Insightful Views About the Global Economy, Financial Markets and Investments.

An insightful assessment of the current Macroeconomic Environment

The state of play regarding the macroeconomic environment, supply chain disruptions, global debt as well as the federal reserve and other central banks monetary policies.

The global macroeconomic environment is deteriorating very quickly on the back of tighter financial conditions such as rising interest rates and U.S quantitative tightening (QT) which is removing liquidity from the monetary system. The U.S economy is technically in recession with two consecutive quarters of negative economic growth. However, the Federal Reserve System (FED) chairman, Jerome Powell has a different view and suggests the strong U.S jobs market and economy is not consistent with a recession. Those who keep a keen eye on their poorly performing investments may beg to differ.

There may be some truth to Powell’s comments due to the effect of interest rate hikes and tighter monetary conditions taking a while to work their way through the economic system. The consequence of higher interest rates is that capital expenditure decisions get shelved, companies focus on cost savings, shedding staff and repaying debts whilst households cut back on discretionary spending consequently destroying aggregate demand in the economy with a lagging effect on corporate earnings.

The problem with Powell is his credibility. He has been stating at Federal Open Market Committee (FOMC) press conferences that inflation is transitory for more than a year. He has recently changed the narrative to inflation being so deeply entrenched in the U.S economy that we need to raise interest rates more aggressively. At the last but one FOMC press conference he stated that the U.S jobs market was too strong for the USA to be in a recession. However, at last week’s press conference, the narrative had changed again. This time he warned about economic pain and that the possibility of a soft economic landing had diminished and warned of a looming recession. Despite the wealth of experience Powell brings to the table, inconsistency in the narrative does little to instil confidence in the market.

If he hadn’t focused on unemployment data which is a lagging indicator and looked at something more indicative of current and future job prospects such as new job openings, he would have realised that the U.S economy is in a recession.

Financial markets crave stability, certainty and consistency in messaging and Powell provides neither of these. The economic environment is becoming increasingly challenging with rapidly rising interest rates, reduction in monetary supply through quantitative tightening, rampant inflation and an energy and food crisis.

This is starting to impact discretionary consumer spending which in a largely services-based economy ought to drive equity prices lower. Not all sectors of the economy can pass on the higher prices to consumers so profit margins in the corporate sector are going to be squeezed.

There are also geopolitical tensions between liberal democracies and the authoritarian states of Brazil, Russia, India, China and South Africa (BRICS) resulting in more barriers to trade which in itself is inflationary. The war in Ukraine is resulting in supply chain disruptions in food and energy sectors again feeding the inflation narrative. Global instability is also having a detrimental impact on investments leading to volatility across all asset classes.

Meanwhile the strong U.S dollar is causing havoc in emerging markets who have to raise their own rates to compete for and attract foreign capital inflows which slows down economic activity in these economies.

The situation we are in is of the Federal reserve’s own doing. They did too much, too soon during lockdown doubling the U.S money supply from $5 trillion to $10 trillion with helicopter money thrown in for good measure. Whilst post pandemic they have done too little too late to mop up the excess liquidity when the economy opened up resulting in too much money chasing too few goods. Remember that supply chains take time to restart causing runaway inflation. Whilst the inability to spend allows wealth to accumulate for an individual, it does little for the economy.

The problem is, in a normal economic cycle when interest rates peak the economy overheats and goes into recession. The central banks then use all available tools (fiscal and monetary) to engineer a recovery. Unfortunately, we no longer have free markets and the problem with manipulated markets is that interest rates have to be increased not decreased as the economy contracts.

Given the global debt burden, the ability to inject liquidity into the system or indeed to use government borrowings to drive growth is severely constrained. Therefore, governments and central banks are truly trapped and having to choose between the two seemingly conflicting economic objectives of taming inflation or supporting the economy? Looking forward we feel that they have well and truly run out of tools to pull a rabbit out of the hat!

Today’s Macroeconomic environment begs a number of questions, none of which come with a particularly short or straightforward answer.

1) How are supply chain disruptions contributing to the inflationary problem?

Covid related lockdowns had a huge effect on the supply chain, so much so that many sectors have not yet fully recovered. That aside though, Europe is at war. Ukraine is the breadbasket of Europe. Wheat, rye, oat, corn, barley and rice are all exported far and wide from the Ukrainian farms. With no end in sight to the ongoing conflict, food prices are set to continue rising. War in Europe also has a negative effect on investment performance, creating uncertainty and volatility.

There is also an energy crisis with demand for gas naturally higher than during the covid related lockdowns and Putin continuing to use the Russian supply line as a political tool threatening to cut off the pipeline to the West. More instability across investments and financial markets.

There is however, a lot that can be done to address the supply line issues which are currently feeding the inflation narrative. This is a more sensible approach than demand destruction and economic pain. It will take decades for renewable forms of energy to replace oil and gas and during this transitional period towards zero net emissions, oil and gas still have a significant and vital role to play. With the end investor more ethically conscious than ever before, oil may seem like an unpopular answer but given the instability, the financial markets would certainly benefit from a solution to Europe’s over reliance on Russian gas.

The big oil majors have not been investing in the production of new oil wells. Instead, they’ve been adopting a more financially prudent approach by focusing on cutting capex to pay back debt, increasing dividends and diversifying into greener energy sources. Incentivizing the oil majors to ramp up production could prove a more effective short-term policy.

https://www.naturalgasintel.com/global-ep-capex-in-2022-led-by-u-s-eps-with-privates-playing-outsized-role/

2) Where are we with global debt? Are current levels sustainable and what economic levers do governments have to get us out of this mess?

Global government debt rose by 13% in 2020 to 97% of GDP and has continued to rise since. Debt to GDP ratios have continued to soar in the advanced economies including the U.S which is currently running at 133% and rising.

https://www.visualcapitalist.com/global-debt-to-gdp-ratio/

This is worse than countries such as Portugal at 130% or indeed Spain at 120%. Some African countries also now find themselves in a more favourable position than the U.S. To put this all into perspective, Greece’s debt levels were at 146% in 2010 when they received their first bailout plan to avert crashing out of the E.U. The narrative then, from both the E.U and global media channels, was that Greece was bankrupt. Today Greece’s debt to GDP is 206.70% and deteriorating quickly but everyone turns a blind eye as the problem is endemic in advanced and developing nations alike.

The 2010 Greek bailout was not about salvaging the Greek economy as such, more so preventative action to stop the French and German banks from collapsing under the weight of the loans they’d already extended to Greece which would have turned bad without a bailout plan. Since the global financial crisis, many advanced economies are in financial trouble including of course Italy which has a debt to GDP ratio of 155% and worsening partly due to low birth rates fuelling an unfavourable age demographic.

To grasp the extent of the problem and how the powers that be have ‘papered over the cracks’ let me tell you a short story about two men and a barrel of whiskey.

This has been adapted from the book Adults in the room by Yanis Faroufakis, an author, economist, professor and former Greek finance minister. Faroufakis took on the E.U establishment during the third Greek bailout plan in 2015.

Kane and Abel decide to lift themselves out of poverty by persuading a local publican, John to lend them a barrel of whiskey. The plan was to roll it down the road to the next town where they are holding a public function. The idea was to sell its contents by the cup, make an extraordinary profit and repay John. Rolling the barrel down the road they stop for a rest under a great oak tree. Whilst sitting in the shade, Kane realizes he has a shilling in his pocket and politely asks Abel whether he can give him the coin in return for a cup of whiskey. Abel agrees, pockets the coin, and gives him a cup. A minute later Abel realises he has a coin in his pocket to spend. He turns to Kane and asks the same question to which Kane accepts. Abel hands Kane the shilling in exchange for a cup of the whiskey.

The process repeats itself over time until the barrel is completely empty and the two of them fall asleep under the oak tree with great grins on their faces. The publican never gets paid – suffice to say.

This is exactly how public finances are being run today across the advanced economies. They are masking the root problem and kicking the can down the road for future generations to pick up the tab. We seem to forget that the easiest solution for governments is to reduce the monetary value of debt through higher inflation. Unfortunately for ordinary citizens, this approach succeeds in devaluing the debt but also reduces the purchasing power of our disposable income, reducing our wealth and making us all considerably poorer in the process.

The real issue is that managing your debt at a zero percent interest rate is actually quite easy as there is no debt servicing costs. When interest rates start rising however and government debt is rolled over at higher interest rates, it blows a huge hole in government finances as more tax revenue receipts have to be allocated to debt interest repayments. This is exactly the problem the U.S faces today.

U.S debt servicing costs are rising considerably relative to tax receipts and comes in 4^th in government spending behind social security, defence and healthcare. If the Federal Reserve follows through on its promise to tighten rates until inflation pressures ease, as ambiguous as this statement is, it may well result in more indebtedness.

3) Are central banks in a position to increase interest rates in a contracting global economy?

There have been calls for the Federal Reserve to allow rates to settle at a point where it brings inflation back down. Basically a few seasoned U.S professionals are calling for a return to Federal Reserve chairman Paul Volcker’s 1970’s interest rate policy when interest rates climbed to double digits. A decade in which the U.S entered a period of stagflation for the first and only time.

https://www.longtermtrends.net/us-debt-to-gdp/

That expectation is completely flawed as public finances are considerably worse now than they were then. The debt to GDP ratio was less than 35% back then compared to 133% now so how on earth can they expect or believe that the Federal Reserve in all their wisdom can push rates significantly higher? Interest rates will rise to a point at which debt becomes unserviceable forcing governments to either cut public expenditure, increase taxation or raise more debt.

Let’s not forget that these measures would be taken in a contractionary economic environment with rising unemployment. Clearly, we are in unchartered territory because we have never been in this position before where markets are highly manipulated and therefore not free markets anymore. It’s difficult to say how much interest rates ne0eds to rise to bring inflation down but if history is anything to go by then rates would have to be in double digits to put the genie back into the bottle.

So, what are they playing at? The Federal Reserve and indeed most major central banks are playing a game of pretence. Wanting to calm inflationary expectations without having the firepower to go through with their threats. The one-million-dollar question is how far can they go and at what point do they pivot and basically pause or reduce interest rates and potentially even restart quantitative easing.

Nobody truly knows however when this will occur. What we do know is that if they continue tightening monetary policy, they will destroy demand and the housing market, investment market, jobs market and discretionary consumer spending will collapse precipitating a recession of which the length and duration are unknown.

This is why the odds are stacked in favour of the Federal Reserve reversing its hawkish monetary policy in quarter one of 2023.