Until recently, good news (a strong rebound from the COVID-19 pandemic) was bad news (higher interest rates). Now, bad news (an economic slowdown) is good news (accommodative policies). For investors, previously successful investment strategies carry risks.
Economic activity, largely based on government stimuluslow borrowing rates, central bank liquidity injections and pent-up demand financed by lockdowns, will stagnate. Inflation may decline (as price changes slow), but absolute costs will remain high. This combination reflects fundamental shifts that markets may not have fully priced in.
Go forward, not investing in existing energy sources will likely lead to a lasting deficit in the electricity grid. The energetic transition and decarbonization will be slow and costly due to the need to first electrify many industrial processes, reconfigure the grid, inefficient energy storage and shortage of materials (lithium, cobalt, nickel, copper, rare earths). Effects of climate change on refuelingtransport links and insurance costs will increase.
On the geopolitical level, the return of great power rivalry will complicate things. Trade restrictions and sanctions will hamper cross-border trade. Higher defense spending and eventually the reconstruction of Ukraine (perhaps up to $1 trillion or 1% of global GDP) will absorb scarce resources.
Focusing on sovereignty and minimizing unexpected disruptions will mean reorganize supply chains to avoid bottlenecks, like China (the factory of the world) and its zero-Covid policy. Relocation or offshoring of production will be slow and costly. The global supply of cheap labor and raw materials will not rein in costs and sustain prosperity, as it has for nearly three decades.
Unfavorable demographics will also be a major factor. The declining workforce, the great quit fueled by COVID-19, the aging population, declining birth rates, resistance to immigration – will compound the difficulties.
Interest rates and the cost of capital will rise and liquidity will tighten as central banks normalize policy and governments clean up public finances. Deglobalisation, concerns confiscation of foreign investmentsas a result of the West’s actions against Russia, will hamper global capital flows from savings-rich Asia, which has provided cheap financing.
These self-reinforcing factors will work through multiple channels and feedback loops. Here’s what investors should be concerned about now:
1. Asset prices: Equity valuations are high, particularly given prevailing market structures; a large number of companies have negative earnings and cash flow (approximately one third of the Russell 2000 index
) and cross-border trade is down (40% of the S&P 500
business income is from outside the United States). Lodgingthe largest asset class, faces higher mortgage rates and threats in strong labor markets, which is supporting it.
2. Financial crises: Debt levels are high and personal, corporate and government balance sheets are strained. Falling valuations will test borrowers, who have been buoyed by overvalued assets. Highly indebted private equity players may become the focus of a new crisis.
Europe’s debt problems have been covered up by the European Central Bank acting as a buyer of last resort for near-bankrupt members. France (public debt at 113% of GDP), Greece (193%), Italy (151%), Portugal (127%) and Spain (118%) have seen their interest costs rise sharply. Cracks are appearing between the inflation-phobic creditor countries, namely Germany, and the debtor countries. Tighter monetary policy will expose the lack of independent monetary policy, fiscal capacity, monetary flexibility and ability to monetize the debt of indebted Eurozone members.
Rising rates, strong US dollar
and high energy and food costs threaten to trigger a emerging market debt crisis. Interest rate hikes were factors of Debt crisis of the 1980s in Latin America and the Asian crisis in 1997-1998. Sri Lanka’s Recent Economic Collapse is a taste of what could come.
Although better capitalized than in 2008, banks are exposed to increased defaults both directly and through lending to other lenders through the shadow banking system.
3. Policy Limits: Central banks are constrained by inflation fears and negative real (inflation-adjusted) rates, even after the planned hikes. The Great Recession of 2008, the pandemic and Russia’s invasion of Ukraine strained the government’s debt capacity. Then there is currency volatility, that Japan discovers. Sudden movements fuel domestic inflation, loss of access to foreign financing or reduced export competitiveness.
4. Social tension and political paralysis: In the advanced economy, unmet expectations and rights fuel unrest. In emerging markets, high prices and a lack of basic necessities are driving more violent versions of the same worry. Growing electoral polarization, political instability and a lack of leadership make it difficult to reverse an increasingly difficult position. The chances of international cooperation on global issues are also low.
The best outcome may be a continuation of a “muddle,” with an extended period of low and volatile investment returns. Worst of all is the arrival of the long-delayed financial market calculus and its crushing reset. It’s worth remembering that the tech bubble of 2000-2001 and the mortgage mess of 2008 each took almost a year to fully materialize.
To thrive, investors now need the sure footing of a tightrope walker and the flexibility of a gymnast. Perhaps with short-term rates heading towards 3%, the Wu-Tang Clan’s 1994 hit “CREAM (Cash Rules Everything Around Me)” provides some useful pointers.
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