Central bankers and policymakers are struggling to quell surging costs — but despite their efforts, Saxo Bank’s Steen Jakobsen believes it is a Sisyphean undertaking. Inflationary pressures are already akin to a “runaway train” that “will not moderate” over the rest of 2022 or the near term, he warns.
Jakobsen, chief economist and chief investment officer at the Danish firm, notes that for two decades, investors have been served well by “endless policy support” through which “infinite monetary easing” has become the norm. Private balance sheets were put in their “best shape ever”, as each market hiccup was soothed by policymakers stuffing the speeding train full with economic stimulus, leading to the world’s financial economy growing at the expense of the “real economy”.
“In an intangible business, most of the value sits in intellectual property, technology and knowledge. Whereas the real economy is where goods are moved around, its supports and its infrastructure. To put it simply, it is between investments in the physical world and the virtual world,” says Jakobsen in an interview with The Edge Singapore.
This momentum gained traction from the “macro paradigm” of the early 2000s, which saw investors quicker to recognise that the combination of easy money paired with the compulsion of investing for green transformation had become “too large” for the real economy to cope with meaningfully.
Sensing the “magnitude and velocity” of this economic impetus, Jakobsen was already warning about inflation as far back as late 2019. “Then, of course, Covid-19 and the war in Ukraine reinforced that view, because when you sanction Russia, you basically take away 5% of the supply of commodities in the world, which increases the supply-demand line by a minimum of equivalent demand,” he adds.
Financing ‘disequilibrium’ requires ‘compromise’
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From Jakobsen’s perspective, a couple of data points best illustrate how the finance industry is overvalued relative to its real economic value. The energy component of the benchmark S&P 500 was less than 3% of the overall index at its extreme low during the Covid-19 pandemic. On the other hand, the five most valuable companies on the index — all financial firms — make up 25% of the index’s value.
As more institutional investors throw the weight of their combined capital behind chasing after environmental, social and governance (ESG) mandates, that has merely added more hot air to the situation. “I’m not saying that the 25% is going to drop to zero — although certainly, to some extent, the 25% needs to go down — what I am saying is that the 3% needs to be higher. Because the real economy, which requires electricity to function, needs to grow. All of the free cash flow that is generated from intangible assets is going to be, and has to be, transformed,” he reasons.
Yet new variables have further complicated the system that is trying to go green. The West, by imposing sanctions on Russia, a leading oil and gas exporter, has caused a significant uptick in carbon dioxide emissions, with the likes of Germany — one of the countries that has led the “political agenda” of moving towards alternative energy — forced to burn more coal, deemed one of the dirtiest forms of fossil fuel.
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Jakobsen believes there is a “disequilibrium” between green transformation and the demand for conventional energy. According to him, the 50% to 70% of capital inflow directed towards ESG objectives is unavailable to fossil energy investments, creating the “practical issue” of oil prices, which, despite currently trading in the range of US$80 ($110) to US$100 per barrel, has a five-year average of US$55 per barrel.
“It is not sustainable to invest with an expected price of US$55. The disequilibrium also creates a forward curve in which the forward price of oil is too low, which is a combination of regulations, ESG compliance and the lack of capital investment,” Jakobsen says. “If you asked a private equity investor what the threshold for the return profile needed to invest in energy is, it would not be 15% in a market that trades at 3% on US Treasury yields.”
Jakobsen’s view is that society’s requirements of electricity “preempt” the need for ESG goals, regardless of how compelling the push for renewables has been. He says: “The success of the narrative of ESG and green transformation has created a story that reality has not followed. There is the biggest mismatch ever between the progressive narrative and the reality of the situation. They have oversold the story and created a vacuum behind it.”
To him, the solution lies with “compromise” — not entirely abandoning green financing on the path to meeting climate goals, but continuing to fund fossil energy investments that have a “sunset date” assigned to them. “We still need to pursue the 1.5°C target set by the Paris Agreement, but in doing so we need to get from here to there by using fossil energy and investing in fossil energy projects. But these projects should not be infinite in nature, they should be terminal in terms of their end date,” says Jakobsen.
Policymakers continue with ‘binary’ approach
In the same interview, Jakobsen draws a parallel between the challenges of investing in ESG, and policymakers’ struggle to rein inflation back. Jakobsen observes that policymakers and central bankers are fettered by their black-and-white principles, making decisions from “simple” permutations as they choose between inflation and the unemployment that would result from a deep recession.
“To accept a 2 percentage point increase in unemployment would hurt 6 million people in the US; not dealing with inflation would hit 300 million people. Right now, the bigger problem is the 300 million people who have seen their paychecks being diluted and are losing purchasing power from the inaction of the Federal Reserve [Fed] over the past two years,” he says.
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“As long as we are south of an unemployment rate of 6% in the US, I think the Fed will continue to ramp up and continue to hike interest rates,” adds Jakobsen. “The choices being made today, like in energy, are very simplistic, they are binary — either you do electricity or you do not, or in the Fed’s case, either you
fight for 6 million people or you fight for 300 million people.”
Jakobsen says it is “unattainable” to base policies on the smaller figure with the US midterm elections coming up, and that it is “clear” to him that in the next 2.5 years, inflation will grow beyond the Fed’s agenda of reducing the burden of the full US population.
Historically, he says that economists are more worried about the second-round inflationary effects, when wages are driven up by rising consumer prices. “Talk to any employer in Singapore, Denmark or the US and they are already having difficulties attracting talent. The wage effect is already in play and to kill that
you need a tighter monetary policy.”
In late July, the Fed raised rates by another 75 basis points but it is still playing catch-up with the issue of inflation. “It would be much better just to send a shock to the market with a marginal higher interest rate, but that rate would be high enough to actually have a material impact on the economy,” says Jakobsen.
On the other hand, he believes that with Singapore’s exchange rate-based monetary policy and a “highly flexible and agile” economy, the fluctuations of the US dollar are less of a concern, calling the moves by the Monetary Authority of Singapore to strengthen the Singapore dollar the “right way” of dealing with inflation. A relatively strong Singapore dollar makes imports cheaper and also allows Singapore to remain as a “safe haven” for “significant” global capital flows from the likes of Hong Kong and other parts of China.
For the wider region however, Jakobsen says the “highs and lows” of the dollar rate are a “concern”. “When [the strong US dollar] coincides with high inflation, which impacts food and energy prices, it makes the emerging market very vulnerable since the percentage of household income spent on necessities is much higher in emerging countries than the developed world,” he explains.
The great reset
Given a policy choice of either higher inflation or a deep recession, Jakobsen expects the political response to be to instruct central banks to bring up the inflation target. For years, the US Fed has set 2% to be a desirable long-term inflation target — a level deemed not too hot, as it provides a safety margin against the risk of deflation, nor too cold, helping to keep monetary policy effective when it needs to respond to inflation that is too low. The “optics” of this move of this would hopefully mean requiring
slightly less tightening, but also that negative real rates, or financial repression, are a real embedded policy objective now, he says.
He argues that whether the Fed has a 2% or 3% inflation target will not create more cheap energy; what is clear is that the political system will favour the “soft option” for inflation in which the chief imperative is financial repression to keep the sovereign funded and a reduction of the real value of public debt via inflation.
Jakobsen believes that this is “exactly” why inflation will continue to rise structurally, as softer monetary tightening continues to chase inflation from behind in perpetuity.
But from a more “holistic and philosophical” perspective, Jakobsen thinks inflation is not necessarily a bad thing. “In the commodity market, we say that in order to get lower prices, you need higher prices. By making the cost high enough, you are forcing every action to that price, which in an environment that we’ve had over the last 30 years of low inflation and low rates, you are not doing,” he explains.
Jakobsen also argues that in order to grow the real economy, there needs to be a boost in productivity, which has fallen in the West since the fall of the Berlin Wall. In order to reverse this productivity slump, he says that “better components” will be required, from logistics to digital connectivity and infrastructure.
“Everything needs to be done on a basis of productivity, not on progressive ideological ideas of what is going on,” he says. “The global economy coming out of this will be much stronger because priorities are now being reset.”
