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The Climbing Cost of Hard Capital

Benjamin M. Lavine, CFA, CAIA, RICP

Co-Chief Investment Officer

5/9/2022

Source: istockphoto

“The Army is a broadsword, not a scalpel. Trust me, senator – you do not want the Army in an American city.” – Bruce Willis playing General William Devereaux in The Siege (1998)

The 1998 movie “The Siege” came out during a period when overseas terrorism started to bubble up on American soil.  Prior to the 9/11 terrorist attacks that brought down the twin towers of the World Trade Center, the World Trade Center was hit with a truck bomb in 1993, one of the first indications that overseas terrorism was “evolving from a regional phenomenon outside of the United States to a transnational phenomenon (source: U.S. State Department).” As is typical with Hollywood narratives, the Siege is premised on an extreme policy response in reaction to heightened anxieties over domestic terrorism that called for the U.S. military to occupy sections of New York City.  The movie’s antagonist, General William Devereaux, did warn politicians that imposing martial law enforced by the military is akin to attacking the problem of terrorism with a broadsword, instead of a more directed and measured response implied by the wielding of a scalpel.

The broadsword vis-à-vis scalpel analogy comes to mind when we contemplate the challenges behind global central bank efforts to curb inflationary pressures without disrupting the economic recovery since the worst of the COVID-19 pandemic shutdowns.  Central bank policy measures to deal with inflationary pressures, such as raising interest rates and reducing bank excess reserves, represent broadswords that raise borrowing costs for everyone as well as reducing overall market liquidity and credit access.  Blunt policy instruments indeed that leave little room for nuances better addressed by scalpels (more on that below).

But the inflationary pressures we face today come with additional challenges as central banks are having to contend with supply side shocks.  Arguably, one could argue that the 1970s present a close analog whereby supply shocks, such as the Arab oil embargoes, exacerbated wage-driven inflationary pressures built up during the Guns-and-Butter era of the post-World War II period.  Central banks, namely the U.S. Federal Reserve with its dollar reserve status, are trying to address the inflationary dragon with an unwieldly broadsword that threatens to knock out the economic princess central banks are trying to save.

Typically, the central bank broadsword of higher interest rates and lower credit availability addresses inflationary pressures by discouraging excess aggregate demand (i.e. consumption and excess euphoria). This has been the primary monetary playbook since the 1970s when high inflation was brought under control by the Paul Volker-led Federal Reserve, and global economies (at least those aligned with the U.S./Western alliance against the USSR) enjoyed the fruits of a disinflationary globalized trade system.  Tighter financial conditions brought on by higher interest rates did lead to recessions but without the onset of high inflation that could only be addressed through aggressive rate hikes such as the double-digit hikes by the Volker-led Fed in the late 70s/early 80s.

The challenge we face today is one of excess demand coming out of the global pandemic in the face of supply constraints characterized by limited raw materials, transportation logistics, and cost-effective labor made worse by the Russia/Ukraine conflict and renewed COVID lockdowns across China’s key urban areas (notably Shanghai).

Very few strategists demonstrated foresight to today’s supply challenges, as those who warned about supply deficits were characterized as Chicken Little Cassandras.  Investor preference for ‘stay-at-home’ beneficiaries of retail delivery services and remote access technologies during the height of the 2020 pandemic shutdowns only seemed to confirm the analog-to-digital transformation.  ‘Hard’ assets and industrial capital expenditures became heavily out-of-favor  as investor capital sought ‘technological innovation’ to take advantage of total addressable markets (TAMs), caring very little about the price paid for that innovation in the face of uncertainty.

Figure 1 captures this ‘digital’ zeitgeist as the share of traditional capital expenditures (i.e. industrial, energy, mining, etc.) of the U.S. economy has been dropping over the last 25 years while the share of ‘innovation’ (i.e. research and development, software expenditures) has risen such that the latter is about to surpass the former.  Incidentally, this was the kind of chart we would typically see from investment managers explaining (defending?) the persistent outperformance of ‘growth’ stocks, represented by the new age digital economy, over ‘value’ stocks, representing old-line industrials.

Figure 1 – Capital Expenditures Share of U.S. Economy In Structural Decline Offset by Increasing Share of ‘Innovation’ (R&D, Software)

Source: Bloomberg for the Quarter Ending 3/31/2022

So, today’s Chicken Little Cassandras would likely surmise that the underinvestment of capital across traditional industry has contributed to today’s ‘supply’ shortages that run the gamut from housing inventories (Figure 2) to industrial metals (Figure 3) to energy distillates (i.e. fuel) (Figure 4).

Figure 2 – U.S. Existing Home Sales Inventories (Millions) at Fresh Cycle Lows

Source: Bloomberg for the Quarter Ending 3/31/2022

Figure 3 – Total Inventories at London Metals Exchange at Cycle Lows

Source: Bloomberg for the Period Ending 5/6/2022

Figure 4 – U.S. Energy Distillates Also At Cycle Lows

Source: Bloomberg for the Period Ending 4/29/2022

The constrained global supply chain is being made worse by China’s Zero-COVID policy and lockdowns of key urban centers, notably Shanghai.  China’s deteriorating economic situation, heightened by regulatory crackdowns across technology and property sectors, is showing up in the decline in its currency value (USD/CNY – Figure 5) and foreign currency reserves (Figure 6) that could spark fears of another financial meltdown such as what occurred in 2015.  A supply-constrained trade system will likely suffer even more resulting from China’s lockdowns, not to mention the ongoing Russia/Ukraine conflict.

Figure 5 – Chinese Yuan Is Crashing versus the U.S. Dollar As Investors Respond Negatively to China’s COVID Lockdowns

Figure 6 – Rising Risks of a Financial Meltdown Spurred by a Precipitous Decline in China’s Foreign Currency Reserves

So, the monetary broadswords are starting to hack away at inflationary pressures, even as expected demand out of China declines due to COVID lockdowns.  For the first time over the post-pandemic period, real (inflation-adjusted) interest rates (Figure 7) have turned positive in anticipation of a U.S. rate hike campaign that is expected to result in a 2.75% Federal Reserve Funds rate by the end of 2022.

Figure 7 – Real (Inflation-Adjusted) Interest Rates (Federal Reserve 10-Year Constant Maturity) Have Now Turned Positive

Source: Bloomberg for the Period Ending 5/6/2022

And as one would expect with a monetary broadsword, overall financial conditions (Figure 8) have tightened with higher borrowing costs for homebuyers (Figure 9) and corporations (Figure 10).

Figure 8 – Goldman Sachs Financial Conditions Have Tightened in the Face of Higher Interest Rates Stemming from Central Bank Monetary Policies

Source: Bloomberg for the Period Ending 5/6/2022

Figure 9 – Mortgage Rates Have Risen Sharply (Proxied by the Bank Rate Average 30-Year Mortgage Rate)

Source: Bloomberg for the Period Ending 5/6/2022

Figure 10 – As Have Corporate Borrowing Rates (Proxied by the Yield-to-Worst Implied by Global Corporate Bond Prices)

Source: Bloomberg for the Period Ending 5/6/2022

So, the monetary broadsword is raising the cost of capital across the board, but should it?

You Can’t Eat Innovation Unless It’s Accompanied by a Plate of Hard Capital Spending

“You can’t eat a Sharpe Ratio” was a retort given by a pension officer we knew to an investment manager defending their risk-adjusted performance.  Likewise, you can’t ‘eat’ innovation if the productivity enhancements (lower marginal costs, higher efficiencies) can’t make up for supply-side deficits and deficiencies.  Innovation can be disruptive to the existing order but tends to produce a more dynamic, competitive economy over the long-run.  However, the day-to-day supply needs still need to be met even in the face of disruptions wrought by innovations.

And what we’re now realizing in hindsight (and worsened by COVID) is that underinvestment of traditional capital spending has now caught up with the global economy as this underinvestment is serving as the proximate cause of today’s supply shortages that are not being offset by ‘fruits’ of innovation in terms of greater productivity and more efficient consumption.  Monetary policy can only address so many things, and long-term capital cycles are not one of them, especially if we’re seeing a breakdown of a globalized economy fine-tuned to produce the barest of working capital needs (i.e. just-in-time-inventory policies).

In the past, a monetary broadsword was sufficient to address inflationary pressures in the absence of global supply shocks.  Not so today, where the ghost of 1970s inflationary spirals and supply shocks is haunting the Powell-led Fed just as it was haunting Arthur Burns.  By wielding a broadsword to slay excess demand, central banks run the risk of mortally wounding an industrial complex already suffering from decades of underinvestment and COVID shutdowns.  A targeted response (the scalpel) would serve as a more ideal solution that would raise the borrowing costs for some but not for others.

Putting aside any populist-fueled objections of favoring one side over another, how can a central bank address inflationary pressures brought on by excess demand without unduly raising the cost of capital that would impair a industrial-driven response to help meet today’s supply constraints?  Do you raise the cost of capital for the homebuyer but not the homebuilder?  Do you raise the borrowing costs to meet everyday living expenses (food, energy) but not to the suppliers responsible for meeting those needs, such as the farmer, energy driller, or industrial manufacturer?  Even if you had the ‘will’ to discriminate borrowing costs of one group versus the other, would you have the ‘means’?

Raising interest rates and reducing market liquidity (excess bank deposits) raises the costs of borrowing for everyone.  Central banks only have broadswords at their disposal, not scalpels.  But, in this supply-constrained world, reducing excess demand via higher borrowing costs can only help slow inflation up to a certain point without a sufficient supply response normally witnessed as suppliers are induced to produce more to meet higher prices.  And raising the cost of capital for the suppliers could worsen current inflationary pressures as the supply response needed to address shortages would be arrested due to higher capital costs.

What central banks need are monetary scalpels, not broadswords, but they only possess the latter.  Perhaps, the supply side can be better addressed through economic incentives, especially with government policy.  But the current debate over whether monetary policy is too tight or too loose in the face of inflationary pressures lacks the supply-side luxury we’ve taken for granted over the last few decades.

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By: Benjamin Lavine