R as in Recession

It should be clear that after each crisis follows the recovery

09:00 | 29 юли 2022
Снимка: Bloomberg L.P.
Снимка: Bloomberg L.P.


by Yulian Voynov

The main question that politicians, financial experts, stock players, corporate managers, and ordinary citizens have asked themselves in recent months is whether countries and the world are sliding into recession. And if so, how deep it will be. The answer to the first part of the question already seems clear. Yes, most likely, the biggest Western economies are entering a downturn. According to the latest data, the U.S. may already be in one, considering that the country's GDP contracted in the first quarter by 1.6%. According to the preliminary forecasts of the Federal Reserve Bank of Atlanta, output contracted in the second quarter by another 1%.

The data of the customers' demand in the western countries in the E.U. also show that the economic activity has a severe delay and probably the recession processes will develop during the upcoming months until the end of the year.

Before answering the question of how deep and prolongated the forthcoming recession will be and which parts of the world it will cover, it would be necessary to trace the causes that led to the current state.

In the beginning, was inflation. The direct cause of the current recessionary expectations is the increase of interest rates by the major central banks and primarily by the U.S. Federal Reserve. Fed rates have risen sharply since early March, with the most recent hike in June by 75 basis points, the sharpest increase in 28 years. The reason for this drastic jump is the immense inflationary pressure in the country, with inflation in May reaching 8.6%, or a 40-year high.

Inflation in the Eurozone is similar, and for June, it is also expected to be 8.6%. However, when we talk about inflation, it might be reasonable to point out that the indicated values are far from the highest levels reported by countries such as Venezuela, Lebanon, Zimbabwe, or Turkey, where price levels are already around 100% or even above them. Inflation in the U.S. and the eurozone is in the middle, about 50th out of 111 countries analyzed by Deutsche Bank, with countries such as Japan, China, and smaller Southeast Asian countries in the queue for price shocks.

The reasons for this widespread inflationary explosion are mainly related to the rapid recovery from the Covid crisis, which led to the blockage of international supply chains and the lack of certain products and goods in the markets. However, the root causes of global inflationary processes can be divided into three main groups: the fiscal stimulus during the covid crisis (with a minimum weight of about 1%), the rapid recovery from the economic collapse after the opening of the economies (with a weight of about 25%), and the main reason should be sought in Russia's war in Ukraine (with a weight of about 50%), which is related to the drastic increase in the prices of energy raw materials and mineral resources and natural materials. The difference to 100% represents the actual inflationary processes in the economies responsible for less than a quarter of the inflationary growth. Interestingly, this list does not include the monetary policy of central banks, whose influence on inflationary processes, in this case, is zero, which is in complete contrast to the positions advocated by many authorities on the subject.

Central Banks Strike Back. Although the monetary policy of central banks is not the real cause of the price tensions around the world, there is no other short-term tool that can relatively quickly and reliably affect rising prices worldwide. Therefore, since the beginning of the year, central banks have gradually entered their role as guarantors of price stability, and de facto, almost all central banks of major economies in the world have started to raise their basic interest rates, mainly to fight the expectations of businesses and citizens for endemic price increases.

Financial markets react with a sharp decline. Market expectations until recently were that the Federal Reserve would continue to hike its central interest rate in increments of 0.75% until they reached levels of 3.5% and even 4%. That amounts to a significant interest rate increase in a relatively short period and quite predictably led to a stock market crash and a massive asset sell-off. Financial markets ended the first half of 2022 with an unprecedented decline for this period of the year, leaving only a few sectors unscathed. According to Dow Jones Market Data, the S&P 500 fell 21% through the end of June, suffering its worst first half since 1970. Investment grade bonds as measured by the iShares Core U.S. exchange-traded fund. Aggregate Bond lost 11% - marking its worst start to a year on record.

Glooming forecasts. All these events have forced governments and mainly international financial institutions to lower their projections for the world economy, with the World Bank's latest forecast now at 2.9% (from 3.2% previously) and the OECD's at 3% (from 4.5%). According to the latest forecasts, the slowdown is expected to continue in 2023, which almost certainly means a possible return to a recession just two years after the initial contraction caused by Covid-19. There are already enough signals of such a development, and some of them are frightening. For example, the inversion in the yield curve between the 2-year and 10-year U.S. government bonds, which happened very recently, is a rather severe signal and perhaps the most definitive harbinger that the crisis is approaching.

Meanwhile, the latest data on German new export orders, a good proxy for global demand, fell to their levels since 2019, when German manufacturing was in recession. In May, Germany posted its first monthly trade deficit in three decades as companies faced rising import costs and weaker demand for their products. In May, the fiscal deficit in Europe's largest economy reached €1 billion. With the rising cost of living and high uncertainty resulting from the Russian invasion of Ukraine and the Covid-related shutdowns in many countries, including China, the outlook for trade is quite bleak.

Inflation is finally going away. After the measures taken by the central banks, inflation has started to recede and is going away. The trend is evident even if there are last gasps, primarily due to Russia's unpredictable actions regarding the wheat harvest and wheat exports from Ukraine. Of course, there will most likely be more turbulence and spikes in the prices of certain goods, but the global trend is already known.

Three critical supply-side drivers driving today's global inflation rates have already reversed course, meaning relief could be on the horizon for shoppers worldwide.

1. The best barometer for the cost of electronic products - the cost of semiconductors, which are used in such a variety of appliances as laptops, dishwashers, LED bulbs, and medical devices, shipped worldwide is at least 15% lower than the middle of the last year.

2. The spot price of shipping containers, which says more about the costs we can expect later in the price chain process, has fallen by more than a quarter from its peak in September 2021.

3. North American fertilizer prices, an indicator of where global food inflation is headed, are also about a quarter below their record high in March.

Some additional arguments for declining inflationary pressures are as follows:

4. Accumulated vast stocks of goods due to blocked supply chains. As consumer demand shifts to services instead of goods, these inventories will need to be sold at lower prices due to reduced demand, easing production orders and pressure on supplies.

5. As central bank interest rates increase, property prices begin to moderate, if not fall, given the dramatic increase during the health crisis.

6. The slowdown of China's economy due to the policy of zero cases of Covid. Calculations show that a 1% slowdown in the Chinese economy leads to a 5% drop in the price of oil.

7. And finally, the effect of the base: last year, inflation increased significantly, and for this year, the calculation base will be higher, automatically reducing the price increase.

Even though prices will not go back down en masse to pre-pandemic levels, easing these supply-side pressures could eventually allow central banks to slow their monetary tightening measures. Indeed, concerns are mounting over the expectations that the shock will soon fade as supply chain gridlock eases and energy costs stabilize. Warnings are also mounting that central banks risk making a big mistake by raising interest rates too aggressively, even as price pressures show signs of peaking.

The effect of recessionary expectations on businesses and citizens. Based on everything already said so far, we might argue that the following perspectives are emerging for businesses and households:

First of all, it is clear that the deflation of inflation is underway, and within the next few months, this trend will strengthen, and at the beginning of next year, the inflation levels will fall to the extent that they do not raise concerns about their development.

Secondly: there is every prospect that the world economy is facing a significant slowdown in certain regions, even a recession. How deep and long-lasting it will depend on three main factors. The first one is related to the monetary policy of central banks and the extent to which they are willing to raise interest rates to tame inflation. The second, naturally, is the war in Ukraine and the prospects for its termination. And the third is the fear of new restrictive measures in connection with the recent cases of Covid, which may be an additional brake on the development of the world economy.

In times of uncertainty and unpredictability, the best policy from the capital expenditures and household budgets point of view is to rethink planned expenditures and limit non-essential ones - at least until the situation clears up and the development of any or all of the above three factors is clear.

It should be clear, however, that after every crisis comes recovery. The point is not to let short-term turbulence knock us off track and to have learned the lessons that every crisis brings along!