EMR September 2022
INFLATION – MONETARY POLICY – GROWTH = UNCERTAINTY
There is a wide divergence of opinion on short- to medium-term economic forecasts. We have the impression that the divergence has not been as great for a long time as it is now. We wonder if there are concrete reasons for these disagreements. As we all know, there is no one way to deal with reality. It depends on how the “specific model” is defined. In other words, there are different ways to quantify perspectives, but there is no certainty of uniquely quantifying them.
Interest rates were kept low – too low – for a while. Then came the pandemic, Covid 19, followed by the Russian invasion of Ukraine and the subsequent economic measures to “stem financial flows” against the invader. The rather complicated web was further obscured and made opaquer by Chinese maneuvers around Taiwan. In our view, the confluence of all the above factors has led to a focus on economic growth rather than raw politics.
WHICH ARE CURRENTLY THE REAL QUESTIONS FOR INVESTORS?
As central banks are “forced” to do everything in their power to contain the rise in inflation and bring it down to an acceptable level. Many forecasters begun to focus on economic growth as the major determinant. It should not be forgotten that the inflation rate, in many industrialized countries, has reached intolerable levels, which we have not seen for several decades.
This basic constellation is increasingly causing uncertainty and fear among both consumers and investors. Some analysts are worried about a possible increase in unemployment and thus a slowdown in economic growth. We would like to point out that not long ago feared an overheating of demand, because of low interest rates. Nevertheless, one should not forget that inflation might not be reduced as fast as expected via higher interest rates. Telling indeed is a close analysis of the chart on interest rates both nominal and real long-term for the USA. Worthwhile is to examine the reduction of 10-year interest rates, both nominal as well as inflation adjusted since the 1980’s.The question one may ask is: Is the US-economy moving back to the below 4 to 5 % interest rates, or will it go higher over the short-term?
The chart of the Dow Jones index by inflation rates over the period since 1872 is indeed revealing. What conclusions can be drawn from the data? It is striking that both inflation rates above 5 percent and negative inflation rates below 3 percent signal negative returns on capital.
Another way to analyze the current development is that the supply of inputs (intermediates, crude oil and gas, and food) is predominantly due to very “constrained” supply chains and continues to be largely determined by barely quantifiable but increasingly unacceptable political as well as economic behavior. At this stage, we doubt that the prediction of a price decline will follow a traditional cyclical scheme, as policymakers tend to follow a completely “non-economic” model.
A third argument to quantify concerns the adaptation of technological innovation in the energy sector, which, in due term would imply the “repatriation” of specific production lines.
Another difficulty we continue to face relates to the assessment of the impacts on income and on market liquidity. Will they offset each other, as it can be assumed that income will not react immediately and to the same extent as liquidity? At this stage, it is difficult to precisely quantify the proportionality of the change, also because of the war in Ukraine, especially in light of the current interest rate policy stance of central banks.
FINDINGS FOR SWISS INVESTORS
A closer look at the current environment reveals that the focus is on raising interest rates to counter inflationary pressures. The actual determinants of the current inflation are almost ignored. Assuming that the rise in inflation is mainly due to factors (such as Covid-19 and, above all, the invasion of Ukraine and China’s threat to invade Taiwan) that put dramatic pressure on the rise in crude oil, gas and food prices above and be-yond normal supply and demand trends, we should rather focus on how to solve the bot-tlenecks in the supply chain.
At this point in time, we believe that an extraordinary tightening of monetary policy could rather constrain demand without a rapid improvement of supply! However, supply disruptions are expected to ease in the coming quarters, while “financing costs” may rise. We agree with Fed Chairman Powell that monetary authorities can manage de-mand, but not supply. Therefore, it would be worthwhile to distinguish between compa-nies whose prices move in response to changes in demand from those that move in re-sponse to changes in supply. In this context, we argue that the most promising invest-ment approach would be one that focuses on increasing supply as prices fall. We consid-er it deterministic to focus on technological improvements as well as on the adjustment of wages to the cost of living.
Examining the main components of real GDP, and focusing at this juncture to the Swiss market we find that a most intricate question mark refers to whereabouts of the mortgage market. Increasingly we read about the possibility the Swiss property market could suffer while losing some attractiveness. If the available data represent the most probable reality, that risks exist. Nevertheless, despite the recent increase in the ratio of real estate to income and the ratio of mortgage debt to GDP, the environment remains sustainable. Particularly deterministic is, in the case of Switzerland, that employment has remained sustained.
At this juncture, it can be assumed that we are close to the cyclical peak in real estate prices. Fact is, that there is a great demand for real estate (residential and commercial), thus, the threat of higher interest rates should not be underestimated. Land and also property remain in demand in Switzerland. Well known is that real estate also can offer protection against inflation. The big unknown remains the timing of the respective peaks of inflation and interest rates. Let´s not forget the special role of the Swiss franc.
Comments are welcome.