My thoughts on the market - August 2022
War and Interest Rates & why inflation is just getting worse
A bit later than usual, but here comes your monthly-ish newsletter dealing with the bigger picture of the financial markets.
If you are lazy to read the whole text but still want to get the core takeaways, read only the highlighted parts.
If you like my work, please don’t forget to like this post and share it with others who may also benefit from reading it.
In this recent issue you will read:
a bit about the Ethereum protocol update, aka “The Merge”
and a lot more about Zoltan Pozsar’s essay on “War and Interest Rates”, which introduces us to the prospect of an already ongoing World War III, why inflation may be structural and not cyclical as the majority believes, and how it can lead to a long-lasting recession.
Although in one of the previous issues I wrote that we should not expect big market moves during the summer months, I must admit that we have seen a lot more than I expected. But to be fair to myself, I also pointed out that due to the high level of uncertainty following the remarks of FED officials (they will rely on data when deciding the rate of future interest rate hikes, thus leaving the market without an anchor) could increase the volatility both in traditional markets and in the crypto market too.
And well, that’s exactly what we got.
And technically the market hasn’t moved anywhere since we last spoke, as Bitcoin is still pretty much range-bounding between the 19-22k region with failed break-out attempts to both directions. And since we should consider Bitcoin as the main driver of the cryptocurrency market, this is one of the most important indices we should care about. The other one is the second largest cryptocurrency by market capitalization AND real-world use cases: Ethereum.
Having an eye on Ethereum has never been more important than now, and the reason is that in only 3 days, this smart-contract network is going to implement the biggest update of its history. The so-called “Merge” will take place approximately on 15 September 2022, around 03:38 UTC, when the blockchain reaches the specific block which will be mined with a Terminal Total Difficulty of 58750000000000000000000. You don’t need to understand this terminology, I just wanted to mention it because it sounds fancy.
To simply put what it means is that at this point, the Ethereum network will change its consensus algorithm (the way how decentralized networks decide which transactions can be added to the blockchain, what is true and what is not within the network) from the energy-intensive Proof-of-Work to a more efficient one, which is called Proof-of-Stake. The majority of the market expects a huge increase in the price of the Ether (ETH), the native token of the Ethereum network. Although I also understand the long-term positive effects of the upgrade, currently I see a lot more risks around the implementation and I believe that the event can only negatively surprise us, regarding the short-term outlook. I also believe that this event has been priced-in by the market a couple of weeks ago, when we saw Ether gaining more than 100% within a month, outperforming Bitcoin too.
To connect the dots, at this point I want to refer back to the core idea of this newsletter, which is to take a look at the markets (and mainly at cryptos) from a bigger perspective. To do this we have to be aware of what’s happening in the global macro environment which nowadays means having a clue about what the FED is going to do next and how the market will respond (which turns out to be the false approach and I will explain it in a minute why). It is the most complicated task to deal with, and the more you are trying to understand it to the smallest details the more confused you get.
That is the reason I always prefer getting my information from individuals who are able to explain complex things in an easily understandable way and can translate the financial jargon for mortals too.
One of the sources I started to follow is Zoltan Pozsar, who serves as the Global Head of Short-Term Interest Rates Strategy at Credit Suisse. Yes, he has Hungarian roots and yes, he definitely has a clue about what is happening in the economy.
Just a few weeks ago he published an essay with the title “War and Interest Rates”, which is one of the most interesting views I encountered since the beginning of the ongoing inflationary cycle. It is also an approach that differs from the mainstream views that you can read on the internet and it is also the most important one to understand. To demonstrate how much I value your precious time (as you are reading my newsletter right now instead of doing some other useless stuff) I already read this very important piece, so you only have to pay attention to this not-so-brief summary to get the core thoughts about where our world might be heading.
We can differentiate between different forms of wars:
hot wars (direct confrontation between powers using military forces)
cold wars (like the one we had between the Soviet Union and the US)
“hot wars in cold places” (threatening each other in the cyberspace via hacks, space war, and war in the deep sea via nuclear submarine fleets, see here)
“hot economic wars” (like the ongoing one between the US and China) which also contributed to the recent inflation.
Pozsar claims that inflation did not start with the war in Ukraine and that the biggest driver of inflationary forces can not be related solely to the ongoing crisis. Still, the war accelerated those inflationary forces that have been working in the background for a while (see the 3 pillars above). Most importantly, if the war and zero-Covid policies are here to stay for a longer period, the mainstream thesis about inflation being cyclical and driven mainly by excessive central bank stimulus, could turn out to be completely false.
According to Pozsar, most of the market participants expect that inflation is about to peak and that “we are near peak hawkishness” (meaning that the FED is about to switch their policy from tightening to easing again, printing money and sending asset prices to the moon again).
The problem is that the supply side issues (geopolitical risks) are more severe than the demand side problem (which central bank policy tries to address with the easing and tightening process).
So if we can assume that the current inflation is mainly driven by the economic war and not by the stimulus that has been injected into the financial system to tackle the COVID aftermath, we can also assume that we are not at peak “FED hawkishness” (central bank policy will not have a U-turn in the near future as the market expects).
We had a low-inflation environment in the last decades.
This low-inflation world relied on three important pillars:
in the United States, the cheap immigrant workforce kept wages in the service sector stagnant
cheap goods from China contributed to the raise in living standards amid stagnant wages
cheap Russian energy powered the European Union’s economic powerhouse, the German industry and thus the whole EU
The rise of protectionism and geopolitical tensions destabilized this low-inflation world:
Trump’s protectionist immigration policy cost the US a loss of 2 million jobs which made the US labor market extremely tight. The same happened in the UK after the Brexit.
Trump’s protectionist sanctions on China that started as a trade war became a technology war.
China’s zero-Covid policy periodically causes distractions in the global supply chain that intensifies inflation too.
The tension (energy dependency of Europe on cheap Russian gas that threatened the US and the expansion of the NATO that threatened Russia) between the US and its allies and Russia erupted in the hot war in Ukraine where both sides started using economic tools to weaken the other: the US weaponized the dollar and Russia weaponized commodities like natural gas and oil.
This started a new era of the war economy where geopolitics matter more than central bank policies. An economic war is a “fight between the consumer-driven West, where the level of demand has been maximized, and the production-driven East, where the level of supply has been maximized to serve the needs of the West”, until this relationship between the West and the East broke, which ruined the balance between the supply and demand side.
There is a strong alliance between Russia and China and these two accounts for 2 of the 3 pillars that made a low-inflation environment possible for the last decades: Russia is the biggest producer of commodities and China is the biggest producer of consumer goods.
In this low inflation environment, made possible by China and Russia, central banks could print money and thus inflate asset prices to fight deflation, but now they fight inflation by deflation of asset prices.
Today’s inflation is more about supply and less about demand and is more about geopolitics than domestic politics.
There are two perspectives on inflation:
you can see it as cyclical, being caused by the massive money printing to fight the COVID aftermath and the extreme demand shock after the re-opening
or you can see it as structural, as a byproduct of a changing multipolar world where Russia and mainly China are challenging the status quo of the US as the world leader.
If you believe in the former being the case, you can assume that inflation has already peaked.
If you are in favour of the latter one, inflation has barely started and it will get much worse.
We may already be in a World War III: wars are changing too, so we should not expect a war like WW II was. This time the confrontations are not necessarily military ones with physical confrontations but based on cyber warfare, commodities, currency wars etc. which are already in place for years.
“It’s time to think more about the risk of inflation staying higher for longer due to economic warfare, and less about inflation being driven by a messy re-opening process and stimulus.”
Food and energy are basic necessities, thus the rise in those prices has a much greater effect on the well-being of the people than the rise in the prices of consumer electronics for example. Not buying a new TV won’t influence your quality of life but not being able to buy the same quality or quantity of food and oil and gas to drive your car or heat your home definitely will. And it is dangerous when the labor market is as tight as it is now, because people will keep demanding higher wages which puts huge pressure on wages globally. If companies have to pay more to keep their workforce they will also have to raise prices which fuels inflation even more.
We can see how complex the inflation problem is getting, and that multiple factors can influence it in an unpredictable way. So the question arises:
if it is so impossible to forecast, how can the market be so confident that inflation has already peaked?
Market participants argue that rising energy prices are not as relevant to today’s economy as it was in the last big inflationary period of the 1970s, arguing that the economy now is a service-based economy. Pozsar claims that “what oil is to an industrial economy, people are to a service economy” and considering the extreme tightness of the labor market we can assume that today’s labor-driven service economy has the same problem as the oil-dependent industrial economy had in the 1970s.
The market assumes that hiking interest rates and creating a recession to demolish demand will be enough to fight inflation —as it was in the 1970s when Paul Volcker, FED chairman aggressively raised interest rates for years. But according to Pozsar the circumstances that made Vockler’s policy effective (excessive investment into the oil sector leading to the exploration of new oil fields which helped to ease the supply issue + President Reagen stepped up aggressively against workers’ unions when going on strike thus not enabling the labor market to fight for higher wages) are not given today due to the underinvestment in the oil sector (no new supply is available in the near future, so the oil market is only going to get tighter in contrast to the 1970s). Stepping up politically against the labor force demanding higher wages is also extremely difficult given the shortage of labor in the US and Europe due to the anti-immigrant policies (immigrants could be the only solution to maintain cheap workforce in ageing societies)
Pozsar states that in order to curb inflation effectively we will need a long and lasting recession.
We require an "L"-shaped adjustment in economic activity, and an "L"-shape consists of two parts:
first, an "I" that represents a vertical drop (perhaps a deep recession)
and second, a "_" that represents a flatline (stagnation, as in stagflation).
There is nothing that guarantees an interest rate cut after the vertical drop: stagnation, especially when paired with inflation (stagflation), means that interest rates may be kept high for a while to ensure that rate cuts won’t cause an economic rebound, which might trigger a renewed bout of inflation — that’s why we need an “L” and not a “V” shaped recovery.
Talking about inflation I feel the same as Pozsar:
“Maybe it’s because I do not have a PhD degree, but I don’t see why inflation is about to peak. Why can’t it go higher from here?”
Thanks for reading,
Norbi