Interview of the Month with Andre Chelhot, CFA, Global Macro Economist

Could you briefly elaborate on the evolution of the global monetary system since World War II and highlight the key changes that we encountered during this period?

The key feature of the Bretton Woods Agreement which lasted from 1945 to 1971, was the establishment of a fixed exchange rate regime for the world's major currencies against the USD. Many countries agreed to peg their currencies to the US dollar, which was in turn convertible to gold at $35 per ounce.

In 1971, the United States suspended the US dollar's convertibility into gold, leading to the transition to a system of floating exchange rates. The collapse of the Bretton Woods Agreement was mainly due to the growing balance of payments deficits of the United States, against which there was not enough gold. In other words, the United States defaulted on its external debt. The US dollar, like most other currencies, became fiat money. Fiat money is a government-issued currency not backed by a physical commodity, but rather by the government that issues it. Its value is derived from the trust and confidence people have in the stability and credibility of the issuing government.

In 1974, the United States reached a pivotal agreement with Saudi Arabia that significantly impacted global finance and the oil market. The key points of the agreement:

   1. Oil Sales in USD: Saudi Arabia agreed to price and sell its oil exclusively in US dollars. Any country wanting
       to purchase oil from Saudi Arabia had to use US dollars, increasing global demand for the dollar. Other OPEC
       producer countries followed suit and accepted to price and sell their oil exclusively in US dollars.

   2. US Military Protection: In return, the US provided military protection to Saudi Arabia and its neighbors in
       the Gulf and helped modernize these countries' armed forces. This aspect of the agreement was crucial for
       Saudi Arabia and other Gulf countries' monarchies, which sought security assurances amid regional
       instability.

   3. Investment of Revenues: The Saudis agreed to invest a significant portion of their oil revenues in US
       Treasury bonds and other dollar-denominated assets. This helped recycle petrodollars back into the US
        economy, supporting the US financial system and government spending.

By ensuring that oil was traded only in the US dollar, it became backed again by a physical commodity. This time around the physical commodity is oil since the US is the only country that can print the US dollars at will. In addition, countries needed to hold substantial dollars to buy oil or any other raw materials, which rendered their monetary and financial systems hostage to the monetary and fiscal policies of the United States.

The second foundation of the global monetary system was the entry of China into the WTO in 2001. Since most of the raw materials traded in the global economy were priced in US dollars, China’s exports of manufactured goods were being priced in US dollars. The rapid ascendance of China in global trade has created a massive divergence between the external balance of the United States and that of China and other major exporters countries like Japan and Germany.

The third foundation of the current global monetary system was the establishment of the Euro Zone in 1999, which led to the surrendering of the monetary and fiscal sovereignties of the Eurozone member countries to Germany and France. Unlike the USD dollar, the Euro is not backed by any physical commodity. Hence it remains a satellite currency to the USD. The establishment of the Euro has led to a massive divergence in the external balance between the northern countries and the southern countries.

The current debt-based fiat global monetary system seems to be more and more unstable. Macroeconomic data and macroeconomic development across the globe seem to be more and more volatile, especially in comparison with the Great Moderation period since the mid-1980s until the Global Financial Crisis in 2008 and the zero interest rates & QE period since the Global Financial Crisis until the pandemic in 2020. Moreover the total global debt is also at the all-time in absolute dollar terms and close to the all-time high in relative terms to global GDP. What are the key drivers of these global secular macroeconomic trends?

All three foundations enumerated above of the current global monetary system are now under significant threat and are starting to crack:

•  The war in Ukraine meant that the US and its allies no longer control the global oil market. Russian oil is being sold to China and other big emerging countries in Ruble, Yuan, or Rupee. KSA has recently announced that it will not renew its pledge to sell oil exclusively in USD. In addition, the GDP of the BRICS is now equal to that of the US and is about 60% of that of the G7 nations. The BRICS countries as an economic bloc can introduce a new global currency backed by their wealth of raw materials.
•  The rising trade tensions between China on the one hand and the US and the EU on the other hand are causing a major change in the global trade flows. Chinese exports to the rest of Asia and other large emerging countries are now outpacing exports to the G7. This trend is expected to continue especially if Trump wins the next Presidential elections.
•  Many Eurozone member countries have their debt at unsustainable levels, which would ultimately necessitate either a rescheduling or a total monetization by the European Central Bank. Recall that Eurozone member countries cannot print the Euro at will.

We call the new global macroeconomic trend “the walk in reverse”. Several secular forces that led to the Great Moderation and low inflation era in the developed economies over the last 30 years are reversing. This reversal in economic forces is happening while global debt is now close to 350 trillion dollars or 3.5 times the world GDP. Historically, when debt levels reach unsustainable high levels, and the cost of capital remains high, an outright default or a significant rise in inflation has always followed. We need to add here that the seizure of Russian assets by the G7 in the aftermath of the Ukraine War is a disguised form of default.

We strongly believe that the new secular trend is of a high volatility in economic data, high volatility in monetary policy and fiscal policy decisions, amid a structural stubborn high inflation rate. All these factors should exert upward pressure on long-term interest rates.

Real inflation-adjusted (median) wages across the developed economies seem to have been stagnating at best during the last several decades. What are the major reasons behind it?

Real wages in the manufacturing sector have been stagnating for the last two decades. The main reason behind the weakness in real wages in the manufacturing sector is the avalanche of cheap labor from various emerging countries that hit the world economy in the late 1990s. The second reason is that these large emerging countries have continuously ensured that their currencies would remain competitive. Thus, they have amassed massive FX reserves to the detriment of manufacturing jobs in developed countries. This trend is reversing. Wages in the manufacturing sector are now growing at a much faster pace than the rest of the economy. The reason for this recent development is that it has become much cheaper to produce in the United States than to produce in China and ship the produced goods to the USA. The reshoring of manufacturing activities back to the US means that growth in wages in the manufacturing sector should outpace that in the service sector.

Income and wealth inequality have been significantly increasing across the global economy during the last several decades. Could you explain the key drivers of this unfavorable trend and which major risks does it present for the current and especially the future global economic growth?

Many government policies that were adopted over the last thirty years can explain the rapid rise in inequality in the USA and other major developed countries:

1. The implementation of free trade agreements led to the outsourcing of manufacturing jobs to countries with lower labor costs, which reduced wages and job opportunities in the manufacturing sector in developed countries.
2. The deregulation of the labor market weakened collective bargaining power, contributing to stagnant wages for lower- and middle-income workers.
3. The deregulation of the financial markets and the rise of financial instruments have generated significant wealth for investors and capital hoarders.
4. Reduction in top marginal tax rates and corporate taxes, with capital gains and dividends taxed at lower rates than labor income.
5. Cuts to social welfare programs and public services have reduced support for low- and middle-income households.
6. QE boosted financial markets, disproportionately benefiting the wealthy, who own a larger share of financial assets.
7. Low borrowing costs have driven up real estate prices. Property owners and investors have seen substantial gains, while affordability for first-time buyers has declined, widening the wealth gap. Low borrowing costs have also enabled stock buybacks and increased dividends. These actions primarily benefit shareholders, who are typically wealthier individuals.

In your opinion what are the major effective connections between fiscal and monetary policies?

We don’t believe in the independence of central banks. A central bank is no more than the bank of the State. In the long term, there is no distinction between monetary policy and fiscal policy. A state that adopts a fiat currency system has recourse to two forms of funding: government bonds or bills that carry interest, and money which is no more than a zero coupon perpetual bond.

The budget constraint of any country that adopts a fiat currency system can be written as follows: deficit = Δ Debt + Δ Monetary Base. If a country increases too much marketable debt, it risks a significant rise in interest rates. If it increases by too much the money base, it risks a rise in asset inflation first and then in goods and services inflation. In the long term. There is no free lunch.

The US runs a tremendous budget deficit at around 6% of GDP right now, annual interest costs have surpassed USD 1 trillion and are now higher than the defense budget. How sustainable is this fiscal trajectory in general and as regards the dollar global status as the reserve currency in particular? Is it also driving the ongoing de-dollarization?

The US government debt held by the public is now approaching 110% of GDP, its highest level since the end of WW2. To reduce the debt-to-GDP ratio you must have two conditions satisfied.

1. Interest Rate below GDP growth rate.
2. Deficit as a percentage of GDP below GDP growth rate

To achieve the above goals, the US government will resort to financial repression which has the following characteristics:

1. Keep real rates in negative territory.
2. Put a cap on interest rates on deposits.
3. Raise the tax rate on savers and capital holders.
4. Price cap on goods and services.

If the above policies are not implemented, the debt of the USA will embark on an unsustainable path. This will weaken the position of the US dollar's status as the reserve currency of the world. We did a simulation with the help of AI for the debt-to-GDP ratio under two scenarios: a) weak growth, low inflation, low real rates b) weak growth, high inflation and high real rates. The simulations showed that the debt to GDP ratio would rise above 150% and above 200%, respectively by the end of 2034.

Are we going to see a second major inflation wave in a similar fashion like in the 1970s?

The world economy is hit by two opposing forces. On one hand, we have the advancements in technology and artificial intelligence that are supposed to raise the level of productivity in the world economy. On the other hand, we have the forces of deglobalization, labor hoarding, disruption to maritime routes, and the shift to clean energy. We believe that the advancement in technology will not be enough to keep inflation under control. We believe that the inflation rate for the world's developed economies will average between 3% and 5% over the next few years. So, to answer your question, we don’t see a second wave forming but believe that inflation will remain sticky and above the target of many central banks – financial repression.

You have been reasoning recently that the global economy is going to enter a long period of stagflation. Could you elaborate on why you think so?

Economic growth in the USA and other developed countries will start to weaken mainly because the impulse of large fiscal and monetary expansions is beginning to fade away. It is the change in the fiscal deficit that enters the calculation of the GDP growth rate and not the size of the deficit itself. In addition, the monetary expansion has led to a high concentration of income and wealth among the top household earners. Very little of that monetary expansion ended up in the pockets of the middle- and low-income classes who have a propensity to consume close to 50% while that figure for the top earners is no more than 5%. The concentration of wealth and income will prevent the economy from expanding further, absent another fiscal or monetary boost, which is politically and socially no longer feasible.

On the other hand, the world economy is still being hit by negative supply shocks: deglobalization, labor hoarding, transition to clean energy, and disruption to shipping routes, due to the wars in Ukraine and the Middle East.

A negative demand shock, along with a negative supply shock would lead to stagnant output and higher prices.

The most logical solution is for large emerging countries to boost their domestic demand, reduce their capital accumulation, and reduce the level of their overall national savings. But for this to take place, democracy and free markets in most of these countries must be implemented. However, we don’t see democratic governments being formed in China, Russia, or in the Middle East.

What are your key takeaways from the recent elections into the European Parliament, and the general elections in France and the UK?

Many people cheered that the far-right party in France failed to form a majority government. However, if we look closely at the results, the far-right party gathered 38% of the electoral vote, the largest share among all other political parties. In 2017 only 14 members of that party won seats in the legislative elections. That figure was 90 in the elections of 2022 and close to 140 in the elections of 2024. If France had not adopted a two-round election system, we would have a far-right government by now and maybe a President in 2027.

In the UK, the Labor Party won by a landslide.

These election results reflect the discontent of the electorate in many developed countries with the current establishment. The main reason for that discontent is the massive rise in wealth and income inequality across these nations. This means that sooner or later we will have populist governments that will adopt populist policies.

What do you think about the increasing geopolitical tensions during the last several years in general and the BRICS/global south detachment from the global west? What are the major implications of this fundamental secular trend in the global economy for investors and global asset allocators?

We see a kind of divorce or disengagement between the major superpowers. The implications are that investors will prefer to invest locally than to venture abroad.

What is your long-term investment view on the major global asset classes, in terms of equities, government bonds, corporate bonds, commodities, real estate, venture capital and private equity, Bitcoin, and other alternative investments?

I am an economist. I prefer not to give predictions about financial markets but as I noted above, we like to call the new era the walk in reverse. Our world will look more like the world of the Cold War Era than the world of the Great Moderation Era. The rise in the cost of capital will have profound implications on asset allocation decisions. In an era of high volatility and high uncertainty, investors will go to assets that are safe, productive, and can generate income. In a nutshell, we like residential real estate, inflation-indexed government bonds except those of the Eurozone, and value stocks that offer high dividend yields. In FX, we believe that the Euro and the CNY are about to enter a major downward trend and we like currencies of countries that are net exporters of commodities.