This year is proving to be a dizzying one.
A multitude of events has buffeted markets: a sharp collapse in European gas prices followed by the rapid reopening of China’s economy; resilient US growth and stubborn inflation requiring sustained increases in interest rates and central bank asset sales or quantitative tightening; shocking bank failures necessitating the very opposite – aggressive central bank liquidity injections; and most recently, unforeseen cuts to oil supply from a Saudi-led OPEC coalition.
Investing is beginning to resemble multiverse-jumping; alternative realities all possible all at once.
Making sense of the multiverse
Today, uncertainty about the trajectory of the economy has risen materially because short-term cyclical pressures are colliding with long-term structural shifts. This is possibly creating one of the most challenging economic backdrops since the global financial crisis.
In particular, the post-Covid economy is proving to be the inverse of the post-GFC economy, which was ruled by insufficient demand and low and inertial inflation.
Long-term shifts like geopolitics, demographics and the energy transition have intensified.
Economic outcomes are being driven by the security, scarcity and agility of supply. Great power politics is cleaving the world apart, demographic shifts are increasing labour scarcity and the energy transition is creating winners, losers and a more expensive market for carbon.
At the same time, the post-Covid economy is having to reckon with meaningfully strong cyclical pressures.
Aggressive fiscal and monetary stimulus collided with discombobulated supply chains, scrambling supply and demand like never before.
Inflation responded by racing higher and signalling to markets that supply needed to keep pace.
Over the past year, these signals have worked and supply shortages have started to ease, most notably in the market for goods.
Labour markets, however, have remained tight as the US economy continues to create jobs far in excess of the growth of new workers. As a result, service sector inflation remains resilient.
It is this intermingling of cyclical pressures with longer-term shifts that is creating a highly complex environment where a multitude of outcomes is still possible. To navigate this landscape, it is best to disentangle and understand the cyclical pressure points.
A slow dance to recession
For over a year, the US Federal Reserve has been raising rates in an aggressive bid to bring demand in sync with supply. As the Fed tightened, other global central banks had little choice but to follow suit. The result has been a synchronised tightening in financial conditions.
Notwithstanding a concerted tightening in monetary policy, global growth has remained surprisingly resilient. In particular, the US economy has shown relatively low sensitivity to increases in short-term interest rates.
Strong household balance sheets, long maturity of mortgage debt (typically 15 to 30 years) and the ‘terming out’ of corporate debt as businesses took advantage of the era of ultra-low rates have kept demand resilient even as rates marched higher.
