Every now and then it is prudent to stop and pause. Assess what’s going on, how you got to this point and where to from here. I’m going to try and explain this in a very simple and straightforward way so that everyone can understand what is currently going on with the global economy. I’ll break it down in specific sections that will follow onto each other. 

The START

During the late 2019 and early 2020 the Covid-19 virus spread havoc across the world on a scale that has never been seen before. Worldwide governments scrambled to assess the situation and make the best decisions for their citizens. Most governments decided to introduce hard lockdowns and restrictions, effectively killing most economic activity in their jurisdiction. Time will tell if this was the correct decision. 

Their respective Central Banks and financial ministries jumped into action to try and help financially during this torrid time. Most governments have two different policies to use in terms of finances of a country. 

1) Monetary policy – managed by the Central Bank of a country. It focuses on the money supply in an economy which they manipulate with the interest rates of the country. 

Relaxation of policy (also known as a dovish approach) = Reduction of interest rates = More money in the system = Economic expansion = Good times. Conversely a Tightening of policy (also known as a hawkish approach) = Increase interest rates = Less money in the system = Economic hard times. Every instrument in the financial world is priced using some form of the current interest rate. The bigger the number (interest rate); the lower the valuation of the asset (financial markets). 

So remember :

Interest rate goes up = Financial markets goes down

Interest rate goes down = Financial markets goes up

It is important to note that purely the expectation of the rate increasing or reducing will trigger a response from the markets. Most financial markets are very integrated globally and a large group of very clever people acutely monitor every aspect of the markets. 

A sneaky new strategy that certain bigger Central Banks also apply is referred to as Quantitative Tightening and Quantitative Easing. 

Quantitative Easing (QE) – If they ease, the Central Bank purchases long duration bonds (and also other securities [I’ll come back to this point in a follow up article]). This has a double whammy effect. Firstly, if you have a very big institution buying financial instruments this reduces the interest rates on the instruments. How come? Well if you have someone (like a big institution with very deep pockets) chasing after a limited numberof instruments this will have the effect of increasing the price, which will lead to the reduction in the yield (or the interest rate) attached to the instrument. QE thus also leads to an effective reduction of interest rates. What happens again if interest rates reduce? Yes, that’s correct – financial markets expand and grow. 

Quantitative Tightening (QT) – If they tighten, the Central Bank sells bonds. Inverse happens – the interest rates on the instruments increases. How come? Again, if you have lots of people (or one institution with lots of money) selling into a market the price will reduce, which will lead to the increase in the yield (or the interest rate) attached to the instrument. QT thus also leads to an effective increase of interest rates. What happens again if interest rates increase? Yes, that’s correct – financial markets contract and well, number goes down. 

2) Fiscal policy – managed by the Finance department of a country. It focuses on revenue collection (in the form of taxes) and expenditure to run and operate the country. 

Most countries literally gave their citizens money (like the inverse of taxation) to support them during the Covid19 pandemic. They could have also reduced temporarily tax collection to give support that way. Either taking less money in the form of taxes or giving grants or other form of support cheques. 

By now you should have figured out what most governments did during the initial parts of 2020 and some countries deep into 2021. They effectively constrained the economy by applying very strict lockdown restrictions. In an effort to help financially they went to the two financial levers they have : Monetary Policy and Fiscal Policy. 

Monetary Policy – reduced aggressively interest rates and started with Quantitative Easing (markets enjoyed that and the rich got richer). 

Fiscal Policy – sent people cheques in the mail (to support the lower income and most vulnerable people). 

The MIDDLE

The initial stimulus from the government helped immediately and most markets responded in kind by completely recovering the losses incurred (in record time) and then continued to march upwards and upwards for the balance of 2020 and the entire 2021. 

As was well and everyone got comfortable using Zoom, buying everything online and wearing masks. 

However, during 2021 the nasty side-effect of the stimulus started to raise it head. Inflation! What is inflation again? Inflation is the general increase in goods and services in an economy. Why did inflation increase? Well, initially it was thought that it was because of supply chain issues. During the restriction periods factories couldn’t produce at maximum capacity, moving goods from the factory to the consumer was seriously impeded, but the customers were cash flush and demanded the products. 

If demand stays the same (people didn’t stop living) and supply reduces (Covid19 restrictions); the price of the goods will increase -> inflation increases. 

The term “transitory” inflation was coined meaning that the clever people thought it would be temporary (till the supply chain side was fixed). However, inflation across the world was increasing much faster than anticipated. Most economists underestimated how strong the demand for goods and services would be. Remember there was an enormous amount of stimulus from governments. This extra cash was slushing around in the system and eventually a ginormous piece of this chases a limited number of goods and services. 

During late 2021 governments finally realized that inflation is not transitory, and it might be much stickier that they would want. A sustained high inflation level in an economy breaks a lot of other parts in the economy. The first pressure vault to show this weakness is the currency of an economy. If inflation is rampant, the currency of an economy will start to depreciate relative to it’s trading partners.

To reverse the rising inflation the governments needs to make corrective decisions. The corrective decisions being the exact opposite of the decisions they made during the initial lockdown phase. 

Reducing interest rates becomes increasing interest rates.

Quantitative easing becomes quantitative tightening. 

Think of it as a pendulum that swings wildly to one side. At some point it will need to correct and most likely will swing wildly to the other extreme (and past the point of equilibrium). 

The END

We are still firmly in the middle part, but I’ll do my best to try and predict what the end will look like. The Federal Reserve (the United States Central Bank) has made it crystal clear that they are willing to plunge the economy into a deep recession to ensure price stability. Note price stability is code for having inflation below 2%. Currently inflation is north of 8%.

Inflation will eventually come down. But at what price. The price that will be paid is lost employment – expect lots of retrenchments. The markets have already tumbled. Remember financial markets (especially equity markets) are forward looking and looking forward the cost of debt will increase dramatically which will reduce profitability. But my view is that we are closer to the bottom than we think. Most countries have hit peak inflation (the highest inflation will go). The question now is how fast will it come down? 

History will tell whether the decision to stimulate on such a grand scale was the right decision. Most likely it was excessive and just like if you have excessive alcohol, the hangover is pretty bad. 

The one thing I’m sure is that the human spirit will continue to flourish. The reality is that decisions are made by a handful of people that effects all of us. In the future that might change but for now it is the status quo. You can’t control the decisions made by other people but you can control how you react to the decisions. You need to have an internal locus of control. 2023 will most likely be filled with lots of uncertainty but I’m fairly confident that 2024 will already be much better than both 2022 and 2023. So, don’t wish time to pass. Invest in yourself. Enjoy the journey. Money comes and goes. Enjoy the everyday memories. Time is very limited and precious.