American corporate leaders have been warning of impending economic doom and gloom. The CEO of banking giant JP Morgan Jamie Dimon says ”brace yourself” for an economic hurricane. The illustrious head of Tesla and SpaceX quipped that he had a ”super bad feeling” about the economy and announced layoffs.
Institutional investors cite economic recession as one of their top fears according to investor polls. The two other chief fears, surging interest rates and inflation, are in fact really the two other sides of the same dismal economic story. As sources of fear war and corona have taken a back seat.
Rising inflation and rates will hit economic growth
The world economy is slowing down, because of surging interest rates and inflation. Rapid inflation erodes purchasing power and drives workers to seek higher wages, which forces firms to hike prices further, in an inflationary spiral. Rising interest rates dampen household and corporate spending by increasing the cost of mortgages and raising funding costs.
Inflation is always and everywhere a product of supply and demand imbalance a no one famously said. Too much money chasing too few goods will be solved by the market by allocating goods to those most able to pay. There were too few goods because corona restrictions hampered both production and production chains. Simultaneously squeezed supply was subject to demand bolstered by stimulus that was even greater than during the financial crisis.
Central banks made a policy mistake by stimulating too much, which in turn resulted from a misdiagnosis of the recession. The mistake was a result of the financial crisis, during which large scale stimulus did not result in inflation. The lesson learned was that stimulus was needlessly held back and resulted in economic pain. During the corona crisis these lessons were applied, and stimulus was injected faster and in copious amounts, which this time around resulted in inflation.
Central banks realised their mistake too late. Hence policy needs to be tightened faster than in decades before inflation becomes entrenched and inflation expectations become unanchored. Rising rates squeezing economic growth by raising the cost of mortgages and the funding of investment projects.
Russia’s war against Ukraine and China’s zero tolerance strategy towards corona add further inflationary impetus. Russia’s war raises energy and food inflation, and China’s restrictions raise the possibility of supply disruptions that feeds into goods inflation as witnessed in the corona recession.
The global economy peaked in terms of economic growth around mid-2021. Economic growth has been surprisingly resilient and has decelerated only gradually. Economic growth is supported by the household accumulated savings and the release of pent-up demand. Household and firm balance sheets are strong and should help soften the blow of rising rates and inflation.
USA, Europe, and China are at different stages of the business cycle
China, USA, and Europe are at different stages of the economic cycle. China is ahead of the pack and is already lowering interest rates, whereas the West is hiking interest rates. China has its own problems due to its zero-tolerance corona policy. The policy results in a series of stop start spurts that Western economies experienced during the corona crisis. It remains to be seen how long this predicament can last as the virus becomes increasingly infectious and possibly less dangerous.
US and European economic growth rates are slowing but remain at a healthy level. European growth has been particularly robust as the post omicron boost has trumped war effects. Forward looking indicators such as sentiment and new orders point towards decelerating. Slowdown is likely. The key question is of course whether the central banks can manage a soft landing or not.
Markets may be oversold
Stock markets have had a dismal year. The tech heavy Nasdaq has fallen around 30 percent since its autumn highs. The flagship S&P 500 index entered bear market territory having fallen around 20 percent this year. European stocks flirt with bear market territory having fallen almost 20 percent.
As a result, stock market valuations have fallen significantly and are increasingly looking reasonably priced. The S&P 500 price earnings ratio reached a level of 26 in December, which has since fallen to 18. The European Stoxx 600 index hit a price earnings ratio of 20 in December and has now fallen to 14.6.
Central banks are lifting interest rates to stifle inflation pressure, which raises the risk of recession. Given the significant equity market correction, the market is already pricing in a mild recession. If corporate earnings continue to hold strong and a recession does not arrive, the market will correct its gloomy assessment and begin to rise anew. The stock market turn may manifest once markets detect that inflation pressure in the US begins to abate.
