As we all know, correlation isn’t causation. It is hard to argue higher energy prices had nothing to do with the many recessions with which they are correlated, though. This chart makes the point clear.

 

 

One reason to think this is more than coincidence is that severity correlates, too. The biggest oil spikes coincide with the worst recessions (1973, 1980, 2007) and are associated with the highest-jumping oil prices. But we’ve also seen recessions without oil spikes and oil spikes without recessions. So the connection isn’t perfect. As for now, there are good reasons to think recession was approaching anyway. If it happens, the war-induced oil surge may not be entirely to blame. But it will certainly have contributed.

 

 

What does a Recession Look Like

 

“Now it’s 2022 and another strange recession looms. That’s right, I’m calling it: Recession is here, or will be soon. And unfortunately, it will be a global recession. Like the COVID recession, this one has little to do with the business cycle. It’s a recession of choice—not your choice or mine, but Vladimir Putin’s. He clearly miscalculated how hard capturing Ukraine would be and how the West would react.”

 

– John Mauldin

 

According to the National Bureau of Economic Research, the referee of such things, a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months.” What is “significant?” How many months are “a few?”

My friends at Investopedia point to four specific markers of recession.

  • Loss of jobs
  • Declining real income
  • Production and manufacturing slowdown
  • Lower consumer spending

All those are bad individually and worse together.

Let’s start with employment. The total number of nonfarm jobs was growing steadily until the brief COVID recession, fell hard, and still hasn’t fully recovered. It has been making good progress, though.

A longer-term look at this same data series shows employment tends to peak just as recessions (the vertical gray bars) begin. But notice, since 1940 every pre-recession peak was higher than the last pre-recession peak. If the same doesn’t happen this time, we’ll have yet another reason to call this recession strange.

 

 

Unfortunately, I think that scenario is possible. Today’s higher energy prices and war-related disruptions will start to bite soon. Businesses who are desperate to hire right now will see slower sales and stop adding staff. That’s the first step to reducing staff.

As for the second marker associated with recessions, declining real income, it’s already happening. But here again, it’s a strange picture. (Remember, this is inflation adjusted.)

 

 

The chart shows income popping sharply higher in three peaks, which correspond to the three COVID stimulus bills. If you extrapolate the pre-COVID trend forward, today’s level is about where it should be. But it’s been declining for several months despite higher nominal wages, partly due to rising inflation. But whatever the cause, people change their behavior when they perceive it is becoming steadily harder to make ends meet. Consumer sentiment surveys have been showing sharp drops, likely due to rising prices caused by supply chain issues and inflation.

Marker three, a manufacturing slowdown , is harder to measure with COVID and supply chain problems in the mix. But it seems almost certain to decline as the war makes components and materials even harder to obtain than they are now.

Note, too, it doesn’t take much to disrupt production. The Financial Times had an interesting story last week about automotive wiring harnesses . Many European manufacturers source these from factories in Ukraine. It’s simply a little device to hold the various cables that snake through your car’s engine. They’re made to very precise specifications. Unable to get them, BMW and Volkswagen have idled entire plants since the war started. That means lost sales, profits, and wages.

Another example is increasingly scarce and expensive diesel fuel. In the US, diesel prices have almost doubled from the pre-COVID level, with inventories at multiyear lows.

 

 

Europe’s diesel problem is even worse. Quoting from the Bloomberg article:

“The loss of Russian supplies is particularly acute for northern Germany, which receives seaborne Russian cargos directly via Hamburg and other ports. In a reflection of the crisis, benchmark wholesale European diesel prices hit a new high last week. The premium for diesel for immediate delivery exploded—at one point, it was 100X more than usual—in a sign of extreme tightness.”

 

 

“The situation is made worse because Europe doesn’t just import finished diesel from Russia, but also semi-processed oil that it further refines to make diesel. The lack of that feedstock, including vacuum gas-oil and straight run fuel-oil, is forcing some refiners to cut supplies. Both Shell Plc and OMV AG have started to restrict their wholesale supplies. OilX, a consultant, has told clients it sees ‘a real risk of physical shortages of diesel in Europe.’ Privately, oil traders and oil companies say the same. No one wants to raise the alarm, fearing a run on gas stations, but everyone is quite worried.

“If nothing changes, by early April, some European countries may need to restrict diesel sales to conserve supplies.”

We’ll see more such interruptions as the war’s direct impact as well as the sanctions reverberate through the economy. The microchip shortage was on the mend but may now get worse again. All this has snowball effects, one of which will be lower output.

The fourth and last inflation effect is lower consumer spending. This is also murky because the spending mix matters a great deal. When people have to spend more on food, fuel, and utilities, they have less to spend on other things. We saw with COVID how these shifts can devastate certain sectors. A non-COVID recession will look different but may not be much better.

Bear markets and recessions are linked. Stock and real estate prices fall, interest rates rise, and companies often cut or suspend dividends.

Here’s an interesting long-term look at the connection. The line is the S&P 500 since 1945 on a log scale. The blue bars are recessions and the brown bars are bear markets.

 

 

You can see recessions and bear markets usually coincide, but not always. Nor are they always of the same duration. In theory, we could have a recession but stocks continue higher, or at least hold steady. I would not bet on it. And note carefully: What look like small blips on this very long-term chart are 40% to 50% declines, followed by years making up lost ground. This isn’t a case for buy-and-hold index fund investing.

The table below shows the maximum drawdowns during major recessions since World War II. The 2001 and 2007 bears were particularly ugly.

 

 

Massive QE helped the stock market recover in 2020‒21. Note below the extraordinarily high correlation between stock prices and quantitative easing, beginning on March 23, 2020.

 

 

We can safely assume everybody on the FOMC is aware of this correlation. It’s why they only gave lip service to reducing the balance sheet. It will be interesting to see how rapidly (or not) the Fed’s assets actually fall. Like a junkie coming off a drug high, it could drag on stocks and make the bear market normally associated with recessions even worse.

Everything I said to this point is the “conventional” recession scenario. But we already know this one isn’t conventional. I don’t expect it to look like 2000 or 2008 at all. A better analogue is the 1970s stagflation era. That was an entirely different world, and certainly different kinds of markets. There were no ETFs back then. Mutual funds were a new idea and the 401(k) hadn’t been invented yet. Online trading was science fiction. So, it’s hard to visualize how that kind of recession will combine with today’s kind of markets. We haven’t seen anything like it.

I keep saying this but it bears repeating: Most recessions are deflationary events. Consumer prices decline as growth weakens. That’s one of the qualities that makes them bearable, though not pleasant. Your income falls but so do your living costs. Stagflation isn’t like that. Your income falls while your living costs rise —in this case due mainly to higher energy costs.

We will see this directly in fuel and utility bills, and indirectly in many other expenses. In some respects it will be like a value-added tax, tacked on to prices at every level of production. But this is hardly tax reform. All the usual taxes will continue, at current rates if not higher. Then we’ll have the new energy “tax” on top of them. It won’t matter what Congress does or how you vote. The tax will be there and you’ll have to pay it.

Larry Summers wrote a particularly somber Washington Post op-ed this week, gruesomely titled: “The Fed is charting a course to stagflation and recession.” Only a few weeks ago he was talking about how difficult the choices facing Jerome Powell would be. Now he feels the choices they’re making will have very ugly consequences. I’m going to quote a few paragraphs but the entire piece is really worth reading.

“Anything is possible, and wishful thinking can sometimes prove self-fulfilling. But I believe the Fed has not internalized the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely. The Fed’s current policy trajectory is likely to lead to stagflation, with average unemployment and inflation both averaging over 5 percent over the next few years—and ultimately to a major recession.

“Powell has emphasized his admiration for Paul Volcker recently. Current inflationary conditions are not as bad as those Volcker inherited as Fed chair in 1979, but they are the worst since then. To prevent inflation from metastasizing, Powell and his colleagues need to be absolutely clear on two propositions that Volcker took as axiomatic.

“First, price stability is essential for sustained maximum employment, while overheating the economy leads to stagflation and higher levels of average unemployment through time.

“Second, there can be no reliable progress against inflation without substantial increases in real interest rates, which mean temporary increases in unemployment. Real short-term interest rates are currently lower than at any point in decades. They likely will have to reach levels of at least 2 or 3 percent for inflation to be brought under control. With inflation running above 3 percent, this means rates of 5 percent or more—something markets currently regard as almost unimaginable.”

Think about that for a moment. Summers knows full well what such a policy would mean to the economy. But he (and I agree) feels letting inflation get out of hand is an even worse option. The current go-slow, 25 basis points per meeting plan may have the desired effect of not spooking the financial markets, but it will also let inflation expectations increase and lead to wage and price spirals. I can’t emphasize enough how dangerous this particular environment is.

In fairness, numerous economists and analysts believe Powell has everything under control, and will taper the balance sheet more than expected. I hope they are right.

My belief is the Federal Reserve made its major monetary mistake well over a year ago. Arguing in August 2020 that letting inflation run hot wouldn’t be that bad, that inflation would be transitory, simply brings up the ghost of Arthur Burns. Combine inflation with supply chain issues, plus war-related energy and food shortages, and we have a very volatile mixture.

Eventually, inflation will be brought under control and we will be back to a disinflationary/deflationary environment under the weight of a heavy debt load. But the current path the Fed is on could mean “eventually” is more than a few years.

The saying in uncertain times is “hope for the best, plan for the worst.” I certainly hope the war ends quickly through some series of events that bring Russia back into the global economy quickly. I don’t anticipate it. I think we are transitioning to a new era and the transition could take some time—not months but years. Here in the US we aren’t feeling much pain yet. We will.

We are entering an extended period of sharply higher energy and food prices, which will raise the cost of everything else. Add to it the shortages we will see in the commodities that enable all our electronic devices and infrastructure, and higher financing costs as the Fed raises rates and may well overshoot.

It’s going to be difficult. But it will also bring opportunities, which I’m excited to explore. I do believe in the American entrepreneur and in the future of marvelous technology.

 

The Fed

 

The Federal Reserve hiked rates by 25 basis points as expected. The statement and the rate projections were hawkish, as the central bank “plays catch-up.” Here are some takeaways.

  • The Fed acknowledged “broader” price pressures.
  • Russia’s invasion increases uncertainty but puts “upward pressure” on inflation.
  • Rate hikes will continue.
  • The balance sheet runoff could be announced in May. This time, the balance sheet reduction will likely be more aggressive than the last time (more than the $50 bn/month).
  • James Bullard wanted to see a 50 bps hike (as he communicated earlier).

Here is the FOMC statement (changes vs. the previous version).

 

 

  • We expect six more rate hikes in 2022. The FOMC now expects to be done hiking rates by the end of next year. The market sees rate cuts in 2024.
  • The dispersion of rate projections for this year has exploded, highlighting increased uncertainty.
  • As expected, the FOMC reduced the 2022 GDP projection and raised inflation forecasts across the board.

 

 

  • The Treasury curve (2 yr to 10 yr) flattened further to 20 bps.
  • The 3-year – 10-year portion of the yield curve is about to invert as market participants worry about recession.
  • Fed hikes tend to be negative for the dollar over the full cycle.

The central bank is about a year too late and trillions of dollars too heavy in its attempts to make a difference about inflation in the present.

As prices of homes, food, rent, cars, and now gas have skyrocketed throughout the pandemic. Congress did its part by shoveling trillions of dollars of new spending into the economy through its bureaucratic mess, but let’s not forget that the Fed was party to the crime of inflation too.

It just kept doing the same old thing, keeping bank lending rates near zero and buying $120 billion worth of financial assets every month to stimulate the economy, until its backward-looking data only recently confirmed what people on Main Street already knew.

 

The US Dollar as the World’s Reserve Currency

 

The U.S. dollar is, of course, the world’s reserve currency. Central banks around the world hold more than $7 trillion in reserves, and it serves as the basis for almost all international trade.

But nowhere is it set in stone that the dollar must play that role. If the past 572 years of history are any indication, the dollar’s days as the global standard may be numbered.

 

 

Since the world stopped using ancient Roman currencies around 1450, every subsequent shake-up in the global economic order has been caused by excessive debt. And by any possible metric, our debt in the U.S. is unprecedented.

We’re not saying the empire will end tomorrow, but we are believers in history meaning something.

The U.S.’s percentage of debt-to-gross domestic product (“GDP”), a measure of how much the federal government owes compared to economic production, sits at a staggering 123% as of the fourth quarter of 2021.

That means the government owes more money than the economy is producing. It’s been this way for nearly a decade, when the debt-to-GDP percentage first went above 100% in late 2012.

No wonder the Fed, which can determine how much interest the government (and a lot other people) has to pay, wanted to keep rates lower, longer despite the evidence of inflation everywhere.

 

US Economy

 

  • The U. Michigan consumer sentiment indicator deteriorated further this month as gasoline prices surged.

 

 

  • Households expect further worsening in their financial situation
  • Buying conditions for vehicles appear to have bottomed.
  • The NY Fed’s manufacturing index tumbled in March. It’s the first regional factory activity signal of the month.

 

 

  • Employee hours are down sharply.
  • Price pressures persist, with factories quickly boosting output prices.
  • Gains in producer prices hit 10%, which was in line with expectations.
  • Financial conditions have tightened sharply this year. According to Morgan Stanley, that’s equivalent to 140 basis points of Fed rate hikes.
  • Demand for gasoline appears to be inelastic, which could be negative for discretionary spending.
  • The labor market remains robust, with initial jobless claims holding near the lows.
  • Homebuilder sentiment points to softer residential construction activity ahead.

 

 

  • The 30-year mortgage rate is now above 4.5%
  • First-time homebuyers are getting squeezed out of the housing market due to deteriorating affordability.

 

Market Data

 

  • The Nasdaq 100 is in bear-market territory, down more than 20%.
  • Fund managers are now confident that the broader US indices will also see a 20% drawdown.
  • The S&P 500 entered a death cross.

 

 

  • CTAs are getting very bearish.
  • Hedge funds have been cutting their equity exposure.
  • Brent crude dipped below $100/bbl

 

 

  • There has been no worse place to be than Chinese technology stocks. Over the past month, they’ve suffered massive selling pressure and it has triggered record extremes in many breadth metrics. The average stock has lost nearly 75% of its value, and almost all are trading at 52-week lows.
  • After falling to a 52-week low on Monday, the Nasdaq Composite has surged at least 2.5% on consecutive sessions. In the index’s 50+ year history, this kind of behavior has triggered 5 other times, 4 of which marked mutli-year lows. That failure in 2008 was a major outlier, however. It was also the only signal to exceed a 5% drawdown within the first 2 weeks of the back-to-back surge.

 

 

Thought of the week

 

“Find the thing you do well in life and do it again and again for the rest of your life.” – Johann Johannsson

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker