The Transition to Transition

Markets ponder what's next for the global economy, but tectonic shifts in supply and demand will make sustainable balance impossible for now

I once heard a wise diplomat describe his country as undergoing “a transitional period.” After a brief pause and a wry smile, he clarified: “It’s a transition from one transitional period to another transitional period.”?

Unsatisfying, perhaps, but this may nevertheless be the best way to think of the current state of the global economy and the outlook for markets. For investors, it’s a time to watch carefully, avoid sudden moves and await a more settled combination of geopolitical and macroeconomic forces. Government and corporate bonds still look attractive, especially compared to the steep valuations in many equity markets, but it’s probably unwise to bet heavily on that we are on the verge of either boom or bust.

Consider the different transitions we have lived since first learning of a deadly disease spreading from Wuhan. There was the alarming shutdown, which in Boston, meant frequent robo-calls from the mayor with urgent pleas to stay inside and wipe everything down. Then came the dramatic government response, which started the day the Federal Reserve announced aggressive programs to stabilize bond markets and continued through the first rounds of vaccinations. Soon enough, this sharp recovery?morphed into a third transitional phase as central banks began to grapple with the first persistent inflationary surges they had seen in four decades.

This launched the current ‘transition,’ in which sharp and mostly synchronized interest rate hikes seem to have slowed inflation, but have yet to bring credible price stability. Increasingly, there is more certainty that the next phase will not set new highs in the “misery index” – that simple-minded, but politically potent sum of unemployment and inflation. For the United States, this peaked at 20.98 in June 1980 and currently stands at 7.73. For now, the big mystery around inflation is how fast it will fall; the main question around unemployment is when it might finally drift up from current historic lows.?

Europe, which suffered an inflationary shock from high energy following Russia’s invasion of Ukraine, now benefits from falling oil prices. But the stubbornly high ‘core’ reading that excludes energy has kept the European Central Bank signaling more policy hikes. The end of China’s lockdowns this year was once viewed as a likely boost to global demand, but now seems to be sputtering.

There are two main candidates for the next phase of the global economy.?

Lately, markets are pricing in yet another burst of fear that central banks still haven’t tamed prices. Fed minutes promise more summer rate hikes and the European Central Bank is still tilting hawkish. This is a world in which persistent consumer demand, poor monetary transmission mechanisms and further reorientation in supply lines will make it hard for the economy to cool. This is a world in which U.S. inflation and interest rates continue bounce in a range above 3% through this year and next. This is a world in which central banks remain in tightening mode long beyond even current expectations. Presumably, it’s a bad period for government bonds, but perhaps good for commodities, corporate credit and stocks of companies that can pass on their own rising costs.

The second most likely next phase involves a rapid cooling of demand, when inflation falls decisively below central bank targets of 2%. Call this the “old normal” as globalization, technology and demographics undercut wages and dampen demand. If this is hard to see in the latest U.S. jobs numbers, just think of the precarious state of commercial real estate, the tightening corporate profit margins and weakening manufacturing sector. Economic weakness that forces monetary accommodation is a great world for bonds and, given mild recessionary forces and a weaker dollar, can also favor Emerging Markets.?

But if these are the likeliest next chapters, neither one looks set to persist for very long. Simply put, the forces that shape the balance of global savings and investment remain very much in flux, as do the growing impacts of technological and geopolitical change. Baby boomers may no longer be saving as much, but it’s unclear how quickly they will start to spend those savings in retirement. China’s surpluses persist, but its reliance on exports continues to fall.?

Meanwhile, political leaders insist on more secure (and therefore more expensive) supply chains and most developed countries are planning significant new outlays for national security and the climate transition. Normally, it would be easy to view these as sure-fire fuel for a period of lasting inflation, but astonishing new applications of machine learning and blockchain seem likely to upend the global workforce in ways that will severely dampen wage and price growth. For now, it's impossible know which will prevail.

My current bet is that recent markets are largely right that the next phase will see central banks fighting to restore credible price stability given the persistent strength of household and corporate balance sheets. But I’m much more certain that whatever comes next won’t last for very long. “The only certainty is that nothing is certain,” wrote the Roman philosopher and commander Pliny the Elder. Or as my thoughtful diplomat would suggest, everything is always in transition.?

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