These Truths Are No Longer True
“When the facts change, I change my mind. What do you do, sir?”
British economist John Maynard Keynes supposedly said that in a debate about 60 years ago.
Over the last decade, lots of facts have changed, forcing the entire economics profession to rethink many ideas that had become truisms. And that overhaul of old ideas has spilled over into financial markets, forcing investors to reconsider how they value assets and approach markets.
Here are two truisms that don’t seem so true anymore, along with their impact on investors.
Truism No. 1: Free trade benefits everyone!
That idea drove trade and economic policy for some six decades, until recently. (And the theory behind it dates to classical economist David Ricardo in the early 1800s.) The worship of free trade resulted in a relentless push after World War II – led by the U.S. – to ink trade agreements that removed tariffs and most other barriers to free trade.
Those trade agreements included NAFTA and the European Union, among many others. But perhaps the most consequential free trade policy was allowing China to enter the World Trade Organization in 2001. That greased the wheels for the Asian giant to become a manufacturing powerhouse.
Nearly 20 years later, however, it seems that maybe everybody doesn’t benefit from free trade after all.
The “elephant graph” – so called because it resembles the shape of an elephant – is perhaps the best way to illustrate this.
The points on the graph represent all global workers. Those further to the right are higher up on the income ladder. Those nearer the top of the graph saw bigger income gains during the peak of free trade growth, from 1988 to 2008.
The people near point A are typically workers in low-income countries, predominantly India and China. Free trade has treated them well indeed, with income gains of 60% to 80% on average – and much higher in some regions.
Those near point C are the global 1% – typically wealthier people in advanced economies. Think of bankers, executives and high-income professionals in the U.S. and Europe. They, too, enjoyed big gains from freer trade.
So, who was left behind? Those near point B, who experienced little or no income growth during the period. These are middle- and working-class workers in wealthy nations.
Of course, these workers didn’t need a chart to see the impact of free trade. They felt it acutely, as industrial regions in the U.S. and Europe were hollowed out by competition from low-wage workers in Asia.
The backlash to that has unfolded over the past decade, including a screeching halt to the expansion of free trade in recent years, Britain’s shocking vote to leave the European Union (Brexit), and the election of Donald Trump and his brand of economic nationalism, among other reactions.
For investors, this has meant much greater volatility in recent years as attempts to drag down or overhaul the international trade order have sent financial markets whirling. Recall the Dow’s plunge of 724 points on a single day in March 2018 when President Trump first proposed major tariffs on Chinese imports.
There have been many similar market drops since then, caused by the ongoing U.S.-China trade war. And the seemingly endless stops and starts of Brexit have spurred similar market gyrations.
Uncertainty surrounding trade policy is playing a prominent role in market volatility. And investors will most likely just have to get used to it for the foreseeable future.
Truism No. 2: Robust economic growth leads to higher inflation .
This one has been a cornerstone of economics for decades. When the economy expands at a good clip – as the U.S. economy has been doing since 2010 – prices and wages are supposed to rise, causing inflation.
Central bank policy has long been based on this idea. The modus operandi for the Fed and other central banks has been to prevent inflation by slowing the economy when it grows faster than usual or the unemployment rate falls “too low.”
But in the current 10-year U.S. economic boom – the longest on record – inflation has been conspicuously absent. Pundits have called this “an unsolved mystery,” the “missing inflation puzzle” and “a whodunit that hangs heavily over the Federal Reserve.”
Theories to explain this mystery abound:
- New technologies have lowered costs for businesses and allowed them to profit without raising prices.
- An aging workforce, with baby boomers retiring, is driving down compensation levels.
- Labor unions, which drove wages – and therefore prices – up, have become much less powerful.
- The entry of 1 billion low-wage Chinese into the global labor force has depressed wages and prices worldwide.
Which of these theories is correct? Nobody knows! And your guess is as good as the experts’.
For us investors, it’s something to watch very closely.
The Fed, unable to detect much inflation despite strong growth and low unemployment, finds itself at a loss. It ended up lowering interest rates three times this year, despite unemployment hovering near a 60-year low.
A policy move like that was once unheard of. And it sent the stock market higher just when analysts were warning that valuations were already too high and a bear market was approaching.
It seems the Fed is no longer in the business of “taking away the punch bowl just as the party gets going,” as former Fed Chairman William McChesney Martin famously prescribed.
But the Fed also may have little ammunition to fight the next recession when it does inevitably arrive.
Trade-related volatility on the one hand, powerless policymakers on the other.
Buckle up, investors.
About Matt Benjamin
Matt has worked as an editorial consultant to the International Monetary Fund, the World Bank, the Economist Intelligence Unit and other global macro-institutions. He wrote about markets and economics for U.S. News & World Report, Bloomberg News and Investor’s Business Daily, among other publications. He also worked for several years as head of political economy for a Financial Times-owned macroeconomic consulting firm, advising hedge funds around the world. Matt’s claim to fame is that he’s interviewed two U.S. presidents and has spoken with five Federal Reserve Chairs from Paul Volcker through Jerome Powell. Matt also served as The Oxford Club’s Editorial Director for two years.