"There Is No Later. This Is Later."
The Credit Strategist April 2023
The warning signs were hiding in plain sight that 2023 would be a tough year. It seems like many people expected the calendar to turn from 2022 and bring with it a newly positive investment environment. But that isn’t how the world works. The IMF offered the following gloomy prognosis:
“The 2023 slowdown will be broad-based, with countries accounting for about one-third of the global economy poised to contract this year or next. The three largest economies, the United States, China and the Euro Area, will continue to stall. Overall, this year’s shocks will re-open economic wounds that were only partially healed post-pandemic. In short, the worst is yet to come and, for many people, 2023 will feel like a recession.”
Indeed, for many it is already feeling like worse than a recession. The question is whether it will end up feeling like a depression. We are in a period where several negative cross-currents are creating enormous strains on the financial system.
First, the exogenous shocks and imbalances caused by the pandemic and the war in Ukraine disrupted global supply chains and unleashed massive government support. Supply chains are easing for the most part but government support is being withdrawn.
Second, companies are raising prices in response to labor and supply shortages, unleashing the highest inflation in forty years that is not receding as quickly as hoped. Further, this inflation is being further exacerbated by record government spending related not merely to the pandemic but to political demands to address climate change, wealth inequality and military threats from strategic adversaries.
Third, higher interest rates are causing artificially inflated asset values to unwind, causing stress for leveraged financial structures of all sorts around the world.
This is a culmination of the financialization of the global economy that began with the United States exiting the gold standard in 1971 and the post-1971 liberalization of exchange rates and deregulation of savings and then extended to the growth of shadow banking, derivatives, and foreign exchange trading and then the explosion of public and private debt throughout the world. These developments led advanced economies to shift their focus from productive to speculative investments and from domestic manufacturing to cheaper offshore production while the explosion of leveraged credit allowed consumers to spend beyond their sluggish wage growth. Debt levels grew far beyond the productive capacity of the global economy to sustain them, forcing governments to intervene to support the system every time the system cracked and experienced a debt crisis (as just happened with the banking systems in the U.S. and Switzerland).
When debt levels became unsustainable in 2008, governments intervened to support the system. But that support came in the form of more and cheaper debt over the next 15 years that only worsened the problem. A debt crisis was solved with more debt which solved nothing in the long term. Further, that support was not accompanied by reforms to encourage productive investment or discourage speculation. Instead, governments adopted pro-debt policies such as ZIRP and QE that rendered debt even more attractive and resulted in an explosion of global leverage that can never possibly be repaid other than through default, inflation, or currency debauchment.
Even before the 2008 financial crisis, the global economy lacked the productive capacity to generate sufficient income to service or repay its current debt burdens (which are growing much faster than that productive capacity). Today the situation is far more dire. Developed country governments can try to inflate away the debts they incur while paying lip service to fighting inflation but their citizens’ buying power is being obliterated. And even after nearly 500 basis points of rate hikes in a little more than a year, real interest rates are still in negative territory in the United States. The prospects that real rates will move into positive territory are questionable (especially if you look at real world rather than government inflation numbers).
But for the moment, the world is sleepwalking past these problems. But there are virtually no political constituencies willing to seriously address spending, taxation, entitlements, inflation, or any of the issues that must be addressed to prevent another crisis. As painful as it is, inflation is politically easier to bear than the spending cuts, interest rate hikes and other measures required to tame it. It is a silent destroyer. Complaining about it makes good press but suppressing it causes too much pain for politicians and voters to bear. It’s easier for the government to intervene when something breaks and cover the costs than to lower the costs upfront.
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