Singapore, SINGAPORE – Inflation has been so low for so long despite rapid economic growth in the developed world that it’s easy to take it for granted. That somehow, “this time is different” and that the masters of the economy have managed to have their cake and eat it, while still maintaining those six-pack abs. But the inflationary genie is not some sort of mythical creature who appears straight out of the lamp, sometimes inflation can be creeping. And there are many portents that this might be one of those occasions.
In the simplest terms, inflation (at least for consumers) means that the buck you used to buy a loaf of bread yesterday can only buy you half a loaf of bread today. The developed world had bouts of rabid inflation, including a period in Germany’s history where German marks were so worthless, people used them as wallpaper and kite-building material.
The current economic cycle of almost zero interest rates and glacial inflation has led to a dangerous confluence of economic factors, distorting the valuation structure of assets across the globe where valuations are now in the realm of fiction, P&L statements be damned!
First, certain regular-paying dividend stocks have emerged as “pseudo-bonds,” where companies which deliver reliable earnings, but are not exactly on high-growth trajectories. In this corner, some of the largest names in the business in utilities, household goods and foods can be found. But to treat a company’s stock as good as a bond, is a bit like granting Walmart sovereignty. Bear in mind, that in a liquidation, bond holders rank as unsecured creditors, well above shareholders who can expect to receive next to nothing in a liquidation. Couple that with the fact that bonds pay out a coupon rate and represent a debt owing from the company to the bond holder, whereas a stock entitles its holder to the somewhat more speculative dividend payouts. That the two have now grown to be regarded as pari passu is testimony to just how distorted low interest rates and low inflation have distorted market behavior.
Second, it was not too long ago that a company had to have regular and steady profits before it could be listed on any major stock exchange. All that changed with the first dotcom bubble and it seems that we really haven’t learned anything from that era. Today, stocks of companies with low or zero earnings but allegedly scalable business models are trading at eye-watering valuations so divorced from reasonable expectations that they can only be described of as existing in a parallel universe. Juiced by the low interest rate environment, generous discounts on future earnings are the norm, with money pouring into huge, potential, future payouts — not dissimilar to investing millions of dollars to buy Powerball tickets — by leveraging the law of large numbers. This parallel universe, where valuations are based on talented storytellers and marketing men has led to the era of “unicorns,” companies with billion-dollar valuations, but very little by way of revenue or profits to show for it. Many do however boast nice offices with plenty of bean bags and foosball tables.
Third, low interest rates undermines banks and financial institutions. With the collapse in lending spreads — the law of “3–6–3” no longer applies (you pay 3% on deposits, charge 6% on loans and were on the golf green by three o’clock) — banks and financial institutions wil lbe the first to face the headwinds of sustained rises in interest rates — which is exactly where things are going right now.
Despite the U.S. achieving the fastest rate of nominal growth in decades (let’s not discuss who should claim credit for that), there has yet been very little pick-up in inflation or more importantly, inflationary expectations. And it’s the last point that is the most disconcerting. Low inflation can’t last indefinitely. Not with the pace of economic growth and global asset inflation. But it is the inability for economic participants to cater to the possibility that the inflationary genie will come out of the bottle once again that will hamstring policymakers ability to deal with it when it happens.
There are plenty of inflationary risks. Besides the global rise of populism (Brazil just elected their version of the Donald), the specter of full blown trade wars lies on the horizon. Tariffs and quotas on traded goods, the demand for higher minimum wages and heavy deficit spending on infrastructure (China is one of the most prodigious) are thinly veiled attempts to placate populations by attempting to raise labor’s share of national income — which is inflationary. So while wages may rise in the short term, long term, with rampant inflation, those wage rises will be erased in a heartbeat.
In the 1970s, many observers, including future chairman of the Federal Reserve, Alan Greenspan, believed that relatively high levels of inflation was an inevitable consequence of the fiat money system. But two decades later, there is no evidence that inflation is inevitable from a fiat money system. Periods of high inflation have been countered by periods of deflation, with no linear arithmetic rise in inflation. But the 1970s was also when the dollar went off the gold standard (in other words, every dollar was no longer backed by its equivalent in gold) held by the Federal Reserve. Over four decades on, have we really confined the inflationary genie to his or her bottle? Maybe. But there is sufficient reason to believe that this time may really be different, just not in the way current pundits expect it to be.
It’s oft said on the trading floors that when the last pessimist becomes an optimist, it’s time to get out of the market. Today, too many people believe that low inflation is here to stay, much in the same way many on Wall Street believed in the 1920s that the stock market could only go up. Much in the way that towards the tail end of 2017, many ICO (initial coin offering) punters believed that ICOs could only keep rising. But just as trees do not grow to the sky, nothing can last forever. To borrow a poem from the American poet Robert Frost,
Nature’s first green is gold,
Her hardest hue to hold.
Her early leaf’s a flower;
But only so an hour.
Then leaf subsides to leaf.
So Eden sank to grief,
So dawn goes down to day.
Nothing gold can stay.
And while I would love to believe that low or no inflation can last indefinitely, the geopolitical risks, the return of populism (I thought we got rid of that after the Second World War), the rise of nationalism and the undermining of global structures and the rule of law, all portend to rising inflation and the consequent and escalating risk of global conflict amidst the backdrop of high inflation and rising tensions. Given challenging economic situations, it’s not difficult for populists to fan already seething sectarian differences and feed into the ideology of “us versus them.”
But there can be a better way.
While today, Venezuela is a dystopian landscape, the only thing stopping it from turning fully into Mad Max Thunderdome was ironically, Bitcoin. While not all cryptocurrencies are deflationary, Bitcoin (as articulated by its whitepaper whose anniversary we celebrated yesterday) most certainly is. Being borderless and decentralized, Bitcoin avoids the machinations of megalomaniacal governments, crosses national divides and bridges value transfer across the world — all without the special interest groups which manipulate global foreign exchange trading as well as value transfer. By banking the unbanked and acting as a backup for global trade and commerce flows, cryptocurrencies could be the one potential saving factor that could help to prevent another global conflict (let’s not forget that this time a lot of countries have nuclear weapons). Because inflation may be bad, but we’ve also seen what prolonged periods of inflation with tepid economic growth have led to — global conflict. That it hasn’t happened so far provides cold comfort that it will never happen again.
So while regulators argue about the legal status of cryptocurrencies, duke it out over the intricacies of what does and does not constitute legal tender, a financial asset or a commodity — they may be missing the point completely. Cryptocurrencies may be the one thing that helps stop the world from destroying itself — that in and of itself, is worth celebrating 10 years from the Bitcoin whitepaper. To Satoshi Nakamoto, whoever you or they are, I personally thank you. And someday, I expect the world will as well.
The writer is Patrick Tan, Partner and General Counsel for cryptocurrency quant trading firm Compton Hughes.