/or the reserve currency at the same time (Chinese renminbi?).
The question was about stock markets. As Ray Dalio said, and proved so many times, stock prices (asset prices) depend on the availability of money and credit. We do not expect that availability of money will change by much, just temporarily. Like in 2018, maybe stock markets will finish negative at around -10% to – 12%. Maybe in 2022 we may have a low of -15% (or – 20%) or so. Within equity, some “value” stocks may continue to do well, others not so, as it is hard to pass inflationary increases from inputs to consumers and corporates who purchase their goods and services. Some growth and “high quality” stocks would probably continue to suffer, mainly due to a reduction in multipliers.
The one-million-dollar question: Once this happens, would stock markets go up again? Again, it depends on the availability of money and credit. If savers increase significantly (towards 10%) their savings rates, or FED starts again an expansionary balance sheet due to a recession in 2023, this is likely, otherwise not.
In short, fiat money creates a huge problem, too much money chasing either goods and services or an investment return. If they chase goods and services, we have high inflation, if they get hoarded and accept a mediocre return (like 0% real return per annum), FED balance sheet would start to slowly reduce, as some fiat money get retired.
Ray Dalio said in a recent interview: “Nevertheless, when the US dollar is compared against other currencies, it still shines like a safe-haven currency. Only when USD is measured against commodities, particularly soft commodities, that inflation from currency debasement becomes apparent.”
If it can maintain this “shine”, future FED expansion policies when needed will continue to work. We could expect another one, maybe no later than 2023. Our forecast is that “extravaganza” would not happen this time, and it would be quite easy to tame inflation. Some signals from China, which cut already interest rates, with a view to help economic growth, would also devalue renminbi versus USD, to keep exports flowing out. And with cheap imports from China, inflation should be under control!?
We shall not blame the FED and other Central banks for printing fiat money policy. They had no choice in 2008. In 2012-2014, Mario Draghi famously said: “we will do whatever it takes”. In 2020, FED bought even junk bonds (its Statute was not that clear on that, and it was masked as buying only “fallen angels” bonds, bond which previously were rated as investment grade!). It is not impossible to think that next time they would buy equities, to help prop-up asset prices.
As Woody Allen famously said, "One path leads to utter hopelessness and despair, the other to total extinction. Let us hope we have the wisdom to choose correctly."
From time to time, I am asked “what about a return to the mean”? These people usually refer to a return to lower P/E multipliers (or CAPE P/E), given that in their opinion the markets trade at “extreme” valuations, this will indicate that stock markets should drop by 50% or 60%. To this my reply is simple, historically, stock prices were not determined by some written down previously known P/E ratios, but by the “availability of money and credit”. I do not think this will change now. Given the higher availability of money and credit at this time than other times, it would be normal for stocks to trade at higher multipliers than other times.
One last word of caution: I am writing this in a period when Russia is flexing its muscle on Ukraine. There is a lot of uncertainty around the outcome between Russia and Ukraine, and it could lead to something like in 1973 when Oil prices tripled, and it did it again in 1978, resulting in 10 times increase over a decade. Such a high demand-supply inflation would be hard to curtail by monetary policies.
The overall conclusion is to own mainly real assets, not fixed income, or fiat money. Although volatile, real assets are a better store of wealth; this applies in both cases, high inflation, or stable inflation (2% per annum).
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.