The first post for this substack was ‘Welcome to kayfabe - whatever the hell that is’ and today would be a good time to go back and do two things. First, either watch or re-watch the two videos linked at the start of the piece- combined they are less than 30 minutes.
I cannot stress enough how valuable doing so will be, even if they seem unrelated at the start. Second, read the remainder of the piece for perspective on the analytical prism through which this substack is written.
While I focus upon business cycles and markets, unfortunately, sometimes politics become omnipresent, such as government responses to the pandemic, and/or recently with the emerging crisis in Ukraine. As the gap between narrative and reality has widened, as examined in the two videos, sometimes narratives are so ridiculous relative to reality, it almost seems like a professional wrestling plot. With propaganda running off the charts all over the place, it is increasingly difficult to maintain an objective analytical framework.
The major escalation in conflict this week took place largely within the realm of macroeconomics and ‘financial warfare.’ I have written in recent weeks about how the global economy was likely entering a recessionary window of vulnerability independent of the invasion of Ukraine and subsequent global financial warfare breaking out. From an analytical perspective, while it is unpleasant to consider potential consequences, I believe it is prudent to consider what the probabilities may be of recession and/or depression.
As has been my focus, the goal is to KISS it - keep it simple, stupid. Let’s start with initial conditions:
Record sovereign debt levels across various major economic blocks entering this period, combined with record-low interest rates.
Supply chain problems and inefficiently distributed pandemic-related government transfer payments fueled consumer inflation rates which were likely double digits BEFORE the recent explosion in many commodity prices.
Real average weekly earnings were -2% BEFORE the invasion, which is comparable to the levels reached in July 2008, when crude oil peaked at around $147 per barrel.
Central banks around the world, but in particular in emerging markets, have been tightening monetary policy for the last year, with many having flat to inverted yield curves BEFORE the invasion.
Hard assets had experienced a decade of low investment due to depressed commodity prices and other factors such as ESG raising the cost of capital. This created a likely long-term supply deficit BEFORE the invasion.
Measures of global liquidity had already turned sharply lower BEFORE the invasion.
Corporate earnings guidance had turned down sharply BEFORE the invasion.
I could go on, but I hope my point is clear - there was a lot of potential problems which the invasion and subsequent financial warfare have made exponentially worse, as well as likely introducing a myriad of new ones; some of which we probably cannot even yet conceive.
Independent of any policy debate on what should be done from a geopolitical perspective, the intended and potential unintended consequences of global financial warfare could be massive. One need only do a modest amount of research on what the global financial war may do to fertilizer and grain markets to understand the gravity of the situation.
I’ve referenced the analysis and writings of Lacy Hunt in the past, this section focused upon the US economy from his Q3 2021 letter is worth revisiting:
The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation. In the 1970s, the economy was beset by a string of such supply curve shifts primarily because of falling oil production. Then the inflation rate did not fall but continued to march higher. However, before Paul Volcker was made Fed chair late in the decade, the Fed actions allowed money supply to accelerate steadily. During the 1970s, unlike currently, the velocity of money was stable (although not constant). As a result, the aggregate demand curve (C + I + G +X = M x V) also shifted steadily outward. This allowed the inflation from the supply side disruptions to become entrenched. Currently, however, the decline in money growth and velocity indicate that the inflation induced supply side shocks will eventually be reversed. In this environment, Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.
Many of these supply-side issues are now being amplified due to the global financial war, but the underlying analytical underpinnings remain the same, in my opinion. The ‘deflation gap’ is likely to explode and then be filled, with the potential for a severe drop in demand which accompanies a global recession, or worse. Emerging markets are particularly vulnerable, with Europe and Japan also heavily indebted and at the mercy of currency markets as fiscal deficits would be likely to explode.
My base case for a ‘worst case’ pathway forward is as follows:
Consumer prices get much worse as supply shocks hit food supplies and many other important consumables.
A global recession (or worse) and related demand destruction begin to fill the deflation gap, causing sharp drops in many prices.
Governments respond by exploding fiscal stimulus and revert to massive quantitative easing.
Various currency crises emerge due, and various governments resort to direct monetization, introducing Gresham’s Law.
Please note, all of this is independent of geopolitical risks surrounding things like physical war, cyberwar, mass migrations/refugee crises, political revolution, etc. Failure to plan is planning to fail. Unfortunately, the probabilities of some form of a ‘worst case’ appear quite high.