Sir John Templeton said the four most dangerous words in the world are ‘this time it’s different’. But this time, in my opinion, it is indeed different.
Over the past 40 years, the world has seen a bull market in stocks, bonds and real estate due to low inflation, low real interest rates and the advent of globalization (with the fall of the Berlin Wall and the end of the Cold War).
But investors have become complacent. Fear of missing out and greed dominated markets, sentiment and trading. Years of excess at all levels of government and in the professional and retail investment community have pressured a dormant volcano that it is now ready to explode, leading to the mother of all meltdowns.
Here’s why I think so.
There are unfavorable secular shifts in inflation and real interest rates, as well as globalization that bode a predictably bleak outlook for stock, bond and real estate markets.
First, the age-old trend of globalization has come to an end.
- The pandemic-related disruptions have prompted a major rethink of how companies outsource production. Businesses now place greater importance on proximity to manufacturing and distribution assets.
- Russia’s invasion of Ukraine has dealt a fatal blow to globalization. This will intensify de-globalization.
Second, secular forces are pushing both long-term inflation and real interest rates higher.
Inflation and real interest rates react to both short-term and long-term forces.
While in the short term inflation is driven by the increased intensity of economic activity and the resulting pressures on productive capacity and labor and commodity markets, in the long term it is taxes, economic efficiency and productivity, and supply and demand imbalances, which affect inflationary expectations.
While in the short run the real interest rate is influenced by the ups and downs of the economy (i.e. the business cycle), its secular trend in the long run is affected by factors that change only slowly, namely technology and demographics.
The economic effect is transitory. It is the rise in the long-term trend that is the problem this time.
The long-term inflation decline is over and we are now on the other side of the mountain with long-term inflationary pressures to the upside.
- We may reach a peak in productivity growth as experienced baby boomers retire and are replaced by less experienced workers who will nonetheless be in high demand due to weak population growth. These workers will demand higher wages.
- Pandemic-related deficits and soaring debts will require higher taxes in the future. Many have compared the pandemic to a world war. The pandemic, like the First and Second World Wars, has been costly and, like both wars, will require high taxes to meet accumulated deficits and debts.
- A pause in globalization could lead to higher inflation as companies, trying to hedge against supply chain disruptions, bring production back to North America. This means a higher production cost environment.
- While central banks have historically acted counter-cyclically, over the past 10-15 years they have increased the money supply more permanently, which will also add to long-term inflationary pressures.
- During the credit crisis of 2007-08, aggressive QE did not produce higher inflation, because QE occurred as banks and individuals deleveraged and these two offset each other. But in recent years, there has been an overly aggressive QE program without any offsetting effects, which will also lead to higher inflation.
- Finally, years of underinvestment in the oil and gas industry, heavy regulation and the ESG craze have not only changed the dynamics of oil prices, but also those of all commodities. For example, mining companies are returning capital to investors rather than investing to increase production for fear of ESG regulations. This implies significant shortages of metals at a time when demand will increase due to the production of renewable energy and electric vehicles.
Why is the secular trend in real rates rising?
1. Demographic developments push up the trend in real interest rates. Baby boomers have retired and stopped saving; in fact, they are in their years of dissaving (decumulation), which reduces the supply of funds.
2. This occurs in the face of increased demand for capital by companies that need to integrate innovation and new technologies into their production processes, as well as by governments that need to borrow to finance structural deficits.
3. To fill the imbalance between supply and demand, the trend in real interest rates is pushed up, much like what happened in the late 1970s.
The US Fed may not be able to help this time as it will face a catch-22. The surge in global debt issuance (including margin debt) in recent years has made economies and financial markets very sensitive to interest rate increases.
Additionally, stocks have recently tipped into a bear market. The last eight bear markets, as reported by MacNicol & Associates Asset Management, have been fought by the US Fed via interest rate cuts and quantitative easing. In the current bear market, the Fed is raising interest rates.
The Fed may abandon the inflation mandate to support the financial system as it has done in the past, but given the debt stock in the presence of all the structural changes mentioned above, this may lead to too rapid a fall in financial markets and the economy. replenish. The markets have not yet updated this outlook.
George Athanassakos is Professor of Finance and Ben Graham Chair in Value Investing at the Ivey Business School at the University of Western Ontario.
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