HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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May 8, 2022

Demand Destruction, Supply Reforms and Financial Repression

Global demand growth is slowing, and inflationary concern is peaking. The cure for high prices is high prices, they destroy demand and stimulate new sources of supply. The adjustment time depends on how efficiently the supply side functions. Right now, this is a matter of intense debate. But demand destruction remains the primary goal of Government and Central Bank policy, particularly in the UK, where we have both monetary and fiscal tightening into the teeth of an economic slowdown.

Given that interest rates have only just started to go up, it is tempting to think that this battle has only begun and rates have much further to travel. However, this is not a normal cycle. This cycle is a self-induced short sharp shock followed by an unexpected external shock, all wrapped up in a massive bundle of debt. This cycle is nearly done. As Lyn Alden says, with debts relative to GDP near historic highs, major deflationary shocks can’t be allowed to last long or the whole financial system will collapse.

Over the past two years, our complex supply chains were switched off and then switched back on again. This manoeuvre might be an acceptable means of improving the performance of our computing devices, but it’s not good for the efficient operation of the global economy. Furthermore, just as our supply chains reloaded all their post-pandemic applications, the system was hit by a massive attack on our supply of energy and commodities. This exogenous shock is making further huge demands our sources of energy to rid ourselves from the unwanted demands of Mr Putin.

Meanwhile, the US economy benefits from being far more adaptive than Europe’s. Thanks to strong agrifood and energy sectors that fully embraced the respective technologies of GM and fracking , the US is virtually self-sufficient in food and energy. Currently, the US enjoys natural gas between one fifth and one-tenth the price of Europe. For this reason alone, capital is flooding to the $. At the same time, the increase in $ interest rates is a bonus. However, the $ is also the world’s reference currency, and as the value of the $ rises, the US effectively exports inflation to the rest of us, and imposes an extra financial burden on poorer countries with $ denominated debt.

The job of the Federal Reserve is to land the US economy in what Jerome Powell described last week as a “hopefully softish” way. While this might sound straight forward, there are no successful precedents of the Fed achieving this. The FOMC is applying gentle downward pressure on the joystick, but they don’t appear to have noticed the economy’s existing unassisted rate of descent.

The everything rally has turned into the everything slump. The wealth effect is becoming apparent, soon negatively impacting consumer spending and tax receipts. In particular, the sharp rise in the long bond has caused US mortgage rates to nearly double in a month, thus shutting the US consumers’ ATM of choice. Consumer bellwether Amazon also admitted last week that it had overinvested in both distribution assets and staff in the medium term. The yield curve remains indicative of a recession. The Fed’s policy is to keep tightening until something breaks. We are not far from this moment. As Alfred Henry Lewis said in 1906, there are only nine meals between mankind and anarchy.

The Fed cannot print energy, commodities or food, but government policy can assist in improving their supply. These policies take time and resources. But nothing makes these difficult decisions more palatable than a good crisis. In this regard Putin has replaced the pandemic. A hundred years ago, the UK’s government War Loan sustained financial repression that solved the massive debt burden of two world wars. This was achieved by duping patriotic private investors into taking below-market returns on their capital as inflation ran hot. Today’s War Loan will come in the form of ESG tagged instruments of energy transition away from Putin’s grasp. Watch for these instruments to become mandated components of approved and regulated portfolios. A green new deal will be the rallying call for the next generation of savers and investors to be fleeced as governments have to find innovative ways of rationing credit in a world where market clearing interest rates have to remain suppressed. If they want to keep the show on the road, the current round of policy tightening will be shortlived.

Jeremy

Ealing

08/05/2022

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