Investment Newsletter – September 2022
Globalization was deflationary, Deglobalization is inflationary. The entire point of globalization is to 1) lower costs as a means of maximizing profits and 2) find markets for surplus domestic production. Both serve to export deflation as offshoring production keeps prices stable (and profits high) and dumping surplus production in high-cost developed-nations suppresses their domestic producers’ pricing power, noting from Charles Hugh Smith. In such an environment, central banks will contend against inflationary geopolitical events. A world where central banks manage the demand side of the economy. They are very adept and have the tools to control demand. However, they do not have the tools to manage supply. The world is on the cusp of enormous change.
Higher debt levels as a percentage of GDP were made possible with continually lower interest rates and increasing amounts of unproductive debt. In some cases, negative interest rates and frequent QE kept economies running and countries from defaulting. Central bankers got away with neglectful monetary policies because inflation was not a concern. The globalization of trade allowed for the flow of cheap goods. Accordingly, the central banks conducted easy monetary policies with little fear of controlling inflation. Such an environment was conducive to high asset valuations. Higher levels of inflation are likely to accompany higher interest rates. High-interest rates are extremely taxing on economies with burgeoning debt levels. Such an environment is unfavourable for high valuations and strong asset price performance, noting from Michael Lebowitz.
Corporate debt has been on the rise globally for more than a decade. The COVID-19 pandemic has coincided with a further increase in corporate indebtedness with inflation having now risen. In Goodhart et al. 2021, it is argued that high corporate debt levels may render contractionary monetary policy less effective in controlling inflation. Interestingly, when the level of corporate debt is sufficiently high, a contractionary monetary policy even increases inflation.
Consensus foresees slightly more than USD 2 Trillion in balance sheet reduction: the Fed is expected to sustain its USD 60 Billion per month reduction of Treasury holdings until the end of 2023. Weaker economic performance would first bring a halt to rate hikes, but then could slow or end balance sheet reduction. Overnight rates moving outside the Fed’s corridor: the Fed wants to exert strong control over rates through its setting of the interest on reserves, the fed feds rate and repo rates.
Again, earnings estimates were overly optimistic and would need to come down to align with economic realities. That process has now begun. In the last couple of months, estimates for fourth quarter 2023 have dropped by roughly 12%. This would be considered normal for an economic slowdown. However, if the economy slips into a recession, a decline of 50% in estimates would be in line. While it is possible for earnings to grow faster than the economy at time, that is, post-recession, they cannot outgrow the economy indefinitely. The earnings surge in 2021 is something never witnessed previously and must eventually revert to norms.
