We Stand to Lose Much. Can We Gain More?
Article originally hosted and shared with permission by The Christian Economic Forum, a global network of leaders who join together to collaborate and introduce strategic ideas for the spread of God’s economic principles and the goodness of Jesus Christ. This article was from a collection of White Papers compiled for attendees of the CEF’s Global Event.
Inflation is now at multi-decade highs globally and is affecting countries that are not accustomed to dealing with it. The implications for the global economy in general and asset prices specifically are of great consequence.
Last year, I argued that inflation would be longer lasting and much more impactful than was commonly thought. On a related note, I made the case that as we pivoted from monetary policy to fiscal policy interventions in the context of Covid, politicians would be hesitant to relinquish the political power gained by distributing cash to constituents. Though I would love to have been wrong, both predictions have turned out to be correct. Clearly, inflation remains an issue and is likely to average well above central bank targets far longer than expected.
This year, I’d like to look at the consequences of inflation in three areas. First, I’ll consider the impact of inflation on the stock and bond markets. Then, I’ll balance a bullish and bearish case for hard assets including real estate, which is the largest asset for most households. Finally, I’ll consider the political implications of inflation and, by extension, the geopolitical implications that provide a contrast between the WEF versus CEF (World Economic Forum, Christian Economic Forum) vision of global change.
Now that inflation is at 40- to 60-year highs, it might be tempting to consider the worst already behind us. Two arguments militate against that possibility. One, inflation becomes entrenched when consumers see it as an inevitability. They alter their consumption patterns, increasing demand in the present to pay now rather than waiting and seeing what prices will be later (hoarding). Supplies thus remain artificially tight, and prices remain elevated based on excess demand buttressed by this psychological fear of higher costs in the future. Two, bringing inflation down requires a policy-induced slowing of economic activity. Monetary policy has traditionally been the tool of choice, via the hiking of interest rates to trigger recession, cool off demand, and allow for prices to come off the inflationary boil. This is not now an option for the FED as it would sacrifice the current low level of unemployment—a major policy win so far this year.
In the absence of a central bank policy-induced economic squeeze via targeted rate hikes, the bond market may step in to do something comparable. To rationalize a continued investment in fixed income, bond investors will sell until the price of fixed income assets drops and their corresponding yields increase in real terms to a level that is attractive. (By real, I mean adjusted for inflation. Current yield minus the inflation rate gives you a number that is either positive or negative. That is your real yield. Yields should exceed the inflation rate by 1–2% according to the Taylor Rule.)
If fighting inflation is that straightforward, why hesitate to enter the fray and aggressively raise rates? Here we land on our first consideration for this paper—the impact of inflation on the stock and bond markets. Let’s consider three elements: the Fed’s trilemma, the demographics of wealth destruction, and the solvency of banks and other leading financial institutions.
The Fed is required by mandate to 1) control prices (which is one of their core mandates, at which they are now failing with the consumer price index above 8%) and 2) keep the jobs market stable (a current success story with unemployment at 3.6%). But they have a third unofficial mandate to maintain financial market stability. At this point, to regain control of prices and manage inflation rates lower, they would need to raise rates above the level of inflation. That would destroy both the jobs market and cause a bear market in stocks and bonds. Why does a bear market matter so much?
It brings up the second element I mentioned: the demographics of wealth destruction. Retirees from the baby boomer generation are still leaving the work force at a rate of ten thousand per day. Covid accelerated that trend, leaving over 11 million job openings and adding upward pressure to wages. With a huge cohort transitioning to reliance on their portfolios as a supplement to social security and pension incomes, the direction of stock and bond prices is particularly relevant. The US population over the age of 65 (https://www.urban.org/policy-centers/cross-center-initiatives/program-retirement-policy/projects/data-warehouse/what-future-holds/us-population-aging) has exceeded 55 million and is on target for reaching 80 million by 2040. This group has the most to lose in a bond and equity bear market induced by inflation and hardened by increasing interest rates. A bear market for both stocks and bonds simultaneously doubles the damage and impairment. With higher rates of inflation comes the natural rise in interest rates, along with the policy increases in rates that reinforce the downward bear trend in financial assets.
The third element I mentioned is institutional solvency. Banks and financial institutions maintain highly leveraged balance sheets, typically 95% debt to 5% equity, and significant exposure to the leveraged loan market. Corporations are geared at a much more conservative 50:50 leverage ratio (https://www.bis.org/speeches/sp140226.htm). When considering the impact on institutional solvency, banks and financial firms are particularly at risk with sizeable portfolios of fixed income securities. The conclusion is that raising rates aggressively puts banks and financial institutions at risk from a solvency perspective since their assets are under pressure in the context of rising rates.
Next, let’s consider the difference between financial assets, which I described above, and hard assets. There is an approach to asset preservation and growth in the context of abiding inflation that is distinct from the traditional 60/40 portfolio blend of stocks and bonds. Let’s begin with the definition of a hard asset: a tangible asset or resource with fundamental value. This could include oil, natural gas, gold, silver, farmland, timber, commercial real estate, or companies that derive their value from producing and selling these resources.
Now let’s consider why these assets can perform differently than financial assets. An increase in the price of the resources that hard asset companies sell contributes to an increase in margins, all else being equal. In an inflationary environment where the price of goods and services is on the rise, the challenge is for management teams to contain costs effectively and allow the commodity price increase to benefit their bottom line. Wage increases, fuel costs, shipping costs, and many more can mitigate this success. Effective management and quality assets are critical.
A risk factor for some hard assets ties to the possibility of effective inflation management. If rates are in fact raised to a level where demand can be reduced and recession triggered, economically sensitive hard assets take on a unique risk profile. Industrial metals come to mind, along with gasoline and oil. My preference is for the precious metals because they are less economically sensitive (versus copper or iron ore, as an example) and more liquid. They provide inflation protection without stagflation vulnerability. The king of hard assets is gold. Oil is arguably more vital from an economic standpoint, but therein lies its vulnerability. In a period of economic expansion and inflation, oil would be king. In a period of economic stagnation and inflation, gold wears the crown.
Some hard assets are still at risk in an environment of rising interest rates. Real estate has mild inflation insulation with upward rent mobility. If it’s encumbered, it will benefit from a diminished debt burden due to devaluation. However, those benefits accrue to long-term owners. Buying and selling real estate assets in an inflationary environment can be dangerous due to the repricing of cap rates in lock step with interest rates. So a future sticker price is likely to be lower as cap rates and interest rates move higher together.
Finally, we look at the political cost of inflation. In a democracy, how people feel matters a great deal. It influences how they vote. Job insecurity, financial and budget insecurity, and feeling threatened or at risk moves the moods of voters. Inflation hits home with the average household whether they can specifically identify the cause of their anxiety of not. Current presidential approval ratings seem to confirm that, despite reasonably strong economic statistics and a very strong jobs market, something is not quite right. Digging into the most recent University of Michigan consumer sentiment numbers, you find a level of desperation and despair that is completely out of step with other economic metrics. The consumer is on the ropes. Why? Inflation.
History is not all about democracy, and most of the inflationary periods of the past did not take place in democracies. The Roman republic witnessed great upheaval as the empire neared its end, with inflation a hallmark of the period. It is no coincidence that the number of emperors who were killed versus those who died of natural causes rose to 80% between 175 and 300 AD as the Roman currency was devalued.
The famously misquoted “let them eat cake” came not from Marie Antoinette but from a Royal of the court many decades before, yet it still cost her head. Just as fake news today serves to magnify bias, so too the peasant crowds of Paris in the 1790s were angry, vengeful, and embittered by the scourge of inflation felt most painfully by the poor. Angry mobs in the 1700s and food riots in Tunisia (kicking off the Arab spring in 2011) have in common desperate household budgets unable to provide even the most basic staples.
Another political hallmark of inflationary periods is a rise in populism and national self-interest. This coincides with the concerns of the WEF over globalization coming to an end and national policy objectives displacing the global cooperation of recent decades.
CEF was originally conceived as an organization that, like the WEF, would approach the biggest global challenges facing modern society and bring solutions. However, instead of being strictly man-centered, its solutions are Christ-centered, Kingdom-focused, and redemptive both in inspiration and in best practice formation, learning from all God’s people, from every nation and ethnicity. Seeing the world through the lens of God’s redemptive desires and Kingdom identity creates a radically different global agenda. Hearing the voice of God and aligning our actions with a plan that transcends our ingenuity also helps differentiate the CEF vision of the future from that of the WEF.
Globalization, in a single word, captures a process of cooperation between nations, improving terms of trade, facilitating greater capital flows, and working on a variety of public policies across borders. Increased globalization brings about periods of growth characterized by peace and improved prosperity. These episodes are recurrent through thousands of years of recorded history, with enough periodicity to describe them as cyclical.
Deglobalization, by contrast, is a breakdown of the process. It’s characterized by increased insularity, implementation of capital controls, erection of trade barriers and tariffs, and competitive currency devaluations. National priorities supersede international ones, and cross-border cooperation is constrained by domestic, sometimes populist, politics. Many issues are influencing this shift to deglobalization, but constrained household budgets and the reprioritization around immediate needs, driven by inflation, is a key factor.
When these periods of globalization end, there are always financial market ruptures, currency crises, and war (Harold James explores these themes in his book, The Creation and Destruction of Value). If the current period of globalization is ending, then the peace dividends of the past 50 years will no longer be present, and the world will look and feel quite different. An increase in economic friction and costs will reshape the decisions and planning for business leaders and non-profits for decades to come.
How does courage relate to the topic of deglobalization and inflation? I Corinthians 15:58 reminds us,
“Therefore, my beloved brothers, be steadfast, immovable, always abounding in the work of the Lord, knowing that in the Lord your labor is not in vain.”
In God’s economy, the work of redemption is always afoot, and under some circumstances is accelerated. The end of the Roman empire and the trend of deglobalization between the third and fourth centuries AD provided a dynamic backdrop for the spread of the Gospel. There is a spiritual battle afoot in any period of change for what set of values will define the times and the days ahead. Measured by global GDP growth, or in terms of real inflation adjusted wages, the years ahead may seem pressured and strained. Seen through the lens of the Gospel, we have our Roman roads and the means of carrying the good news to all the world.
Could the remnants of globalization and the disillusionment and disorientation of deglobalization provide a profound context for discipleship, Christian charity, and a ratcheting forward of Kingdom works? I believe that they can.
Can the most courageous among us operate without the tailwinds of credit growth, cross-border cooperation, and the hyper economic growth experienced in the late 20th and early 21st centuries? What does Kingdom work look like in an era of financial compression, asset deflation, and currency instability? We are accustomed to a patron model of philanthropy for organizational viability. Is there a complementary mode of operation that is less dependent on concentrations of capital and thus less contingent on prevailing economic and financial market conditions?
Craig Deall and Foundations for Farming stand out as exemplars. Kingdom-rich principles of stewardship do not require the riches of the world to take root and grow. Our willingness to be led by God and obey Him, to serve and love others, and to take our God-given talents and share them with those who are desperately in need of basic resources opens the way to echoing the kerygmatic spirit of the early church.