The Ambassadors

One of the best paintings, I think, that’s ever been made is Hans Holbein’s ‘The Ambassadors’.

It shows two men of similar age and stature. They seem to be connected somehow. They are surrounded by books, maps, instruments. But something is wrong. A silver crucifix hangs half obscured by a velvet curtain. The lute has lost a string. There is detritus scattered and books torn. And there is the apparition. The distorted skull set between them. Somehow the two men, the Ambassadors, so similar in outlook, are riven by forces greater than they can control. This picture is so good, I think it is almost up there with Velasquez’s painting ‘Las Meninas’ - the Maids of Honour. Both were painted by great artists in disquieting times. And somehow that disquiet makes its way into the very form of their work, causing them to push the boundaries of painting in their, or to be honest any, time.

A good mate asked me today what we should buy when this sell-off is done. I struggled to answer. And, if you know me, you’ll know that’s a rare occurrence. The problem is that whenever I try to conceive a good way out – and with it the opportunity to accumulate stocks that can get into virtuous cycles of growth and good returns – well, I just keep seeing detritus. Signs foretelling dangerous times.

Now of course, you might say that it is the preponderance of bad news that often marks a major low in stocks. Or, more subtly, that it is a peak in negative sentiment that marks a bottom, as by that time people have priced in more bad news than is ever likely to occur. My problem, I see forces at work that will make news that is not priced in. Investors are still anchored to a benign outcome.

It’s not that I lack imagination. I can see a benign outcome. I’ve constructed a roadmap to get us there. The only problem is that it takes a collapse in the US current account deficit, a primary dollar bull market, and an implosion in the ‘reflator’ states from Romania to Spain before we get there. In short, I need a panic to get positive. Now this is unfortunate, as I’m a big believer in a positive mental attitude. What I’m positive about now is that I’ll make lots of money before I turn positive.

Now, I thought of a new way to frame the debate. Well, not exactly new – I wrote it up in an essay called ‘pancake’ a couple of years back. The idea was simple. It concerned the new world order – the ‘Bretton Woods II’ system that redistributed cash from savings and investment rich China, to the savings and investment poor US. This depressed yields, boosted earnings, and led to all round financial good times. But it had an invisible symptom. One that, like a dodgy ticker, would only show up when the central banks exerted themselves, and then, potentially, with catastrophic consequences.

The symptom was a flat Phillips curve – as flat as a pancake.

Now the Phillips curve, as I’m sure you know, is the trade off between unemployment and inflation. Back in the 1990s, in the US at least, it was incredibly steep. It only took a small rise in unemployment to give inflation a real bashing. Donald Kohn at the Fed described it as a low sacrifice ratio. The Fed wouldn’t have to sacrifice many jobs to get inflation expectations anchored. And with a low sacrifice ratio, Greenspan saw to it that inflationary expectations got anchored a little bit lower each cycle, with all the fantastic benefits that brought. It was the golden age of central banking.

But the advent of ‘Bretton Woods II’ (BW2) in 2002 changed the dynamic. And since then the Phillips curve has collapsed. Now somewhere like the UK might need to see unemployment back at 4m to get inflation and inflation expectations back in check.

What’s changed? Well BW2 was incredibly effective at reflating consumption in the US, UK, Western and Eastern Europe. With utilisation rates low around the world we saw an unprecedented boom, with little or no wage pressure. Resources fared a lot better than wages – due to the high intensity of demand and the relatively scarce supply.

So far BW2 looks like BW1 – that lasted from 1944 to 1971, with the first 20 years of that period ‘good’ years. So what’s the problem?

The problem is that they are not exactly alike. Barry Eichengreen - - the ‘Daddy’ of global financial analysis - highlighted in his book ‘Global Imbalances and the Lessons of Bretton Woods’ – that Germany and Japan redirected capital flows towards infrastructure and capital investment over the period. The infrastructure investment helped promote massive, initially disinflationary growth, and a continuous productive redeployment of underutilised workforces.

This time round, lower yields caused a massive increase in asset prices – particularly real estate – around the world. Barry’s view; that’s highly unstable. BW2 will break down much faster than BW1. In my view, the primary cause of the breakdown will be the same – inflationary pressure stemming from the guns and butter policies of the US. Policies that saw – both from 2002-7, and from 1962-1971 – rapid deteriorations in the US current account. The second inflationary pressure came from the full utilisation of the workforces of Europe and Japan by the end of the 1960s. It could be argued, though I’ll admit it’s controversial, that China is now seeing a similar tightness as migration slows and wages rise.

But there’s also no doubt that the monetary authorities in the West are a different breed nowadays. All have an inflation mandate. And I think to a person, the members of the Fed, the ECB and the MPC believe that the effects of a ‘de-anchoring’ of inflationary expectations would be dire indeed.

But there’s the rub. Because BW2 keeps grinding. Only now what we’re seeing is robust domestic demand growth of the BRICs (where, mostly, the growth is self-sustaining) and relentless demand growth out of the oil exporters. All this when utilisation rates in these areas are at generational highs. The result; bottlenecks and resource price spikes. Spikes that are fraying inflationary expectations in the West.

That leaves us in trouble deep. If the West lets inflation expectations go unchecked, then we’re headed for a massive inflation ridden bear market, not dissimilar to the 16 years of pain from 1966-1982. But to check them it must induce more unemployment than would be politically, or socially, acceptable. On account of the flat Phillips curve – the fact that rising unemployment in the West will struggle to affect the dynamics in the oil market, the oil rich states, or the BRICs.

Is there no way out? I have to admit that I’m with DR Pangloss. I think a disciplined Fed, a dollar bull market, a collapse in Eastern and Southern Europe, and falling resource prices, while painful, would be by far the least painful outcome. You see I’m no Ambassador – I’m an optimistic guy – from here it would be the best of all possible worlds – and that’s what I’m betting on.