While every asset price cycle is different, they all end the same way: in tears. Successful, long-term investing is predicated on not just knowing where the happening parties are during reflationary parts of the cycle but more importantly, knowing when it’s time to leave the dance floor. In our view, that time has already come.

Over the past 25 years, the traditional business cycle has been replaced with an asset price cycle. Rather than let recessions run their painful but necessary course, central bankers move to dispense monetary morphine. The Fed’s playbook is well worn. Policy rates are lowered, triggering a daisy-chain of events: low or zero rates promote a reach for yield, which lowers capitalization rates across a variety of asset classes and spurs a rise in asset prices.

Buying growth today with credit that needs to be repaid tomorrow is not a free lunch! Artificially “stimulated” credit creation means marginal or unprofitable enterprises are fed when they should be starved. Further, low-rate induced asset price inflation preferentially directs credit to those who are already asset rich. Those whose assets have inflated now possess more collateral, making them more creditworthy to lenders.

The longer term consequence of policies focused on credit growth is a system-wide expansion of leverage. Credit inflation disempowers market-based mechanisms that otherwise allocate resources to their best uses. The result? Leverage goes up faster than income available to service it. Thus, the creditfueled expansion inevitably comes to a bad end. Leverage has indeed returned, notably in the corporate sector where debt now exceeds levels experienced before the Great Recession.

Unless everything we understand about economics is wrong, the Fed cannot continue adding printing press dollars to the system and expect no ill effects. Inflationist monetary policies cannot be the answer to problems caused by inflationist monetary policy.

Our counsel: avoid assets that will be broken in the coming deleveraging while keeping a “steady as she goes” attitude toward the future purchase of assets that will merely bend when the flood comes.

 

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