No pain, no gain: economies need to contract

No pain, no gain: to get inflation under control, economies need to contract. After two years under the thumb of Covid and amid increasingly problematic inflation, the global economy needs to take time for some R&R: recession and recalibration

We realise that first ‘R’ might ring some alarm bells, so we’ll get straight to it: the economy needs to enter a recession to sort itself out from the loose monetary policy and free cash that has circulated the developed world since the spring of 2020. Intent on easing hardships born from lockdown job losses, central banks enacted a number of policies that would enable economic activity to carry on largely as usual—and inadvertently created an environment in which inflation could thrive.
 
In other words, that the UK economy may already be in recession is, in some ways, a good thing. Figures released at the end of April revealed the US is halfway there, with GDP declining by 1.4% in the first quarter, in defiance of analysts’ expectations of modest 1% growth. (For those not familiar, an economy needs to contract for two consecutive quarters to be considered in technical recession). There are a number of pressure points that are going to stress the worldwide economy as we pull back from the post-pandemic euphoria of bull markets and Treasury checks. Principal among them, as anyone with a house to heat and mouth to feed full well knows, is inflation. And a recession is the way to fight inflation.
 
We’ll explore this further in Investment View. But first, a rundown of the stressors you can expect to see in what will undoubtedly be a year of transition.
 

The yield curve inverted. What will happen next?

It looks likely that the classic indictor of US recessions (an inversion of the yield curve in which two-year Treasury yields rise above those of the 10-year bonds) is going to be accurate again. The chart below shows the correlation between yield curve inversions and the most significant US recessions, including the dot-com bubble and the ‘Great Recession’ of 2007-09.

Chart-1-Market-Outlook-1-5-22.PNG

This tends to happen when investors start to fear that the Federal Reserve will raise interest rates with the aim of slowing growth. And indeed, we’ve entered a tightening cycle. The other things that will happen as we move toward recession? GDP figures will stall a bit (the US can check this one off the list) and purchasing managers’ indices will begin to slip below 50 (the important designation between growth and contraction).
 

Change is the only constant

. . . in 2022’s equity markets, that is. A fair few indices will be hit by volatility in the coming quarters. But—not to toll the contrarian bell too hard—like ‘recession’, the word needn’t always carry negative connotations. Remember that volatility can be good thing; it doesn’t always mean the value of your investments is falling. There could be plenty of opportunity to capitalise on quality companies dragged down by the wider market. Likewise, there are gains to be made when holdings unpredictably bounce. It all goes back to preparation: at a time like this, focus on quality companies that are not necessarily linked to the economic cycle.
 

Fixed income is regaining some sparkle

The roaring ‘20s have thus far been anything but for the bond markets. But the good news with bonds is that once they sell off, they become a more attractive investment given their higher yields. There's an expectation that interests rates are going to continue rising as central banks throw those punches with the aim of slaying inflation; and as a consequence, longer-term bond yields have risen. As yields on government bonds have risen, they’ve also pushed yields on corporate bonds higher.
 
Overall, it’s going to be a bumpy ride. We can’t predict the future, but we accept that there are going to be surprises along the way.
 

Investment View: What Goes Up Must Come Down

We can all admit that inflation is spinning out of control. Below, a brief history of our current predicament—and what central bankers need to do to rein in the monster of their making.
 
It’s an ancient story but a sad one nonetheless. Man uses his power for creation. Man’s creation becomes too powerful. The monster wreaks havoc on the world (economy).
 
Okay—that last line may be a bit niche. But here’s what we mean:
 
What we are likely facing at present is a consumer-led recession. Prices are rising primarily because people are trying to buy too much stuff, and in some cases, these products haven’t even been made. And if they have been made, it may be difficult to package and ship to them due to workforce shortages in places like China, the world’s biggest exporter and a country still imposing Covid lockdowns. This creates a supply-and-demand imbalance, and therefore, these products have to be rationed. The way to ration them is to raise prices. And there you have inflation.
 
Chart-2-Market-Outlook-1-5-22.PNG

Where our current situation differs from a historical perspective is that this time around, more people had cash to buy at those higher prices due to hefty stimulus checks from the likes of Presidents Trump and Biden. (Japan announced stimulus plans to keep households hitting the shops as recently as November.) But while consumers had cash, businesses didn’t have the supplies or staff to produce more goods due to raw material shortages and quarantining employees. So prices kept rising and people kept paying. The monster’s claws unfurled.

Chart-3-Market-Outlook-1-5-22.PNG
 

What goes up must come down

It’s time for policymakers to rein in their creation. Inflation is at a 40-year high in major developed markets like the US and Germany. For many investors, these particular financial conditions are as uncharted as the plague that inspired them. The Federal Reserve and Bank of England admitted their miscalculation in the final weeks of 2021, and promptly pumped up interest rates. They’ll have to continue tightening monetary conditions. Making it harder for businesses and consumers to take out loans slows the rate of both monetary growth and consumerism, and that lower pace of spending ultimately morphs into a recession, which in this rare case is a good thing.
 
The balancing act central banks need to achieve is stalling the system enough to curb inflation but not so quickly that the economy crashes. With less cashflow comes the decreased desire, or ability, to go out and spend money. So businesses lose the motivation to raise prices because they’re not necessarily going to get customers buying at that those elevated prices.


Chart-4-Market-Outlook-1-5-22.PNG


For inflation to fall, interest rates need to keep rising. The system needs to recalibrate; growth needs to falter. Interventionist central banks should be left in the past, at least until the next (inevitable) global economic surprise arises.


Phil Smeaton
Chief Investment Officer

Sanlam is a trading name of Sanlam Private Investments (UK) Ltd (SPI) (registered in England and Wales 2041819), Sanlam Wealth Planning UK Ltd (SWP) (registered in England and Wales 3879955). Registered office for SPI and SWP: Monument Place, 24 Monument Street, London EC3R 8AJ.

 

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