London Broil, And Other Spikes

The UK experienced its highest temperature on record yesterday, as thermometers reached 40 C near London.  A friend sent me pictures from Hyde Park where lush green lawns turned yellow overnight.  Camel rides may come next?

Seriously though: non-technical people may be excused of ignoring dire warnings from scientists when they say "average global temperatures will rise 2 C"  over the next few decades.  After all, how bad can a couple degrees be?  It can be very bad...

The "average" rise is completely misleading, and this is why: engineers design systems, structures, etc. to operate safely within a defined range of environmental parameters, plus a safety margin.  For example, a metal bridge is designed to withstand a certain amount of stress from expansion/shrinking cycles, in turn calculated from expected temperature extremes. When those are exceeded by far - even once! - the bridge could fail catastrophically, even as "average" temperatures only rise by 1 or 2 degrees (look up Hammersmith bridge covered in aluminum foil).

Back to finance.

Remember the CDO market based on home mortgages? Yes, on "average" single family home mortgages only defaulted by 2-3% historically, so tranching using this average was supposed to be "safe". The extra default risk was sequestered to the riskiest tranches, while the rest were rated investment grade all the way to AAA. All it took was a sudden rise in defaults to over 6-7% (and eventually to 11%) for the debt market to collapse and produce the Great Recession of 2008-09. 

Today, we are experiencing a spike in inflation, produced by a spike in money printing. Inflation may subside at some point, but the damage has already been done.  In my daily experience I see companies still operating as if inflation is still at 2% or less.  Yes, they are concerned but they cannot believe that they should be raising prices by over 5-10%% to cover their future operating cash flow needs.  Their finance people are simply not used to operating in a high inflation environment.  In a word, they are clueless.

What is going to happen very soon is that corporations are going to hit a brick wall, or two actually.

• As their input costs continue to spiral upwards and their FIFO accounting runs out of cheap material in stock they will face a choice of (a) raise prices significantly or (b) accept much lower profit margins. Or both.
• Labor will demand wage increases much larger than in recent memory.  There is inertia in the labor pool, but once they get going wage and salary demands will become a wave.  It is already happening in Europe, where strikes are becoming much more common than in years past.

I will repeat ad nauseam: the only way to kill inflation is for central banks to remove money from the system via QT.  Lagarde and Powell should just go on TV and say three words: "Whatever it takes".