Laying the Foundations
The first publication of Lykeion Research lays the groundwork for the converging worlds of Geopolitics & Macro.
by Jacob Shapiro
What is Geopolitics?
Geopolitics is an approach to analyzing and predicting the behavior of nations and governments by focusing on the intersection of geography and power.
The intellectual origins of geopolitics are in late 19th century Europe when geopolitical thinkers like Rudolf Kjellén and Halford Mackinder applied their geopolitical insights to help explain a particularly tumultuous time in European politics, marked by rising and falling great powers, the rise of the nation-state, and the decline of multi-ethnic, monarchical empires. The essence of geopolitics is that the state will always pursue survival and power within the limits of geography, and most of its behavior will be driven by these basic instincts, whether conscious or not.
In contemporary usage, “geopolitics” is often used interchangeably with terms like “international affairs” or “global politics”. This is an incorrect usage of the concept of geopolitics, which is an analytical discipline that seeks to explain and predict the future course of international affairs rather than a fancy synonym for the relations between states. Geopolitics is also often incorrectly wielded to produce prescriptive goals or to support policy aims. Instead, the discipline of geopolitics is descriptive and objective, and it’s a useful tool to inform decisions about policies, investments, and even moral issues.
Why We Started Lykeion Research
I have made a career out of applying geopolitics to decisions about investments and supply chains. Throughout my career, I’ve also realized that whilst it’s often informative, on a more practical level, geopolitical research tends to lack strategic and tangible outcomes that can be useful and enjoyable for investors, entrepreneurs, and consultants that live and breathe outside of the academic world. Said another way, geopolitical research tends to be written for geopolitical analysts, by geopolitical analysts.
We believe this approach to be “intellectually incestuous”, especially because we’ve learned through experience that debates tend to be much more informative when different points of view and schools of thought are taken into consideration. This is even truer in the context of financial markets, which are impacted by governments, entrepreneurs, investors, consumers, economists, journalists, and nowadays, FinTwit influencers.
That is one of the reasons our first Lykeion Research product is structured around the intersection of geopolitical analysis and global macro, where I supply the former and Roger supplies the latter.
- There will be times when Roger and I reach similar conclusions about a particular subject but via different paths.
- There will be times when the geopolitical insights I generate clash with Roger’s macro perspective.
- Geopolitics will place more importance on the rationale and likely outcomes of issues related to the intersection of geography and power, while macro will more practically focus on how those issues will translate into global markets.
The basic premise of this research product is that the whole is greater than the sum of its parts. There are many wonderful macro newsletters and research reports available, and many equally wonderful geopolitical newsletters/research services available, but our value-add lies in the combination of these two complementary ways of understanding the world, which we believe will allow readers to build better-informed, more tangible, and less biased frameworks of analysis of the key issues that shape the direction of travel of global markets.
Why Geopolitics Matters Now
It is an especially important time to integrate geopolitical thinking into investment decision-making processes. Geopolitical nerds like me have been warning that the world is becoming more volatile, competitive, and even violent ever since the 2008 Global Financial Crisis, and while there have been geopolitical blips on the radar – Russia’s 2008 invasion of Georgia, Brexit, the failed 2016 coup in Turkey, the U.S.-China Trade War – it was not until Russia invaded Ukraine in February 2022 that it became clear that the world had changed irrevocably. It is fitting that Russia inaugurated this new global era: it was the fall of Russia’s predecessor, the Soviet Union, that bookends the previous era of American hegemony, the Pax Americana (RIP 1991-2022).
This is not to say geopolitics was not useful for the last ~30 years – would you really expect someone who earns a living by being a geopolitical expert to confess that his chosen discipline was not particularly important for such a long span of time? In truth, geopolitics was still useful in the unipolar American moment, but it was just boring and did not change very much:
- After the collapse of the Soviet Union, the United States was the unquestioned global superpower.
- By almost any metric, the United States was the most powerful and influential country in the world.
- Unshackled from the constraints of the Cold War, Washington remade the world in its image: free trade blossomed, globalization reached unprecedented heights, the World Trade Organization and the Washington Consensus defined the strategies and policies of all but a small fraction of pariah states like North Korea and Iran.
An investor making long-term decisions in 1991 simply required an understanding of the growing dominance of American economic and military power to make the best possible decision: go long the United States. There were peaks and valleys (the Dot Com bubble most notable among them), but generally speaking, one of the wisest and most secure investment decisions you could have made in the last 30 years was to park your money in a passive index tracking the returns of the S&P 500, which between November 1990 and November 2019 returned over 900 percent.
Remember: geopolitics is a discipline that analyzes and predicts relations between nations. In eras where a single nation is so relatively dominant over its peers, geopolitical research is not very informative. To the extent it is relevant, geopolitics was mostly applied to non-states (like al-Qaeda) or demented laggards (like North Korea), but at the top level, as long as the U.S. dominated, geopolitics produced stable, consistent, and predictable insights. But as the world moves away from American hegemony, understanding the course of action of other, incrementally relevant, geographies around the world becomes once again critical to inform investment decisions, which is why geopolitical research is once again useful and informative.
In this first Lykeion report, we are not going to dive deep into a single topic. Rather, we are going to set the stage for the myriad topics that we must understand to prepare for a much different kind of world – a multipolar world. No matter how old you are or how much experience you have, if you are reading this report, you have never lived in a multipolar geopolitical environment.
- The last 30 years were a unipolar environment, dominated by the United States, and the ~50 years before that was a bipolar era – a contest between the Soviet Union and the United States. Before the Cold War, two massive wars – World War I and II marked the end of the last multipolar era and the contest for who would dominate what would come next.
- The last truly multipolar era in global affairs was the 1890s – the very world that geopolitics was invented as a discipline to understand. That is why geopolitics is important today – not just because it seems like the world has gone haywire, but because geopolitics was designed precisely to analyze and predict the kind of macro-environment that is beginning to emerge.
So for the rest of the geopolitical section of this report, I will try to accomplish three goals.
1. I will explain what multipolarity is and how it is emerging in the world today.
2. I will identify four key themes related to deglobalization and why those themes will be constant refrains on these pages.
3. Lastly, I will identify five key geopolitical hotspots for 2023 – not an exhaustive list of the things we will cover in this report over the course of 2023, but the issues that, projecting outwards from this moment in time, I am positive we will have to address as the year progresses.
So sit back and relax; buckle your seatbelt, raise your tray table, and maybe pour yourself a glass of something adult. Let’s get to it.
What is Multipolarity?
We’ve already arrived at a simple definition of what multipolarity is: a world divided into distinct spheres of influence, or “poles,” of military, economic, and political power. In a multipolar world, no one power is stronger than any other. (Note: as we will see a little later on in this report, the world still possesses many aspects of the American unipolar moment. That is because the shift to multipolarity is at a very early stage.) The U.S. still retains immense amounts of power, especially in terms of military might (aircraft carriers!) and economic inertia (the US dollar!). That said, it is already possible to trace the contours of what a multipolar world will look like, which is to say, we can identify which powers are rising, which are falling, and which are standing still.
Treading Water – the United States
The argument that the world is turning multipolar is not an argument that the U.S. is in decline. Far from it. The U.S. remains a dominant global power and will be the most powerful country in the Western Hemisphere for the foreseeable future. U.S. power relative to other powers, however, has begun to decline. Some of that is due to a uniquely American penchant for political self-absorption.
The U.S. has myriad political problems at home – but most countries in the world would love to have America’s problems. There is no problem the United States faces that it does not have the resources to solve on its own. Most countries have no idea what it is like to have an inter-navigable waterway system like the Mississippi River, not to mention total energy security, food self-sufficiency, and a demonstrated capacity to integrate immigrants into its labor market. All of these things are true for the United States, which means even at times of terrible governance, the U.S. does well. That is how the U.S. can lose wars (Vietnam, Iraq 2.0, Afghanistan) and not suffer much worse for the wear.
That said, the U.S. is flashing classic signals of a decadent empire entering a self-absorbed stage. The British Empire experienced something similar at the end of the 1890s, as its power abroad began to decline and its debt levels ballooned, all while British politics was largely about irrelevant squabbles and not the rise of true challenges to British power in the form of the U.S., Germany, and Japan.
- U.S. wealth inequality is at record-high levels.
- U.S. domestic politics are becoming increasingly polarized, to the extent that the labels “Republican” and “Democrat” no longer communicate a certain worldview or set of political positions.
- Populist demagogues abound, on both the right and the left. (Politics is a circle – the far extremes of the “right” and “left” will eventually bump into each other if they keep going.)
The U.S. has experienced similar moments in the past.
- The Roaring 1920s was a period of excess and political short-sightedness. It eventually yielded a political revolution in the form of Franklin Delano Roosevelt and his New Deal and victory in World War II.
- The 1970s was a similarly fraught time – an era of stagflation, culture wars, and pessimism about the future of the nation. It eventually yielded to a political revolution in the form of Ronald Reagan and victory in the Cold War.
The U.S. is likely in for a similar arc this time around, which leads us to arguably the scariest thought in this piece: things are going to get much worse in the U.S. before they get better. To get a polarized, distrustful society to compromise means things have to be so bad that pride is swallowed for the greater good. That will eventually happen, and when it does, the U.S. will still be here, and still be one of the most powerful countries in the world – but it won’t be alone.
The Rising Powers: Turkey, Brazil
Multipolar eras are ideal environments for countries that are powerful enough to assert their own interests and aspire to build their own sphere of influence. There are two countries that are clearly set to prosper in a multipolar world: Turkey and Brazil.
Turkey is the heir to the Ottoman Empire, a power that at its zenith dominated the Mediterranean, extended far into southern Europe, and dominated large swathes of the Levant and the rest of the Middle East.
Turkey is the only sophisticated industrial economy in the Middle East (plus, its manufacturing companies are stealing market share from Europe). Its control of the Bosporus confers Turkey control over access to the Black Sea, one of the most critical trade chokepoints in the world. The Turkish military is one of the most formidable in NATO and has been expanding – in the form of de facto conquests in northern Syria and building military and naval basis throughout North Africa on both the Mediterranean and Red Seas.
Turkey’s geopolitical fundamentals far outweigh more immediate concerns about its domestic politics, especially on a long-term basis. Turkey is a rising power and will shape the balance of power in at least four regions: North Africa, Southern Europe, the Middle East, and the Caucasus.
Brazil is a power that has been punching below its geopolitical weight for decades. That is finally beginning to change. Brazil is rich in all sorts of commodities that other global powers are eager to get their hands on. Brazil’s only potential rival is Argentina, whose economic policy has been a dumpster fire for decades and is not likely to change soon. Like the United States, it is insulated from the vagaries and tribulations of Eurasian wars and competition.
Brazil is a massive power that is poised to dominate a sphere of power in South America, and if it plays its cards right, it could even look to expand Westward, most likely by emphasizing trade and economic integration (though force cannot be ruled out). If Brazil could project power across the South American landmass to the Pacific, it would contain many of the same aspects that make the U.S. such a formidable power at a geopolitical level. Lastly, Brazil was one of the big losers of the globalization era because China soaked up many of the advantages Brazil might have been in line to receive. But it’s a new world, and that is a good thing for South America’s most important country.
Could Go Either Way: China, India, and the European Union
One of these is not like the others – so let’s address China and India first before turning to whatever the European Union is.
No country in the world produces stronger analytical feelings than China. Some geopolitical analysts, like Peter Zeihan and George Friedman, think China’s imminent collapse is inevitable. Others view China as an existential national security threat to American power, and the first country the U.S. has competed against with a size disadvantage.
The truth is more mundane. China is a weak power and has reached a critical juncture in its national development. The export-led growth model that allowed China to ascend to its current position is obsolete. China is attempting to redistribute wealth internally on a massive scale and has turned to a dictator – Xi Jinping – to oversee this process. Whilst it is rapidly improving its military capabilities, China remains too weak to accomplish basic geopolitical goals like conquering Taiwan.
China is also staring squarely into the face of a massive real estate property bubble – a huge deal considering that the average Chinese citizen prefers real estate to equities, fixed income, and savings accounts for preservation of wealth.
The next 18-24 months in China will be absolutely critical and will tell us whether China will join Turkey and Brazil as rising powers – or will be facing a Lost Decade similar to what Japan endured in the 1990s after it looked like it was going to take over the world too. I think China will make it through this period and emerge as a rising power – but my certainty level is low. From a global geopolitical point of view, the fate of China is the most important issue to understand, as it will profoundly shape the balance of global power in either scenario.
If the world was continuing to embrace globalization, India would be a no-brainer rising power. The world is de-globalizing, however, and that poses significant challenges as India tries to assume the mantle of next Asian economic growth miracle. India has impeccable demographics – no other country in the world can compete with India’s size and youth. But that is where the positives end.
India is one of the poorest countries in the world, with a GDP per capita roughly equivalent to that of Haiti. India’s infrastructure leaves much to be desired. It is bordered by an arch-nemesis with nuclear weapons, and while India has won every skirmish it has had with Pakistan, the threat from Pakistan and the rise in Hindu-Muslim tensions puts significant constraints on its development.
India is also an incredibly diverse country – this helps to fuel a resilient democracy, but it also makes it very difficult for the Indian government to get anything done in a cohesive and efficient way (just look at India’s aborted effort to reform its agricultural markets in recent years, a much-needed policy that even the most popular Indian leader in a generation - Narendra Modi - could not push through).
While it remains to be seen whether India can transcend these problems and become a global power in its own right, India will be a major economic center of gravity simply by virtue of its size and demographics, no matter what.
Last but not least, we reach the European Union. I am on record as saying that I believe the Russia-Ukraine war has transformed the European Union – in a good way. The EU faces a similar moment to the original 13 U.S. colonies – to join or die. Europe can no longer afford to squabble with itself if it wants to remain relevant in global affairs. Turkey, Russia, China, and even the U.S. pose threats to Europe’s future, and no European country – not even France or Germany – can compete by itself. If the European Union does not come together as a more cohesive whole and unravels, then Europe will become a fractious place of rival blocs, each with its own strategic orientation to the major poles of power elsewhere in the world. United, however, Europe becomes one of the most powerful poles in the world in and of its own right, especially if Europe can capitalize on Russia’s misstep in Ukraine by welcoming Ukraine into the EU (along with other countries in the Balkans that have been waiting for their turn to join for years). From Europe’s energy “crisis” (if you’ve been following me for a while you know I think the crisis is overblown) to the squabbles between Brussels and Budapest, or to German sentiment on bailing out the profligate Italians – we will focus heavily on the issue of European unity because it will define whether Europe is a center of power and wealth in the future – or a chessboard for the powers it took such pleasure in colonizing once upon a time.
The Declining Power: Russia
Transformative moments in global politics seem to revolve around Russia – a point Mackinder made in a roundabout way in some of his most prominent work. After all, it was the collapse of Russia during World War I that eventually led to the rise of Communism and the Cold War. It was the collapse of the Soviet Union that led to the unipolar moment. And we may be on the cusp of another Russian collapse ushering in a new multipolar era. Russia has terrible demographics and at the economic level, it is basically a Slavic Saudi Arabia (no economy aside from the export of raw materials). If Russia did not possess nuclear weapons, it likely would have already lost the war it picked with Ukraine and looks unable to win. The question is what will Russia’s decline look like – will it be a slow, well-managed descent into irrelevance? Will it be a Russian-Revolution-style civil war? Will it be the fracturing of Russia into different warlords and fiefdoms all competing against each other? In any case, the weakness of Russia means wonderful things for powers like Turkey, China, and even the European Union, all of which will be eager to avoid joining Russia in this unenviable geopolitical category.
The U.S. led the charge toward globalization. It is now leading the charge away from globalization – just look at the recently unveiled U.S. Industrial Policy, which can basically be summed up as “Make Things Great in America Again.” Deglobalization is a more nuanced idea than you might think, however. It does not mean that every country is going to try and recreate supply chains from scratch for itself – that is not possible.
Remember, the world is going multipolar.That means we should see more economic integration between different economic poles. So for instance, the United States will probably experience more globalization with countries in Latin America even as it pulls back from China. Turkey will increase economic integration with portions of the Middle East and North Africa. The European Union is eagerly looking for free trade agreements with countries in Africa and Southeast Asia. Deglobalization in the current geopolitical context really means reglobalization – and an admission that there will not be a single global market, but a few top-level markets that will compete with each other.
Deglobalization will manifest in four key areas: Trade, Energy, Technology, and Currency.
The two most important economies in the world today are China and the United States. Since 2017, those two countries have been locked in a trade war that is only getting worse.
- China is still dependent on imports of U.S. agricultural products (especially corn and pork) and technology (especially semiconductors) – but it is urgently attempting to delink its economy from this dependence on the U.S.
- Washington wants to have its cake and eat it too – it wants China to buy more U.S. commodities, but also wants to kneecap entire Chinese companies and even industries by restricting advanced dual-use technologies like semiconductors, artificial intelligence, and 5G from China.
- The big U.S. problem is that so many of its companies bet on access to the Chinese market and on the ease of making things in China during the era of globalization that American industrial productivity has been hollowed out.
The long-term trajectory is clear: the U.S. and Chinese economies are decoupling – but that process will be disjointed and uneven, marked by occasional challenges like the recent U.S. semiconductor restrictions, and then followed up by exemptions because both sides recognize they are still dependent on the other. Remember: Britain and Germany, rival powers in the 1890s and 1900s, traded more with each other right up until World War I started. The story of U.S.-China trade is also just one case study – these sorts of dynamics are present throughout the world.
As if all this change wasn’t enough, the world is on the cusp of two major transitions: an energy transition and an industrial revolution.
The global economy today is run on hydrocarbons - oil, coal, and natural gas. But for the first time since the turn of the 20th century, different energy technologies are rising. In response to environmental concerns, uncertain oil prices, and security concerns, the world is steering toward renewables.
The tricky part is that it is not clear which of the renewable technologies will win the day – will it be solar? Wind? Hydrogen? Nuclear? All of the above?
Europe is making massive investments in hydrogen, while most of the new nuclear capacity coming online in the next 2-3 years is in India and China. The U.S. is awash in natural gas, and most of its focus is on capitalizing on its newfound energy reserves. We live in a world today where a barrel of oil means roughly the same thing to everyone in the world (that is not true for wind, hydrogen, solar, you name it). We are heading toward a multipolar energy environment where different countries will have profoundly different energy mixes depending on their resources and their policy decisions, all of which will certainly have significant investment implications.
The Fourth Industrial Revolution is also nigh. We are evolving from the digital era to the era of automation, artificial intelligence, and Internet of Things. Do not underestimate the extent to which geopolitics is at the core of these technologies. After all, semiconductors were first created in the U.S. with the support of the Department of Defense to create more accurate U.S. missiles – not to create personal mobile devices to watch cat videos on. That is why one of the first things the U.S. did in its trade war with China was kneecap Huawei – a company that had become the best in the world when it came to 5G telecoms infrastructure and technology. This tech competition will be reflected throughout global supply chains and even in space, and the country or countries that can assume the commanding heights of the information economy will be in a prime position to assert geopolitical power and prosper economically.
Currencies offer a slightly different story. While trade, energy, and tech fragment, the dollar remains king. That may sound strange but consider that the U.S. dollar is still by far the most used and trusted currency in the world today. The dollar has lost some market share over the last two decades, but not to the Chinese Yuan, as most like to think, but to the Euro. (Think of the EU as in some ways a more serious economic competitor in the short-term to the U.S. than China.)
Global reserve currency status usually does not change unless something catastrophic happens – think World War II or the Napoleonic wars. What that means is that the dollar is here to stay – and that the move in dollar strength in the last year is likely just the beginning. It also shines a light on the truly disruptive aspect of cryptocurrencies – which offer a challenge to the traditional world of nationally-based fiat currencies. If we stay on the current geopolitical trajectory for a decade and a truly global war happens, the dollar could lose its status, but in the interim, the more interesting geopolitical question is whether cryptocurrencies will progress from digital assets to true means of exchange – and what governments will do in response to that challenge.
This is hardly an exhaustive list of the most pressing geopolitical issues of the year ahead. After all, I was not writing about Russia’s invasion of Ukraine in November 2021. We will be nimble and respond to developments as they occur. That said, here are four key issues that will dominate geopolitics in the year ahead:
1. The Russia-Ukraine War – As I alluded to in the section about Russia as a declining power, the key question here is whether Ukraine can keep putting pressure on Russia to the point where the Putin government falls or the Russian Federation begins to buckle at the political level. I think the fighting has hit a lull due to weather and that neither side is ready to call it quits, which could materialize in a much more volatile spring/summer of 2023 than most are ready for, especially for agricultural commodities.
2. Will the EU stick together? – As I write this, the EU has finally decided to punish Hungary for its recalcitrance. Poland and Germany are signing energy security agreements. Weapons are flowing to Ukraine from both the U.S. and EU member states, and no one is forcing Ukraine to the negotiating table with Russia. The biggest issue for Europe in the year ahead may well turn out to be debt (specifically the debt of Italy, which is hovering around 170 percent of GDP just as a new more populist Italian government has come to power). If Germany tries to give Italy the same treatment it gave Greece, things could get interesting.
3. Turkish elections – Turkey had one of the worst-performing currencies last year… and one of the best-performing equity markets for emerging markets as Turks sought refuge from 80+ percent inflation. Turkey is heading into a pivotal election campaign over the summer which will decide whether current President Recep Tayyip Erdogan retains his position, or the Turkish opposition finally overcomes Erdogan and returns Turkey to a path of economic and monetary orthodoxy. The real wildcard is what happens if Erdogan loses… but does not want to leave? Turkey needs a peaceful transition of power no matter who wins the election, and any threat to that would be highly significant.
4. Regime change in Iran? The anti-government protests in Iran are the most significant since the unrest that led to the Iranian Revolution in 1979. Supreme Leader Ali Khamenei is reportedly ill, and rival factions within Iran’s political system – hardliners and clerics aligned with the IRGC vs pragmatists with a more enlightened approach to the role of religion in government – are positioning themselves for a battle royal for power even as Iranians turn out into the streets and decry their country’s terrible economy. It is hard to exaggerate what change in Iran could do to the global economy – this is a massive potential energy exporter, a massive potential food importer (85 million inhabitants), and a key to the balance of power in the Middle East and Central Asia. Regime change is not the most likely scenario – but has become realistic enough that this bears very close watching in the year ahead.
by Roger Hirst
2023 in the US: Unemployment, Recession, and Higher Terminal Rates
The first step towards understanding global macro is to have a good grasp of the macro situation in the United States. This is why we’re mostly focusing on the US in this initial research piece – we believe that the course of action dictated by both US policy and economics will have a direct impact on global markets in a way that no other country has.
The last twelve months have been extremely difficult for financial markets.
- Markets have repriced for higher-than-expected inflation and the hawkish response of the US Federal Reserve.
- Balanced portfolios that combine bonds and equities have had their worst year since the 1930s, according to Bank of America.
- Whilst equities have repriced lower on the back of earnings compression, 2022 mostly differentiated itself by how badly bonds behaved (Bank of America has noted that this was the worst year for the US 10-Year Treasury since 1788).
The debate in 2022 was mostly about trying to understand the level at which inflation would peak; in 2023, it will instead focus on recession risks.
Our framework for next year is straightforward:
- The starting point of the US macro discussion will be inflation and employment, both of which help us assess recession risks.
- The impact of those two variables on the economy will inform policymakers (i.e., central bankers) about the future path of monetary policy, which will also end up having a direct contribution to the likelihood of a recession taking place.
- Inflation, employment, and monetary policy, together, will shape not only the likelihood of a recession, but most importantly, its depth, duration, and reach, which will drive asset prices into next year.
In future publications, this framework will work hand in hand with Jacob’s Geopolitical framework, as policymakers’ decision-making must, for the first time in a long time, take into consideration global events that have not always resonated in the purview of investors and may exist outside the framework of their traditional mandates.
This is the core of Lykeion Research – navigating the converging worlds of Macro and Geopolitics.
Policy in 2022
The US Federal Reserve has a varied and complex agenda, but for the broad-based economy it boils down to a dual mandate:
- Growth (managing recession risk)
- Price (managing inflation risk)
The most important thing to remember when thinking about central bank policy is:
- Since the 1980s, the status quo for the Fed was to focus on recession risk as inflation risk was structurally subdued (thanks to the rise of globalization, worsening demographics, and technology advancements).
- In the post-COVID world, and for the first time in decades, the focus of the Fed has moved from managing recession risk to managing inflation risk.
- The implication of this is that policy is being drafted with the assumption that higher unemployment, and even a recession, would be an acceptable price to pay to get lower inflation.
Chairman Powell of the US Federal Reserve has been relatively consistent throughout 2022. Once the Fed put its foot on the rate-hike accelerator, it kept it down. In fact, as of early December 2022, cumulative rate hikes have been the fastest since 1994.
Going into 2023, all eyes are on the Fed:
- Will they pause rate hikes?
- Will they actually pivot? And if so, when?
- Or will they continue to tighten until inflation is defeated?
This will all depend on how inflation and employment develop from here.
Inflation in 2023
Most analysts think that peak inflation is now in place for this cycle, but, as we’ve said in the initial segment, inflation will remain a key variable for 2023. The key considerations for next year are:
1. If inflation has peaked, how quickly will it reset to normal levels of c. 2% (if at all)?
2. Will inflation be a one-off or recurring event?
3. Will wage inflation become entrenched (i.e., sticky)?
If inflation has peaked, how quickly will it reset to normal levels of c. 2% (if at all)?
- For next year, it is not the peak in inflation that matters, but rather the speed with which it resets.
- November CPI beat expectations, coming in at 7.1% YoY versus consensus at 7.3%. Having peaked at 9.1%, the trajectory is to be celebrated, but the absolute number is not.
- Lower levels of inflation do not mean lower prices: if inflation drops from 10% to 8%, it means that prices are still going up, but at a slower pace. As can be seen on the previous chart, the Consumer Price Index (year-on-year change) has rarely been in deflation (below zero) since the 1940s.
- The US Federal Reserve currently has a target of 2% (YoY). If annualized inflation resets to a higher level, will they raise this target? It is one of the key market considerations, though the consensus is that they will hold their course unless 2% becomes an unrealistic goal.
- Fed Funds interest rate expectations flag that the first rate cut will take place by June or July of 2023. This would require CPI (and other measures of inflation) to continue a steep descent from current levels.
- Overall, Bank of America has shown that it normally takes at least 4 years (and an average of 10 years) for inflation to return to 2% once it has breached 5%. Whilst Greece has skewed the data, inflation has not usually dropped as quickly as markets currently expect.
- Additionally, Fed Funds interest rate expectations should take into consideration that policy makers will be wary about easing too early and fueling another leg higher in inflation. The fiscal cliff (the speed with which stimulus goes from a positive to a negative year-on-year change) does support the case for a rapid decline in consumer prices as M2 rolls over and goes negative, which should help revert durables demand back to trend.
- This all points to the fact that a June/July pivot might need to be reconsidered in 2023 as it seems a tad too early to us.
Will inflation be a one-off or recurring event?
The current spike in inflation is the largest since the early 1980s when it reached 15%. That was one of two periods that saw multiple inflationary spikes into double digits – in the 1940s and in the 1970s (ending in the early 1980s). Both periods saw three consecutive peaks of inflation, though the primary causes were different for each.
The following is a broad simplification of those periods:
- 1940s: the transition from a war footing to a post-war footing created huge dislocations in supply chains that took years to re-align, exacerbated by the onset of the Korean War. This means that peaks were mostly driven by supply-chain shocks.
- 1970s: Post-war western economies had focused on government intervention over free markets, helping to entrench labour over capital (wage inflation), exacerbated by the OPEC and Iranian oil shocks. This means that peaks were mostly driven by shocks in the labour market.
For now, today’s inflation perhaps has more in common with the dislocations of the 1940s than the institutionalized wages of the 1970s (free markets have been in the ascendency for the last 40 years, meaning there is less unionisation today, so it’s harder to see entrenched wage inflation).
For now, the parallels of today with the 1970s mainly overlap with the energy crisis. More importantly, the battleground for 2023 is if higher labour costs will indeed materialize or not, which would make the present day a blend of what happened in the 1940s and in the 1970s as well.
- The case for a soft landing is that the fiscal impulse disappears (M2 rolls negative) and wage inflation never materialises, meaning inflation never takes hold (doubly so if we head into recession). But… if we head into recession, does fiscal come back again, and so we’re back at the starting point?
- We have also previously experienced periods of higher commodity prices whilst CPI has remained well-behaved, such as 2000 to 2008 (growth from China fueled demand for raw materials), so stickier and higher commodities don’t necessarily mean stickier higher inflation (higher commodity prices tend to drive increases in supply, albeit with a time lag).
Therefore, wages are probably the critical consideration for the outlook on inflation.
Will wage inflation become entrenched (i.e., sticky)?
- Commodities, which help fuel inflation higher or lower as we’ve all noticed over the last year, can trend higher or lower for long periods, but they also often mean revert. Declining commodity prices are a regular feature of the global economy.
- However, wages behave differently. Once they rise, they rarely mean revert (a wage cut is immediately a cut in a person's standard of living, which is why lower wages are almost taboo and why companies prefer to lay off rather than reduce wages despite both having a negative net effect on the economy). Therefore, rising wages are one way that inflation can become entrenched in an economy.
For now, whilst nominal wages may have risen, real wages (the rise in wages minus inflation) have struggled for the last couple of years.
The jobs market (employment) can then offer critical insights to assess how ‘sticky’ inflation can continue to be (more so than commodity prices). This matters because if we see sticky inflation take hold, it will inform the Fed to maintain its hawkish stance, contrary to what we would see in a ‘transitory’ inflation scenario, which implies that the market needs to reassess the pivot in June/July.
Employment in 2022
The key takeaway is that the market is very tight by any historical measure:
- The US unemployment rate is very low (3.7% for November 2022), bested a few times since 1950.
- Initial jobless claims are a weekly data point that has less of a lag when compared to unemployment numbers, but these have also been close to record lows throughout 2022.
- Lastly, job openings have been running at almost double the number of unemployed in the US. This number may be somewhat convoluted, however, as the same job may be posted multiple times, but in any case, US policymakers need to see a reduction in this demand gap before they turn around on monetary policy.
This tightness has been a real surprise to many, considering the deterioration in Consumer Sentiment (record lows for the University of Michigan Survey) and the outlook for small businesses (record lows in the NFIB Small Business Survey).
- There is anecdotal evidence that post-COVID work-from-home trends have reduced mobility (including the influx of foreign workers) which is why businesses have been reluctant to reduce headcount.
- Corporate margins have also been protected as the increase in wages has lagged the increase in prices (which increases revenue for businesses assuming they’re able to pass on inflation to consumers). Because margins have been protected, there has been less of a need to reduce headcount.
Employment in 2023
There is huge uncertainty in wages (we know this because of the failure of the Phillips curve before COVID). The Philips curve states that the lower the unemployment rate, the tighter the labor market, and therefore, firms must raise wages to attract scarce labor, which we have not seen yet.
Whilst there’s no dispute that the employment market is currently tight, what matters to policymakers is how strong the market really is. A tight labor market may not necessarily translate into higher wages and higher inflation if real wages continue to be negative.
What evidence is there that employment will deteriorate in 2023?
- Most of the evidence that points towards a deteriorating labor market has been isolated to the widely publicized layoffs across the tech sector and financial services. Realistically, the former is more of a readjustment after the hiring boom of the pandemic period, whilst the latter is a typical retrenchment after a difficult year for risk assets (which the financial sector is highly correlated to), especially after how it ballooned during the post-pandemic rebound in risk assets.
- The year-on-year change in Challenger Job Cuts (measures the change in the number of job cuts announced by employers) is clearer evidence that unemployment may be about to rise dramatically, as it has surged to its highest level since the dotcom bust (ex-COVID).
If unemployment is to rise, which sectors are likely to lead the charge in 2023? Enter the housing and construction sector (as a share of GDP, housing and construction is 16%, vs. tech at 9%, and financial services at 7%).
- The NAHB Home Builders index has dropped as rapidly as it did during COVID and faster than the onset of the mortgage crisis in 2006-2007. Below we can see that the US unemployment rate ebbs and flows with the NAHB index and that the NAHB index leads the unemployment rate.
- This should not come as a surprise as the average 30-year US mortgage rate has shot up to 7%. The absolute level of rates matters, but when assessing the direction of the market, what matters more is the rate of change. Coming off a low base, this has been one of the fastest increases (in percentage terms) in history.
The rate of change in mortgages has reached historical levels, but its implications will take time to feed into the real economy.
- Whilst many people are locked at lower rates, higher mortgage rates will discourage households from moving. Housing and construction activity will decline, and this should lead to job losses.
A rise in the unemployment rate would take some additional pressure off inflation, which is already seeing the benefits of (1) commodity prices that have rolled over (or at least, stopped rising), and (2) the work-from-home (WFH) trend, which has seen employees accept lower wages as an offset to the benefits of this new lifestyle.
That said, there are pockets of the employment market that are instead putting upward pressure on inflation:
- For sectors where in-person jobs are a requirement, WFH has created competition. Why should someone commute unless they receive improved compensation? It is these types of jobs where inflation-beating wages are being negotiated.
- In fact, unions in the transport sector have been demanding 2-year increases of 20-30%.
- The entertainment sector (e.g., restaurants and bars) is paying inflation-beating wages.
The overall takeaway is that, given the current level of uncertainty, we need to closely monitor the developments of the employment market as it’s likely to dictate how serious the risk of higher wages really is, which will help determine how sticky inflation may actually end up being and consequently, help investors assess both recession odds and timing of the pivot.
Employment, Recessions, and Equity Performance
Getting a grasp on the direction of the employment market matters quite a bit:
- Rising unemployment is the most consistent variable for an NBER recession (change, rather than absolute level). In 2022, unemployment remained close to record lows.
- Since 1950, on every occasion where unemployment has meaningfully risen, a recession has followed.
- Since 1960, the S&P500 has made a significant low either during or after every recession. Without exception. Even when the pullback was relatively minor (1980, 1991), there was a tradeable low.
During recessions, households liquidate assets to offset lost earnings or job insecurity. These redemptions drive equity markets to their lows, and since we’ve not seen that, there is a reasonable argument to be made that equity markets are yet to see their lows.
Policy in 2023 and Market Implications
The presence of offsetting forces that push inflation in different directions is what makes the life of central bankers complicated as they need to make decisions about monetary policy without being certain of which side of the employment market will prevail (tightness and higher wages or rolling over of housing market and higher unemployment).
So far, we’ve postulated that:
- Peak inflation is likely behind us, but history says that the expectations the market has for how quickly inflation will decrease seem to be unrealistic.
- The employment market is the most important driver of how sticky higher inflation will be (with a particular focus on the housing and construction sector).
- Sticky inflation is the most important driver of hawkish monetary policy.
- The issue we face is that the employment market is sending mixed signals, which makes the calibration of monetary policy significantly trickier.
At the end of 2022, the market had started to act like a simple deceleration in the trajectory of rate hikes was the same thing as a pivot (equities rallying hard on better-than-expected inflation prints).
Fed Funds futures have priced a pivot (reversal) in rate hikes for the end of H1 2023:
(Note: Fed Funds futures are a measure of interest rate expectations. They are calculated as 100 minus the Fed Funds futures level. If the Fed Funds future is at 95, the expectation for interest rates is 5%).
Is it reasonable for consensus to be expecting the Fed to pivot (and not pause) in 6 months? We don’t think so.
We see, instead, three possible scenarios:
1. The Fed keeps hiking until they conclusively cap inflation, independently of a recession: This is a hawkish stance that sees a higher terminal rate, probably over the 5% rate priced into June 2023 Fed Fund futures. This likely implies there’s still is significant downside for equity markets unless you’re willing to assume that inflation is below 2% by mid of next year (unlikely).
2. The Fed waits for a recession to take place and then pivots: If the slowdown is established, then the Fed can cut interest rates (as they have through almost every recession since the 1970s), but for consensus to be right on the pivot by mid-2023, we need to see the economy quickly turning around in the first half, which will mostly be driven by developments in the employment market. This would be dovish, but not necessarily bullish for risk assets (if you are cutting rates into a recession, then risk assets are usually selling off; buying risk assets on the back of a rate cut has a poor historical record).
3. The economy starts to decelerate, and the Fed pauses: Wage inflation remains subdued (even if labor is tight) meaning that CPI data continues to decline. The economy has not yet entered a recession and the Fed pauses its hiking cycle to reassess the data. Interest rates plateau near the terminal rate, but a pause is different than a pivot, meaning that consensus might still be underestimating the length of time at which terminal rates can remain around 5% (instead of decreasing in the second half of 2023, as consensus expects). This would be relatively hawkish versus current market expectations.
The only way to assume that a pivot materializes by mid-2023 is to assume a strong rollover of the employment market in the first half, which would allow the Fed to move away from managing inflation risk to managing recession risk. Whilst that’s possible, the problem with consensus is that it is simultaneously pricing in a mild recession (which doesn’t create enough economic damage to allow for a pivot) and a pivot.
Something’s got to give, and we believe it’s better to position for terminal rates moving higher (or staying higher for longer) in 2023 than to expect a deep enough recession to take place in the first half that it justifies a pivot by summer 2023.
These scenarios will be key in future Research publications when assessing and stress-testing our frameworks.
In order to see a pivot by mid-next year, we need to see a deep recession. This would need to include:
- Depth: A slowdown needs to shave significant percentage points off growth. Q2 2020 was an extreme example. H1 2022 just scraped into negative territory, and it did not qualify as a deep deceleration in growth.
- Duration: The slowdown should last for a significant period. In 2008, it lasted for four consecutive quarters. Although 2020 only lasted two quarters, it made up for it with its depth. In 2001, the economy didn’t manage two consecutive quarters of negative growth, but slow or negative growth lasted for over a year (intermittently), and the slowdown spread across the economy.
- Reach: The slowdown needs to be widespread, entering many broad-based sectors. This will nearly always be accompanied by unemployment rising by a few percentage points. This qualified the 2000 recession.
There are some signs that a recession is baked into the cake, including the following:
- Low levels of unemployment and rapidly rising CPI have usually preceded or coincided with recessions.
- The Chicago PMI has fallen to levels that existed only during recessions since 1970.
- University of Michigan Consumer Sentiment has fallen to recessionary levels.
- The Outlook for Small Businesses has fallen to recessionary levels.
But other key data sets are still inconclusive.
- The ISM Manufacturing Survey has dropped into contraction territory (under 50) but remains at levels associated with true recessions (around 45).
- The ISM Services Survey has rebounded to 56.5, comfortably in expansion territory.
A recession may be inevitable, with or without further tightening from the Fed, but policy could still impact the severity of it. What this means is that, whilst the economy might be headed towards a mild recession, the Fed could force it to become a deep recession by continuing to increase rates at an accelerated pace. This is what Julian Brigden of MI2 Partners means when he argues that the Fed needs to ‘break something’ (the economy or the equity market) to prevent inflation from taking hold.
Overall, our framework for policy is:
- The more the Fed maintains its hawkishness, the sooner it’ll be able to pivot by allowing higher rates to force the economy (and consensus) into a deep recession.
- The gentler the Fed is right now in terms of monetary policy, the higher the risks of terminal rates needing to adjust higher (or stay high for longer) to ensure that inflation is under control given that a milder recession will be less of a factor in capping inflation.
Asset Outlook for 2023
- We’ve mentioned how the S&P500 has made a significant low either during or after every recession, without exception, since the 1960s.
- So far, we have seen sector rotations in stock markets (out of tech and into old economy and resources). This type of activity is commonly associated with a topping process rather than a capitulation event, which would imply further downside.
- If we expect unemployment to rise, we should expect a recession, and during a recession, we should expect a tradeable low in the US equity market.
- 2-Year yields are a proxy for rate expectations and 10-Year yields are a proxy for growth/optimism.
Based on the scenarios we’ve laid out in the Policy section, we see multiple ways the curve plays out.
1. The Fed continues to hike until they conclusively cap inflation, independently of a recession: 2-Year yields should keep rising, and at some point, 10-Year yields will reflect the tightening of financial conditions and the probability of a deeper recession (lower growth), which should force 10Y yields lower. The yield curve inverted by 250 basis points in 1980 (i.e. 2-Year yields were 250 basis points higher than 10-Year yields). We should expect the same today. In early December 2022, 2-Year yields were 85 basis points higher than 10-Year yields.
2. The Fed waits for a recession to take place and then pivots: 10-Year yields should be more sensitive to growth than 2-Year yields and they should fall first (bonds rally). A deep recession increases the potential for a true pivot (rate cuts), which should force the whole yield curve lower (bonds rally).
3. The economy starts to decelerate, and the Fed pauses: If the Fed pauses at the current expectation for rate hikes (e.g. 5%) then the yield curve could be in limbo. If they pause too early, they may stoke inflation expectations, pushing 10-Year yields higher relative to 2-Year yields. If they pause and plateau at 5%, front-end yields should be forced higher because they are currently priced for a pivot (rate cut) from mid-2023. So, unfortunately, in this case, “it depends”.
- The bullish narrative for commodities is based on short-term supply constraints and long-term demand dynamics. This is a powerful argument for commodities over the next decade, and there will be heavy overlap with the Geopolitical side of this report in future publications.
- That said, in the short term, the dynamics of a recession can trump the dynamics of longer-term demand. The pandemic was an extreme example of that, where demand destruction saw most commodities fall, even though underinvestment was already an issue in many markets.
- A mild recession in which demand stays strong and commodities rebound would be met by a swift response from policymakers (higher rates) to combat this potential uptick in inflation, which would drive commodities lower.
- Thinking long term: If a true recession pushed down commodity prices, then this could present an opportunity for people looking to invest in some of the longer-term commodity themes that were hot topics during 2021 and 2022.
- US Dollar: If US policy remains hawkish relative to other regions, we should expect the Dollar to rebound. If the Fed genuinely pivots, then the top in the dollar could be in. However, if the pivot is due to a recession, then investors typically seek safe havens, which the US dollar is. These flows would benefit the US dollar (as well as Swiss Franc and Japanese Yen). Therefore, the circumstances of a potential pivot are a more important driver of the US Dollar than the pivot itself.
- AUDJPY: Australian dollar to Japanese Yen is a currency pair to watch for signs of a global recession. The Australian Dollar, widely considered a commodity proxy as the country is a heavy exporter of commodities, benefits from global growth (commodity demand), whilst the Yen has historically been a safe haven currency (due to capital repatriation during times of economic stress). Since the COVID lows in 2020, the Australian Dollar has generally been stronger versus the Yen, with the Yen particularly weak in H1 2022 due to yield curve control (capping yields for 10-year government bonds) and the rising costs of energy imports. AUDJPY has been consolidating in recent months, and if the Australian Dollar breaks lower versus the Japanese Yen, it suggests that the global economy is shifting from an inflation scare to a growth scare.
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