A post-COVID paradigm shift
BY JAMES WILLIAMSON
A paradigm shift is underway in financial markets, economies and geopolitics. The shift is from a pre-COVID world of low interest rates, low inflation, cheap money and globalisation to a post-COVID world of higher inflation, rising interest rates, conflict in Europe, de-globalisation, and tribalism. How do we invest, prosper, and simply live, in this new era?
Fire and ice
Jamie Dimon, JP Morgan Chase CEO and Wall Street titan, recently remarked that a “hurricane is coming.” Dimon wasn’t talking about Hurricane Ian but rather a financial storm with potentially bigger long-term effects. JP Morgan’s Head of Institutional Securities, Ted Pick, believes that financial markets will be dominated by “fire” - inflation - and “ice” - recession, and that global markets are at the start of a fundamental shift driven (originally) by low interest rates and cheap corporate debt.
Financial markets hate uncertainty - but that’s what they’ve grappled with this year. ‘Greed’ has turned to ‘fear’ over what the new investment, economic and geopolitical landscape will look like. Red flags in 2021 became harsh reality in 2022. Markets and economies face a tough blend of oil and food price spikes, global supply shortages, rising interest rates, and low investment returns.
Tailwinds, headwinds and spikes
Investors, used to the tailwinds' of cheap money, low inflation and interest rates, and globalisation, have watched in dismay as their portfolios moved into the red this year. The problem is that these tailwinds have become headwinds in the form of high inflation, high oil prices, reduced liquidity, and supply chain issues. You can see in the chart below the recent energy and food price shocks spike compared with other times.
Central banks have hiked rates aggressively, albeit belatedly, to combat rising inflation. They have also instigated ‘quantitative easing’ by reducing liquidity in the financial system. But the pathway to reducing inflation while avoiding recession is a narrow one, and fast-rising interest rates have corroded market returns and investor sentiment. Higher rates adversely impact share returns by lifting company borrowing costs and reducing share valuations. Higher rates impact bond returns by reducing bond prices. Prices of older bonds fall to compensate investors who can buy a newer bond with a higher yield (coupon rate).
Is stagflation retro?
1970s ‘stagflation’ - low or negative economic growth with high inflation - was like poison for financial markets and economies. Central banks are painfully aware of this. US Federal Reserve Chair Powell recently said that “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t”. At its September meeting the Fed hiked its federal funds rate by 75 basis points or 0.75% to the 3%-3.25% range - its third straight three-quarter point rise this year.
US borrowing costs are now at levels last seen in 2008. US interest rates will likely reach 4.4% by this December, well above the 3.4% projected in June, and rise to 4.6% next year. US inflation is running slightly north of 8% annually with food inflation above 11% annually. Australian inflation is just above 6% annually and the Reserve Bank cash rate is at 2.35% with further rises to come.
GDP growth is solid, but economies are slowing. Stagflation is still a possibility, though the economic, trade and investment environment is different to that of 50 years ago. The jury is out as to whether there will be a global recession and long bear market like the early 70s. History rhymes more often than it repeats.
“We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”
Transition or revision?
The higher inflation and interest rates remain, the greater the paradigm shift will be. It will impact most areas of the economy - consumer demand, bank borrowing in global wholesale markets, mortgage, credit card and corporate borrowing and lending, venture capital allocation, and the willingness of start-ups to take on risk.
The paradigm shift will challenge financial markets and economies until the transition to a new business cycle and investors become more certain about how and where they allocate capital.
Black swan or dove?
Some investors are worried that ‘Black Swan’ events may occur - unpredictable events beyond normal expectations which impact the global financial plumbing. One event is a bursting of the what has been the greatest credit bubble in human history. Jamie Dimon believes there will at least be “huge volatility” in markets because traditional, major buyers of government bonds may not be able to or have the appetite to step in again.
Morgan Stanley’s Pick believes the current paradigm shift will usher in a new business cycle: “It’s been so long since we’ve had to consider what a world is like with real [inflation-adjusted] interest rates and real cost of capital that will distinguish winning companies from losing companies, winning stocks from losing stocks.”
Importantly, the paradigm shift is self-reinforcing and comes amid a major conflict in Europe. Countries and economies will seek to be more self-sufficient. We’re already seeing this as countries want more energy, manufacturing and geopolitical independence and less reliance on the global trading system and globalisation.
“It’s been so long since we’ve had to consider what a world is like with real interest rates and real cost of capital that will distinguish winning companies from losing companies, winning stocks from losing stocks.”
Trade-off or face-off?
Markets and central banks - and ultimately, consumers - face difficult choices in the emerging paradigm.
A key choice is the trade-off between spending less money or borrowing more money to pay back high debt at higher rates of interest. Another key choice is how to invest money in portfolios in a stagflationary or semi-stagflationary environment that most investors have never had to deal with.
Today, equity (share) returns are not much more than bond returns, which are not much more than returns from cash. For investors, the essential question is how to generate returns above the cost of borrowing money. For economists, businesses and government, the key issue is how to ensure trust and fairness in a system in a way that can redistribute opportunity, make people more productive, and help eliminate large wealth gaps and internal conflicts at home and abroad.
