By David Matias
August 26, 2022 – As the summer of 2022 comes to an end, the world looks like it is slowly turning upside down. Drought, war, pandemic, epic heat waves, and inflation are all in the headlines and on our minds. The confluence of these events is not entirely coincidental, nor are some as dire as they sound. The summer will be over in just a week, and fall rains will replenish the barren landscapes of Northern Europe. The war in Ukraine is entering a critical phase, with the tide slowly shifting against Russia and European assistance continuing unabated. Natural gas — Europe’s achilles heel — might not bring the continent to its knees as some have predicted, given summer’s stores and new LNG ports coming online in the spring. Yet all of these events are concerning for a simple reason — what comes next?
From our viewpoint, inflation is the most pressing issue at this time. The Fed has taken very aggressive measures in raising rates while signaling that it will continue to do so for the rest of the year. The two-step process that the Fed has employed over the past decade was to lower rates in combination with trillions of new money pumped into the markets (Quantitative Easing or QE). Now that this process is being reversed, the Fed is scheduled to expand the process of reducing their balance sheet by up to $95 billion per month starting next week. With eight trillion in total on the balance sheet, this may not sound like much, but in terms of asset flows it is a significant amount, most of which will occur in the Treasury market.
The process of Quantitative Tightening (QT) will impact the bond market initially, and then slowly filter into other asset classes, from equities to crypto. The impact of QT and higher rates is already starting to show in the inflation data, with July’s inflation relatively tame as compared to prior months. Granted, the drop in oil prices helped tremendously, along with the natural process of peaking prices as panic subsides, but the trend is encouraging. It will take several months of consistent declines before the Fed changes course, but the immediate concern over runaway inflation is, for now, alleviated.
For the fall, all eyes will be on the jobs market and wage pressure. Typically, persistent inflation is rooted in wages and the cost to employers, which fortunately have not been the main driver in this cycle. Nevertheless, we are still in a very tight labor market while a wide swath of the labor pool has contracted significantly. Namely, we have seen a reduction of young men in the labor pool, creating all sorts of disruptions in our most basic services. The good news is that wages are finally starting to catch up to years of lagging behind inflation, helping those on tight budgets. The bad news is the timing — a tight labor market on top of challenges in filling basic service jobs may cause further upward pressure on wages, making them a future contributor to inflation. It is a good news/bad news scenario, but given the Fed’s aggressive rate hikes and a pending recession, any persistent wage pressure should be offset by layoffs and a greater pool of available workers.
The rest of the world, however, is not faring as well. Drought is causing serious concern across Europe and Asia and isn’t likely to change anytime soon. Water is one of the resources that has been assumed to be readily available in the industrialized world, an assumption that is now coming under pressure. As reported in Foreign Affairs, China has spent decades depleting their aquifers and dumping chemicals into the groundwater at levels that threaten the long-term viability of their manufacturing industry. Europe has also taken for granted the ability to use major rivers to transport goods, rivers that have gotten so low this past summer that water-based transportation has come to a slow grind. Just this past week the level on the Rhone was so low that ships have been reduced to carrying only 25% of their typical cargo.
The prognosis is for adaptation… and sooner rather than later. Whether it be water or any of the myriad of climate change crises, the world as we know it will have changed permanently by the end of this decade. The “hysteria” around climate change is justified, and it’s happening in ways that we cannot anticipate. From rail lines in England to water filtration in China, the world is going to have to deal with major environmental changes. We have the technology to do so, but the cost will be astronomical. New or burgeoning industries will thrive while many will suffer. Nations will protect their resources and states will scramble to attract new residents and investment. In short, change is coming at an accelerated pace, and those who can adapt will survive and maybe even thrive.
Adaptation is exactly what we might see in the U.S. over the medium term. Thanks to the Inflation Reduction Act passed by Congress and signed into law this month, the U.S. will again be at the forefront of addressing global climate change. With $369 billion in climate and energy provisions (Politico, August 7, 2022), slated to be deployed this decade, this legislation will be a boon to the economy unlike anything we have seen in a long time. We could be looking at the beginning of a new economic era of climate technology and implementation—not unlike the internet era that was spawned by Department of Defense spending.
While this legislation is a tremendous move forward, we still face a major domestic vulnerability. The basics of labor markets and immigration are working against the prospect of strong future economic growth. Depending on which estimates you use, finding enough worker growth to support anything beyond minimal economic growth heavily relies on immigration. By some measures from JPMorgan Chase, three-quarters of the future labor growth will need to be immigration (J.P. Morgan Asset Management – Guides to the Markets 2Q 2017).
Sadly, in the past few years we have shunned those folks in the surge of nativism and nationalism. Barring a major change in productivity, U.S. growth will never go back to where it was. Not to dismiss the possibilities of AI and Machine Learning, but it takes many years for technology advances to make their way into everyday worker productivity (remember how long it took before Microsoft Word actually improved people’s lives?). Two percent annual growth — well below our long-term average and behind all the emerging economies — will be a stretch at best.
For a broad stock market investor, it is a mixed picture. Relying on the traditional stock picking techniques, such as firm profitability and macroeconomic growth, it will be a challenge to find persistent growth. But it is important to remember that the tech sector today — the core driver of stock market returns for the past decade — was a nascent sector in 1990 and didn’t exist in 1950. Imagine investing in a world in which Apple and Google don’t exist. With climate change technology just beginning to take shape, and trillions yet to be invested globally into climate remediation, the playbook for stock investments may be re-written yet again.
Until the mix of challenges in climate change, inflation, global conflict, and immigration is better understood, investing in reliable and relatively safe structures will be a sound path forward. While bonds may not be as exciting as crypto, they do accomplish something that crypto has failed to deliver — stable returns. We have also seen a vast push of money into private funds and private investments. While these pools lack the kind of regulation and transparency of the public markets, when chosen wisely they yield very impressive returns with less volatility than the stock market. Especially as the climate change industry emerges and matures, these private pools might be the best avenue for long-term investment goals.
In the interim, I hope you enjoy the closing days of summer, and may the fall bring some welcome changes in the world.
DBM