Inflation, Growth, Debts, Economic decisions and potential outcomes of those on asset prices

1.) Drivers of economic growth

In the past years Economists made different economic predictions based on past history.

There are two main camps. One camp is focusing on unsustainable debts and continuous money printing of Central Banks, the other is mainly focusing on technological innovations and used to say that this time is different. I m in a third camp. I do not believe in the this time of different mantra, but neither of mystification of the debt problems. Main drivers of the world economy are not really changing. Population growth, capital expenditures and technological innovations not related to physical capital stocks are driving global GDP growth. Growth used to slow, if one or more out of these elements slow. Debt has an effect as well. If we go through these elements, then we can clearly see, that global population growth is slowing down and in 30 years it will go to 0. Number of active people will top out around 2070.

In the past 50 years change in the number of active people was responsible for 1-1,25%/year economic growth and this will totally diminish in the next 3 decades. Growth in capital stock was responsible for an additional 1-1,5% and the rest came from technological developments and from change in labour productivity.

2.) Disappearance of global savings glut

Lately growth of capital stocks came through large debt buildup, due to large infrastructural developments - firstly - in the developed markets (until 1980) and after 1980 in the emerging economies, mostly China and South-East Asia. Latest wave of infrastructural developments resulted in an unprecedented debt build up. Further infrastructural developments cannot be financed from savings, if interest rates could stay where it was 3-5 years ago. In the past 10-15 years Central Banks stepped in and indirectly started to finance these developments through QE. The unprecedented QE was able to keep interest rates artificially low and have led to many distortions. After the pandemic we are left with very high government debt and there are still certain amount of leftover funds in the system, which keeps inflation a bit elevated.

3.) Questions of Medium term inflation

Global savings rate have started to drop, which is coupled with growing investment needs in the developing countries. Energy revolution and the growing appetite of emerging markets for many commodities will drive up demand for certain commodities more and more.

3.a) Commodity prices

Lots of investors are worried about a generalized commodity boom, which could be reflected in global inflation. I m not so worried about it, since internal weights of CRB index is tilted towards fossil fuels and grains, where prices can stay relatively stable, since demand for those will not rise so dramatically. There could and will be larger problems around basic materials, since demand for those will double in the next 25 years and such demand growth can not be matched by the increase of supply, if prices will stay where it is as of now. About 4 percent weight in CPI will be severely affected in the next 25 years and an additional 10-15 percent will be moderately affected. Those goods are tied to energy revolution and infrastructural developments. Price growth of such commodities and products tied to those, could outgrow overall inflation by 2,5-3 percentage points every year, which will push inflation higher by 0,35-0,45 percent/year as an average in the following 2 decades.

3.a.1) Medium term supply and demand mismatch in basic materials

Given, that demand and supply mismatch will be the most apparent in the first 5-7 years, until prices will not reach a new equilibrium, which will allow new mines to be opened en masse. Fossil fuel price inflation could stay lower than the overall inflation, due to topping consumption, which could substract 0,2 percent from overall inflation. Grain prices and agricultural commodity inflation could add something to overall inflation due to climate change, but it is difficult to be measured. As an overall impact of commodity inflation, global inflation will be 0,2-0,3 percent higher in each year as an average, but worst effects of this could/will be seen in the next 5-7 years until new mines are not opened and Global economy does not adjust to higher demand of emerging economies. We should not exclude, that until the end of decade, just thee will add about 0,5 percent to annual inflation.

4.) Effects of AI and technological innovations on inflation/growth

Artificial intelligence and technological innovations can supercharge the growth and even could lower inflation, but not until it will not have substantial share in the Global GDP. Tech spending and AI related spending will grow by 40 percent/year in the next 4-6 years, which could result in some more inflation in this decade, but could lower inflation afterwards and could supercharge economic growth from 2027 onwards.

4.a) Medium and long term price effects of AI

At the very beginning AI spending is mildly inflationary and does not have visible effect on growth, later on will be deflationary and its effect could be very large on economic growth. AI and tech spending could add 0,2-0,25 percent to global inflation (at the beginning) due to heavy spending in the next 5 years, but after its effect will be rather deflationary, then inflationary.

5.) Central banks should recalibrate their monetary policy, questions of neutral rate.

These above mentioned 2 factors will add 0,7 percent/year to Global inflation until the end of this decade, which should force Central Banks to recalibrate their monetary policy. At the same time savings/investment imbalances have started to grow (global household savings are projected to drop by 4 percentage points until 2050, meanwhile investment ratio needs to be raised by minimum 2 percentage points, just because of the needed infrastructural and green developments). Such imbalance could add 0,3-0,4 percent/year to the global inflation (this can be avoided, by more restrictive monetary policy), if monetary policymakers will stick to their previous 2,5-3 percent neutral interest rate assumption.

Higher debts and the much needed infrastructural developments, coupled with lower household savings rate result in higher neutral rates. The described long term structural changes will result in higher nominal interest rates than in the past 15 years. If we believe, that global growth will pick just due to stronger growth in emerging markets, then we must assume, that interest rates must be minimum 1,5 percent higher than in the past 10 years. Given, that interest rates were lower than neutral most of the time, we should not be surprised, that interest rates should be minimum 200 basis points higher than in the past 10 years as an average.

These changes will require much more forward looking Central Banks. Alongside of these savings and investments imbalances will put further upward pressure on bond yields. Real rates are expected to stay substantially higher than in the past 10 years. These expected changes are related to the changing economic structures, but do not take into account the effect of lax fiscal policies, etc.

6) Profit growth and nominal GDP growth

We should not forget, that there are lots of positive aspects of these structural changes. Like higher" inherent" economic growth than in the past decade. Higher labour productivity and stronger overall economic growth could help to fund the growing g debt burden, if fiscal policies will make the necessary adjustments. Due to the aforementioned effects profit growth can stay higher than nominal GDP growth, which could help to reduce the gap between equity valuations and cash flow generation, which is too wide as of now and makes stock markets extremely vulnerable to the downside.

When we make forecasts, then we need to consider 2 more important aspects. One is the debt trajectory of any given country and another one is geopolitical stability/instability. I view geopolitics and fiscal policies as external factors, which are a bit more difficult to forecast.

7.) Summary of internal factors of economic growth and inflation.

Let me summarize the internal factors. Inflation will be higher than in the past, due to climate change, other infrastructure related investments and due to some other mentioned factors. Economic growth could slowly pick up and could gain momentum, especially after the needed macroeconomic and multilateral adjustments will happen. These internal factors and corrections of the past excessively lax monetary policies will lead to substantially higher interest rates environment, but economic growth will not be influenced very negatively by that, as long as Central Banks understand the new realities.

The internal factors will result in minimum 200 basis points higher nominal interest rates and an about 1 percentage point higher global inflation than in the past 10 years, barring neutral fiscal policy and not worsening global geopolitical situation. Major Central Banks should not be so worried about such situation and should try to avoid to overreact to such medium term changes.

8) Higher equity valuations and lower corporate credit spreads than in the past

Global profit growth can be higher than in the past, resulting higher equity valuation and lower equity risk premiums. Equity risk premium should drop by minimum 150 bps compared to the past 10 years as long as real interest rates are not moving above 2,5 percent. Global corporate credit spreads should be lower as well, but it does not mean, that there cannot be any more cyclical widening.

The changes are rather positive and could result in a much better global economy in about 15 years. After such structural analysis let's turn our attention to the more problematic external factors, like fiscal situation and geopolitics.

9.) External factors (fiscal and geopolitical risks)

9.1) Fiscal situation

Let's start with the current and projected fiscal situation. The excessive fiscal spendings of the past 2 decades has pushed up (including US, EUR, China, etc) Debt to GDP ratio by 65 percentage points as an average compared to GDP and in some countries it was even more excessive. Cyclically adjusted fiscal deficits have risen by 3 percentage points in almost all major economies, except a few.

In a balanced economy cyclically adjusted fiscal deficit should be around 2 percent of the GDP, but now we experience 7 percent in US and 4 percent in Europe. Until now such fiscal deficit has been easily financed due to artificially low interest rates. In the past 15 years interest expenses of the major governments were running around 2-3 percent of their GDP, although debt to GDP ratios have moved to 100% or higher.

9.2) Rising debt levels and its effects on interest rates

Due to aging population and to constant fiscal interventions, primary deficit of the major economies have moved from 0-1 percent to 2-2,5 percent and unfortunately we can not expect any major policy changes until bond markets do not implode. The high fiscal deficit started to crowd out some part of the economy and puts constant upward pressure on bond yields. According to some estimations each percentage points increase in Debt to GDP ratio drives up interest rates by 2-3 basis points. This does not look too much in a 1 year horizon, but it is more worrisome on long term basis. In 10 years time it could mean 25-35 basis points higher real interest rates than now, which could lower GDP growth by 0,2 percent.

Considering my other forecast, that AI could start to drive down inflation by 0,3%/year from 2029-30 onwards and could push up GDP growth more and more, it could mean, that current trajectory of the fiscal policy could - at least partially - annul positive effects of AI.

9.2.1) The inverted yield curve and its forecasting power.

Most of the Internal factors (not all, since savings/investment imbalance is negative for long term interest rates) are pointing towards a structurally less steep yield curve, but cyclical factors plus debt dynamics of major economies should steepen the yield curve. Although the yield curve should steepen compared to its current state, but some structural changes lead us to less steep curves, even in case of heavier recessions.

One of the biggest economic warning sign is the inverse yield curve in most of the western countries, but due to the above and the later mentioned factors we should not overemphasize it. The last time when the yield curve was inverted for such long period was in 1928-29 and until now it has been one of the best forecaster of major economic crisis. Geopolitical situation was similarly tense in 1928-29 and fiscal problems were similarly big, but in those years not in the US, but in Europe. We have lots of similarities with 1928-29, but we have many differences. We should not forget, that corporate leverage are much lighter than in those year. Major problems are the governmental balance sheets. In a new crisis, governments will not be able to intervene without causing massive inflation. Inflationary pressures make difficult for CBs to come to the rescue again.

9.3) Balance sheets of States and Central Banks

Fiscal situation and balance sheet of Central Banks are in a bad shape, but a collapse is not imminent and the financial system can be saved/reformed. We are in the last hours, but the system is still curable, if current adversaries are willing to cooperate and build a new system, which could put the global economy on a more sustainable and stronger growth trajectory. The current situation is especially dangerous since there are many conflicting forces and those need to be handled in parallel.

If countries are not making joint efforts on climate change, waste management and biodiversity protection then we could end up in an irreversible situation. The current geopolitical situation is not helpful, since wedges among great powers are getting bigger. We are moving from a kind of unipolar world order towards a multipolar one, which we did not experience in the past 80 years. We have lived in bipolar, but never in a real multipolar world. When resources are scarcer and more countries are rising, then accidents can happen much easier.

9.4) Rising geopolitical problems.

I m more worried about the geopolitical problems than about anything else. We have serious conflicts in Ukraine, Middle East and the Taiwanese situation is not settled either. Geopolitical dynamics are more inflationary in the next 5-7 years (especially if those are mishandled), than anytime in the past 40 years and fiscal situation is more stretched than anytime in the past 80 years. At the same time rising emerging markets and technological innovations could provide unique growth opportunities, if regions/countries/people are able to cooperate with each other. Technological innovations and AI could help a lot. If we are able to move to a new more competitive multipolar world from the current one, without major casualties, then there is chance, that global economic growth could skyrocket. The game is not zero sum.

9.4.1)National security concerns and supply chains, inflation

Lets focus a bit on the changing geopolitical environment, which carries as many risk as opportunities. Globalization has slowed down and even reversed a bit. National security concerns started to disrupt the supply chains in many areas and tit for tat tariffs, sanctions are raising prices as well.

Nevertheless the move towards a multipolar world is not totally inflationary, since more competition among Great Powers could be deflationary in itself, but current block behavior of major economies overshadows downward effects on prices. Geopolitical problems in Ukraine, Middle East, Taiwan and in some other areas can turn out to be very ugly, which could drive up prices and could create major economic recession.

9.4.2) Mentality of politicians, populism or cooperative behavior.

Mentality of the current politicians is more problematic than in the past. Most of them are thinking in zero sum games and are not able to understand, that cooperation could create many more opportunities and greater competition could create much larger cakes. Politicians used to compare the status of their own country to the other ones. When their own country have internal economic problems, then instead of reforming domestic economic policy they try to extract resources from others through higher tariffs, sanctions or by other means.

Current situation is especially dangerous since informations (fake and real ) are flowing much faster than in the past and it is much easier to influence minds of people than before. Populists are spreading simplistic ideas and selling - in reality non existent - easy solutions. It is more popular to blame an another nation on our economic problems, then try to fix those with unpopular political decisions.

Given that most of the people do not understand macroeconomic rules it is easy to tell them , that tax cuts are good, which will raise economic growth, etc, then to tell them them that fiscal deficit should be put under control because imbalances are too large and that could raise prices and interest areas, etc. Very few politicians are willing to take serious and unpopular decisions and explain, that those decisions must be taken for the sake of future generations.

9.4.2.1) The way of handling of US fiscal imbalances will determine many things

Given the large fiscal imbalance in the US economy, temptations for populist policies are getting bigger in many places. The situation is especially dangerous now, since US unemployment rate is historically low, but fiscal deficit is high. If a recession would hit the US economy, then fiscal deficit could easily move to 8-9 percent even without fiscal stimulus . Everyone (including friendly countries and adversaries as well) knows, that adjustments needs to happen. At the same time rising powers would like to remake the existing the current global governance and are asking much bigger say for themselves. Almost all major multilateral/global organizations need a complete revamp. Weights, votes, etc need to modified. There could be good adjustments/reforms or bad ones.

If geopolitical situation worsens and/or more populist economic policies will come in some major economies (mostly US), then chance for geopolitical escalation will grow dramatically. We should also not forget, that there is no chance for fiscal stimulus among the G7 countries at the foreseeable future and only China has some fiscal leeway among the major economies.

9.5) Potential political resolutions

9.5.1) Populist, irresponsible resolution and its effects

American President understands the seriousness of the current fiscal situation and vulnerability of US and will try to put US fiscal house in order by populist policies.

a.) Introduces large tariffs on all imported products. New tariffs can be between 10-25 percent for the so called friendly countries , and between 30-100 percent for the unfriendly countries.

Answers for such measures and its effects: Most of the countries will retaliate, which could create major supply chain problems. Although such steps could temporarily reduce US fiscal deficit, but could immediately result a global recession and a jump in inflation.

b) US government decides to make a change within FED and the President appoints super dovish members and forces them to reduce interest rates.

Effects: Strong upward pressure on prices and potential collapse of the USD, which will push up import prices and destabilize the US bond markets. Super steep yield curve and skyrocketing gold price.

c) Across the board tax cut to stimulate an already hot US economy.

Effects: Stronger growth, but more macro imbalances

d) More sanctions (secondary sanctions) against adversaries to create more space for US goods. USD is used as a real weapon.

Effects: Higher prices everywhere, but temporarily stronger US economy. Pace of dedollarization quickens and USD looses its major reserve currency status.

Although such populist measures could create global economic chaos, but short term could stabilize the US economy, but at the expense of other major players. The most important countermeasure would be tariffs and an implementation of a new alternative financial/payment system. In case of populist resolution Trade wars will become the new normal and fragmentation of the global economy will be much more visible.

As a result of such steps Asia/Africa could be economically consolidated under a BRICS+ umbrella, Europe, part of LATAM and some Asian countries under a US umbrella. Such populist measures could dramatically slow the global economy and would ensue a painful asset price correction. Wars could become quite frequent and supply problems could be more visible in many places.

Although US has a chance to be economically successful in such case, but only in case of it will be able to consolidate the developed economies and some major Asian economies (including Russia) against China. I'm not saying , that such policy cannot succeed, but it is difficult and global casualties will be big, and potential economic rewards will be substantially smaller than in a cooperative game. Such populist policy will lead to subpar global growth in the next 10 years similarly to the 1928-38 period and most probably, but not inevitably will end up in a large war. If China and Russia will stick together and China will be willing to finance Global South, etc and even India, then outcome of such US economic strategy will be horrific for the Western societies.

As I have described there are two potential resolutions of the current stalemate. A populist one will result in more fragmentation, more sanctions, much higher tariffs and higher prices, which will eventually culminate in major economic conflict among the great powers, starting sometime next spring . In such case we will be barely able to avoid larger (nuclear exchanges) military conflict and supply chain issues will be much more problematic than anytime in the past. Commodity prices will start to move higher in tandem with the worsening situation between RUSSIA/NATO, RUSSIA/CHINA/NATO. Major chokepoints will be under constant pressure and logistical costs will skyrocket again. In such case a strong global recession will start sometime in 2025 and inflation will move substantially higher.

9.5.2) Growing risk of massive Chinese liquidations and asset price corrections.

Even a hint of such policy could result in massive Chinese liquidations. Situation could get similar to 1928-30, when trade wars were frequent and impact of those were very severe. Although technological advancements and inherently strong growth among various emerging markets lessen the chance of a new Great Depression , but asset price changes can and will be very dramatic. US equities could drop by 30-40 percent and US companies could loose their access to fast growing emerging economies.

9.5.2.1) Massive Chinese economic stimulus and its effects

Initially China could get a large economic hit as well, even bigger than in US, but they could counterbalance it with a large scale fiscal/monetary stimulus program plus by withdrawing liquidity from western markets. We should not forget, that Chinese inflation is extremely low and China did not enact any serious fiscal stimulus in the past 5 years, not like the Western economies, which have exhausted their fiscal buffers. In a potential economic and financial fight between West and East, firstly China could get bigger hit, but after 2 years China could come out stronger, due to their larger fiscal and monetary buffers and their ability and willingness to financially consolidate BRICS+/SCO.

9.5.3) A cooperative resolution

Currently I put 35 percent chance for the populist resolution and 65 percent chance for a cooperative resolution, but risks are extremely high, if populists will get an upper hand in the next 6 months. I hope, that some major corporates and more traditional players understand the seriousness of the situation and will do everything to support the cooperative solution and those who understand the seriousness of the situation. Populist resolution will take us into major economic and political calamities, but cooperative solution can create much better economic wellbeing and could supercharge global economic growth.

Cooperative resolution will lead us to lower inflation, higher economic growth and more stable geopolitical situations, the populist solution will result in higher inflation, much slower economic growth, lower asset prices and it risks to ignite major wars.

A cooperative resolution needs major revamp in global financial/economic/political architecture and technological companies could be a big help in this.

Summary

The world has drastically changed in the past. 15 years and will change even more in the next 10 years. Both the risks and the opportunities are getting much bigger. Any miscalculations could have very serious consequences. Success depends on proper actions of each of us. Either we simply go back to the past or we build on our past experiences and fix the bad ones and start to move forward . We should avoid to take simplistic populist steps .

Peter Heim

Main Promoter of Seraphim's Trust (a cooperative, technological solution)

Budapest, 05/26/2024