Puzzles and Crossroads in the Global Economy

Puzzle 01: Stagflation

With inflation in booster mode and nominal rates low, the real interest rate remains an interesting indicator when reading the economic development in the US. One possible interpretation is that we are looking at the first indicators of stagflation. What does that mean and why is it not entirely unrealistic?

What we can clearly observe is a massive monetary stimulus having hit the economy which already raises the question of nominal inflation. We can see clearly that demand in nominal volume has not decreased and households are trying to both participate in the asset inflation that is increasing their wealth cushion while going along with the flow on inflated energy and food prices while retaining their buyer habits for luxury and non-essential goods. Partially celebrating the recovery from Covid-19 and going out more, spending more on home refurbishments and spending more on vacation and leizure. That being said, we have a steady and likely short-term lived increase in nominal volume demand that should not trigger any inflation.

The inflation we are currently seeing is a cost-push inflation from the supply side that is triggered by e.g. regulation on clean energy which is driving energy costs, clean vehicles which increases transportation cost, a builder boom which is driving prices in the building and construction sector and supply chain issues from the Covid-19 area that is driving cost from the supply chain all of which push into consumer prices. This is where we have the current inflation.

That being said, the unit volume demand — measures in # of goods consumed — has to be dropping. This means the consumers buy and get less goods for their money but the nominal GDP remains stable and real GDP deflated from nominal terms not fully reflecting the cost-push impact on prices is overstating the recovery in real growth.

This can be interpreted as a great achievement in terms of reducing the ecological footprint as less goods are being consumed, but it also goes hand in hand with a de facto inflation-based melting away of consumer spending power.

As of right now, the economic environment does not truly stimulate the push for higher wages that would cope with the rising inflation. Instead we mid- to long-term inflationary powers that are not transitory that are eating away the consumer income. From increasing rental — some households may save in nominals, but cut down their overall volume in rental space, but enjoying higher energy efficiency while energy prices are likely to increase, leaving the individual net off equal with lower space and lower eco footprint. Is it by design? We do not know.

So in unit demand, we can see a clear reduction while the inflationary pressure is keeping the GDP in nominal terms in check for minor growth. This is important to understand from a global investment perspective. If this regime is the new normal and the trend continues to perceived growth in GDP alongside perceived retaining of quality of spending power while reducing unit demand overall, this has impact on the economics of scale of mass producers which will have a higher cost per unit that they will push to consumers in the form of permanently higher prices. This means the economic capacity will be shrinking and the increasing margins provide opportunity to re-think supply chain and logistics networks if such a great de-coupling will prolong as the geopolitical discussions suggest. Leading to lower than expected growth expectation of capacity in emerging markets and yielding a higher relative benefit compared to all else equal of exposure to developed economies.

Puzzle 02: The fiscal booster and staglation

The above painted picture of stagnation seems little worrysome and even like something beneficial to the clean agenda if consumers willingly accept the reduction of consumption power and higher price levels on low-cost economic goods even reduces switching costs to higher quality products. The example case being mass produced meat rising in prices and making it more affordable to consume high quality produced wholesome foods, which in turn may have lower margins but might be supported by fiscal stimulus.

The new regim,e can not be understood without a proper understanding of the new role of fiscal policy in the global arena. Without a doubt, China has committed itself to an even stronger centralized economy which economists call the “benevolent dictator” economy. But the increased centralization observed throughout other developed economies as part of the the pandemic response measures is also likely there to stay. Some countries saw a stronger centralization of power against their federal structure. Almost all countries saw an increasing in the errosion of civil and privacy rights for the benefit of control and oversight. This is only an example of how national states have seized the opportunity of the crisis to install an overall stricter stronghold over the economy and pushing for more involvement of the government into the economy. This has an impact on the role the fiscal authority will play in the transformation of society as well as how new regulation on taxation, centralized digital currency and possible welfare will change how the developed economies will conduct policy in the years to come.

This bears several consequences which have to be considered when evaluating the economic atmosphere of the global economy.

At one point, taking another look at stagflation, we can see a massive support of the economy from fiscal stimulus packages. These can by and large be classified into three categories:

1. Consumer Helicopter money that distributes their future income to current consumption to dampen the macroeconomic impact of the pandemic and the countermeasures.
2. Tax and payroll benefits distributed to companies that lowered their cost base and ensured the dampening of profit margin shocks in the economy and ensure profits and dividends remained at tolerable levels (e.g. furlough schemes)
3. Direct investments into transformative technologies and infrastructure using massive stimulus bills, which mostly hit businesses and organizations in the private sector that are majorily not listed.

All three measures had a direct impact on nominal GDP and tax income and was financed by the future cash flows of the economy. To truly understand the current state of stagflation, one has to clearly understand how these measures pushed the unit volume demand up where it outherwise would have stagnated more and GDP would have likely suffered while inflation would not have occurred as pronouncedly.

This means, the recession in the unit demand economy is likely largely more pronounced that one could read from the current economic data. At the same time, the measures impact of inflation pushed the real interest rate on the macroeconomic level down and into negative territory.

Puzzle 03: the negative real rate

A negative real rate essentially means that investment projects into the real economy will yield a negative rate of return. And this is in line with expectations. Because the real economy — as we stated before — is shrinking with increasingly lower volumes of unit demand. One could say as a consequence, this is just the effect of the transformation towards a greener economy. And the relevance of the real rate is simply not there for a while, as long as consumers remain confident.

But one has to understand the consequence of a shrinking unit volume economy in the context of increased labour efficiency driven by technological development. This means we see a tremendeous acceleration of technology crowding out workers who in turn increasingly will find it difficult to retain their bargaining power for higher wages.

What does this mean? If all else remains equal, this simply means higher unemployment and lower consumption power and lower taxes. At least if all else remains equal.

The alternative is of course a transformation of society that enabled the developed economies to increase the profit per capita versus the rest of the world — e.g. by turning 10% of the population into global brand influencers and increasing the margin surplus of highly profitable global industry leaders in highly consolidated industries — while accepting a higher unemployment rate and re-thinking the welfare equation.

Only by re-thinking the welfare equation can the overall nominal consumption rate be sustained and can infrastructure and education systems be sustained that turn the following generations of the economic disadvantaged into valuable members of the transitioning economy.

What economist have to re-think and re-learn is very likely the proper conduct of economic policy in a world of permanently negative rates. A model that seems to fare quite well as long as global coordination of fiscal expansion is taking place and limit the risk of defectors triggering a unilateral default.

Puzzle 04: Fiscal Debt and Credit Cycle

If all economies continue to increase their government debt levels and participate in the ever expansion of credit, this can lead to two scenarios. One where we see debt forgiveness and one where debt levels keep rising for eternity.

Both cases have a similar effect. If debt is to be forgiven and the asset and wealth distribution is not touched, this just simply resets the debt clock but it ultimately rewards the individuals who assumed massive amounts of debt to gain a relative economic advantage in increasing wealth levels which mean at the end of the day nothinge else than a larger relative ownership of productive assets and hence a larger share in the globally generated cash flow. A model that seems to work rather beneficial, as such increased capture of cash flows goes hand in hand with an increased understanding of the global economic workhorse model and will naturally lead to improved allocation of these cash flows.

Continuing to increase debt levels will have little other effect. It disproportionally disenfranchised individuals who do not assume debt to increase their balance sheets and who do not use their debt to increasingly invest into the more accretive investment opportunities. It is essentially an economic model that drives the wealth gap between active investors and active members while punishing by ever increasing wealth gaps the ones who merely consume and fail to participate in this game.

Without sounding alarming, this is the natural approach to ensuring a maximum activation of the creative forces in society and increased upward and downward mobility. And as long as the winning regional economies who produce most of the economic wealth surplus are able to re-distribute this wealth to their general population, the income or at least consumption levels will be increasing relative to other economies, which will fuel these economies exports and economic development.

In essence, this is the cornerstone of the MMT paradigm that we currently see dominating the global economy and that keeps individuals who think in the old concepts of a gold-standard type of economy puzzled. The risk of a defect and breakdown of such a regime remains alive and well, of course. But betting ones horses on a potential scenario while forgoeing participation in a model that is currently dominant and operates as the oil in the economy is likely not going to be beneficial for asset managers.

Only time will tell which direction we are heading.

Puzzle 05: Margin Cycles

When studying the macro cycles of profit margins over the last decades, it is clear that there were some key waves of margin expansion.

A first one starting in the 70s to 90s with the start of the globalization wave, the implementation of liberal market regimes and the opening up of capital markets all went hand in hand to support the expansion of industrial operations into overseas and offshore territory, which reduces production costs and drove margins up while also supporting the strategic domino in the cold war. This lead to an extreme boom in margin expansions at the time of the collapsing Soviet Union which then saw a short period of decline which likely was due to economic developments.

A next wave clearly started with the emergence of new technology and peaked around the dot com bubble, which then lead again to. decline as technology procurement and overall higher risk sensitivity as well as ongoing investment into the then emerging core ERP systems and capex changes drove down the margin throughout industries.

The next boom after the dotcom crash was clearly driven by the acceleration of technology invesmtents and ROIs generated by it, ongoing low wage bargaining effects on real wages, increased efficiency in global supply chains and the globalization of the downstreams of the supply chain. The wave only temporarly ended and halted due to the 2008 financial crisis. A short halt that ended quickly given the new monetary regime emerging from this period and lasted untill today.

It is only now that the green transformation of society, the re-thinking of supply chains and the running out of steam of the low interest rate regime alongside the unit recessionary environment is starting to bring down margins yet again. The interesting part here was that the information technology revolution massively helped increase margins, and the green revolution cycle, if we consider this in a Kontradieff kind of way, is likely to massively dampen margins. But here again the relative margins around the global economy might likely be the deciding factor on allocation as it always was and always will be profit margins and the domicile of those margins that is driving the long term dominance of companies and industries.

Puzzle 06: The big question about welfare

The only thing truly unknown in this global enviornment apart from the big question of how to proceed with the credit cycle and fiscal deficits, is the welfare equation. Lower real incomes means less consumption of foreign goods and means higher retention of wealth for the developed economies. For a while, it might also trigger a prolonged re-thinking of consumption habits by the local population and support the green agenda. But mid- to long-term, it is the wealth participation and consumer power that is attracting global talent to a regional economy and it is talent and the economic creativity that yields long term comparative advantages and wealth distribution which stabilizes the geoeconomic regime.

The only options on the table is finally increasing the real wages of the relevant workers or the “profit per capita” of the productive parcicipants of the economy while redistributing wealth to the less productive population to keep them within the inter-generational evolution of the economy that allows their offspring to adapt to the changing working model of the economy.