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Rafiki Capital Management (Hong Kong) Limited

2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong


Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017

Asset prices are underpinned by low inflation


• Below target inflation underpins global asset prices …
• … forcing policymakers to respond to any negative economic or asset market
shock …
• … curtailing the downside skew associated with risky assets.

• The big risk is that a shock occurs that policymakers cannot offset …
• … either because inflation is above target and prevents a response …
• … or because the shock is so big that the tools are inadequate

The formula for robust asset markets has been:


1) Below target inflation realizations
2) Limited investment response to low interest rates
3) Central banks’ reluctantly tolerating wealth effects to gin up demand.

Our bottom line for asset markets is that definitively rising inflation or wage growth
would be the beginning of the end of this rally. We see disinflationary forces as
structural and persistent, so do not see a quick end to the rally as inevitable. Even if
central banks talk the talk of normalizing, as long as inflation is not clearly headed to
target, they will not risk withdrawing stimulus at a pace that endangers activity or asset
markets. However, getting to inflation targets will result in higher implied and realized
volatility and much more unstable markets. So be careful what you wish for.
The first section below discusses the pivotal role that low inflation has played in making
the extended recovery and asset market robustness possible, the second part discusses
structural forces that make monetary more effective at stimulating asset prices than
activity, and the final sections discuss how it can go wrong.
Why has everything gone right in asset markets?
Imagine you are in a world where inflationary pressures are minimal, unemployment
keeps falling and the business cycle runs longer than anyone expected, all while central
banks keep rates lower for longer. The question is not ‘what can go wrong?’ but ‘what
can go wrong that policymakers won’t respond to?’. Provided you are certain that
policymakers will act in response to a negative shock -- cutting rates, delaying raising

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


them or finding some assets to buy -- you are pretty comfortable that asset market
downside is limited. Combine that with surprise disinflation that keeps policymakers on
the back foot longer than expected and an economy that doesn’t respond much to easy
money, and you have a formula for persistently strong asset markets (and low volatility).
This may not be an optimal economy from a social welfare viewpoint, although some
parts work very well, but it is pretty close to optimal for investors.
This is very different from a world in which CBs are aggressively and desperately trying
to stimulate their economies because they fear that a renewed downturn is around the
corner. In that world, monetary policy is easy because risk premia are high. Now, many
central banks would like to tighten but they cannot find the justification in incoming
data. Their rhetoric changes more than policy does.
Missing inflation targets to the downside means that central banks are able to keep
their collective feet on the gas for much longer than has been the case in normal
recoveries. This stimulative bias means they are quick to respond to negative output
shocks and have some flexibility in responding to oil price and other shocks that would
trigger inflationary fears at full employment. If inflation is at its target level, you have to
respond to any surprise drop in the unemployment rate or price shock for fear that it
will generate persistent inflationary pressures. When you are below target you have a
buffer, so the central bank’s tolerance for shocks is higher. Below target, it is incumbent
to respond to negative inflation shocks. Bottom line, until inflation definitively hits its
target the market has little fear of an abrupt tightening.
The fear that asset markets take the stairs up and the elevator down means that we
normally overweight downside risk as part of risk management. Hence the focus on tail
risk and black swans. Low inflation may not make black swans white, but they could
become greyish if the policymaker reaction function is there to bail us out.
If policymakers a) do not want asset markets to fall for fear of putting the recovery at
risk, and b) actively push back against negative shocks, the stairs/elevator metaphor is
unsuitable. They are not actively trying to get the elevator to go down. When it goes
down on its own too rapidly they apply a mechanism to slow or reverse the descent. As
investors begin to recognize that incentives have changed, they price out the historical
skew that they apply to risky assets.
In some markets, risk reversals typically apply a higher volatility to downside risk than
upside, reflecting that the risk of a large down move is typically higher than the risk of
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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


an equivalent up move. As confidence grows the risk reversal becomes less skewed and
at the money (ATM) implied volatility drops – curtailing the fat downside part of the
distribution of outcomes means that ATM volatility drops, even if upside implied
volatility does not change much.
In a world of low inflation investors have central bankers over a barrel. The old adage is
that central bankers “take away the punch bowl just when the party gets going”. With
central banks assigned inflation targets or inflation and employment targets, they have
a hard time tightening to cool off asset markets when inflation is low. Investors know
that any effort at reining in asset prices will end if the economy looks affected or if
inflation risks going even lower. So while central bankers will complain about asset
prices, they won’t do much about it until inflation targets are hit.
Why have central bankers found themselves in this position? Assume that real demand
does not respond much and asset prices respond a lot relative to the previous cycles.
The limited investment response to interest rates encourages the central to push harder
on asset prices, hoping to lever up small response to monetary policy by increasing the
monetary policy thrust. The wealth effect is part of this effort, even if policymakers
would prefer other transmission mechanism. Monetary policy is then like pushing on
styrofoam – more impact than pushing on a string, but hardly an iron girder. You need a
lot of it do have the desired effect.
Central banks use ineffective demand stimulus tools under pressure
The crisis began with central banks thinking they were driving hot rods, when in fact
they had a treadmill and some hamsters under the hood. It doesn’t mean that the
hamsters can’t move the car, but you probably need a lot of them to get some
acceleration. Housing starts are below any non-recessionary period in the last 50 years,
and there is a constant refrain that non-residential investment is inadequate1. However,
policymakers want more investment in order to create more jobs, and they are right
that jobs creation from investment has lagged.
The central banking problem is that asset prices have responded normally to monetary
policy while the demand response has been abnormally weak. FOMC members were not
thinking of making the rich richer, but they tolerated that outcome in order to get as
much employment and inflation out of the tools they had.

1
I think low nominal investment is driven by technological factors, so do not think that is inadequate.

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


The best way to make monetary policy great again is probably to rely on fiscal more and
monetary policy less. It would not necessarily make the GDP response to a 25bps fed
funds move any bigger, but it would create room for more 25bps moves, and shift the
balance between employment and asset market effects in favor of employment 2.
In conclusion, it is easy to say that the economy and asset markets are where they are
because of irresponsible monetary policy, but we disagree. We would argue that low
inflation and monetary policy framework forced central banks to use tools that were
very effective in stimulating asset markets, but not very effective in stimulating GDP. But
these were the only tools at hand. Structural disinflation shocks mean that central banks
have kept their feet on the pedal longer and harder than anyone would have expected,
curtailing downside risk and enhancing the asset market impact.
Does monetary policy matter anymore?
Say marginal GDP in the US consists of restaurants, health clubs and old age homes.
Many new firms consist of a room, a desk, a phone, a laptop and a few bodies. These
are not particularly capital intensive industries. Networking economies in ride shares,
short term residential letting and other areas are capital saving, so punch below their
GDP weight in generating investment. Drones may even be making war both less capital
and labor intensive.
If marginal GDP growth is less capital intensive, aggregate investment should be less
sensitive to higher rates just as it seems to have been less sensitive to lower rates. I can
convert my Canadian themed restaurant to a hot Norwegian dinner spot by trashing the
Mountie hats on the wall and replacing them with yodeler posters. The write-off is
small. I can even keep the salmon posters and just tape over the text. It’s a lot different
than if I bought equipment to lay high-speed rail track and discovered that the project
was not economically viable.
It is perversely possible that higher rates would be stimulatory. In an extreme case,
assume that you need minimal plant and equipment to produce – say the economy is
divided 50-50 between retired people who live off the income of their short term assets
2
That doesn’t mean it is better policy in all cases. Fiscal intervention can be seen as a short term transfer of
resources from bond owners to the government, who presumably use it to stimulate employment. It can be used
ineffectively, such as in the not-quite-shovel-ready projects of a few years ago and the transfer has to be reversed
at some point unless there are big supply side effects. QE can be seen as temporarily restoring the purchasing
power of bond holders without immediately diminishing the purchasing power of others, but it remains to be seen
how that plays out in the long-term.

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


and millennials who sit with their imported laptops under a tree a couple of hours a
week and write great code. If the central bank tightens and real rates go up, the retirees
spend more and the millennials’ imported laptops get cheaper. So why should anyone
spend less?3 This is an unrealistic economy, but even if higher rates lead to lower
spending, the response is likely to be less than in a baby boomer economy where
growth is heavily capital intensive. Maybe the question we should ask is ‘what if the fed
hiked and not much happened?’
This is a worse economy for savers. If they are saving for their old age and living longer
in a low capital intensity economy, there will be a lot of people chasing a few assets,
driving down the rate of return. Depending on how desperate savers are, modest real
rate hikes could induce a clot of capital availability.
None of this is good or bad. Arguing about technological parameters is like making a
moral judgment on the height of tides. We have a poor handle on what drives
technological progress overall, even less of a handle on what determines whether
technology is capital saving or capital using, and almost no handle whatsoever on
policies to affect either. There is a literature but almost always the best assumption we
can make is that the determinants are persistent and exogenous.
Lending for human capital formation could be an alternative, but the mechanism for
doing so efficiently is not really developed. It is possible that the current tax reform
proposals and their emphasis on incentives for physical capital formation will give us the
optimal tax code for the 1970s.
How can it go wrong for asset markets?
My short answer is that the worst possible outcome is that we hit our inflation targets
anytime soon. A quick acceleration of core inflation from 1.3% in the US, 0.2% in Japan
and 1.1% in the euro zone to approximately 2% in each country would mean that real
interest rates would have to rise to roughly their equilibrium very quickly. It would also
mean that the UR was almost certainly well below the NAIRU, so the tightening would
temporarily have to be beyond the long-term equilibrium.

3
The answer is that demand will exceed production, so we will become increasingly indebted. However, right now
there is no sign that anyone would care, so it is an empirical question whether initially the spending outweighs any
risk premium from the higher indebtedness. It is not a policy recommendation but an observation that you can get
perverse effects in a low capital, demographically skewed economy.

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


Some FOMC members have argued that a long period of below target inflation should
be offset by a roughly equal overshoot – this would be roughly equivalent to price level
targeting. The same problem emerges. If we get to, say, 2.3% relatively quickly, the
message is that you have to tighten abruptly because you overshot full employment.
From an asset market perspective hitting the inflation target means that the friendly
central bank is not as friendly anymore. There might be a gain in output but the
confidence in the reaction function and ongoing low volatility would be much less.
For asset markets the last seven years have been like heaven, all investor needs being
taken care off by a transcendental power who makes sure nothing goes wrong. Hitting
inflation targets is getting tossed out of heaven (link for musical accompaniment), and
having to live in the real world that we lived in before volatility collapsed. In this normal
world, central banks tighten at times when the economy is softening because they are
much more cautious on stimulus when inflation is on target. This restores the downside
to asset market pricing that the central banks effectively removed when inflation was
below target.
Similarly, policymaker tolerance for asset market exuberance drops when inflation is at
target. They then view rapidly appreciating asset prices as a forerunner of further
inflation. Whereas policymaker hands are tied to some degree when inflation is below
target, once inflation is at target policymakers are more comfortable acting on asset
prices that look out of line.
Bottom line – investors should hope that we keep missing inflation targets, it is the best
guarantee of continued asset market robustness. In the limit, as investors we want to
get to inflation targets very slowly. Any faster, monetary policy would have to switch
from stimulatory to restrictive (not stopping at neutral) before we get to the target.
Otherwise the odds are that we overshoot. Once the target is achieved or is in sight, the
central bank friendliness to the market is gone, so the forces restraining volatility
disappear and asset market risk is more two-sided again.
How can Japan go wrong?
Investors have been discussing the sustainability of Japanese debt, deficits and
demographics for decades, and like a bumblebee it continues to fly even though there
are forces that look as if they push overwhelmingly against it. My conjecture is that
Japanese policy works because low inflation and QE are generating real asset price
appreciation without generating major pressure on real JGB prices. The persistence of
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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


low inflation means that Japanese real rates are about zero but not deeply negative.
There is incentive to buy equities but if you want to hold on to cash or bonds you don’t
lose much. As long as inflation does not increase, the rapid reserves creation raises
some asset prices (eg. equities) without lowering bond prices, so no one loses.
If I am right the breakdown in Japan will occur if they succeeded in raising inflation but
asset prices did not keep pace, leading to wholesale dumping of JGBs. Confidence would
break down if investors refused to accept significantly negative real interest rates and
sold JGBs hand over fist. If the BoJ raised interest rates sufficiently to stabilize JGB
holdings in the short term, unsustainable deficit and debt dynamics would come back in
play. As long as low inflation maintains JGB value, they can stabilize the economy and
asset markets and activity. This will not work if real rates are so low that JGB holders
dump on a wholesale basis or if the BoJ is forced to tighten so much that fiscal
unsustainability reasserts itself.

Sidebar on structural forces versus the Phillips curve


The disinflationary forces emphasized at the start -- technology driven disinflationary
shocks and low investment response to interest rates -- are structural so we don’t see
any reason that there should be an abrupt unwind of these forces. In fact, the best
forecast is that these slow-moving forces are likely to persist. However, our knowledge
of what drives such structural forces is poor, so we cannot be certain.
The Phillips curve4 is on the other side. The premise is that if cyclical resource demand
picks up, we are bound to see aggregate price pressures.
In any standard model, both cyclical and structural factors drive inflation. If the
unemployment rate were 1%, well below what is considered even frictional levels of
unemployment, we would expect to see sharp wage acceleration as labor gets bid up. If
productivity growth were 6%, much higher real and nominal wage growth would be
consistent with low inflation.

4
In a different world, I once contributed to rehabilitating the Phillips curve: Englander, Steven A., and Cornelis A.
Los. 1983. “The Stability of the Phillips Curve and Its Implications for the 1980s.” Federal Reserve Bank of New York
Research Paper no. 8303, February. Then the issue was whether a modest recovery would generate immediate
inflationary pressures.

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


Equally, if there were structural changes in labor markets, for example, lower returns to
job-specific human capital, we would expect to see lower wage growth for any given
unemployment rate. Or if there were a sequence of negative price shocks coming from
technology or foreign competition, we would expect lower inflation for any given
unemployment rate as long as the downward shocks persist.
Differences in views are related to how much weight we put on the two sets of forces.
Fed Chair Yellen sees tightening labor markets as the more certain driver, while she has
several times referred to the disinflationary shocks as one-off. If you are pretty sure that
labor markets are going to generate wage inflation and disinflationary price shocks will
ebb, then you pencil in three or more hikes.
Conversely, many (including me) see technology-driven disinflation as likely to be
persistent, technology diffusing over a much longer time horizon then a couple of
months. The basic Taylor rule formulation depends on two very poorly estimated
parameters, R* and (in one form or another) the NAIRU. Ask anyone who makes an
estimate of these parameters what the standard error of their estimates is.
Those who see low inflation persisting tend to be agnostic on the value of these
parameters, allowing them to be pinpointed by when inflation accelerates, but not hung
up over ex ante estimates, sympathetic to the “don’t tighten till you see the white’s of
inflations’ eyes” view. The caveat is that you don’t want the unemployment rate to be
dropping too fast when you might be in the vicinity of the NAIRU, otherwise the risk of,
and damage from, overshooting is high. But if the UR is dropping, say, 0.5% or year or
less, the need to anticipate inflation is modest.

Steven Englander
Head of Research and Strategy
Rafiki Capital
Steven.Englander@rafiki-capital.com

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Rafiki Capital Management (Hong Kong) Limited
2001 Kinwick Centre, 32 Hollywood Road, Central, Hong Kong
Email: ir@rafiki-capital.com
Tel: +852 3163 8100
Website: www.rafiki-capital.com

New York, 26 October 2017


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