Market participants need a point of reference. Currently the focus is on inflation expectations as a gauge of the direction and amplitude of coming monetary policy decisions. Inflation expectations are not astronomy; they are an average measure of market expectations. Why would most investors or central bankers have such respect for the acumen of their peers on this particular estimate is beyond comprehension? At no point in the past few years did the market expect inflation anywhere near where it was in the fall of 2021, well before Russia’s invasion of the Ukraine.
We were early identifying the possibility of a period of higher inflation and lower growth. Larry Summers and other economists brought to our attention an excessive growth in public spending. This observation reinforced our conviction in some of the positions in our portfolio. The risk reward of investing in bonds with negative yields, and often no coupon to boot, was one of the worst, if not the worst, investment proposition we can remember. If your investment advisor did not direct you to sell your fixed income exposure in 2021, you should consider a change and we should talk.
It is also puzzling to observe the volatility in the Treasury market of the past few months. It has often been higher than the volatility of the equity market (perhaps not surprisingly, since the equity market has a higher and usually growing coupon).
Many people seem confused by the return of the Philips Curve to conversations in developed economies. In emerging markets, the trade-off between inflation and unemployment has remained more visible. It is highly likely that the current trend towards reversing decades of globalization will lead to higher inflation in developed economies and economic pain in emerging markets. Workers in developed economies will have even more bargaining power than that already afforded by historically low unemployment and terrible demographic profiles made worse by a self-defeating curb on immigration.
The best thing one can say about the current economic slowdown is that it will not be felt as harshly as other recent slowdowns, as nominal GDP growth will remain high. This will take care of some of the excessive debt stockpiles by boosting tax revenues and lowering the debt/GDP ratio.
Trade barriers came down for a reason
Since very few things come free of charge, the other side of this inflation spike is that individuals who are immune to money illusion will save more for their retirements as real returns on investments come down. The savings rate may also go up further, as many spendthrift governments will raise taxes to continue with their popular profligate ways.
Trade barriers will dent global productivity and the quality of goods and services. The next time you feel like accepting that economic nationalism is a great idea, you should recall that there is a reason your smartphone was not made in the EU. Before the WTO reduced trade barriers, before delocalization of manufacturing and freer trade, we had to contend with second best and also-ran products and services.
Those of you who grew up in Spain before the country joined the EU may remember the shoddy automobiles and consumer electronics that were available. These closed markets also led to abuse as firms had much power over consumers. It was a world where companies sold small unit volumes at fat margins and consumers were constantly short changed.
Back-to-the-future response is lacking
It is worrisome that so many people agree that this back-to-the-future scenario is the intelligent and responsible policy response to Covid, the war in the Ukraine, or China’s reaction to Nancy Pelosi’s provocation. Not a single EU politician is on the side of permitting fracking in the EU in order to gain energy independence. Whether this is a case of ignorance or corruption is an open question.
The largely undisputed enlargement of the role of Government everywhere in the West is also a source of concern. We do not fully agree with the 1980s assumption that the private sector can do anything that the government does better and cheaper. It is nevertheless frustrating to see how the progress made over four decades of increasingly liberal economics in the West is being dismantled precisely because the worst businesses are falling into the lap of the State, most recently EDF.
A wondrous era of globalization seems to be coming to an abrupt end. Mercifully, this is not all bad news in the short term, although we are afraid it is mostly bad news in the long run. There are winners in this backpedalling process, especially among unskilled workers in developed economies. Should you have any doubts just try to hire a waiter in Spain this summer or a construction worker in Florida. Immigration barriers may have the benefit of lowering inequality even if they make everybody poorer.
Peaceful handovers of power no longer a given
Perhaps this new trend will reduce the polarization in domestic politics everywhere and bring about a more sedate public discourse. As in the Cold War era, we do have again very well defined enemies that threaten our security. Donald Trump, Boris Johnson, and Jair Bolsonaro have been able to exploit the fertile ground for populist ideas that misguided austerity brought to the surface in the wake of the Great Financial Crisis. Trump is out of office for now, Johnson will soon be out of office, probably for good, and Bolsonaro recently claimed he would not leave office even if his opponent wins the election in the fall. Perhaps this last bit of news is the most shocking aspect of the zeitgeist, the elected president of one of the world’s largest economies warns that he will not leave office because the election will be fraught with fraud and he has the support of the armed forces.
Trump opened the season for contesting the legitimacy of the outcome of an election. Thus far, he is getting away with his alleged incitement of the storming of the Capitol. Surely, in a bygone era, the elected leaders of western democracies would have commented on Bolsonaro’s provocation. Not today. Claims of electoral fraud and actual electoral fraud used to be the remit of weak democracies such as Mexico’s or frontier countries. Not anymore. The peaceful handover of power is perhaps the most salient feature of modern democracies. Let us hope this remains the case. There are few things more terrifying than a larger state run by unelected officials. Should you need any proof of that just take a close look at the workings of the EU Commission.