March 23, 2015

March 23, 2015

The Kondratiev Wave: Today and in the Great Depression
As regular readers know, we have for years talked about Nikolai Kondratiev and his theory of long waves in economic and social life — a theory with which we are in general agreement.  Here’s a brief refresher on Kondratiev waves (also called long waves, K-waves, or the supercycle.)Nikolai Kondratiev (spelled “Kondratieff” in the older system of transliterating Russian characters) was a Communist-era Russian economist who noticed long waves in capitalist societies, lasting approximately 60 years.  He divided these long waves into four phases to which he gave seasonal names: spring, summer, autumn and winter.  Each season has certain economic and geopolitical characteristics, and the transition between seasons often corresponds to political or social events: wars; inflations and deflations; booms and depressions.  In essence, debt builds up in the spring, summer, and autumn, and is repudiated in the winter.One Rough Scheme of Nikolai Kondratiev’s Theory of Long WavesInteresting Image
Source: Wikipedia

We believe that the current long wave’s winter season — characterized by deflationary influences and debt collapse — began in 2000.  We do not know how long it will run, but it could be many more years before sufficient debt repudiation occurs to call an end to winter and the beginning of spring.  Thus far, global financial authorities — the U.S. Federal Reserve under Ben Bernanke, as well as other global central banks — have responded brilliantly to the crisis of deflationary influences afoot in the world economy.  Now the question is how well the Fed will deal with the coming crises in world economic system.  Will they raise rates too soon, and cause another major collapse?  The Fed did this in 1937 and 1938 as we were coming out of the Great Depression, and actually extended the Depression for several years.  Or will they wait too long, and give inflation a serious foothold that penalizes the saving class and hurts the retired class?In order to determine the best course of action for the Fed, let’s review the history of the Fed’s activities during the Great Depression, and perhaps we can identify some parallels to the U.S. experience from 2008 to the present.  While we do not know what decisions the Fed will take and we do not know the outcome of those decisions, we have a strong preference for a course of action from the Fed that will most likely lead to more desirable developments for the U.S. economy and global investors.In what follows, we examine the Fed’s actions during the Great Depression from the peak of the stock market and economy in 1929, and identify parallels to the Fed’s actions since the peak of the stock market and economy in 2007.The primary questions that history may help us answer:

1.  Will the Fed act to head off U.S. inflation before it appears by raising U.S. interest rates soon?

2.  Will the Fed act as if the U.S. Dollar is the world reserve currency?  If they take this view, they must move slowly to raise interest rates, because the world today is plagued by deflationary influences, and the world economy is growing very slowly.  In this case, the Fed will not raise interest rates soon.

The Historical Parallels

  • Debt hit a bubble top in 1929 and in 2007.
  • Stock and some bond markets crashed, some financial institutions failed (many more in the 1920s and 1930s than has been the case since 2007).
  • Money printing began 1933 and 2009.  No more debt growth was possible, so money printing took place to reverse the downturn.
  • Stock markets around the world rallied, 1933 to 1937 and 2009 to 2014.
  • The economy improved, 1933 to 1936 and 2009 to 2014.
  • In 1937, the Fed tightened reserves, and as a result, the U.S. stock market fell after the second tightening occurred in March 1937 and the third in May 1937.  The market began to fall in March 1937, and fell until March 1938 — declining more than 50 percent.
  • There was a tax component to the problems in 1937 as well — the Social Security tax was inaugurated, and there was a smaller cut in government spending.  The combination of higher interest rates, higher taxes, and slightly less government spending was toxic for stocks and the economy.  2013 saw an increase in U.S. income tax rates, and 2014 saw the approval of the Affordable Care Act, which has 21 different taxes imbedded in it.  Spending is falling as a percentage of GDP, but it is rising in absolute terms.  So there are two similarities and one difference between 1937 and today.

We are confident that the Federal Reserve would not like to see a significant decline in the stock market accompany their interest rate increases.  The Fed did not expect interest rates to rise and stocks to fall so hard when they took action in late 1936 and early 1937.

We wrote the above analysis in the lead-up to yesterday’s statement from the Fed’s Open Market Committee (FOMC).  In her press conference yesterday afternoon, Fed Chair Janet Yellen gave us a reason for optimism when she assured us that even if inflation were to return toward 2 percent, and employment were to continue to make gains, the Fed was unlikely to press for higher rates until the economy was stronger and inflation appeared to be on the verge of becoming problematic.  We view her remarks as bullish for stocks in the U.S., Europe, India, and China — in great part because we expect no Fed rate increases until the beginning of 2016.  We had been of the opinion that they could rise in September 2015.   

In last week’s Commentary, we also discuss:

  •     We can have economic growth and protect the environment.
  •     Brazil, a case study in Murphy’s Law.
  •     Meet your new robot underwriter.