The print this week: The Bank of England was forced to intervene after new fiscal spending measures sent UK rates skyrocketing. Putin announced mass mobilisation of troops. A massive gas leak at Nordstream pipeline is leaking methane, equivalent to the emissions of 5.5m cars over 20 years. What could possibly go wrong?
There is a common misconception about the world economy, that this is a sum of various countries who exercise their right to govern their monetary policies the way they please. The reality is that the US is still the one economy to rule them all.
By letting the USD rip higher, the US are imposing monetary sanctions on all the rest of the world. The dollar reached a 20-year high this week. The benefit is that the US commercial deficits are evaporating fast, money is flowing into USD assets, which gives a great deal of room for manoeuvre on the US fiscal policy.
Conversely, the rest of the world is a train wreck. The JPY, the GBP, the EUR and emerging market currencies have been in freefall. Some might argue that their declining economy was partially a root cause, but in reality, they have no choice. Central banks around the world have little alternative but to hike rates as well, in the wake of the Fed aggressive stance. This tightening does not suffer any leniency on Government budgets either.
Any foreign Government that thought the contrary was up for a stark wake-up call. The GBP fell 5% in one go after the newly appointed Liz Truss announced tax cuts. In Italy, the new nationalist Prime Minister Georgia Meloni was quick to re-assert her allegiance to European technocrats, despite her campaigning to the opposite. The singular exception is most probably China, where credit and monetary policy had been tight for the past 2 years, and are just loosening right now to support an ailing domestic situation.
Otherwise, the overall hiking cycle comes at a very inopportune moment. The global economy is slowing down fast. In the US, the Conference Board forecast 1.4% for FY22 and 0.3% in FY23. China, the world’s second largest economy, will grow at 2.8% in FY22, as per the World Bank in Sept22.
The stagflation combo is in fact very nasty. Inflation brings down consumer’s purchasing power. Higher rates further restrict credit. Assets go down in value. Everybody ends up poorer. Consumption further slows down. In hindsight, contraction cycles are expected in capitalism, and the current one arguably had been delayed by the exceptional money infusions in 2008’s GFC and 2020’s covid crises. The return of the tide is expectedly violent.
Where does it end? First, it ends with inflation coming down, which is now expected considering the drop in activity. Secondly, it ends with consumption waning as morale goes down. Thirdly, it ends with declining corporate profits. Fourthly, it ends with asset valuations crashing down and not long cheap debt financing to prop them up. Well, it ends badly you’d say, but it doesn’t necessarily have to.
We believe that economy could stabilize at a high level. That the level of fiscal capacity in the US can lift the boats that need to. Interest rates at 4.5% or so are no longer making money dirt cheap, which prevents erratic risk-seeking behaviours. As rates reach this level, i.e. soon, we would already notice that inflation has come down a long way. Besides, it looks like people haven’t stopped innovating at the fringe of the new frontier, and this is bull future. Let’s be constructive on selective bonds, and money market and enjoy higher fixed income returns, until the moment comes to re-invest in equity.
360 Advisory LLC is a Boston-based RIA managing investments, including crypto