22 Nov 2022
Global Macro-economic and Geo-political Update
This newsletter covers a range of interrelated topics and provides our views on critical macro-economic and geo-political events.
The global macro-economic environment continues to be strained with high levels of debt which in a rising interest scenario means increasing servicing costs. There continues to be supply chain shortages and a global shortage of USDs. Downward pressure on asset prices continue, except for energy products. The positive news is there are low levels of unemployment and there is strong consumer demand for services and products. Folks are happy the Covid lockdowns are over, and they are out spending with retailers and travel agents indicating strong demand.
Although house prices have fallen there is strong demand for properties seen as having value. In Sydney, million-dollar mortgages are common which means that a borrower’s repayments since the start of the year have gone up between $2k-$3k per month or $24k-$36k per annum from after tax income. This is a substantial hit on a borrower’s take home pay, which some folks in the short term can sustain, but not in the long run.
The geo-political environment is characterised by quickly changing political events while de-globalisation continues as the world splits between autocrats and democracies. The US mid-term election results reveal that key independent swing voters have called time on Trump, the man, while some of his policies of Make America Great Again (MAGA) resonant. There has been a further shift to the right in Israel with the re-election of Netanyahu. Italy has also embraced the right with the election of Giorgia Meloni, the first female Italian prime minister. In China, President Xi has become president for life while in the UK there has been three Prime Ministers is 3 months and the Conservative Party is on the nose.
CPI v Inflation
The media confuse inflation with Consumer Price Index (CPI) changes. Milton Freidman famously said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Whereas, CPI reflects changes in prices driven by imbalances between demand and supply. Across the globe there are supply shortfalls in many products, e.g., grains, oil, gas and coal, as reflected in commodity prices and empty shelves in supermarkets.
The world is experiencing both inflation because of the monetary and fiscal responses to Covid by governments, and CPI increases are a consequence of supply chain disruptions caused by Covid (China’s zero policy limiting production activities), the Ukraine war, floods and drought, and 20 years of lack of investment in primary energy, (i.e., oil, gas and coal) exploration. For example, the US has not built a new oil refinery since 1970 (52 years) even though its population and GDP have grown significantly. Once supply and demand come back into equilibrium prices will adjust and CPI will fall. Inflation (monetary) will fall once monetary expansion reduces to a level where the demand and supply of money are aligned.
Inflation, Interest Rates and Unemployment
Which is the worse of the two evils: High Inflation/CPI or High Unemployment? The answer is High inflation and CPI as it impacts everyone including the unemployed.
The US Federal Reserve (Fed) increased the targeted Federal Funds Rate by 0.75% to 3.75% to 4.0% on 2 November 2022. This is the 4th consecutive rate hike of 0.75%. US equity markets responded by falling 2.50%, as many investors/analysts had argued the rate hikes were either over or would be less for a variety of reasons. Equity markets are now betting that the Fed will pivot and either stop or reduce the size of rate rises even though Chairman Powell has clearly outlined that inflation is the target.
US Consumer Price Index is 8.5% which means that real returns continue to be negative (around 4.0%). The actual US CPI figure is much higher than the published figures as it does not include energy or food. As reported in the media on 1 November 2022, the Reserve Bank of Australia (RBA) increased the cash rate by 0.25% to 2.85% and this rate rise will not flow through to mortgage rates until December. A nice Christmas present!
The unemployment rate globally continues to remain very low although there are signs this is starting to creep up, particularly in the technology area in the US. Twitter has reduced its workforce by half since Elon Musk took over and Meta (Facebook) has fired 11,000 employees. Amazon has reduced its staff and is reviewing its various product lines with a view to rationalisation. The crypto-currency space is in free fall with FTX being the latest casualty with loses of over USD6billion.
Markets and Yield Curve Inversion
It is well documented that many of the key yield curves, e.g., Eurodollar Futures, 10 Year US Treasury and German Bund are all inverted. An inverted yield curve is where short term interest rates are higher than long term rates. This is not normal, as short term rates should be less than long term rates because investors should be rewarded with better returns for locking up their money for longer periods of time.
What does an inverted yield curve tell you? The markets are predicting a recession and interest rates will fall. How can interest rates be predicted to fall while central banks are increasing them? Markets trade on future earnings and are looking past the expected recession when earnings start growing again, and the markets believe central banks will pivot and stop the rate increases and may even reduce rates. It is for these reasons that equity markets have recently bounced. Of course, the risk is that central banks will ignore the recession signals and continue to increase rates and markets then see a deeper recession and fall accordingly.
Life is Energy
The current energy crisis is a supply issue caused by the Ukraine/Russian war and lack of investment, but in the medium term to long term it’s a demand issue. The developing world’s energy requirements are increasing as their populations demand better living standards. Renewables are unable to produce the energy necessary base load power that the developed world needs, which also means that the world is unable to meet the energy needs of the developing world. The bottom line is that it is highly unlikely that global emissions targets will be achieved, rather we predict the use of fossil fuels will increase for some time into the foreseeable future.
On an equivalent unit cost basis the price of coal is greater than the price of oil, and the price of gas has skyrocketed. The UK Government is subsidising household gas bills to the tune of GBP400 (AUD700) per month. This automatic, non-repayable discount will be applied in six instalments between October 2022 and March 2023 to help households through winter. This equates to AUD4,200 per household in financial support for 6 months.
Energy rationing to businesses has started in Europe, and consumers could also face rationing, if the winter is severe. About 70% of France electricity needs come from nuclear power, and due to the anticipated shortage over winter it is restarting all its nuclear reactors. Unlike France, only about 11% of Germany electricity comes from nuclear power. It had planned to shut down its last 3 remaining nuclear reactors, but the Government has decided to keep 2 of them open over the European winter while it seeks alternative gas supplies. Italy has no nuclear reactors because after Chernobyl disaster it took the decision as did Germany to close them down. Renewable sources account for the 27.5% of all electricity produced in Italy, with hydro alone reaching 12.6%, followed by solar at 5.7%, wind at 4.1%, bioenergy at 3.5%, and geothermal at 1.6%. The rest of the national demand is covered by fossil fuels (38.2% natural gas, 13% coal, 8.4% oil). As the statistics show Italy is still very much dependent, like the rest of the developed world on fossil fuels. Finally, Japan is planning to have all 9 nuclear reactors operating for this coming northern hemisphere winter where previously it was only operating 5.
As previously outlined in newsletters, those countries that are energy deficient, e.g., UK, Europe, Japan, India and China may suffer a drop in living standards unless cheap energy products can be sourced. Less wealthy countries, e.g., Bangladesh and Pakistan have introduced rolling blackouts because they could not afford the higher prices of LNG which European countries can afford and will pay. Whereas, those countries which have a surplus of energy, e.g., Australia, Canada, USA, Russia although impacted will get through with higher prices which the consumer pay.
We all want a green and clean environment! A key question facing the developed world is: Are folks in the western world willing to accept a drop in living standards by switching to renewals? We do not think so.
Government Financial Support
People of all political persuasion have their hands up asking for money which governments happily oblige.
A high percentage of OECD Governments’ budgets go to social welfare, and this will increase with aging population and higher health care expectations. In Australia, about 35% of the Federal Government budget goes to social security and welfare. This is a growing global trend. The UK Government’s energy support payment is an example and, in the US, the Government’s debt relief to students and farmers are two more examples where USD1.3 billion goes to 36,000 farmers and USD400billion over 30 years is for the benefit of 43 million students (borrowers).
This trend of increasing dependency on government wealth fare reduces economic growth and is not good for society.
Debt to GDP
It is important that the Australian Governments keep the Debt to GDP ratio below 100%, otherwise we will suffer the same fate as Japan which is over indebted at 266% Debt/GDP ratio. Its falling birth rate and aging population are contributing to driving down Japan’s real economic growth. The Debt/GDP ratios of the largest economies in the world are US 137%, China 72%, India 90%, UK 96%, Germany 70%, Italy 151%, France 113% and Spain is 118%. Australia’s Debt/GDP ratio is around 60% which the Federal Government, as reflected in the budget has made a priority to maintain or reduce.
In summary, the world has entered a new paradigm of stagflation characterised by increasing interest rates, the high levels of debt, adjusting asset prices, supply chain shortages, de-globalisation, energy shortfalls and splitting of the world between democracies and autocrats. Investment returns are adjusting accordingly and in doing so new opportunities are arising.
If you have any questions on this newsletter on any other matters, please feel free to contact us.