August marked the end of the calm. The deadly boring days in which everything stood still have given way to more normal and livelier markets. From August to October the season of corrections historically unfolds, sometimes even of crashes. Pessimists of every creed and color break their frowning silence and raise their cry of pain to heaven, prophesying doom. Optimists retire behind the scenes to wait for better times.
As we all know that this is the season of penance, every time the markets fall potential buyers fear that the fall is the beginning of a correction and that the correction is the beginning of a bear market and for this they sip the orders purchase or place them in the drawer. This is how the bearish prophecy is self-fulfilling. The opposite occurs between November and December. This August has so far respected the tradition of making it a negative month, but the modest damage is currently limited to America and Japan.
The other markets, Europe, China and emerging countries, are positive. Bonds are also calm and positive. These results are all the more remarkable if we consider that for a few days the possibility of a North Korean nuclear missile launched into American territorial waters seemed real. The resilience of the markets to geopolitical events of this magnitude is the confirmation that the dominant variable, in the eyes of investors, is not politics but monetary. As long as monetary policy is perceived as supportive, or at least not hostile, the rest doesn't matter.
For this reason, in these hours there is great anticipation for the traditional annual seminar that the Kansas City Fed organizes in the mountains of Jackson Hole. It is a meeting where central bankers from all over the world discuss medium and long-term strategy. In the past it has been chosen to launch or test large-scale projects such as quantitative easing, negative rates or the exit strategy and this time it could shed light on important policy issues such as the reduction of the Fed's balance sheet (quantitative tightening) or the tapering by the ECB.
Our impression is that these expectations will largely be disappointed. The two programs, Qt and tapering, have already been decided and what remains to be known is only the start date of the first (December 2017 or early 2018) and the end date of the second (September or December 2018). The choice will have its importance for traders and for the performance of the markets in the coming weeks, but it will be irrelevant on a strategic level.
Regardless of this (and a modest further dollar correction over the next few months) central bankers are unable to bail out because they are at a standstill. In fact, the fact that in the ninth year of growth inflation has started to fall rather than rise radically upsets all the models on which they are used to reasoning. That this happens after recent years of quantitative easing has increased the global monetary base by almost 15 trillion (with central banks now holding 20 percent of public debt) is even more shocking.
It is starting to become clear to central bankers that to determine inflation, real rates and, consequently, the level of financial assets, there must be something even deeper and more structural than the output gap (which at this point nobody really knows what it is and, if it really exists in nature, how it should be measured) and the monetary policy that takes its cue from it. To this day the idea has prevailed
that technology and demography are the forces that have kept inflation and real rates low and therefore pushed up stock markets and bonds. Technology paralyzes the Phillips curve because it takes away the competitiveness of human work and lowers its market value.
Demography, for its part, with the aging of the population and the consequent faltering of the welfare state, leads to saving more for old age. The excess of savings compared to the demand for financing for productive investments causes a structural fall in the real interest rate. Almost non-existent wage inflation and negative real rates, in turn, are pushing up financial assets.
A study last October by Etienne Gagnon, influential head of the Fed's monetary studies section, looks back to 2080 and concludes that demographics, as far as the United States are concerned, will continue to depress economic growth and, even more plus, the level of real rates. Be careful, however, because a thesis in complete contrast to that of Gagnon was expressed by Charles Goodhart (ex Bank of England, now LSE) in a stimulating and provocative study published in recent days by the Bank for International Settlements.
It is wrong, says Goodhart, to think of the labor market on a national basis when in reality it is global. It is in this globalized world that work has been extraordinarily abundant in the last 30 years due to high demographic growth, baby-boomers of all working age and the arrival on the market of almost a billion Chinese and Russians. This abundance will turn into scarcity in the coming decades, when the baby boomers will retire and when the only areas that will enjoy growth in their workforce will be India and Africa (which, however, have human capital that is incomparable, for quality, to the Chinese one of the last three decades).
For these reasons, wage inflation will pick up just as the savings available for productive investment will fall, causing a rise in real rates, which in turn will lead to a deflating of financial assets. The debate has just started and it is too early to say who can be right. What we want to say is that, however solid it may appear, it is incautious to base any strategy on the sole terrain of monetary policy because even more powerful tectonic plates are moving underneath it, and it is not yet clear in which direction they will take us.
