World famous economist Nouriel Roubini is perhaps best known for his often laser-sharp predictions about the economy, including correctly predicting the 2008 financial crisis. In fact, this New York professor not only predicted a US recession by the end of 2022, but he also forecast long-term high inflation, saying those claiming the downturn will be mild are “delusional.” Perhaps that is why he is affectionately known as “Dr. Doom” in financial circles.
As investors, we all know the importance of data, but sentiment also plays a crucial role in the markets. With that in mind, our CEO and founder Yoni Assia sat down with Roubini for our “The Bull Club – Conversations with Leaders”, in the hope of gaining some insights into the future trajectory of the economy and any other gems he cared to share with us.
Why is high inflation bad?
Inflation is harmful for many reasons. Currently, prices are rising faster than wages, meaning that real incomes are falling. This puts stress on the consumer, on the households and on the workplace. That’s one of the many costs of inflation. Therefore, it seems obvious that we should reduce inflation to the target number, which is historically 2% in advanced economies.
Now, according to Roubini: “The way to do it is to use monetary policy, and you have to raise interest rates. When you raise interest rates, many things happen. You cool down the economy, and you cool down aggregate demand. You cool it down, because when interest rates are higher, the cost of borrowing to buy a car, to buy a home, to have other consumer credit is higher, so people have a rise in their borrowing costs, and they spend less.”
When you raise interest rates, you are really aiming to cool down the economy. In effect, you are creating a “controlled” mini-recession. With fewer people borrowing and buying, demand for products drops, thus, forcing manufacturers and retailers to lower prices.
Will rising interest rates help inflation?
Roubini thinks the Fed has acted “too little too late.” The consequence is that the Fed will have to raise the rates higher than planned. While inflation will “start to fall gradually, it’s going to fall too slowly.” If the Fed wants to “cool down the labour market, pull down the economy and get inflation to 2% by next year, or the year after,” it needs to raise rates to between 4–4.5%.
Failure to fight inflation now would be disastrous
So the Fed is walking a thin line, because if the bank raises interest rates too quickly or by too much, it could result in a hard landing, however, if the Fed raises interest rates slowly and by a more gentle amount, that could result in a soft landing.
According to Roubini, a soft landing is not going to be possible in this case “because for the last sixty years in the United States, any time inflation was above 5% and any time the unemployment rate was below 5%, (and today inflation is 8.5% and unemployment is 3.5%), any time you have been in this condition when the Fed has increased interest rates, we have had a hard landing rather than having a soft landing.”
Roubini continued: “Unfortunately with a hard landing, there’ll be a recession, people are going to lose their jobs, and their wages are going to fall, and they’re going to be worse off.”
So the question is, should we be fighting inflation or letting nature take its course? According to Roubini, the case for raising rates and fighting inflation is based on a few arguments.
“The average person is already worse off as inflation erodes real wages. Secondly, if you don’t fight inflation and you get behind the curve, then inflation will get higher and prices will get higher until you need to raise rates to around 20% and then you need a huge recession to break the back to fight inflation. If you are behind the curve, eventually the loss of jobs and recession will be even worse.”
GDP vs labour paradox
The labour market in the United States is still strong, and that’s a paradox because for the last two quarters — economic growth was negative, while job creation was positive. How do we reconcile that?
According to Roubini: “We have what technically looks like a recession based on output, and demand is slowing, but the labor market is suggesting a robust labor market. Now the trouble is that the labor market is so tight, unemployment rate is so low, GDP is suggesting a recession but the labor market has seen a really strong throughout.”
Inflation in the US peaked at 9.1% and during the last month, the number was slightly lower than expected at 8.5%, mostly because the price of oil fell and gas too. But, core inflation excluding gas and food is still high. Inflation in the UK is 10%, and in Europe it is close to 9%, therefore, Roubini thinks “it’s not the time to declare victory yet!”
Roubini was proven right as Fed chairman Jerome Powell reiterated a similar message at last week’s Jackson Hole speech which led to a heavy drawdown in the financial markets.
Balancing your portfolio
Recently, investors have distanced themselves from the riskier assets and moved to the safer classes. The question is how should we position our portfolios bearing in mind that holding cash may not be the best idea right now?
Roubini explains that “you want to reduce your exposure to equities. But there are other risky assets that are a good hedge against inflation, and one of them tends to be real estate because real estate tends to be in limited supply so when you have inflation going higher you can have rising rents, and therefore it’s a good protection against inflation. Also, I would say, some people think about crypto, short-term bonds, index bonds, gold and commodities, and some exposure to real estate can also be a way of hedging yourself against the inflation risk as well.”
In the webinar, Roubini outlined two possible outcomes from our current state of affairs: “either a severe recession or runaway inflation.” Which do you think is more likely? Be sure to let us know what you think and leave comments below.
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