In my last article I suggested that stock markets may be soaring to new records because the Covid crisis could indirectly produce a stronger world economy in the coming decade, rather than weakening growth and creating permanent mass unemployment, as most economists, investors and business leaders now expect (see Will A Keynesian Phoenix Arise From Covid?).
I may, of course, prove completely wrong, but if Covid-19 does turn out to be a blessing in disguise for economic policy and asset prices, the contradiction with current expectations should not be too surprising. Conventional wisdom always extrapolates recent experience and the most decorated generals always prepare for the last war. Whenever deep transformations happen, whether in economics or politics or even in scientific concepts, there is a natural reluctance to believe that a big change has really occurred. People are understandably attached to the world they know and the strongest resistance to new ideas is often among those with most experience and expertise. This is why trend-following usually works in financial markets. Even when an asset has been rising or falling for a long period, many investors continue to believe that it should still be valued at yesterday’s price—and until these skeptics are all won over, the trend goes on.
Almost all economists and politicians at the end of World War II expected a global depression at least as bad as the 1930s, because millions of men in uniform were being demobilized and would find themselves unemployed. What happened instead, admittedly after several years of wrenching upheavals in the defeated countries, was an economic boom of unprecedented proportions and labor shortages on a scale never seen before. European governments that had braced for mass unemployment switched to subsidizing mass immigration of workers from Turkey, north Africa, and the Caribbean. And economists who had devoted their careers to explaining under-investment and weak consumption, found themselves struggling to explain excess demand.
I cannot claim great confidence in my belief that a similar unexpected boom could follow Covid. It is possible that the structural reasons I have presented for stronger long-term growth and investment will be overwhelmed by the financial instability and misallocation of capital predicted by Charles in his Wicksellian analyses, or by the inflation and geopolitical chaos that worry Louis, and which the gold market seems to expect. A much more serious threat, in my view, is that the Keynesian policies now enthusiastically embraced by all governments will turn out to be a brief flirtation instead of the regime change anticipated in my last article. It is easy to imagine that fiscal stimulus will be reversed prematurely and replaced by self-defeating attempts at deficit reduction. That, after all, is what happened in Europe after the global financial crisis, in the US during the 1930s, and in Japan throughout its two “lost decades” from 1990 until the start of Abenomics in 2013.
Despite these caveats, my bias is to expect fundamental transformations in macroeconomic policy and structural conditions along the lines that I described yesterday. I stick to this bias partly because I believe that democracy and capitalism create strong long-term incentives to overcome problems, rather than make things worse. Therefore, betting on positive outcomes tends to pay off over time.
Following this logic in response to the global financial crisis, I wrote a book in 2009 called Capitalism 4.0. This tried to anticipate a new era of growth-oriented macroeconomic policies and structural transformations in technology and geopolitics with more than a passing resemblance to the “golden age” scenario I now suggest for the decade ahead. My views turned out to be wrong in many particulars; but a nicer way to put this is that my book was “before its time”.
I pointed out, for example, that it took 10 to 15 years for new models of capitalism to evolve from the three previous systemic global crises: the period of European revolutions and turmoil from 1848 onwards that inspired Karl Marx to write The Communist Manifesto; the near-collapse of capitalism after the Russian Revolution in 1917 and in the Great Depression; and the Great Inflation from 1968 until the elections of Margaret Thatcher and Ronald Reagan in 1979 and 1980. It would therefore have been reasonable to wait for 10 or 15 years after the 2008 crisis before suggesting that a new model of capitalism was about to emerge. I was far too impatient to wait so long, but is it possible that the regime change I expected is finally happening?
It could be that the Covid crisis now plays the same historic role as the elections of Margaret Thatcher and Ronald Reagan 12 years after the riots and assassinations of 1968 marked the end of the Keynesian “golden age”. Or the election of Franklin Roosevelt and breaking of the British gold standard 15 years after the Russian Revolution. Or William Gladstone’s negotiation of the 1860 Anglo-French free trade agreement, which inaugurated laissez-faire liberalism 12 years after the revolutions of 1848. Could Covid mark the point when the ad hoc reforms necessitated by the 2008 crisis—quantitative easing, unlimited fiscal deficits, redistributional and environmental politics, and China’s emergence as the dominant engine of global growth—start coalescing into a recognizable new policy program?
That is what Thatcher and Reagan offered after the failure of Keynesian capitalism in the “great inflation”, what Roosevelt and Keynes offered after the failure of laissez-faire capitalism in the Great Depression, and what Gladstone and Napoleon III offered after the failure of quasi-feudal capitalism in the revolutions of 1848 and beyond. The emergence of a coherent government program out of the messy prototype created by years of tinkering with the earlier failed model of capitalism, is what my book described as the transition from “Capitalism 4.0” into “Capitalism 4.1”.
This digression into my literary endeavors is only relevant for my work with Gavekal clients because of the conclusions it suggested for financial markets. I turned unequivocally bullish on equities as soon as the Federal Reserve launched QE in late 2008 (see The Fed’s Monetary Tsunami), and I remained doggedly optimistic throughout the next 11 years, monotonously urging clients to “buy on dips” in response to setbacks such as the US treasury default scare, the Fed taper tantrum, the 2015-16 China panic and the 2018 monetary tightening. Unfortunately, I abandoned my perma-bull convictions during the Covid crisis (see Too Early To Buy Equities, But Time To Sell Dollars) and failed to recognize my mistake until two months later (see Time To Run With The Herd?), by which time there was hardly any dip left to buy.
Why did I make this mistake? And what does this error suggest for the credibility of my opinions now about the markets?
The potentially bad news—for my reputation and also for my modest personal finances—is that my perma-bull faith was restored only about one month ago, near the top of what could still turn out to be a treacherous bear market rally. Meanwhile the loss of faith that hit me at the end of March, suggests that perhaps my swings in sentiment should be treated as contrary indicators, rather than consequences of rational analysis. I am naturally reluctant to believe this. In this I am somewhat encouraged by the fact that so many other analysts and investors with far greater influence than mine, remain doggedly bearish. Therefore, my return to the bullish camp is not quite a case of the last remaining bear throwing in the towel.
Which brings me to the positive good news about my latest Damascene conversion. I can now see three clear reasons why my capitulation from the bullish position back in March turned out to be wrong. All of them now suggest that equity markets are more likely to continue moving higher than to retest their lows, even if the world is hit by another wave of Covid.
First and foremost was the argument I presented here yesterday: The Covid crisis looks like it may mark the start of a new “golden age” of Keynesian macroeconomic management combined with a boom in long-term investment driven by energy transformation, European integration and China’s need for technological self-reliance. None of these things is certain, but hopes of a structurally stronger world economy will become increasingly credible unless there is evidence to the contrary and provided expansionary macroeconomic policies persist.
The second reason for my bearish error was simply failure of imagination: the scale and speed of fiscal stimulus and monetary expansion in response to Covid-19 turned out to be far larger than I ever imagined politically possible. Keynes once said that he was devastated to realize that his policies would never be implemented by democratic governments except in times of war. If only he had lived in times of Covid!
Speaking for myself, I wrote an article four days before the bottom of the bear market, making the crazy suggestion that the only way to prevent the Covid crisis turning into an economic disaster would be for G7 governments to borrow by up to 25% of GDP so they could guarantee fiscal compensation of 80% or more for wages and company revenues lost in the lockdowns, and for central banks to finance all this debt by expanding their balance sheets (see A Modest Proposal To Avert Economic Catastrophe). Since I thought it was inconceivable that policymakers would actually do this, I concluded that the world economy and stock markets would collapse. But four days later the British government announced exactly the inconceivable policies that I had suggested—and the US government followed suit with even more compensation and borrowing by the end of that week.
But northern European politicians still refused to support Italian and Spanish fiscal policy through the crisis, so in mid-April I wrote another crazy article (see A Modest Proposal For Europe). This time I argued that the only way to avoid a breakup of the European Union would be for national governments to agree a program of joint borrowing worth around €1trn, backed by guarantees and tax revenues not from individual governments but from the EU as a whole. Since any such agreement seemed out of the question, I concluded that the EU would succumb to a financial crisis even worse than the euro crisis of 2010. On May 18, Anglea Merkel and Emmanuel Macron announced an unprecedented pan-European fiscal initiative worth up to €1trn, including all of the elements that I had dismissed as impossible, along with every other pundit, investor and politician just three weeks before. My second biggest mistake in turning bearish, therefore, was simply failure to respond to policy changes so extreme that they seemed impossible, even when I had advocated them myself.
My third mistake was failing to appreciate how much investor attitudes to macroeconomic policy had changed. While I believed that Keynesian stimulus had a 70% probability of counteracting Covid and reviving the world economy within a year or two, investors decided to believe with 100% conviction that Keynesian policies would restore the world economy to something like normality before the end of 2021. These expectations may prove right or wrong. But investors are now unlikely to change their minds about the success of the Keynesian experiment unless and until they see solid evidence that it is failing. By definition this cannot happen until economic and financial data for 2021 appears a year or so from now. In the meantime, another wave of Covid will only make governments and central banks even more determined in their Keynesian convictions, and this could even be treated by equity investors as bullish news.
For these three reasons, it now seems reasonable to focus on the simplest possible explanation for soaring equity markets: investors now believe, perhaps subliminally, that a new model of successful Keynesian capitalism will arise from Covid. This expectation may turn out to be right or wrong, but until some contrary evidence emerges, I think investors should dissect the market’s message with Occam’s razor: the simplest explanation is usually the best one. And remember that the trend is your friend.
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