Dark clouds hanging over investments hint at return to a more sustainable economy
2022 has been a punishing year for investors and for savers. Global stock market indices have declined by an average of 18%. This will be their worst year since 2008. Bond markets that trade debt issuance – a safe haven in times of economic stress for more than three decades – are down by an average of 12%. Taken together these downward moves in financial markets have eliminated approximately £30 trillion in wealth over the last twelve months. To put this number in some sort of context, this is similar to the combined annual output of the US and Chinese economies. This destruction of wealth has been amplified by high inflation that has reduced the spending power of households around the world. These rapidly rising prices have challenged even the lowest risk savings strategy of holding cash. Digital assets such as cryptocurrencies and non-fungible tokens (NFTs) have experienced far larger falls, exposing the folly that they represented a credible store of wealth for serious investors. As these financial market dislocations make us all feel poorer – which they almost universally have in 2022 – they tend to result in less spending and investment. It is a reasonable estimate that this year’s asset price falls will reduce global consumer spending by more than £1 trillion over the next few years. This is one of the reasons that fears of a prolonged global recession are so prevalent. But make no mistake, this negative wealth effect is a design feature – rather than a bug – of the policy response to high inflation.
The deflating of bubbles in asset markets has been something that the world’s central banks have collaborated to deliberately engineer during 2022. These actions have triggered a vigorous debate on whether policymakers can engineer something widely called a “soft landing”. Such terminology is typically reserved for airline pilots. However the major pilots of the global economy – central bankers – are now attempting a landing amidst limited visibility, with swirling crosswinds and on an air strip they have never visited. All this with a set of controls that influence their craft with considerable delays. The risk of a hard landing, or worse still a crash landing, is high. To stretch the analogy still further – there is a respectable argument that the plane will land itself without further touching the controls. Inflation is now falling across most countries, and the pace of these falls is expected to pick up next year. It is the transition to something resembling policy autopilot that looks set to be the big question for investors in 2023.
Financial markets are currently expecting interest rates to stabilise in the first half of next year. Whilst this may offer some relief, interest rates will widely be higher than the world economy has faced since early 2008. Furthermore, even if interest rates do plateau it seems inevitable that Quantitative Easing or money printing will be replaced by sustained Quantitative Tightening, or money destruction. This is hardly the backdrop to trigger a quick recovery in economic growth. Even putting aside the direct impact of higher borrowing costs, there are some big behavioural considerations. Will consumers continue to spend as they refinance their mortgages and loans at higher interest rates? Will companies continue to invest when their cost of finance is now typically between 6%-8%? As other assets like residential and commercial property inevitably get revalued lower how will the banking system treat stressed borrowers?
Economic history is littered with examples of where prolonged periods of stability generate their own instability. American Economist, Hyman Minsky, is the most celebrated for his work in this area. The rock bottom interest rates that have defined the last fourteen years look like a textbook example of the conditions that create “Minsky Moments”. Whilst the major retail and investment banks are far better capitalised to deal with any economic shock that may result, it would be naïve of investors to conclude that this will be enough should households and businesses respond by battening down the hatches. Risk in financial markets rarely gets eliminated. It simply moves around in response to regulation, innovation and speculation. In 2008 the global economy was brought to its knees as the major banks didn’t know where bad debts resided and lowered their shutters. This opacity crippled economic activity. If 2023 is going to include another moment of instability it is unlikely to take the same form. My best guess is that the unwinding of the “hunt for yield” from investors – that boosted the prices of many assets of questionable value – will be disorderly. We are already seeing this in non-profitable technology companies where share prices are down more than two-thirds from their highs. Financial markets in the Eurozone are braced for a European Central Bank that is soon to start selling debt rather than buying it. This is uncharted territory.
But amidst this dark cloud hanging over the investment landscape is the hint of a silver lining. One that investors should cling to as the counterpoint to recent and looming pain. The adjustment to higher interest rates has the potential to help make the global economy more productive – indeed more efficient – than has been the case since the Global Financial Crisis in 2008. Companies failing, jobs being lost and price volatility sends important signals to where economic effort should be focused. This “creative destruction” is the lifeblood of all economies and the era of exceptionally low interest rates helped to neuter these signals. Unproductive companies and jobs were able to persist. Older workers were able to retire early on unearned wealth gains. This contributed to a slowdown in efficiency gains across the world economy, and a stagnation in wage growth. As this process goes into reverse and these important price signals return it seems likely that a more sustainable economy will result. It won’t be pain free in 2023. Adjustments on this scale never are. But our future selves may just be thankful it is now underway.
Author: Simon French, Chief Economist and Head of Research, Panmure Gordon
Managing Director, Head of Research