The Butterfly Effect
The wise tell us that a nail keeps a shoe, a shoe keeps a horse, a horse keeps a knight, a knight, who can fight, keeps a castle. – An old proverb
According to butterfly effect theory, when a butterfly flaps its wings in the Amazonian jungle, a storm ravages half of Europe. It is that small change in the initial conditions that lead to far reaching results. In essence, financial markets are complex systems that are influenced by small changes which makes it incredibly difficult to predict the future and as such, the success and failures of companies may seem completely random.
Preparing for the future and discovering logic in in highly complex systems where pushes & pulls and bears & bulls co-exist is challenging. In this newsletter, I take account of some of these opposing forces playing tug of war in the current macroeconomic setting.
The recent economic data is showing the clear signs of a healing global economy. A rush of consumer spending has helped to bring the total US output to the cusp of pre-pandemic levels and the applications for unemployment benefits have declined to a 13-month low since the start of the pandemic. US Federal Reserve officials are now projecting the US economy will grow at 6.5% in 2021, the highest level since 1984.
In Australia, the economic recovery has been stronger than expected. As per the recent RBA statement, the unemployment rate has fallen further to 5.6% and the number of people with a job has exceeded the pre-pandemic levels. The bank has also revised its GDP growth forecasts from 3.5% to 4.75% now for 2021.
First in and first out of the covid crisis, the Chinese economy has bounced back from the deep coronavirus slump. China’s GDP grew by 18.3% in the first quarter of 2021 which is its highest quarterly year on year growth since the data began to publish in 1993. China has been the manufacturing workshop of the world for the last 25-30 years. The assertions of reshoring the supply chain is blown out of proportion as there is no quick way to reverse the process and replicate all the technological capability, talent, and the know-hows.
As demand recovers and the global economy improves, commodity prices have continued to rise. The Bloomberg Commodity index, a basket that includes gold, crude oil, natural gas, and corn currently sits at 92 which is 50% above the lows of last year. The resilient commodity prices support the story of a robust recovery. Inventories fell during the pandemic as supply chains were disrupted. Now, there is more demand to be filled.
Central banks remain accommodative – the US Federal Reserve plans to hold its key interest rate near zero and vowed to keep it there until inflation rises moderately above their 2% target for some time. The Reserve Bank of Australia is on the same page as the US Federal Reserve and has reinforced its commitment to maintain supportive monetary conditions to encourage a return to full employment in Australia and inflation within the 2 to 3 per cent target range, which is unlikely to be until 2024 at the earliest.
Although uneven, the global economy continues to recover and setting forth a strong growth outlook for the short to mid-term. Global equities are now hovering around all-time highs on back of the fiscal stimulus, central bank liquidity, strong earnings momentum, and rapid vaccination of world population.
What could go wrong from here? Remember, the butterfly effect. The compounding impact of one episode of market volatility can present challenges for the entire system.
In 1929, just before the great depression, the US was growing rapidly and saw game-changing advances in the steel, electric and automobile industries. In 2000, at the time of the dot com bubble, internet was reinventing e-commerce. And in 2007, new financial instruments were making home ownership possible for people who were not able to buy homes before.
Market corrections do not occur with some terrible burst of bad news. It occurs when investors realize things are not as good as yesterday. With a friendly fed and ultra-low interest rates, one can become complacent with the view that it will last forever. However, the possibility of rising interest rates is very real, even if the probability is low in near future.
Similarly, we have been living in a disinflationary world for a very long time and portfolios are constructed on the assumption of low and stable inflation. The key disinflationary forces at play are an ageing population, technological advancement, globalisation, and wealth inequality.
An ageing population reduces the availability of labour and the burden of economic output stands on the smaller working age population. Technological advancements have assisted businesses to reduce labour costs, expand profit margins and lower the prices of goods. This is also known as the Amazon effect. With its platform, scale and technology Amazon can afford to sell goods lower than its major competitors and still be profitable. Similarly, with globalisation comes fierce competition which leads to lower real prices and eventually lower inflation.
It has been debated that wealth inequality has also been an invisible force to keep inflation down. When a small number of people own majority of wealth they can only buy limited goods based on their requirements and are most likely to park most of their wealth in savings or investments.
The forces mentioned above have kept the inflation down for decades. Even though most of these structural forces are still in place, the inflation alarm bells are ringing loud amidst the surging commodity prices, agricultural goods, used cars and electronic devices. When a stronger than expected rebound in demand is met with supply blockages it becomes a recipe for a rise in inflation.
For example – Semiconductor chips are the brain of every electronic device from TV’s, mobile phones, cars, and games. To deal with the pandemic chipmaking factories were shut down and the chip dependent industries halted their purchases. Now the demand for chips is back to pre-pandemic levels. However, it is not as straightforward to ramp up the supply to make up the shortfall. The shortage in chips has been intensifying since last year which has led to price rises and shortages of electronic devices.
Some economists believe that there will only be a short-term bump in inflation before it goes back to normal levels. Due to strong disinflationary forces of the pandemic and the oil price crash in 2020 a lower inflation base was created for 2020. A comparison of this lower base with 2021’s inflation data translates into a big jump in inflation. In the short term, CPI inflation is expected to rise temporarily to be above 3 per cent in the June quarter because of the reversal of some COVID-19-related price reductions. (Source: RBA Governor, Philip Lowe)
The reassurance from central banks to keep the interest rates low and their view of a short-lived inflation is not shared by the market. The most recent bouts of volatility in the markets are based on the investors’ fleeting expectations whether it is about interest rates, inflation, or valuations.
As the humbling butterfly effect indicates there is not much that needs to change for a bigger event to occur. Please get in touch to know how to prepare for a left-field uncertain event.
