The No Growth World
How Bitcoin might be the break-out investment amid the end of all indexes and passive investments.
Inflation is extremely sticky. The US economy is already on very shaky grounds. There is little chance that Powell can bring inflation down in one go. Powell is not Volcker. Volcker was the big gun Carter brought out when inflation ran rampant for more than ten years, and two previous Fed Chair failed to contain it. Powell is a legacy we inherited from Trump, who replaced Yellen only after one term to gain more control over the Fed.
If we assume that inflation will continue for the next 5-10 years and Powell will not be replaced any time soon, this leaves Fed only one strategy, to oscillate between QT and QE by changing Fed Fund Rate and controlling the money supply. A No Growth World is a hypothetical scenario for how assets play out in this environment. A few assumptions were made to arrive at the No Growth scenario. These assumptions are based on the analysis of historical data and the extraction of its underlying mechanisms. The future is impossible to predict. This hypothetical scenario is a thought experiment of a possible world state that repeatedly happened in history and has a high probability of repeating.
Current State
The current state of the world has high inflation (Core CPI at 6.66% and Core PCE at 5.15% for 09/2022) and high-ish interest rates (FFR at 3.75%-4%). In the US, the hawkish Fed predicts higher terminal FFR in the near term, with a longer holding period. Gilts (British Bonds) almost imploded, with the Bank of England stepping in to buy unlimited bonds to rescue banks. The world is unprepared for high endemic inflation and the requisite high-interest rates to fight inflation. US Economy had two quarters of negative real GDP in early 2022 but no official declaration of recession, a strong labor market, and one quarter of real positive GDP growth leading to the Fed’s confidence in continued FFR hikes to fight inflation (which has remained stubbornly high).
Assumptions
Core CPI will not come down meaningfully for the next 5-10 years. In the 1970s, it took more than 15 years to finally bring inflation down (without it going up again). Successful rate hikes on inflation have an average lag of 19 months. The fasted CPI returning to pre-hike equilibrium (2-3%) took three years (2004). The current Fed does not want to crash the economy too hard, so they prefer to keep inflation in check (at 5-6%) while avoiding a depression. It will take an extraordinarily hawkish and different Fed to willingly induce a depression to bring inflation down to 2%. Especially when the current Fed is counting on supply-side factors resolving themselves over time, the likelihood of a Volcker-style hike (FFR doubling core CPI) is unlikely.
To tread the fine line between fighting inflation and avoiding a significant recession, Central Banks will need to alternate between monetary expansion and contraction. This will lead to volatile interest rates and M2 money supply.
Real Estate tracks inflation (but does not beat inflation) over the long run. From 1970-1980, Case-Schiller Index for National Real Estate had real returns of 0.9% YoY (adjusted for inflation).
The S&P is highly correlated to the M2 money supply with a 0.99 correlation coefficient at a lag of 8 months. This has been true since 2008. We assume that Equities have an upper bound limited by corporate profits. The S&P had a lost decade from 1970 to 1980. In early 1970, the price of S&P hovered around 85. By 1980, it was at 127. Real returns were -3.5% YoY.
Precious Metals, specifically Gold, saw historically high (25% real YoY) growth during this period. The US went off the gold standard in 1971. With the US dollar depreciating, global demand for gold increased significantly.
Primer on Money Supply
GDP increases over time. To eliminate a deflationary scenario, governments need to raise the money supply to maintain slightly faster money supply growth than GDP. This means that Money Supply is constantly increasing. As the money supply increases, asset prices will always rise since asset prices reflect supply and demand.
With GDP real growth at 2% and inflation at 2%, an increase of 4% in money supply is needed to keep up with the 2% + 2%. So 4% increase in money is chasing a 2% increase in goods and creates a 2% increase in demand. The differences in the supply elasticity of goods determine how much price movement will occur for a rise of 2% in demand.
The Setup: Inflation and Money Supply Crunch
During COVID, deficit spending by the US Government increased the money supply to support the economy. In March 2021, CPI went up to 2.65% after being at 0 during COVID. Within a few months, CPI shot up to 5%. Central bankers called inflation transitory—no need to be alarmed. Federal spending started to fall in June 2021, reducing monetary expansion.
On January 2022, the M2 money supply turned negative for the first time since 2003. Nearly 20 years of free money came to a sudden halt. When core inflation reached 6% and the money supply turned negative, asset prices collapsed. Equities dropped, Bitcoin dropped, Bonds dropped, and Gold dropped.
At the same time, the Fed decided it needed to fight inflation. So the Fed began to increase Fed Fund Rate in the most aggressive rate hikes since the Volker era of 1980 (although still not close to the magnitude of increase). As a result of monetary contraction and high fed fund rates, USD became deflationary, and the dollar index skyrocketed as all other currencies fell against it.
Another Headwind to Growth: Peak Globalization
COVID created shocks to global supply chains. Globalization peaked around 2008, according to McKinsey Global Institute. The response to COVID supply chain issues is a shift from “just in time” to “just in case,” where local supply chains are being built to safeguard from global events. This shift will likely continue for at least the next decade, making goods more expensive to produce.
In the 1980s, when Volker brought down inflation, two things happened: Volker raised interest rates to 20% (in fact, he targeted money supply, and the interest rate at 20% was the result), and China entered the global economy and flooded the world with cheap goods. A combination of reduced demand and increased supply brought inflation under control. In today’s China, the relative price of a good produced by a Chinese factory vs. an American factory is 0.95 to 1. Fixing the supply chain with China is not enough to alleviate supply-side inflation. We need to establish inflows of cheaper goods from other regions, which will take 3+ years to unfold.
The No Growth Period
Interest rates and money supply play a massive role in determining asset growth in how our current economy is set up.
The last 15 years have been a unique period of passive investing. Near zero interest rate meant an unlimited money supply, pushing all asset prices up. Passive indexing and buy-and-hold strategies have beaten the most sophisticated fund managers. Low interest rates meant home prices could continue to float upward relative to inflation and wages. That period is now in the past. This is the start of the period of no passive investments.
Since early 2022, Fed has stepped in and is actively altering the macro landscape to rein in the effects of inflation. As inflation is inherently sticky and supply-side inflation is not likely to resolve within the next few years, the Fed’s control of the interest rate and money supply will drive the macro landscape for the next 5-10 years. Treading between inflationary forces and fears of deep recession will undoubtedly be a rocky ride for most asset classes.
Aggressive rate hikes come with the danger of putting the economy into a deep depression. A deep structural depression like the 1930s takes decades to rebound and would worsen geopolitical issues for decades to come. US monetary policy affects all global powers. Continued rate hikes put the US economy and its allies at risk. Based on the 1970s, we estimate that an interest rate 1.5x higher than inflation for more than two years will be necessary to calm inflation. Core inflation is at 6%. It is unlikely that the Fed will be able to hike rates to 9% soon. Fed projects interest rate hikes to peak at 4.5%, which we believe will not be able to bring inflation down. Since inflation lags interest rate hikes by 2-3 years, at minimum, we expect interest rates to stay high at>4% for 2-3 years. And given that this is unlikely to be a one-and-done scenario, we will repeat this for at least one more cycle, putting us into the 4-6 year range before interest rates come down. Most likely, with contractions of the economy and long lags in determining impact, the cycle will continue for 5-10 years as a slight improvement over the 1970s.
We are still at the beginning phase of the Fed’s interest rate and money supply intervention. Assuming that the Fed will be the primary factor driving the macro landscape in the next 5-10 years, the assets less sensitive to Fed’s levers will have a higher probability of weathering the storm.
Let’s break down the relationships between different assets classes and Fed’s levers: interest rate and money supply:
Equities correlate with M2 money supply since interest rate determines the access to capital for business growth
Real estate reversely correlates with mortgage rates, which is derived from Fed Fund Rate
Bond price reversely correlates with bond yield, which is derived from Fed Fund Rate
Gold has no fundamentals to determine “true value,” and its price is mainly determined by supply, demand, and investor behavior. Gold is also traded globally, insulating it from Fed’s intervention.
Bitcoin, similar to gold, is traded globally, has no “true value,” and should have no fundamental ties to monetary policy or economic condition (more on this later). But unlike gold, bitcoin’s total supply is capped, and supply change is pre-programmed.
In the scenario of the Fed driving the macro landscape for the next 5-10 years, there is no passive investment opportunity because the money supply is shrinking, and interest rates will remain high for as long as inflation is around. Because the Fed will dominate the macro environment, free market investment based on asset fundamentals will not prevail. That’s not to say that asset prices will not move. There will be plenty of volatility during these years as the economy hovers on the cusp of recession and most likely will enter one or more recessions. Like in the 1970s, equities will crash once recessionary fears are realized and will rally on small bits of hope. Overall, asset classes will not grow as long as Fed intervention prevents M2 growth and low interest rates.
Forecasts by Asset Class
Equities
Equities are historically correlated with the M2 money supply. And Equities will be constrained by the increasing costs due to inflation plus lower demand due to the economy hovering on the brink of a recession.
There will be exceptions to this. Some businesses will thrive as they optimize and out-compete their competition. But broad index-based investing will be non-viable (does not provide returns that beat inflation) for this period, similar to the 1970s.
Real Estate
From 1985 to 2022, rents increased 149% while income grew by only 35%. While this may suggest that rents can continue going up faster than wages, rents are already at historic highs and are reaching unsustainable territory. The current rent-to-income ratio is 28.4%.
Wages lag inflation historically. Negative real wage growth will set an upper bound on rent increases. Most likely, rents will barely keep up with inflation or will be negative in real terms.
In the 1970s, Housing on the national level returned real returns of less than 1%. Certain hot markets like San Francisco had almost 5% real return yearly1. Certain markets with growth industries might still achieve meaningful real returns this time around. But remote work trends continued from the Covid era might be a strong headwind to real estate growth.
The Urbanization trend was reversed during COVID as office workers sought ex-urban locations with lower rent and better amenities. Now that remote work has normalized, downtown office demand has fallen dramatically to half its pre-pandemic level.
Urbanization in the US has seen a turning point during the pandemic as crime increased and wealthy residents relocated to exurban areas. Funding for police dropped, and businesses are closing shop. The loss of tax revenue in urban areas will create a negative feedback loop, and we expect urban flight to continue for the next decade.
Bonds
Bonds are selling off in historically low bond returns. Expectations around high interest rates have caused plenty of upheavals already in the bond market, and pensions in the UK forced a pivot in the Bank of England’s policy.
If the Fed Fund Rate peaks at 4.5%, as the Fed predicts, we expect the bond market to recover. High-interest rates usually make bonds attractive, but when your bond coupon is less than inflation (because debt levels are high), Bonds are not giving you real returns. Periods of high volatility in the bond market are sure to follow as the Fed Fund Rate oscillates over the next 5-10 years to find the correct terminal rate (given economic conditions and inflation rates).
Gold
In the 1970s, Gold returned 20% YoY real returns. The US stopped redemption for gold in 1971, and gold demand shot up from fears of the devaluation of the US dollar. As a result, OPEC passed Resolution XXV.140, which demanded gold in payment for oil.
Given the strong Dollar, it’s unlikely to see gold demand increase significantly in the next 5-10 years (unlike the 1970s). A study done by Erb and Harvey2 has shown that gold is a good hedge against inflation only in the time scale of a century.
Bitcoin
Bitcoin is the only asset that is supply-agnostic to Fed policy. Bitcoin’s supply rate is mathematically locked in and will be reduced by 50% in 2024. As a result, bitcoin is highly sensitive to demand increases. Price changes tend to change demand in a feedback loop. Bitcoin has the unique property of halving the supply rate every four years. As the supply constricts, the price will start to drift upwards with no change in demand. This will increase demand, driving the price upwards even more. Our scenario projects a high probability of Bitcoin as the breakout asset class during the next 5-10 years.
As other currencies fall against the US dollar, Bitcoins priced in GBP, RMB, or YEN are already rising. Bitcoins are traded globally, and demand can arise from any geographic location. But, we have never seen Bitcoin perform in an inflationary environment, so time will tell how it behaves. If Bitcoin is an inflationary lemon, it will wither and die. If Bitcoin has a bull run while all other assets trade sideways, Bitcoin has a good shot at becoming taken seriously as a reserve.
References
S&P500 Historical Data. https://www.macrotrends.net/2324/sp-500-historical-chart-data
Gold Historical Data. https://www.macrotrends.net/1333/historical-gold-prices-100-year-chart
Core CPI Fed Fund Rate Data: https://fred.stlouisfed.org/graph/?g=W7qj
Peak Globalization: https://www.dw.com/en/has-globalization-passed-its-peak/a-61325661
Case, Schiller (1987). Prices of single-family homes since 1970: new indexes for four cities. NATIONAL BUREAU OF ECONOMIC RESEARCH, https://www.nber.org/papers/w2393
Erb, Harvey (2013). The golden dilemma. National Bureau of Economic Research. https://www.nber.org/system/files/working_papers/w18706/w18706.pdf