On February 24, the day that Russia invaded Ukraine, we wrote a blog called “World War Three” that warned of an acceleration in inflation and increased volatility in currency, commodity, crypto and equity markets. In the three months since then, US CPI inflation has risen from 7.9% in February to 8.5% in March and 8.3% in April; the US dollar has moved up 6.4%; the price of oil has gone up by 40%; Bitcoin has fallen by 20% and the S&P 500 index has fallen by 3.3%.
As we look at the world today, three things become obvious:
1. Change is happening even faster than before.
2. We have gone from a world of surplus to a world of scarcity and
3. Central Banks have lost their omnipotence and have become, as the Governor of the Bank of England recently admitted, virtually impotent in the face of higher inflation.
1. From Fast to Faster
Over the past thirty years the Information Revolution has been responsible for the digital spread of information that has transformed the way our society functions. The Information Revolution created two powerful forces that account for much of what is happening in the world today – the empowerment of individuals and the fragmentation of historic power structures. The Information Revolution in the Western world dates back hundreds of years to the invention of the movable-type printing press by Gutenberg in the 1440s. Caxton brought the printing press to England in 1476. Five hundred and nineteen years later the public internet began a digital transformation that has witnessed the growth of social media, the sharing economy, blockchain and now Web 3.0. That pace of change seemed to accelerate with Covid, which speeded up the process of digitalization and fundamentally altered the way we live, at least temporarily. Politicians and governments used Covid as an excuse to try to regain some of the power they had lost as a result of the fragmentation of information. Fortunately for the libertarians, Sweden showed that big government is not always the correct answer. Russia’s invasion of Ukraine created an even bigger economic shock. Few realized just how dependent the world is on food supplies from Ukraine. Europe’s addiction to Russian energy was also put into relief. The Russian war in Ukraine has been dismissed as the irrational fantasy of a madman. However, when we look at Russia’s proud imperialist tradition, it might better be understood as a revisionary attempt by a failed empire to claw back territorial losses and influence. Leaving aside the human tragedy of the conflict, Russia’s mis-adventure is bound to fail as it goes against the trend of history and the fragmentation of anachronistic power structures. The only Russian success of the whole campaign might be the unintended consequence of disrupting global food and energy supply chains and exporting inflation to the West.
2. From Surplus to Scarcity
For the last forty years, inflation was trending lower, rates were trending lower and capital was becoming available all around the world. As the world opened up and became more global, businesses moved from being vertically integrated to becoming federations of global supply chains exploiting labor and material price arbitrages to deliver consumer goods at ever reducing prices. The accession of China to the World Trade Organisation in late 2001, brough more cheap goods to the world. As productivity rose and inflation fell, central bankers duly responded with lower interest rates. When the world almost fell apart in 2008, central bankers drove interest rates to zero by pumping excessive amounts of money into the system. That money stayed for the most part in the pockets of financiers, inflated financial asset prices and increased wealth divides with the result that populist politicians were elected to power by the victims of globalization.
Policy changed as a result of the Covid crisis. Rather than putting free money into the pockets of already wealthy bankers, governments placed cash into the hands of ordinary citizens. It is estimated today that there is an excess of $4 trillion in retail deposit and savings accounts in the US. This excess cash has had two effects: 1. Increased demand for goods and services in the US creating strong economic growth 2. The great resignation as people flush with cash seem reluctant to rejoin the labor market. Both of these effects helped to drive up inflation in the US to 7.0% in December 2021.
Then the war in Ukraine hit and food and energy prices went through the roof as Ukrainian food exports were turned off and Russian food and energy exports became unavailable to the western world. So what appeared to be a temporary spike in inflation has become more entrenched. Intelligence estimates in the West are that the war will last years not months. As a result, companies are re-investing in vertically integrated supply chains at home, favoring security of supply over lower costs. The consequence is a reversal of the disinflationary benefits of globalization. It did not help that China also decided to lock down large parts of its economy, further exacerbating the supply shortages.
3. From Omnipotence to Impotence
The success of Paul Volker’s anti-inflationary policies in the late 1970s and early 1980s led to the gradual dominance of monetary policy over fiscal policy. At every financial crisis, central bankers were called upon to provide the liquidity that kept the system afloat. The massive injections of liquidity that accompanied the Global Financial Crisis of 2008/9 were dwarfed by the funds provided during Covid, including directly to consumers. Driven by this excess liquidity, financial asset valuations reached absurd levels. Investment in the real economy was simultaneously discouraged by negative real interest rates and as companies borrowed cheap money to buy back their own stocks and those of their competitors.
The excesses of the past are now coming home to roost. Faced with spiralling inflation, central banks now need to respond to help avert a cost of living crisis and social unrest. However, no amount of monetary policy can stop the war in Ukraine, increase food supplies or encourage people to start working again. Central banks are relatively impotent in the face of supply side shocks. So, the war against inflation will not be as easy or painless as printing more money. Financial asset prices are likely to suffer further as people learn to sell the rally rather than buy the dip. And sadly, like the war in Ukraine, plenty of innocent investors will get injured.
For older investors, caution will be the name of the game. For those earlier in their investing journeys, cheaper financial prices offer an opportunity to build portfolios gradually over time and to learn that true investing is a marathon and not a sprint.
I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand.
