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Inflation’s Endgame, Volatility’s Vengeance

A gradual decline into disorder?
GAM’s Christian Gerlach examines the phenomenon of ‘modern growth’ and ponders the potential implications of the destruction of the ‘utopia of the future’ on distorted asset prices.

6 December 2017

Surprisingly, global inflation pressures have remained muted despite marked economic improvements. Most troubling, without the massive supply cuts in commodity markets, most consumer-price indices would actually still point towards deflation. Thus, as wage pressures are failing to materialise, OPEC and others have provided the world economy with the convenient illusion of actual progress towards attaining a sustainable inflationary recovery from the “Great Recession”.

Alas, the real struggle for secular inflation is still ahead of us. Inflation’s endgame will have to consist of combining the current supply cuts with three vital measures: government expenditures far in excess of revenue, trade protectionism and deliberate currency depreciations. Sadly, by embracing this holy trinity of excess-capacity elimination, our age of liberal globalisation will be laid to rest.

Globalisation's purpose

In contrast to appearances, today’s globalised economy is not a natural phenomenon but a particular grand strategy of statecraft. It originates from a state’s desire to produce “modern growth” within the confines of a “great geopolitical order”. Great powers typically conceive of such grand ordering strategies after a major hegemonic war. Before liberal globalisation constituted mankind’s highest state of peaceful economic competition, the most beloved grand strategy was mercantilism.

Until the late 18th century, arguments regarding gains from peaceful trade to all parties appeared ludicrous as chaos and interstate conflict were commonplace. The struggle for wealth and commerce was seen as a Hobbesian zero-sum game, producing clear winners and losers. And so, economic growth became exclusively linked to geopolitics. Winning wars was all that mattered.

All this changed with the Industrial Revolution, as countries slowly started to realise that one could produce “modern growth” by identifying international trade as a non-zero-sum game. Soon, relative peace, achieved through a benign “shielding geopolitical order”, became a precondition for prosperity. During the so-called Pax Britannica, economies started to pivot towards “Smithian” (economic specialisation via international trade) and “Schumpeterian" (innovation through knowledge accumulation) growth. International commerce had successfully been disconnected from war. But from now on “modern growth” depended on an “international political order” being in place.

Globalisation's deflationary drift

During the 1930s, this fragile type of globalisation collapsed for the last time. The “Great Depression’s” catastrophic debt-deflation made it possible for mercantilism’s brutish anti-internationalism to infect world politics anew. A preceding deflationary wave in the 1920s, partly engineered by the liquidity restricting gold standard, allowed the two aforementioned forces of “modern growth” to overshoot alarmingly. An unforgiving onslaught of creative-destruction resulted. As soon as globalisation had gone into overdrive, not only did inflation seem to disappear but a new kind of techno-globalisation (not unlike today’s) rapidly materialised.

It was this kind of environment that invited the massive debt build-up, which precipitated the “Great Crash” of 1929. As the cosmopolitan sources of “modern growth” became discredited and protectionism “successfully” reconnected reflation to Mercantilism’s zero-sum games, the “shielding geopolitical order” collapsed completely. In 1931, Britain left the international gold standard, suspended all debt payments and adopted protectionism; globalisation’s “deflationary trap” had forced Pax Britannica to self-destruct.

As Britain’s example demonstrates, it is possible for globalisation to become too effective for its own good. If an asymmetrical monetary system mutates into a deflationary catalyst (forcing deficit countries to adjust their imbalances but leaving the equally distortionary balances of creditors unsanctioned), liberal globalisation easily metamorphoses into a deflationary regime. It is then almost impossible for a declining hegemon to escape deflation, without destroying globalisation itself.

Today, the world suffers from such an asymmetrical system yet again. Sizeable current account surpluses in Asia and Europe have resulted from the toleration of considerable distortion of currencies and bond markets. Thus, global disinflationary forces spread for too long, resulting in ultra-low interest rates and rapid, socially destructive, technological innovation. In the future, criticism of the current asymmetry by Anglo-Saxon indebted economies will only increase, and finally crystallise around an ideology of reflating enabling mercantilism. But what then will happen to financial markets?

Entropy rising

Throughout history, the disappearance of a “great geopolitical order” did not simply make markets more volatile but resulted in a rare paradigm break. That is to say, the prevailing dogma of “calculable risk” supremacy over “incalculable uncertainty” is eradicated via volatility surges of a seminal nature. Fatal events, such as massive geopolitical shocks, suddenly start to happen with unexpected frequency.

However, today’s markets continue to show a pristine confidence in the future, refusing to reflect a scenario in which liberal globalisation decays all too rapidly, peaceful technological progress ends and real growth subsequently suffers. This has helped to create a dangerous “disconnect” of extreme proportions, most visibly manifest in the extreme outperformance of bond and equity markets against “real economy” prices (such as commodities), under conditions of extreme low volatility.

Like in the 1920s, today’s techno-globalisation variant continues to reward most handsomely the branches of industries which actively fan the economy’s embers of deflation, eg technology. In contrast, all assets related to a possible reflation under Mercantilism’s “utopia of the past” are greatly discounted.

Looking ahead, secular inflation is most likely to return through the abandonment of liberal globalisation’s asymmetrical monetary system first, and then the great order itself. In such a scenario, reflation will be achieved by curtailing globalisation, rather than enhancing it. This upcoming break will destroy today’s “utopia of the future” and connect financial markets to mercantilism’s brutal inflationary drive. As of now, volatility in financial markets still lies dormant. However, the upcoming end of Pax Americana will surely awaken it.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of the author in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the author. Past performance is no indicator for the current or future development.