We are living in the mirror world of the 2010s in many ways. Where the fundamentals that brought us low inflation – even at historically low-interest rates and full employment to boot in much of the developed world – are now almost in unison beginning to pull aggressively in the opposite direction.
I hate being the bearer of bad news. It’s all I seem to do these days. But reality is what it is and fundamentals never lie.
In August 2021 –I wrote two pieces: One was about how inflation would remain high for longer because of historic and unprecedented long-term shifts in supply-side dynamics in the global economy: http://georgephilipas.com/the-source-of-inflation-that-no-one-is-focused-on-and-everyone-needs-to-worry-about/ This was at a time before the Russian invasion of Ukraine in February 2022 and when inflation – driven then only by pandemic-related supply-side bottlenecks was just beginning to take hold. We were all promptly assuaged by far wiser voices than my own: From prominent economists, leading editorials to government officials such as Treasury Secretary Janet Yellen and central bank stalwarts such as ECB-head Christine Lagarde and Federal Chair Jerome Powell, that inflation would be transitory and would be nothing to worry about.
Of course, we all know (and are all still suffering) from that collective lapse of reasoning.
I suggest very much in the same vain as today’s bullish stock markets: Where the S&P, Dow Jones and Nasdaq have surged ahead into bull market territory with gains of over 20% and hitting record highs until recently. These rallies have been mostly driven by what history I am sure will judge to be yet another stampede into herd-mentality-lead greed and delusion – this time focused on excitement about AI tech and a revolution in productivity gains that probably won’t happen for a while; Suffering from the same hallucinations as their beloved tech, it resembles a mini-incarnation of the NASDAQ bubble of the mid to late 1990s that burst in spectacular fashion in March 2000. That was also based on premature hype around tech companies, at a time when Mark Zuckerberg was still at school and Larry Page and Sergey Brin – founders of Google – were trying to offload the company for a paltry million dollars.
The second piece, ( http://georgephilipas.com/why-worries-about-inflation-are-missing-the-pointits-the-debt-and-low-productivity-stupid-an-idiots-guide-to-the-last-days-of-the-post-1945-economic-miracle/ ) was about global debt and its effect on growth and productivity. explaining much of the so-called “productivity puzzle” that accelerated the last decade. (but took root way further back in the late 1990s). And how the GFC (global financial crisis of 2008) and the pandemic, were economic apocalypses postponed, and that cheap money from the last decade would soon come back to haunt us with a vengeance and destines for the most almighty of crashes, with corporates leading the proverbial charge of the light brigade this time so to speak.
The second prediction of course hasn’t come to pass yet, but I stand by it. At least Ray Dalio, billionaire and founder of asset management company Bridgewater Associates seems to agree: In a recent interview he gave for Bloomberg, he claimed, “We are at the beginning of a late, big-cycle debt crisis.”. Citing the cause as a looming credit crunch where there is too much debt and a shortage of buyers. All roads seem to lead there. As I say, fundamentals never lie.
First, the good news
While stock markets did waiver momentarily at the beginning of July 2023, as of 13th July they started again on their merry way on an upward trajectory after data released on 12th July pointed to a sharp cooling in U.S inflation data. Consumer price inflation fell to 3% in June compared to a year ago from 4% in May. This was largely driven by a collapse in energy prices of 16.7% overall and oil prices, a whopping 26.5% since last year. Also affected by steady drops in food prices as well (although they held up in the U.S. in June 2023) it is likely that, for the rest of the year at least, inflation will indeed follow the predicted path down well on its way to the Fed target of 2%. And it is probably correct that the forecast of only one, maybe two, further Fed interest rate rises to around 5.5, maybe 5.75%, may indeed come to pass.
And with China’s economy spluttering almost to a halt after an initial energetic burst after its post-pandemic reopening earlier this year, and corporate earnings likely to be disappointing in the coming two quarters, downward pressures on commodity and energy prices and therefore inflation as a whole, are likely to continue in the short-term. The ideal scenario, that many have bought into – that of a soft landing for the U.S. economy and most of the developed world – is now the common mantra in the world of business and finance.
But a deeper dive into the stats reveals a broader underlying picture that might not be so rosy. Strip out volatile food and energy prices, so-called core inflation, and in most of the developed world it has held up alarmingly well. While consumer prices have eased in the back of lower food and energy prices alone, consumers themselves seem to still be on a sustained spending frenzy. Shipments of non-defence capital goods, considered to be a proxy for actual spending, increased end-June by 3.4% to the highest level since end-2020. U.S. house prices were up 7.8% and the number of people buying was at the fastest rate in a year.
Core inflation is also being driven by an all-too-hot labour market. Unemployment in the U.S. is now at just 3.6% – around where it was before the pandemic hit. And with near-to-full employment has come a severe skills shortage, not just at the top-end of the labour market, such as in finance and IT, but also at the lower end in leisure and hospitality; Conflating to push wages up by 4.4% in June (compared to a year before).
In the U.K. widely considered to be the f*ck-up of Europe (sorry “sick man of Europe”) at the moment, wage inflation is considerably worse. There, average weekly earnings continue to trickle up to 7.3% (from 7.2%) in the three months up to May 2023. And worryingly, private sector pay is cruising ahead at 7.6%. If the latest round of wage settlements are also anything to go by – with Heathrow for example just averting a summer strike with a 10% wage settlement there end-June, backdated to January and rising to 11.5% in October 2023 – the future doesn’t augur well and the knock-on effect on general prices.
Interest rates ain’t what they used to be….
So with the highest interest rates now in decades in much of the developed world, what gives?
The immediate problem is mainly twofold and widely covered in the media. Firstly, the savings boon accumulated during the pandemic has been insulating many, especially the well-off, from the rising cost of living and mortgage payments that higher interest rates bring. According to Goldman Sachs, a U.S. investment bank, there is a direct correlation between excess savings and resilience in the housing market.
And secondly, like in the labour market, severe supply-side constraints persist even as supply-chain-related blockages immediately following the pandemic have eased. Interest-rate increases that focus on bringing down demand will not be as effective if the problem remains on the supply side. Again, as has been widely reported, nowhere is this more apparent than in the housing market. With higher mortgage costs, have simply decided to hold off selling to buy. This is exacerbated especially in the U.S. where 30-year fixed-rate mortgages are the norm. The result has been that the overall stock of houses on the market has fallen an amazing 40% from pre-pandemic levels in the U.S. and all signs point to more falls as of June 2023.
Only a drastic rise in unemployment that would have the effect of increasing distressed sales will likely shift this pattern and ease price pressures. Something that is unlikely any time soon. And it is not just in the U.S. and the U.K. where interest rates no longer have the same impact as before. In the E.U. fixed-rate mortgages have risen from below 15% in 2011 to make up 40% of the market in 2021.
All this means that interest rates will take longer and have a weaker impact on price rises than they did before: Quelling demand for goods and houses won’t do much if people have a lot of savings and more importantly, the problem really lies on the supply-side.
In emerging markets, this problem of unreactive interest rates seems to be worse. Nowhere can this be better observed than in the country I reside in, South Africa. Here the Reserve Bank (SARB) has aggressively increased rates to quell inflation. By dampening demand when external supply-side issues outside the country’s control are the problem, inflation has been slow to respond. And not only that, the long-term effect of subdued economic activity (made worse by chronic power cuts) has been to scare off foreign investors from buying the country’s debt and investing in its economy. This has contributed to a weakening currency, particularly against the major currencies of countries and blocs with which South Africa mainly trades with. This in turn has impacted the price of imported goods, putting more pressure on inflation rather than easing it. After a three-month fall in food prices, they seem to have changed course again in June. Preliminary data shows a rise of food inflation to 15% in June 2023 from 12% in May.
It’s the supply-side, stupid!
While all these immediate and persistent supply-side constraints – especially in labour and housing, will continue to weigh on inflation and will mean that interest rates have less of an effect as they did in the past – even as food and energy prices fall for now – it is in the long-term that supply-side dynamics should be of real concern.
The reason inflation stayed so low in the 2010s – even in the face of historically low-interest rates and near-to-full employment (that should have pushed it up) was down to globalisation and in particular, cheap manufactured goods from China. This helped keep not just goods prices in the developed world in check but labour costs there too. Firstly, the boon brought about by the Chinese economy that powered the world to the tune of 40% of all global growth in the 2010s, is almost certainly coming to an end. Weighed by an ageing population and fast-falling prime-age labour force, a tightening grip by the ruling Communist Party on businesses and most of all laden with a large debt pile, China may even fall into disinflationary territory soon.
But it is the end of the era of free-flowing trade and globalisation that will almost certainly create an inflationary decade and maybe even beyond as countries wise up to geopolitical tensions and rush to protect important parts of their economies, keeping interest rates high and dampening global economic growth. Many multinationals back in August 2021 seemed to be implementing a “wait-and-see” strategy – strengthening inventory and diversifying their supply chains rather than “near-shoring” (that is moving supply lines geographically closer to home), or “friend-shoring” (investing in geopolitically-friendly countries). It seems now though that, friend-shoring especially, has really taken off driven by a worsening geopolitical climate following the Russia-Ukraine war and tangible tensions between U.S. and Taiwan.
The world is increasingly being corralled into two trading blocs: One dominated by the U.S. and E.U. and the other by China and Russia. One has only to look at the rise in protectionism between the two blocs to understand that there is only one way this is inevitably going. And the impact it will have on inflation could be dire and chronic, reversing all the gains the world economy has enjoyed for nearly four decades. Forget recent attempts to quell tensions (following visits to China from Secretary of State, Blinken followed by Yellen). One has only to look at exports to the U.S. from Asia as a whole, where China’s share has fallen from 70% of all exported goods from the region in 2013, to just over 50% today to understand that friend-shoring has now firmly taken hold.
According to IMF economists, restrictions on goods and investment rose by 14% just from 2021 and are 6 times higher than they were in 2013. Restrictions on FDI (foreign direct investment) has been particularly brutal, increasing fourfold since only two years ago. The Biden administration is currently considering an executive order (that could become legislation in Congress later on and therefore set in stone) to screen all outbound investment (having already put in place checks on inbound investment). This would be the first of its kind. It will apply only to semiconductors, A.I. and quantum computing technology although would be expanded if Congress got its act together.
The result of all this will be a 2.3% average fall to global GDP according to IMF economists and that could be as bad as 4% for developing economies, if forced one day soon, to choose between the two sides. And that losses to living standards could be even worse than that caused by the pandemic. More importantly for our purposes, it will put real and constant upward pressure on costs to industries, as multinationals have to pay more tariffs on imported inputs and may not be able to source from the most cost-efficient supplier if it is deemed to be in an “unfriendly” country.
And the future doesn’t bode well. In retaliation to U.S. restrictions, China recently imposed export controls on two rare metals, germanium and gallium, a market it largely dominates and critical to semiconductor and silicon chip production. Gallium prices (that were not stockpiled in the West) shot up by 27% as traders rushed to beat the early August deadline. It doesn’t take an economist to realise what this – along with future restrictions – might do to the price of a computer or smartphone.
In this dark mirror universe we are living through, we must also quickly dwell on quantitative easing and tightening (QE & QT). Since the GFC and in response to the pandemic, the largest central banks bought up long-dated government bonds and assets to prop up a world economy that threatened to fall into deflation in the 2010s by basically increasing liquidity in markets. All in all, the Fed, the Bank of England, the Bank of Japan and the European Central Bank between them bought USD$19.7 trillion worth of QE. This process is currently being reversed. Higher interest rates mean that central banks must pay out dividends on all those assets and bonds that ultimately falls on the taxpayer. And given their already-stressed balance sheets, it gives little room if we were to be beset by yet another crisis.
It has been estimated by Fitch Ratings, an independent economic intelligence research body, that the U.S. alone will have to sell U.S. 1 trillion in such assets a year. While there is enough liquidity in the markets to sustain this currently– banks in the U.S. have USF$3.2 trillion parked there. But it will make markets more volatile and susceptible to shocks. There is a worry this may all add to a brewing credit crunch, as money for loans to an increasingly distressed private sector becomes scarcer still.
The Elephant in the Room… Debt, Debt….DEBT!!
Why should this all matter?
Well, apart from the obvious cost-of-living component to all this, ultimately it is the mountain of debt in the world economy – both public and private – that higher interest rates could have the darkest potential consequence. Between chronic inflation, and higher interest rates needed to quell it, made worse by tightening liquidity, with central banks selling all those assets and bonds. It conflates to make it far harder to borrow, which could put a swathe of companies and countries in a difficult situation.
How bad could it get?
Well, the corporate sector especially borrowed freely in the last decade when interest rates were low and even when day-to-day costs were covered. Many simply borrowed to pay higher dividends to their shareholders, in the knowledge that debt was cheap and would be for a while. There has been an alarming deterioration of corporate debt quality since 2010 as the level of debt has increased. And 2023 may yet be a watershed moment. In the first three months of this year, USD$11.8 billion worth of corporate debt was downgraded to junk – that’s 60% of the entire amount of 2022 already and we could be heading for a total that is behind the years of the pandemic and GFC.
If interest rates have to stay higher for longer than is currently forecast, a severe course correction may be in store. U.S. Federal economists recently noted that U.S. companies face a US$2.6 trillion debt pile in the next two years. As of end-June, a full 37% of firms are in major trouble.
Let me just repeat that (in bold and asterisks) so it sinks in:
**Federal Reserve economists themselves are saying (as of June 2023) that more than a third of U.S. companies may default on their debt pile in the coming months.**
And it is not just private sector debt that is a worry. Public debt in the developed world has ballooned to unsustainable levels and many governments are unrealistic about the urgent need to bring it back down. In the U.S. the GDP-to-debt ration stands at 98% and is projected to rise to 115% by 2033. Government revenue shortfall is now an unbelievable 8.1% of GDP (or US$2.1 trillion) – something that has been unseen outside of a major crisis – such as the Second World War, the pandemic or the 2008 GFC but is now the norm.
The need to fund government spending, which is set to stay high as the world population ages (requiring higher levels of spending for pensions and medical health as revenues and productivity fall from a dwindling prime-age working population) and spending on green infrastructure – essential to our very survival – will almost definitely add more pressure on an increasingly limited pool of liquidity and will have the inevitable and dire consequence of increasing the price of money (ie even higher interest rates). It may meaningfully “crowd out” (as it is known in monetarist theory) borrowing to a private sector that – as we have shown above – is on the brink of crisis and in need now of more funds to borrow than ever before.
Soft-landing? Yeah right..,
Since the GFC and especially following the pandemic, increasing levels of debt have been passed essentially from corporates, financial institutions and households to government. Both though are now saturated and unlikely to be able to take on too much more before something gives. And if interest rates stay higher for too much longer – it may well be sooner than expected.
History may well deem the lull in inflation in the second half of 2023 to be momentary – a calm before the storm so to speak. And if it is, then it can only lead to a reckoning with the unsustainable debt pile that hangs over all of us – everywhere.
Like a hangman’s noose that has only now come into focus on the proverbial horizon as we all insouciantly dance towards our merry doom.