In his speech, Jerome Powell announced a change that ends 40 years of global deflation, but above all 20 years of monetary experience linked to globalization. (Photo credit: Federal Reserve)

o The FED Governor, Mr. Jerome Powell, announced an American reflation towards the natural rate of 4/5% during the Jackson Hole conference.
o This “announced inflation” will strongly impact the valuation of financial assets and therefore investment strategies. We can speak of a “big reset” of the economic and financial environment, the theme of the next Davos conference.
o A new Golden Age will perhaps emerge from this reflation if we think that Western economies have accumulated a significant gap between their real GNP and their potential GNP, starting with Italy. In this case, the rise in stocks has only just begun ...

A refounding speech on a major change in Fed policy

In a 20 minute speech, FED President Jerome Powell has certainly written a page that will go down in history.

The Jackson Hole conference is a kind of central banking Davos that takes place every year at the end of August in a dream mountain resort. This is where the Fed has repeatedly announced major turning points in its policy: the start of Bernanke's Quantitative Easing (QE) in 2008, the end of this QE via the “FED tapering” in 2012. These speeches have had a strong impact on valuation. markets and all economic activity.

In his speech, Jerome Powell announced a change that ends 40 years of global deflation, but above all 20 years of monetary experience linked to globalization. We must indeed go back to Paul Volcker and his announcement of an end to the "great inflation" Nixon / Kissinger of the 70s. This high inflation had put an end to the Bretton Woods agreements and caused American long-term rates to soar to nearly 20% during the Carter years.

Mr. Jerome Powell is certainly not announcing a return to major inflation à la Nixon / Kissinger. It only announces a "renormalization" of inflation and US long rates towards their "natural rate" of 4/5% (target given by Mr. Powell).

This rate objective refers to the notion of "natural rate" of an economy defined by Wicksell during the 1920s. This theory asserts that there is a “natural equilibrium rate” which makes it possible to optimize the investment / savings allocation. It is therefore the basis for maximizing optimal growth in wealth creation. This approach has been implemented in Germany since the 1950s via Ludwig Ehrhardt's “Stabilitaetspolitik”, taking up the founding principles of the Austrian school of money (Miese, and especially Hayek).

The natural rate corresponds to the historical average rate around 5/6%, or 2/3% of inflation, 1% of productivity growth, 1% of population growth and 1% of risk premium.

Comparative interest rates of the United Kingdom, the United States of Germany and the official rate of the euro zone. (source Bank of England, Bloomberg, FRED, TR)

What economic impact of a divergence between real rate and natural rate?

Friedrich von Hayek studied in a seminal book “Price and Production” the economic impact of a creation of money which makes the nominal rate diverge from this natural rate. Unlike Keynes, who focused his research on macroeconomic aggregates, which are simpler but necessarily more distant from reality, Hayek starts from a “bottom up” microeconomic analysis. He reflects on the impact on investment and also consumption decisions of moving the inflation rate away from its natural rate.

Businesses tend to underinvest when inflation is low because demand decreases. In fact, consumers have no incentive to spend their savings as the prices of goods stagnate or fall. They therefore postpone their purchases and favor precautionary savings. As a result, economic growth stagnates as a result of this stagnation in consumption and investment. We have here all the criteria of the “lost generation” of the last 20 years in many European countries, starting with Italy.

Towards the end of “forced saving”?

Bernanke summed up the impact of this stagnation of the past 20 years with his famous “saving glut”. The rich countries undoubtedly experienced a period of “forced saving” (forced savings) via a Japanefication of their economies towards the famous “liquidity trap” of Keynes. This “liquidity trap” corresponds to a situation of under monetary creation which reinforces the behavior of postponing consumption and investment decisions in a monetary environment which does not allow the risk / investment balance of an area to be optimized. Unfortunately, Japan and the Eurozone seem very close to such a situation.

Towards a new Golden Age?

The European Commission seems to have validated this downward trend in structural economic growth in European countries. It thus estimated Italy's potential growth rate at less than 1% by reducing its estimates of the “output gap” (differential between real GNP and potential GNP). This therefore justifies a posteriori the stagnation of the GNP per capita of Italy for 20 years, i.e. the creation of the Euro. Italian wealth would no longer rise because Italians are aging and have lost their creative genius. It is an alternative explanation to a monetary explanation of the Italian “under growth”.

Boris Johnson said in the aftermath of Brexit that the UK was on the brink of a new Elizabethan Golden Age and not Italian stagnation. He insists on the significant productivity gains linked to the digitization of the economy as well as the lag of GNP in relation to its long-term growth trend.

The Italian GNP has stagnated since the creation of the Euro. Two analyzes clash. The European Commission has reduced Italy's potential growth rate downwards due to the aging of its population. On the contrary, other analysts see a strong “output gap” compared to pre-Euro growth rates and therefore the possibility of a new Golden Age if Italian monetary growth returns to its natural trends. By interpolating the long-term historical trend, Italy has an "output gap" of nearly 20/25%.

Has China monopolized global savings?

Some analysts believe that this stagnation of the “lost generation” of the past 20 years in Europe, in particular in the South, is linked to an “over-drain” of European savings by offshore finance in order to finance Chinese growth.

China has captured a major chunk of global growth and therefore global savings over the past 20 years.

Share of different countries in world GDP, in%. (source: Bloomberg, World Bank)
What investment strategy in such reflation?

Jerome Powell's announcement of an imminent reflation of the US and therefore global economy will have major consequences on investment policies.

Towards the end of the 60/40?

For 20 years, the classic investment strategy of large wealth managers has been a fixed allocation of 60% in bonds and 40% in equities. Such a strategy has a risk of around 10% and a potential return of around 6% before fees and around 4/5% after fees. It therefore ensured a return of around 4% for investors, ie around twice the inflation.

This strategy is clearly called into question by the announcement of the FED. In fact, it has benefited a lot from the fall in inflation and therefore long rates over the past 20 years and also from their anti-correlation with equities. The anticipation of a rise in US long rates to 5/6% will result in a loss of bond indices around 25/30% in the coming years. It is impossible to know when such a rise in long rates will materialize. It will certainly depend on the strategy of China and central banks regarding their purchases / sales of bonds.

We therefore recommend looking for alternatives to this 60% / 40% strategy, in particular via dynamic allocation managed by artificial intelligence.

Towards an outperformance of equities?

A reflation strategy is always better for stocks than for bonds. We can think that we will be able to get out of 20 years of stagnation in European equities with a Euro Stoxx 50 which has had a performance close to zero over the last 20 years.

Towards an outperformance of inflation-linked bonds?

Jerome Powell made it clear in his speech that the FED would look at inflation expectations valued by inflation-linked bonds. In such a reflation environment, we can expect a rise in real rates on the long-term growth rate of the economy, ie around 2 / 2.5% against 0% currently. Likewise, inflation expectations will rise to around 2.5% / 3% against 0% currently. This corresponds well to an equilibrium rate of nominal long-term interest rates around 5/6% as indicated by Jerome Powell.

Which real assets to favor? Gold or industrial metals?

Many analysts are currently very positive on gold. Despite this, gold has been rather disappointing (at least compared to copper ...) and it is the copper which has especially shone by its performance. We believe that the Fed's reflation strategy will negatively impact gold through the famous anti-correlation between gold and the real rate highlighted by Keynes in his seminal article on the “Gibson paradox” which shows the anti-correlation fundamental between gold and real rates. Gold is a barbaric relic that rises in lean times and not in the “golden age”.

Towards a fall in the dollar?

Foreign exchange is clearly the most difficult financial asset to anticipate. In fact, its fluctuations are extremely complex and dominated by central banks via flows that are difficult to identify. One thing is certain, if the ECB does not adjust its inflation targets to those of the FED, the Dollar will continue to fall against the Euro as it has started to do. In fact, the over-creation of the US money supply will intensify while some German voices such as those of Mr. Weidman are already talking about the desire to slow down the ECB's liquidity injections.

We would then come back to the historic “big gap” between the BUBA and the FED, which marked the 70s.

Once again, the dollar will be “the currency of the USA and the problem of Europe” ! But this problem will undoubtedly save Europe from its monetary anemia by forcing the ECB to inject more liquidity, in particular in southern Europe.

Towards the moment of truth in the Euro zone?

But it is questionable whether southern Europe will then be able to withstand such a deflationary macroeconomic shock after 20 years of economic stagnation and the coronavirus crisis. The risk of a collapse of the euro zone may then increase again.

Christine Lagarde in her last press conference was very evasive on the consequences of the reflation announced by the FED on the policy of the ECB. She announced the establishment of a strategic reflection of the ECB on its inflation targets.

But she also rightly highlighted the capital importance of the measures announced at the last European summit thanks to the renewed effectiveness of the Franco-German couple. We must recognize here the political genius of President Macron and Chancellor Merkel. They mastered, against all odds, to change the German position by accepting after 20 years the creation of a European debt. This debt can play a capital role in better balancing growth between Southern Europe and Northern Europe and therefore save the Euro zone.

Redeem “funds in euros”

For several months, we have been recommending the outflow of funds in euros towards dynamic asset allocations. Certainly, French savers have lost their sense of risk via the opium of the fall in rates. This deflation has euthanized in Europe the “animal spirits” (capacity of entrepreneurs to create wealth via the creative destruction of Schumpeter) of which Keynes spoke, as the foundation of capitalism and the creation of wealth.

In fact, it is impossible to compete with euro funds as to their ability to smooth out performance and therefore hide (but not eliminate) risk. But these very sophisticated techniques brilliantly implemented by French insurers have reached their limits with the end of the rate cut. The large insurers are the first to curb investment in these funds in euros by putting brakes on underwriting and recommending allocations in units of account.

Conclusion: towards a “Grand Reset”?

The theme of the next Davos seminar is that of a “Grand Reset”. This big reset certainly begins with this reflation announced by the FED. The absolutely FUNDAMENTAL nature of Mr. Powell's speech at Jackson Hole cannot be over-emphasized. He announced the end of 40 years of disinflation which saw US rates and inflation drop from 20% under Volker after the dark Carter years to 0% for its last few months with US long rates at their all-time low around 0.5%.

This announced renormalization of inflation and therefore of the growth of nominal US GNP will have major consequences in the redistribution of wealth. It will "ruin the rentiers to save the entrepreneurs" as Keynes said. It will tap into the savings accumulated by retirees and the winners of globalization to redistribute them to the younger generations and entrepreneurs. It will revive investment and consumption and therefore revive the “animal spirits” of the creators of wealth. It lays the foundations for an exit from Europe of 20 years of stagnation. It makes it possible to envisage a return to the “golden age” years, making it possible to make up for the growth losses accumulated over the past 10 years compared to potential long-term GNP.

It is fundamental to put in place as of now the asset strategies to adjust its investment policy in the face of such an environment: increase the share of equities, lower the share of bonds not indexed to inflation, and above all, adopt an allocation of dynamic and no longer static assets!

The “Next World” is changing. It is built from month to month. No one can dare to predict the future that awaits us. Everyone must therefore know how to adapt to this History under construction by leaning on the new tools of digitization and artificial intelligence.

This article is for informational purposes only and does not constitute an offer of any products or services, nor an offer, recommendation or solicitation of an offer to provide any investment advice or service to buy / sell instruments. financial.