Submitted by Eric Peters of One River Asset Management
The future is unknowable. Yet never has capital been so concentrated in strategies that depend on the future closely resembling the past. The most dominant of these strategies requires bonds to rally when stocks fall. For decades, both rose inexorably. And a new array of increasingly complex and illiquid strategies depends on a jump in volatility to be followed by a rapid decline of equal magnitude. They appear uncorrelated until they are not.
Virtually every investment portfolio measures risk by utilizing some combination of volatility and correlation, both of which are backward-looking and low. But the present is knowable. The past too. And the multi-decade trends that carried us to today produced levels of inequality rarely seen.
Low levels of inflation, growth, productivity, and volatility are features of this cycle’s increasingly unequal distribution. But cycle extremes produce pressures that reverse their direction.
On cue, an anti-establishment political wave washed away the globalists, with promises to turn the tide. Such change is nothing new, just another loop around the sun.
Now signs of a cycle swing abound; shifting trade agreements, global supply chains, military dynamics, immigration, wage pressures, polarization, nationalism, tribalism.
To an observer, it’s neither right nor wrong, it simply is. Some see parallels between today and the late-1930s, which led to World War II. We also see parallels with the mid-1960s, which led to The Great Inflation.
What comes next is sure to look different still. But investment strategies that prospered from the past decade’s low inflation, growth, productivity and volatility will face headwinds as this cycle turns.
Those strategies that suffered should enjoy tailwinds. That’s how cycles work. And we know the 1940s was a strong decade for Trend performance. The 1970s was the best decade for Trend in 150yrs. And following cycle turns in both the 1930s and 1960s, the world became a profoundly volatile place.
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And, as a bonus, here are three observations from Peters on what he calls “Groundhog Day”
“Starting in the mid-1960s several significant policy changes, made in the context of a belief that inflation wasn’t a concern, all but caused the outcome that was considered impossible,” wrote Lindsay Politi in her latest thought piece. “The first proximate catalyst to the great inflation was the Tax Reduction Act of 1964. At the time, it was the largest tax cut in American history. The Act slashed income taxes, especially on higher income households, by reducing income taxes by 20% across the board in addition to reducing corporate rates. The expectation was that the tax cut would ultimately increase total tax revenue by lowering unemployment, increasing consumption, and increasing the incentive for companies to invest and modernize their capital stock. The tax cut did increase growth, but it also pushed unemployment very low, to one of the only sustained periods of unemployment below 4% in the post war period.”
“The 2nd policy change was how employment was considered,” continued Lindsay. “In the mid-1960s, there was concern about a cultural divide. The US social critic Michael Harrington spoke about “The Other America”: the unskilled Americans in mostly rural areas who had a “culture of poverty” and were being left behind by the post war economic boom of the 1950s. In that context the drop in the unemployment rate after the tax cut was welcome. The belief was that pushing the unemployment rate to very low levels would help transfer wealth from the prosperous urban and suburban areas to “The Other America.” They thought that, while very low unemployment might increase inflation, the increase would only be modest, and the social benefits of modestly higher inflation and lower unemployment were desirable. At the time, there wasn’t a uniform theory for the relationship between inflation and unemployment, so when inflation started to increase with very low unemployment rates it wasn’t a concern.”
“A 3rd proximate cause of The Great Inflation was the failure to appreciate a significant, structural productivity decline. Capital deepening for WWII and the Korean War had boosted productivity. However, much lower peacetime capital spending had caused productivity growth to slow. Despite the relative lack of capital spending, productivity declines were generally dismissed. It became clear at the end of the 1960s into the early 1970s that inflation has a self-reinforcing trend. Stability in inflation can reinforce stability, but acceleration also reinforces acceleration. As inflation increases, all else equal, it lowers real interest rates which stimulates growth, creating higher inflation. It’s part of why anchored inflation expectations are so critical to inflation staying low, but also why expectations of higher inflation can be hard to fight.”