The war in Ukraine will bring a dramatic change to the inflation outlook.
The way we currently think of dealing with inflation through more or less drastic liquidity cuts by central banks is about to become obsolete.
How come?
The fact is that since the 1970s the financial world has understood that inflation generated by energy shocks external to the economic system is impossible to control with the normal monetary measures of central banks.
After the historic oil embargo by OPEC in 1970, inflation only started to fall below 5% 10 years later, in 1981.
No monetary manoeuvre has been able to change this long inflationary wave and would not be able to do so today.
Even today, therefore, inflation, which has gone from being a residual phenomenon due to the pandemic to a fundamental condition created by non-economic factors, will start to fall increasingly outside the "jurisdiction" of the US central bank.
After all, the Fed's mandate is to stabilise the dollar, foster economic growth and employment, NOT to change commodity trends.
This means that once the Fed has scaled back, as promised, the excess liquidity created during the pandemic, it will NOT prolong the tightening with the idea of attempting an impossible calming of the commodity and oil price increases triggered by the war.
On the contrary, this war could even turn out to be the pretext the Fed has been looking for in order to raise rates much more gently than planned.
Even a mild rate hike would be a drag on the state budget.
That is why I have always assumed that when the facts were in, the central bank would disappoint media expectations of five, six, seven ... endless rate hikes by 2022.
The outbreak of this war could be the right premise for this scenario not foreseen by the media, as:
- Inflation would officially become a phenomenon beyond the reach of the Fed, relieving the latter of its responsibilities.
- a possible recession caused by the war would give the Fed the excuse to abandon tightening or to reduce it to a minimum.
But even economic growth would encourage the Fed not to overstretch the tightening in order to achieve a goal (lowering inflation) that the war has made impossible.
What would be the outlook for the markets if we are facing a decade of inflation?
If the pandemic had not already minimised the responsiveness of global economies, we should have expected a positive reaction from the predictable economic growth that always follows wars.
In the past, inflation was made acceptable by triggering economic upturns that made it possible to put a higher value on safe haven assets.
To put it practically: in the 1980s there was, it is true, very high inflation, but the economic system could afford to attribute enormously high interest rates to the bond sector.
Today, however, with globalisation at a low ebb and the central banks' ability to trigger economic recoveries, however nominal, undermined, we could be looking at a decade of inflation coupled with little value creation in traditional safe haven assets.
The bond market looks set for a season of falling rates, not rising ones. So at best you can use these assets to take advantage of their long-term price rise, not for guaranteed "returns" as was the case in the 1980s.
Today, investors are "condemned" to rely on "risk", not on "return".
So bonds are becoming a lot like cryptos and high-growth equities, in the sense that you invest in these assets in the hope that they will create value faster than inflation, not because they give you "guaranteed returns"...
But even in seeking value on the growth of certain sectors, there are many risks.
If, for example, China wanted to imitate Russia by invading Taiwan, it would achieve the double aim of putting an end to a centuries-old geopolitical dispute and destroying the high-tech production capacities of Western countries for at least a decade (Taiwan, as we know, is the home of microchips and it takes at least ten years to rebuild the production of these components in the West).
The economies of East and West are less and less interconnected; and this makes it less and less risky for Eastern countries to make unilateral moves that three years ago would have been considered self-defeating, but which today are just another blow to a situation that is already hopelessly compromised.
So I do not want to sugarcoat it: we are at an unpredictable historical turning point, where anything can happen.
It will take time to start identifying well-defined trends to invest in.
News items overlap and the situation changes from one hour to the next.
We don't usually publish news or political topics, but the news that the EU is going to war directly, by ̶s̶e̶n̶d̶i̶n̶g̶ ̶t̶r̶o̶o̶p̶s̶ ̶a̶n̶d̶ ̶v̶e̶h̶i̶c̶l̶e̶s̶ sending weapons and supplies in Ukraine, and moving soldiers and vehicles to countries on the border with Russia, for the first time in its short history is rather worrying.
Until two days ago, everything pointed to an entirely contained instrumental conflict in Ukraine. But now the conditions are in place for a widening of the war, i.e. its extension to other countries and a much longer duration.
From my point of view, there are conditions for a change in the markets. From a simple bear market scenario to a real crisis scenario.
The question we need to ask ourselves as investors is: what would the markets look like if Europe became a theatre of war?