Daniel Lacalle, economist and fund manager at Tressis, joined Erik Townsend for an interview on this week’s episode of MacroVoices. With COVID cases soaring in Europe and the US, markets are trying to balance the promise of a COVID vaccine, which has helped goose markets in recent weeks, with the risks of more restrictive public-health measures.
With stocks near record highs, Townsend asks Lacalle for his view on whether markets are perhaps being too hasty in pricing in all this vaccine optimism. As Lacalle sees it, investors have lazily latched on to the positive headlines, while failing to really understand and analyze the risks that could create problems in the coming months.
Daniel: I completely agree. I think that markets are only accepting the positive newsflow without analyzing the real path to the widespread distribution of a vaccine. And even if you look at (for example) the messages that Pfizer, AstraZenec, and Moderna are saying, you’re absolutely right, we’re talking about the latter part of the second half – best case – third quarter of 2021. And in the meantime, you have a much worse situation in Europe, much worse situation in the United States. The hospitalization rates are much higher. The level of tightness in the intensive care units is extremely, extremely complex right now. And very, very, very, very challenging. So I think that you are absolutely right: Things will get worse before they will get better.
However, I think that for the average investor it is almost the following: When you get very bad news, as you’ve seen for example in Europe, what you bet on is that central banks, European Central Bank will massively increase the stimulus package, increase the purchasing program, launch a bazooka as they call it, etc.
And when the news are good, you just buy it because the news are good. You see what I mean? That the level of risk taking that an average investor is adding on to a portfolio is completely disconnected with the reality of the path of the vaccine – obviously a very, very, very positive piece of newsflow, however very challenging in terms of distribution.
You just mentioned the storage complications. But even in the most benign scenario (which I recently put in my Twitter feed), the most benign scenario assumes that by the end of 2021, less than 38% of the population at risk will have access to a vaccine, which means that the situation is getting very, very difficult in developed economies.
In the United States it is quite probably that if there is a new administration, lockdowns will be implemented. We are seeing lockdowns implemented in countries that rejected the idea – like for example Austria recently, in Europe.
So you’re absolutely right. The erosion of the potential of growth and the weakness of the economy is something that is much more important and certainly much more challenging than what markets are willing to take into account.
And everybody seems to be betting aggressively on the combination of massive monetary stimulus plus the idea that vaccines will solve everything at some point.
Does Lacalle see all this monetary and fiscal stimulus leading to a surge in inflation coupled by slowing growth? Maybe in the long term, but not right away.
Daniel: Well, I think that there is certainly a risk of stagflation. But more in the mid-term. We will first probably see a very aggressive level of deflation. Because inflation only happens when the newly-created money is going to the real economy. And therefore it becomes a massive devaluation of the purchasing power of the currency, which leads to a widespread rise in prices despite no economic growth. In this case, what is happening is that newly-created money is going to bonds – and fundamentally to sovereign bonds, obviously. And therefore inflation is being generated – and massively in sovereign bonds. We have in the Eurozone countries that are all but bankrupt or completely insolvent financing themselves at the lowest yields in history.
That is massive inflation. Okay? And when all of that newly-created money is utilized by governments to do two things – one is to perpetuation overcapacity and current spending that does not generate real economic return. The reality is that it does not create inflation the way that we would expect, because you’re basically adding overcapacity to overcapacity that makes it impossible to generate inflation. Second, the newly-created money goes actually to current spending with no real economic return.
So it’s very difficult to see the levels of inflation that we saw in the ‘70s. And, also, economies are much more open. Everybody is exporting, so that makes it more difficult. However, on the other side, what you have is a situation that I find fascinating, is that while official CPI, official index of consumer prices, is very low, the goods and services that people actually want to buy are actually rising much faster than real wages, than nominal wages, and than the official CPI. So, for example, we’re seeing how health care, education, food, clothing, utility bills, those elements are actually growing faster. And what’s coming down is everything that is subject to technology.
So non-replicable goods go up faster than official CPI and replicable goods go down significantly. Technology, tourism, hospitality. You name it.
So I think that what we are seeing right now is that, on one side, central banks do not see inflation. And, on the other side, you have a growing discontent among the lower classes, the less well-off, and the middle class because the access to goods and services is more challenging.
Cost of living is rising faster than nominal and real wages.
So, in my opinion, the risk of what is going on right now with the policy of central banks is, first, ignoring that the cost of living for the people in the middle to lower classes is rising much faster.
Second is to ignore the fact that there is actually a level of inflation in financial assets that is significantly more worrying than what anybody would imagine.
Think about this.
Just an increase of 100 basis points in the yields of sovereign countries would really bring them to absolute collapse in an environment in which 100 basis points would still be at a completely abnormal level of yield.
The problem from the central bank perceptive is that they are doing the following: Central banks are looking at the rearview mirror. It’s like somebody driving down the road at 250 miles an hour, looking at the rearview mirror, and saying “We haven’t crashed yet. Let’s accelerate.”
And the point here is that the risk of stagflation is rising very, very rapidly because of those factors that I mentioned. Because the non-replicable goods and services are rising faster than expected and because, at the same time, the economy is stagnating because of the debt saturation effect.
Another debt crisis in Europe?
As Europe pushes to pass its biggest-ever pan-European rescue package, what’s the risk that this seeds another round of core vs. peripheral frustrations in Europe, potentially tearing apart the EU?
Daniel: It’s a very, very good question.
Monetary policy in the Eurozone should be what it was designed to be, which is a tool to provide countries time to implement the structural reforms that are going to allow them to be stronger, more productive, and more solvent in the future.
However, monetary policy in the Eurozone had gone from being a tool that looks to provide some time for governments to implement structural reforms to being an excuse not to implement them.
And that tension between the north and the south is already happening.
You’ve seen it, for example, with the European Recovery Fund. How immediately there was this idea that the frugal countries were attacking the southern European countries because they did not want to monetize and mutualize all of the spending without question.
Because solidarity mechanisms exist in the Eurozone, but they don’t have to be something that goes from being a solidarity mechanism to a donation mechanism. And especially a donation to perpetuate and accelerate the structural imbalances and the weaknesses of the economy.
So what I think that the European Central Bank should do is to be a lot less strict about the rule. I think that the only thing that they need to do is to follow very, very simple rules by which both sides feel that there is a support. But at the same time it’s not a perverse incentive to undo reforms.
Which is what we’re seeing, for example, in Spain or, at some point, we saw in Italy.
And everything, just like in the United States it would be solved as well, would be solved by a set of measures in which discretionality of the individuals at the European Central Bank is limited.
So, for example, you have an asset purchase program. The asset purchase program goes to X amount of bonds but it doesn’t go beyond that.
And you say it very clearly, you explain it well in advance – communication consistent and constant about those rules – so that it’s very clear that those are the rules and those have to be implemented.
And then you have at least some level of security that governments will not use the period of expansionary monetary policies to simply get worse and to become almost too big to fail, as you were mentioning.
Because what’s happening right now is the following, and we saw it between 2014 and 2017 with Mario Draghi. Mario Draghi used to go to the market and say monetary policy is not enough. Countries have to implement structural reforms. If structural reforms are not implemented, monetary policy is not going to work.
And, literally, governments heard that the same way as they could hear a commercial on TV. They just didn’t even pay any attention.
What ends up happening is that governments would be at least aware that they could not use monetary policy to continue to increase the imbalances of the economy and the European Central Bank. The only thing it needs to do is to follow very strictly those rules. That would certainly prevent the perverse incentive that is being created right now.
As Lacalle claimed, the first signs of trouble ahead for the dollar and the dollar-based financial system will be when demand for greenbacks really starts to decelerate. Of course, one could argue that we’re already seeing that as Russia and China work to use both of their respective currencies more frequently to settle bilateral trade.
Listen to the full interview below: