Macro: Sandcastle economics

The policy paradox of the two-lane economy 

The economy has been full of surprises since early 2020, with the lack of recession last year being the biggest surprise to consensus. This year, the big surprise has been the persistent inflation not coming down as fast as expected, underpinning the notion that central banks do not fully understand the current inflation dynamics. Being wrong again on the path of inflation has likely made the Fed more cautious and thus we expect no rate cut until later this year, unless the global economy materially slows down.

Indicators are suggesting parts of the economy, such as real estate and car manufacturing, are struggling with high interest rates, but in other sectors of the economy, such as defence, semiconductors, AI, and obesity drug manufacturing, things are booming. Capital expenditures in those parts of the economy are growing faster than in the decade leading up to the pandemic. It is this “two-lane economy” that is complicating monetary policy, because helping the weak part of the economy can come with prolonged inflation which is more costly.

All sandcastles are vulnerable to even small waves 

Sandcastles are fun to build, but they are inherently fragile and the same goes for the global economy. Economic growth will remain stable, but down the road several factors can destroy our sandcastle economy.Fiscal spending in the US is not sustainable in the long run and the current government bond yields are increasing government expenditures related to its debt, carving out resources for welfare and infrastructure. The US government must address the risk of cooling the economy or risking letting inflation run high for longer. 

The war in Ukraine has shown that geopolitics can shock the economy unexpectedly and this source of risk will continue for years. Other trends such as friend-shoring of manufacturing and an evolving war economy not just in Europe will also put upward pressure on inflation. Exploding health care budgets, due to e.g. increased focus on obesity drugs, an increase in unpredictable weather patterns, and gloomy demographic trends as the globe becomes older also suggest that we should enjoy our sandcastle economy while it lasts.

Investment allocation

Our macro assessment above suggests a positive outlook in the short-term, ahead of the crucial fourth quarter featuring the US election. In addition, periods with a calm financial turbulence environment and inflation running above the inflation target of 2% have historically been positive for asset class returns and especially equities, commodities, and corporate bonds.