Last week, in the weekly version of our newsletter, I hinted that the concept of globalization could be coming in a future long-form newsletter that we publish once a month. Well, I didn’t think that it would be coming so soon either, but if we want to unravel where we are in the market and where we could be going, our relationship to the rest of the world is a critical piece of the puzzle.
After World War II, the secret of the United States’ success was really not found in the US itself, but in the rest of the world. Europe was still being rebuilt well into the 50s, and did not have the manufacturing capabilities we enjoyed here in the states. Japan, a future technological heavy-hitter, was still in the same position as our European friends. China, at the time, was not manufacturing products that the largest economies needed or wanted, and was busy trying to achieve communism through a famine. And so, due to a process of elimination, the United States rose decisively to the top of the economic and political stage. The Bretton Woods system was imposed in 1944 to offer peace and stability by allowing other countries to trade US dollars for gold at a fixed rate. This allowed the US dollar to achieve ubiquity all over the world.
As the decades rolled on, an interesting economic phenomenon revealed itself which many are still struggling to understand today: the fact that trade is not zero-sum. Of course, this fact was nothing new to the economists who had been studying for centuries by this point, but to see the phenomenon play out in real time was a sight to behold. Countries that had, historically, not seen trade as a national priority were now coming into the fold in a big way to the benefit of everyone.
Take the Republic of Korea, for example; after the Korean War ended in an armistice in 1953, the southern part of the peninsula did not seem to have much going for it. Sure, it was backed by the United States, but the economy was decimated and it had no land borders with allies. The only land border that it had was shared with the very country that had invaded it just 3 years earlier. So how did this fledgling country fare in these troubling circumstances? Today, Korea dominates the cultural export game. Korean music, fashion, and beauty products are demanded all over the world and consumers are willing to buy these cultural exports at massive premiums. Not only that, but small products that sell for high prices seem to be a specialty of this economy with semiconductors and high-tech components being exported at increasing rates over time. And how do all of these products leave this peninsula? By sea, of course, and which country is home to four of the seven largest ship building companies on Earth? That would be the Republic of Korea.
Korea is a fascinating story; a beautiful story. The Korean story is incredible and it was only possible in a time of peace, stability, open trade policies, and secure shipping routes. From the perspective of the United States and other free-traders, Korea is a country to be friends with because the relationship is mutually beneficial. We are able to invest in, and purchase from, this economy. In exchange we get those highly desired cultural and technological exports. These kinds of positive economic shocks lower prices, increase the diversification of goods available to consumers, and raise the standard of living for all. In other words, these economic shocks are ANTI-inflationary, and they are exactly the kinds of shocks that we experienced from the end of WWII to the present.
Today, however, we are at an inflection point. There are two things that are always true about US embassies abroad: the first is a political protest. This is true to almost every single embassy with the exception of Canada. The other thing that is true about US embassies abroad is that outside there will be the longest line you have ever seen for visas. There is a deep uncertainty and internal conflict that many feel with the power of the West and this free-trade empire that was built over these last several decades. Who exactly gave the United States the power to impose their own currency as the currency of the world? Many are uncomfortable with the fact that the multinational institutions that reside in the west (IMF, World Bank, United Nations, etc.) have sometimes more power over the lives of individuals than their own national governments. There is deep resentment in some parts of the world that never bought into the free trade narrative for one reason or another. Some do not believe that trade can truly be beneficial to all parties. Some believe that trading with the West is inherently bad and props up an immoral world order. Some take deep issue with the US dollar being used as the world reserve currency now that the gold standard has been abandoned. There are many reasons as to why countries are not jumping on board, but the fact that they have paused means that the positive supply chain shocks that we were talking about earlier are no longer coming as frequently.
This is not a fact lost on the Federal Reserve which, by the way, is the most powerful international financial institution even though it is only a domestic institution for the United States. Last week, when we covered the statements of Chair Powell and Former Chair Bernanke, we touched on the fact that these positive supply chain shocks helped manage inflation for decades. The fact is that when new economies are buying products, and new labor pools are added to the global economy, inflation is relatively easy to control. With those external crutches removed from the picture, the Federal Reserve is going to have a real hard time landing that inflation number at or under 2%, especially with future negative supply chain shocks coming. The fact is that the countries that did not embrace free trade like Russia, Iran, North Korea, are agents of supply chain shocks whether it be by erratic leaders, wars, sanctions, or a casual disregard of international norms (the China Model).
So where do we go from here? Well, we cannot fix the whole world and any attempt to do so will most certainly backfire. We need to acknowledge that some of the countries that have not joined our system have good reasons for doing so. Free trade, when left unchecked and with no oversight, can absolutely be exploitative. An economic dependency on the United States leads to a dependency on the Federal Reserve’s policies which are not accountable to foreign actors in any way. US foreign policy is erratic itself and oftentimes our hand in a situation is not one that promotes stability and predictability. Regardless of why these countries are reluctant, we need to understand the reality of today and assess today for itself, not a fictionalized version that we would prefer.
The goal of this piece is not to advocate for any policy change, but to remind everyone that in the global economy that humans have built, nothing moves in isolation. The actions of an ally abroad might signal instability to a potential ally elsewhere. One of the largest positive shocks that was left unmentioned earlier was the fact that after WWII, the enemies that we fought against became our friends. Germany and Japan went from being our enemies that we declared war against, to being large trade partners capable of producing higher quality goods at cheaper prices than we could muster ourselves. In many cases, internal developments cannot be understood in isolation, but are instead much clearer when developments abroad are taken into account. This is the real story of inflation. If you want to understand where the market is going, this piece of the puzzle must be understood and internalized.
So with future positive supply shocks slowing down, and future negative supply shocks increasing, inflation will become more difficult to control and the idea of keeping it at 2% using the blunt weapon of interest rate hikes is a fantasy. Blockrock made the prediction last year that inflation will level off at some point significantly over the Fed’s 2% goal and, with the global macro pressures that we are currently living through, I believe they are correct. This will not stop the Fed from trying though and it is very safe to say that we will be living with high interest rates for some time to come. We find it very unlikely that rates come down this calendar year and the times of 0% interest rates are over for the foreseeable future.
Uncertainty, a stubborn inflation problem, and higher interest rates than many real estate sponsors expected. This is the environment that we find ourselves in, and it is the environment that we will continue finding ourselves in for many months ahead. We still find it unlikely that the Fed will raise rates on June 16th despite the strong unemployment numbers that just came in. Inflation is coming down and, with the banking woes already tightening credit markets, the Fed’s job is effectively being done by the natural market. That being said, predicting the future is always a dubious proposition and we do not have a crystal ball here at Peak 15 as we often remind our readers. What we do have, however, is a team of highly motivated, and well-read investors that are ready to take advantage of the opportunities that come to us throughout this challenging time. Higher than expected interest rates means more expensive debt which means that many deals that sponsors thought would work a few years ago, do not. This leads to distressed sales and owners motivated to exit a troubled asset even if it means not getting a top dollar sale. Wherever there is a troubled seller, there is a happy buyer, and through our fund, we intend to be the latter during the second half of 2023 and beyond.