Productivity, innovation and pricing power have never been more important.
Helmets on, as 2022 will prove a wild ride for global markets. The macro outlook picks apart the argument that we are seeing a repeat of the 1970s as the world faces a supply shock unlike any it has previously seen. It’s one that risks a “great erosion” as negative real rates erode purchasing power on all levels and rising costs erode profit margins for corporations.
The global economy has suffered two major shocks in the short space of two years. Both will have a tremendous impact on markets and especially on economic policy as these shocks have created new geopolitical priorities by exposing huge vulnerabilities in what turns out to have been an excessively tuned globalised economy. The outlook addresses the tectonic shift already underway in global macro and politics.
Before government handouts and central banks dumping rates to zero helped drive a post-pandemic overstimulation of the global economy, years of ample supply with steady prices had reduced investments towards new production, thereby leaving producers ill-prepared for the demand surge that followed. Key events that could trigger additional uncertainty remain the prospect for an Iran nuclear deal, Venezuela being allowed to increase production and, not least, an increase US shale oil production, should producers manage to overcome current challenges related to lack of labour, fracking teams, rigs and sand.
While the energy transformation towards a less carbon-intensive future is expected to generate strong and rising demand for many key metals, the outlook for China is currently the major unknown, especially for copper where a sizable portion of Chinese demand relates to the property sector. But considering a weak pipeline of new mining supply we believe the current macro headwinds from China’s property slowdown will moderate throughout 2022. In addition, we also need to consider the prospect that the PBOC and the government, as opposed to the US Federal Reserve, is likely to stimulate the economy, especially with a focus on green transformation initiatives that will require industrial metals.
Inflation is anything but transitory. At its March meeting, the European Central Bank released its latest staff macroeconomic projections. In all scenarios, the euro area Consumer Price Index is expected to decrease close to 2 percent year on year in 2023. This is wishful thinking; it currently stands at 5.8 percent year on year (the latest figure for February). It’s not just oil and energy prices that are rising fast anymore. Food, non-energy industrial goods and services are all accelerating at more than 2 percent; inflation is now broad-based.
Supply chain disruptions will last until at least 2023. Supply chain disruptions are increasing. Things are getting worse; this is the biggest trend unfolding in front of us. On top of closed and sanctioned Russian mineral exports, several countries are limiting their exports of basic goods. On March 14, Argentina shut down its soya and soy oil exports (41 percent and 48 percent of global exports respectively) for an unlimited period. At the same time, Indonesia tightened export curbs on palm oil—the world’s most widely used vegetable oil and used in several food products. Many countries are following the same path, including Serbia, Ukraine, Egypt, Algeria and Bulgaria.
Others are still dealing with the pandemic. Shenzhen, China’s enormous manufacturing hub and port city, went into lockdown in mid-March. Shenzhen is home to some of China’s most prominent companies. It’s also the fourth largest port in the world by volume with the transit of 15 percent of Chinese exports. It could take six to eight weeks to clear the backlog; a sustained improvement in international shipping is only expected in 2023 onwards when new containers will arrive in the market.
Port congestion is not the only driver of inflationary pressures. In the past few months, we have mentioned several times that the European green transition is fundamentally an inflationary shock for the European households and companies. Instead of the COP26 resulting in a phasing down of coal, the sad reality is that coal and gas are growing.
History doesn’t repeat itself, but it does rhyme. In our view, comparing today’s inflation with the 1970s or the 1973 oil crisis does not make sense. There are at least two main differences: the Covid-19 policy mix in the developed world was out of all proportion to what we have known in the past, and there’s no price-wage loop in most euro area countries. In the 1970s, wages were automatically indexed to inflation. This is not the case anymore, with a few exceptions (in Cyprus, Malta, Luxemburg and Belgium, indexation is based on core CPI). So far, wage negotiations in euro area countries have led to an average increase below inflation (less than 1 percent in Italy and between 2 and 3 percent in the Netherlands, Austria and Germany, for instance); this is not the stagflation we experienced in the 1970s.
Some economists call this new period the Lowflation. We call it the Great Erosion: erosion of purchasing power, corporate margins and growth due to the explosion of supply costs at the global level. This is the fifth regime shift over the past twenty years: the Great Moderation, the housing bubble, the Secular Stagnation and the Taper Tantrum were the other four. The main question now is who will bear most of the cost. Our bet? Corporate margins.
What could prevent this? Basically, we need productivity gains. Unfortunately, we don’t see strong evidence in the data of sustained productivity gains from remote work, and whether the green transition will have a net positive or negative effect on productivity is debatable. The inflation/recession dilemma all the central banks are officially committed to fighting inflation—this is obvious. The hawks clearly took control of the ECB narrative at the March meeting, but some central banks are certainly more committed than others. We suspect they could take a sustained 3-4 percent annual inflation rate rather than engineering a recession to get them lower. This means they could bluff about it staying hawkish in words rather than deeds. This is certainly more the case for the US Federal Reserve than for the ECB. Don’t forget inflation above the last 20-year average has a positive impact on the debt burden too; this is an added bonus.
After the Global Financial Crisis of 2007-08, many countries tried the conventional way to reduce debt—meaning austerity and structural reform. It has failed and now it’s time to adopt a more unconventional approach: inflation, repression and, in a few cases, default. This will have major implications in terms of investment (outweigh commodities and real estate amongst other options) but also fiscal policy with increased income redistribution for the lowest quintile of households. Not everyone is prepared for what is coming: a prolonged period of high inflation before it drops.