Carry On

Corruption of the best things gives rise to the worst. ― David Hume

The summer in Europe ended abruptly. Heavy rain and unseasonably cool, fall-like weather replaced high temperatures and heat. As a result, many affected countries experienced severe flooding, which disrupted supply chains and caused extensive damage to homes and industrial facilities, bringing hardship to thousands of people.

However, amid this tragedy, some political parties and activists have attempted to exploit the catastrophe to advance their own agendas under the guise of "fighting climate change." In my opinion, this is quite distasteful. Moreover, just because someone disagrees with certain policies aimed at combating climate change doesn’t mean they don't care about the environment or that they are a "climate denier."

Regardless of one’s stance on these issues (which isn’t the focus here), what is concerning is the growing polarization that has intensified for as long as I can remember. While the rise of social media algorithms may have contributed to this trend, I’ve also noticed it spreading through traditional media, particularly since the pandemic in 2020.

It seems that no matter the topic, few people attempt to take a balanced, middle-ground position. Instead, issues are framed as either completely right or entirely wrong, black or white, with little room for nuance or compromise.

During the pandemic, for example, you were either a staunch supporter of the lockdowns and business closures imposed by politicians and the media or you were branded a "COVID denier." This polarization intensified even further with the vaccine rollout. If you took a middle-ground approach—critical of lockdowns and mandatory vaccinations but also rejecting conspiracy theories like those about the World Economic Forum—you found yourself in the crossfire of both extremes. This centrist position, which used to be more common and reasonable, is now a rarity, while the extreme views have become more vocal and prevalent.

We see similar polarization with other issues, such as the Russian invasion of Ukraine and the recent escalation in the Middle East following the October 7, 2023, terrorist attack. Yes, Russia is responsible for starting the war and inflicting suffering, but it’s also true that Russia repeatedly warned the US about the presence of NATO forces near its borders. The US would likely react the same way if Mexico or Canada joined a BRICS military alliance. However, acknowledging these facts doesn’t make someone a "NATO supporter" or a "Russian troll."

In the Middle East, it’s possible to condemn the attack on Israel and stand with its people while also questioning whether it's justifiable to target civilians, even if many of them may support Hamas. It's not antisemitic to question the Israeli government's role in the rise of Hamas, just as it isn't supporting civilian casualties to denounce antisemitism when Jewish students are barred from universities because of Israel's actions.

Ultimately, it would be a positive step if centrist positions were once again viewed as reasonable rather than being dismissed as simply supporting one side or the other. Unfortunately, with the current polarization, it's unlikely this trend will reverse anytime soon.

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Moving on to the financial markets: while the summer was relatively calm, particularly in terms of interest rates, the debate over whether the US is headed for a recession or a "no-cession" remains front and center. This has naturally sparked interest in how the Federal Reserve might respond. As a result, Wednesday's FOMC (Federal Open Market Committee) meeting garnered a great deal of attention—but I'll touch on that shortly.

While the US economy has performed moderately well, other parts of the world continue to struggle to regain economic strength. In the current geopolitical environment, with politicians pushing for an end to globalization and a renewed West-East divide, America's largest economic competitor,

China, is still far from a full recovery. In Q2 of this year, China reported real economic growth of 4.7% year-over-year. Even if we question the accuracy of these figures, the official data alone indicates that China's growth rate is slower than at any point since it joined the World Trade Organization. This slowdown is occurring despite the Chinese yuan's significant depreciation against the dollar, which should serve as a warning that a weak currency alone isn't enough to drive economic recovery.

Chinese consumer and producer price inflation has not gained momentum despite the easing measures implemented by the People's Bank of China. The stock market is underperforming compared to other major economies, and the housing market bubble continues to deflate despite various safety nets.

Even though domestic demand remains weak, China's industrial sector is still expanding, driven largely by foreign demand. While export growth slowed in July, industrial profits continued to rise. In fact, they accelerated in August, highlighting that global demand for cheap Chinese goods remains strong, even as its domestic economy undergoes a protracted deleveraging process.

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This weakening of Chinese domestic demand has significantly impacted European businesses, which had been heavily engaged in China. In recent years, Europe has lost several industries to China, mainly China's subsidization of consumer demand while increasing regulations hampered European producers. Chinese manufacturers stepped in to fill this gap, producing goods more cheaply and capturing market share from European companies.

In an effort to restore Europe’s economic strength, Ursula von der Leyen sought the help of none other than Mario Draghi, the former head of the European Central Bank (ECB). In April, Draghi delivered a widely discussed speech, which I commented on at the time:

Being the Keynesian that he is, Draghi's solution essentially boils down to the argument that European countries need to invest more and emulate the US Inflation Reduction Act to implement an "Industrial Deal." In this sense, he aligns with those who claim that European governments aren't spending enough, although the debt levels indicate otherwise.

Unsurprisingly, Draghi also joined the chorus of voices accusing China of "unfair price dumping" to push European and US competitors out of the market. What this narrative overlooks is that such tactics occur not only internationally but also domestically. It’s a common business strategy to undercut emerging competitors by accepting initial losses or leveraging political influence to impose higher costs that are easier for large corporations to absorb but harder for smaller businesses to manage.

Nevertheless, Draghi’s report this week glorifies centralized decision-making, just as I predicted in April. As the Financial Times reports:

The many very good policy proposals include: more investment and more common funding for common goods; using better the EU’s size to improve terms by procuring raw materials and natural resources jointly; creating a truly single market for company financing (the capital markets union project) and removing barriers for companies to scale up to the level of the continent-sized market; and defining the desired trade-off between promoting domestic clean tech production and making use of Chinese capacity to meet European decarbonisation goals.

While I applaud Draghi's call for a smarter regulatory framework within the EU, which could make it easier for businesses to operate, the rest of his proposals miss the mark. They fail to acknowledge the core reasons why Western European economies are struggling.

For instance, while it’s true that joint procurement of raw materials might lower average costs due to economies of scale, this doesn’t mean every country will benefit equally. Some countries, like Austria, have historically secured better deals on natural gas due to specific factors. Thus, while collective procurement might lower overall costs, not all member states will necessarily fare better.

Most of Draghi’s recommendations align with what EU politicians have long desired: more influence and centralized political power. His proposal for majority voting instead of unanimity effectively diminishes the influence of smaller countries, eroding their ability to protect their national sovereignty.

His call for more centralized budget capacity is particularly concerning, as it aligns perfectly with von der Leyen’s vision. This would allow the EU to issue joint bonds regularly to fund various projects. Draghi seems convinced that Europe’s stagnation stems from not having its own version of Bidenomics:

Some joint funding of investment at the EU level is necessary to maximise productivity growth, as well as to finance other European public goods. The more that governments implement the strategy laid out in this report, the greater the increase in productivity will be, and the easier it will be for governments to bear the fiscal costs of supporting private investment and of investing themselves. Joint funding for specific projects will be key to maximize...the productivity gains of the strategy, such as investing in breakthrough research and infrastructures to embed AI into the economy.

But will the EU make better decisions than individual member states did in the 2010s? Each country then pursued its own version of Bidenomics, which did not lead to sustainable growth. The problem is that joint bonds will pull money from the private sector, which could otherwise be invested more efficiently. This approach assumes that the EU has superior knowledge about the needs and wants of consumers than the thousands of smaller entities in the marketplace—a classic example of the "pretense of knowledge."

Germany's economic struggles are not due to Robert Habeck being a worse decision-maker than his EU counterparts. The real issue lies in central planning, which lacks the flexibility and information necessary for effective decision-making and is prone to lobbying influences. As these centralized measures, especially joint EU bonds, are likely to be implemented, it seems probable that Western EU growth will remain sluggish and political divides will deepen.

Rather than pushing for more centralization, European leaders could learn from the highly competitive economies in Central and Eastern Europe, where excessive regulation and taxation have been kept in check.

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Now, shifting focus to Wednesday's FOMC meeting and the US economy. Since my last update on June 28, US stock markets have traded sideways, showing only moderate gains. The same trend can be observed in European stock indices. Meanwhile, interest rates have begun to fall, mainly due to developments in the US, where inflation has continued to decline, and the labor market shows signs of loosening.

However, the Nonfarm Payrolls report from early September did not indicate that a significant weakening of the labor market is imminent. Payrolls increased by 142,000, and the unemployment rate remains at 4.2%. These numbers don’t support claims of an impending economic slowdown in the US.

Many bearish commentators point to the recent uptick in unemployment as a potential sign of a recession. Still, it's important to note that this rise is mainly driven by youth unemployment (under 25). While this isn't great for long-term prospects, it does suggest that high-income earners remain employed.

According to the Atlanta Fed’s GDP Nowcast, real GDP for Q3 is projected to grow at an annualized rate of 2.9%, indicating solid economic performance. Additionally, inflation has dropped significantly over the summer, with the CPI now at 2.5%, matching the Fed’s preferred PCE measure as of July.

Given these data, the Fed’s decision to cut interest rates by 50 basis points on Wednesday might seem surprising. However, financial media had already hinted at the possibility. In his press conference, Fed Chair Jerome Powell explained the rationale behind the decision:

The Fed chief said launching the unwind of its historic tightening campaign with a big move while the US economy is still strong would help limit the chances of a downturn. But he was careful not to commit the Fed to a similar pace going forward, saying future moves would be based on how the economy performs in the months ahead.

Beyond Powell delivering precisely what Wall Street hoped for, it’s clear that the Fed has essentially declared victory over inflation, shifting its primary focus to the labor market to orchestrate a soft landing. Many Keynesians, including Paul Krugman, will likely be pleased with the decision, as they believe lower interest rates will spur growth and support employment without reigniting inflation.

The unemployment rate has remained at record lows for some time. However, with the Fed initiating a 50 basis point cut, the key question is whether this can ensure the desired soft landing. Many economists and analysts seem to think it can. While the recent uptick in unemployment has mostly affected younger workers, with only a modest rise among prime-age workers, it's important to note that 50bps rate cuts have preceded every recession since 2000.

During the 1990 recession, the Fed had already cut rates by 150 basis points before the downturn began. Notably, youth and prime-age unemployment rates moved in tandem in past recessions. Today, however, youth unemployment is rising while the unemployment rate for 45-54 year-olds has remained steady at 2.7% throughout the year.

This divergence helps explain why consumption levels remain robust, especially with stock markets at all-time highs, making people feel wealthier and encouraging spending. As a result, I don’t foresee a recession hitting in 2024. Instead, we could see one last "melt-up" in the stock market before any major struggles, similar to the period leading up to the 1990 recession.

That raises the question: is the Fed’s declaration of victory over inflation premature? It’s important to remember that Keynesian models often overlook changes in the money supply. In theory, lower interest rates should encourage money growth by making borrowing cheaper. However, as Milton Friedman pointed out, this is the "interest rate fallacy."

Interest rates aren’t the sole determinant of bank lending. Economic outlook also plays a role. If banks believe the economy is on the verge of a downturn, they will scrutinize borrowers' creditworthiness more closely and may reduce lending. Worse, if the economy starts contracting and banks face mounting credit losses that outweigh new loan demand, this could trigger a deflationary spiral.

Currently, we’re far from such a scenario. People are still enjoying low-interest mortgages, stock investments are at record highs, and nominal wages have risen significantly. Bank earnings remain strong, and as long as banks aren’t forced to sell off their "hold-to-maturity" bonds, their capital structures are sound.

But could this situation reignite inflation, and could the Fed’s move backfire? The answer isn’t as straightforward as it seems. Looking at the money supply, inflation doesn’t appear to be a threat—at least through the end of next year. But, as I mentioned earlier, economics is complex, and just one or two variables cannot explain real-world phenomena.

The latest monetary expansion was unprecedented. At its peak, M2 grew by 26.75% year-over-year, meaning the Fed essentially printed more than a quarter of all the money that existed before 2020. Inflation, meanwhile, only reached 8% and has hovered around 3.5% since 2023 until it has started to go lower.

Moreover, stimulus money from the US government is still circulating through the economy, trickling from consumers to those who haven’t yet spent it. Much of it may still be sitting in bank accounts, waiting to be spent or invested in the real economy. This might explain why the savings rate has been falling rather than rising. Coupled with low borrowing costs, some people may be saving less, not borrowing, and still relying on existing savings. As a result, inflation could remain more persistent than the money supply alone suggests, as unspent money could still flow into the economy and drive up consumer demand.

Consequently, the economy may continue to hold up, keeping interest rates higher than the market expects, which could lead to a bear steepening of the yield curve. For now, stocks could benefit and experience another leg up, but caution is warranted going forward! No matter how you decide, carry on and manage your risk!

All we have is this fight against the wind
And fire in our bones (in our bones)
Now it seems that with darker days before us
Through terror, we carry on, carry on

The Wise Man's Fear - Carry On

Have a great weekend!

Fabian Wintersberger

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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.