April Newsletter: ‘Let the Fed be With You’

14 April 2022

“Where is the security that the Security Council needs to guarantee?”

Zelensky to the UN Security Council April 2022

The world’s attention is drawn to the Ukraine, the horrors of war and the sanctions against Russia. We worry about the inevitable shortages of oil, gas and foodstuffs as Ukrainians die in the streets. The world awaits the coming inflation tsunami. High inflation has the chance of washing away the West’s economic globalisation of the world. The death of globalisation has been exaggerated, but now a move towards regionalisation looks increasingly inevitable. For the West to save globalisation it must underline its values and step out of its comfort zone. As Europe continues to buy Russian gas and oil it seems that is a step it is not willing to take!

Living in the comfort zone has been nice. Nice for consumers and nice for investment returns. While we rail against its inequalities, globalisation has fed the ever-increasing population. Many live the lives Kings and Queens of the past merely dreamed of. Much of this wealth has been fueled by credit expansion – debt to you and me. Since the financial crisis this expansion has been enabled by ever lower interest rates set above all by the US’s central bank, the Federal Reserve (the Fed).

Now things are changing. Interest rates are rising. The credit expansion is about to go into reverse. Ostensibly the main reason for this is to conquer inflation. But the fact that the collateral damage of rising interest rises is likely to help the West in its battle to save globalisation may mean faster increases than expected.

When the US starts raising interest rates there is always collateral damage. Something goes bust. Mexican banks, Thai banks, US real estate, the list is long. What goes bust is normally a sector or an economy which is highly indebted. Raising interest rates, if you like, is the financial world’s equivalent of ‘there’s 10 in the bed and the little one says roll over….’. The Fed is the one that calls out ‘roll over’ and the one that falls out of bed is the one with the biggest debt.

The good news for the West is that the one on the edge of the bed is the Chinese property sector. Chinese support of Russia is a thorn in the West’s side. Its economic miracle has been built on property. Until 1997 Chinese rural migrants were given city flats for free. All that changed. Local authorities were given control over land sales and property development. Over the next two decades the Chinese economy has become increasingly reliant on a property sector fueled by debt. Forty percent of local authority income comes from property related transactions. But with reportedly enough empty flats to house 90 million the cracks were already appearing. Its 50 million construction workers are facing a struggle for work. Increasing US interest rates could well push the sector and therefore the Chinese economy out from under its economic comfort blanket.

The West will struggle if it continues to fail to lead by example. It seems its central bankers rather than its politicians are more willing to take the step out of the comfort zone that is needed. The impact for markets short term is likely to be bumpy but materially better in the longer term if the collateral damage is mainly limited to its adversaries. As President Zelensky’s pleas fall on deaf ears at least the Fed is with him….