An era of true wealth destruction

The writer is the founder of hedge fund consultancy Totem Macro and a former head of emerging markets at Bridgewater Associates.

We’re in the kind of inflection that only hits once or twice a century. That’s what makes it complicated.

Most people alive today grew up alongside a simply historic rise in financial wealth. We know nothing but relentless asset appreciation, fueled by disinflation and falling rates. Liquidity outperformed the economy. So did asset prices. But violent financial and geopolitical regime change is disrupting that status quo and the bubbling valuations that depend on it.

Disinflationary and liquidity-dependent assets are, of course, the opposite of what is desired under opposite macroeconomic conditions. But after 40 years of hyperfinancialization and the recent orgy of money-financed speculation, these assets account for most of the global market capitalization.

What good is financial wealth, if not to finally spend it? The period of creating “paper claims on real things” is over, and these claims are being claimed. Therefore, assets deflate and “real things” inflate. Aggregate measures such as market capitalization to GDP and wealth to income have declined, but have barely strayed from the extremes. In this new age, much of the “financial wealth” we build will prove to be illusory.

These arcs of history are bigger than any one man, but Richard Nixon’s gold and China policies set the parameters of the world we are now leaving. More money has been printed since the United States came off the gold standard than during any other period of peace. We spend more than we earn. But globalization simultaneously gave us the production of the world’s cheap labor and a privileged ability to import the world’s savings.

Global integration kept prices low and the dollar supported them, financing twin imbalances by providing ample buyers of US paper, which of course only rose under that regime like all assets. This was fueled by a unique global peace under a unipolar dollar standard. The point is that it was a virtuous cycle, and it was a fluke.

We agree secular American exceptionalism with cyclical American exceptionalism. The boom in the old economy gave way to a bubble in the new economy. Winners naturally rotate between cycles, and that rotation was long overdue before the Covid-19 pandemic. Then our great leaders seized on the excuse to drive printing and spending to an unsustainable extreme. So what’s happening now is the inevitable cyclical passing of the baton, secular regime change, and a monetary contraction of untested size (always bad), all from bubble levels.

This time there is no pristine disinflationary force to counter the demand shock. This is not a supply crisis: volumes of almost everything are at record levels. But pristine deflation is what’s included in the price. Markets expect inflation and interest rates to converge at around 3 percent, with real rates negative all the time. Seasoned observers of emerging markets know that a Brazilian policy mix gives you a Brazilian growth/inflation mix.

The economy is overheating, external dependencies are growing, real rates are negative, and policymakers are just waking up. The next step, its currency falls and inflation persists until it gives its foreign creditors the positive real returns they demand, crushing the economy at the same time. What emerging market investors have never seen is what this macro volatility looks like on overleveraged emerging market balance sheets. Volatility and leverage are antithetical concepts. Therefore, inflation must remain above interest rates to first consume the debt. Therefore, the base case must be a repeat of the inadequate adjustments and chronic inflation of the 1970s.

There are countless strategies, but only two ways to make money in the markets. You can bet that something is going to happen that is not included in the price, earning alpha. Or you can position yourself along the “zero to maximum risk” spectrum and earn the prevailing rate. This gives you cash returns or a positive risk premium, beta. Cash pays below inflation, while risk premiums are historically small.

Assets simply extrapolate what were always fundamentally unsustainable cyclical and secular conditions. Therefore, you will need to earn real alpha returns. What is “not included in the price” is that both inflation and interest rates will be much higher, for much longer, than the markets are willing to lock in. Both are, independently, a death sentence for assets, at least in real terms. Higher rates will not reduce inflation if they remain below nominal growth, because in that world cash flows increase faster than the cost of acquiring and maintaining them. But the end of abundant liquidity can certainly crush assets that trade at many multiples of sales.


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