An epic battle is looming among central bankers and economists around the world over the fate of money supply and the fate of the markets. The one side is best characterized by legendary investor and manager Jeremy Grantham of GMO who has been making the rounds on business talk shows warning of impending doom. On the other side we have Stephanie Kelton, Modern Monetary Theory (MMT) proponent, and pretty much everyone else.
This might not sound like much of a battle, but it’s mostly because Grantham is uttering predictions that aren’t allowed in polite company—specifically, that we’re in the middle of a historic bubble that is likely to pop this year.
It’s worth mentioning that not everyone who is lined up against Grantham’s thinking is an MMT devotee. To the contrary, this theory inspires great debate on its own, though supporters were buoyed by market behavior in 2020. Essentially, MMT holds that a handful of economies, particularly the U.S., have almost unlimited capacity to increase money supply without pressuring inflation.
As Alexander Oxenham of the Hilton investment team indicated in a recent article on inflation and interest rates, 2020 could very well be an anomaly that gives partial credence to MMT because of the specific circumstances related to the shutdown of the global economy. In the article Oxenham notes, “the Federal Reserve M2 money supply measure has increased 25% over the past year. But money supply is only half the story. The other half is velocity… You have 25% more capital flowing through the system but there’s been an 18% collapse in velocity.”
Those in Grantham’s camp acknowledge the rationale for strong market performance and the absence of inflation despite historic flows of money supply into the system. But where some pundits see this as sustainable, Grantham believes that we are simply inflating the bubble further, as he details in a recent policy article on his company’s website:
“This time, more than in any previous bubble, investors are relying on accommodative monetary conditions and zero real rates extrapolated indefinitely. This has in theory a similar effect to assuming peak economic performance forever: it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices. But neither perfect economic conditions nor perfect financial conditions can last forever, and there’s the rub.”
If it’s the case that “perfect economic conditions” cannot last, it puts the Federal Reserve (Fed) in a tight box given all it has already done to prevent a collapse of the financial system on par with what we experienced in 2008. The Fed has already indicated that it will allow the economy to “run hot” in 2021 to allow velocity to increase, which would theoretically increase inflation.
In fact, Raphael Bostic of the Atlanta Fed said as much in a recent statement intended to clarify the Fed’s position on money supply. Yahoo Finance reported that “[Bostic’s] modal forecast is for U.S. GDP to grow by 5% to 6% in 2021,” adding that he “emphasized that the Fed does not want to give off the impression that it is ‘eager’ to pull back monetary policy support.”
While Oxenham takes the Fed at their word that they are “willing to let the economy run hot before they withdraw support,” he does believe that “once jobs and inflation above stated goals recover, the Fed will absolutely begin to taper the bond purchases slowly.”
This type of withdrawal is what the markets focus on more than a general public that often equates money supply solely with stimulus. And where buybacks are concerned, Oxenham believes “the market will know when the taper is coming. And if markets incorrectly call the taper, the Fed will ‘jawbone’ the markets and lay down the hammer like they did last month and get fixed income markets back in line.”
Hilton Capital CEO Craig O’Neill introduces a more fundamental issue to the conversation. “As managers we have to be prepared for different outcomes based on the inputs that are available today,” says O’Neill. “Under one scenario, inflation does indeed pick up due to velocity, in which case we would continue to rotate into assets/sectors that should benefit in this environment. TIPs [Treasury Inflation-Protected Securities] in fixed income, financials and energy sectors in equities are areas that could be emphasized. If velocity does not pick up and inflation remains tepid, it means the economy is not getting the boost from all the stimulus, then you could see growth stocks continue to perform well.”
O’Neill’s point strikes at the heart of the dilemma faced by central banks and policy makers around the globe. Global financial leaders are grappling with strange circumstances such as the rise of digital currencies like Bitcoin that have seen a rush of new investments on bets that such seismic influxes of capital into economies throughout the world will result in massive global currency devaluations.
As Robert Guy proposes in a recent Financial Review article, “In an era when monetary policymakers are trying to out-dove each other, where once unconventional policies—such as quantitative easing and yield curve control—have become standard operating procedure, it's easy to understand why more capital is seeking an exit from, or a hedge against, a system where central banks have gone wild.”
The rise of digital currencies to protect against currency devaluation and the questionable valuations in equity markets are precisely what worry investors like Grantham and challenge portfolio managers such as Oxenham. As Grantham notes in his recent screed, “I am doubling down, because as prices move further away from trend, at accelerating speed and with growing speculative fervor, of course my confidence as a market historian increases that this is indeed the late stage of a bubble. A bubble that is beginning to look like a real humdinger.”
Whether we are indeed in the late stages of a bubble, portfolio managers don’t have the luxury of waiting to see who’s right in the debate.
“There should be signals that indicate larger issues,” says O’Neill. “Again, in a scenario where velocity doesn’t pick up and the economy stalls, we would decrease our credit exposure on the fixed income side by underweighting preferred stocks and high yield credit and add to medium and long-term treasuries.
“On the equity side,” he continues, “we would overweight staples and utilities and underweight financials, energy and industrials.”
Oxenham weighs in on the flip side scenario. “Assuming we’re not in a massive speculative bubble, I think the fundamentals will begin to normalize somewhat and there are important factors that we’re examining closely,” he says. “For example, if velocity begins to increase we’ll see inflation over 2%, maybe even 3% for a short period of time this year. But what matters for inflation and the Fed’s response to it will be long-term inflation.”
“If that’s the case,” Oxenham continues, “financial and material equities would do well in an inflationary scenario whereas tech would probably be an underweight as higher inflation would mean a higher discount rate on future earnings.”
O’Neill offers the closing thoughts, saying, “every bubble is different so even if we’re in one, it’s difficult to say what will give first and how sustained it will be. While we don’t see anything on the horizon such as the housing market collapse in 2008, we need to be prepared for the markets to come back to Earth based upon any number of variables that are out of our control.”
“It’s one of the things that has made Hilton so resilient since 2001,” O’Neill adds. “The disciplined strategies and evaluation processes that our founder Bill Garvey put in place has allowed us to persevere through several boom and bust cycles. Even when we’re in what we would consider a ‘risk on’ allocation in the portfolio, we’re mindful of the positions we hold and the sector weightings to ensure we’re never too far out from our stated risk profile.”
“A hit to the economy and the markets like we saw in March and April of 2020 is one where everything goes into freefall at once,” he adds. “With this in recent memory, there’s no question that it spooks investors. But market bubbles—and I don’t mean to downplay this in any way—are such that you can sustain a decline in one area with strong defensive postures and allocations that are designed to preserve capital and deliver income. That’s our directive in Tactical Income so we stay focused on the things we can control.”
“The bottom line is that it has worked for us and our clients and we have both the battle scars and the performance to show for it over time.”