Year 2023 in Hundred-Year Perspective

Where are we, and how did we get here?

·???????Unprecedent measures result in massive consequences. A palliative approach to resolving problems extends the existence of the latter, but issues themselves might be also misunderstood. Alan Greenspan’s policy was probably a part of a long cycle, and not a purely individual strategy. Thus, it all is not about “personal mistakes”, it is about cycles.

Going into 2023, almost anywhere we look, a troubled picture emerges before the eyes. The Covid years now behind us, the hope for things to return to their usual state becomes elusive. The “this time is different” scenario does not end.

The irregular state of the economy is more than explicable. After the credit crunch and the ensuing Great Recession of 2008-2009, fight against deflation evolved into a series of QE, an unpreceded strategy by global central banks, a step that bought us a few years of a wobbly economic growth, but a long sky-high rally in financial assets.?Central banks of the world, firmly concentrated on the deflation threat, followed, in general traits, the BOJ strategy from its “lost decade(s)”, but did that with a more ardent passion, applying heavily their once chosen silver bullet remedy every time when the sluggish growth was starting to limp again and the markets were staging deeper corrections. That remedy is ZIRP and QE, aka “helicopter money”, denoted so by Ben Bernanke. Governments were also voluntarily contributing to this liquidity bonanza that led to another impressive jump in the amount of public debt outstanding.

Further on, Covid-19 broke in, hurting in a horror film mode the unsure economic revival. It created a previously unchartered economic scenery, in which monetary authorities did not hesitate to apply their “helicopter money” weapon again to avoid new disaster. A series of weird economic phenomena, partly exogenous, partly fabricated, voluntarily and involuntarily, by deflation busters, finally led us to the rather specific point where we find ourselves today.

Unanswered - or partly answered - questions are getting on us again and again. We can easily recall those numerous voices that blamed the Great Recession personally on Alan Greenspan, who was the first policy maker to ease monetary policy to that utter stimulative threshold and to keep the easy money for so long. Was that a fully justified accusation? Not an easy question to me. On the one hand, given the shape of economy in late 1990s and early 2000s, decreasing key interest rates turned out to be a logical and an effective lever to help things getting out of the economic mess. Matured market economies were becoming more and more dominated by their financial segments, and the role of central banks was growing proportionately.

On the other hand, the question is not about an excessive role of the key rate, but whether interest rates were set by the Fed too low and for too long. Given that the rates were on a steady downslide as long as since mid-1980s, for 15 to 20 years in a row, the Greenspan stimuli do not look absurd. Fed chairman only was surprised to face also falling long-term rates, that should have been not affected by central bank’s policy (remember here Alan Greenspan’s “conundrum”, widely discussed in late 2000s.)?

Maybe, more measures had to be taken at that time, like tighter bank regulation as an instance, but it was obviously beyond Greenspan’s doctrine and, in certain cases, authority. Greenspan came to replace Volker, and he turned out to be the antipode of the latter in a certain sense while managing the US monetary policy. The next five terms of chairing the Fed were his golden era: the public had few real reasons to complain about his two epic rounds of monetary easing, in mid-90s and early 2000s, as the economy managed to overcome the crises gloriously, and finances prospered - unless the Credit Crunch exploded to cut the achieved prosperity in a brutal way. Still, it was not all probably about Alan Greenspan personally, but about the intrinsic logic of a certain long economic cycle. ?Of which Greenspan was an important constituent, of course.

When numerous episodes of irregularity line up to build a complete and uncut picture of uncertainty, this might happen not by occasion, but because of a new, formerly hidden consistency starts to reveal itself. In the days of Bernanke, the 20-year long trend of falling interest rates finally hit its bottom: nominal negative rates were the only territory where monetary policy was able to develop further on in its old paradigm, as all other options had been already in play; ZIRP and QE had been both applied. All for the sake of inflation and a steadier economic growth. The both goals were slipping away from the Fed year after year, bearing additional testimonies of a worn-out paradigm.

Tout à coup, monetary authorities have obtained what they were aspiring to, but did not expect to get it as it really came: inflation itself, but all in unwantedly large digits. As it started straight after Covid-19 disrupted numerous global supply chains, and stimuli designed to alleviate the epidemy impact allowed a large number of people to withdraw themselves from the ranks of potential labor force, hope was that high inflation would be nothing but transitionary. That is still disputable, though. Today, seems like the war in Europe may help high inflation to stay for somewhat longer. In addition, despite early signs of wage inflation to ease, the actual inflationary remains very high, and its future trajectory stays unresolved; I’d prefer to be cautious on this.?

On this background, as it has been said, at present, the long historic downtrend of interest rates has been broken by US Trys yield shooting well beyond its upper border. Farewell to Greenspan’s epoch now!

Outlook for 2023

·???????The figures are worrisome, but glimpse of hope loom. A false hope? The main questions are: 1. So, is inflation transitional, or is it here to stay? 2. Can the Fed normalize with a minimal pain? 3. Is it able to “normalize” at all?

So, what do we get? The Fed started tightening in the briskiest way on record, four points up in seven months (compare, e.g., to 4 points in 23 months in 2004) but the markets are still just eager to catch any glimpse of hope of a more contained hike or of a pause to keep the long, once Fed-induced uptrend in equities and other assets. This would not be so easy if Fed normalizes furthermore, as fast or slower. Anyhow, the high inflation might be already stepping back reluctantly in the face of a global economic slowdown. But how far do they both go?

Inflation data overall remains painful: in the USA, October CPI was at 7.8% vs. the same period of 2021, in Eurozone in November it hit 10%, in Japan October figure was 3.8%. All those figures were within the highest range since late 1980s, but US data for October was the lowest since the year start. In Eurozone, CPI merely tiptoed slightly back from the previous month level of 10.6%, the multi-decade peak.

Core CPI in the named economies for the same dates was as follows: in USA 6.3%, in Eurozone 5.0%, in Japan 1.5%.

Overall OECD inflation totaled 10.7% in October, CPI ex food and energy at 7.6%, the highest level in about 30 years. G7 CPI was at 7.8%, ex food and energy 5.3%, all at the same multi-decade highs.

On the economic performance side, according to S&P Global, November flash PMI spectrum in the US looks nothing short of appalling. Flash US PMI Composite Output Index was at 46.3 vs. October showing of 48.2, marking the 3-month low. Flash US Services Business Activity Index registered 46.1 vs. October figure of 47.8, the 3-month low again. PMI indices at below 50 pts mean contraction.

November Flash US Manufacturing Output Index was at 47.2, vs. October of 50.7; this is the 30-month low. Flash US Manufacturing PMI at 47.6 vs. October figure of 50.4, a serious worsening and another 30-month low.

(Source:?https://www.pmi.spglobal.com/Public/Home/PressRelease/d9ef5b8294e24a6f876372b65141b93e)

More relevant headlines from the site of S&P Global: ?Global manufacturing PMI signals further steep worldwide trade slump in November, Global manufacturing downturn intensifies as firms cut capacity in line with slumping demand, Flash PMI data signal falling output in the US, Europe and Japan, but price pressures also cool, Flash PMI point to rising Eurozone recession risks, but price pressures cool as supply improves.

In Europe, PMIs from Markita are not good either: Eurozone Composite Output PMI at 47.8 in November, Manufacturing PMI at 47.1 and Non-Manufacturing PMI at 48.6. All new lows since early 2021. ?New car registrations in Germany in October, 2022, were below 2000 figures by roughly 1 mn, in UK and France by approx. 0.6 mn.

On top of this, Europe sees additional threats to its economy from the US Inflation Reduction Act, that is already luring businesses from the EU offering persuasive prospective advantages, partly of a non-market nature.

In China Official PMIs also point at contraction: Non-manufacturing PMI in November was as low as 46.7 pts, Manufacturing at 48.0.

Hence, a few scenarios of 2023 performance look plausible today:

1.??????Recession scenarios (more probable, 45% to 55%):

1.1.??Recession sparked off by Fed tightening that should result into the long-awaited disinflation, but might be brutal: as it emerged, so it may go,

1.2.??Major recession in the EU with a contagious effect elsewhere. EU represents about 25% of the world economy, contributing 20% to 25% to the S&P500 annual revenue. Some do not consider this dependence as very large, but this is obviously a matter of personal taste; even 20% look big,

1.3.??All-in crisis in China putting emerging markets on fire and reverberating through the region and the global investment universe. This is all but guaranteed, even with the Chinese growth slowdown in mind. A few times turmoil in China have seemed imminent, just to pass away silently. Despite the local economy being awash with debt at 270% of GDP, the authorities are always finding ways, if needed, to sweep parts of it under the carpet again, sometimes with more state-extended debt: a dubious advantage of a regulated economy that has been working, though.

2.?????Non-recession scenarios (less probable, 35% to 45%):

2.1.??Given the passing of a part of one-off factors, a step-by-step normalization of economy and smooth disinflation,

2.2.??Stagflation, the recent darling of many analysts. This scenario still might be considered given the impressive turbulence on the energy markets.

3.?????An obligatory residual of black swans (ca.10-15%)

Not so long ago, I was also mulling a version of a gradual negative build-up caused by the ailing risky debt market, mainly of the HY debt in the EU and, to a less extent, the US. But I would not add it here as a materially probable outcome. So far, forecasts of a possible HY debt crunch missed the point, while the market was secured by the Fed who did not choose to push monetary breaks too hard at that time. Actually, the situation looks different, and less favorable, for HY bonds. If the Fed becomes less cautious, it should aggravate furthermore. Nonetheless, first, the entire HY market is about 15% of the entire US bond market at face value, and may be even lower today, and, second, in 2022, the issuance of HY bonds already dwindled drastically in response to rising risks and expectations of Fed tightening: it dropped 77% vs. the busy 2021, borrowing is the lowest since 2008. The deficit of supply of that scale is by itself a supporting factor for the prices. Sure, it is inadvisable to wait for spreads to narrow, on the contrary, the spreads might increase if the Fed tightens more and if recession hits, but the overall situation here do not picture any spectacular and contagious crash going forward.?

Long cyclic approach based on crises

·???????If we take crises, like Great Depression and Great Recession, as pivotal points for economic paradigms, we can pretend there is periodicity. However, long cycles cannot have rigid limits in time. The purpose of huge crisis events is changing economic paradigms, or even socio-economic ones. “Creative destruction” should run its course. It is not so easy to say, whether 14 years after the Great Recession are we in a transitional period, or a new paradigm? Most probably, this is still transition.?

At this point, I find it challenging to try to answer a part of unanswered questions touched above, and to try to position the current unusual environment within the framework of a long economic cycle.

In attempting to do so, I suppose it logical to consider major economic crises of the past as beacons, or pivotal points of long economic cycles. I do not intend to dig dipper into this matter here, but to paint a general picture using pure facts.

Every large crisis which is bigger than a regular cyclical recession and a market meltdown occurring after approximately ten to twelve years of growth does not result in a correction of excesses, but in a paradigmatic shift. While a shorter cyclical recession and market correction are expected to end up in the liquidation of oversupply and a bubble in assets, a larger turbulence leads to the replacement of obsolete rules and principles for new ones. Consider, for instance, Kondratiev’s cyclical theory based on technological cycles, Kuznets’ demography-based cycles (waves), etc.

Let’s attempt to apply a cyclical approach to the year 2023.

It looks quite natural, that large cycles are not so rigidly defined in time, with their limits blurred by a high inertia of huge processes involved in their evolution. The Gold Standard (GS) as the major financial paradigm is considered to have started worldwide in 1870, with its adoption by Germany. But in the USA, the introduction of it is spread by historians over a rather time span, starting as long ago as in 1830’s. However, juridically, GS was enacted in 1900 via the Gold Standard Act passed by the Congress. The Act, among other items, fixed the price of gold at USD 20.67. If this date is taken as the official birth day of GS in the USA, it lasted there for approximately 33 years.

The Great Depression (GD) that was raging through almost entire 1930s, retreating and striking again, in its course led to the elimination of GS in its classic form. Generally, the turmoil was so violent, that it took WWII to finally heel the depression-stricken global, primarily, the US economy. The end of that epoch is marked by the Bretton Woods agreement of 1944, that installed the new currency and financial paradigm, although major elements of GS remained.

The big turn also affected the relations of the financial segment and the state, and the liberal approach of 1920s gave place to a stricter bank regulation and the emergency of a series of controlling bodies, the introduction of deposit insurance and, in the doctrinal aspect, the rise of Keynesianism. It took roughly 12 years to clear up the debris of the classic GS and to design the replacement. That extraordinary period also embraced the World War II, which was quite a reasonable excuse for the delay and the break in continuity.

Once the Bretton Woods system was installed, it still featured bulging traits of the defunct GS. This conservative approach played out rather soon. After having contributed to the overall stabilization of the global economy and having underpinned the post-war industrial boom, the Bretton Woods paradigm started to amass problems before too long. As the global economy, including the economies of war-devastated Europe, was becoming more robust and more complex, and international trade was intensifying, the system proved unable to handle the fast-evolving environment because of its lack of flexibility. In the course of early to mid-1970s, the Bretton Woods system finally collapsed on the background of jumping gold prices, and inflationary shocks in the US in particular. It finally gave place to the fiat currency system as we know it. Notably, it took around 30 years, since 1944/45 till 1973/76, but luckily no world war, only a few regional ones flaring up.

As it is not so complicated to predict, a more flexible currency system requires a freer financial infrastructure. The grip of the state on banks and other financial companies introduced as an anti-bubble remedy in the aftermath of GD was eased first in 1980s, and then, to a higher grade, in the Greenspan era. In the fiat world, finances started to play more and more important role in the economy who got an easier access to investments through new financial instruments. Central banks got an utmost mighty lever to handle growth and inflation, that made Keynesianism looking somewhat archaic.

In a symbolic coincidence (or not a coincidence), computer processor chip Intel 8080 saw light in 1974. The 8080 chip was in fact the ancestor of the modern distributed computing, the enabler of the IT revolution, as it was disruptive in terms of calculation power and speed. The 8080 made it finally possible to create affordable personal computers, the base of the worldwide web and, finally, the new economic paradigm that is still emerging.

Now, if we assume that there’s magic in figures, we may subtract 1973, the year when EEC countries and Japan decided to float their currencies, from 2008, the year of the Great Recession, and here we go: 35 years again. The crisis of 2008 fits into its place of a cyclical pivotal point nicely.

Considering all this, should we assume that fiat system is actually doomed and is hurdle to a sustainable future growth, like once GS and its descendant, the Bretton Woods system? Debate around this issue sparked off almost straight after the Credit Crunch of 2008, and involved a few prominent personalities, but, as we know, it did not end in practical results in terms of legislation, theory, etc. Probably, because it was not the time for cryptocurrencies yet. But is it now?

The question here should be whether we are already inside a new big cycle (“new normal”), or in a transitional period, similar to that 12-year somber passageway between the abolishment of GS in the US in 1933, and the installation of Bretton Woods in 1944/45? As we can also recall, GD lasted through 1930s, and then there was the six-year war which was the only event able to turn all tables. Let’s be reasonable: the 16-year duration of a painful transition is just history, not a natural law and a prediction of the future. However, instances of turbulence, like the war in Europe, an ambiguous worldwide fight against Covid, episodes like Brexit, etc., coupled by technological disruption and financial irregularities are probably hinting at the world passing through a pivotal point in its global socio-economic development that is huge.

Features of the new paradigm are only emerging against a controversial backdrop of, for instance, a tighter financial regulation (that still leaks) and the explosive mix of unprecedent Keynesian and monetary stimuli which, on the one hand, extend the existence of the older paradigm, and on the other, allow for the rise of new forces that are to displace the current system that might be depicted as fiat money under elite control. Those forces are green shoots of a more egalitarian, distributed economy, for which the technological basis has been already at the finishing and refining stage. 2023 stands a good chance to be part of that stormy transition, the end of which is yet not well defined in time.