“ It’s naïve to assume that the biggest credit-fueled bubble in half a century can proceed indefinitely or be deflated without pain. ”

Talk show pontifications notwithstanding, the trajectory of the world’s two most serious geopolitical conflicts — Ukraine and the Middle East — is unpredictable. Within the Israel-Hamas war, the potential for serious escalation isn’t trivial. These and other uncertainties are aggravating known stresses on the worldwide economic system.

Consider inflation. Slowing price rises have been driven by easing demand, as consumers’ COVID pandemic savings dwindle and energy and food-price costs decline. While several aspects suggest that inflation may stabilize at around current levels, it could increase for several reasons. 

First, on the demand side, strong employment will support consumption. Government deficits, currently around 5% and projected to grow, will add to demand. The energy transition, subsidies for strategic manufacturing, semiconductors and war-footing defense spending, will proceed to spice up spending.

Input costs show no signs of easing. While volatile, energy prices remain under upward pressure on account of production cuts by Saudi Arabia and Russia to maintain prices at levels which meet their revenue targets. Fuel hungry military activities will influence demand. The specter of an 1974-like oil embargo shouldn’t be discounted.

Food prices are affected by geopolitical conflicts, reducing supply from major producers, extreme droughts and floods in addition to export limits as nations prioritize their domestic needs. Commodity prices, comparable to for copper, can be underpinned by demand for transition critical minerals and armaments. There are looming shortages on account of inadequate investment  due to, partly, efforts to satisfy ESG targets.

Manufactured goods prices may fall on account of excess Chinese capability but services, that are a big portion of advanced economies, will reflect rising labor costs. Furthermore, an aging population and skills shortages will drive higher salaries, in nominal but not real terms, generating a wage-price feedback loop.

Housing is also affected. With affordability at record lows, strong housing markets will feed inflation via real or imputed rents. Rising insurance costs on account of increased extreme weather risks will flow into rising prices.

Inflation is also present in the tit-for-tat China-U.S. trade restrictions on technology and rare earths, which impacts supply chains. Relocating production facilities to boost U.S. sovereignty will contribute to higher costs due to inefficient operational scale and better inventories.

Second, public funds. Government spending, which can be affected by wars, isn’t being matched by higher tax revenues, resulting in larger deficits and increased borrowing. U.S. government debt, for instance, is forecast to rise to 107% of GDP by 2029 from its current 97%, exceeding the 1946 post-World War II historical peak of 106%.

“ Geopolitical conflict will divide the world, driving a shift away from the U.S. dollar. ”

Third, de-dollarization. Geopolitical conflict will divide the world, driving a shift away from the U.S. dollar
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for trade and reserve assets to cut back exposure to U.S. sanctions and asset seizures. While unlikely to get replaced within the near term, the increased use of non-dollar currencies will fragment global capital movement. The U.S. will face increasing difficulties in financing its budget and trade deficit, now a combined 8% of GDP, from foreign investors, who hold one-third of US government debt, increasing borrowing costs. 

“ The effect of upper rates on financial stability and asset prices is underestimated. ”

Current rates of interest reflect an extended overdue normalization. Central banks also need scope to chop rates in an emergency. Barring a severe downturn or financial crisis, rates could remain at current levels for a protracted period.

The effect of upper rates on financial stability and asset prices is underestimated. The banking issues revealed in March and April of 2023 haven’t disappeared. Long-term rates now are above levels when Silicon Valley Bank collapsed. Mark-to-market losses on bond holdings at the moment are higher at around $9 trillion of losses. Deposit outflows are continuing. Loan losses from defaults as corporations are forced to refinance with higher borrowing costs lie head. Write-offs could be compounded if the economy slows.

Recoveries in stocks, albeit narrowly based, and residential property have increased the degrees of overvaluation as measured by fundamental measures. Weaker businesses with low- or no money flow and reliant on constant capital infusions are especially vulnerable. Other areas of vulnerability remain, particularly amongst venture- and early stage capital, private markets, leveraged finance, shadow banking and structured products.

As well as, problems in business real estate and funds unable to navigate choppy trading conditions may foretell troubles ahead.

The tested meme of “bad news is nice news,” with its promise of lower rates and extra liquidity, ignores this altered environment. The truth is that governments have unsustainable debt, and central banks must cope with bloated balance sheets and enormous losses on existing QE bond purchases. Policymakers are juggling accelerating geopolitical issues and the necessity to contain inflation.

It’s naïve to assume that the biggest credit-fueled bubble in half a century can proceed indefinitely or be deflated without pain. Higher rates of interest, in the event that they proceed for long enough, will force an adjustment, a method or one other, to popular investments that were made based on comically low costs of capital.

Satyajit Das is a former banker and creator of A Banquet of Consequences – Reloaded ( 2021) and Fortunes Fools: Australia’s Decisions (2022)

More: 70% probability Israel-Hamas war spreads beyond Gaza, threatening oil, strategist warns

Also read: What Israel-Hamas war means for gold as investors seek safety