Uncertainty has declined

Business Standard, 6 February 2023

One year ago, there was unusual uncertainty in the world. Sustained DM inflation was hard to diagnose, the Fed was going to raise rates to an unpredictable extent, this was going to inflict damage on unpredictable pockets of the world economy, Putin invaded Ukraine, and China lost its way. Over the year, the radical uncertainty has subsided and a healing can now commence. This helps us interpret the immediate difficulties faced by many firms and individuals in India, and strategise from here.

Four difficult puzzles, all at once

By late 2021, some of us knew that the world economy was in for a torrid time. The foundations of price stability seemed to be under question and central banks globally would be raising rates dramatically if they were to protect the hard-won gains in credibility of the post-1983 period. But alongside this, we knew that sharp global tightening would trigger difficulties in as yet unknown aspects of the world economy.

In this difficult situation, we got two more problems. Russia attacked Ukraine and China tried to get to zero covid through repression.

There was radical uncertainty in this period as the pieces of the puzzle interacted with each other. The phenomena in front of us (Covid, inflation, Russia, China) were not in the historical experience, so our models -- the mental maps with which we navigate the world -- were less reliable. February 2022 was a turning point in the data, where the Fed started hiking and Russia invaded Ukraine. It is striking to see how (appropriately measured) Indian exports growth stalled at this point in time.

We are now able to look back and decipher this year, and uncertainty has declined greatly.

The global economy over this year

DM central banks embarked on the project of conquering inflation. This was a difficult time for the monetary policy frameworks and models that had been established based on the 1983-2019 data. Monetary tightening caused some trouble, as it always does. Higher interest rates in DMs is at the core of the difficulties of crypto currencies, startups in India, and the one-year price corrections in the tech giants, e.g. Amazon (-35%), Google (-25%), Meta (-15%), Apple (-10%).

The light is in the tunnel for the restoration of macroeconomic stability in the global economy. Supply chains have significantly healed, assisted by China's return to production. The DM workforce is getting back to work. While more DM tightening is in store, we may expect that by 2024, we will have more normal values of inflation, interest rates and asset prices.

Russia's invasion of Ukraine looked dangerous at first because it was felt that Russia could readily win. If Ukraine could be conquered, this would pave the way for other such wars, ranging from Chinese invasions into India or Taiwan, or other Russian invasions. That radical uncertainty of February 2022 has subsided, as the weakness of the Russian state has been revealed. It is one thing to flaunt military hardware in a parade, it is a very different thing to actually organise men and materials into combat. The war has not ended, and the possibilities range from a frozen conflict to something analogous to 1917. But this much is now clear: Russia's failure in Ukraine has improved deterrence against would-be invaders the world over.

In China, Xi Jinping swallowed his pride and stepped away from the lockdowns which attempted zero covid. China's vaccine nationalism has harmed the legitimacy of the regime. Things are very difficult in China right now, but the light is in the end of the tunnel for a restoration of normalcy. While a weak Xi Jinping regime would continue to play the nationalism card in overcoming domestic unpopularity, the experience of Russia in Ukraine will shape and circumscribe the possibilities.

These three factors have helped calm financial markets. The VIX (a forward looking measure of future equity market volatility) today is lower than it was on 99% of the days of the last year, and the MOVE (a forward looking measure of future US interest rate volatility) is lower than it was on 93% of these days. This restoration of macroeconomic stability should help set the stage for a period of sustained growth starting from 2024.

Thinking for individuals and for firms

For the people directly affected by the macroeconomic adjustment, it has been hard, and I feel their pain. But this is how macroeconomic policy works. Supply and demand in the world were out of balance, and DM tightening has helped solve the problem. The reduction in demand through DM tightening does not take place uniformly: the pain is concentrated in some places. We now see more sane prices in many important markets: real estate, computer programmers, consultants, senior managers, and firm valuations.

For many of the previous years, many input prices were out of whack, the fundamental paying capacity of the customer was low, and a decent ROE was out of reach. Under these conditions, making the business plan work required a liberal dose of magical thinking in the equity valuation. Everyone knew this could not last, which led to a jittery "take the money and run" behaviour. With all these price corrections, it is more feasible to make business plans where all the pieces coherently come together: the prices paid for these inputs, the ROE, and the valuation of the business.

Every bout of economic effervescence has its useful afterglow. In the wake of the Indian startup frenzy there is now a greater pervasive computer engineering capability. There are more teenagers in India who know Google Flutter than is the case anywhere else in the world. Business solutions that appeared exotic a decade ago (cloud based dynamic sizing, API-based connections that cut across the boundaries of the firm, nice frontend UX that runs consistently in browser or phone, statistical intelligence) are now routinely feasible for a broad range of companies in India. This is a good time for business building: getting to world class productivity with modest input prices in a way that makes decent operating profit margins.

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