Hedge Fund CIO: “Are We on The Cusp of Economic Regime Change And Unprecedented Wealth Destruction?”

The comments below are an edited and abridged synopsis of an article by Eric Peters

One man’s debt is another man’s asset. In theory, it shouldn’t matter how large either grows. But debt creates asymmetry between borrower and lender. When the economy is stressed, borrowers must retrench, and lenders must decide whether to fill the economic void. By repairing their balance sheets, the borrowers do additional economic damage.

Hedge Fund CIO: “Are We on the Cusp of Economic Regime Change and Unprecedented Wealth Destruction?” | BullionBuzz
Silhouette of young businessman pushing large stone (representing economy) uphill.

Lenders tend to wait and see how things shake out before stepping in. Central banks provide stimulus to lure them back. The higher an economy’s debt, the more susceptible it becomes to failure and the less responsive it is to stimulus. So central bankers must work harder. By doing so, they slow necessary adjustments in parts of the economy where balance sheets are unsustainable. This leads to leveraging up in places where balance sheets are strong, creating new excess.

During each downturn, central bankers must step in aggressively.

Financial markets have tied themselves to the wrong inevitabilities—low interest rates, asymmetric central bank reaction functions, and negative bond-equity correlation. Now a financial system that is intolerant of inflation faces a political economy regime change that makes inflation necessary.

Seeking to escape 1970s-style inflation, policymakers engineered a deflation machine. China’s rise into the global trading system amplified its deflationary force.

From the S&P 500 peak in 1972 to the 1974 trough, a 60:40 stock/bond portfolio lost 60% of its nominal value. In real terms, it lost 70%. There was no V-shaped recovery that quickly returned portfolios new highs.

Is this the cusp of economic regime change and wealth destruction not seen since the 1970s?

It doesn’t take much imagination to see where this comes from—a shift in regime with government spending financed by central banks, secure in the belief that their deflationary machine will grant them license. Today the climate is deflationary, and the machine is being dismantled. The instability inherent in one extremity can easily swing to the opposite. Such a shift is not merely possible, it is inevitable.

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