The Messy Road Ahead

March 25, 2023

The next phase in the war on inflation is likely to be messier than it has been so far. After highlighting in late October that all the bad news seemed to be taken as good news, the market has generally done well. As 2023 unfolds, there is real risk that economic pressures may be difficult to hold at bay.

Perhaps the most important issue facing the world today is inflation. The impacts are being felt throughout the economy and many of the actions being taken today reflect attempts by central banks to slow inflation (or crush it, depending on the optics). Of course inflation has been raging in many parts of the economy for some time (housing, food, transportation), but government measurements are just now starting to acknowledge the impact, and the numbers are excessive. Notably, inflation has not been this high since the early 1980’s and that means the vast majority of people alive today have no experience or understanding of how inflation impacts their daily lives.

To fight inflation, the government has a number of tools, and the two being utilized currently are to raise interest rates and to remove funds from the financial system. Interest rates have risen substantially in the past year and the impacts will certainly affect spending, but higher rates may also help to reduce asset prices.

The reality of higher rates takes time to impact daily lives. The typical family who relies on a mortgage to buy a home or an auto loan to purchase a car may have locked in lower rates for months or years in advance and so those higher rates may not affect them for a long time after rates start rising. If there is a significant rise in rates during that period, when the effects hit, it can be very difficult.

One area of concern is short term debt like credit cards and personal lines of credit. The impact for higher rates may be felt here much sooner, due to the short term nature of the debt, but also because of consumers increasing reliance on these forms of debts for everyday requirements such as food and shelter. Penalties, such as for failure to pay an outstanding balance on a credit card, can add up quickly and make it impossible for consumers to recover from short term imbalances in financial needs. Below is a chart of outstanding consumer loans and credit card debt with all commercial banks since 2000. This number is up almost 500%.

One key component of the increasing debt levels is that asset prices have moved (mostly) in lock step with these increases, whether it be housing debt or auto loans or corporate valuations, and incomes seem to support the burden in a typical analysis. But almost every significant financial analysis suggests that the artificially low interest rates have created ‘asset bubbles’ in almost every asset class. In simple terms, everything is more expensive than it should be. There is a whole philosophical argument about whether that is true, who should decide and when do governments and banks step in. Those conversations have been at the heart of almost every financial media outlet for the past year.

Central banks have decided that they need to change the trend. An important question could be . . . Why?

As central banks around the world raised rates it makes complete sense for some market participants to be under strain, and the past two weeks has demonstrated the level of damage that can be done. Two weeks ago a medium size US bank (SVB) collapsed wiping out shareholders. Last weekend a well known (and long troubled) Swiss Bank (Credit Suisse) collapsed wiping out many bond holders (although the equity maintained some value).

The worries about the system are spreading and governments continue to advise calm and remind participants that all is well. Caution is certainly warranted, but it might be meaningful to review bank failures from the past 22 years. (See the chart below). The notable bit was at the start of the last crisis (2007), only three banks failed with a total value of $2.6 billion. In the worst year by dollar value (2008), 25 banks with assets of $373 billion went bust. In the worst year by number of banks (2010), 157 banks with assets of just $96 billion went bust.

Context would be helpful here. In the past two weeks, two US banks (excludes Credit Suisse) have failed with assets of about $320 billion.

As rates are normalized, it is likely that there is more difficulty ahead. Central governments face a very difficult dilemma. The first is to continue fighting inflation either by sustaining rates, or even raising them. This will cause a lot of damage to many consumers and organizations who don’t have the financial flexibility to withstand sharp adjustments to their business model. The second and arguably more troublesome path is to relent and weaken the resolve to fight inflation. This will almost certainly result in significant difficulties for many nations (not least the USA) when they can no longer find lenders to buy their bonds and fund continuing large deficits.

This space has been used to guess at the outcome (it is pessimistic), but the point is that things are beginning to break and the amount of difficulty ahead is likely going to be significant and may last for many quarters or perhaps years.

A cautious approach to investing would be wise for the near term future and diversification would help to distribute risk when making investments with so much uncertainty.


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