by Damon de Laszlo, ERC Chairman
We are living in a bizarre world where pressures are building in different spheres. The mood in general is pessimistic but the world seems to trundle along without seriously attempting to address the pressure points, while at the same time acknowledging them to be there. Money is poured into the seven or eight technology companies that revolve primarily around building huge data centres to manage the population’s addiction to their computer screens on the one hand and serious businesses developing so-called AI systems. Data centres themselves are huge buildings with massive computers that generate an enormous amount of heat while consuming vast amounts of electricity. The electricity drives the computers and added to this, cooling requirements are met by using air conditioning or water, or building in cold climates. Electricity consumption is beginning to have a serious impact on Western countries, to the point where the local grids have banned more centres from being connected to them. While planning for the enormous increase in green electricity generation required to decarbonize the economy is starting, there is very little acknowledgement of the need to hugely expand the distribution network to deliver it – the global warming impact is largely ignored.
Other areas of concern are the movement of institutional and private funds into the Junk Bond arena, to diversify out of equities whilst still earning a return. Government debt, along with the pools of debt generated by private equity funds pose a considerable systemic problem outside the banking system. Private equity, to a large extent, has made money by taking advantage of borrowing at very low rates of interest that were common until recently, lending it to companies that they have bought and taking the cash out of those companies to distribute to themselves and other shareholders.
As an aside, this has enabled the partners of private equity companies to pay what is basically obscene amounts of money to themselves. As interest rates have risen and stock markets have in general become more leery, particularly of ex-hollowed out private equity owned businesses, it’s become a lot more difficult to liquidate the partnerships, and debt finance in general has become a lot more difficult to raise and does not make sense unless applied to investments that are going to make a proper return on capital. Higher interest rates apply discipline to asset allocation.
All this is causing the City financial engineers, in particular in New York and London, to apply maximum pressure on the central banks to reduce interest rates. There is also pressure on the central banks from politicians as we head into elections. The question today is if or when there will be a great number of defaults on these outstanding debts as the businesses supporting them, in whatever sector, find they cannot re-finance and don’t have the profits to even start repaying. It is an oft-forgotten phenomenon that debt has to be repaid out of after-tax income. Apart from a potential financial meltdown, the enormous gains in the stock market have been made, as mentioned, by a very small number of companies in the tech area, producing a growing Bubble albeit, compared with history, in its relatively early stages. US, UK and European central banks hopefully seem to have learned from history and are working to lower expectations of large drops in interest rates, despite the pressure being applied to them. The enormous amount of government debt is also draining liquidity and, in itself, is putting upward pressure on interest rates.
On the other side of the equation, countering the potential for a financial crisis is what I would call the real economy – small, medium and large businesses in the non-financial area are getting on pretty well, We effectively have full employment, with rising wages and capital expenditure on an upward trend. All this augers well.
The impact of political shenanigans and government incompetence coupled with regulatory complacency seems to some extent to be being ignored by businesses, which is great news as, if business confidence holds, it is possible that a financial market fiasco will be avoided. While the productive sector of the economy is learning to walk the tightrope … what they need to do and invest while avoiding the paralyzing effect of headline bad news about economic meltdowns etc. There is a high possibility that we could get through the 2024 political chaos, hoping that the Ukraine and Palestine wars do not escalate. There is also the hope that 2025 will bring a consensus and a political will to address the incompetence of regulators over swathes of our infrastructure and there is pushback on the interference by Quangos and ‘not for profits’, imposing often contradictory requirements on the management of businesses, regardless of whether they are well run or not, basically putting sand in the works of the part of the economy that produces wealth.
There are more than the usual number of uncertainties coming from directions that are not normally part of the agenda of running companies. One could say there are a lot more black swans than usual circling. By definition, one cannot tell when or where they are likely to land.
Damon de Laszlo
26th February 2024