There is a great need in the human psyche for normalcy and predictability. This is what investors and policymakers have been hoping for since the chaos unleashed by the pandemic, followed by the war in Ukraine. But the current brutal pace of change and volatility is here to stay for now. Don’t expect any return to moderation or calm over the rest of 2022, or for some time thereafter for that matter.
This outlook addresses how the economy and markets react when undergoing a paradigm shift from high economic visibility and low inflation to one of high volatility and high inflation. And we are talking about a real paradigm shift, really the first of its magnitude in modern history since President Carter and Fed Chair Volcker did in the late 1970s what President Biden and Fed Chair Powell are trying to do today—kill inflation. Back then, the task was somewhat easier, given a young population and low leverage in both the public and private sectors of the economy. Now we have an older, asset-rich private sector and a massively indebted public sector. Spoiler alert: it won’t be easy.
The last two decades of endless policy support have served investors well, as the main macro policy has been one of infinite monetary easing at every stumble and plenty of countercyclical fiscal stimulus. The buy-the-dip mentality prevailed and was rewarded at every turn, as policymakers continued to increase the ‘speed of the train’—the quantity of money feeding into the economy—with no or negligible impact on goods inflation due to the labour and cheap energy arbitrage of globalisation. This, even as asset inflation raged due to the rising leverage driven by ever lower policy rates.
‘The great moderation’ was the narrative of the time, and former Fed Chair Bernanke went out of his way to boast that the standard deviation of quarterly GDP had halved and inflation had declined by two-thirds during this period. In other words, the economy was supposedly becoming ever more predictable and less volatile, not recognising that it was a one-off process allowed by ever easier policy rates, hidden leverage and globalisation. The seemingly endless cycle of being able to simply ease at every speed bump in the economy or markets even allowed us to indulge in the fantasies of Modern Monetary Theory (MMT), which claimed there is no real hindrance to simply printing money for fiscal stimulus.
But the final phases of the rinse-and-repeat of policy stimulus aggravated growing imbalances, as policy rates began falling below realised inflation. This resulted in deepening negative real yields, which became necessary to continue to fuel the rise of asset prices but which also brought weak capital returns, as negative real rates drove increasingly unproductive investment.
Over the last two decades, we have created an economy and society where the financial part of the economy kept growing at the expense of the ‘real economy’ of physical goods and activity. Simply put: the real economy became too small in relative terms, something that was made suddenly and painfully clear in the wake of the pandemic outbreak, when the enormous push generated from the financial economy to sustain demand fed straight into inflation. That’s because the physical economy, the supply side, could not come close to meeting a stepwise shift higher in demand. That was in part due to the shutdowns limiting production, but also as the long-term underinvestment in energy infrastructure and the dream of shifting to far more expensive alternative energy meant that the physical world simply couldn’t keep up.
At its recent extreme low during the pandemic outbreak phase, the energy component of the S&P 500 fell below 3 percent of the index’s market cap. This at a time when the five most valuable companies, all from the digital financial world, were worth more than 25 percent of the index. Meanwhile, pension funds, sovereign wealth funds, asset managers and even governments (Sweden and Finland) banned investment into fossil energy due to environmental, social and governance (ESG) mandates, despite this energy driving the bulk of the economic activity upon which our daily life is based. And then the Russian invasion of Ukraine added fuel to the flames.
This brings us to today and our core outlook for the second half of 2022. Central bankers continue to peddle the idea that ‘normalisation’ to around 2 percent inflation target is possible within an 18-month horizon. But why should we listen when these same people never conceived that inflation could reach above 8 percent in both Europe and the US? The risk is that inflation expectations are rising fast and driving second-round inflationary effects that will require central banks to tighten even more than they or the market currently conceives until the runaway train is controlled, likely sending us into a deep recession.
This creates the next macro policy change and response we will need to look for in Q3 2022. Given a policy choice of either higher inflation or a deep recession, the political answer will likely be to instruct central banks directly or indirectly to move the inflation target up from 2 percent. The optics of this would hopefully mean requiring a bit less tightening, but also that negative real rates, or financial repression, are a real embedded policy objective now. It’s also a risky bet that there is some Goldilocks-level of demand destruction from a higher policy rate that will start to force inflation lower, all while demand is subsidised for the most vulnerable with support schemes for power, heating, petrol and food. The holes in this policy argument are that none of this addresses the imbalances in the economy. Whether the Fed has a 2 or 3 percent inflation target does not create more cheap energy. What is clear is that the political system will favor the ‘soft option’ for inflation in which the chief imperative is financial repression to keep the sovereign funded and a reduction of the real value of public debt via inflation. This is exactly why inflation will continue to rise structurally. Q3 and beyond will make it clearer that political dominance pulls far more rank in the new cycle than monetary tightening, which will forever chase from behind. The great moderation is dead—long live the great reset.
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