“ It is naïve to assume that the largest credit-fueled bubble in half a century can continue indefinitely or be deflated without pain. ”
Talk show pontifications notwithstanding, the trajectory of the world’s two most serious geopolitical conflicts — Ukraine and the Middle East — is unpredictable. In the Israel-Hamas war, the potential for serious escalation is not trivial. These and other uncertainties are aggravating known stresses on the global financial system. Consider inflation. Slowing price rises have been driven by easing demand, as consumers’ COVID pandemic savings dwindle and energy and food-price costs decline. While several factors suggest that inflation may stabilize at around current levels, it could increase for several reasons.
First, on the demand side, strong employment will support consumption. Government deficits, currently around 5% and projected to grow, will add to demand. The energy transition, subsidies for strategic manufacturing, semiconductors and war-footing defense spending, will continue to boost spending. Input costs show no signs of easing. While volatile, energy prices remain under upward pressure due to production cuts by Saudi Arabia and Russia to keep prices at levels which meet their revenue targets. Fuel hungry military activities will influence demand. The threat of an 1974-like oil embargo should not be discounted. Food prices are affected by geopolitical conflicts, reducing supply from major producers, extreme droughts and floods as well as export limits as nations prioritize their domestic needs. Commodity prices, such as for copper, will be underpinned by demand for transition critical minerals and armaments. There are looming shortages due to inadequate investment because of, in part, efforts to meet ESG targets. Manufactured goods prices may fall due to excess Chinese capacity but services, which are a large portion of advanced economies, will reflect rising labor costs. Moreover, an aging population and skills shortages will drive higher salaries, in nominal but not real terms, generating a wage-price feedback loop. Housing also is affected. With affordability at record lows, strong housing markets will feed inflation via real or imputed rents. Rising insurance costs due to increased extreme weather risks will flow into rising prices. Inflation also is found in the tit-for-tat China-U.S. trade restrictions on technology and rare earths, which impacts supply chains. Relocating production facilities to enhance U.S. sovereignty will contribute to higher costs because of inefficient operational scale and higher inventories. Second, public finances. Government spending, which will be affected by wars, is not being matched by higher tax revenues, leading to larger deficits and increased borrowing. U.S. government debt, for example, is forecast to rise to 107% of GDP by 2029 from its current 97%, exceeding the 1946 post-World War II historical peak of 106%.
“ Geopolitical conflict will divide the world, driving a shift away from the U.S. dollar. ”