You don’t know what you’ve got until it’s gone

Nicholas Rilley

The global economy has shifted from a multi-decade backdrop of oversupply to one of shortages as a result of the pandemic. Between 2000 and 2019, the inflation rate for durable goods in the US averaged -0.9% per annum but now it is 17.4%. People lucky enough to be born in a developed market country are not used to shortages. Seeing supermarket shelves without food, or products and services being unavailable, has been a jarring experience.

The abundance of goods and services enjoyed by many had come to feel like the normal state of affairs. However, the period of relative peace and prosperity since the Second World War that helped to facilitate this has actually been more of an anomaly when placed in historical context.

In particular, the period since the dissolution of the Soviet Union in the early 1990s saw a huge rise in global living standards; particularly in emerging markets where hundreds of millions of people were lifted out of poverty. Many factors that have helped keep inflation so low for so long have reversed over the past two years and these have both structural and cyclical elements to them.

Historically, pandemics have proven to be deflationary, while wars have been inflationary. This is because pandemics destroy demand more than they hurt production, whereas wars destroy productive capacity. However, over the past two years the massive government stimulus programmes to tackle the COVID-19 crisis have maintained incomes and therefore demand.

Russia’s invasion of Ukraine is an inflationary crisis for the world due to the scale of commodity exports from the two countries which span energy, agriculture and metals. This war has come at a moment when the world economy was already experiencing inflation at 40-year highs.

The economic sanctions imposed on Russia by the West have been vast and essentially aim to disconnect them from the global trading system. Given Europe’s dependence on Russian energy, the process of sanctioning their energy exports has been slow but the coordination of the sanctions has been impressive. The importance of these financial and economic sanctions should not be underestimated.

In a letter to shareholders, Blackrock CEO Larry Fink recently wrote: “In the early 1990s, as the world emerged from the Cold War, Russia was welcomed into the global financial system and given access to global capital markets… the world benefited from a global peace dividend and the expansion of globalisation. These were powerful trends that accelerated international trade, expanded global capital markets, increased economic growth and helped to dramatically reduce poverty in nations around the world.”

Fink continued, “The ramifications of this war are not limited to Eastern Europe… they are layered on top of a pandemic that has already had profound effects on political, economic and social trends. The impact will reverberate for decades to come in ways we can’t yet predict.”

He concluded that this “has put an end to the globalisation we have experienced over the last three decades”.

The theme of deglobalisation has been with us for a while. Some suggest that globalisation peaked in 2008 when the global financial crisis hit, but the history books are more likely to mark 2016, when the UK voted for Brexit and Trump was elected, as the turning point.

The US-led global system that has existed for over 70 years was the result of a unique set of factors after the Second World War that included the size and strength of the US economy relative to the rest of the world.

The benefits to the US of helping to rebuild Europe meant that the US could shape important global institutions in keeping with its view of how the world should operate. America has largely acted as a benign hegemon that has tried to put a lid on global problems. This helped to guarantee global security which has been an important factor in keeping global trade routes open. It allowed countries to focus on building more productive economies rather than having to worry about defence.

In response to the Russian invasion of Ukraine, German Chancellor Olaf Scholz announced a big shift in defence policy and vowed to invest €100 billion to modernise the military and increase defence spending above 2% of GDP. Furthermore, he made a very strong statement that “with the invasion of Ukraine, we are in a new era”.

The combination of the existing globalisation backlash in the West, the COVID-19 crisis and recent events in Ukraine – with the associated economic and financial sanctions – has been a powerful inflationary force for the global economy. A mistake that is often made in finance is to extrapolate current events too far into the future. However, it is no exaggeration to say that Russia’s invasion of Ukraine is a jarring wake-up call for the West. The war in Ukraine has overturned the comfortable status quo that has prevailed across the world, and especially Europe, since the fall of the Berlin Wall.

There are positives to take from recent events such as the likely acceleration away from fossil fuels to renewables and infrastructure spending more generally. Furthermore, wage growth in developed markets is strong after many years of anaemic wage rises.

It is also likely that we are now close to a peak in the rate of inflation as pandemic distortions unwind, although lockdowns in China present a near-term challenge and commodity price pressures remain. However, there are increasingly troublesome dynamics that suggest we have entered a less safe and more inflationary world than we have been used to. As the saying goes, you don’t know what you’ve got until it’s gone.

Nicholas Rilley, CFA, is Investment Manager and Strategy Analyst at Butterfield Asset Management.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.