The Road to Oz Part II


And I’ll stand there with the Wizard…When people see me, they will scream for half of Oz’s favorite team: The Wizard and I!

Elphaba, Wicked—The Broadway Musical

For those of you not familiar with the storyline of the Broadway musical “Wicked,” the story begins by taking the audience back in time from the death of the Wicked Witch of the West to her creation and that of her arch enemy, the Good Witch of the North. Further, the play also gives us insights into the humble beginning of the great and powerful Wizard of Oz. Our analogy is not perfect, in “Wicked” it is the Wizard of Oz himself who spawns Elphaba, the future Wicked Witch of the West, or in the vernacular of our analogy, the terrible phenomena of deflation. However, from that point forward the plotline not only parallels the challenges of your average economist, but once again lauds the accomplishments of the Wizard (central banks) and their able accomplice, the Good Witch Glinda (inflation). It is rather humorous to note that many believe the deflationary struggle of the 30s was brought about at least in part by the U.S. Federal Reserve’s handling of monetary policy following the stock market crash of 1929, and that the Wizard of Oz premiered at the end of the Great Depression in 1939.

As “Wicked” opens, Elphaba (deflation) is not that most feared of witches…rather, she is simply a poor misunderstood girl who finally has the opportunity to attend a wonderful school of magic. She is to room with the most dazzling of students, Glinda, already well on her way to stardom and future glory much like inflation in today’s version of capitalism. While initially Elphaba and Glinda absolutely detest one another, they are brought together by Glinda’s attempt to reform Elphaba and make her presentable. Unfortunately nothing can make deflation completely presentable, but perhaps if Elphaba can make it to the great and powerful Oz, the two of them will make an unbelievable team. Despite all of her efforts, Elphaba is eventually rejected by the Wizard who chooses to align himself with the much more palatable Glinda. After all, what good would a central bank be if it didn’t try to conjure up a little inflation now and then? We find that in the end despite his close affinity to and responsibility for Elphaba, the Wizard turns his back, and deflation rears its ugly head turned into the most threatening villain in society today…of course, we mean Ozian society.

In much the same way, the central banks of today seem to have a significant aversion to even a whiff of deflation. It is certainly true that if deflation fully catches hold, it can be catastrophic in its impact. As consumers postpone purchases, prices fall and a downward spiral is created where wages ultimately follow prices, and consumers and corporations are unable to service their debt. Finally, a wave of defaults sweeps across the economic landscape. However, the concept of stable prices does not really include the necessity of inflation. Rather, stable could be just that…”stable” i.e., neither rising nor falling. In our view, there are significant deflationary forces at work in the world today. The large and growing pool of labor that is easily accessible through technology puts downward pressure on the developed market wage base. Further technological efficiency and productivity enhancement may also put downward pressure on certain goods. Technology improvement and scientific advancement may also lower the price of various commodities. However, given the rapid growth of the emerging world, its markets and its consumers, it is hard to accept that a widespread deflationary spiral is just around the corner. We would also contend that by trying to spur inflation, central bank intervention may ultimately result in more economic destabilization rather than less. In our view, the recent actions of the Swiss Central Bank support this view. While the action by the Swiss Central Bank was focused on a specific issue…The Bank was not willing to face the possible currency intervention required to maintain the Swiss/Euro peg if the Euro were to continue to depreciate based on additional QE on the part of the European Central Bank (ECB). Currency markets were certainly caught off guard. No one expected the Franc to appreciate so dramatically or so quickly, and significant volatility in both currency and securities markets was the result. This destabilizing impact came about, at least in large part, due to the ECB’s willingness to consider additional unconventional monetary policy measures to support the Euro zone economy. Follow on effects of this nature are the negative byproduct of continued monetary intervention in what is largely a political issue. The Euro Zone is a currency union, not a full blown political union. Until the political ties are more clearly delineated, the situation will remain inherently unstable. The fallout from this situation is informative and may assist us in formulating our current macro-economic viewpoint.

Central banks will continue to engage in monetary experiments when under political or economic pressure to do so. At the extreme, this may prove even more destabilizing to investment markets than the outcome the banks were seeking to avoid. The follow on effects are often too difficult to model, and while Central Banks often claim political independence, in the end they will often bow to political pressure resulting in unforeseen outcomes. The crisis in the Euro Zone has not been effectively dealt with. The ultimate issue is political, not monetary. Until the various countries deal with the political differences, the currency zone will, in our view, remain inherently unstable. Further, it is quite likely that various countries may find it in their best interest to leave the zone, further exacerbating the instability of the current system.

Rather than address the structural and demographic issues plaguing their economies, developed countries seem content to rely on their central banks to create monetary solutions to their economic problems. We believe this continued interaction on the part of central banks around the world negatively impacts true price discovery and probably impedes capital allocation and the flow of funds around the world.

Initially, the challenges faced by other developed economies and the subsequent monetary easing employed by their central banks to address these issues will likely make international equities less palatable to U.S. investors. Unhedged positions may appreciate in local terms, but that appreciation may be wiped out by falling currencies. The U.S. macro environment is relatively strong, and we believe this fact coupled with reasonably accommodative monetary policy should result in continued gains for U.S. equites throughout the remainder of 2015. However, as the U.S. Central Bank seeks to normalize policy, we remain concerned that the gradual removal of the monetary tailwind and the subsequent rise in interest rates will lead to additional volatility in risky assets. We do not expect the Fed to be able to reach their goal of full monetary normalization. Rather, we believe that as rates begin to rise the effect will “feel” more significant to market participants due to their longstanding reliance on low and perhaps even negative real rates. Consequently, recession may choke off the Fed’s normalization program sooner than expected, perhaps as early as mid to late 2016.

Financial Advisory Consultants DBA/Cornerstone Management Inc. is a Registered Investment Advisory Firm. Although the information in this report has been obtained from sources that the Firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

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Bryan Taylor