In 2020 asset prices have been supported by widespread money creation. This has staved off a worse economic collapse, but raises the prospect of an inflationary outlook. Iran offers an interesting case study on what can happen to equity markets.
Conventional central bank policy has always used interest rates as a tool to steer economic activity; raising rates to cool an economy, and cutting rates to encourage lending and economic growth. By controlling the supply of money, policy makers have historically been able to smooth the economic cycle and shape asset prices.
In 2020 we have seen this taken to extremes. Interest rates have been cut to near zero, corporate bonds are being systematically purchased to lower company re-financing costs and the consumer has benefitted from direct cash transfers through furloughing schemes and generous unemployment benefits. By August, the US money supply as measured by M2, increased by +23.3% year on year.
To date this has not increased inflation, due to collapsing demand from the virus pandemic. Yet with elevated savings rates, prospects of further direct financial transfers into the pockets of consumers and government spending on infrastructure projects anticipated to rise sharply, the money supply and central bank balance sheets could continue to expand at a fast rate.
Consequently more and more investors are expressing genuine concern about the future purchasing power of their investments, and the knock on impact on equity and fixed income markets. While it is not our base case that authorities in developed markets lose control of the money supply, in a slightly dystopian future, it’s not an impossibility and emerging markets can offer us a clue as to what might happen.
The Iranian experience
Between 1998 and 2013 the Iranian stock exchange experienced a most extraordinary bull market, multiplying in value by 54 times. A 2014 academic paper Response of Stock Markets to Monetary Policy: The Tehran Stock Market Perspective attempted to work out what had been the main drivers behind this. In the paper they highlighted the importance of a falling exchange rate, rising inflation and the money supply, which all combined to drive the index higher.
Over the time period, the monetary base increased by a factor of 18 due to government subsidies and cash handouts designed to offset the negative impact of US sanctions; cash which, like today, found its way into risk assets.
The authors found that a change in the monetary base leads to “strictly significant and positive values” in the stock market. Furthermore substantially increasing the money supply causes 1) increased economic activity, 2) portfolio shifts from bonds to equities, and 3) shifting inflation expectations.
With the benefit of hindsight, and some knowledge of behavioural economics, it’s not all that difficult to see why this might be the case. The prospects of rising inflation eroding your capital should elicit more economic activity, while portfolio asset allocations will change in the face of higher inflation. If you started 1998 with a 50% holding in fixed income, it’s unlikely that you would look to end 2013 with the same portfolio mix. When there is no alternative, a higher allocation to the more volatile equity market can offer better inflation protection in the long run.
This brings us neatly to the present day, and another challenging backdrop for Iranian investors. Coronavirus, a low oil price and threats of economic sanctions have seen annual inflation rise to 34% (Source: Trading Economics) and the black market value of the currency drop by more than fifty percent against the dollar. All bad news in theory for the stock market, yet a return of 290% (down from +400% in August) suggests otherwise.
So where does all this leave us? Looking ahead to 2021, we see further increases in the money supply providing some support for equity markets and risk assets in general. Nevertheless, with the US elections, Brexit negotiations and the ripple of virus containment measures, the recent market volatility experienced in September should be expected to continue and rebalancing portfolios back to their target weights will grow in importance.