Looking into this Tumultuous World and What’s Next? (Part I)

What we have today is definitely not a Garden of Eden, and unfortunately what’s coming next could be much worse.

Written by Prominent Ventures (A Member of HCM Capital)

You might notice whenever you log in to your social apps, the trending words are relatively pessimistic: “crisis”, “Great Depression”, “collapse”, etc. In fact, these keywords reflect the chaotic reality of our global economy with a combination of inflation crisis, restrictive monetary policy, economic slowdown, and energy crisis. True, it’s not the best time in the world, especially compared to the growing, stable, and cooperative macro environment over the last several decades.

Even though the world has already looked like a mess, it could be even worse given the debt crisis in the shadow and political tensions among major countries. On September 26th, the sabotage attacks on Nord Stream pipelines exposed so many political interests and incentives behind. On September 29th, China’s central bank asked major state-owned banks to be prepared for selling dollars for the local unit in offshore markets even as the US dollar is still in the middle of value appreciation. It’s important to note that we are not here talking about politics, but we cannot help to notice countries’ relationship is not the same, and so is the global economy and our world.

1. Central Banks Kick off Aggressive Global Tightening

Over the last several months, we cannot help to notice the global monetary policy tightening around the world. Since March 2022, the US Federal Reserve has raised its target federal fund rate by 300 bps cumulatively, and Federal Reserve had very aggressive rate hikes of 75 bps in June, July, and September. At the same time, ECB has raised its policy rate by 125 bps over the last several months, and Lagarde actually implies the policy rate will be lifted further. Moreover, central banks around the world, including Bank of Japan, Bank of England, and central banks of emerging markets, have similar monetary tightening patterns.

Global tightening is not just about policy rate hiking. It’s also directly associated with the contracted balance sheet for central banks around the world. For instance, the Federal Reserve has announced that they would implement quantitative tightening (QT). Specifically, they planned to reduce the holdings of Treasury securities by at least $30 billion per month and mortgage-backed securities of $17.5 billion per month since June 2022. Those numbers will increase to $60 billion (Treasury securities) and $35 billion (mortgage-backed securities) per month over time. In terms of the specific numbers, the US Federal Reserve reduced its balance sheet by $100 billion over the last three months, not exactly consistent with the plan. But, the fact is the Federal Reserve has started the tightening process and it’s not going to end soon.

Why are global central banks so impatient and so aggressive in tightening the monetary policy? The obvious answer is they have to do so to stabilize the price level. Since early 2021, the US has experienced an inflation rate over 5% persistently, and today the latest number is still 8.2%. Not just the US, the latest inflation rate in the UK is 9.9%, while the price level in Euro Zone increase at 8% on average consistently. Those numbers are generally observed in emerging markets but now become widespread across developed countries today. Then it’s not hard to imagine the crazy numbers in developing countries. Here are some if you are curious: Argentina (78.5%), Turkey (80.2%), Sri Lanka (64.3%).

Such a high price level will do nothing good to the economy, especially in terms of devaluation of household deposits, depression of purchasing power, and the surge of social unrest. Those are the basic reasons why central banks are so aggressive in rate hikes.

Will monetary tightening solve the inflation problems? Probably yes! But at what costs? By December 2022, the median projection of the federal fund rate is around 4.25% to 4.5%. And as a reference, the target federal fund rate range before the 2008–09 financial crisis was 4.5% to 4.75%. The obvious fact is we are heading toward an economic depression as the Federal Reserve will not stop hiking the policy rates until the market collapses. So it’s important to take a closer look at how bad this global depression will be.

2. Another Worldwide Great Depression?

2.1 Economic Stagnation? Still Early Stage

If you log in to your twitter account and search for “economy”, you might notice discussions about #recession all over the place. Why? Because we are heading toward one. Economically speaking, restrictive monetary policy will discourage people from borrowing for investment or consumption. Therefore, corporations will have less capital to expand production and can generate very limited sales due to lower demands. In order to maintain operational sustainability, companies have to lay off. Thus, people are unemployed, have lower incomes, invest and consume even less. And the vicious cycle continues. What we just described is basically the term “recession”.

If you do not enjoy any theoretical description, let’s take a look at very specific indicators of recession. The latest US 10-year Treasury bond yield is about 4%, and the 30-year fixed mortgage rate climbs to 6.3%. You might have no idea what these numbers imply. If we tell you that those numbers were 4.5% and 6.5% for Treasury bonds and mortgage-backed securities just before the 2008–09 financial crisis, you might gasp and feel we are on edge of cliff. And that’s exactly where we are going, unfortunately at an accelerated speed.

Some of you might not believe us and tend to argue that the world is not the same, and history generally does not repeat itself. Then, we could check other evidence further support what we are heading to.

In Figure 5, we could easily observe the downward pressures of US consumption, which is one of the most important pillars of the US economy. Very specifically, the US nondurable goods consumption has experienced a negative growth rate for five consecutive months, and the latest number is -1.3%. At the same time, service consumption is also trending down even though the US has almost removed all the COVID-19 restrictions.

Now, if you insist that previous numbers are just indirect evidence, then the next one will be as solid as a rock. Let’s take a closer look at the US PMI, one of most leading indicators of the economy. Specifically, the latest US PMI is 52.8, slightly above the threshold of 50. If you do pay attention to this number over time, you might notice that this indicator has declined since March 2021, when the US had PMI around 65. More importantly, it looks like the US PMI is not at its bottom yet, given the more restrictive monetary policy later this year.

It’s also important to note that economic recession does not centralize around the US. Actually, the economic conditions outside the US looked much worse.

It’s not hard to notice that the global composite PMI dropped below 50, implying that the global economy formally steps into the contracting stage. Given the complex global environment, including inflation, restrictive monetary policy, military conflicts between Russia and Ukraine, and commodity shortage, it’s not that surprising to observe such a weak economic number. At the end of the day, we should agree that the upcoming recession is inevitable.

Now we are possibly on the same page about the bad economic conditions. But how bad it is? In fact, macroeconomic is a complex system and most factors are correlated. So we would not like to jump to the answer without including and analyzing other related factors.

2.2 No Magic Spells Can Make Inflation Disappear Abruptly

One important factor we need to consider here is when inflation will “truly” cool down. Even though central banks around the world have exhausted their efforts in raising policy rates, the price level cannot be fixed abruptly. The most important reason is that restrictive monetary policy could only calm down the price level indirectly through credit contraction and demand destruction. So it generally took three to six months before such mechanism works.

In Figure 8, we could observe that the US Federal Reserve started raising the policy rates as early as March 2022, but the inflation rate was trending down until July of the same year. Because of the lagging response, the inflation number will not magically disappear with the restrictive policies. It will be a long process, usually taking several months or even years, and this process is not going to be fun.

Another fact is that today’s inflation is not a 100% demand-side problem. In fact, supply side plays a very significant role in driving our current price level. According to Figure 9, energy and supply-side issues contribute to 75% of CPI growth rate in the US, and this number is 87% for the Eurozone. This is the other reason why the global price level keeps growing even with very aggressive rate hiking around the world. Central banks can deal with the problems of the demand but not those of the supply.

Before we make a conclusion, we need to point out there are so many misconceptions about CPI index on both twitter and podcasts. People tend to be happy when they see a lower CPI growth rate, but this makes nonsense. Please note that inflation is about price level not about the growth rate. Even if CPI growth rate dropped from 8.3% to 5% or 3%, it does not mean that the price level bounces back. The lower growth rate only indicates that the price level is increasing at a slower rate. In fact, we are not better off, we are just worse off at a slower rate.

This is the reason why we rarely see US CPI growth rate over 10%, but the price level in the US has increased 29 times since 1913. The bottom line is that as long as the CPI growth rate is positive, our price level will keep climbing. In fact, our fiat system is only sustainable with this ever increase in the price level because its unlimited credit expansion needs an easy solution, and inflation is the answer.

Overall, we do not foresee that inflation will calm down very soon, even if Fed has more aggressive tightening in policies. It takes time for the policies to work, and the supply-side issues cannot be solved by demand-side policies as central banks cannot print oil, gas, copper, or any other useful commodities. Even if the inflation rate bounces back later, we still need to live with a price level much higher than what we enjoyed before the pandemic. The world is not the same, and so is the price level.

2.3 Governments’ Debt, Your Problems

Unlike the inflation problem that is well discussed on twitter, very limited attention is drawn by the long-term debt cycle we have today, until Credit Suisse CEO said that the bank is at a “critical moment” as it prepares for its latest overhaul. How “critical” is it? Actually, it could be another Lehman’s moment. Specifically, the latest Credit Suisse’s CDS spreads exceeded 250 basis points, and it moved very close to its peak before the 2008–09 financial crisis.

The other scary fact is that the Federal Reserve actually planned to tighten its monetary policy even further. The current target range of the policy rate is between 3.0% and 3.25%. By December, the median projection is to move the federal fund rate to the level of around 4.25% to 4.5%. As a reference, the target federal fund rate is between 4.5% and 4.75% just before Lehman’s moment. That’s possibly another rhyme of the history.

From these historical facts, you might notice that certain systematically important banks might have another Lehman’s moment several months later. As the policy rates keep hiking, the banks will feel harder to collect interest payments from borrowers as they have limited alternative and cheap ways to refinance their debts. At the same time, those banks might also have their own issues in maintaining the size of their balance sheet, as liquidity is constrained all over the capital markets. Overall, the bottom line is that those “too big to fail” will have greater exposures to default risks and liquidity issues with further tightening in monetary policy. As one’s liability is the other’s asset and so on, the default and bankruptcy for any of them will cause negative chained effects that spread across individuals, institutions, countries, and ultimately the whole world.

That’s it? Unfortunately no. The ultimate villain of this debt crisis is still in the shadow, and its impact will be definitely more destructive. Now, who is the ultimate villain? The answer is the “Government”.

It’s hard to believe that the boss of money will have any issues in paying back their debts. Unfortunately, that’s the fact today.

Today according to the Bank of International Settlement, the US government has its leverage ratio of around 118%. You could notice that this number was only around 60% back to the time before the 2008–09 financial crisis. More importantly, the trigger of the 2008–09 financial crisis was actually the over-leveraged households, who had a leverage ratio of around 100% before the crisis. Now you have a basic idea about how risky the US government is.

If this leverage ratio is still confusing, we could think about this number as the Debt-to-GDP ratio. The latest Debt-to-GDP ratio for the US government is 121%, implying that the size of the debt from the US government only is 1.21 times the size of the US economy. To be more specific, the US government cannot pay back its own debt even if it put the whole economy on the table.

This debt issue appears not only in the US. If we looked at Europe, it’s an even messy situation. Specifically, the latest government’s debt to GDP ratios is 67.7%, 114.3%, 152.6%, and 117.7% for Germany, France, Italy, and Spain, respectively. Those numbers are much higher than the period of the European sovereign debt crisis. Even worse, these European governments have to pay back debts denominated in US dollars, the fiats that they could not print by themselves. If combining this with the fact that the Federal Reserve is still tightening its monetary policy that further constrains the US dollar liquidity in Europe, we could conclude that Europe will have the sovereign debt market collapses way before that in the US.

Normally, investors are not concerned about the default risk in the sovereign debt of developed markets as they believe developed markets are more reliable and could always find their way out. Yes, both Europe and the US could and will find their way out of this monstrous debt crisis. In fact, Bank of England recently announced that it would carry out a “temporary purchase of long-term UK government bonds from 28 September” to stabilize the financial stability, and the net asset purchase “will be carried out on whatever scale is necessary”. That sounds like a feasible solution, right?

Yes, money printing is the most or the only feasible solution to the upcoming debt crisis. Now, the central banks step in and we will be all set, right? Not exactly. There is no free meal in this world, and so is free money. There is a significant cost to money printing, which is inflation! Nowadays, the inflation rate is already 8.3% for the US, 9.9% for the UK, and 9.1% for the Eurozone. We don’t want this number to become any higher, but more money printing will further deteriorate the inflation outlook and drive the price level to an even crazy place, making everything unaffordable. At the end of the day, money printing is not the panacea, and it will cure the debt crisis with the costs of the inflation crisis.

Is there any solution without any side effects? Unfortunately no, at least not for this time. There is no reverse of time, and so is the debt accumulation. The bust of the debt bubble is inevitable, and so is the following money printing. The only question left is how many debts will default before we see another round of global monetary easing. After that, we will be forced to step into the Era of Great Inflation, a chaotic and conflicting decade.

2.4 Energy Crisis not just in Europe

If the debt crisis is still in the shadow, the energy crisis in Europe has been widely discussed since the military conflicts between Russia and Ukraine. As European countries implemented serious sanctions on the commodity and energy export from Russia, Europe should have foreseen the serious shortage of energy and thus the “cold winter”.

The direct impact of the sanctions is the supply shortage of major commodities, oil, and more importantly gas. In fact, the EU used to be the largest buyer of Russia’s oil and had a significant reliance on Russia’s gas export. Rome wasn’t built in a day, and so are the gas pipeline and oil supply chains. Therefore, the major European countries cannot find an alternative and effective way to fill the supply gap even though the US has continuously increased its energy export to its alliance.

Specifically, the latest PPIs for Germany, France, and Spain are 45.8%, 29.5%, and 40.1%, respectively. Those numbers could directly show us the energy mess in Europe today.

Why is PPI so important? Because it is associated with the costs of materials for most manufactured goods and energy we consume everyday. If we take a closer look at the electricity prices in major European countries, it’s not hard to notice that most of them were suffering from higher energy costs. Even though the average electricity prices have corrected a little bit from the peak, the level is elevated by at least 10 times what Europe had back to 2021. Today, the only hope for Europe is possibly the end of military conflicts between Russia and Ukraine. In this hypothetical scenario, Europe could reconnect with Russia to alleviate the supply issues of commodities and energy.

However, this hope is gone not only because of the elevated tension between Russia and Ukraine but also due to the sabotage attacks on Nord Stream Pipelines, which transport around 20%-30% of gas from Russia to Europe and cannot be easily fixed within years. Therefore, major European countries will have to deal with this energy crisis mostly by themselves. In certain extreme scenarios, they have to protect the interests of their own first. And that’s why we will see more and more energy nationalism.

So only Europe will have this energy crisis, right? Not exactly. Even though Europe might suffer the most during this upcoming winter, it doesn’t suggest that other countries will be free from this shortage. Let’s turn our attention to the oil inventory in the US, the latest commercial oil inventory in the US is around 430 million barrels, one of the lowest levels since the US’s success in “Shale Revolution” back to 2015.

You might point out that the US still has its Strategic Petroleum Reserve (SPR) to back up the potential shortage in oil. True, the US has this option to fill in the supply gap, and in fact, the US began to do so as early as October 2021.

However, the latest SPR for the US is only around 440 million barrels, the lowest level since 1984. If this number is still abstract to you, then here is a different way to interpret this number. Today’s US demand for petroleum products is about 20 million barrels per day, so the current SPR could only sustain such an amount of consumption for 22 to 23 days. Yah, the US’s last card could not even postpone the energy crisis for a single month. Worse still, OPEC+ agreed to reduce oil production by 2 million barrels per day from November, even as the US holds very strong positions against this move. In the end, we are not trying to argue that the US will have an energy crisis, but it’s important to note that the energy shortage will also bother the US during this upcoming winter.

So even the largest economy, the US, will face certain constraints in energy supply. What about others? Like China? You might have heard about Sichuan electricity rationing back in August 2022. If you have no idea what this is, here is the thing: Sichuan, a Province in China with one of the largest hydropower supplies, declared electricity rationing for factories from August 15th to August 20th, extended to August 25th later.

Sounds like China’s version of energy crisis, right? Before we say anything about this, let’s figure out why this happened in the first place. Back in the summer of 2022, Sichuan experienced the most extreme heatwave in six decades, causing temperatures in the province to hover around 40–42 degrees Celsius (around 104–108 degrees Fahrenheit). Such high temperatures will stimulate soaring demands for electricity for air-conditioning. At the same time, China suffered from severe droughts from the heatwaves, and this led to lower river water levels, thus limiting the electricity production output from hydropower. It’s important to note that Sichuan province has significant reliance on hydropower, 85% of Sichuan’s electricity production output comes from hydroelectric power. Together, these issues caused an obvious electricity demand-supply gap, and as there was no readily available workaround solution, Sichuan had to shut down factories to support the residential electricity demand.

This was what really happened in Sichuan, and in fact, the electricity rationing was mostly driven by seasonal and cyclical factors. More importantly, China has a sufficient supply of coal and could always rely on thermal power for electricity supply. Here, the bottom line is that China is very unlikely to experience the energy crisis happened in Europe.

However, it’s still important to point out that China will also have certain constraints in the commodities and energy supply for the next several years, even though China does not implement any sanctions on Russia in the first place.

Now, it looks like the supply issues of commodities and energy are everywhere. You are right. In contrast to political propaganda from the media, the military conflict between Russia and Ukraine is not the determinant behind it. To be clear, we are not saying that this military conflict does not affect the supply of commodities and energy around the world. Actually, it did have a direct impact. However, we tend to argue that the most important determinant of today’s commodity supply constraints is something else. Good support of this is what happened in China, which cooperates with Russia in the whole process but still has certain issues with the electricity shortage.

If it’s not Russia, what’s the reason behind the global energy shortage? It’s the commodity cycle we have today. Generally speaking, in the commodity cycle, we will have certain periods of structural undersupply that inflates the price of commodities and energy, which encourages investment, production, and transportation. After several years of commitments, the commodity and energy become oversupplied, and prices started to bounce back, which delays further commitments and eventually leads to structural undersupply again.

Over the last decade, we had an oversupply of commodities and energy, and an underinvestment in CAPEX. That’s why most commodity and energy suppliers have very constrained production capacity at this point. At this point, we are still at the early stage of this structural undersupply cycle.

Meanwhile, we are in the middle of an energy innovation cycle. The popularity of ESG and concerns about the environmental sustainability redirect the energy sector to renewable but currently less cost-effective energy sources, such as wind, solar, and nuclear. The uncertainty about this innovation itself discourages traditional commodity and fossil fuel suppliers from expanding production capacity, as they do not know if their investments will become stranded assets abruptly.

Overall, the “root” of today’s energy and commodity supply shortage is the combination of the structural undersupply commodity cycle and the energy innovation cycle. Therefore, the structural undersupply of commodities and energy will persist for an extended period, possibly even after the end of military conflicts between Russia and Ukraine. Unfortunately, such a supply shortage will spread across every corner of the world.

3. Key Takeaways

Now, we have covered a lot of topics about the global economy, and we tried to provide our perspective, hopefully objective and professional, on these issues. Before the end of this part, here are the key takeaways from what we have discussed:

• 1) Central banks have started the global monetary tightening cycle, and the US Federal Reserve will not stop its policy rate hikes until the collapse of the capital markets.
• 2) In response to the global restrictive monetary policy, demand destruction caused by credit contraction leads to global economic recession.
• 3) Inflation pressures will not simply disappear as the price level has a lag response to the shrinkage in the money supply.
• 4) Over-leverage in government’s fiscals will push the whole economy to endure an unsustainable aggregate debt level, and the only feasible solution to this debt bubble is another round of global monetary easing.
• 5) Energy and commodity shortage does not concentrate in Europe but will spread around the world due to the structural undersupply from the combination of the commodity cycle and energy transition periods.

More macro patterns in China and economic projections will be covered in Part II. You may learn more about us by following our Twitter @HCM_Capital and visiting our website: https://hcm.capital

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