We are who we are, shaped by our past experiences and the lessons we learn from others. Similarly, today’s decisions on economic policies are heavily influenced by historical events, and the thinking and theses of economists-academics of the past.
From the 1930s, economic stability was largely driven by the ideas of British economist John Maynard Keynes (1883-1946). He advocated countercyclical fiscal policies, for the government to step in when market forces fail to do the job. In other words, governments should act to counter normal business cycles — spending more during recessions but also reining in excesses during boom times.
The problem is, everyone is a Keynesian during bad times — pump priming the economy to boost aggregate demand — but far less so during good times. This is especially true in democratic countries where politicians are loath to make the tough decisions that inflict pain on the people. Taking away the punch bowl in the middle of the party is never popular. As a result of rising fiscal spending, by the late-1960s, global inflation was running high and morphing very rapidly into a major problem.
Enter Milton Friedman (1912-2006). The American economist and statistician was a strong advocate of monetarism, spurring the shift in macroeconomic ideas from predominant Keynesian fiscal policy to monetary policy. He promoted the idea of controlling money supply to control inflation. Double-digit inflation rates in the early 1980s were finally brought under control by sky-high interest rates — the federal funds rate rose to 19% — at a huge cost to unemployment and the economy. The US Federal Reserve’s commitment to maintain price stability eventually helped it to earn back its credibility.
In the 1970s, John Kenneth Galbraith (1908- 2006) advocated controlling inflation as the foundation of macroeconomic policymaking. In other words, easy monetary policy (printing money and lowering interest rates) to grow economic capacity when demand is falling and prices are deflating. And vice versa. This seems to have worked well during and after the global financial crisis and Great Recession — with central bank policies focused on record-low interest rates and quantitative easing (QE). It, however, carries the same risks as Keynesian policies — will central banks (like politicians) be responsible and independent enough to take away the punch bowl, when prices (inflation) are rising, either sufficiently or in a timely manner?
It is this belief and these policies that are driving central bankers around the world today. This is especially true of the Fed, which has pivoted to aggressive tightening to rein in the highest inflation rates since the early 1980s. The question is, are the Fed’s tightening actions (in pace and scale) today sufficient? Or is it too late, having fallen so far behind the curve, after predicting — wrongly — that price increases were transitory throughout 2021? Perhaps even more importantly, is it the right policy — given that the prevailing inflation is predominantly due to supply shocks rather than being demand-driven?
We think the economic costs will be higher than what markets currently expect, because monetary tightening is not the best tool to address the current inflation problem. Central bankers understand this — but they will, nevertheless, persist. Because they have no choice. We think the US and global economies are heading into recession, and maybe stagflation. We will attempt to explain this in two simplistic charts.
We are not alone in this view. That said, it is seemingly at odds with the analyst community. According to data provider FactSet, the current number of “buy” ratings account for 55.6% of total ratings on stocks in the S&P 500. While this is down from the peak of 57.4% earlier this year, it is still the highest level since September 2011. As we noted before, analysts are an optimistic lot — it pays to be positive and most are loath to put a “sell” rating on any stock, for fear of being denied access to management in the future. Hence, downgrades tend to be lagging, and usually after the fact. Or perhaps they are in denial? Analysts and investors may be complacent because they believe the Fed will relent and ease off tightening as stock prices fall and growth slows, as it did in 2018. The difference is that inflation is running hot today. Central banks have to regain control of inflation and prevent inflationary expectations from being entrenched in mass psychology, as in the 1970s — to retain its hard-won credibility and preserve the ability to deploy monetary tools in the future. And this is why we raised cash holdings in both the Global Portfolio (to about 52% of total portfolio value, including proceeds from last week’s disposal of Commercial Bank for Foreign Trade of Vietnam) and the Malaysian Portfolio (100%).
It’s all about demand and supply
See Chart 1. At the outset of the pandemic, both the aggregate demand and supply curves shifted inwards — from D0 to D1 and S0 to S1 — due to border closures and movement restrictions. That would have resulted in a sharp contraction in economic activities. To protect productive capacities (prevent business failures) and alleviate economic hardship for the people, central banks acted quickly to cut interest rates and flood financial systems with liquidity (QE). Governments implemented massive fiscal aid packages to replace loss of income. Fiscal stimulus in the US totalled some US$5.3 trillion, or 25.4% of gross domestic product, a big portion of which was in direct cash handouts to households.
With limited spending avenues (for travel, dining out, entertainment), people splurged on goods (gadgets, exercise bikes, cars) with this “free money”. The sudden surge in demand for consumer goods amid widespread supply disruptions created shortages and pushed up prices — this is known as demand-pull inflation. This was especially evident for new and used cars in the US, where the complex global supply chain led to a semiconductor chip shortage that forced carmakers to curtail production.
As the worst of the pandemic receded, becoming endemic, economies reopened and activities normalised. Supply shortages were expected to be resolved and the supply curve would return to where it was pre-pandemic, that is, S2 = S0. And prices would return to P0. This is the rationale behind the Fed’s “inflation is transitory” belief.
But the reality was that prices continued to rise. The only reasons why prices (P2) remain elevated are 1) if there is excess demand — that is, D2 has shifted too far right from D0 — and/or 2) supply has not returned to pre-pandemic levels, S2 < S0. We think both factors are at play.
As we mentioned last week, US households are, on average, in (too) good financial shape and consumers have kept spending, even as inflation rises. Central banks and governments have provided too much stimulus for too long. Cash handouts boosted household savings beyond pre-pandemic levels while cheap money drove asset prices sharply higher, including for stocks and property. The latter created a wealth effect that further fuelled consumption. In short, D2 > D0 and Q2 > Q0. If this is the reason, then the countermeasure would be to tighten monetary policy — hike interest rate and quantitative tightening (QT). This would bring down aggregate demand, D2 = D0. And voila — all is well again!
But what if, D2 = D0 but S2 still lies somewhere above S0, meaning to say, aggregate supply — especially of labour — is still constricted? As a result, prices stay elevated, P2 > P0 — otherwise known as cost-push inflation (see Chart 2).
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Pandemic-induced supply disruptions have proven to be far more persistent due to various reasons, which we will elaborate on in a bit. To control inflation, the Fed will (as in the previous scenario) tighten monetary policy — hike interest rate and QT. But now, prices will only return to P0, if demand falls to Q2 — that is recession (demand falls below pre-pandemic levels, Q2 < Q0). Worse, if prices turn out to be sticky — and that is looking more and more likely due to persistent labour shortage, at least in the near to medium term — or the Fed does not do enough, we could be headed into a period of stagflation. That is, reduced demand but prices stay elevated.
Why are there still supply shortages months after reopening?
There are myriad reasons for why supply disruptions have persisted. Firstly, while most countries have reopened, China continues to enforce its zero-Covid strategy. That is prolonging snarled supply chain issues.
Some productive capacities have been lost, due to business closures, and cannot be quickly replaced. For others, pandemic restrictions and uncertainties have resulted in delayed capacity expansions (to preserve cash) and backlog in staff training and recruitment. For instance, airlines are struggling to cope with reopening travel demand due to a shortfall in planes and staff, including in the broader aviation ecosystem, and as a result, ticket prices have soared.
Russia’s invasion of Ukraine is one of the biggest — and unpredicted — factors. Wide-ranging sanctions imposed by the West have reduced Russian output and severely disrupted the commodities market, especially for energy and food. Oil and gas prices are currently well above pre-pandemic levels — and will likely remain high given prevailing geopolitics and uncertainties. Europe is heading into a harsh winter — and certain recession — on the back of soaring energy prices and shortage-induced rationing. Incidentally, prices for coal — a key feedstock for power generation — have soared almost 2.5 times higher than the previous 2008 commodity boom record.
Equally critical is the persistent labour shortage. Wages are incredibly sticky and inflation expectations — if not clamped down quickly — get built in, and could result in the dreaded wage-price spiral reminiscent of the 1970s and early-1980s. Since 1990, there have been periods of robust wage gains in the US but these have not triggered another wage-price spiral — inflation remained relatively modest, thanks, in large part, to globalisation (see Chart 3).
Globally, consumer goods prices declined with the abundance of cheap labour in China, emerging markets and Eastern Europe, as well as the relative free flow of trade and capital. Businesses benefited greatly, profits grew and stock prices rose. The S&P 500 total returns index is up nearly 22-fold — rising at a compound annual rate of 10.2% — since 1990.
There is a whole lot more friction in the world today and globalisation is in reverse due to geopolitics. We will explain why we believe the trade war, started by former US president Donald Trump, is fundamentally not about trade balances and why geopolitical tensions between the US and China is unavoidable, next week.
The job market in the US is very tight, with approximately two job openings (job vacancies totalled 10.7 million in August 2022) for every unemployed worker currently. Wages have risen sharply since the pandemic, with growth running at four-decade highs (see Chart 3). As we wrote last week, the unemployment rate, at 3.7%, has barely budged and is still near 50-year lows even after all pandemic restrictions have been lifted. The labour participation rate, currently 62.4%, remains below the pre-pandemic level of 63.4% in February 2020. Chart 4 shows the participation rates for three different age groups, all of which have yet to return to pre-pandemic levels. We think the tight labour market will persist for some time yet. Why?
The reasons include lingering health concerns, lack of childcare options, delayed education-training and geographic dislocations due to the pandemic. Positively, much of these should be largely resolved or will be in the near future. We wonder if there are longerterm behavioural changes, induced by the pandemic and large handouts, that would be more structural.
For example, workers that were let go during lockdowns may have relocated from city centres, where most of the jobs are, especially in the services sector. A segment of these workers may not be willing to relocate again, delaying returning to work, and/or are unwilling to tolerate poor working conditions-low wages, because they are still sitting on excess savings-handouts.
Some may have started small businesses from home or switched professions. Many, and especially the younger generations, are opting for self-employment, freelance work or joining the gig economy because they have found the flexibility (during the pandemic) attractive. The digital economy too has opened up a lot more options, such as being online resellers, digital influencers, YouTubers and TikTokers. And thanks to the pandemic rally, there are likely more than a few full-time stock day traders.
The pandemic may also have accelerated retirement for those in the older age groups. Many are choosing not to rejoin the workforce for health concerns, especially if they own assets (property, stocks) that have appreciated significantly in value. The pandemic has brought forward America’s ageing population problem. The baby boomer generation (those born between 1946 and 1964) has been gradually going into retirement — creating a big drag on workforce numbers. This is especially given that population growth has been trending down since the early 1990s, resulting in sharply lower growth for the workforce since the 1970-1979 and 1980-1989 cohorts, when baby boomers entered the job market (see Chart 5). In the past, this slower growth was, at least partially, offset by healthy immigration. But in recent years, growing populism, which is being increasingly politicised, has created an anti-immigration sentiment.
Also worrying are the lingering effects of long Covid-19 — and its huge impact on loss of productivity. A recent Census Bureau Household Pulse Survey found that 16.3 million people (around 8% of working-age Americans) currently have long Covid-19 — and as many as four million may have left the workforce because of it. Other studies corroborate the findings. Many sufferers are struggling with debilitating symptoms such as severe fatigue and brain fog that have forced them out of permanent jobs, or to work reduced hours. We know very little about long-Covid-19’s effects and the potential treatments.
Fed, and other central banks, have no choice but to raise interest rates
Where does all this leave us? High energy cost (for coal, oil and gas) is hugely inflationary for the world — driving broad-based price increases. We do not know when and how the Ukraine war will end. Labour shortage in the US, due to its ageing population and made worse by reduced immigration, will take time to resolve (with digitalisation of the economy and advancements in artificial intelligence and automation). Geopolitical tensions between the US and China will worsen and globalisation is in reverse. These are not problems central banks can resolve by tightening monetary policies. But monetary policies are the ONLY tools they have.
The Fed is truly stuck between a rock and a hard place — it must regain control of inflation, at all costs, to retain credibility and ensure future policy effectiveness — as are all other central banks in the world. They too have little choice, given the US dollar’s central role in trade and finance. Keeping rates low or even raising at a slower pace comes at the price of weaker currencies, which just leads to imported inflation (ending with the same higher cost of living as rising borrowing costs) — nearly all commodities including fuel and food are priced in US dollars — and likely capital flight. Worse, low interest rates penalise savers and discourage savings, which is an important source of funds for investments. During the recent economic symposium in Jackson Hole, Fed chair Jerome Powell quoted his predecessor, Paul Volcker at the height of the Great Inflation in 1979: “Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.”
Powell went on to say: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth … they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” In other words, recession is coming, globally.
The Global Portfolio fell 1.9% for the week ended Sept 21, lesser than the MSCI World Net Return Index’s 3.8% loss. All the five remaining stocks in our portfolio ended in the red, the biggest losers being Yihai International Holding (-6.5%), Alibaba Group Holding (-4.7%) and Guangzhou Automobile Group Co (-4.4%). Total portfolio returns since inception are pared to 17.4%, trailing the benchmark’s 29.8% returns over the same period.
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