You can’t see what is in front of you by looking backwards. Yet economists fill their days doing just that. Their blind use of models suggests that there is some law of nature that says that economic forces must act tomorrow as they did yesterday. That is lazy at best, dangerous at worst.
For those readers that remember my writing from FIIG Securities and FirstLinks, you’ll hopefully remember a directness and (shock, horror!) specific predictions of where I thought markets were going based on the real economy, never based on horribly backward-looking and irrelevant headline data like GDP, CPI, or unemployment.
Well I’m pleased to say that I’m back! And I’m equally pleased to say that I expect to be wrong as often now as I was then — but I will always give you the reasons for my predictions so that you can form your own. Again, not a popular approach, but I’ve always erred on the side of arming readers with the tools to eventually not need me and my peers, and to learn that they have always been able to see the big picture themselves — they just needed to look past the jargon and spin.
Enough about me though — what’s been happening and more interestingly, what could happen next?
Prior to the Covid pandemic we had clear signs of:
- Chronic underemployment and anaemic inflation in Australia
- Trump threatening trade wars
- The Fed was clearly on a tightening path well ahead of the rest of the world
- Heavily indebted China increasingly boxing themselves into trouble for the rest of us
- The EU struggling with Italian debt and populism
Other than the pandemic itself, everything we needed to know to predict today’s market was available back then — and much earlier in many cases. Yet it wasn’t until the shocks caused by the pandemic that bank economists started predicting lower interest rates. Then, bizarrely (yet not really), the banks started predicting rising interest rates again.
Why Economists Keep Getting It Wrong
Right now, more than any other time in the last 60 years, models based on the past will fail to predict the future. The world economy is changing permanently. This isn’t new; there have been major revolutions every few hundred years.
The Agricultural Revolution sent workers into the cities. The Industrial Revolution broke all of the economic models of its time, replacing labour with capital equipment. The Digital Revolution is lowering the costs of so many goods and services that it has broken all predictive models of inflation — and for its next trick it is fundamentally changing the nature of employment itself. (None of this is due to the pandemic by the way. It has accelerated the impact of the Digital Economic Revolution, but they were always coming.)
Well, I’m back to tell you they are wrong, and why. Just the headlines today, but I’ll get into the detail on each of these over the coming weeks.
Outlook for Markets
- Rates won’t rise until underemployment falls
So here is the first lesson for the new world order: unemployment won’t drive interest rates, “underemployment” will. The favourite tool of economists, “The Phillips Curve”, tells them that low unemployment = rising inflation. The theory is good; if there is less labour available, employers have to pay more to attract new employees.
But using unemployment as a measure of labour availability doesn’t suit this modern era called the “Gig Economy”, in which so many people work full-time but in two jobs. The Phillips Curve needs to be modernised to tell us that low underemployment = rising inflation. Australia’s underemployment rate was chronic prior to the pandemic at around 8.8% in 2019, up from 6.3% in 2007-08.
- AUD/USD downside threats stronger than upside
Meanwhile, the US’s underemployment was 8.8% in 2007-08 and 6.9% in 2019. Underemployment drives wage growth, which drives inflation, which drives interest rates. In other words, the US’s Fed is more likely to tighten rates than Australia’s RBA, unless we (Australia) can turn the real employment tap back on. Again, I’m not talking about recovering from the pandemic — something was wrong before. We need to innovate to improve productivity and attract jobs to Australia.
- Inflation is still anaemic
This point will be controversial as economist surveys show an average forecast of 2.2% p.a. for the next two years, but the core driver of inflation is wage growth, and without employment growth (hours, not jobs), wage growth will stay at its historic lows.
The Digital Economic Revolution will continue to put downward pressure on goods and services, and export markets will be hypercompetitive as the world recovers from the pandemic. Expect to see CPI stabilise around 1.5% p.a. once the pandemic’s volatility dies down in early 2022.
- Global trade tensions will get worse
As the world emerges from the impact of the pandemic, governments will be doing everything they can to rebalance their fiscal and capital accounts. Globalisation suffers in these times and trade barriers rise. Australia is heavily reliant on exports, so this will be a long-term test for our economy and is linked to points 1 and 2 above.
You will see spot-fires crop up and disappear, such as the tension with China over the past two years, and issues such as the French submarine contract will persist. They might seem unrelated, but they all lead back to governments needing to shore up export markets in an uncertain trade environment that will persist for the next 10-20 years at least.
- China is facing its own Lehmann Brothers debt collapse
China is different to the US as it has centralised control of the economy, not a free market. But it is not immune. Evergrande owes a total of around USD400bn, including USD97bn to suppliers — some of which it already started the extraordinary measure of paying through uncompleted properties. Evergrande’s collapse would be the biggest test to China’s financial system in 20 years, and represents the greatest chance of a China hard landing.
For Australia, the timing of a China hard landing couldn’t be worse. A central government enforced restructuring is highly likely. That said, as there are an estimated 2.8 million jobs at stake, there’s a Communist Party Congress in 2022 and Evergrande’s problems could be traced back to debt-tightening laws introduced by Beijing last year. That restructuring will not help foreign investors and companies; it will be strictly for the benefit of the domestic economy. One to watch for the impact on Australian markets over the next few weeks.
- Spend like the Great Gatsby
Here’s a wildcard: the last time we saw such a massive global suppression of freedoms was the Spanish Flu of 1918-1920, which, when it finally abated in the early 1920s, led to the greatest consumer spending boom in history. Low inflation and booming share markets caught relatively inexperienced central banks unprepared, and the party was allowed to run for too long.
Whether we get the more depressing phase of that history is very uncertain, but there is a strong chance of a significant increase in discretionary spending by consumers and balance sheet spending by corporates as cash reserves in both cases are very high at the moment.
- Spreads to tighten
And finally, due to Gatsby companies looking for M&A activity, and in the near term due to central banks ceasing bond-buying programs as the RBA just announced, corporate bond spreads are likely to tighten. Quality will matter more than usual as the pandemic will leave some sectors particularly vulnerable and we won’t have seen the impacts of that yet. But overall, expect corporate bond spreads to tighten across all credit ratings and across the yield curve.
So Where Should We Be Looking?
Predicting the future is never easy, but intuition often provides the first clues. Data can then be used to test whether there are early signs that your intuition was right. Because investing in bonds is a long-term strategy and isn’t the domain of day traders, I have always looked at trends that could drive prices over the next 3-10 years. Using some of those predictions as examples of where to look for tomorrow’s market trends shows where some clues might be hiding.
Stay tuned as we fill in the details on these and other trends hitting bond, equity, and currency markets over the next few years.