Our human brains are wired to reduce complexities into simpler parts, from which we then draw linear conclusions. While this may have served us well from an evolutionary standpoint, it often misleads us when it comes to navigating financial markets.
The financial landscape is littered with many examples of this, the most enduring of which might be the “market as economy” paradigm, which always seeks to explain market moves with economic rationale.
The allure of the paradigm is twofold, first because it forces logic onto often chaotic and inexplicable movements in asset prices, and people crave the certainty provided by logical reasoning. Second because the paradigm works some, but not all of the time.
The second reinforces the first because if prices move counter to how economic logic dictates they should, people figure that their original rationale is incorrect and then bend over backwards to come up with a new line of reasoning to explain why. In this way, the paradigm works just enough to make one think that the fault lies in their reasoning, rather than with the paradigm itself.
In this Collection we discuss the “market as economy” and similar paradigms, their limitations that lead to erroneous conclusions, as well as other ways of thinking about cause and effect in markets. We hope that this Collection helps readers to think differently about markets, or at least gain an appreciation of how different ways of thinking about markets can lead to drastically different outcomes.
When trying to understand the relationship between the stock market and the economy, it is important to consider how the market is structured. Who are the participants in the market, and how are they related? More importantly, how do the majority of participants affect market prices?
The majority of stock market participants, by dollar value of assets, have to be long. Dollar value of assets here means how much money these participants control, because that’s what ultimately matters in markets. Think of it this way: ten thousand individual investors with $10,000 each control $100 million in total. While that is a large amount of money, from the perspective of the asset management industry, $100 million isn’t large at all.
In fact, equity mutual funds in the US had approximately $12 trillion in assets at the end of 2020. That’s only mutual funds. It excludes other pools of capital that invest in equity markets such as hedge funds, exchange traded funds, mutual funds that are not incorporated in the US but invest in US equities, etc.
Of course, one of the reasons that equity mutual funds in the US are so large is that they are the primary vehicle through which American retail investors invest in the stock market. While this gives them, as a group, a lot of power to move the markets, they don’t actually wield this power. Instead, they pass on their power to make buying and selling decisions to the asset management industry when they purchase mutual funds.
And this industry is largely long only. That’s trillions in dollars which have to be long. They do not have a choice – their investment mandates ensure it. Investment mandates are what funds can or cannot invest in, and what strategies they can or cannot use when investing. Investors who buy into a fund will presumably be familiar with what its mandate is.
As such, the largest pools of capital in US equity markets (it’s the same situation around the world) are in a position where they can only make money when the stock market goes up. This means that after every sell off, large or otherwise, there will always be capital needing to be deployed on the long side.
Put another way, trillions of dollars of mutual fund money always has to buy stocks at some point – it is the very reason for their existence.
Of course, this structural long bias does not exist in isolation. On top of it comes other important factors such as what other investors are doing in the market, and which narratives created by the financial media/analyst community are in vogue. This is in turn related to what paradigm the majority of investors hold, which leads us to current market psychology and herd behavior.
Let’s put all of this in today’s context. We have trillions of dollars with a structural long bias, and a majority which holds the paradigm that QE actually increases liquidity in the financial system (it doesn’t). We also have financial media/mainstream commentators reinforcing this mistaken paradigm by constantly reiterating the “boom times” narrative. Finally, as markets keep going higher in response to all of these factors, we have even more money coming into the market to chase returns, because it seems that all the market can do is keep going higher!
After a historic rally post March 2020, the price of lumber in the US is down by about 50% from its May ‘21 peak. Even though this drop comes after a sixfold rally in prices from their 2020 lows, a 50% selloff in slightly less than 2 months does hint strongly at some kind of underlying change.
In 2020, this change took the form of Covid related disruptions affecting producers’ ability to bring their products to market in a timely and consistent manner; as well as a boom in consumer demand for new homes and DIY upgrades. The result was the sharp sixfold rally shown on the chart above.
The current selloff, by its sheer speed and magnitude, speaks to a similar kind of change in the supply-demand dynamic. Given the optimism engendered by vaccinations and a second re-opening of the country, it would seem that demand for housing related pandemic spending has either topped out, and/or fallen in response to the perceived fading of the pandemic. Of course, lumber producers can also be expected to have played a part, considering that they were heavily incentivized by sky high prices to bring more supply to market.
If this structural shift continues, and producers continue to bring lumber to the market (at what are still relatively very high prices), while consumer demand persists in shifting away from housing related spending; then it would be reasonable to expect lumber prices to keep falling in the near future.
Should this scenario play out, then one of the most visible and discussed sources of recent price inflation in the US would dissipate. While this may tone down the inflation narrative a little, it might not mark the end of inflation hysteria.
This is due firstly to the demand for lumber being driven by only a segment of the US population – those with access to credit. As such, the rally and subsequent fall in lumber prices are not reflective of overall economic strength or weakness.
Moreover, commodities that are more global in nature remain mired in their respective supply chain disruptions. Good examples of this are copper, microchips, and container shipping. Container shipping and microchips in particular, given their pervasive use, will continue to boost global (not just American) prices. With shipping, it’s a matter of the world not having alternatives to transporting manufactured products in bulk. Some products can only be moved by ship, which means higher prices will be passed on to someone down the line. In the same vein, use of microchips in today’s technology is so pervasive that manufacturers and consumers cannot avoid having to pay more.
These prices, unlike lumber prices that only affect those able to participate in the housing market, affect almost everyone. As long as these disruptions continue to plague the production and distribution of goods and commodities globally, prices will be pressured higher. Unfortunately, and contrary to popular belief, these higher prices are not indicative of a booming economy. Instead they represent a threat to economic recovery.
With labor market optimism still nascent, higher prices are yet another burden for consumers to bear. Too much of a burden, and inflation can quickly morph into stagflation, which is a far more pernicious beast.
Having soared to cycle highs in the wake of the first wave of global shutdowns and reopenings last year, copper prices have finally started to cool off.
Does this pullback tell us anything useful about the future?
Considering that prices of both lumber and copper (and commodities in general), are at the heart of the inflation hysteria that is sweeping through markets, any non-negligible change in their prices will have a direct impact on how mainstream narratives view inflation.
Beginning with copper, which made its latest high a month ago in May, prices are now lower by about 12%.
This really isn’t much considering that copper prices have approximately doubled from their March 2020 lows, and are still trading at higher levels than they were pre-Covid.
This can be observed from the chart above, where the dip in prices over the last month appears to be nothing more than a correction at this point in time.
Furthermore, the fall can, in some part, be attributed to the Chinese government’s robust approach to managing inflation by turning the screws on speculative activity.
While no one knows if copper’s 12% dip will evolve into a deeper downward move, or peter out before the metal heads higher again; what is clear is that developments on the supply side are key to what happens next.
As copper is still projected to remain in deficit this year, it stands to reason that producers have yet to fully work their way through Covid related disruptions. If so, copper won’t be the only commodity still struggling with the pandemic’s ongoing impact; container shipping and computer chips are both in the same boat.
Therefore, copper prices do still have room to move lower this year, if (and it is still a big if) the supply situation somehow improves and producers can bring more metal to market.
What would be of real concern, however, is if copper prices continue moving downward and prices of other commodities follow suit.
If this were to happen, it would signal that global demand is waning. This could be due to a new global demand shock, the end of stockpiling in response to high prices, or some combination of the two.
On top of this, increasing levels of production in individual commodities could lead to prices in some to fall faster or by a larger amount than the rest.
In line with this, it is interesting to note that both copper and US lumber topped out within 2 weeks of each other in May.
This is potentially significant, because unlike say, iron ore, whose price was also affected by the Chinese government’s crackdown on speculators, US lumber prices aren’t heavily influenced by what goes on in China.
Whether or not this is a coincidence will be revealed in the coming weeks by how prices of copper and other industrial commodities, especially the more global ones, behave.
Do fiscal multipliers work? As usual the answer is not a clear cut yes or no. It’s an “it depends”.
Economic theory looks at the issue of fiscal multipliers through the lens of a very academic concept called “marginal propensity to consume”.
Quite simply, after a consumer pays off their bills and buys all their essentials, any money they have left is what is called disposable income. If a consumer has disposable income, they have a choice of whether to spend it, or to save it. The proportion of their disposable income that they choose to spend is their “marginal propensity to consume” (MPC).
According to economic theory, if the MPC of a country’s population is greater than zero, then fiscal stimulus should lead to an overall gain in national income. This gain is a result of people spending portions of their stimulus checks, which hypothetically should lead to further spending in the economy.
The total amount of money that changes hands (remember that someone’s spending is another’s income) in relation to the amount of fiscal stimulus is called the fiscal multiplier. So named because the original amount of stimulus is supposed to multiply once let loose into the economy.
If this sounds familiar, that’s because it is basically a description of how money velocity can create inflation through a dollar changing hands multiple times.
Now, instead of debating the merits/demerits of the theoretical basis of the fiscal multiplier, let us take a different approach in trying to understand what the concept can and cannot do. (There are numerous academic papers out there if you are interested in that sort of debate)
Consider a citizen, Ben. Stimulus money is deposited into Ben’s account, and he goes out to spend all of it (i.e the best possible scenario since nothing is saved). Money circulates through the economy, and if it circulates quickly enough, inflation will rise, and along with it a rise in demand, all due to stimulus money changing hands rapidly.
However, this is ultimately a game of musical chairs. Because money supply is not growing via loans, employers can only pay employees if consumers keep spending. That is, money has to circulate quickly enough around the system for a business to keep selling its products and then use that income to pay its employees.
The moment the music stops and the money ceases to flow through the system, i.e. consumers start saving more than they spend; the business cannot pay its employees, and the economy is back to being in bad shape. As such, fiscal stimulus alone cannot keep an economy afloat, simply because it is a one-off injection of new money into the economy (most probably funded by governments issuing more debt).
It is important to note that the fiscal multiplier would work if Fractional Reserve Banking (FRB) were an accurate description of how money is created. This is because every time a consumer spends stimulus money, the business that collects that money will deposit it in a bank, and under FRB, the bank can then loan it out, creating new money. But, we know that FRB does not work. Which means that fiscal stimulus does not affect the amount of loans that banks create.
Of course, what happens in reality is a lot more of a mixed bag. There will be some degree of money creation as banks are still making loans, but only to a lucky few, and different people will save/spend different amounts of the stimulus checks that they receive.
Regardless, the basic principle remains the same – the fiscal multiplier, without accompanying expansion in money supply, really cannot do more than make the hamster run faster on its wheel.
For those lucky enough to retain access to credit, low mortgage rates have allowed them to participate fully in the housing market. This could be in the form of purchasing a newly constructed house, renovating an existing one, purchasing an existing home from its owner, or some combination of these activities. The net result of which is the ongoing strength of the US housing market, its resilience during the pandemic, and a robust demand for lumber.
But, high lumber prices and the strong housing market mask major economic weakness. And this weakness stems from those who are not lucky enough to have access to credit. For these folks who cannot secure a stable source of income, low rates are no help because they cannot even get a bank to loan them money.
These folks are locked out of participating in the bull market in US housing (as well as other booming markets). Needless to say, they are left behind while the lucky few sees their net worth grow as their jobs remain safe from the effects of pandemic related lockdowns. It really is a case of the rich getting richer in a winner-takes-all economic environment, with precious little left behind for the unlucky ones.
Making matters worse for these folks is policymakers’ inability to do anything to get them back on a sustainable long term trajectory of stable employment and thus income. A good example is Biden’s household stimulus checks, which provide invaluable short term relief, but do not restore these folks’ access to credit.
Without returning to this trajectory, they will remain stuck in the negative feedback loop of unemployment and lack of access to credit, which severely curtails their ability to access opportunities to participate in future economic growth.
This in turn raises a spectrum of outcomes that lie between two extremes. The first being a full economic recovery bringing a large proportion of these workers back into stable employment; and the second massive political unrest from an underclass of disenfranchised workers unable to find their way back into the labor market.
The first extreme is the rosy, happy ending. This is an outcome where we will probably see US new housing construction soar back to, if not higher than, its pre-2008 levels. Needless to say, other financial assets and markets will reflect this ebullience. Considering where risk assets like stocks are trading at this point in time, the bull market brought about by this outcome will be one to remember.
On the other hand, the second extreme is the one everybody wants to avoid. It’s the outcome where economic conditions take a turn for the worse in the future, making life even more difficult for already marginalized workers. This has dangerous political and social ramifications, including the creation of an underclass whose rising resentment at unequal access to jobs, capital, and wealth has the potential to boil over.
Unfortunately, the description above should sound very familiar, simply because it is already happening in the US. The apex of this has of course been the January 2021 march on Capitol Hill that went horribly awry, where very angry and disgruntled voters were protesting in support of a populist politician seen as fighting for their cause.
As such, the bifurcation of US politics is to some extent a reflection of the bifurcation in the American labor market, which is being reflected in today’s high housing and lumber prices. This really should be heeded as a warning that the country is closer to the unhappy ending than the happy one.
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