Perspectives on Inflation – Geopolitics & Technology

And you might find yourself

Last week former British Foreign Secretary William Hague wrote a Times piece titled, Once in a lifetime events are the new normal. Bloomberg journalist Tracy Alloway described the financial world as “tail risky”. These views represent a world that is trying to establish a new order. Some people, like Hague, look at this in a top-down political context, while others take a different, more optimistic bottom-up view based on human ingenuity and technology. For investors, the critical issue of the day is inflation. The question is no longer will we get it, but how long will it hang around, what are the implications for asset prices, and how long will it take to fix the supply side?

Different views

In this context, two influential macro commentators with differing world views offered opposing views on the inflation debate last week. Raoul Pal, a retired hedge fund manager, entrepreneur and techno-utopian, published a piece from his GMI service, The Glorious Days of Yesteryear & the Gods of Times Past. He opens with the view: The idea that inflation is here to stay is one of the strongest narratives I have seen. As many of you already know, I don’t agree with it. Pal went on to illustrate, more with charts than text, the reality of how human ingenuity lowers the cost of everything over time, including the cost of energy. The idea of technological deflation is not new, albeit not widely appreciated. On the same day came the opposing thoughts of Credit Suisse strategist and former U.S. Treasury wonk Zoltan Pozsar from a geopolitical perspective: trust drove globalization, and globalization drove “The Great Moderation”, distrust will drive de -globalization, and de -globalization “The Great Reflation.” Pozsar, who grew up in Soviet-era Budapest, unsurprisingly sees the world more from a geopolitical than a technological perspective.

Hunting oil & gas

While both views can be right over different time frames, the Pozsar piece resonated most while listening to the half-yearly update from oilfield services business Hunting. Hunting, an old British family-owned energy and engineering services company, is today predominantly a U.S. manufacturer of specialist equipment for the horizontal drilling and fracking industry. A proven innovator in this vital sector. It was a very upbeat commentary on the global oil and gas industry’s prospects in improving its lamentable recent record of capital investment. (Notably, among the exhibits on offer was the CAPEX chart used last week when I wrote about the continuing prospects for the energy bubble). CEO Jim Johnson said: the energy industry is likely to remain on a firm footing given the macroeconomic and geopolitical movements reported in the period. Energy security planning will likely support industry growth for western economies into 2023, with the Company well placed to benefit from this outlook. While Pal will be right over the long term, and human ingenuity will prove to be the Ultimate Resource in serving our energy requirements, for the next few years, it is the Poszar narrative and the prospects for companies like Hunting that will pre-dominate.

Breaking up       

In War & Industrial Policy, Zoltan Poszar makes a case for why the era of lowflation caused by the globalised unions of Chimerica and Eurussia has ended. As he says: Both unions were a “heavenly match”: the E.U. paid euros for cheap Russian gas, the U.S. paid U.S. dollars for cheap Chinese imports, and Russia and China dutifully recycled their earnings into G7 claims. But as in marriage, trust is lost when these harmonic relationships turn sour.

Money-go-round 

China and Russia recycled their trade surpluses into the West in the golden era of globalised harmony. China mainly bought Treasury bonds and Russia Knightsbridge real estate. Wealth recycling lubricated the West’s ability to keep interest rates low (QE) while containing inflationary pressures on financial assets and not disturbing consumer prices. This balanced flow is now lost.

Gets tricky 

After a divorce, new relationships form, and new ways of life evolve. An alliance of the sanctioned with the spurned ex-wives club of Chussia at its core: “the enemy of my enemy is my friend.” Pozsar talks not of the BRIC but the TRICK economies (Turkey, Russia, Iran, China and North Korea). As he says: forecasts of a rapid deceleration of inflation are naively optimistic: if Pax Americana enabled globalization and globalization underwrote lowflation, the TRICKs trying to poke holes in the Pax means that inflation is a big risk.

Minsky moment

In Pozsar’s view, the real economy is witnessing a Minsky moment similar to the financial economy’s Minsky moment in 2008/9. Whereas the implosion of poorly understood intermediation chains in financial markets caused the demise of Lehman Brothers, we are currently witnessing an implosion of the just-in-time supply chains of the real world. In both cases, the Minsky moment is that point just as the rollercoaster peaks out where we collectively lose trust in the system that offers the best means of saving us from the forces of gravity. In 2009 the world’s banking system ran out of liquidity. Today the world’s real economy has run out of inventory. The dislocation this time is not loss of confidence in the banking system or the value of contrived financial assets but our faith in our ability to supply baby formula, semiconductors, diesel and missile systems.

Leverage

The European energy market is now the locus of the Minsky moment for the global economy. While financial leverage and just-in-time financing structures caused the financial crisis, operating leverage and inadequate inventory are impacting us today. Germany’s industrial prowess was built on converting $20bn of Russian natural gas into $2tn of industrial output. At 100x, this exceeds the financial leverage ratio of Lehman Brothers. Furthermore, the survival of the banking system after 2009 depended on a central banking system that could do whatever it took.

New priorities  

The survival of the real economy rests on having a global hegemon to protect its supply chains. Countries are losing faith in the USA to perform this role. Policing the Straits of Hormuz, maintaining Taiwan and South Korea’s strategic ambiguity, sending missiles to Ukraine and shoring up NATO don’t come cheap. In this world view, the future is inflationary, and the West’s priorities must be: re-arm, re-shore, re-stock and re-wire. These tasks are capital intensive, commodity-intensive, interest rate insensitive and need financing without access to the foreign reserves of the TRICK economies. Pozsar sees the next five years being dominated by these imperatives. All else will be sacrificed in exchange for missiles, chip fabs, LNG facilities, and giga-factories.

The new paradigm must wait 

Unsurprisingly Pal takes a different view. He shows that over the last 50 years, oil demand has increased by over 300%, but the real price has declined. Our rate of change in oil (and all energy) consumption per unit of economic output has collapsed. Our ability to extract oil and gas and use it more efficiently has improved substantially. Technological improvements in alternative energy sources are starting to move the needle regarding our energy mix and transition to a sustainable future. Pal extrapolates further and talks of the collapse in energy prices over the next two decades and what he terms the coming exponential age of abundance. He even uses the term “a new paradigm”, unseen since early 2001. His is a bottom-up world of spontaneous order responding to price signals and solving problems before they become crises. Pal, like Julian Simon in the 1970s, will be proven right. However, he risks being wrong first, probably for several years.

Jeremy

Ealing

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