Is This The Beginning Of The End For The Era Of Financial Engineering?

March 20, 2017

Is This The Beginning Of The End For The Era Of Financial Engineering?

  • Most developed world economies can’t continue to grow without financial engineering.
  • However, inflation forced tightening will eventually have a significant impact on credit.
  • This will only lead to more accommodation and toward an eventual crash, so be prepared.

Introduction

Each significant historical bear market has an initial trigger. Weak home and car sales killed the 2003 – 2007 bull market, while the realization that stock valuations had gone too far initiated the bear market in March 2000.

But what will trigger the next bear market? Well, there’s a great possibility that it will be monetary tightening. Perhaps it won’t be the latest quarter percentage point rate increase, but it will probably be one of the next rate hikes.

As, after eight years, we have gotten extremely used to accommodative monetary policy, tightening will have a huge impact on the economy and corporate earnings when it reaches its tipping point. After the dotcom bubble and the housing bubble, I believe students will be learning about the financial engineering bubble when this low interest rate experiment is over.

Financial Engineering

Financial engineering is behind the economic well-being and the bull market we have been enjoying in the last 8 years.

In a recent Bloomberg interview with Ray Dalio, I was surprised by how many times Ray mentioned financial engineering. His theory is that as we are already in the final innings of a long-lasting debt cycle and any hope of further economic and market growth lies on excellent financial engineering. The bad news is that he doesn’t yet know whether the current monetary and fiscal leaders have the capacity for managing a financial engineering experiment of such scale.

Dalio is also focused on the fact that populism is increasing around the globe, and we also don’t know whether financial engineering will be a smart idea or a stupid one as animal spirits have to be awaken. Despite all the buzz around better economic outlooks, Dalio still thinks that stock returns will most likely be low in the long term. The only way for that to change is through additional stimulation that spurs economic growth.

Dalio concluded that he doesn’t know whether the financial engineering exercise is sustainable or if it will just fizzle out. However, he doesn’t believe in significant tightening.

Now, this interview was made in Davos in January. Since then, a few things have changed with the main change being higher inflation in the U.S.


Figure 1: U.S. inflation. Source: Trading Economics.

If inflation continues to climb, the FED will be forced into significant tightening which should eventually put a halt to this bull market. Further, initial signs of tightening have already impacted expected GDP growth for Q1 2017 which is now at just 1.2% annually, which is far away from the 4% some politicians were expecting.


Figure 2: Atlanta FED GDP forecast for Q1 2017. Source: Atlanta FRB.

The chart above shows a delicate situation and shows how complicated financial engineering is. You have inflation that is ramping up and forcing the FED to raise rates while the economy isn’t in as good of shape as would be expected.

We’ll see what the real GDP figures will be for Q1 2017 and whether economic growth is sustainable, but there is one economic measure around which everything evolves and it can’t be fooled by financial engineering or any other short term tactics, it is productivity. The GDP is closely related to productivity as short term debt cycles can increase economic growth rates for a while but in the end, it all boils down to productivity.


Figure 3: GDP can’t grow faster than productivity in the long term, only for short term credit fueled booms. Source: FRED.

The last economic expansion was clearly driven by credit. Since March 2008, consumer credit has increased by more than $1.1 trillion. This is clearly the result of low interest rates that have made lending attractive.


Figure 4: Consumer credit has been booming. Source: FRED.

There is only one thing that can push people and corporations away from borrowing, higher interest rates.

Nobody likes higher rates, not even the FED, but if inflation keeps going higher—and given the growth in credit it probably will—there is no other option but to increase rates. Higher rates will make credit less attractive which will lower spending, and that will eventually lead into a recession and before that, a bear market. This could be controlled by more monetary easing, but the game the FED and politicians are playing can get out of control very easily.

The most important things to remember for an investor are:

In the short to medium term:

  • We might see more monetary tightening with the goal of curbing inflation.
  • Tightening will lower spending as it is the only way to lower inflation. This will lead toward a recession.
  • A recession will lead the FED to lower interest rates and a new cycle will begin.

In the long term:

  • The biggest long term risk is that people will lose faith in the value of money due to the unlimited amounts of it being pushed into the economy. This will break the long term credit cycle we have been enjoying in the last 60 years.

How To Prepare Yourself

We’re in a very delicate situation because it’s practically impossible to control what’s going on. The FED might tighten, but this could lead to increased demand for dollars coming from overseas which will keep inflation high for the short term. This might force the FED to tighten even more and put the highly leveraged consumers and corporations under severe pressure. Inflation and a recession could lead toward the main risk I see coming in the future, a collapse of the financial engineering bubble.

It’s possible to be prepared for such an outcome as an investor, but such a topic requires a special article just for that. However, here are some things to think about:

  • Own assets that will perform well in inflationary and even stagflationary times (stagflation – inflation in combination with economic stagnation) like food, pharma, and some other commodities.
  • Start allocating a part of your portfolio to gold even if it doesn’t look like a smart idea now. When it will be a smart idea, it will be too late. Read more about that here.
  • Look around the globe and buy cheap businesses where the return on investment will be very high both in the short and long term.

I’ll write a special article for how to best prepare for what lies ahead of us soon, so keep reading Investiv Daily.