“The Question We Should Ask Ourselves, Is Not Whether We’re Going Into A Recession Or Not, But How Severe Will It Be?”
Our fear is the economic downturn in Europe could be on par with the Great Depression of the 1930’s.
The depression of the 1930’s was preceded by what is known as the roaring twenties, a period of economic prosperity and dynamism in western culture. The Austrian school of economics, led by Ludwig von Mises and Fredrich Hayek’s theories of money and credit, believe that artificially cheap credit and loose monetary policy from the Federal Reserve during the 1920’s, created an unsustainable boom, which eventually led to the inevitable bust. From a macro perspective, inflation was not evident at all. Commodity prices and input costs declined, whilst the Schumpeterian entrepreneur and innovation effectively ensured rising demand as the world rebuilt itself following WWI. But as the world emerged from the Spanish Flu pandemic in 1921, over-investment and credit creation undoubtedly resulted in a period of significant profit and asset price inflation.
One can argue the ‘good times’ resulted in society living beyond its means, eventually leading the west into the depression of the 1930’s. If you are not seeing the flashing red lights, it’s time to wake up! These events sound eerily too similar to our own experience since the global financial crises in 2008.
Inflation, a supply shock of epic proportions
Initial inflationary pressures coming out of the Covid-pandemic was very much driven by supply shocks, exacerbated by a US-China trade spat, and not so much from central bank stimulus (although this undoubtedly had some emotional and sentimental consequences). Fiscal stimulus, on the other hand, ensured capital was available to drive a short-term demand boom for goods as economies opened up…and that demand, combined with supply constraints, created the initial imbalance that resulted in higher prices.
Now, the sad events in Ukraine and the resulting sanctions on Russia, has created a second supply-shock, one of epic proportions. The immediate effects are evident in energy and fertilizer prices, but longer-term consequences will trickle through households all over the world in the coming months.
Rising food and energy costs, inelastic goods, will result in lower demand for discretionary goods and services. At the same time, rising commodity prices will result in higher input costs, pushing up prices, and ensure a double whammy for the global manufacturing industry – demand destruction on steroids!
The logical conclusions from a Supply-Demand perspective
We learn in basic economic theory that prices and quantity will settle at the intersection of the supply and demand curves.
The pandemic resulted in Supply Shock One, exacerbated by a Sino-US trade spat, shifting the supply curve from S0, to S1. The Russian sanctions have now driven the supply curve up further, from S1 to S2. The results: prices go up!
The key question is whether demand is strong enough to sustain a higher price level. On the same demand curve, a higher price would mean a contraction in GDP as the output / quantity declines. For global GDP to rise, structurally, one would require the demand curve to rise. However, our fear is that demand is actually so weak, that the curve is more likely to fall, from D0 to D1.
This is our most likely scenario, a scenario where output and quantity contracts even further, settling at a new price level.
Chart 1: Commodity prices (Goldman Sachs Commodity Index) vs ISM Manufacturing New Orders: higher prices kill demand!
Monetary tightening…fuel on the fire!
Despite rising input costs and dwindling consumer demand, Central Bankers are set on their path of monetary tightening. This after years of extraordinary loose policies, which have only managed to drive asset prices to the moon and exacerbate inequality. Credit creation have not managed to make its way into the real economy, as Keynesian economics would imply. Rather, it’s made its way into risk assets, driving property markets ever higher and equity markets to unsustainable levels.
Now, the Federal Reserve and Jay Powell have belatedly decided that the era of easy monetary policy is behind us, and the time to normalise have arrived. But tightening into weaking economic growth is not an easy task. Add the inevitable rise in prices and the risk of WWIII in the background, we believe it’s become impossible to achieve a so-called soft landing.
Chart 2: US Financial Conditions vs Global PMI’s:
Snowballing into a depression
The consequences of all of this is a snowballing effect, of higher prices resulting in falling demand, weaker sentiment, driving demand further down. This negative cycle, alongside contractionary central bank policy, which will further exacerbate falling output.
The consequence could well be a very deep recession. For markets such as the UK and Europe one can add weakening currency effects, which will further stoke rising prices as import costs goes up, and you are set in a spiralling downturn ultimately ending in a depression that could last not months, but years.
Clearly capital markets are not priced for this outcome. Neither does central banks have the fire power to bail us out. It’s time to buckle up, the ride might get rough!!
Chart 3: Prices vs Output/Real GDP: