The world is currently driven by two broad trends as it emerges from the post-Great Financial Crisis ZIRP/QE regime: (i) sustained higher inflation due to extremely high global debt levels, and (ii) erosion of the post-Second World War global order. Management of these forces poses the greatest test facing American leaders in decades; their shortcomings in meeting them are increasingly apparent. Investors must understand the world as it is, not as Wall Street and the financial media would portray it. As such, they need to acknowledge the following realities:
· While there remains abundant liquidity from pandemic stimulus in the system, this liquidity is abating. That unprecedented liquidity infusion left behind much higher prices that will rise more slowly but remain much higher than before the pandemic.
· Governments are expected to spend a net $2 trillion on interest on their debts in 2023, up more than 10% from 2022 according to the International Monetary Fund and Fitch Ratings. By 2027 that figure could exceed $3 trillion according to research firm Teal Insights. Increasing interest costs will face governments with increasingly difficult spending choices.
· The levels of global debt are so high that there is no reasonable prospect that they can ever be repaid in constant dollars. The only way to deal with these obligations is by default, inflation or currency debasement (the latter two are two sides of the same coin). Western economies are effectively insolvent if the present value of their long-term entitlement obligations are added to their balance sheets (and likely even before those obligations are included) and their banking systems are also insolvent on a mark-to-market basis due to their holdings of bonds trading at steep discounts. But the problem is not limited to the West. China’s debt problems are severe as reflected in its failing real estate sector. One of the tragedies of countries increasing defense spending to pursue hegemonic goals is the diversion of economic resources away from growth and other life-affirming activities, yet this trend will only accelerate.
· Valuations of financial assets remain near record levels and far beyond the ability of these assets to generate sufficient income to justify their trading levels. Virtually all of them were priced during a period of negative or zero interest rates which are unlikely to return absent a severe financial crisis which will seriously impair asset values. Private asset prices have yet to be marked-to-market by many funds in the hope they will return to bubble levels. Very few of them will do so and those that do will eventually collapse in value all over again.
· Corporate and real estate borrowers are wrestling with higher interest rates that are impairing the value of their assets and potentially leading the highly leveraged private sector toward a debt-deflationary bust. The longer the benchmark interest rate stays at its current level of 5.25-5.5%, the odds of such an outcome rise uncomfortably. Even if that rate drops by 100 basis points, it leaves financial assets at risk of significant further losses.
· Heavily over-indebted governments are incurring unsustainable deficits that are diverting increasing percentages of their budgets to servicing their debts rather than funding entitlements, military spending, climate change, and other priorities. And funding growth is an increasingly unlikely possibility. But rather than take responsible action to address a problem that can only be called a crisis, governments are ducking the issue and making it worse. Debt, which grows exponentially rather than in a straight line, isn’t going to sit and wait politely while politicians fight about nonsense. It is going to wrap its iron grip around their throats and squeeze the life out of them and the people they are supposed to serve. It’s starting to do that already.
· Further hurting global economic growth is poor demographics in the West, even worse demographics in China and Russia and Japan, the continuing energy transition (driven by green policies distorted by ideology rather than based on science), ongoing struggles between labor and management, and rising compliance costs to meet unproductive and politically-driven agendas in Western pseudo-democracies.
· Many industries are experiencing seminal changes that are altering their business models and hurting their profitability – media and entertainment, transportation (especially automobiles), finance, shipping, and energy. Change is accelerating against a background of monetary, fiscal and geopolitical turmoil that seems beyond the capability of governments to manage effectively.
· In contrast to these troubled industries, the global defense industry is likely to flourish as violence and war spreads.
· Growing doubts about monetary and fiscal policies will encourage de-dollarization efforts (perhaps better understood as a general movement away from fiat currencies and not just the dollar into hard assets, commodities and cryptocurrencies) flights of businesses from heavily regulated jurisdictions, increasing concentration of industry and finance in the West, and rising political division and violence as nationalism and nativism spike and globalization reverses.
Formulating a successful investment strategy in the coming years requires an understanding of these global trends. While it will certainly be worthwhile to study and form opinions on individual investments, macroeconomic forces will continue to be the primary driver of investment returns because of how markets are currently dominated by passive strategies and momentum trading. In the end, financial outcomes will be largely driven by politics and policy rather than pure market fundamentals which requires investors to be focused on macro as well as microeconomic and company-specific factors.
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