Transcript
Speaker: Hello and welcome to what hopefully will be a short podcast.
Speaker: It's a solo effort, just me this time, and it's really designed to accompany my latest slide deck that I've finished.
Speaker: Now, I guess people that have known me for a while will
Speaker: will know that I like my presentations, my slide decks to kind of evolve through time.
Speaker: I see the way the world economy moves as being cyclical, and as such, the presentations should evolve that way.
Speaker: And it does seem that that has been the case with this one.
Speaker: It does seem to follow on from its predecessors.
Speaker: But what I would say is the need to redo the slide deck seems to be increasing in that I think the wavelength of the cycle seems to be shortening.
Speaker: And in part, I guess that's due to the economic environment and the policy environment that we're in.
Speaker: Now, my slide deck starts with a little table, a timeline, starting in 2019 and tracing developments in aggregate demand, aggregate supply, monetary policy, the political environment over the last four years or so, and actually hypothesizing what we might see in the next few years.
Speaker: And really, it starts with the central banks, sort of relatively neutral in 2019, not sure whether they were tightening or easing it.
Speaker: varied across countries, a little bit of latent inflationary pressure within the global economy.
Speaker: But of course, all that changed with the pandemic.
Speaker: And we then had a policy panic.
Speaker: Monetary policy became very expansionary.
Speaker: Politicians were panicking.
Speaker: And policy was very much framed along the lines that aggregate demand was collapsing because of the pandemic.
Speaker: But I think many of the policymakers, certainly in central banks, failed to recognize that also the economy's supply potential was compromised, was deeply compromised by the pandemic.
Speaker: And so as they poured stimulus into the system and boosted aggregate demand, which really came back very strongly in 2021, the supply side was unable to meet that demand.
Speaker: So we had that unusual situation where output was relatively flat, certainly lower than it was in 2019 in a lot of countries, but demand was surging.
Speaker: Now,
Speaker: 10% demand, 20% more demand, an economy that couldn't produce more, all that did was generate inflation.
Speaker: I think the inflation call was a relatively easy one back in 2021.
Speaker: Central banks, however, were very late to realise that.
Speaker: I think they'd taken their eye off the ball and perhaps pursuing other things that they shouldn't have been.
Speaker: Employment maximisation, really
Speaker: regional policy, all sorts of other agenda items seem to creep into central banking.
Speaker: And I think that distracted them from their core job, their day job, is to control inflation.
Speaker: And they didn't.
Speaker: And it wasn't until 2022 that they started to tighten.
Speaker: Now, as central banks have tightened, demand curves have started to shift to the left.
Speaker: We have seen a weakening in demand, particularly over the last six months.
Speaker: I know many people suspect the global economy is picking up.
Speaker: I wouldn't really agree with that.
Speaker: So what I think is happening is the supply side is coming online.
Speaker: we probably can produce more than we could in 2019 now.
Speaker: And so we're seeing output grow, not particularly because there is demand for it, but more because it can.
Speaker: The builder does now turn up that you've been waiting for for 18 months.
Speaker: The parts that you've been waiting for since the pandemic are being delivered.
Speaker: In fact, we look across Asia and we have a piling up of inventories.
Speaker: We have freight rates collapsing.
Speaker: Even in the service sector now, we're seeing the supply side coming back online.
Speaker: People aren't being asked to work as much overtime because you can now get full-time employees.
Speaker: If I look in the US restaurant sector, the number of diners per employee is
Speaker: is now coming down.
Speaker: It almost looks like there's a few too many people working in the hospitality sector.
Speaker: That's obviously a very different situation to a year ago.
Speaker: So I think we've got this rather confusing situation in markets where aggregate demand is weakening, but aggregate supply is improving.
Speaker: And in some industries, that's giving us more output, in some industries, less.
Speaker: It's a very choppy picture, and that's reflected, I think, in some of the markets' confusion.
Speaker: But the overwhelming implication of this is that disinflation is starting to take hold.
Speaker: We may see more people working in the US, but the decline in overtime working means that income growth has fallen away.
Speaker: That means that ultimately demand is weakening as supply has picked up.
Speaker: Price inflationary pressures are dissipating.
Speaker: Now, again,
Speaker: Long-term readers of ours will know we use something called the Demand Pressure Index.
Speaker: It's a model been running now for over 30 years, and it doesn't try to measure an output gap by looking at, or by coming up with an estimate for aggregate demand, and then coming up with an even less accurate estimate for aggregate supply.
Speaker: Differencing two very large inaccurate numbers is going to give you a very inaccurate answer.
Speaker: So we don't use that approach, the output gap.
Speaker: What we try to do
Speaker: in the demand pressure index is to measure the gap directly by looking at a dozen, in some cases 20 ratios that look at the relationship between supply and demand, trying to directly estimate and quantify the gap between aggregate demand and aggregate supply.
Speaker: And without exception, our demand pressure indices globally are falling away.
Speaker: That's certainly true in the United States, where we may even now have a negative output gap.
Speaker: Just, I think, in the last few months, the US has probably moved into a negative output gap.
Speaker: I would expect core inflation to come down.
Speaker: Germany and Japan aren't quite there yet, but I think we'll be in a few months.
Speaker: And I'd certainly argue that China was there.
Speaker: I think China's economic model is broken.
Speaker: particularly with regard to middle-class consumption.
Speaker: I do believe that the Chinese middle classes are in balance sheet repair mode, not spending mode, that they will be saving rather than spending as they try and strengthen their balance sheets.
Speaker: And that's a very big change for the global economy.
Speaker: In fact, I think China is in a savings mode.
Speaker: I think it's very significant that China is producing
Speaker: Give or take a trillion dollar current account surplus, but its foreign exchange reserves aren't rising.
Speaker: Private sector holdings of foreign assets aren't rising.
Speaker: So what is happening to all these dollars that China is earning in its current account surplus?
Speaker: Well, the answer seems to be that they're being redirected into the repayment of China's substantial foreign liabilities.
Speaker: Now, China, of course, downplays the amount of foreign debt it carries, but the BIS and others, I think, are now showing that China has an awful lot of hidden debt.
Speaker: We certainly hear about that in the context of local governments.
Speaker: Also in the banking system, I think that's becoming more evident.
Speaker: And China at the moment is recycling the proceeds of its current account surplus into debt repayment.
Speaker: Why is that significant?
Speaker: That means you or I, when we buy something from China, are surrendering part of our income, sending it to China to pay for the goods that we buy.
Speaker: And then China is using that to repay loans so that money doesn't come back into the system.
Speaker: Our income is being used to repay China's debts.
Speaker: That is an incredibly deflationary event.
Speaker: And put that on top of the US credit crunch, which I certainly believe is very significant.
Speaker: Does it matter that deposit growth has stabilized for a week or two in the US banking system?
Speaker: I'd argue no, it doesn't, because the damage has already been done.
Speaker: The banks have already decided to shrink their loan books, and that credit crunch will affect US companies.
Speaker: if you take out those very cash flow generative companies like Microsoft and Facebook, Apple and some of the medical companies, the US corporate sector is cash flow negative.
Speaker: This credit crunch will matter.
Speaker: And so I think we've got a lot of deflationary forces, even in Europe.
Speaker: The banks may not be suffering from the type of deposit outflows the US banks have witnessed,
Speaker: But the ECB's decision to remove the TLTROs has had exactly the same effect.
Speaker: Credit growth is falling away in Europe.
Speaker: In the UK, interest rates are high enough to cause a collapse in the demand for credit.
Speaker: So I think we are...
Speaker: In a demand recession, in the near term, that effect is being obscured by the reopening of supply.
Speaker: I feel like it's a sort of sequencing problem.
Speaker: This is a very unusual cycle.
Speaker: It's not like a usual cycle.
Speaker: We've got different sequencing effects.
Speaker: But ultimately, I think we will find that the global economy is in a recession in the second half of the year.
Speaker: And I'm actually quite concerned that the central banks may be over-tightening.
Speaker: There's a lot of talk about resilience and savings and corporate earnings.
Speaker: Well, the real value of household savings has been eroded by inflation.
Speaker: In some countries, such as Germany, the real value of people's savings is back to where it was in 2016.
Speaker: You mentioned the credit crunch affecting cash flow negative companies.
Speaker: I think that certainly is going to be significant.
Speaker: All in all, I think we are heading for quite a tight,
Speaker: monetary environment going into the slowdown that could be made worse if the US is very heavy-handed with its debt issuance once the debt ceiling is raised, assuming of course that it is.
Speaker: Now there's some confusion around the debt ceiling.
Speaker: If we have bill issuance that might improve liquidity, if we have a lot of bond issuance that will subtract from liquidity, we'll have to see how that goes.
Speaker: But ultimately I think there's a lot of forces aligning to suggest that we're going to have really quite a deep recession over the
Speaker: end of this year and into the early part of next year.
Speaker: And I'm fully expecting that to cause another round of panic in policymakers, that we'll see a giant U-turn from tight policies, probably over tight policies at present, to an easing.
Speaker: Now that easing, I suspect, will be some reduction in interest rates in the early part of next year.
Speaker: I am looking for short-term rates, like the Fed funds rate, to come down.
Speaker: 100, 150 basis points perhaps, but more significantly, I think the Fed will have to introduce something like a TLTRO to get funding back into the banking system.
Speaker: All that occurring against the deflationary backdrop should be good news for fixed income markets next year.
Speaker: I'm a little cautious about fixed income markets in the near term, given the amount of issuance.
Speaker: as we get into a deflation scare next year.
Speaker: And let's remember, Asia is already fully in deflation.
Speaker: It's beginning to look a bit like a depression in Asia.
Speaker: Falling exports, falling credit.
Speaker: This looks as bad as 1998.
Speaker: Actually, it looks worse than the GFC in some countries at the moment.
Speaker: So I think we'll see more of that.
Speaker: That's normally good news for bonds.
Speaker: Obviously, equity is struggling a bit in that environment as earnings estimates come down.
Speaker: And I would point out a lot of the strength in earnings over the last few months is actually the effect of the revaluation of inventories caused by inflation.
Speaker: We need to resurrect inflation accounting, I think, to actually get a proper view of what's happening to US profits at the moment.
Speaker: So next year, I think we go from over tight monetary policies to an easing.
Speaker: Now, another, I think, important feature of the global system and certainly the political environment at the moment is
Speaker: is there is a real desire amongst policymakers, particularly governments, to support employment.
Speaker: Unemployment is not supposed to rise.
Speaker: Now, if we get an easing of policy, if companies have not been allowed to shed staff, perhaps in the way they would have done in previous cycles during the slowdown, very bad for their profits, but it also means that when we get the easing next year,
Speaker: You'll have an easing into what are already relatively tight labor markets.
Speaker: And I think inflation will come back quite quickly.
Speaker: So as we get into late 2024 and certainly into 2025, I think we'll be playing the inflation theme yet again.
Speaker: And this really is very much like the 1970s.
Speaker: You had the big monetary easing, 72, 73, the crisis, a big recession, 74 into 75, a panic easing.
Speaker: But inflation came roaring back really, very quickly.
Speaker: I think we'll probably repeat that cycle.
Speaker: And it's worth remembering, I think, that it wasn't the inflation in 73 that proved particularly damaging to the bond markets.
Speaker: Bonds are actually, they did react to the inflation in 73, but not aggressively, which, of course, think back a year or so, the bond markets didn't react as aggressively to the rise in inflation as many people were expecting.
Speaker: But when inflation came back in 76, 77, the bond markets really did suffer.
Speaker: And I think we could see that parallel again, that in a year or so's time, the bond markets could become really quite unstable.
Speaker: There could be a lot of capital destruction if we do see inflation coming back in 2025.
Speaker: So this is a very unstable monetary environment.
Speaker: At the moment, I think secular stagnation is with us, that real growth on average will remain quite weak until productivity improves.
Speaker: Hopefully AI will improve productivity, but at the moment, productivity growth around the world is stagnant.
Speaker: The world therefore can't grow very rapidly.
Speaker: We're not going to get the value added in real terms.
Speaker: I think the big difference between secular stagnation in the 2010s and secular stagnation in the 2020s is the nominal economy is a lot more unstable now than it was five or six years ago because of the monetary excesses that policymakers introduced during the pandemic.
Speaker: And in fact, I think in the conclusion, I sort of view policymakers as being like a sort of tennis player that's got out of position.
Speaker: They're on the back line and the opponent is firing the balls at opposite sides of the court and having to run from one side to the other to return.
Speaker: to return the balls and just constantly out of position, constantly running faster and faster, getting further out of position.
Speaker: And that's how I see the monetary economy at the moment.
Speaker: The central banks constantly chasing after these difficult-to-reach balls, trying to get them back over the net and quite probably going to drop one.
Speaker: I think there will be a miss at some point, and that probably does give us quite a deep global recession, disinflationary recession towards the end of the decade, but we can worry about that one when we get there.
Speaker: In the near term, I think we've got a slowdown, a very disinflationary slowdown that starts to create a deflation scare around about Christmas, a policy response, probably quite a concerted policy response in the early part of next year,
Speaker: But that brings inflation back by the end of 2024, certainly into 2025.
Speaker: So an interesting period for the nominal economy, probably less interesting for the real economy because of the continuing secular stagnation.
