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Visualizing History
Summary Performance in US Inflationary Regimes
“The real total returns of assets analyzed in the paper, through the eight US inflationary regimes shown in Exhibit 1 as well as the annualized return during inflationary, non-inflationary, and all periods. In the first column, the strategy is denoted as active or passive by ‘(A)’ or ‘(P)’, respectively Returns for energies and gold in grey italics are spot returns where we do not have futures data. These are not included in the combined regime calculation. The data vary by start date. Further details are provided in the body of this paper as well as in Appendix A.”
Source: “The Best Strategies for Inflationary Times”
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Sunday Reads
Well, similar to the last few newsletters, there is a lot to discuss today regarding inflation, the financial implications of Russia’s invasion in Ukraine, and monetary policies coming out of the Federal Reserve. In particular, the focus of today’s newsletter will cover:
- The role of economics in causing World War II
- How investors traded when the NYSE closed for 4 months in WWI
- The historical link between monetary policy and stock market booms
- How the US Dollar gained supremacy over the British Pound Sterling
- The history of alternative currencies like Bitcoin, and how they relate to military conflict
- Historical context on commodity cycles, capital flows, and instances of sovereign default
- And MUCH more.
However, since the last few newsletters have focused so heavily on the links between geopolitics, finance, and war, I wanted to offer another historical case study before diving into today’s links: The United States’ occupation of Haiti. Excerpt below from Jennifer Bauduy:
“The United States had had a rocky relationship with Haiti ever since the former slave colony revolted against France and won independence in 1804, the only nation founded by a slave rebellion. Initially, the United States refused to recognize the new nation, and Southern slaveholders, fearing a similar rebellion, pushed for a trade embargo. However, by the turn of the twentieth century, America had replaced France as Haiti’s chief trading partner, and American interests, specifically in agriculture and infrastructure, increased significantly. These powerful business interests drove U.S. policy and ultimately forced the invasion.
A struggling economic situation and political uprisings, sometimes fueled by foreign governments (British, German, or French), had created continuous instability in Haiti. Additionally, Haiti had taken out costly loans from many countries, which sent the country spiraling further into debt. Two especially significant loans were from French banks— one to pay back an indemnity France had demanded for loss of land and slaves after the colony broke free, and a second loan to pay back the excessive commissions of the first. In 1914–15, 80 percent of Haiti’s government revenue was spent on debt service. Although Haiti continued to pay its debts, U.S. bankers used the fear of debt default to take control of the National Bank of Haiti, which served as the treasury and held the government’s funds.
Six months before the invasion, Marines had disembarked in Haiti and removed the equivalent in today’s terms of $11 million in gold from the National Bank of Haiti and transferred it to the National City Bank of New York, on the grounds that the funds might be needed to pay back U.S. bankers.
The move gave the United States considerable control over the Haitian government. Business leaders pressured President Wilson to get control of Haiti’s customs houses, the main source of Haiti’s revenue. Wall Street mogul Roger L. Farnham, at the same time vice president of the National City Bank of New York, vice president of the National Bank of Haiti, and president of Haiti’s railway system, played a prominent role in pushing for the invasion. With so much financial interest and experience in the country, Farnham had become a key Wilson administration advisor on Haiti.
During the same period, World War I was raging in Europe, and German influence in Haiti had been making Wilson uneasy. German merchants had integrated into Haitian society more than their American counterparts, often marrying into Haitian families and therefore circumventing a law that forbade foreign ownership of land. Wilson feared that Germany might try to establish a military base near the Panama Canal, which the U.S. had taken over and completed in 1914. In fact, the United States had an ongoing interest in establishing its own naval base in Haiti’s northern port of Môle Saint-Nicholas (right across from Cuba’s Guantanamo Bay).
Backed by the Monroe Doctrine (established by President James Monroe in 1823)—that the United States would not tolerate Europe’s interference in the Western Hemisphere —and a Jim Crow perception that freed blacks could not govern themselves, the United States landed in Haiti on July 28, 1915, following the killing of the president, and had imposed an election within weeks. By September, the United States presented Haiti with a treaty—the Treaty Between the United States and Haiti (Articles I-XIII of which are featured on pp.246– 247)—which concluded the active invasion and launched a two-decade occupation. The treaty gave the United States total power over Haiti’s financial system through the customs houses and the state treasury, authorized the U.S. to create a new Haitian military, and prohibited Haiti from selling or renting territory to another foreign power.”
The United States finally ended it’s occupation in 1934.
Now, let’s dive in today’s links!
Why This is Relevant:
With such intense focus on how the Federal Reserve will approach rate hikes this year and next, it is worth getting historical context on how monetary policy and asset prices behaved in previous stock market booms.
Summary:
“Capital flow and commodity cycles have long been connected with economic crises. Sparse historical data, however, has made it difficult to connect their timing. We date turning points in global capital flows and commodity prices across two centuries and provide estimates from alternative data sources. We then document a strong overlap between the ebb and flow of financial capital, the commodity price super-cycle, and sovereign defaults since 1815. The results have implications for today, as many emerging markets are facing a double bust in capital inflows and commodity prices, making them vulnerable to crises.”
Visualizing History:
Notable Quote:
“Across some two hundred years, we find that two U.S. stock market booms stand out in terms of their length and rate of increase in market prices – the booms of 1923-29 and 1994-2000. In general, we find that booms occurred in periods of rapid real growth and productivity advance. We find, however, no consistent relationship between inflation and stock market booms, though booms have typically occurred when money and credit growth were above average. Finally, contrary to conventional wisdom, we find that wars have not always been good for the market.”
Why This is Relevant:
This paper is worth reading if only for the brilliant tables on how various assets / sectors perform during different inflationary regimes dating back to World War Two. As debates persist over inflation and how aggressive the Federal Reserve will be with rate hikes, this paper offers a useful look at how different investment strategies hold up during bouts of inflation.
Summary:
“Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors face the challenge of having limited experience and no recent data to guide the repositioning of their portfolios in the face of heighted inflation risk. We provide some insight by analyzing both passive and active strategies across a variety of asset classes for the U.S., U.K., and Japan over the past 95 years.
Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect. Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. Among the dynamic strategies, we find that trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability. We also provide analysis of alternative asset classes such as fine art and discuss the economic rationale for including cryptocurrencies as part of a strategy to protect against inflation.”
Visualizing History:
Summary Performance in US Inflationary Regimes
“The real total returns of assets analyzed in the paper, through the eight US inflationary regimes shown in Exhibit 1 as well as the annualized return during inflationary, non-inflationary, and all periods. In the first column, the strategy is denoted as active or passive by ‘(A)’ or ‘(P)’, respectively Returns for energies and gold in grey italics are spot returns where we do not have futures data. These are not included in the combined regime calculation. The data vary by start date. Further details are provided in the body of this paper as well as in Appendix A.”
Notable Quote:
“Our results suggest that trend-based strategies focusing on equity, bonds, FX, and commodities have strong hit rates during the eight inflation episodes and provide an impressive level of protection. We consider a range of equity portfolios and find that popular factors like value provide some benefit during our definition of inflationary times. While the average benefit is small, for example 3% real returns for a quality strategy to -1% for the value strategy, these factor portfolios perform far better than passive investments in stocks or bonds. The equity factors also have the extra advantage of high capacity.”
Why This is Relevant:
The Russia-Ukraine conflict has underscored the power of currencies, and the geopolitical influence they can wield. For example, the state of Russia’s economy and its ability to pay interest on sovereign debt has been precariously linked to whether such payments and money flows were transacted in rubles or dollars. In a world where United States dollars are the global reserve currency, nations (like Russia) at odds with America face an uphill battle, to put it mildly.
Summary:
“This paper offers new evidence on the emergence of the dollar as the leading international currency, focusing on its role as currency of denomination in global bond markets. We show that the dollar overtook sterling much earlier than commonly supposed, as early as in 1929. Financial market development appears to have been the main factor helping the dollar to surmount sterling’s head start. The finding that a shift from a unipolar to a multipolar international monetary and financial system has happened before suggests that it can happen again. That the shift occurred earlier than commonly believed suggests that the advantages of incumbency are not all they are cracked up to be. And that financial deepening was a key determinant of the dollar’s emergence points to the challenges facing currencies aspiring to international status.”
Visualizing History:
Notable Quote:
“our evidence challenges the presumption that once international monetary leadership is lost, it is gone forever. Although sterling lost its leadership in the 1920s it recovered after 1933 and again ran neck and neck with the dollar at the end of the decade…
Our results point to the development of US financial markets as the main factor that helped the US dollar overcome sterling’s incumbency advantage. We find that financial deepening was the most important contributor to the increase in the share of the US dollar in global foreign public debt between 1918 and 1932. In the case of the UK, economic stagnation (declining relative economic size) was the most important factor accounting for sterling’s declining share over the period.”
Why This is Relevant:
The Russian stock exchange re-opened on Thursday for the first time since late February to offer very limited trading. Shares rose 4%, but that does not tell the whole story.
“To prevent a steep selloff, Russia’s central bank banned short selling, where investors bet that a stock’s value will decline, and blocked foreigners, who make up a huge chunk of the market, from selling their shares. The Kremlin also directed a Russian sovereign-wealth fund to buy around $10 billion in shares.” (WSJ)
This episode has prompted many to wonder what happened to American stock prices when the New York Stock Exchange closed its doors for four months during World War I. This paper provides answers.
Summary:
“This paper examines how financial markets responded to the longest circuit breaker in American financial history: the four-month suspension of trading on the New York Stock Exchange following the outbreak of World War I. The suspension that began on July 31, 1914 fostered a substitute trading forum called the New Street market. Trading on New Street began almost immediately and offered economically meaningful liquidity services despite its impaired price transparency. A simple cross-sectional model of bid-ask spreads on New Street demonstrates that New Street liquidity responded to economic incentives. New Street’s success implies that, from a public policy perspective, expensive back-up trading facilities are not required to preserve liquidity during a trading suspension in established markets. Back-up records of share ownership and transfer facilities, however, are crucial to maintaining liquidity.”
Visualizing History:
Percentage Bid-Ask Spreads on New Street and The NYSE
“Column 1 shows a stock’s average daily bid-ask spread, in percent, over 28 days between August 25, 1914 and October 26, 1914. The 20 stocks in the table were traded on New Street, the marketplace that arose when the NYSE closed on July 31, 1914. The first ten stocks have the lowest average percent bid-ask spread on New Street over the sample period and the last ten stocks have the highest average percent spread. Column 2 shows the average daily percent spread for the same companies when they traded on the NYSE during a 28-day period ending with July 29, 1914.”
Notable Quote:
“Few economic activities are as reliable as attempts to circumvent regulation… This episode in financial history shows that liquidity can survive a crisis even without extensive preparation. New Street’s technological disadvantage relative to the NYSE in 1914 was substantial, perhaps more than what a substitute market would encounter today. New Street could not disseminate timely price information over the NYSE ticker, and it did not have access to private telephone lines utilized by NYSE member firms to communicate orders. Nevertheless, liquidity on New Street flourished as a substitute for the NYSE.”
Why This is Relevant:
In recent weeks, FBI Director Christopher Wray stated that Russia’s faith in Bitcoin for avoiding Western sanctions was arguably misplaced. In his appearance before Congress, Wray said:
“The Russians’ ability to circumvent the sanctions with cryptocurrency is probably highly overestimated on the part of maybe them and others,” said Wray. “We are, as a community and with our partners overseas, far more effective on that than I think that sometimes they appreciate and there’s a lot of expertise in terms of tools and strategies to help block that kind of effort. Ultimately, what they really need to do is get access to some form of fiat currency, which becomes more challenging.”
That said, this paper looks at the history of “alternative currencies” like crypto, how/why they emerged, and more.
Summary:
“Alternative currencies have appeared regularly for at least the last half-millennia, often arising out of similar socio-economic circumstances and ceasing to circulate within a relatively short time period. While regulatory shifts and technology shocks account for some of the challenges alternative currencies have faced in gaining wider adoption, the most common observed explanation for why alternative currencies decline is insufficient demand due to relatively high transaction costs, low institutional support, inconsistent social motivation, and other factors. Present-day alternative currencies, such as the Brixton pound, are similar to past alternative currencies, while bitcoin features several radical differences.”
Visualizing History:
Notable Quote:
“Given the frequency with which inflation accompanies war it is not surprising that there was a proliferation of alternative currencies during the American Revolution, where lottery tickets, private tokens (shinplasters), and other mediums of exchange circulated. In post-revolutionary America banks frequently failed, which often led to financial panics and shortages in small denomination currency in particular. In these environments various forms of alternative currency proliferated, including notes issued by cities, states, individuals, merchants, and churches.”
Why This is Relevant:
With commodity prices booming and concerns over sovereign defaults rising, this paper offers a timely look at the history of capital flows, commodities and default from 1815 through 2015.
Summary:
“Capital flow and commodity cycles have long been connected with economic crises. Sparse historical data, however, has made it difficult to connect their timing. We date turning points in global capital flows and commodity prices across two centuries and provide estimates from alternative data sources. We then document a strong overlap between the ebb and flow of financial capital, the commodity price super-cycle, and sovereign defaults since 1815. The results have implications for today, as many emerging markets are facing a double bust in capital inflows and commodity prices, making them vulnerable to crises.”
Visualizing History:
Notable Quote:
“International capital flow cycles have displayed similar patterns over the past 200 years, both in duration and amplitude. While not all capital inflow cycles ended with a global wave of new debt crises, all the major spikes in sovereign defaults came in the heels of surges in capital inflows, especially those followed by ‘double busts’ in capital and commodity markets.”
Why This is Relevant:
An analysis of what role economics played in fueling the outbreak of World War II. This paper is relevant for investors today as it discusses the relationship between economics and conflict.
Summary:
“Historians have long recognized the role of economic resources and organization in determining the outcome of World War II: the Nazi economy lacked the economic resources and organization to oppose the combined might of the U.S., U.K., and U.S.S.R. A minority view is that the Germans were defeated not by economics, but by Hitler’s many strategic and tactical mistakes, of which the most important was the invasion of the Soviet Union. Compared to this debate about the outcome of the war, there has been less attention to economics as the cause of World War II.”
“The Germans had great hopes that their own resource shortages would be relieved from the conquered nations, particularly France. But they forgot that incentives matter. French farmers were demoralized by German confiscation of food and by the near‐disappearance of energy, both petrol and coal. The French harvest declined by half between 1938 and 1941. Without food, French coal miners reduced their work effort and at one point were in “open rebellion”, and Tooze argues that in no other occupation is production so related to the food intake of workers as in the coal industry.”
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