In my column from last weekend, "Monetary Policy Can't Create Demand," I discussed the fact that most of the issues that provided a "push" to economic activity and capital market action over the past 40 years have been exhausted.
In this column, I'll discuss the implications of this structural change for the economy and markets.
The four main drivers of economic activity are energy, technology, debt and demographics, as I discussed in the column, "Understanding the Global Metanarrative."
Technology, debt and demographics have been the three main areas providing an exergetic pushback against the entropic pressure caused by energy prices increasing to the point of causing "uneconomic growth."
Exergy and entropy are opposing thermodynamic forces at work in a system. Exergetic forces attempt to bring order to a system, while entropic forces cause disorder. I'll be expounding on the importance of these concepts in future columns as well.
The forces of technology, debt and demographics have also been the prime drivers of what is commonly referred to in capital-market terms as the "drift." The drift is the secular upward bias in equity-market returns that causes the broad equity indices to be greater than the rate of growth in economic activity.
This process is what has given rise to the long-term trend of positive real returns possible by employing a passive strategy of investing in index-based mutual funds and ETFs.
Now that the availability of debt and demographics as exergetic forces, manifested in equity-market action as the "drift," are no longer available, the drift will begin to disappear, and along with it the possibility of positive real returns attainable through a passive, index-based investment approach.
As this process continues, there will also be a greater reliance, by necessity, on technology to increasingly supply the exergetic force that is no longer available from debt issuance and a young consumer base.
Compounding the problem is that debt and demographics don't just disappear as exergetic forces, they actually become entropic forces pushing the system toward disorder.
In the debt markets, this is exhibited as a degradation in the perceived credit quality of outstanding loans. In demographic terms, it is exhibited as a reduction in consumption commensurate with a decrease in declining tax receipts and the increasing cost of transfer payments required by the government.
The economy and markets are in the process of shifting from three exergetic forces and one entropic force, to one exergetic force and three entropic forces.
This is the principal driver behind the increasing rate of technology development and its adoption for commercial purposes; and the focus on creating technology that can replace human labor.
The importance of this shift and its implications for the economy and markets can't be overstated.
Everything we think we know and understand about how economies and markets function, and how monetary and fiscal policies impact economic activity, is in flux.
Most are not aware of why this change is occurring and hope it is a temporary phase that will be followed by a reversion to a mean that is perceived to be known and understood.
This sentiment is most evident in the continuous use of the word "transitory" by the FOMC with respect to the abrupt drop in oil prices and how it relates to measures of inflation and economic activity.
This is not a temporary event, however, but it can be understood. It is also not a bad event. It is a natural evolution in the structure of the economy.
In the near term, however, as the process accelerates, it is going to render most investment and trading strategies obsolete.
As trading strategies begin to fail, traders will panic and magnify the volatility in the markets, which will impact long-term investment strategies.
The one group that has exhibited an awareness that this change is occurring, even if they don't understand it, is the macro hedge funds. Many of them have closed in recent years because of the breakdown in macroeconomic functions.
The migration into negative interest rate regimes in Japan and Europe is the greatest example of that.
Beyond the mechanics of this process playing out between the exergetic and entropic market forces in the immediate is that the process largely follows the rules for such described by the various schools of economic cycle theories, which I wrote about in the two-part column series, "Past Is Prologue in Economic Analysis."
The business cycle and, as a result, economic cycles were believed to have been "solved" by the introduction of neoclassical economic models and the active engagement in the economy with monetary and fiscal policies.
That didn't happen, though.