Primas Insights – May 2022

Is a Global Recession Looming?

As global equities enter into bear market territory with the S&P falling 19% from its recent highs and the Nasdaq composite down 27% year to date, investors are grappling onto fine strands of hope that the market has reached a bottom. However like a vicious cycle, as negative wealth effects start to bite one would inevitably question the state of the economy and start to consider the possibility of an actual recession. Even perpetual bull Goldman Sachs lowered their U.S. economic growth forecasts (2022: to 2.4% from 2.6%, 2023: to 1.6% from 2.2%) and the bank’s senior chairman, Lloyd Blankfein warned there is “a very, very high risk factor” that the U.S. is headed for a recession.

What Exactly Is A Recession?

A recession is a macroeconomic term that refers to a significant decline in economy activity, generally pointing to two consecutive quarters of economic decline. In the U.S., following a robust 6.9% real GDP growth print for 4Q21, the 1Q22 figures caught investors off guard with a drop of 1.4% q/q due to lower inventory restocking, weaker exports, and reduced government spending. Although economists described it as a one-off due to COVID disruptions and focused on the strong fixed investments and personal consumption, this was none-the-less a wakening bell as the first negative print since 2Q20, and if barring COVID the first negative print since 2014 (figure 1). Strictly speaking, the last time we had a “recession” was 1H2020, and then the second last recession was already in 2009/2010!

Why Are We Having This Conversation?

The Fed‘s primary task is to optimize the dual mandate of stable prices and maximum employment. Two years ago it prioritized job security during COVID and today we are left with the aftermath of unchecked inflation. This in reality has left it furthest away from its dual mandate than it has been since the 1980s (figure 2). Despite Powell’s attempts to draw parallels with historic tightening cycles where soft landings occurred, all 3 instances, pointed out in figure 2, were when the Fed was achieving its mandate and being pre-emptive. As further evidence, every Fed hiking cycle since the 1970s (end of the USD gold parity standard) has led to some kind of financial crisis somewhere across the world (figure 3).

With such tight manuvering space one begs to question if the Fed can truly engineer a soft landing without recession, in which Powell’s response was “it’s quite challenging to accomplish that right now” during a May 12 interview on Marketplace. He further adds that “I think the one thing we really cannot do is to fail to restore price stability, though. Nothing in the economy works, the economy doesn’t work for anybody without price stability” – indicating his reversal of priorities of the dual mandate to combating inflation over cushioning a soft economic landing.

May we propose a rhetorical question – What if the Fed deliberately engineers a recession to tame inflation?

Fed Will Always Come To The Rescue – Or Will They?

“If Stocks Don’t Fall, the Fed Needs to Force Them.”?This was the title of an April 6th Bloomberg article by former New York Fed President, William Dudley. Some key points from the article:

“It’s hard to know how much the U.S. Federal Reserve will need to do to get inflation under control. But one thing is certain: To be effective, it’ll have to inflict more losses on stock and bond investors than it has so far.

…In contrast to many other countries, the U.S. economy doesn’t respond directly to the level of short-term interest rates. Most home borrowers aren’t affected, because they have long-term, fixed-rate mortgages. And, again in contrast to many other countries, many U.S. households do hold a significant amount of their wealth in equities. As a result, they’re sensitive to financial conditions: Equity prices influence how wealthy they feel, and how willing they are to spend rather than save.

…Investors should pay closer attention to what Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.”

Given the usually cryptic language used by Fed officials, this instance of umabiguity is highly uncommon if not rare. Coupled with the hawkish pivot by Powell since his confirmation hearings in Jan – that he “expects a series of interest rate hikes” – and in May – where he reiterated half-point hikes are likely in June and July – the Fed seems determined to rein in inflation using all tools available. Negative wealth effects, ie, engineered drop in stock markets, should not be excluded from consideration.

OK This Sounds Scary…But What Does It Have To Do With Me?

Yes investments are taking a toll, but a recession seems like a distant event, why should we start to worry now? The reality is it might have started already. Take the U.K. as an example – which is hit with the triple whammy of record high inflation, dismal consumer confidence, and shrinking household income – the confluence of these factors is bringing the nation to the brink of recession. ?

The National Institute of Economic and Social Research’s (NIESR) U.K. Economic outlook, published in May, says that “for the 1.5 million hardest hit households, just the bills for necessities exceed their disposable income — by up to 90%. To meet these rising costs, households will either have to run down their savings or resort to consumer credit. Where this is not available to them, they will have to go into arrears.”

Furthermore, without targeted support, “in 2022-23, about 250,000 more households will slide into destitution, taking the total number to around 1 million, while approximately another 500,000 households face choices between eating and heating.”

Considering that there are about 28m households in the U.K., that would mean slightly more than 5% of the population will be living in extreme poverty in the next 12-24 months.

Energy and food are two of the most vital priorities for households. With the ongoing Russian / Ukrainian war and related energy embargo, this inflation crisis will inevitably spread far and wide – if the masses cannot afford food and energy, they are effectively on a buying strike for everything else. In December 2021, private consumption in the U.K. accounted for 64% of nominal GDP. Combine that with very low household savings (figure 4), the U.K. lacks resilience to deal with global shocks and may ultimately result in a halt in the overall economy. This has massive ramifications and sets a prime example globally.

How Is Primas Positioned?

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