A lot can happen in a month. In fact the factors buffering the business cycle seems to more acute and more dynamic than ever. To say that continuous change is the new normal would be old hat. But it’s true, and then some.
First there Was Covid
Even before Covid that statement was true. Digital giants and innovative start ups were blazing a trail and creating new markets, disrupting old. Market concentration, that is the percent of a market dominated by the larger, fewer frontier firms, was becoming more stark. Everything was to be digital, or die. Then came Covid.
Every business model, every forecasted action and every investment theses was turned upside down, almost overnight. The experience rippled around the globe as the virus traveled on planes and ships, spreading its mayhem. Government debt soared; more interestingly central banks bought their own government debt, and even marriage backed securities and in rare cases stocks. Monetary and fiscal support was stacked up and piled high, and in many places today remains unspent. But that’s all history.
In December last year recession was not a word anyone cared to bring up. In just a couple of moments we went from, “growth”, to “inflation is transitory”, to “soft landing”, to highest levels in 40 years”, to “recession”, and even, “stagflation”. Incredibly even now most of the market is not listening. For US monetary policy to really drive inflation down it has to be at a level that real interest rates are positive. Today real interest rates are still negative! That is, if you reduce nominal rates by nominal inflation, you get real interest rates. Add into that the fact that the Fed has not yet started to reduce its balance sheet, it is quite clear the Fed is behind the curve. I bet Mr. Powell sleeps rather lightly every night.
Recession in 2022?
So what of the future? Given the data I see in the public domain, I believe there will be a recession in the US before the year is out. It might even be recognized in Q3. It takes two quarters of negative growth to qualify. So it will be touch and go. More practically consumer spending has to deflate due to inflation; my household talks every day about the price of things and choices about what we purchase. Your household might be doing the same.
Second, Central Banks every where are behind the curve. The US by about 6 months. The EU is not much better: They must be hoping that by talking up their economy they can push through the problems, just as the US economy trips up. That sound like hubris. If the US tips into recession, or worse a steep drop in growth takes place, Europe will follow. And the EU is pushing out relaxation of QE until later in the year! What kind of dashboard are those folks looking at?
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A Global Affair
The next item is China. China just lowered interest rates to help improve its growth trajectory, which is not overly rosy. It’s own Covid lockdown is impacting supply chains (again). Property developer debts remain at feverish and risky levels; several remain on watch lists for possibly missing covenants. China is flirting with a jittery economic flight. So there will be no real help from that quarter. It was not long ago that if the West suffered a slow down, the East would help ‘save the day’. Remember those times?
The last item is the dollar. It’s on a tear. Why? When the market perceives risk, capital seeks the safest investments. In the currency and foreign exchange markets that means the dollar. This will actually make imports to the US cheaper, helping manufacturing and reduce inflation. But it won’t slow down growth. This means we need even higher interest rates in the US to curb growth. A strong dollar makes the US challenges harder.
At the same time a strong dollar leads to weakness in other currencies. The Euro is weakening and this will drive up import costs, worsening its own inflation picture. Remember that current interest rates in the EU are, incredibly, still minus 0.5% and inflation is currently running at over 7%. The central banks balance sheet is safely locked away. See WSJ: Germany Warns on Falling Euro and Inflation.
What About Tech?
And so there I was reading my Economist. In this weeks copy an article titled, The Tech Crunch: Pop!, grabbed my attempting and triggered this blog. The article highlights that many market segments underpinned by technology, are popping. Why? All that excess capital (part of the QE bandwagon) seeking a return, has chased ever more riskier bets. There are bubbles everywhere. The article lists many such bubbles and highlights how that are all starting to fizzle out and pop.
The article also suggests that no one is calling the bottom, not even close. And that’s were I sit, with my warm coffee in hand, dogs asleep at my feet, and biscuit at the ready. The next 6 months are going to be critical. Talk of a soft landing as virtually ended. Now debates about the kind of hard landing are more common. Now is the time, and you don’t have much of it, to review your capital structure, debt schedules, and investment plans.
From Here to There
I forecasted in December 2021 that the 10 year yield on US treasury bill would hit 3-4% this year. It hit 3% last week and hovers around 2.9%. When I made the prediction it was hovering around 1% and had been stable for some time.
I also forecasted inflation at 8-9% for the year. That seems to have been prescient too. I figured it would peak and settle at 6% by Q4. For that to happen, nominal interest rates have to be closer or above 7% if real rates are to slow the economy down. The Fed balance sheet reduction may not help at this point. Remember, that’s not even starred yet. And the risk to credit markets gumming up is notable. The Fed has little idea what will happen here.
The US stock market tanked last week. I think some smart investors and economists are starting to do the math with real and nominal interest rates. They are speculating the Fed has to move faster, and higher, than widely assumed. That makes for a more bumpy landing. If it’s a landing at all.
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