This Time is Different

“Throughout history, rich and poor countries alike have been lending, borrowing, crashing―and recovering―their way through an extraordinary range of financial crises. Each time, the experts have chimed, ‘this time is different’, claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters.” Carmen Reinhart & Kenneth Rogoff: This Time is Different

The 2011 Reinhart and Rogoff book This Time is Different is a valiant effort by two academics to identify what preconditions, especially in terms of the levels of accumulated national and external debt relative to GDP, would set a nation on the road to an inevitable crisis. The exhaustive research in the book drew on data from 66 countries across five continents. The implication was that in 2011, major developed markets were well on their way to a new crisis as the policy response to the global financial crisis saw the massive build-up of additional and “unsustainable” debt. But since the publication of the book, the advent of multiple rounds of QE have at least severely delayed, if not disproved, their entire thesis. 

But the size and nature of the pandemic policy response will show that this time, inflation outcomes really will be very different from anything we have experienced in decades, even as the overall Reinhart and Rogoff point that debt build-ups always lead to serious trouble will eventually prove correct. That’s because at such high debt levels, monetary policy no longer gets traction now that we are at the effective zero bound for rates. To avert an immediate crisis, the pandemic response brought fiscal stimulus on the scale of war mobilisation, supporting basic incomes and MMT-like direct transfers to nearly every sector of the economy. It was a massive demand stimulus at a time when the economy was shutting down the supply side to deal with the virus. And even as we open up from the pandemic, the new fiscal dominance will continue as we face three generational challenges simultaneously: inequality, infrastructure, and climate change policy, or the green transformation. 

The economic results of this new focus will be: ever-bigger government, more intrusive regulations, supply chain disruptions, inflation, no price discovery, a general hard swing to the left in the western world and―not least―the increased “channelling of capital” into small pockets of investable resources and assets. This could be the 1970s all over again, except this time it’s all about the political imperative of the decarbonisation of the economy, whatever that means for real growth.

Decarbonisation is needed, absolutely, but the current palette of technologies doesn’t fit the bill, as solar and wind scale poorly because of intermittency. Even worse is the too-readily accepted shift to lithium-ion battery powered electric vehicles. The wind turbines in Europe are being forced to stop when the wind is strong as the grid network is unsuited for peak input. And even if some energy storage option was available, there may not be enough of the key industrial metals to achieve this.

In short, our basic problem is that the physical world is too small for the aspiration and visions of our politicians and environmental movements. The more we decarbonise under the present model the more we metallise the economy. The marginal demand output change on metals under the assumption of 30% of the car fleet being electric in 2030 is 10-20x of current levels. The supply chains, meanwhile, are inelastic due to a lack of support for permitting, board approval, and lack of capital flowing into the “dirty” production side of the equation due to ESG priorities.

The “new black” in investing is ESG, in particular the E (environment), which is everything that touches the green transformation. Money continues to flow into ESG priorities and companies are in a rush to get with the program as a key driver of business and accessing capital. That’s excellent news, except for the fact that the ESG landscape is at best not very well defined, not rule based and often arbitrary. This will not however change what is my chief message to customers and policymakers:

ESG is the biggest political project ever. 

The ESG push and related green transformation effort have so much political capital behind them that failure is simply not an option. The best analogy to me is the euro. I happened to be a student under Professor Niels Thygesen when he was authoring the Delors Committee report in 1988/89, preceding the introduction of the euro and outlining the path to Economic and Monetary Union. We all knew the EMU/euro was born without a proper foundation (fiscal union), that no currency union has survived the test of time and that the stronger nations would “dilute” the weaker ones. Despite this we all underestimated the political capital invested. As with the green agenda and ESG, it had to be a success. The doubt disappeared during a speech by ECB president Mario Draghi at the Global Investment Conference in London on July 26, 2012, during one of the worst phases of the EU sovereign debt crisis, when he said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. 

I compare the present agenda/driver to that same political ideology. The ESG and green agenda will prevail, if only because it will have unprecedented political will and capital behind it. ESG will be 50 trillion USD business in 2030 according to Bloomberg Intelligence by 2025. (For comparison the US GDP is 23 trillion USD per year)

It is the biggest “whatever it takes” commitment and it’s global too, with China joining with their 2050 decarbonisation plan.

The ESG and green transformation is simply the single largest policy bet ever undertaken, and the main consequences will be inflation and ever lower real rates. Inflation in this case will be a function of the physical world not able to deliver the supply relative to the quantity of money and demand, and negative real rates tell us the future is one of low real growth through low productivity growth.

We investors need to embrace, understand and act on this. There are two major assets classes that will do well under this regime: Government-sanctioned assets, and assets with price discovery. This means green and, ironically, commodities have the best odds of producing long-term excess returns. 

This does not mean the projection from here will go from one success directly to the next. Au-contraire: the present model of negative real rates as a funding source for unproductive changes to society will lead to some sort of breakdown. This will however only lead to ever more funds and subsidies for the same failed transition. Eventually, we have to hope, new energy sources will come to the rescue (fusion energy?) with vastly superior outputs per invested unit of energy and per invested dollar. For now though, money talks.

In conclusion, negative real rates are a function of our economic model not being productive into the future. The more we continue to pursue a sub-optimal model for our otherwise noble objective of a cleaner, better and more just future, the lower real rates will go, and the more unequal society will be, blocking the path to a real vision for the future. 

A vision needs to be built on productive societies pushed forward by better education, basic research as a central part of fiscal spending, and rules-based international cooperation that gave us a vaccine against Covid, genome mapping, the internet and so much more. The sad thing is that we have never been further away for this “turn for the good”. 

So again, this time is different as a new inflationary era is upon us―one unlike any of us under the age of at least 60 can remember. But what is not different is that this is the last phase of the process started under Greenspan in 1998 where policymakers interfere ever more deeply into the economy. First it was central bankers bailing out the system, now it is governments trying to force outcomes regardless of their productivity. This has brought zero policy rates and now heavily negative real rates. We need to realise that negative real rates are a doom loop and that we won’t really move toward that bright future we all want to build until real rates move up and turn positive.