October 2022 Economic Update & Some Reasons for Optimism
2022 has been a great year in the sense that we seem to be past the COVID-19 pandemic, but some of our “medical bills” are coming due. Over the last three years, panic led to lockdowns. Lockdowns led to shutdowns and fiscal stimulus. Shutdowns and stimulus led to inflation. Inflation led to monetary tightening. Monetary tightening leads to a recession.
Zooming out a little further, over the past 15 years a global financial crisis led to sustained stimulus. Federal Reserve stimulus that lasts too long and keeps interest rates too low leads to great economic distortions and problems. My friend and fellow investment advisor Nick Lumpp once called it the Fed’s Hotel California Problem: Once everyone gets hooked to cheap money, “you can never leave.”
This was not just the US; the entire world got addicted to the drug of cheap money, and it takes pain in withdrawal in the form of inflation and declining asset prices to start the healing process. The Federal Reserve’s response to inflation has therefore been tough for capital markets. Inflation was an inevitable consequence with trillions of dollars of currency was created, nevertheless, I do not believe that the Fed is the chief culprit for the inflation we are seeing. The residual impacts of lockdowns and sustained labor issues, both numerical and qualitative, are the chief reasons for higher inflation. Secondary and tertiary reasons for inflation are energy and food price shocks due to the war in Ukraine. In my mind, the Fed’s over stimulus comes in fourth.
On the point of sustained labor issues, the retirement of the Baby Boomers has been an unfriendly economic experience. Baby Boomers are the largest demographic cohort in the U.S. history, and we must understand that three things happen when a subset of the labor force retires. First, retirees consume less which drives economic activity down. Second, savings rates are less as retirees earn minimally from labor. Baby Boomers’ savings have been great for asset prices in capital markets as they squirrel away those last few dollars of retirement savings, and now we see de-risking of portfolios in retirement. Third, the missing productivity and availability of skilled workers drives labor prices up due to the relative scarcity given Baby Boomers’ absence.
Despite all these headwinds, I am a rational optimist when it comes to the U.S. economy and markets. It is a great time to be an American, and here’s why:
- The U.S. Demographics Are Surprisingly Good
The last six familial generations in the US have seen an incredible amount of suburbanization and urbanization in the midst of us changing from an agrarian society to a service-based and industrial society. When you live on a farm, kids are free labor, and you have a lot of them. When you live in the city, kids are an expense and you have less of them. Starting at different times and at different rates across the world, the birth rate has collapsed. Unlike most other countries, most Americans live in the suburbs, and a suburban lifestyle supports more children and population growth than living in a condo in the city. The U.S. millennials have a huge advantage over the rest of the millennials of the world: they exist! From more urban lifestyles across the world, for example in the European Union, they have far fewer millennials. The U.S. millennials maturing and entering their higher earning and productive years will shelter the U.S. economy through production and consumption that other countries cannot match.
We have the healthiest demographics in the rich world, along with the most self-contained economy of the rich world. The #1 economy in the developing world is Mexico, and it is great to be bolted together with them.
- U.S. Economic Security
We live in globalized economy, but perhaps surprisingly, we are one of the least globalized economies of size. Because of the shale/fracking revolution, we do not have an energy problem like other countries around the world. As a result of our geography, we do not have to worry about an agricultural problem. The U.S. is the world’s largest producer and exporter of food and refined energy products. We are only as exposed to the global market as we choose to be.
The trend away from globalization started pre-pandemic and has accelerated through the pandemic. We are not seeing WW2 levels of industrialization in the Western Hemisphere, but the industrialization is significant nonetheless and will shelter the blow of having less stuff “Made in China” (more on China below). Supply chains are going to get shorter, and the U.S. has the resources and allies adjacent to the U.S. to support onshoring production.
Getting right to it, China, our chief rival’s economic security and demographics are bad. China has had an incredible last two generations of globalization and urbanization. The Chinese squeezed into two generations what took us more than six generations of industrialization. China has seen immense growth because of this compressed timeline, but we need to recognize that this is not a one-way trend. Globalization is now running in reverse, and China exercised its One-Child Policy up until a decade ago which has really changed their demographic mix for the worst. China is now the fastest aging workforce in human history, and the recent demographic data suggests, by 2050, China’s population will be cut in half. This means they are not destined to “eat our lunch.”
China’s energy costs are also going up significantly. The disruptions of agricultural markets are also highly disruptive as China is the world’s largest importer of food. This is all before we get to Chinese manufacturing. Already there are dwindling products that can be made more cost effectively in China vs Mexico and the United States. As the Chinese labor force is aging out, it may remain manufacturing powerhouse for the short- to medium-term, but not for the long-term. The benefit China does have is the sunk cost of the industrial plant. It takes time to build that industrial capacity somewhere else, but it’s happening!
Starting in the 1990’s, the computer really became ubiquitous with every-day modern activity. Technological innovations in supply chain management and factory production enabled companies to squeeze more economic output out of every hour of work and capital investment, and . This was the most important piece of the boom we have seen over the last 30 years. There is an abundance of new technology that will be more pervasive in the coming decade to further drive growth, automation, and abundance. This is not just in Artificial Intelligence and computing power, it is green energy, medical technology, and beyond. Developing battery technology looks a lot like microprocessors of the 1990s; the price of lithium-ion battery packs has fallen by 90% in inflation adjusted terms since 2010 and is poised for further price declines. Solid-state batteries are growing in feasibility & availability, and advances in solar cells are raising the prospect of widespread, inexpensive, and clean energy.
The future may feel bleak as we close the third quarter of 2022. Inflation remains high, capital markets are volatile, we remain divided politically, and the war in Ukraine remains ongoing. Nevertheless, we have reasons for optimism being in the United States. This is far from our worst time for the country, and our republic was built to handle this. Americans are hardworking and innovative, and, after the short-term pain of our medical bills coming due, I believe we will see robust recovery and growth to all brave enough to hold their course through a storm. Crises like the COVID-19 pandemic and tight labor markets spur innovation. I firmly believe that innovation will accelerate, and this decade has a lot of domestic prosperity to be had.