Tag Archives: interest

A Black Swan In The Ointment

A good person is as rare as a black swan”- Decimus Juvenal

In 2007, Nassim Taleb wrote a bestselling and highly impactful book titled The Black Swan: The Impact of the Highly Improbable. The book uses the analogy of a black swan to describe negative events that appear to be very rare and occur without warning.  Since the book was published, the term black swan has been overused to describe all kinds of events that were predictable to some degree.

Last April, we wrote A Fly in the Ointment, which was one of a few articles that pointed out the risk of higher inflation to the markets and economy. Thinking about inflation in the context of the Corona Virus and the Fed’s aggressive monetary policy, might our fly be a black swan.

Corona Virus

The economic impact of the Corona Virus has been negligible thus far in the U.S., but in a growing list of other countries, the impact is high. In China, cities more populated than New York City are being quarantined. Citizens are being told to stay at home, and schools, factories, and shops are closed. Japan just closed all of its schools for at least a month. Airlines have reduced or suspended flights to these troubled regions.

From an inflation perspective, the impact of these actions will be two-fold.

Consumers and businesses will spend less, especially on elastic goods. Elastic goods are products that are easy to forego or replace with another good. Examples are things like movies, coffee at Starbucks, cruises, and other non-necessities. Inelastic goods are indispensable or those with no suitable replacement. Examples are essential medicines, water, and food. Many items fall somewhere between perfectly elastic and perfectly inelastic, and in many cases, the classification is dependent upon the consumer.

On the supply side of the inflation equation, production suspensions are leading to shortages of parts and final goods. Companies must either do without them and slow/suspend production or find new and more expensive sources.

We are purposely leaving out the role that the supply of money plays in inflation for now.

With that as a backdrop, we pose the following questions to help you assess how the virus may impact prices.

  • Will producers of elastic goods lower prices if demand falters?
  • If so, will lower prices induce more consumption?
  • Can producers lower the prices of goods if the cost to produce those goods rise?
  • How much margin compression can companies tolerate?
  • Will producers of inelastic goods try to pass on the higher costs of goods, due to supply chain problems, to consumers?
  • Inflationary or deflationary?

We do not have the answers to the questions but make no mistake; inflation related to hampered supply lines could more than offset weakened demand and pose a real inflation risk.

The Fed’s Conundrum

Monetary policy has a direct impact on prices. To quote from our recent article, Jerome Powell & The Fed’s Great Betrayal:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

For the past decade, the Fed has consistently sought to generate more inflation. They have kept interest rates lower than normal given the tepid economic growth trends. Further, they employed four rounds of QE. QE provides reserves to banks, which increases their ability to create money. Easy money policies, the type we have grown accustomed to, is designed to increase inflation.

On March 3, 2020, the Fed cut interest rates to try to offset the negative economic impact of the Corona Virus.  How lower interest rates will cure a disease is a question for another day. Today’s big question is the Fed fueling the embers of inflation with this sudden rate cut?

Enter the Black Swan

What would the Fed need to do if inflation were to rise due to compromised supply lines and overly aggressive Fed actions? If inflation becomes a problem, they would need to do the opposite of what they have been doing, raise interest rates and reduce the assets on their balance sheet (QT).

Such policy worked well in the 1970s when Fed Chairman Paul Volker increased Fed Funds to 20% and restricted money supply to bring down double-digit inflation. Today, however, such a prudent policy response would be incredibly problematic due to the massive amount of debt the U.S. and its citizens have accumulated. The graph below shows that there is about three and a half times more debt than annual economic activity currently in the U.S.

Unlike the 1970s, when household, corporate, and public debt levels were much lower, higher interest rates and less liquidity today would inevitably result in massive defaults by both consumers and corporations. Further, it would cause a surge in the Federal budget deficit as interest expense on U.S. Treasury debt would rise.

Over the last few decades, we have seen a steady decline in interest rates. At times in this cycle, rates have risen moderately. Each time this occurred, a crisis developed as funding problems arose. What would happen today if mortgage rates rose to 7% and auto loans to 5%? What would happen to corporate profits if borrowing rates doubled from current levels? How would corporations that depend on routine, cheap refinancing of their debt obtain it?

In such an environment, taking on new debt would be much less appealing and servicing existing debt would require a larger portion of the budget. Clearly, an inflationary outbreak accompanied by higher interest rates would result in a severe recession.


What is a black swan? A black swan is an unforeseen event like the rapid spreading of the Corona Virus that results in inflation. It is not the obvious outcome but rather an obscure second or third-order effect. Our modern economic policy framework is not designed for inflation, nor are many people even thinking about it as a possibility. That is a black swan.  

Inflation is the one thing that prevents the Fed and other central banks from supporting the economy and markets in the way they have become accustomed.

As discussed in prior articles, we believe there is ample evidence of problematic inflation data for those who choose to look. At the same time, global central bankers continue to engage in imprudent policies that are inflationary in nature. Lastly, the Corona Virus threatens to hamper supply lines and change consumer spending habits.

Whether or not those factors result in inflation is unknown. Although one cannot predict the future, one can prepare for it. Inflation is not dead, but it has been hibernating for decades. Even if the odds of inflation are relatively low, that does not mean we should ignore them. As the sub-title to Taleb’s book says, “The Impact of the Highly Improbable” can be important. An event that has a 1% chance of occurring but would cause a massive loss of wealth should not be ignored.

Bubbles and Zombies

They say nobody rings a bell at the top of the market. But whether this is the top or not, two prominent market observers and historians, Robert Shiller and Edward Chancellor, are expressing concern.

First, Shiller warns readers not to take big increases in earnings too seriously because earnings are volatile.

Everyone knows that stock prices have risen dramatically since 2009. A $100 investment in the S&P 500 in 2009 has grown to nearly $400 at the end of August 2018. But Shiller reminds us that earnings have grown dramatically too. In fact, “real quarterly S&P 500 reported earnings per share rose 3.8-fold over essentially the same period, from the first quarter of 2009 to the second quarter of 2018,” according to Shiller. Prices, in fact grew a bit more slowly than earnings since the end of the crisis.

So should we think stocks are reasonably priced since earnings have grown at the same pace as prices? Not so fast, Shiller says. Earnings, the difference between two other data sets — revenues and expenses, are volatile, and cyclical. Rapid rises in earning are often followed by a return to long term trends or subpar levels. Such episodes have occurred more than a dozen times in U.S. stock market history.

Earnings can grow dramatically from things like “panicky demand” for U.S. goods from Europeans at the beginning of World War I. This led to political calls for “wealth conscription” or a heavy taxation on war-related profits. At that time stock prices didn’t follow profit advances as investors seemed to realize those gains would be short-lived.

In the “Roaring ‘20s,” however, emergence from a “war to end all wars” and a spirit of freedom and individual fulfillment spurred stock prices by Shiller’s lights. And this, of course, led to a crash at the end of the decade.

Another period where price gains outstripped earnings gains was 1982-2000. Real stock prices increased 7.5-fold, while real annual earnings only doubled, according to Shiller. Indeed the S&P 500 Index delivered an eye-watering 17% compounded annual return from 1982 through 2000, mostly on the back of multiple expansion (the increased price investors are willing to pay for underlying earnings).

In the next period, from 2003 through 2007, real corporate earnings per share almost tripled, but the real S&P 500 didn’t manage a double, because, as Shiller puts it, “investors apparently were unwilling to repeat their mistake in the years leading to 2000, when they overreacted to rapid earnings growth.”

After the 2008 financial crisis, which decimated earnings and prices, both have increased dramatically in tandem. Shiller can’t easily analyze investor psychology to know why, but he thinks it must be rooted in the “public’s loss of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors.” In other words, nobody think earnings will go down dramatically or that their recent increase might be tied to something that can’t last.

Shiller doesn’t know if this is a bubble. He asks the question initially, but doesn’t answer it completely. I suspect that’s because Shiller thinks bubbles rest more on narratives and human psychology than on things like interest rates, and he can’t find a compelling narrative currently. But Edward Chancellor thinks record low interest rates since the financial crisis have produced bubbles galore and zombies, meaning overpriced assets and unproductive companies sustained only by low rates.

Chancellor, concentrating less on psychology in his recent article, reminds us of Adam Smith’s remark that “the ordinary price of land….depends everywhere upon the ordinary market rate of interest.” That’s because one discounts future income by the interest rate to arrive at the present value of an asset. The lower the rate, the higher the present value, and vice versa. Unfortunately, central bankers refused to accept this Smithian calculation after the collapse of Lehman Brothers. And so, they have kept rates so low for so long that they have created bubbles in industrial commodities, rate earths, U.S. farmland, Chinese garlic bulbs, fine or not-so-fine art, vintage cars, fancy handbags, super-city properties from London to Hong Kong, long-dated government bonds, listed and unlisted technology stocks, and the broader American stock market. Finally, Chancellor wonders whether low rates have encouraged a cryptocurrency bubble.

U.S. stocks are very expensive on dependable valuation measure such as total market value relative to GDP and on replacement cost basis (Tobin’s Q) compared to historic levels. American companies have also been on a borrowing binge. The problem is the economic rebound has been lackluster, and Chancellor blames easy credit and zombie corporates for this. Usually, a severe recession washes out weak companies, and investors reallocate capital to productive enterprises. “Business failures are essential to the recovery.”

Low interest rates have allowed companies that would have otherwise gone out of business to stay alive, and this has caused a tepid recovery. Chancellor notes the cumulative default rate on junk bonds during the entire recession was 17%, or “around half the level of the two previous downturns.” And while central bankers might view this as a victory, he views it as the cause of economic weakness.

The lessons for investors are to remain vigilant about stock valuations and higher yielding bonds. At some point the zombies will not be able to sustain themselves any longer. And that’s when having a good financial plan and asset allocation will help.