The economic recovery began a little over a year ago, and yet the markets are already showing signs of recession (the previous expansionary cycle lasted more than ten years in the US and about seven in the Eurozone). In just a few months, the risks to the economy have multiplied in quantity and intensity. A combination of economic and financial factors are awakening the ‘ghost’ of recession. Now, almost all the analysis houses incorporate the possibility of a new recessive cycle throughout this 2022 or in 2023 at the latest.
The war in Ukraine, the ‘macro-confinements’ in China or the shortage of some inputs and raw materials can hit the supply side of the economy and the confidence of agents (consumers and companies) squarely. On the other hand, rising commodity prices (which are spreading to the rest of the shopping basket) and falling real wages may weaken the demand side. As these opposing forces threaten the economy, the central bank has begun to reverse its ultra-accommodative policies in the face of growing fears that inflation expectations will become unanchored. They are many open fronts and few tools already available to stop what seems increasingly inevitable.
The Fitch rating agency warns in its latest report about the growing risk of recession in the global economy. Beyond the loss of momentum caused by the war in Ukraine or the new covid outbreaks in China, the agency’s analysts focus on the US central bank and the Eurozone (ECB). These experts believe that there are options for the Fed to bring rates to 3% and the ECB to 1% between 2022 and 2023rates that would be consistent with a premature end to the cycle: fighting inflation has short-term consequences for growth.
“Macro themes continue to dominate markets as investor confidence is shaken by uncertainty around monetary policy, inflation and the war in Ukraine,” said Geir Lode, Head of Global Equities at Federated Hermes. Inflation is on the loose and central bankers could lose their nerve at the risk of failing to fulfill its mandate by a substantial upward deviation for the first time in several decades.
“The Russian response to sanctions is still unpredictable, and the uncertainty over Russian oil supply is contributing to an already volatile market environment. With so many headwinds, we find it hard to ignore the ghost of recessionwhich continues to grow, but so far it seems that the equity markets do not share our concerns”, says Lode. The current context of inflation, drop in confidence and uncertainty is beginning to be clearly reflected in the markets, which in turn is feeding back into the fall in confidence of economic agents (companies and households).
The US rate curve is giving warning signs. Some parts of the curve are flattening or even reversing. When all short-term bonds outperform long-term bonds, the countdown to the next recession begins, at least that’s what history says since the 1950s. The yield curve is made up of the maturities of the different bonds, which can range from one month to 30 years (or 100 years in some economies). In theory and under normal economic conditions, the yield on these bonds should be increasing as the maturity lengthens. When this does not happen, it is because the curve (or a part of it) has inverted.
For now, only some parts of the curve have inverted (5 and 30 years, for example), but the 2 and 10-year bond continues to show a slight slope (ever smaller). This occurs because investors begin to anticipate a recession and take refuge in longer-dated bonds (safe assets with a decent return) and get out of short-term bonds. However, this time analysts ask to be cautious because the central bank’s bond purchase programs have distorted the shape of the yield curve more than ever.
Natixis experts believe that there is an increasing risk that this stagflationary scenario will turn into another recessionary one. If oil and metal prices remain at very high levels for several months, this would obviously be of great concern to consumers and businesses as well, as it reduces their margins, profits and purchasing power. On the other hand, monetary policies are another clear risk that feed the specter of recession. Central banks could choose to put a ceiling on inflation with very restrictive monetary policies, a decision that could be very positive in the medium term, but would have a high economic cost in the short term: recession.
With all this, the odds of a recession are increasing, and the US economy is likely to hit a slump in 2023, according to the US bank’s head of macro strategy. Wells FargoMichael Schumacher. In a recent interview on CNBCSchumacher pointed to a number of factors, such as historical inflation, rising mortgage rates, commodity prices, the pandemic and the war in Ukraine, that make the Fed’s path difficult. All of these factors have led Schumacher to forecast a 50% chance of a recession by the end of 2023.
“The idea of having a soft landing was always going to be really challenging, and when you think about the added complications … it makes it super difficult for the Fed to calibrate,” Schumacher said. The strategist also pointed out that the probability that the Fed will go overboard with its plans to raise interest rates is also increasing, and that the market is not ready to handle more aggressive rate hikes. “There’s not really a big path for the Fed to try to limit recession risk, as far as going big, going early, going 50 basis points in May… I don’t know if it really changes the bottom line of how to gauge all these issues that are coming together.
“We are more concerned about the prospects of a soft landing and we see a high risk of recession 1 or 2 years aheadMikael Olai Milhoj and Jakob Sellebjerg Nielsen, analysts at Danish bank. “Inflation is too high right now and the Fed cannot afford to take multiple factors into account when adjusting monetary policy. The Fed needs to curb demand to alleviate underlying inflationary pressure,” they note. According to his own model, the risk of recession 12 months ahead is now around 38%according to the spread between 10-year and 2-year US bonds.
The fall in real wages
Another of the indicators in which analysts are seeing the specter of recession is that of real wages. “In almost all major economies, real wages (defined as income minus consumer price inflation) are negative. The declines in real income are so severe that they are at levels typically only seen during recessions,” said Paul Donovan, chief economist at UBS GWM.
“Consumer demand is also being affected by the erosion of purchasing power due to rising inflation, as energy and food prices are rising. In the short term, inflation in the euro zone could reach 8-9%, which would reduce real wages by up to 6%. A similar situation is evident in the US. We are witnessing the biggest decline in real wages in more than 30 years,” says Allan von Mehren, chief analyst at Danske Bank.
Bank of America (BofA) analysts point out in their latest issue of The Flow Show newsletter the importance of this indicator at a historical level. Echoing that real wages are currently falling by 2.6% year-on-year in the US (the CPI is close to 8% and the year-on-year increase in wages is 5%), these economists highlight that “six of the last eight recessions have coincided with negative real wage growth”. “It’s true that the labor market is very strong today (jobless claims are at their lowest since the late 1960s), but the labor market is a lagging indicator and it takes a weaker economy to reduce unemployment.” inflation,” they stress.
Returning to Donovan, the UBS economist wonders how the world has avoided – for now – when real wages speak for themselves. The analyst himself responds: “Purchasing power may be better than real incomes suggest. Consumer price inflation is not a measure of the cost of living. Used car prices soared dramatically, But hundreds of millions of consumers in developed economies have not bought a used car and have not experienced what consumer price inflation registers.
In addition, the expert emphasizes, some consumersthough not all still have a cushion of savings unusually large after the pandemic: “As it is very likely that the shock of inflation fading over time, the savings cushion can supplement income for now, and help prevent a recession.
“For the policy makers, this unusual situation is a warning. Central banks cannot realistically control the price of oil: your only option is to reduce demand to lower prices not based on raw materials. But going even too far to reduce demand when real incomes are already at recession levels is a dangerous strategy.”
The oil crisis brings the world closer to a new recession dominated by inflation and scarcity
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