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The truth is, there is never any easy money to be made. At some point, the world is always full of uncertainty and risk, casting doubt on investment decisions. If not, the prices would already be very high, reflecting this nirvana.
And so it is today. Today’s environment includes so many “unprecedented problems†that it’s hard to know where to start. From unprecedented levels of sovereign debt, to unprecedented low and negative interest rates, to unprecedented budget deficits and money printing. The list is lengthened increasingly. How come the world’s economies including South Africa have been devastated by Covid-19 and yet the stock markets are doing so well? Giving meaning to all of this is tricky.
But first let’s step back and remember how we got there and start by looking at which of the different types of recessions we’re trying to get out of.
First, there’s the economic recession of common overheating or vanilla from the garden, where central bankers have to remove the punch bowl as capacity – both manufacturing and labor – becomes overheated. The resulting generalized inflation beast must be tamed with a hike medicine of unpopular interest, economic downturns occur, and the whole cycle repeats itself over time. Obviously, the 2020 recession was not that.
Then there is what we call financial or balance sheet recessions. These usually involve far too many loans issued by banks, very often linked to unsustainable real estate booms. And in the case of emerging markets, this sin is often compounded by the fact that they largely borrow in hard currencies, which they cannot repay once the ball goes up and their currency takes a huge hit. There have been several individual country cases (eg Thailand 1998 and Sweden 1992), but these have been relatively easily contained in terms of global contagion.
However, the 2008 global financial crisis was the first time this situation has occurred simultaneously in much of the developed world. Hence the chaos that followed, which led to many of these “unprecedented†economic policies to prevent an economic depression. The process of recovering from financial recessions is usually a lengthy affair, as the main imbalance of excessive debt can take a long time to correct. Consider, for example, the recession that lasted two decades in Japan after the economic bubble of the 1980s. Thank goodness China made the 2008 recovery process much less painful when it opted for its massive infrastructural surge in 2009. .
Obviously, that is not where it is now either, but many of these new economic policies adopted after 2008 are still in effect, simply escalated to “unprecedented†levels.
The last common cause of recessions is the most difficult to see coming, because by definition they are shocks. These shocks can take the form of wars (September 11), oil peaks or health alerts. This is clearly where we are now!
The advantage of these recessions is that because they are usually not caused by an underlying economic imbalance, they tend to be very brief.
The problem this time, however, was that in their efforts to contain Covid-19 with lockdown strategies, governments around the world have brought economies to a near complete halt with the most severe recessions on record. Once they embarked on this path, in order to avoid the economic depression, they had to throw the proverbial kitchen sink on the problem to ease the conditions.
Bank policy rates fell to zero or negative, many long-term bond yields followed suit, and central banks began creating money to buy bonds to fund massive government budget deficits and ‘flood the markets with liquidity. When monetary easing was exhausted, fiscal stimulus took over. Modern Monetary Theory (MMT) is stealthily becoming more and more acceptable – essentially an opinion that governments can issue as much money as they want to central banks to achieve their goals without there being any refund problem.
Economically, their efforts have worked. Policymakers have prevented the recession from turning into a depression. The Covid-19 issues are still with us, but it looks like a combination of herd immunity and vaccination means it will largely be a problem of setbacks for most countries around the world by early 2022 The economies rebounded in a V-shaped pattern. And so paradoxically, it makes sense that the stock markets recovered as they did, given the extreme political support and the resumption of growth.
The question now is, if the Covid-19 lockdowns largely subside soon, can the big central banks gently pull out the bowl of punch without upsetting everything?
First of all, you need to have a perspective on economic growth. Overall, it’s safe to assume that 2022 and 2023 are likely to see at least trend growth, given the still depressed base and continued, albeit reduced, political support. But this view is not without risk. Currently, the Chinese economy is going through real estate restructuring, economic priority and a slowdown induced by Covid. In addition, more recently, the energy turmoil is putting additional pressure on the Chinese economy. Markets are already expecting a slowdown in Chinese economic growth, but there is
Then there is the thorny issue of global supply shortages. Either way – whether it’s the high-profile computer chip shortage, the inability to get a ship, or dockworkers to unload the ship, or too few truck drivers – the lack stock of goods is a major problem. The relevance of this mismatch between supply and demand for goods goes beyond growth. This issue is causing price hikes in some areas, and overall it looks like this issue will be with us until around mid-2022.
Which brings us to the number one problem in financial markets. Will the current rebound in global inflation be transient as predicted by the US Federal Reserve, and will it subside soon? Or will it persist at higher levels for longer before finally easing off, or will it turn into a major inflation problem like it did in the 1980s? It’s the million dollar market conundrum.
At the moment, the markets seem fairly comfortable with the idea that central banks will soon buy fewer bonds and raise interest rates slightly in the second half of 2022 or 2023. Regarding the fight against inflation , pressure on the bond markets should force interest rates to rise faster and higher than expected. The markets really won’t like it!
Our baseline scenario is that due to the supply issues above, this inflation problem is going to be uncomfortable for at least a few quarters, before finally falling back to historic lows. Current bond yields in developed markets imply roughly the same result. As in the 1980s, the pricing power of wages will likely be the key variable in deciding this question. Right now, despite a skills mismatch in the workforce, workers don’t seem to have too much leverage to earn higher pay, but it’s definitely something to watch out for.
Our conclusion is that it is too early to close the risk traps and head for the hills. There will most likely be times when markets fall due to fear of growth or a rattle from the central bank. China’s current slowdown is worrying. But at the end of the day, we’re still only halfway through the cycle in terms of global economic growth, with little traditional excessive leverage or inflationary imbalances in evidence to act as cycle killers.
This time around, the imbalances are not in the private sector, but in the public sector. Weaning economies and markets off life support will take some skillful maneuvering, but it is doable if our view of growth is correct.
So no, there is no easy money to be made. Now might not be the time to move all-in in terms of risk positioning, but if you can handle the inevitable periodic market setbacks, hold the line, as General Maximus urges his troops in the big movie Gladiator. (And suppose we don’t meet the same fate as the general!) DM / BM
This article was written by Chris Freund, co-head of SA Equity & Multi-Asset
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