In his book, “The Black Swan”, Nassim Nicholas Taleb explores our inability to grasp randomness, particularly when it comes to significant market deviations and the difficulty of predicting specific events. History does not always exactly repeat itself and the biggest events are usually not entirely predictable. However, markets have been shown to be cyclical, whether it be the commodity cycle, long-term debt cycle or annual market seasonality events. So, what can we learn from the past given the current market conditions?
TS Imagine provides a Stress Testing Risk Module as part of its suite of Risk Products. This module includes native Historical Scenarios that can be customized to meet specific needs. These scenarios are based on past decades, allowing for a comparison with the current market environment. The resulting scenarios are then utilized as inputs into the engine for further analysis. Below we put this functionality to the test, building specific scenarios from previous events.
The Inflation Deflation Cycle of the 30’s-40’s
The long-term debt cycle theory, made popular by Ray Dalio, details multiple episodes of growth and recession over time where each episode accrues to an expansion of household debt until a severe depression resets the entire system. Over this timeline, the debt to GDP ratio extends to new highs and the interest rate falls to new lows until debts reach their peak and interest rates hit zero.
|These were the exact conditions of the 2008 Global Financial Crisis, where interest rates reached zero and private debt levels were extremely high. The last time this occurred was the early 1930s during the Great Depression. In both occurrences there was a banking crisis, which led to an expansion of the monetary base.|
|During the 1930s, monetary policy reached its limitations in addressing the challenges posed by the private debt bubble. As a result, it was the fiscal response in the 1940s that proved necessary and led to an inflationary surge. Similarly in the 2010s, we had an unwinding of the private debt bubble and a large monetary response, however there was limited fiscal intervention. When we entered the 2020s, private debt remained high despite the deleveraging of the last decade. However, with COVID spreading in 2019-20, the pandemic became the catalyst for a persistent increase in constant cash flow due to the fragility of an economy with such high debt. Globally, fiscal stimulus was at its highest since World War II. This figure highlights the increase in broad money supply – rising at its fastest pace since the 1940s.|
Aligning with the 1940s, the long–term debt cycle has now entered its second phase; the public debt bubble. As Adam Fergusson wrote in his book ‘When Money Dies’ (depicting the extreme impacts of deficit spending, devaluation, and hyperinflation in Weimar Germany), “inflation is the ally of political extremism”. Similar to the circumstances of the 1940s, the present era is characterized by elevated levels of debt, increasing wealth inequality, and the emergence of political populism. These factors have contributed to the growing discourse surrounding the necessity of fiscal stimulus.
|So let’s rewind – what happened to inflation in the 1940s? As depicted here, inflation came in bursts, but CPI never returned to its baseline (i.e., prices remained at those highs permanently). CPI overall went up 90% between 1940 and 1952.|
The reason inflation wasn’t transient in the 1940s was that, after commodity shortages, there was substantial fiscal stimulus, and the currency was devalued. Debt was effectively eroded through inflation, aided by prolonged periods of negative real interest rates. As a consequence, those holding cash and bonds took the brunt of the pain over the long term.
Raising rates, as we are currently seeing globally, serves as a measure to combat inflation, particularly if lending practices are its source (this approach is effective in countering inflationary pressures, as exemplified by the demographic inflation period of the 1970s, which will be discussed in our upcoming blog post). However, if large fiscal deficits are driving inflation (e.g. wartime or post pandemic spending), alongside global supply chain issues and deglobalisation, then increasing rates only increases the federal deficit and this pours into the economy as a form of money creation.
In 2021, estimates suggested that in order to bring the US debt-to-GDP ratio to a sustainable level and normalize interest rates, it would require allowing CPI to increase by 10-20% annually for a duration of 4-5 years. In the 1940s, the US managed to successfully inflate its debt away. However, due to large fiscal deficits, they adopted austerity measures for a number of years. Outside of the US, Europe faired far worse, and Japan went into hyperinflation. The decade was a slow bleed, with yields remaining below inflation for approximately ten years in an attempt to prevent double-digit inflation.
For an example of how to use TS Imagine’s stress test engine for the current period based on the deflationary period after the first inflation spike of the 1940s, we could build risk factors as follows:
Stress Test Input Factors:
- Inflation Yields decreasing by 500bps (“USD-CPI” predictive shock)
- Equities decreasing by 30% (“.SPX” predictive shock)
- Rates Yields decreasing by 250bps (USD-GOVT” predictive shock)
- US Dollar Increasing by 5% (“USD” global shift)
For more information on how we build these stress tests and the flexibility in our input model for the risk factors please contact a TS Imagine expert.