“Change your mind”
by Christophe Morel, Chief economist at Groupama Asset Management
You defend the not very consensual thesis of an “investment boom”. Why is this?
To finance the environmental transition and strategic independence (defense, digital, health, energy, food chain), developed economies will have to invest massively!
For example, in Europe, investment growth in real terms should be around 4% per year for 10 years.
We can indeed talk about the prospect of an “investment boom”.
What about employment?
If companies invest, they need to recruit to make these transitions. Investment and employment are “complementary”.
This favorable cycle for investment makes it possible to envisage the resilience of the labor market, and even “full employment”. This puts the threat of stagflation into perspective if we define it as an environment combining high inflation, low growth and deterioration of the labor market.
On the contrary, the medium-term reconstruction environment is even closer to “reflation”!
So, you’re saying that wage inflation is taking hold?
Companies are faced with a double scarcity of labor.
On the one hand, demographic aging is reducing the availability of human capital in “quantity”.
On the other hand, the need for transition requires new skills that do not always exist.
This scarcity is currently amplified by immigration barriers and by new employee preferences, for example for teleworking. All these factors fuel wage inflation on a sustained basis.
Since the beginning of 2021, you have been repeating that inflation “is not transitory” and that there is even a “regime change in inflation”. Is your view different today?
No. Periods of economic model change are “by nature” inflationary.
Indeed, transitions require a lot of resources that do not necessarily exist in sufficient quantity.
The investment boom therefore translates into a new inflationary regime, which will materialize through increases in the price of raw materials, but also and above all, in the price of human and financial capital.
What do you mean by the rise in the “price of financial capital”?
The rise in interest rates! In the “old world” of high-risk aversion, zero or even negative interest rates were a symptom of low investment.
If the rate of investment increases without any adjustment of savings, this must translate into a pressure on the availability of financial resources through their price, namely the interest rate.
Thus, the trend in interest rates remains upward.
Should we conclude that the recent crises have been catalysts for this paradigm shift?
It is indeed the succession of crises in recent years that has revealed the need for massive investment.
- The trade tensions between the United States and China have revealed the need to invest in digital technologies.
- The Covid crisis has highlighted the need to improve health independence.
- The climatic accidents have reminded us of the urgency of the environmental transition.
- Finally, the war in Ukraine has accentuated the need to reinvest in defense, food security and energy independence.
Didn’t the health crisis play a particular role?
Yes, in the sense that it provoked a change of “software” on public debt.
Everyone was stunned after the sovereign debt crisis in Europe, which was more a crisis of European governance revealing the inability of decision-makers to agree.
With the health crisis, public debt in developed countries immediately increased by 10 to 30 points of GDP, without this having caused a financial crisis.
This fueled a collective reflection leading to a change of “software” on public debt.
What do you mean by change of “software” on public debt?
First of all, we must realize that the State is not an economic agent like any other because its life span is “infinite” and because it issues the money it spends.
Secondly, the priority is not to balance the State budget but to balance the economy.
Indeed, deficits in infrastructure, health, education or the environmental transition should be of greater concern than government budget deficits. For example, the European Commission clearly distinguishes between operating and capital expenditures.
So, there is no limit to debt?
Of course, there is a limit! But debt must be seen in a broader sense than just from a monetary point of view.
It is true that a State that goes into debt leaves the burden of repayment to future generations. But a State that does not act to prepare the energy transition, for example, would also penalize future generations.
Thus, there is the debt that we measure and all those that we do not measure, such as the “environmental debt”. We must not forget that not acting also has costs!
Are you developing a kind of “holistic” approach to the economy?
We need a broader approach to debt. We also need a broader approach to assets.
Beyond physical, financial and human assets, there are intangible assets, which are often undervalued.
The financial crisis has reminded us that transparency is an asset. The European debt crisis has shown us that good governance reduces returns. And the current geopolitical crisis should quickly remind us that peace is an intangible asset that is often undervalued.
So, you are not worried about the sustainability of public debt?
Of course, we must keep an eye on it. But the trajectory of public debt has two brakes on it over the current decade.
First, the rise in the cost of debt will only be gradual, given the past decline in market rates.
Second, nominal growth is likely to be higher than nominal rates during this period of investment recovery, which favors the sustainability of public debt and even allows for a gradual reduction in debt.
Is there a paradigm shift on the part of central banks as well?
Yes, and we can mention two changes.
First, central banks have capitalized on the monetary experience of the 1980s, so that they will not lower their key rate in the event of a recession in order not to revive inflation expectations, even if this is costly in the short term for growth.
Second, the central banks’ “put” in the event of a financial market correction is no longer automatic. The latest statements by central bankers show that the improvement in financial conditions is not necessarily perceived in a positive light.
What are the determinants in the decision of central banks? Inflation expectations?
The role of inflation expectations in price formation may be attractive from a theoretical point of view, but it is open to criticism: are economic agents as rational in their decisions?
Moreover, this reasoning is challenged empirically: what is the “true” causality between inflation and inflation expectations?
I think that central banks put too much emphasis on inflation expectations.
If the influence of inflation expectations in price formation is overestimated, then this means that the impact of other variables is underestimated, in particular the influence of the labor market.
Tensions in the labor market are the number one determinant of monetary policy decisions. The Phillips curve, which establishes a link between unemployment and inflation, is rising from the ashes!
What about monthly inflation statistics?
This is probably criterion No. 2.
Indeed, there is an inflation threshold at which economic behavior changes. We have estimated that at an inflation rate of 8% or more, households and companies become more attentive to price changes and adjust more systematically, particularly through wage demands. The “price/wage” loop is triggered.
You see Fed Funds at 6%. Why do you think that is?
The labor market is the key variable.
Currently, in the US, demand for labor exceeds supply by about 4.5 to 5 million, which fuels wage inflation in the private sector around 6%.
To ensure its 2% inflation target, the Fed needs to bring wage inflation back to a 3.5%-4% pace. Unless it assumes a sharp rise in the participation rate, the Fed must then “force” the decline in labor demand by provoking a cyclical recession.
To do this, it must bring its policy rate back above 5%.
So, you anticipate a recession in the global economy?
The developed economies are facing three adversities that will lead them into recession:
- Firstly, many industrial companies have built up their inventories to such an extent that they are now vulnerable to a fall in order books.
- Secondly, even if there are tariff shields, the rise in energy commodity prices will penalize demand, particularly in Europe.
- Finally, in the United States, the tightening of fiscal and especially monetary policies will push the economy into recession.
Should we fear this recession?
I am almost tempted to say that there is a “good recession” and a “bad recession”.
The last few recessions were deep because they were linked to financial imbalances. This time the recession will be more a “textbook” one, either linked to rising commodity prices in Europe or to an overheated economy in the US.
Economies recover much faster from a cyclical recession than from a recession linked to balance sheet imbalances.
What is the factor that could cause a more severe recession?
Of course, there is always the threat of an escalation in the Ukrainian conflict.
On the other hand, developed economies will have to digest the withdrawal of liquidity, which is bound to be a “test” for the financial system. The contraction of dollars in circulation in the world economy has to be digested.
In this new environment, what about the long-term return on capital?
Over the last decade, the ex-post risk premium on equities has been between 10 and 15%.
This “abnormal” return is linked to the exceptional injection of liquidity by central banks that has poured into the financial markets. In this new environment, the distribution of added value will be more favorable to employees at the expense of shareholders.
This implies a downward revision of the average return on equity with a risk premium that must be normalized.
Should we envisage the end of the dollar’s reign?
In the short term, the dollar should fall for cyclical reasons.
From a fundamental point of view, the imbalance between the “real” weight of the United States (15% of world GDP) and the place of the dollar in financial flows is growing. However, at this stage, there is no sign that the dollar is being dethroned. For example, it maintains its dominant position in international financing (50%) or as an anchor for other currencies (60%).
There are good reasons for this: the weight of the past, the depth of the American markets and, above all, the absence of a credible alternative currency.
Which currency to replace the dollar?
In the event that the role of the dollar is questioned, this hegemony will not be replaced by another hegemony.
In a now multipolar world, the IMS will necessarily be multi-currency. And this multipolar world, faced with global issues (environment, health risks, etc.), implies a rethinking of global governance.
How does this environment change your method of analysis?
Public investment plans are forcing the entire ecosystem (companies, central bankers) to extend the time horizon. I think there is also an urgent need for economists to do the same.
Until now, it was customary to start with the cyclical outlook, then talk about inflation and conclude what that implied for monetary policy. Now, it is necessary to rethink this order: first, it is necessary to extend the time horizon by positing the long-term growth outlook in order to deduce what this means for the inflation regime and for the reaction of central banks. From this, we can deduce the economic outlook. Finally, we need a long-term scenario to anticipate short-term developments.
And for the asset management industry?
Massive central bank purchases have undermined risk discrimination. This new, healthier environment is excellent news for “active” asset management.
It makes research more relevant. It also implies a review of management processes, opting for more tactical and contrarian approaches.
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