Anyone who took introductory economics 50 years ago was barely exposed to finance, for it was considered a backwater field. The standard approach to business cycles was to separate the economy’s spending into private consumption, business investment, housing, government spending and exports.
Significant shifts into any one of these streams would induce economic expansions and contractions. The role of finance was mostly considered passive, but it turned out that this thinking was wrong.
Indeed, it has been finance that has been the main driver of events in the last 40 years. As asset prices rose (whether real estate or capital markets), people spent more, leading to the ‘wealth effect’, until asset prices gave way, leading to contractions.
Whether in venture capital, stock markets, crypto assets or in housing, the patterns have repeated themselves. Easy credit leads to a boom in spending that feeds on itself until the bubble pops and asset prices, no longer supported by credulous credit, start to drop.
Laws of economics take over
In all cases, the initial rise in asset prices - triggered by falling inflation and interest rates - fostered a false belief in the inevitability of ascending values. However, when we look at the paradigm of rising inflation and interest rates, the ‘crowd psychology’ that takes charge in its quest for quick profits starts to abate, as underlying economic principles that dictate greater amounts of annuity income take over.
What inflation teaches us, especially in the age of financialisation, is that economies have a tendency to become more chaotic and uncertain, and this uncertainty leads to risk aversion starting to take over, as individuals, in their desire to seek predictability, look for more certain streams of income.
It is in this context that financial assets that provide for such income streams start to dominate. However, the transitions are hard. Return expectations take time to adjust, as well as investment decision-making that was in place earlier of ‘chasing the crowd’.
Bouts of investor anxiety
The inflection points often come with uncertainty and anxiety, a trend that has proliferated as the frequency of booms and busts have increased. What is clear is that once the importance of finance has been understood, its role in predicting the next stage of economic growth becomes easier.
Rising interest rates necessarily dictate a greater emphasis on annuity generating assets, and even though there remains the psychology of chasing returns, it is equally inevitable these patterns will abate as the next wave of investment flows start to accelerate.
We have already started to see this with high dividend yielding stocks (albeit in a turbulent manner), as the demons of inflation rear their heads. In Dubai and the UAE, capital markets maturing will go hand in hand with real estate market development.
Price gains elsewhere
Even as there continues to be a moderation in prices at the top end, there will be a continuation of emphasis on higher yielding opportunities. Money flows into these sectors will create avenues for the retail as well as the institutional investor up to the point where inflationary forces start to moderate. For the medium term, slower economic real growth is the inevitable consequence of higher inflation.
What is equally true is that the re-allocation of credit and finance towards higher yielding investments is the clearest signal yet that the platforms the government is creating for capital markets will act as a catalyst for channeling investments and creating new avenues for growth.
Traditional economic theory may be outmoded, along with some of policy responses that Western governments are adopting. But what we do know is that an understanding of an economic system that puts finance in the centre helps for navigating the present landscape in a more expedient and efficient manner.
The wealth creation that we so crave and desire and drives our decision making needs to be guided by the current opportunities in the context of inflation. Lest we end up feeling poorer because our expanding wealth can’t meet all the claims made on it.