Doom and gloom abound in the return of stagflation

Published June 25, 2022, 3:25 AM

by Manila Bulletin

When the printing inevitably resumes, the Philippines is poised to outperform

HOMEFRONT Column by Victor Consunji, founder and CEO of Victor Consunji Development Corporation (VCDC)

Victor Consunji, founder and CEO of Victor Consunji Development Corporation (VCDC)

The inflation that we are seeing globally, driven largely in part by artificially low interest rate policy and the expansion of the developed nations central bank balance sheets, further exacerbated by supply chain disruptions have sent shockwaves around the world. Last week, the Federal Reserve of the United States shocked the world, by increasing its overnight lending rate by the largest increase in 28 years, moving the benchmark up by 0.75 percent to a range of 1.5 percent to 1.75 percent. This announcement is still sending shockwaves and stoking fears of a recession globally.

The house of cards of debt that the Western financial system has amassed since the great recession in 2007-2008 is becoming harder to manage and cracks are starting to show, presenting yet another threat to the world economy as a whole. Front and center in the minds of the investors both locally and abroad are questions surrounding the ability of the central banks to fight inflation, and how that fight will ultimately affect the economy.

Astute investors know that the true underlying threat to the too-big-to-fail economies is not simply inflation, but actually stagflation, which is undoubtedly a more difficult problem to solve. Stagflation, as the name would suggest, literally means the combination of stagnant growth and high inflation.

As developed nation economies struggled with the deflationary forces of structural issues such as declining populations GDP, off-shoring of productive manufacturing and factory automation, their only solution is borrowing and spending money to stimulate their economies, particularly in their real estate sectors. This, in turn, has produced asset price inflation, as when investors have the ability to borrow cheap money, it creates a surge of artificial demand which is being pulled forward from the future.

In order to have a game plan for the coming events, we must understand the main reasons as to how we arrived here in the first place. The prevailing wisdom is that the current inflationary environment is due to the low interest rates and money printing that was necessitated by the pandemic, which has been exacerbated by the lockdown in Shanghai and, of course, the conflict between Russia and Ukraine. But that narrative dismisses entirely the longer term forces at play, namely the fact that the Western financial system cannot handle higher interest rates and thus their central banks will be forced to resume printing soon enough.

Fortunately, there are a few lessons from recent history that can guide us down the likely sequence of events and help steer us toward being ready for the next shoe to drop. If you dig a little deeper into the recent global macro events, it becomes abundantly clear that sooner rather than later the current central bank tightening monetary policies will be forced to pivot again. It’s my view that this shift will inevitably play into the hands of the developing countries such as the Philippines, who possess stronger balance sheets and a runway of real, long-term economic growth.

If we look at the supply and demand dynamics globally, it is very clear that the monetary policies employed since before the start of the pandemic led to an excess of cheap money, which had to find a home. This money was desperate to land where a reasonable return can be expected, and this sparked an increased risk appetite that led to a spike globally in everything. Stocks, crypto, bonds, real estate and commodities all soared until the beginning of 2022, when many of these bubbles have popped, as risk appetite has waned in the face of rising interest rates.

What often gets lost in these discussions is that natural or classical inflation is inherently a good thing. The Philippines is a prime example, since most of the inflation we saw domestically pre-pandemic was a result of a growing population that is increasing its productivity levels, earning higher wages and thus spending and investing more over time. Comparatively, the difference in the inflation the West is experiencing is that it stems not from long-term growth, but to put it bluntly, it’s because of the printing press.

Of course, since we rely on the importation so many economic goods, it’s easy to be focused on rising prices, especially as the price of crude oil continues to hover around $100 a barrel, translating to current prices of gasoline and diesel in the Philippines at P80 and P86, respectively. But, I feel we have to stand back and look at the bigger picture to get a sense of clarity about what to do next.

If we back track to the great recession of 2007-2008, central banks around the world not named the Banko Sentral ng Pilipinas, moved to avoid the massive defaults by printing trillions and bailing out their financial institutions, as well as many other market sectors. The system was too-big-to-fail then, and the world leaders decided that papering over the problem and kicking the can down the road was a better alternative than a sea of cascading bankruptcy and default.

While this unconventional monetary and fiscal approach has been declared a success by most economists, the reality is that the structural challenges haven’t gone away. Instead, as these too-big-too-fail institutions have gotten bigger and often more complicated, the sovereign debt has risen and that means that high interest rates will threaten not only banks and businesses, but some of the largest governments themselves. It’s for this very reason, the developed world cannot sustain significantly higher interest rates for very long.

There is a major turning point looming in the horizon, we can identify these events as reasons for the central banks to “pivot” global monetary policy, and this will have a monumental impact on asset prices, especially real estate in developing countries like the Philippines.

When interest rates rise in the United States, it creates a demand for dollars, and usually that comes at the expense of other currencies. The Japanese Yen has fallen nearly 18 percent against the dollar in the past year, but let’s not even dig too deep into Japan’s problems for now. In contrast, the Peso Dollar has fallen only about 10 percent in the past year against the dollar, currently trading around P54.50, which speaks to the relative strength of the economy, despite the fact we are still a developing nation.

The strength in the dollar also hurts the United States from a deficit and sovereign balance sheet point of view, as making their goods and services more expensive to the world will widen their trade deficit further over time. A strong dollar also punishes companies and countries who have borrowed in dollars, as their repayment costs are rising, and thus they will have less to invest going forward. We are already starting to see the deterioration in economic activity, some say the West is already in a recession and we all know the eventual response will be more stimulus.

From a more technical standpoint, I’d like to hone in on the underpinnings of the Western financial system itself, and why I believe there is an inability to function at higher interest rate levels.

Let’s go back to fall of 2019, where were led to believe that the global economy was on a solid footing, but that’s not exactly true. At the end of 2015, the Federal Reserve had ended its Quantitative Easing program (while the Bank of Japan and European Central Bank were still in overdrive) and began to raise interest rates from the emergency rate of zero established since the recession, raising all the way to over two percent by the end of 2019.

It was not widely reported at the time, but in September of 2019, the US overnight money market rates saw huge volatility spikes, primarily due to a large drop in reserves. The money market, which is effectively the trade in short-term loans between banks and other financial institutions, plays a very important role for keeping banks flush with cash so they fulfill all of their obligations. If there is a large redemption, and a bank doesn’t have the cash on hand, they can simply go to the money market for a short-term, low-cost overnight loan.

Without the money markets, Western banks would not function as they do now and would effectively default on their obligations. Facing the potentially catastrophic collapse of the money markets, the Federal Reserve stepped in and starting expanding its balance sheet, i.e. printing money, again. By the end of December 2019, they had already printed almost $400 billion, just to save the overnight repo market.

Please keep in mind, this all happed before the trillions printed during pandemic response and it exposed that the problem is that the western financial institutions are too-big-to-function without low rates and cheap money. Also keep in mind, the Federal Funds rate after last week’s 0.75 percent rate hike is already at 1.50 to 1.75 percent.

But what does this all mean if you are a long-term real estate investor in the Philippines? What is the playbook going forward? The answer is quite simple: Stay the course. Philippines real estate prices increased in Q1 of 2022 and are still on pace to rise further this year.

In the face of a recession, rising borrowing costs and soaring inflation, the urge might be to panic and sell. But the reality is that the newly elected Philippine government was given a clear mandate to continue the build, build, build policy of his predecessor. The Philippine debt-to-GDP ratio at 58.1 percent in 2021 is significantly lower than its Western counterparts, with the US and Japan at 134.24 percent and 256 percent, respectively. Given the geopolitical interest in the Philippines and our relatively stronger growth prospects, there will be no shortage in money available to the government to fund our infrastructure development needs.

Yes, it is true. Inevitably, the current stagflationary environment will either produce a recession or cause new cracks in the system will emerge, but we all now know the truth. The Western central banks have proven time and time again that that instead of risking a deep recession or the collapse of the financial system, they will quickly return to their money printing ways.

Nobody can say for sure when the pivot will happen. I’m convinced it will be sooner than we think, and when it does, we need to be already properly positioned to capture that upside. If this chain of event occurs as predicted, not only will the real estate prices around the world rise sharply, but smart money will continue to invest where it has a chance of higher returns, and the Philippines is one of the last bastions of real growth opportunities.

In my past articles, I’ve spoken at length about the long-term positive outlook of the Philippine real estate and our relatively strong fiscal position, and none of these core factors have changed. If you are buying strategically, investing in quality projects especially in prime location or near major infrastructure development over the course of time, you will continue to be rewarded as you have in the past.