Crypto Market Commentary
29 July 2019
Doc's Daily Commentary
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Mind Of Mav
Are Recessions Extinct?
Today during the Omnia call in Discord we eventually came to a discussion, as we often do, regarding the current state of the macro economy and how Bitcoin / cryptocurrencies can gain from global uncertainty?
But, I thought, what if that line of thinking is flawed because it assumes the market will play by the rules it did in 2008.
What if, instead, we’re witnessing an entirely new paradigm of monetary trends and we need to relearn our understanding of economies?
This led me to learn about the term, the ‘Great Moderation’, and how it tells us of a time beyond conventional recessions.
So, what is it, and should we take it seriously?
In 2002, economists James Stock and Mark Watson published a paper where they coined the term ‘Great Moderation’. They were trying to explain why the business cycle, the ups and downs of the economy, seem to have become less volatile over time.
In my observation, this trend has only strengthened since then, with the underlying reasons giving more and more explanatory power to what we are seeing in the economy today.
The Boom ‘n Bust Cycle
So, what does it mean to say that the business cycle has become less volatile over time?
In a nutshell, the business cycle looks like this:
As the good times carry on, businesses expand their investments in productive capacity such as labor, materials, property and equipment. When the eventual shock happens, and the demand side of the equation freezes up, the economy begins a deflationary cycle as businesses race to reduce their investments, lay off staff and clear out inventories.
Hedge fund manager and all around smart dude Ray Dalio has an excellent animation which explains this business cycle.
The Great Moderation theory observes that the business cycle is far less volatile than it used to be. That is, the highs and lows are less high and less low. So, what’s changed?
Labor is less ‘sticky’ — in the old days, workers could count on a large degree of job security with pensions and union membership. These days, labor is available to businesses more or less ‘on demand’. With the rise of contract work and the gig economy, a business can ‘dial in’ the amount of labor it needs depending on market conditions and shifting product tastes. Gig economy workers are paid for each increment of value that they create, without the overhead cost of a traditional full-time employee (benefits, pension, etc) or the cost of an employee’s idle time.
Just-In-Time Production — When businesses don’t have accurate information about market conditions and product tastes, they are, in essence flying blind in determining the amount of production they need. In the old days, a business could only guess how much inventory to produce in anticipating future demand. Guessing wrong could lead to huge surpluses or deficits of inventory, forcing businesses to make drastic changes to correct. These days, businesses don’t need to guess. Improved sales forecasting and inventory management allows businesses to dial in the amount of production they need.
So why is it important to understand the Great Moderation? I would argue that it is hugely important to consider the economy through the lens of this theory if one wants to understand and respond appropriately. Unfortunately, many market observers fail to grasp the implications of the Great Moderation.
Debt and the Money Supply
Let’s understand why by looking at the current state of things.
Many observers have become alarmed at the multiple-fold increase in debt and money supply in the financial system. Governments, businesses and consumers have all greatly increased their level of borrowing relative to income in recent years.
The alarm would be understandable if you think like Ray Dalio — one thinks in terms of boom and bust cycles. The fear is that, when the economy turns south, the amount of debt in the system would not be re-payable leading to a cascade of defaults and a contraction of the economy.
This is what we witnessed in the Great Recession of 2008.
The counter to this argument is that lower volatility allows us to normalize the idea of huge debt loads. The more stable your future cash flows are, the more debt you can take on.
Here’s an analogy: when road conditions are treacherous, one must reduce the speed of driving so as not to lose control of the vehicle and cause an accident. However, when conditions are clear, with no obstacles, twists or turns in the way, the vehicle can travel at maximum speed with little risk.
So it is with debt.
Debt holders have been loading up, because there is a sense that the risk of a sharp contraction is very low. The market knows this and acts accordingly. Despite the massive debt loads, the return premium required to invest in risky assets has remained compressed.
If one accepts the Great Moderation theory, then what can we expect to see in the future? My thoughts:
Instead of sharp contractions followed by huge booms, we will see slowdowns followed by low/moderate rates of growth. We may never see a technical recession again (defined as two consecutive quarters of negative economic growth).
Monetary policy will become less effective. Already we see that despite the huge amount of liquidity in the system, central banks have been ineffective at stoking inflation and faster growth.
Structural changes (exponential technology, zero marginal cost energy, 4th Industrial Revolution) will create value that is not captured by traditional measures of economic growth. So the slowdown periods may actually be masking what is a time of huge value creation.
Risk premia will continue to compress. With less volatility comes less risk, and with less risk comes less reward. The market will continue to bid up investment assets to the point where payback periods will stretch towards … infinity and beyond.
So, where does this leave us?
There’s quite a lot of uncertainty in the global markets right now and I’d be quite bold to claim I know where it is headed exactly.
What I do know is that the market is both cyclical and unpredictable.
Great Moderation theory is an interesting lens with which to view our current circumstance and see opportunities where others may not.
No matter what, we can be certain that the times ahead are uncertain, and also very exciting.
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