Economics & Growth | Monetary Policy & Inflation
It’s a great pleasure to be here at MIT in Cambridge, US. But I must start by correcting an earlier comment by another speaker. It was said that MIT invented modern finance. While I know that Americans have a habit of thinking they are the first at everything, having studied at the original Cambridge in the UK, I can say that the Cambridge economist John Maynard Keynes, author of the General Theory in 1936 among other things, articulated theories of hedging, portfolio replication, and term premia. I should add that he ran one of the earliest macro hedge funds for King’s College, Cambridge.
History Before America
Keynes in turn owes a debt to Adam Smith’s articulation of key economic concepts in the Wealth of Nations written in 1776. But so far, I’ve given a particularly Eurocentric view of the developments of economics and finance. Indeed, the great Persian philosopher and Islamic scholar, Al-Ghazali, wrote about the production of pins and the division of labour in his Iḥyā′ ‘Ulūm al-Dīn in the twelfth century – 700 years before Adam Smith. And I’m sure, other works from earlier periods from India or China can be found.
So, finance has been around as long as people have – and to think otherwise is to dismiss the growing body of historical evidence to support this notion.
Marvel Movies and the Fed
With that out of the way, let me move to the current period. To help clarify what the financial markets are going through, I like to think in terms of movies. I’m a big Marvel fan, you see. Now how many of you have watched a Marvel super-hero movie? Most of you. For me, these films represent CGI, and a certain artificiality of movie making. You can easily imagine the actors standing in front of green screens and not really doing anything real.
Well, the first Marvel movie came out in 2008; it was Robert Downey Junior’s Iron Man. This kickstarted the Marvel franchise. The last successful Marvel movie was Spider Man: No Way Home, which came out in 2021. So, we saw an impressive run of Marvel movies from 2008 until 2021. This was a run of artificial movies. As it happens, this was also the period of ultra-low interest rates too.
So just as CGI allowed Marvel to create an array of imaginative yet unreal worlds, low rates did the same in financial markets. It allowed the discount rate on cashflows to fall to zero, which meant that cashflows in the far future were worth as much as cashflows today. Startups and businesses that had losses today but amazing profits in the future could therefore be easily bid up.
This concept also applied to private markets, like private equity. PE firms could borrow cheaply to lever up their targets and then easily exit and attractive valuations. They could also provide a compelling narrative to asset holders that they could offer attractive returns in return for illiquidity.
But the Fed and other central banks dramatically raised interest rates last year, and they are likely to remain high for the foreseeable future. This has dramatically changed the valuations of start-ups – now cashflows in the future are worth less as the discount rate has gone up. What matters now is profits today. Fundamentals are back.
End of the PE Myth
Private equity can no longer borrow so easily, so they cannot lever returns like they did before. On top of that, their holdings will likely have to be marked down. They have yet to do this even with public markets dropping sharply in 2022. So far, PE firms have struggled to get any exits in public markets – a first in recent decades. On top of that, there is growing evidence that the PE as an asset class offers no superior return to public markets.
The success of PE has, if anything, been to attract inflows to their funds, rather than better returns. These flows are less likely to be forthcoming in the years ahead.
The worrying thing is that pension funds have been big investors in PE. If they find that the returns were not as promised, they may well get upset at the size of fees they were paying. One could easily start to imagine politicians getting involved and attacking PE firms to protect pensioners. Anyone who has worked at an investment bank has seen this script before.
Why are central banks raising rates? The simple answer is inflation. It’s back. This is a major regime change. After decades of falling and low inflation, which in turn allowed low rates, inflation has now returned. The causes of recent inflation are well-known – it is some combination of COVID-induced supply chain issues, fiscal stimulus, and further monetary easing.
But if we step back, there is a larger trend in play.
Karl Marx would know this well. In his Communist Party Manifesto of 1848, he writes that ‘The history of all hitherto existing society is the history of class struggles.’ He wrote about the bourgeoisie or capitalist pitted against the proletariat or workers. In today’s terms, you the audience are the bourgeoise, the 1%, the ones who have the means to pay for MBAs and become future captains of industry and finance. Meanwhile, those serving coffee outside this hall are the proletariat, the ones dependent on wages with little cushion of savings.
In some ways, what COVID did was to decimate the supply of labour. People died, got sick or no longer want to work under their current working conditions. At the same time, the reliable supply for foreign workers has stopped as tight border controls from COVID have remained. This has suddenly shifted the power balance between capital and labour.
For decades, capital and corporates have captured the state and been rewarded with ever lower corporate taxes, while workers have seen their rights diminished and their worker benefits taken away. Even since COVID, central bankers keep talking about wage-price inflation spirals, but they fail to discuss the reality of price-price inflation that we have actually seen. This is where companies have not only passed on higher input costs, but also added something on top. That’s why companies profits have gone up so much.
But that may not last – labour is now increasingly re-asserting its rights and power, and we’re seeing demands for higher wages. This re-balancing of the power between capital and labour should see higher inflation and lower profit margins going forward.
Become Like Water
How to cope with so much change? For that, I turn to one of my inspirations – Bruce Lee. He’s known for his action movies, and his martial arts, notably Wing Chun kung fu and later his own style Jeet Kune Do. But for me, it is his philosophy that resonates most and most applicable to today.
Lee once wrote, ‘You must be shapeless, formless, like water. … Become like water my friend.’ This idea of being like water harks back to the Tao Te Ching of 400BC, in which Lao Tzu wrote: ‘True goodness is like water. Water’s good for everything…It doesn’t compete…It always finds a way.’
It’s better to be like water in times of change. This allows us to experiment with new ways of doing things. For example, at Macro Hive, which is a financial research start-up where I work, we’ve adopted new ways of working.
The traditional model, which is really based on the industrial era, is for everyone to work 9-5 or longer. Most financial firms still work to this model.
But at Macro Hive, we’ve adopted a different model. We adapt the workday to suit people’s family lives. For example, for working parents, the parent, often the mother, who does the school run, can now do it without any guilt. As long as they deliver the work they need to, we don’t mind how they get the work done. They can shift their work hours around their family. We also give people extended bonus holidays when they get married so they can enjoy such a momentous life event.
All this is to say that we need to let go of rigid ways of thinking. So business schools may tell you that the network you build will set you up for the future. They must tell you that as they need to justify the fees. But hanging out with finance people and MBA types is perhaps the most rigid thing you can do. Instead, broaden your network to hang out with dissident technologists, communists, and artists. They’re on the margins of society, but it’s at the margin that you first see change.
So the world is changing, old structures are breaking down, and new regimes are emerging. This means the era of Marvel movies and cheap money is over, Marxism is back with labour gaining power over capital, and we need to be fluid like water and adapt quickly to change. Good luck.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.