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A Rare Consensus

The world is only starting to mourn the exceptionally benign macroeconomic circumstances experienced over the last thirty years. It is dawning on it that the future will require a different approach to almost everything. In a recent report, Kearney talks about hyper-transformation.’ It is no hyperbole.

An excellent speech from the BIS in Jackson Hole supports that assessment. According to it, the three decades leading up to the pandemic and the Ukraine war benefited from four positive factors: geopolitics, technology, globalization, and demographics. These factors allowed aggregate supply to meet a growing aggregate demand without triggering inflation. The result, in crude terms: cheap labor, cheap energy, cheap food, cheap national security.

Global supply was so plentiful that productivity investments and growth dropped. There was no incentive for firms to tighten screws and for the government to implement structural reforms.

When aggregate demand received a shot of financial engineering (read: leverage), it got carried away, and the whole system crashed, leading to the Great Recession. Exceptional fiscal and monetary measures were implemented to cushion the blow, and the world muddled through the 2010s, with dire socio-political implications, as discussed last week.

The pandemic and the war in Ukraine hit over-optimized global supply chains frontally. They shattered, leading to unexpected inflationary trends. Decades of underinvestment in fixed assets, which economic actors were hoping to get away with, have come back with a vengeance.

The solution to these woes is the subject of a rare consensus amongst economists: investments to replace the lost or dwindling supply, i.e., to use terms that are unnecessarily politically tainted, supply-side economics. It is driven by the need for enhanced productivity (automation, digitalization), reshoring (supply chain resilience), labor replacement (demographics, attitude towards work), sustainable products and processes (e.g., circularity, electrification), and defense.

Crowd-pleasing politicians focus on supporting consumption as opposed to investments. This demand-driven approach will lead to further waste of scarce fiscal firepower and persistent stagflation as the root cause of the problem is not addressed. Instead, tax incentives and investments linked to industrial policies (see Hamilton & Socrates’, 2018) can help boost the economic output potential. The alternative to seeking to do more with less is to end up doing less with less – an unappealing prospect.

These dynamics represent a historic opportunity for long-cycle, capex-orientated businesses, including in industrials. Short-cycle activities may not be so lucky. Until the output potential is expanded, persistent, uncontrolled inflation will lead to shorter economic cycles. While long-cycle businesses will provide some earnings visibility, short-cycle businesses will be subject to unusual volatility and risk.

For M&A and equity/debt financing transactions, timing the macro cycle has been a key source of value creation for decades. If the new economic regime were particularly volatile, any attempt to do so would prove futile. A long-term strategic perspective relying on structural trends is left to drive decisions.

Starting from a wider-than-usual bid-ask spread, buyers and sellers will need to learn how to compromise to get transactions done. To get there, they will first have to accept that the easy times of cheap everything are gone and ‘reset.

When the new supply kicks in, a new era of smart everything can begin.

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