COVID-19 precipitated the current economic crisis. Liquidity injection again emerged as a panacea. But, Is liquidity injection a curse or a cure? It would be unfair to come to a conclusion without appreciating the origin of money, how money evolved, what is the current context, what are the consequences of the current economic system and how it is priming to make a shift towards a distributed financial system. We foresee the emergence of a flourishing and co-existing economic system led by the ‘Decade of digitization and digital assets’.
Liquidity injection – Quantitative Easing and Fiscal Policy
Quantitative easing (QE), simply defined, is a fancy name for ‘on tap currency’ that can be printed at will at extremely low cost for stimulating economic activity and consumption.
QE is a form of extraordinary monetary policy used by central banks to quickly increase the domestic money supply and spur economic activity. Increasing the supply of money is similar to the increasing supply of any other asset—it lowers the cost of money. A lower cost of money means interest rates are lower and banks can lend with easier terms. At the same time, it greatly expands the central bank’s balance sheet.
FED’s latest moves signal a resounding whatever it takes approach from the central bank, and dispels any notion that monetary policymakers are either sparing ammunition or running out of unconventional tools. It represents a new chapter in the FED’s money-printing regime, as it commits to keep expanding its balance sheet as necessary, rather than a commitment to a set amount.
The actions announced by FED in three weeks of March, took them eight months to put into motion in 2008. This was unthinkable three weeks ago, but the response to the sudden economic hard stop has been tremendous. G-20 finance ministers and central banks are more coordinated today than they were 12 years ago which boosts the probability of a coordinated action worldwide to support the financial system against any kind of dramatic collapse.
Governments world over are also unraveling stimulus in stages through Fiscal policy by utilizing Government spending to further expand the money supply.
Anticipating recession, the governments are expected to employ expansionary fiscal policy by lowering tax rates to increase aggregate demand and fuel economic growth.
Will it stimulate markets enough? A simple answer seems to be – Yes, it already has. After all, April 2020 has seen the best monthly returns in the past 33 years. We will also see many policy decisions to ease trade and commerce.
Digging a little deeper reveals there are three actors driving current strength in the markets :
- First one, we have FED front runners. Smaller cap firms, with poor balance sheets, loaded with debt, had been decimated during the crash. Such companies witnessed resurgence after FED declared its intention to backstop credit markets. Here, the thought pattern is along the lines of “We can move down the chain of market cap without increasing our risk because of FED PUT”. Investors going down this path need to be very aware of the difference between solvency risk and liquidity risk. FED PUT solves the liquidity risk but not the solvency risk.
- The second line of support has been from retail investors. Unlike past experience, when retail investors sold in face of rising unemployment and increasing uncertainty in the economy, the last eight weeks have witnessed a surge of investment from mom and pop investors. This is evident from the record increase in accounts opened with online brokerages in Q1 2020. Retail investors have steered away from typical defensive portfolios to scoop up battered sectors in hope of future recovery. Whether this is due to retail learning from the global financial crisis, better resilience due to fiscal policy response, or lockdown impact as gamblers turn to stock markets for their dose, it is up for debate. An important point to note is that vehicles favored by buy-and-hold investors have seen an exodus of US$ 4.5 billion in April. Is this simply a change in strategy from buying ETFs to alpha picking behavior akin to professional investors? Or is this a case of buy-and-hold investors leaving in hoards while newbie gamblers picking up pennies in front of a fast-approaching train? We believe it is the latter.
- Finally, we have mega-cap tech and particularly FAANG worshippers. These mega-cap tech stocks have very strong balance sheets and double-digit growth, creating an allure for investors. This is evident from the fact that ETFs tracking these stocks attracted US$ 12.5 billion during March and April.
Will it stimulate the markets in the short term (0-3 months)?
Predicting market direction is one of the toughest things. Even the best investors get only about 60% of their calls right. With this disclaimer, our humble opinion is that given the structure of current market strength, it is premature to assume we are out of the woods. There is a very high probability that over the next 2-3 weeks, the usual adage of sell in May and go away may, after all, pay dividends in the short term.
Will it be positive in the medium term (6-18 months)? Barrons published their Big Money Poll a week ago. An interesting observation is regarding the outlook for the stock market in 2021. Only 4% of investors are bearish while 83% are bullish. In general, this can be interpreted as a vote of confidence in scientists, business leaders, governments, and the resilience of consumption. It represents expectations that demand has been pushed out rather than completely eliminated. The sector considered most attractive was “Technology” while the one that was least attractive was Energy. Whether we have at hand a momentum investor or a contrarian, investors are at heart an optimistic bunch. Without that essential feature, no investing is possible.
Liquidity injection – Cure or Curse
Gambling by governments is irresponsible, even if the results turn out to be favorableNassim Nicolas Taleb (Author ‘Black Swan’)
If one were to be optimistic, there is a possibility where QE and Fiscal policy flow together and become the cure. For the first time in a millennium, all the nations have been impacted at once. There could be a silver lining to it that may lead to global alignment due to a deep understanding of shared global context and consequences. All the nations are more coordinated (through communication technology) and represented (through multilateral agencies and media) than ever before in our recorded history of over 5500 years. Ideally, QE and Fiscal policy should flow together and central banks and governments may have become wiser after the global financial crisis in 2008.
In all probability, nations will choose to protect their interests first; governments and central banks will take popular band-aid decisions.
Over a decade back in 2008 after the global financial crisis when FED launched its first QE program, it caused many US businesses to go bust and retail investors watched their savings dwindle. With the vested interests of many intermediaries and centralized banking institutions at play, artificial liquidity injections seem to do more harm than good.
In the last decade of experiments with QE, we have seen a pattern globally:
- Increase in inflation worldwide
- Increase in wealth inequality
- Increase in NPAs (Non-Performing Assets)
In nutshell, if history were to repeat itself it would be a curse.
Where are we going wrong
QE can’t work as expected if the new money being injected in the system ends up in the pockets of a select few, creating more and more wealth inequality. It is a perpetual trap where big corporations get bailouts (“too big to fail”) as they are handed over absurd amounts of bad loans which in turn lead to NPAs and then rinse repeat.
Remember every pattern forces us to make choices. Making the same choices, again and again, leads to similar consequences. Are we doomed to follow this vicious cycle? Or do we have a choice to find and explore other solutions?
To understand what choices we have, let’s understand how the money came into being, and how it evolved.
Money and its evolution
What is Money?
Money was created many times in many places. It’s development required no technological breakthroughs – it was a purely mental revolution.
Money is not coins and banknotes. Money is anything that people are willing to use in order to systematically represent the value of other things for the purpose of exchanging goods and services.
Money is the most universal and most efficient system of mutual trust ever devised.Excerpt from ‘Sapiens – A Brief History of Humankind’ by Dr. Yuval Noah Harari
What created this trust was a very complex and long-term network of political, social, and economic relations. Why do I believe in the cowry shell or gold coin or dollar bill? Because my neighbors believe in them. And my neighbors believe in them because I believe in them. And we all believe in them because our king believes in them and demands them in taxes and because our priest believes in them and demands them in tithes. Take a dollar bill and look at it carefully. You will see that it is simply a colorful piece of paper with the signature of the US secretary of the treasury on one side, and the slogan ‘In God, we trust’ on the other. We accept the dollar in payment because we trust in God and the US secretary of the treasury.”
Let’s look into what makes Sound Money i.e. money that propagates mutual trust, stimulating human to human exchange of value.
Many people seem to have the misconception that fiat currencies like the US Dollar are a store of value. Truth can’t be farther away from the same. World history shows almost all fiat currencies eventually tend to go to their intrinsic value – zero.
Interestingly, US$ has lost more than 95% of its purchasing power in the last century alone.
Digital assets (like Bitcoin) stand shoulder to shoulder with their incumbent counterparts. Except for lower acceptability and higher volatility at the current stage, which is understandable as digital assets have only been around for a decade vs thousands of years of history of Gold, hundreds of years of paper currency, and 50 plus years history of fiat currency. Improving infrastructure and maturing regulations are paving the way for mainstream adoption of this emerging asset class. Strong hands eager to participate will enable deeper liquidity and more stability in prices. These trends unfolding over the medium term will ensure Bitcoin and other digital assets solidify their position as an important asset class in most portfolios and may even lead to Bitcoin’s acceptance as an alternate, international “money”.
As per some reports, as many as 19% of the world’s population has already familiarised themselves with Bitcoin and other digital assets, be it for value transfer, investment, or pure speculation.
Never before in human history, has a completely new form of potential money gained such high traction, global awareness, and acceptability within a decade.
Future of Money – Emergence of distributed financial systems
‘Ebbing’ of COVID-19 is critical before markets regain confidence. We are observing a reduced number of new infections in most countries around the world.
With the current scale of COVID-19 breakout pushing all major countries under lockdown, a recession can’t be ruled out. Almost all businesses have been adversely impacted and unemployment levels are hitting a record high. Global economic machinery has come to a standstill (at least temporarily) and everyone wants to stay in the safety of cash. This is a period of survival of the fittest and most adaptive.
Smart investors will realize that the value of cash they are holding (or hoarding) will potentially lose its purchasing power due to the liquidity injection.
When central banks print currency, they cause the base money supply to increase. This base is referred to as M0 in financial parlance. An increase in M0 by itself does not cause inflation. However, because our existing financial system is a fractional reserve banking system, an increase in M0 creates a money multiplier effect through new loans that are given out by banks based on new money (newly minted M0). This multiplied money is referred to as M2.
During the Global financial crisis in 2008, we witnessed a huge increase in M0 but M2 remained relatively stable. This happened because most of the new money was hoarded by the banks and was used to shore up their battered balance sheets and to buffer against toxic assets. Very little money actually flowed back into real businesses, especially small businesses that create the bulk of employment. The loans that were given out were mostly concentrated in larger corporations who then used these funds to buy back their shares rather than invest in the real economy. Repressed interest rates created fertile ground for larger corporations to also tap into credit markets and funnel it back into further buying equities. Thus, individuals and businesses at the bottom of the pyramid saw very little trickle-down benefits from central bank largesse. As a result, the consumption of real goods and services remained capped and the ability of businesses to pass increased costs to consumers was severely restricted. Inflation in real goods and services thus remained modest while financial assets experienced huge growth.
This nuanced view into mechanics of QE playing through the economy explains how despite modest inflation, mom-and-pop savers and marginalized sections of society were penalized while rich cream of society benefited from participation in the financial asset boom. Here again, nuance is important. Not all financial assets inflated equally. Private markets experienced much higher growth than public markets. As only the richest are allowed to participate in private markets, they benefited even more than the middle class who were able to participate in public markets. This is how wealth inequality increased between the bottom of the pyramid versus the middle class versus the top 1%. As you can decipher, the top of the pyramid benefitted extraordinarily from the central bank bounty.
The most important questions now are, how will the current round of liquidity injection play out in the near future? Will it finally cause the much-dreaded hyperinflation?
We don’t know with exact certainty but we will place certain facts before you.
- Bank balance sheets are much healthier than in the previous crisis.
- Central banks are directly participating in credit markets.
- Much better models are being used by central banks, having learned from their previous experience. These models account for “households being unequal”, “households having different asset portfolios” and for the fact that individuals consume 60% of windfall increases in their “deposits” compared to under 15% of gains in less liquid asset portfolios like mutual funds or home equity.
- Thus Fiscal policy response is much more aggressive than before. Money is being directly distributed to smaller businesses as well as individuals through unemployment and other benefits.
- Large corporations receiving backstop from government or central banks have been banned from using these proceeds to buy back stock.
- Interest rates will remain low for a long period of time.
- A major commodity (oil) is witnessing never-before-seen cooperation across all producer nations, which will lift up prices in the medium term.
With these facts in front of us, we can deduce that this time, there is a higher likelihood of more widespread inflationary impact on financial and real assets (commodities, factories, land) as well as goods and services. Savers will be more severely penalized for hoarding cash or cash-like instruments. Investment into appropriate asset classes will be more important than before to preserve buying power – even for everyday consumption and basic needs like providing for the education of kids (we are not talking luxury here).
Gold and Silver will remain important constituents of a well-balanced portfolio. Bitcoin and few other digital assets have proven to have unique qualities of being uncorrelated with other asset classes and cannot be expropriated. Thus it will attract large inflows. Other important asset classes providing inflation protection would be commodities, inflation-indexed bonds, real estate, and very importantly private markets.
Some of these asset classes are currently inaccessible to mass retail participation due to regulatory, economic, or operational issues. We believe this crisis will create massive tailwinds for businesses creating access to such investment opportunities for mass adoption. Digital assets that democratize access to private markets, real estate, commodity-linked structured products and other such sophisticated investment options through appropriate regulated vehicles will be big winners in the new world order that will seek to reduce poor side effects of QE such as wealth inequality.
Will the millennials and generation Z born with computers, tablets, smartphones, and global internet connectivity continue to prefer traditional assets or will they adapt to digital assets?
A recent report showed that Millennials are set to inherit over 68 Trillion US dollars from Baby Boomers (1944-1964 generation) by 2030.
The distrust Millennials have in governments and corporations is already high, and multiple reports have shown Millennials are preferring digital assets over gold and equities.
Institutions are also experiencing this shift. Most recently, Deutsche Bank not only tweeted this image of Bitcoin at the center of fiat currencies, but they have also even predicted a possible demise of fiat currencies in their research report Imagine 2030.
Has Bitcoin and digital assets infrastructure matured enough to be explored as an alternate option?
Many die-hard digital asset fans would claim it has. The technology and the infrastructure indeed have come a long way in the last decade and has shown tremendous potential for the future to come.
So, the question is will Bitcoin and digital Assets substitute currencies and precious metals or emerge as a formidable alternative asset class in its own right?
Convincing the world and billions of humans to shift to a new value exchange system is impossible. It is also good to have alternatives. The current approach of one size fits all is not working. As Bitcoin and other digital assets become more distributed, their market value will be more akin to intrinsic value. As the software, protocols, security, scalability, and most importantly the user experience mature, we will see a J curve in adoption.
Can it be done? Why not, when the smartest talent in technology, business, and financial services is involved.
Can it happen within the next couple of years? No, the evolution of technology and its social acceptance takes time.
Can we see this happen in this decade? Absolutely yes, read more.
The decade of digitization and digital assets
We believe that this decade will be called the decade of digitization & Digital assets.
This is the beginning of chaos, bringing in its wake phenomenal opportunities for the adoption of Distributed Ledger Technology (DLT) and sound money. In general, the trend towards digitization across all industries will accelerate. Finance will be at the forefront of this change.
Regulatory clarity is emerging fast. In the last twelve months alone, most of the global institutions and standard-setting bodies have got deeply involved in creating frameworks for digital assets. Financial Stability Board, IMF, BIS, FATF, International Organization of Securities Commission are just a few of these, as an example.
New players are building required infrastructure while traditional capital market players are showing promising signs of paving the way for mainstream adoption.
A new financial system is being created even as you read right now. This new financial system will be more democratic, more efficient, more effective, and more widespread in its reach than anything we have ever seen before.
Authors: Himanshu Yadav, Pranav Sharma, Tuhina Singh
Infographics: Deepa Vishwanathan
The views, information, and opinions expressed are solely those of the authors in their personal capacity and do not reflect the official position or views of Woodstock. The authors have taken the utmost effort to ensure the research is up-to-date and accurate. However, no warranties or representations, express or implied, are made as to the timeliness, completeness or accuracy of the information. Readers are advised to obtain independent professional advice before making any investment decisions or investing. Woodstock does not endorse the views expressed by the authors. Under no circumstances shall Woodstock, its affiliates, partners, directors, employees, or advisors be liable for any loss suffered by a reader on account of the views, information, and opinions expressed herein.
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