Expert Sinologists Needed
Summary
Fund managers consider an inflation resurgence as 2023’s biggest risk. There are three sources which could make inflation ‘sticky’.
One is the consumer, who could begin to shift long-term expectations. Global consumers have been very careful post the pandemic. US consumers who had been more buoyant have started to cut down, after maxing out credit cards causing delinquencies to spike.
The second source of sticky inflation is the services sector. The services sector continuing to hike prices is a concern, but the wider consensus is that the economic slowdown will eventually cap prices at reasonable levels.
The third potential source of sticky inflation is also the biggest unknown. China. On the one hand, as the IMF predicted, this should increase growth. On the other, however, it could boost inflation, just as it was coming down. The outcome is very difficult to calculate.
And that is exactly the problem with China. Increasing unpredictability. While plans exist for production to be friend-shored and moved out of China, the realities are harsher. The world has bought the narrative of China as ‘the Future of Everything’ long enough to become very dependent on it. Disentangling will take many years and large costs, and even then it is not certain that it can become reality as Apple is finding out.
In 2002 US Secretary of Defence Donald Rumsfeld talked about ‘known unknowns and unknown unknowns’. Despite widespread derision by the media, Mr Rumsfeld referred to what is known as Constantin Kichinsky’s Known-Unknown Matrix template.
Fund managers consider an inflation resurgence as 2023’s biggest risk. This is the known unknown. Higher inflation would force central banks to maintain tight conditions, even as we are heading for an economic downturn.
Inflation has already been coming down in terms of raw materials and energy prices, which is already feeding through supply chains in US and Europe.
There are three sources which could make inflation ‘sticky’.
One is the consumer, who could begin to shift long-term expectations. With 360% global debt/GDP rates can only go up so much before they disrupt the global financial system. If long term inflation expectations become higher than rates, then it’s a matter of time before consumers begin to borrow at lower rates, expecting inflation to reduce that debt. This was the playbook of the ’70s. However, we must remember that it took a decade of rising prices for that mindset to take hold. We are nowhere near there. Global consumers have been very careful post the pandemic. US consumers who had been more buoyant have started to cut down,
…after maxing out credit cards causing delinquencies to spike.
So consumers are not currently a huge concern.
The second source of sticky inflation is the services sector. Services companies are slower to see increased input prices, but raise salaries as fast as anyone else (consumers are affected at the same time, regardless of where they work). This makes the sector slower at reducing prices.
The services sector continuing to hike prices is a concern, but the wider consensus is that the economic slowdown will eventually cap prices at reasonable levels. The whole objective of front-loading rate hikes was exactly to put quick pressures on the services sector (70% of the economy), to prevent wage hike spirals and steep competition for talent (in other words also pricing power to labour).
The third potential source of sticky inflation is also the biggest unknown. China. Until a few weeks ago China’s zero-Covid policy dented global growth and caused problems in global supply chains. After the Plenum and demonstration following the World Cup, third-time President Xi performed a U-turn and abruptly ‘opened’ China to the world. On the one hand, as the IMF predicted, this should increase growth. On the other, however, it could boost inflation, just as it was coming down. The outcome is very difficult to calculate.
And that is exactly the problem with China. Increasing unpredictability. China’s growth was based on a blueprint crafted by ‘The Architect of Modern China’ Deng Xiaoping in the 1960s and implemented after the death of Mao Zedong in 1976. Since the plan was that no senior official would hold as much power as Deng or Mao before him, it made sense that Deng’s vision would endure, adjusted by each President after him. Xi’s unprecedented third term, however, changed that. Not only will China now take new shape under him (a blend of Mao’s and Deng’s thinking), but his potential long-term tenure increases unpredictability. Leaders, when unchallenged, can become a source of instability when their power goes unchecked. The more transformational in the beginning, the more erratic they can become after a long time in power. While Xi has not shown the erratic behaviour of other long-time autocrats, western business leaders are watching carefully.
China’s ‘Great Leap Forward’ from the secondary to the tertiary sector is enough to transform the global economy. It's handling of Covid, in the initial and the end stages has also been very impactful. Its approach to foreign technology and secrecy around its own technological achievements (not unlike the US military) leaves the world confounded.
While plans exist for production to be friend-shored and moved out of China, the realities are harsher. The world has bought the narrative of China as ‘the Future of Everything’ long enough to become very dependent on it. Disentangling will take many years and large costs, and even then it is not certain that it can become reality as Apple is finding out.
Going forward, what China will do and how the West will behave with China, will, by and large determine the course of the global economy, interest rates and inflation. If China takes a conciliatory approach to the world, which it has on occasion shown it’s capable of, then globalisation would go back on track. If not and tensions continue to grow, then the developed world will grow even more co-dependent on a very large economy it doesn’t understand.
For 2023 the question remains: Will China’s reopening cause inflation to resurge enough for central banks to turn up their hawkishness?
Beyond that, however, the larger question is how do deal with the known unknown that is China, and the unknown unknown of what its greater impact will be on the world?