Positioning Ourselves for a New World Order
Economic theory and practice are rarely completely correlated. There are so many variables interwoven into a highly complex system that it becomes virtually impossible to accurately predict outcomes based on economic models. We are also not able to test these theories in a controlled environment to verify their reliability.
Having said that, there is certainly no shortage of professional (and arm-chair) macroeconomists out there engaging in (mostly) healthy debate.
A thought provoking take I have been considering recently is one presented by Scottish economic historian and investment manager Russell Napier. He posits that we are living in a new economic and financial world order where central banks are losing their ability to dictate monetary policy while these powers have instead shifted to geopolitically motivate governments.
Below I attempt to summarize the key observations and arguments Napier highlights about the changing world order and in particular its impact on how we should approach macro investing for the foreseeable future.
“The worst thing an investor can do is get all the answers right, but to the wrong questions.”
So what are the questions and fallacies that are leading us astray in 2022?
Russell’s main concern is that we are still asking ourselves where the central bank will set interest rates. This has been the core question since 1979 when Paul Volcker arrived at the Fed. He believes it has largely become an irrelevant question, yet professional investors will still spend most of their time on it.
The two key misconceptions he presents are:
- The belief that we live in a market based economy; and
2. The belief that interest rates have an impact on inflation.
The escalating debt to GDP burden
The current (now old) regime has been predicated on most global currencies being linked to the US dollar. This has depressed the rate of inflation in the US, and central bankers have attempted to counter it by keeping interest rates low, which has led to an increase in debt burdens.
We have effectively been living in a disinflationary environment for the past 30 years, with very little increase in broad money supply.
When the financial crisis hit in 2008, it became evident that lower interest rates would not suffice, and the Fed turned to quantitative easing (QE), which in turn expanded the central bank’s balance sheet. This created an increase in non bank debt as low interest rates combined with inflated asset prices allowed for the issuance of more corporate bonds.
QE basically resulted in no real broad money growth, low GDP growth and an increase in debt.
Enter Covid. A relatively severe recession, and what do you know? Debt/GDP increased even further. In fact, the highest we’ve ever seen. So now we are trying to solve for a dangerously high debt/GDP rather than maintaining price stability, which has historically been the approach.
But something interesting also happened during this time. Governments realized they could circumvent central banks and underwrite commercial bank loans to specific sectors of their choosing within the economy. Finally a significant increase in money supply, and voila… inflation!
In all likelihood, this politically attractive lever is one that governments will not want to let go of anytime soon.
Recessions have the potential to lead to depressions when debt/GDP gets too high. Hence it is imperative that the ratio is brought under control. There are various approaches to achieving a deleveraging, including:
Austerity:tends to be an issue as we are living in an age of great social programs and it would not be popular amongst voters for governments to pull back on these.
Default: has a tendency to cause crushing impacts on the economy as one person’s liabilities is another person’s assets.
Hyperinflation: is defined by over 50% monthly inflation. Would technically get rid of debt burdens, but overall outcomes are highly uncertain.
High Real Growth: is the ideal scenario. Needs high population and productivity growth however, of which there is no evidence currently.
The only other approach is financial repression. It is a more subtle approach, and hence a popular political tool.
Financial repression
If debt balances are to be brought down, governments will need to be selective about what parts of the economy funds flow to.
They have now figured out how to pull the right strings to directly impact this process. And it is likely they will start to prioritize areas that favor geopolitical matters, such as strengthening their position against China.
Napier believes that private equity and many corporate balance sheets will struggle to get the leverage that they have become accustomed to. He also thinks there will be capital controls imposed in the West. Initially a European phenomenon, but could eventually also impact the US.
Governments today hold a tremendous amount of power over our savings as we tend to hold our wealth in financial institutions that are centrally regulated. For example, if I have 30 holdings in my name, it would take some time before they knocked on my door to get me to increase my exposure to government bonds. If I held them via a mutual fund however, it would be much easier for them to tap this regulated intermediary directly.
Plus governments find it much easier to interfere in private sector property rights in an emergency situation. The types of situations we tend to increasingly find ourselves in as of late (Canadian trucker incident for example).
Geopolitical predictions
The global economic architecture has historically had a name (Bretton Woods system, Gold Standard, etc). Not anymore though. For the past 30 years, most of the world, including China, have chosen to link their currencies to the USD. This has broadly defined the system we have been living in.
With regards to the new world order that we find ourselves on the cusp of, arguably the most interesting relationship to watch is that of Russia and China. As the situation in Ukraine unfolds, the majority of the world are cutting ties to Russia.
For China on the other hand, this is an opportunity to source energy and resources — potentially even transacting in RMB. Thereby reducing their reliance on the Middle East for oil.
Europe will struggle as a result. Germany has been a significant benefactor of trade with China, particularly for high quality machinery. With regards to the Euro, individual states are increasingly valuing sovereignty over EU centralization. Should state banking systems start to manage monetary policy themselves then you no longer have a centralized monetary system.
China will likely need to start managing its own monetary policy as we enter what Napier calls the new “Cold War”. This would mean China delinking its currency, allowing them to meet common prosperity and domestic social goals.
This would require the rest of the world to pick sides between the US and China. It would seem we are living in an increasingly deglobalizing world.
Positioning ourselves as investors
So as investors in the West, how do we best position ourselves should these predictions come to fruition.
If we are in fact entering a cold war (verdict still out), industries that have fled to China will partially need to come back. This presents some upside for old economy businesses. Equity markets are overpriced in aggregate, but there are numerous undervalued companies that have been neglected.
Industries like manufacturing, steel, ship building, chemicals and defense should benefit as many of these industries will likely be brought back to the West from China should tensions escalate.
Being aware of capital controls and in particular making sure you have access to whatever currency you will be spending in retirement may also become a consideration. Savings and investments need to be convertible into such currency.
To the extent feasible, we may consider retaining flexibility through having our investments in our own name rather than investing through an intermediary.
Approach index funds with caution as they are made up of the winners of the previous period, who may not be the winners of the next one. Value investing may provide better returns despite having almost become a dead art over the past few decades.
Industries like private equity, companies that issue debt to buy back stock, and anyone who gears up to buy existing income streams rather than creating new ones, will likely fall out of favor. Napier posits that the age of financial engineering is dead.
As for ESG, not all of it is created equal. ESG can be misused and missold, but public funds will likely still get directed towards it. The best approach for an investor may be to have exposure to the picks and shovels for green gold.
In summary
A global pandemic and the invasion of Ukraine have been catalysts for the rapid acceleration of a new world order. One in which Western governments (the US in particular) are increasingly able to control monetary policy at the expense of central banks.
We are living in times of unprecedented debt/GDP, which will need to be brought under control. Governments will likely resort to measures of financial repression to achieve this.
The potential introduction of capital controls may mean owning assets directly rather than through intermediaries that are tightly regulated could be a way to retain flexibility of our asset allocation.
As politically motivated actors, governments will need to ensure that funds flow into sectors of the economy that will strengthen the West’s position as we enter a new era. With fresh capital flowing into industries such as manufacturing, chemicals and defense, growth stocks and other darlings of the past few decades are likely to underperform.
It is not clear how things will unfold. As mentioned at the beginning, macroeconomic predictions are at best a roundabout approximation of the direction we may be heading in. What is undeniable however, is that we find ourselves in interesting times and are likely to see some significant shifts in the global order and all things downstream from there. I remain open-minded and flexible.
