Opinion: Our bill for easy money is due: Prepare for low and volatile yields, or the long overdue financial market reckoning.

Until recently, the good news (a strong rebound from the COVID-19 pandemic) was bad news (higher interest rates). Now, bad news (an economic slowdown) is good news (accommodative policies). For investors, previously successful investment strategies carry risks.

Economic activity, largely based on government stimuluslow borrowing rates, central bank cash injections, and pent-up demand financed by lock savingyes, it will stall. Inflation may decline (as price changes slow), but absolute costs will remain high. This combination reflects fundamental changes that markets may not have fully accounted for.

Going forward, lack of investment in existing energy sources it is likely to result in a long-lasting deficit in the power grid. the energy transition and decarbonization will be slow and expensive due to the need to first electrify many industrial processes, reconfigure the grid, inefficient energy storage, and material shortage (lithium, cobalt, nickel, copper, rare earths). Effects of climate change on food suppliestransport links and insurance costs will increase.

At the geopolitical level, the return of great power rivalry it will complicate things. Trade restrictions and sanctions will prevent cross-border trade. higher defense spending and finally, rebuild ukraine (perhaps as much as $1 trillion or 1% of world GDP) will suck up scarce resources.

Focusing on sovereignty and minimizing unexpected disruptions will mean reorganize supply chains to avoid bottlenecks, such as China (the world’s factory) and its zero-Covid policy. Re-shoring or almost propping up production will be slow and costly. The global supply of cheap labor and raw materials will not control costs or underpin prosperity, as it has for nearly three decades.

Adverse demographics will also be an important factor. Shrinking workforces, the Great Resignation brought on by COVID-19, an aging population, lower birth rates, resistance to immigration will compound the difficulties.

Interest rates and the cost of capital will rise and liquidity will shrink as central banks normalize policies and governments repair public finances. Deglobalization, concerns about confiscation of foreign investmentsfollowing the West’s actions against Russia, it will impede global capital flows from savings-rich Asia, which has been providing cheap finance.

These self-reinforcing factors will work through multiple channels and feedback loops. Here’s what investors should be worried about right now:

1. Asset prices: Stock valuations are high, especially given prevailing market structures; A large number of companies have negative earnings and cash flow (about one-third of the Russell 2000 index
RUT,
+3.50%
) and cross-border trade is declining (40% of the S&P 500
SPX,
+2.76%
the companies’ revenues originate outside the US..). Accommodationthe largest asset class, is higher mortgage rates and threats to strong job markets, which have been holding it up.

2. Financial crises: debt levels are high and personal, business and government balance sheets are stretched. Falling valuations will test borrowers, who have been backed by overvalued assets. Heavily indebted private equity works it can become the focus of a new crisis.

Europe’s debt problems they were covered up by the European Central Bank acting as a buyer of last resort for near-bankrupt members. France (public debt at 113% of GDP), Greece (193%), Italy (151%), Portugal (127%) and Spain (118%) have seen sharp increases in the cost of interest. Cracks are emerging between the inflation-phobic creditor countries, namely Germany, and the debtor nations. A tighter monetary policy will expose the lack of independent monetary policy, fiscal capacity, monetary flexibility and the ability to monetize the debt of the indebted members of the eurozone.

Rising Rates, Strong US Dollar DXY,
-0.05%
and high energy and food costs threaten to unleash a emerging market debt crisis. Interest rate increases were factors in the Debt crisis of the 1980s in Latin America and the asian crisis in 1997-1998. The recent economic collapse of Sri Lanka it is a foretaste of what could come.

Although better capitalized than in 2008, banks are exposed to increased defaults both directly and through lending to other lenders through the shadow banking system.

3. Limitations of the policy: Central banks are constrained by concerns about inflation and negative real (inflation-adjusted) rates, even after expected hikes. The Great Recession of 2008, the pandemic and the Russian invasion of Ukraine have tested the government’s ability to borrow. Then there is currency volatility, as Japan is discovering. Sudden movements fuel domestic inflation, loss of access to foreign financing, or decreased export competitiveness.

4. Social tension and political paralysis: In advanced economy, Unfulfilled expectations and rights are fueling the malaise.. In emerging markets, high prices and a lack of essential items are fueling more violent versions of the same concern. Increasing electoral polarization, political instability, and the absence of leadership make it difficult to reverse an increasingly challenging position. The possibilities of international cooperation on global issues are also low.

The best outcome may be a continuation of “getting out of the way,” with an extended period of low and volatile investment returns. The worst is the arrival of the long overdue financial market reckoning and its landslide reset. It’s worth remembering that the tech bubble of 2000-2001 and the mortgage disaster of 2008 took almost a year to fully come to an end.

To prosper, investors now need the security of a tightrope walker and the flexibility of a gymnast. With short-term rates perhaps reaching 3%, the Wu-Tang Clan’s 1994 hit “CREAM (Cash Rules Everything Around Me)” provides a helpful guide.

Satyajit Das is a former banker and author of A Banquet of Consequences – Reloaded (2021) and Fools Fortunes: Australia’s Options (March 2022)

Plus: I see buying opportunities. How this stock trader with 40 years of experience makes money in a bear market

Also read: Typical S&P 500 CEO Earned 324 Times More Than Median Salaried Worker Last Year: Report

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