The Bear’s Lair: The Great Normalization may be starting

The Gods of the Copybook Headings have been asleep for the last four years, as the miserable state of my stock portfolio can attest. Assets that were overvalued at the end of 2011 have got more overvalued, inflation that should have appeared due to funny money hasn’t, U.S. stock prices have trended steadily upward, as has the dollar in spite of twin $500 billion deficits in the budget and the balance of payments and unlisted tech stock valuations have headed through the stratosphere towards outer space. We keep expecting reality to return, and keep losing money by doing so. However, in 2016 there are signs this miracle may finally occur.

The central process that has been stopped up by a decade of ultra-low interest rates is that of creative destruction. As Joseph Alois Schumpeter wrote as long ago as 1934: “Any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future.” Frankly, I couldn’t have put it better myself!

At some point, the funny money stops working. We appear to have reached that point. There are a number of signals, such as the accelerating decline in quarterly corporate profits. Perhaps the most important is the behavior of productivity over the last year, falling at a 3% annual rate in the fourth quarter and increasing only 0.3% over the year. Even if Dr. Robert Gordon is right and all the good stuff has already been invented, we would expect a gradual slowing of productivity growth over the rest of the 21st Century, as Gordon projects, not a sudden slam into a brick wall.

The productivity shortfall is not due to slowing technological innovation, it is due to more and more and more investment being misguided. I wrote last week about the proliferation of Ponzi schemes, both explicit and implicit, where the investment is not designed as a Ponzi scheme, but simply functions as such in the current economy. We now seem to have reached a point at which the diversion of investment into rubbish no longer works, and the Schumpeteran process of destruction takes over. In this case, the destruction will not in itself be especially creative, but it is necessary to allow the creative forces in the economy to reassert themselves and productivity of the shrunken remainder after destruction has taken its toll to resume growing at the normal rate of 2.5-3%.

As in 2007-08, real estate represents a lot of the misguided investment, but only in a few places is that investment directly into housing. The San Francisco real estate market is as overblown as it was in 1999 and the London housing market is infinitely more overblown than it has ever been. Both markets are due for a comedown, San Francisco as the tech bubble deflates (more on that later) and London as reality returns – in that case possibly triggered by a favorable “Brexit” vote to exit the EU this summer. In both cases, a deflated real estate market will be unalloyed good news; it will allow ordinarily successful people to enjoy the amenities of the city where their career forces them to work. It will also remove huge amounts of speculative capital from the more unpleasant mega-rich foreigners.

This time around, commercial real estate is a much bigger problem (though I’d also bet that Tesla’s Nevada GigaFactory will be one of the few truly surplus industrial real estate projects.) Driven by cheap financing and by expanding demand fueled by easy consumer credit, hotels have expanded far beyond the natural demand for them, as have retail outlets, made partly obsolescent in any case by the rise in Internet retailing. The real estate cycle is already beginning to turn down in some paces; we can expect to see reality reassert itself with exceptional vigor.

You can expect similar developments in the junk bond market, which looks very like the subprime housing debt market in late 2007, and where the first fund closed its doors in December. It’s somewhat larger than the subprime mortgage at $2.5 trillion, and probably will cause a much bigger hole when it craters, because most subprime mortgages had value and most junk bonds don’t. The most immediately endangered sector is energy, where Chesapeake Energy, with $11.7 billion of debt, is beginning what appear to be its death throes and many other investors in high-cost U.S. energy in 2010-14 must inevitably follow. Again, funny money has caused far too many junk bonds to be issued, and has bailed out most of the worst LBOs of 2006-07. Schumpeter would tell you that very few of those errors have gone away; they are merely waiting to inflict their devastation. That process has now begun.

Finally, there is the most egregious of all valuation excesses, the “unicorns” of Silicon Valley. Pumped up by endless rounds of private equity financing, many of them have run for close to a decade without achieving profitability, while their valuations have swelled to enormous size. Most of them will never achieve decent profits; in that respect they are not unicorns, but triceratops, long dead, indeed fossilized as economic entities, kept alive as zombies only by their funding and rotting to disintegration as soon as that funding disappears.

The recent spate of resignations, profits disasters and revelations of what may amount to fraud at privately held tech companies is almost certainly the small tip of a very large iceberg. As J.K. Galbraith said in relation to 1929, the “bezzle” of naughty behavior becomes alarmingly revealed in a downturn. Other unicorns may be as honest as the day is long but will be proved to have expanded far beyond where their business model makes any sense at all. Events in the first weeks of this year suggest the meltdown in this sector may finally be beginning; its denouement will not be pretty, if only because of the number of very capable people who have come to believe the hype.

The world economy’s trajectory until January of next year is thus already set. Unexpected bankruptcies will proliferate in real estate, the junk bond market generally and tech, but not so much in emerging markets which in this cycle have been far less overblown than the U.S. economy. U.S. GDP will decline for several quarters, and by the latter months of this year job losses will accelerate, as entities that had no economic justification lay off much of their unfortunate workforces.

After January, it depends what policies are pursued. The present trajectory, of zero or even negative interest rates (Janet Yellen is sure to be tempted to try these) huge budget deficits and massive regulation is sure to be very tempting to the political class faced with another liquidationary recession. Monetary stimulus and fiscal stimulus will appear irresistible to Keynesians, with Paul Krugman perhaps finally getting to stage his imaginary Martian invasion in order to boost state spending still further, as he proposed in 2011.

Needless to say that will only cause a further misallocation of resources, with productivity diving by perhaps 4-5% annually. Since growth in living standards depends crucially on productivity growth, the living standards of the U.S. and Western middle class will decline rapidly towards Third World levels. The unfortunate inhabitants of emerging markets will be blamed for this by politicians turned suddenly Trumpian, causing a re-imposition of tariff barriers similar to that of the 1930s. Imagine a U.S. and indeed global Greatest Depression, with Gross Private Product in Western countries declining 40-50% (GDP will decline less because government output will spuriously be taken at 100% of par.) That’s where present policies will lead us, doubtless with World War III to follow.

The alternative will only occur if decisively better monetary, fiscal and regulatory policies appear at least in the United States in January 2017. The liquidation process will be painful, but we need to avoid the mistakes of 2009 in order to end it quickly and ensure it does not repeat itself, avoiding the problems that Schumpeter perceived clearly in 1934. Interest rates need to be pushed up to a more normal level, around 2% inflation, at which savers are rewarded and misguided investment is discouraged.

The budget deficit needs to be tackled properly (since it will rise to $2 trillion in the recession) with the bulk of budgetary correction coming via spending cuts not tax increases, inevitably damaging recovery (and especially not Bernie Sanders’ (D.-VT) income tax top rate of 73%, which would have the same effect as President Hoover’s top rate increase to 63% had in early 1932.)

A bonfire of regulations is needed to jump-start productive investment in sectors such as energy and financial services where the last decade has been lost in a jungle of excess regulation. The blessed regulatory bonfire should allow new business directions and technological opportunities to appear, counteracting the depressing effect of monetary and fiscal stringency, thus avoiding yet another prolonged period of high unemployment.

Finally, post-2017 policy would need to ensure that international trade remained as free as possible. This means not burdening it with crony capitalist rules like the intellectual property portion of the Trans Pacific Partnership. Like taxes and tariffs, tight intellectual property protections are depressing to economic activity, especially when they tie up wealth in unproductive legal work.

After a four-year hiatus, the signs are that normal economic laws are coming back into force. Unproductive investment is being destroyed, money printing will start to cause inflation, the stock market will decline to reflect real underlying earnings and the dollar will decline to lessen the gigantic $500 billion annual payments deficit. If this happens, the conclusion to draw is clear: it is more than time we got back to conventional small-c conservative economic policies.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)