Modern economies go through cycles, always either expanding or contracting. The “recovery” phase is the part where it makes up the gains lost during the prior recession/contraction. The last US recession was the brief but sharp COVID downturn in early 2020. It ended in April 2020 and the economy has been expanding ever since, though at a highly uneven pace.

Austin Kimson, chief economist in Bain & Company’s Macro Trends Group recently described the global recovery as a kind of drama in three acts.

“In the first act, China and the US experienced organic recoveries from the shock of various pandemic-inspired policies. We use a beachball analogy to describe these recoveries: when you release a beachball after holding it under the water, it pops up and then settles back to the surface relatively quickly. Because Europe lagged behind China and the US in its pivot away from aggressive disease-mitigation policies, economic activity in that region remained depressed even as it popped back in China (first) and then the US.

“In the second act, US fiscal policy delivered rocket fuel to the organic recovery process, briefly producing some of the highest economic growth rates of modern times. But then high demand collided with constrained supply, leading to inflation. During this time, Europe enjoyed its own bounce-back, a delayed version of the recovery the US and China experienced in the first act, while China’s economy began to decelerate.

“In the third act, all three players seem to be aligning around shared choreography—a shuffle to a slower pace. Last week’s IHS Markit composite PMI data (for the month of January 2022) indicates the US, Chinese, and European economies are in their closest proximity to each other since January 2020.”

 

Source:  Bain Macro Trends Group

 

Kimson says the third act seems to be reaching a climax, with all major economies simultaneously slowing, though not yet contracting. He sees three potential scenarios from here.

The first possibility is “substantial softening” of growth compared to 2021. If we’re lucky, it would resemble the pre-COVID period of mild but positive growth with low inflation. Unfortunately, relieving today’s very high inflationary pressure might require more than just a soft stretch. The word Kimson uses is “stagnation,” which is never pleasant to hear.

Another scenario is what he calls “continued heady growth with a side of continued heady inflation.” In my opinion, this would come about if the Federal Reserve does not lean against inflation aggressively enough. Imagine, for instance, the Fed raises rates by 75 basis points over three meetings, inflation slows (helped by year-over-year comparisons) but stays relatively high, and then the Fed shifts to quantitative tightening and defers further rate increases. It may think the economy has cooled enough and inflation will keep retreating. That all sounds good but the problem is that wage growth, while up, still lags inflation for most workers. That is not conducive to the consumer spending needed to sustain GDP growth.

The third possible outcome would be rising market instability, similar to 2001 and 2007. This would help moderate inflation but imperil growth. Given today’s crazy valuations and the activity of so many inexperienced investors, this is a real possibility. It would likely end in recession.

Kimson concludes that in all the scenarios he thinks plausible, GDP growth will take a hit and maybe a substantial one, pushing inflation out of mind.

 

The Fed

 

Jerome Powell’s testimony showed that while the March rate hike is coming, the Fed may be more cautious going forward.

The implications for the U.S. economy are highly uncertain, and we will be monitoring the situation closely.

The near-term effects on the US economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain. Making appropriate monetary policy in this environment requires a recognition that the economy evolves in unexpected ways. We will need to be nimble in responding to incoming data and the evolving outlook.

Stocks surged on Thursday.

 

Russia

 

According to many of those headlines, the conflict is getting worse… One headline warned that Russian President Vladimir Putin told French President Emmanuel Macron that Russia’s plan was to “take control of all Ukraine.”

There’s a massive humanitarian crisis brewing as the Russian army seeks to surround the city of Kyiv cutting residents off from critical food and medical supplies, causing incalculable hardships on many innocent civilians.

I’ve heard news reports that the Russian army plans to execute prisoners in front of firing squads as they take each Ukrainian city.

Wars have a long history of being inflationary, and this geopolitical conflict will be no different… But that’s already been talked to death in the mainstream and social media. It’s obviously being priced into markets every day.

The Soviet Union was never a great economic power. Not at all. It was a brutal dictatorship that sent people to work and starve to death in Siberian gulags for reading banned books.

Putting the USSR back together strikes me as a desperate, pathetic plan, like a middle-aged man who wants to reunite his high-school rock band so he can feel young again.

If Putin really wants to put the band back together, he has a lot of work to do… The collapse of the Soviet Union created 14 independent countries besides Russia.

Belarus is already a Russian puppet. If Ukraine falls, that’s two down, 12 to go. Moldova is just south of Ukraine… Is it next?

The republic of Georgia borders Russia on the eastern shore of the Black Sea… Latvia and Estonia border Belarus and Russia just northeast of Poland. They seem like obvious future targets if Putin is serious about his plan.

I find it hard to believe that Western governments would stand by and watch Russia take over Moldova, Georgia, and the Baltic states… though so far they’re content to watch from the sidelines as it flattens Ukraine with missiles and tanks.

Though we clearly aren’t there yet, at some point, protests, political pressure, and the rhetoric to stop Russia from reassembling the “Evil Empire” could reach politically intolerable levels. War helps distract voters from any unpleasantness going on at home.

Could Russian attacks on former Soviet states really bring the U.S. and its NATO allies into direct conflict with Russia? I don’t see why not… but I also have no feeling for the probability of such an event.

Don’t get me wrong… I’m not saying I know what will happen because I understand geopolitics. I’ll be the first to admit I’m no geopolitical expert. I’m just sitting off to the side of it all, not quite sure what’s happening… like a squirrel watching a bank robbery.

Maybe economic sanctions against Russia and financial sanctions against prominent Russians, including Putin and his pals, will be so devastating to the Russian economy that Putin won’t be able to even keep control of Ukraine… much less invade Moldova or any other former Soviet state.

Or maybe those sanctions will make him desperate to show the world how strong his country is, causing him to speed up his timeline.

Or maybe Putin will be assassinated by the wealthy oligarchs who don’t like having their yachts taken away… The only problem with that idea is that they might be grateful to have their boats taken away.

No one who takes a boat away as a punishment has ever owned one. A better punishment would be to make them buy another boat.

I have no idea how the war in Ukraine will play out, or what will follow it nor do I believe anyone else knows. The performance of certain asset classes recently has reminded us how important it is to be aware of cycles.  It has been fun to watch our different managers investing in the trending sectors of the markets.  Commodities are the big winner so far this year!

The US and others have done something almost no one anticipated by freezing Russia’s central bank reserves. Some $300 billion is on deposit in Western institutions. Russia is now unable to access it, which is why the ruble is collapsing.

The ruble plummeted at the open last Monday.

 

 

The central bank hiked rates to 20% (an unprecedented increase) to stem the ruble’s decline. For now, it’s not working.

 

 

The central bank implemented exchange controls and is now prohibiting the sales of Russian securities by foreigners to stem the selloff.

Futures on the MSCI Russian stock index are down over 90% this morning (last Thursday).

 

 

S&P downgraded Russia into junk territory.

 

 

As of this point on Monday, Feb 28, the CDS price implied a 56% chance Moscow would default, and it was briefly over 90%. This means foreigners aren’t likely to buy any Russian debt even if the economic sanctions allowed it. The country’s bonds are the financial equivalent of toxic waste.

The line is the price of credit default swaps on Russian government debt—basically insurance that Russia will make its bond payments. As you can see, the price just shot higher, reflecting the dramatically higher default risk.

 

 

Russian-occupied Ukrainian territory:

 

 

US Economy

 

  • A 50 bps Fed rate hike in March appears to be off the table. Now it appears to be a 25 bps hike.
  • Consumer spending surprised to the upside in January.
  • Household incomes eased last month.
  • Durable goods orders started the year on a solid note.
  • Orders for capital goods have been particularly strong, pointing to improvements in business investment.
  • The core PCE inflation measure, the Fed’s preferred indicator, is now above 5%.
  • Inflation is expected to stay higher for longer as oil prices surge.
  • Pending home sales were disappointing in January amid tight supplies and surging prices.
  • The Chicago PMI showed a downshift in the region’s business activity in February

 

 

  • Moreover, the spread between the indices of new orders and inventory dipped below zero, pointing to slower growth ahead. Supply-chain strains remain elevated.
  • The US trade deficit in goods hit another record

 

 

  • as imports surged.

 

 

  • Retailers continue to build inventories at a rapid pace. Will we get an inventory overhang if demand slows?
  • Rent inflation could have further room to rise
  • Here is Wells Fargo’s inflation forecast.

 

 

  • Slower growth in shipping activity points to moderation in price gains
  • PGM Global expects a moderate stagflationary event this year.
  • Consumer confidence follows the Misery index (the sum of the unemployment rate and inflation rate) closely.

 

 

  • Crude oil is now up about 45% year-to-date, with Brent blasting past $110/bbl.

 

 

  • Gasoline prices, in particular, will keep putting downward pressure on sentiment.

 

 

  • Here is Bloomberg’s scenario result of a 40% oil shock. This, of course, doesn’t take into account other commodity prices and supply chain issues exacerbated by Russia’s invasion.

 

 

  • The increase in fuel prices amounts to a meaningful tax increase.
  • Concerns about growth sent Treasury yields sharply lower
  • A 50 basis-point rate hike this month is now off the table.
  • And the market is not even confident we are getting five hikes this year.
  • As oil prices surge, the projected CPI peak keeps moving further out.
  • Short-term inflation expectations are surging.
  • Supply chain issues worsened again as demand has increased.
  • The Atlanta Fed’s GDPNow model points to very slow GDP growth in Q1.

 

 

  • The Fed’s Beige Book showed a surging focus on inflation. Concerns about childcare and school closures have eased.
  • Unlike the manufacturing sector, services registered slower business activity in February.
  • The Atlanta Fed’s real GDP model for the first quarter now shows 0% growth.

 

Market Data

 

  • The bull run across commodities is not yet extreme compared with previous rallies.

 

 

  • Many Nasdaq Composite stocks hit 52-week lows this year.

 

 

  • Treasury yields declined sharply on Monday.
  • Tech shares in Hong Kong are trading at the lowest level since the spring of 2020.
  • Commodities have posted the biggest weekly gain since the mid-1970s, with massive increases in prices of grains, energy, and industrial metals.
  • Industrial commodities continue to surge.
  • Brent crude is nearing $117/bbl, the highest level in a decade.
  • Russia is having difficulties bringing crude oil to market (chart shows a massive discount for the Urals crude).

 

 

Thought of the week

 

“He who chases two rabbits catches none.”

 

Pictures of the Week

 

 

 

 

All content is the opinion of Brian J. Decker