Capital manufacturing capital
‘New Ideas, more than savings or investment or education, are the key to prosperity, both to private fortunes… and to the wealth of nations’ – David Warsh; ‘Alex Poyarkov, a former goldmedal winner of the Mathematical Olympiad’ was the subject of a ‘bidding war among hedgefund heavyweights Renaissance, Citadel and TGS’ – Wall Street Journal, May 22nd, 2017
Victor Shvets writes
The key to current macro-economic and investment climate is that we are residing in a world that can be best described as the age of ‘declining returns on humans and eroding returns on incremental capital’. As the Third Industrial Revolution (or Information Age) picks up pace, it is not labour hours, demographics or conventional capital investment that generate productivity, but rather a far more oblique concept of knowledge and social capital.
The key challenge is that even though neither labour nor capital spending are any longer the key drivers, we are busily creating fresh capital to maintain and lubricate global liquidity and avoid any sustained de-leveraging. If we define capital holistically (anything from repo and derivative markets to equities and bonds), the ‘fireball cloud of finance’ is getting ever larger. However, most of the incremental capital cannot find productive deployment on the ‘ground’ in real economy and hence it is incessantly looking for allocation within the ‘cloud of finance’ itself. As it gets bigger, the ‘cloud’ presents an ever greater danger to a small underlying real economy below, forcing CBs and the public sector to act aggressively to control and corral it, so that the cloud does not collapse on itself.
In the world that is drowning in excess capital, cost of capital can never increase. In the world where ‘fireball of financial instruments’ must continue to expand (otherwise it is always in danger of collapsing on itself), there is limited tolerance for any volatility. Neither CBs nor investors can be confident that volatility in one segment however small) will not suddenly impact completely unrelated asset classes. This type of ‘butterfly effect’ could cause an explosion in the sky’. Hence, Central Banks and other public sector instrumentalities are likely to continue to ‘corral and direct’ financial markets, and if needs be, public sector might resort to outright nationalizations. It is all for our own good, as ‘financial cloud’ is now at least 4x-5x the size of real economy, and any disturbance in that cloud would unquestionably have devastating consequences on the ‘ground’.
We are essentially describing a world of no discernible business or capital market cycles and the world where ‘financial cloud’ must remain disconnected from fundamentals. While eventually the time of reckoning would arrive and the two spheres would need to (once again) converge, it is far from clear how this will occur.
Victor concludes by saying that it as the fight between Olympians (representing technology and overfinancialization) and Titans (representing political reaction against globalization and deflation, in favour of localization and reflation). While Olympians are ultimately going to win this fight, some rounds could go the Titans’ way (primarily when the US and China are on the same page) and it could take some time, before Titans are finally exiled.
In our view, disinflation remains the ‘beating heart’ of the investment landscape.