The politics of trade protectionism, nationalism, and anti-immigration are the match which will ignite dormant inflationary gasses bubbling underneath the surface after years of short-sighted monetary policy experiments.
Governments have failed for several years to enact meaningful structural reforms that would set economies on a more sustainable path. This is just now beginning to lead to the realization of painful, inflationary solutions. Losses in real wealth and spending power for many advanced economy citizens in the name of “economic competitiveness” and “growing out of debt” are under way. Central banks are somewhat subtly engineering an inflation overshoot as it is implicitly understood that government gridlock, corruption, and incompetence are preventing wiser legislative solutions from coming to fruition. Central banks have been “the only game in town,” as coined by Allianz chief economic advisor, Mohamed El-Erian. In other words, growing out of debt with real growth, innovation, and productivity gains is much less likely at this point than inflating out of it with falling real wages, lower standards of living, and stagflation.
Real average hourly earnings in the US fell by 0.5% in January versus the prior month; nominal wages rose by 0.1% while the BLS CPI-U Consumer Price Index increased by 0.6%. Even excluding energy, nearly any measure of consumer prices leads to a trend of deteriorating real incomes and saving rates going forward. Bank of England Governor Mark Carney has warned of accelerated losses in purchasing power on the way for the United Kingdom.
While the UK’s 20.5% year-over-year manufacturing input price inflation in January was largely inspired by pound sterling depreciation after voting to leave the European Union, the reflation trend is a global phenomenon. Germany, Norway, Sweden, and countless emerging markets including Mexico, China, Chile, Turkey, and Egypt, are experiencing a pace of wholesale (PPI) price increases faster than has been witnessed since at least 2011. PPI increases of this magnitude are generally a leading indicator for CPI to follow suit, though wholesale businesses will absorb a portion of the input cost increases through margin contraction.
I have been warning about building inflation risks for the past couple of years. Contrary to what new Keynesian economic advocates will have you believe with their gravity and logic defying models, there exists a simple mathematical problem of too much debt and not enough productivity to legitimately grow out of it in developed nations with aging demographics.
Prominent demand-side economists such as Larry Summers have been advocating currency debasement, money printing, debt-fueled fiscal stimulus, and interest rate repression continually since the financial crisis. Paul Krugman famously called on then-Fed Chair Alan Greenspan to create a housing bubble in 2002 to replace the .com bubble bust. This cyclical mentality of monetary bubble manufacturing has been blind to the secular economic rot festering underneath those same policies. It has also had unfettered control of the levers within the world’s most powerful central banks for the past 20 years. Financial history books will eventually hold these highly flawed policies and their proponents accountable for doing little other than fueling the next great bubble—the credit bubble. Or, as I alternatively call it, the global QE bubble.
Keynesian economists calling for debt-financed spending, ultra-easy monetary policy, and demand-pull inflation during a period of economic stagnation is nothing new. It isn’t only the usual suspects, however, singing the inflationary gospel now. That is why we are at such a significant inflection point. The populist right is winning political momentum and its policy prescriptions are astoundingly inflationary—border taxes, import tariffs, currency debasement, immigration restrictions limiting the labor market supply, etc.
Economic populism is credited with giving birth to the new political paradigm. Its recent “scalp prizes” were supporters of the UK staying in the European Union and the entire US political establishment. Lines between the traditional political left and right have become blurred in the developed world. Right wing populist candidates are closely vying for power in the least likely places on earth one would expect—the Netherlands (Geert Wilders) and France (Marine Le Pen).
Established politicians and their party infrastructures are more at odds with each other than they have been in decades. Yet, grass roots supporters of what are typically opposing parties have converged as strange bedfellows in supporting several key areas of common ground: reforming global trade rules with the intention of better protecting their own domestic workers, reducing cronyism within big government and big business, decriminalizing marijuana, and protecting civil liberties from government overreach, to name a few.
US President Donald Trump has lashed out concerning a too-strong dollar and flirted with altering a decades-long US strong dollar policy. France Presidential Candidate Marine Le Pen wants to leave the euro currency bloc, take control of the central bank, kick out the immigrants, and print money to fund social spending; and this is coming from someone widely considered to be of the political right wing. What could possibly go wrong? This has not gone unnoticed in the FX market or the French bond market. I’m afraid we haven’t seen anything yet, however.
These inflationary macro trends will continue to surprise many, even if Le Pen is not victorious in the France elections this year. The easy monetary policy leanings of the establishment-left and nationalistic fiscal policies of the populist-right are in alignment. They are both clamoring for a wave of higher consumer prices to erroneously “fix” structural problems of high debt and low labor productivity. It is completely illogical and will only have the opposite effect, but that is beside the point.
I sensed a stronger populist undertone than given credit by the press before the UK referendum to leave the EU and before the US presidential election. My base case doesn’t currently have Marine Le Pen winning the France presidency this year, but there is little room for error in the upcoming election season in Europe. Economic populism is here to stay due to the alignment of interests between grass roots supporters of opposing parties against political elites in general.
Punishing the globalist-minded political elites who have presided over declines in living standards for middle and working class Average Joes throughout the developed world is no longer exclusive property of the hard left. The populist right wants to make its dent in the elites’ armor as well. The result of anti-elite political sentiment will have profound impacts on financial markets for the next several years and some of these impacts are relatively predictable.
Behind the tire marks of the new anti-elite political paradigm exists a trail of how we got here. Gross mismanagement of government budgets globally and the inability of labor to share in the economic gains created during the previous period of high productivity have contributed to a deep structural hole that might prove too deep to escape with a “healthy” type of growth. This is especially the case given the drop off in productivity in recent years and aging demographics. It has also created outrage amongst the masses who feel duped for trying to play by the same rules the elite class gamed in order to gain even more wealth; ie, the carried interest deduction allowing billionaire money managers to pay lower tax rates than electricians.
The current hot topic of “low productivity” is often lazily discussed as if it is the reason real wages have been stagnant (or falling) for decades. Low productivity is more of a post-Great Financial Crisis phenomenon probably caused by a misalignment of corporate incentives. With Zero Interest Rate Policy (ZIRP) and central bank quantitative easing (QE) flooding the capital markets with fresh cash, why invest in new equipment to improve worker productivity when you can simply borrow for a negligible cost and use the cash to immediately fund common stock buybacks, dividends, and M&A? Excessively easy monetary policy distorted market dynamics and reduced incentives to increase productivity. Additionally, governments used the temporary benefits of monetary stimulus as cover to avoid taking more unpopular measures to improve their structural situations.
A decade of global central bank activism paired with several dysfunctional governments did not permanently address very many structural issues. What it did is limit the immediate severity of the 2008/2009 financial crisis, inflate asset prices to bubble territory, boost employment mainly for lower paying service sector jobs, and change the composition of the next recession to an inflationary debt reset rather than a deflationary bankruptcy-based debt reset, thus destroying responsible savers to the benefit of debtors.
What kind of a market environment will persist in a political climate of economic populism combined with excessive global debt? Real wages will take a beating initially, as will fixed income markets. Equity indices will be tugged higher on the illusion of inflated corporate earnings and then yanked lower after resulting interest rate spikes. FX rates will have multiple “Brexit-esque” caliber events, causing pockets of illiquidity and displacements in rates. A targeted Chinese yuan devaluation of 15% or more within 1-2 years is likely as one prime example. Any implementation of border taxes or tariffs designed to protect domestic workers will likely be met with retaliatory actions that will greatly harm those same workers, unless the new trade rules are negotiated and agreed upon by both sides. Bilateral trade deal negotiations and politics could be the chief drivers of global markets for the next five years in the same way monetary policy divergences drove markets in the past five years.
The best case scenario is governments use a period of unsustainable increases in budgets and financing costs over the coming years as political cover to get leaner, more efficient, and more responsive to the needs of their citizens (hopefully this doesn’t cause readers to erupt into spontaneous laughter). In a glass-half-full world, wages will eventually catch up to price increases. Those who are unemployed, retired, renting their primary residence, net savers, or whose incomes are not closely tied to actual inflation will feel like they were on the wrong side of a crash. It probably won’t be a traditional nominal price crash so much as a crash in real terms; however, there could be flashes of both.
Ultimately, the same forces that have always been responsible for real wage increases and higher standards of living still hold true: high productivity, broadly enjoyed technological innovations that lower costs without displacing too many workers, and a peacetime dividend enjoyed during times of no major war conflicts. Does it seem like we are headed toward this scenario?
Remember this: when someone tells you the surest path to economic prosperity involves devaluing your savings, lowering your real wages, and paying down old debt with new debt—run away and call the police—someone is trying to rob you.