The age of delusions is ending – but what will replace it?

For years, we have been living in an “age of delusion”, says Max King. The return to normality will be painful, but a dose of reality might be a very good thing for markets and economies.

This millennium has seen two of the four biggest bear markets in global equities in the last 100 years. Surely it is too soon for another? 

Yet a drawdown of more than 20% in the S&P 500 index in the year to date has led to dire warnings from market sages, pundits and the media that the bear market has much further to run.

The central theme of the gloomsters is that we have been through an age of delusion – but that those delusions have now been shattered. The return to normality, they believe, will be a painful one. 

It is time to repent our past misconceptions

The list is a long one, encompassing many sins, including the following:

  • UK government bond yields were trading at multi-century lows and, at the peak in late 2020, $18.4trn of bonds had negative yields globally. Yet taxation is at historic highs and the propensity of governments to borrow and spend has never been greater.
  • Huge valuations were attributed to intangible assets such as cryptocurrencies and non-fungible tokens (NFTs) that had not stood the test of time.
  • Huge valuations were also attributed to early-stage companies with no or negligible revenues and frequently no visible pathway to profitability or cash generation.
  • A belief that the transition from hydrocarbons to renewable energy could be achieved in one giant leap rather than through the acceleration of a long-term trend.
  • The belief, in the pandemic, that governments could compensate for the sharp drop in economic activity caused by lockdowns through money-printing and hand-outs without causing inflation.
  • A strong inverse correlation, especially in the UK, between a growing faith in the ability of governments to solve problems and their declining ability to do so. The old adage that there are few problems in the world that are so serious that they cannot be made worse by government intervention has been forgotten.
  • The belief that autocracy was a viable alternative path to prosperity rather than to corruption, megalomania, repression and misery. Democratic capitalism may not, as once hoped, be sweeping the world and may have its faults but, as Churchill once observed, it is better than all the alternatives.

The question, though, is whether the end of these delusions is negative or positive for the long-term outlook for the global economy and markets. 

The gloomsters believe that there is a terrible price to pay in terms of inflation, energy prices, interest rates, popular discontent and a bear market for equities that combines the inflationary collapse of the 1970s and the tech wreck of 20 years ago. 

They have an almost religious belief that other investors have to atone for their sins of delusion in a Day of Judgement, but hope to pick up the pieces when “new money” investors who have had it too easy sell out at rock-bottom prices. 

A dose of reality might be a very good thing for markets and economies

A more optimistic view argues that the end of the massive misallocation of capital of recent years and its redirection to productive investment is a positive for the global economy and for markets. Ultra-low interest rates encouraged governments to borrow and spend, usually wastefully. Higher interest rates and inflation will reimpose discipline.

Russia has been shown to be a paper tiger and its failure in Ukraine must make a Chinese invasion of Taiwan less likely. It should reverse the global trend to autocracy. The energy crisis will, hopefully, encourage greater realism in the transition to renewables but underpin it. So there are plenty of reasons for long-term optimism.

In the shorter term, equity valuations have retreated such that significant further market weakness will require either much higher bond yields, a big drop in corporate earnings or both. Higher bond yields imply that inflation is sustained; lower corporate earnings that a recession is imminent

Investment strategist Ed Yardeni estimates a 45% probability of a mild recession but sees no evidence of one in current indicators. However, he points out that a recession is generally described as two consecutive quarters of falling real (ie, after-inflation) GDP and that US GDP contracted at an annual rate of 1.5% in the first quarter. Growth in the second quarter is estimated at 0.9% but could turn out lower. 

This would fit the definition of a recession, but a slashing of corporate earnings forecasts would require much worse. Moreover, investors would have to believe that recession would not be followed by recovery in growth and corporate earnings or they would not sell. 

That in turn would probably require inflation to be sustained, preventing central banks from responding to a growing liquidity squeeze with looser monetary policy. The sharp drop in monetary growth implies either lower inflation or a recession next year, or some combination of the two. For the outcome to be a soft landing rather than a recession requires energy and food prices, the core of inflationary pressures, to fall back.

Yardeni points out that the “shock” May inflation report, in which the headline rate reached 8.6%, was primarily attributable to energy and energy-related areas such as transportation. Food inflation rose modestly but core inflation and durable goods inflation fell.

The normal market response to higher energy prices is an increase in supply and a fall in demand, but some pundits argue that “it’s different this time” due to environmentalism, under-investment and the war in Ukraine continuing indefinitely. 

Given how toxic stagflation is for the popularity of governments, the high returns on capital available on investments, and more pragmatic environmental attitudes, that looks unlikely. When energy prices fall, the inflation rate will come tumbling down, disposable income will rise and economic growth pick up.

Don’t listen to the doomsayers

Yardeni’s view is that “the S&P 500 will remain volatile below its January 3rd record high for the rest of this year before climbing to new highs in 2023 and 2024”.

This stands in marked contrast to the Gavekal warning of “world crash ahead”; to Jamie Dimon of JP Morgan advising “brace yourself for an economic hurricane”; or Jeremy Grantham of GMO saying that “the S&P 500 will likely plunge another 40%.” Armageddon views get noticed, boring common sense doesn’t.

The UK is in a curious position. Its stockmarket has outperformed all others this year while both interest rates and bond yields remain lower than in the US. Yet sterling weakness is exacerbating inflation and thereby popular discontent. 

Old hands fear we are reliving the chaos and incompetence of the Heath government (1970-1974) and its pre-Thatcher successor. In the early 1970s, the UK market fell 70% (80% in real terms) and exchange controls meant there was no escape. Now there is, so there is no reason for domestic pessimism to infect the global picture.

Surveys show that investors everywhere are bearish, populations are fearful about the future and electorates are disgruntled with their governments. That makes this a good time to bet the other way, if not now, then in the coming months. 

It’s better to risk modest short-term losses in volatile markets than wait for the risk but also the reward to have dropped. Scrambling into a rising market is difficult and may not even be an option; in early 1975, the UK market doubled in barely a month, but liquidity on the way up was non-existent.

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