While being the philosopher of optimism, gottfried leibniz he was a court intellectual and it is known that, when one depends on the will of the prince and lives among intrigues, one tends to develop a sense of prudence. For this reason Leibniz never said that the world is perfect but, less emphatically, that we live in the best of all possible worlds.
Even in this lighter version, however, perfection, as a concept, has a major problem. It can't be improved. Perfectio comes from perficio, which means I reach the end, the impassable limit. Reached the limit, I either stand still (hence the static idea of divine perfection especially in Greek thought) or I withdraw, returning imperfect. Once perfect, however, I cannot go any further and become more perfect or most perfect. Perfect is just an emphatic way of saying perfect, but it adds nothing to the concept.
Between the end of December and the end of January we lived in a perfect world. Intoxicated and enchanted, we have forgotten what perfection is a point of arrival, not a departure. The most widespread concept in January was instead that of take-off or even that of the meltup, the upward explosion. The unfortunate (at least for now) Jeremy Grantham, a short-armed value manager who for all these years has denounced the bubble in formation, chose precisely January to capitulate and affirm that, before a new downward cycle, the market will the note in meltup and it will come directly and quickly to 3400. Many others let themselves go like him. And here we are instead down to 2650, after having passed through 2530.
Why do we say the world was perfect in January? Because for a moment we found ourselves in that magical point in the cycle where monetary policy is still expansionary while fiscal policy begins to become expansionary in turn. The whole without inflation and without the dramatic uncertainty that characterizes the initial phase of the cycle, such as spring 2009, when it is perfectly legitimate not to believe in the possibility of success of fiscal and monetary reflation. At the beginning of a cycle, it is equally legitimate to have doubts about the viability of a particular bank or company (bankruptcies lag behind the minimum point of the cycle by months or years). In the ninth year of expansion, on the other hand, practically all companies are in good or excellent financial health and it is easier to buy them.
To recap, having maximum fiscal and monetary thrust, the absence of inflation, a clear political framework and good visibility on earnings (booming) are, for the markets, perfection. What about the ratings? Well, here lies the logical leap from perfect to the most perfect, the thought that in a perfect picture, evaluations, regardless of their level, can only go up and up a lot.
In reality, one can only withdraw from perfection, it is only a matter of time. We thought we could get away with it, to avoid overheating, and instead we started to see the first sparks, in the form of wage inflation. For more than six months, to tell the truth, the Fed's Beige Book, that curious report in which there is no number and there are only impressions and anecdotes, has been telling of companies ready to hire aggressively that were unable to find anyone . This factory would like to increase its workforce by 30 units, but says that, as no one shows up, it is forced to give up a very interesting order. Some other transport company would like to open new routes but cannot find the 50 people it needs and postpones its plans. And so on, for pages and pages. A dry prairie, the job market, ready to catch fire.
Welcome back Nairu, wrote David Rosenberg, welcome back Phillips curve. Even in Europe, some modest signs of tension are beginning to be felt even outside of Germany.
Mind you, tensions on the labor market can be attempted in various ways. Immigration is allowed into Germany, even if they often lack the required qualifications. In Japan, women and robots are brought into the labor market. In China, there are still a few tens of millions of peasants to draw on. In America, investments will be made in productivity, taking advantage of the strong tax breaks, but a progressive increase in labor costs will be inevitable, with consequences on profits and downstream prices.
For the markets, the return of the Phillips curve, albeit in a still mild form, represents a paradigm shift. On the other hand, pricing this new paradigm in bonds and equities is very complicated because this time inflation it won't be, for central banks and governments, the wolf to drive away as quickly as possible, but the prodigal son to celebrate.
In practice, for a few months (as we have already begun to see in America with the first reactions of Evans and Bullard) we will try to minimize the issue. Then, for a few more months, you will admit that inflationary pressures exist, but welcome them. Central banks will continue to turn off the liquidity tap and raise rates, but they will do so with Olympic calm and trying to follow as much as possible the long-term path already announced to the markets some time ago.
The fact that central banks will be perceived to be increasingly behind the curve, ie lagging behind in raising rates, will create both problems and opportunities for bonds and equities. For the bonds it means that the yield curve, instead of becoming flatter, will become steeper. For the stock the prolongation of economic growth will guarantee higher profits for a longer period, but also a contraction of the multiple by which profits are multiplied to form the price. The multiple is in fact a function of the long-term rate which, as we have seen, will tend to rise.
For bonds, it will be a question of staying on short maturities and inflation-indexed securities. For equities, it will be a question of withstanding high volatility in a range between the highs of January and lows of 10-15 per cent lower, at least for the first half of the year. The adjustment to the new paradigm will be laborious because there will be dispose of, hopefully a little at a time, the speculative positions accumulated in recent years on volatility.
After the first decline in recent days, many, seeing the rapid rebound, thought of a simple flash crash. No, things will be more complicated and for some time we will have nervous markets. The rebates will only be purchasable on the condition that the increases are then sold. But since everyone today only has derisking in mind, it will be good to sell first and then buy.
Sometime in 2018 this lightening and cleaning work will be done and the positive fundamentals will be back in focus. However, we recommend not to be too complacent and to accept the idea that in the coming years we will still be able to aspire to new highs, but we will have to give up getting there very charged.
Il dollar salt for three reasons. The first is the possibility that the Fed will harden its stance and that US rates will rise more than expected. The second is that the repatriation of foreign multinational funds is starting. The third is that the volatility of these days is forcing the closure of at least part of the huge anti-dollar positions that had been accumulating in recent months. Who has dollars gradually take advantage of this opportunity to lighten up.
We were kicked out of Eden but we weren't thrown into hell. We'll just have to accept that we have to go back to earning money on the markets with the sweat of our brow and not simply by sitting on some comfortable passive instrument.
