Where's the Economy Headed

With fears of recession looming the US and European markets have been under intense pressure from the past few months, and with the advent of war in Ukraine, things became even worse. 'Will the world economy slip into recession?' is the big question in many minds. On the other hand, some argue that we are already in a recession. Let's dig deep

The Quantitative easing done to counter deflation and economic slowdown during the covid lockdowns has resulted in high inflation rates in the US. The inflation in the US is at a 40-year high. The Russian invasion of Ukraine has added to the woes. Brent Crude crossed the 100-dollar mark after many years. The pressure on crude has stressed developing countries. In the US, this has further increased inflation. To counter the inflation the Fed is aggressively increasing interest rates. The fed is expected to raise interest rates four times this year. The rising inflation has brought about stagflation. Stagflation is a combination of inflation, unemployment, and economic slowdown. Fears of recession grip the US markets. The fears of economic recession are even higher in Europe as Russia is threatening to stop gas supplies to Europe. Russia has already stopped gas supplies to Europe through the Nord Stream Pipeline I, under the disguise of technical maintenance. But it is clear why Russia has actually stopped gas supplies to Europe, and it is definitely not for technical maintenance. Russian gas leader Gazprom has its plants shut in eastern Russia. Some countries in Europe like Hungary, are trying to work out a deal with the Russians. There is a clear divide in the EU. Poland is the only country that has enough gas in reserves to last through winter. Its gas reserves are almost full and is not ready to ration gas with other European countries. Hungary has backed out of the rationing plan of the EU. According to the EU’s plan to ration gas, every country will have to cut gas supplies by 15%. Poland seems reluctant, and Hungary has clearly stated that they would not take part in any such arrangements, but would rather sort out differences with the Kremlin. Nonetheless, Europe doesn’t have enough oil for the winter. Less gas means industries will have to shut down. Russia demands an easing up of sanctions in order to timely deliver gas to EU countries, but the EU is hell bound on standing by the sanctions levied on the Russian aviation industry and the economy because backing off now would be humiliating to the EU.

With all these uncertainties in the world, and raising interest rates, sovereign funds and hedge funds are moving their money back to America. Demand for US treasury bonds, often known as T-Bills(short-term debt instruments) has increased significantly. The increased demand for US T-bills means a higher demand for the US dollar. The US dollar index which usually remained stable at the 90s level in 2020 has reached 109. This has devalued other currencies in the world. The rise in demand for the US dollar might help combat inflation in the US. The United States will have to pay less for its imports since more goods can be bought with a higher valued dollar today. On the other hand, the strengthening of the US dollar exports inflation to other developing countries like India. Other developing countries’ currencies fall in value when the dollar rises, and therefore developing countries will have to pay more for what they import. This would increase local inflation in other countries around the world where economies rely heavily on imports. The ripple effects of the pandemic are being felt continuously as supply chain bottlenecks have still not been eliminated since the easing of lockdowns all over the world. The energy crisis and the Chinese economic slowdown are being felt worldwide. Chinese real estate giant Evergrande is facing bankruptcy, and if Evergrande goes bankrupt, this might trigger many Chinese banks to go under. The fall of Evergrande could pop the real estate bubble, and also start a crisis in the banking sector. All current Evergrande projects have been abruptly stopped as banks have stopped giving loans to Evergrande, in accordance with the new rules set by the government to be eligible for bank loans. The government came up with three-point conditions, a company must satisfy in order to be eligible for bank loans, and restrictions are placed on the amount a company can borrow depending on the number of conditions it can satisfy among the three. Among all the urban real estate developers in China, none qualify or satisfy all the three criteria, and Evergrande doesn’t qualify for even a single one of them, which means that Evergrande can not borrow money to finance their constructions. Therefore current projects have had to be abruptly stopped as financing for these projects has been cut off by the banks. On the other hand, customers who had pre-booked Evergrande flats, are holding protests and are threatening to stop repaying their home loans if they don’t get their flats on time. Amidst all these the one stuck here is the banking system of China. Evergrande which is often considered too big to fail has borrowed more than 300 billion dollars and if it falls, so do the banks from which it had borrowed.

It is unclear whether the US has already entered an official recession. In Layman’s terms, any two consecutive terms with negative real GDP growth would mean that the country is in recession. But the fed and many other official sources of the US deny that the US is already in recession but point out that a recession might be imminent in the next eighteen months. The Jobs data of the US in July has increased by o.1% from 3.5% to 3.6% from the previous month. Average hourly wages have increased by 5.2% YOY against an expected 4.9% increase, indicating that the fed hasn’t yet been able to tame the inflation. Even one of the most bullish investors in the US, Cathie Wood, founder of Arc Investments, has gone on to claim that the US is already in a bad recession and things could worsen in the coming months.

Inflation being at 40 years high in the US is creating a demand-destruction. Of all, the housing market is really feeling the heat of inflation as demand for houses has gone down to a huge extent. Mortgage rates now are at about 5.5% which is way higher than last year, and expected future fed rate hikes would likely increase the mortgage and push it to about 5.5%.

There are also talks of government debt defaults all over the world. From Russia to Pakistan to Sri Lanka, and then to European countries, many governments are running out of operating cash, and the strengthening of the dollar is making things worse for governments all over the world. Russia has already defaulted on its foreign debt and claims that it is a result of the sanctions placed on the country. Russia today can’t make dollar payments as sanctions prohibit banks of other countries from working with Russian banks. Russia claims that it transferred the required amount to the specific foreign bank, but the payment request was denied/blockaded due to sanctions placed on the country’s banking system. Russia defaulting on foreign debts are not likely to have a major impact on the market but it still induces fear in the bond markets all around the world. The aviation industry in Europe is also in a huge problem with Russia: thanks to the sanctions. In response to sanctions, the Russian government has nationalized many assets. On one hand, Russian flights have been cut off from access to spare parts for repair due to sanctions, and in retaliation, Russia has seized many European flights. European flights stuck in Russia continue to be stuck in Russia even today. European flight contractors are prepping for a legal battle against Russia, but it is unlikely that the issue would be solved any sooner.

But in case a recession happens in the next 18 months it would be very different from what we have witnessed all through modern history. Every time a recession happens, the GDP growth rate slows down and slips into negative territory and the unemployment rate rises significantly because companies start laying off a lot of people. This is a chain cycle where when employees get laid off, they tend to spend less because they have less cash, or probably they fear they might go homeless, and when people purchase less, the GDP or the Gross domestic product goes even lower. The recession then turns into a self-fueling cycle, and the only way to break out of it would be to increase consumer spending.

But today’s scenario is totally different, though in Layman’s language we are witnessing a recession in large economies like the US, the unemployment rate in the US is actually decreasing if we consider the last one year, and not just the last few two or three months. So here unlike all other recessions, we are witnessing an economic slowdown but not an unemployment increase. Employees are not yet being laid off, so consumer spending should have been normal right? But no, the consumer sentiment index is at its lowest in the last decade, thanks to inflation. But businesses are in a different position than in past recessions; the average profit margins of companies are at their highest. During every recession, the profit margins of companies usually dip to single digits, but the average profit margins today are near 16%. Along with this the amount of cash the companies have in the US is close to 4 trillion dollars which is the highest ever. This is due to the huge amount of cash printed by the fed in the last one year, and the stimulus checks issued by the US govt. All the new cash printed has likely ended up with big entities and has flown into the financial markets. Many tech companies last year had record profits, indicating that much of the money printed went into accounts of big entities. As a result of all these, companies might decide not to lay off workers, which might actually prevent a recession from happening.

The labor force participation in the US is also at its lowest, which means that it is more difficult for companies to find labor than ever before. This might discourage them from laying them off. This phenomenon in the US is being dubbed ‘The Great Resignation’. A “Pandemic Epiphany” as about 20 million people have quit their jobs since April 2021, and people trying to more ways of being financially independent. All these might actually prevent a recession from actually happening, and this is the reason why economists and officials of the fed are trying to redefine the meaning of “recession”. There is still existing confusion on whether we are actually in a recession or not.

But nonetheless, the consumer sentiment index is at its lowest, meaning the GDP is not likely to see a boost, because as consumers spend less, the lesser the production will be. But if production goes down, companies might be forced to lay off employees triggering a recession. On the other hand, a lower consumer sentiment index can help tame inflation. As consumers spend less on purchasing the demand for goods drops drastically, and if demand drops the prices of goods reduce, and therefore inflation reduces. Simple Supply demand equation.

The current financial indicators are very clumsy and difficult to interpret and have puzzled economists. But what can be done to tame inflation other than increasing interest rates? The democrats in the US favor the environmentalists and don’t want more oil to be produced. This is something that Biden repeatedly promised in his elections: to reduce shale oil production. Shale oil production in the US has dipped to a large extent since the democrats have taken office. The resale of leases for drilling on public land has largely been paused. In 2018, the US was the largest crude oil-producing country in the world. But in the subsequent years, restrictions have been placed on shale oil production due to pressure on the government from environmentalists. Today the US isn’t the world’s largest oil-producing country, and the Russia Ukraine war has further increased oil prices. The sanctions on Russia have tried to restrict the purchase of Russian oil by other countries, therefore there has been a reduction in supply in the oil markets. The OPEC countries have also taken advantage of the situation, and have not boosted production but instead cut down on a few. Strained relations of the US with the OPEC countries and Saudi Arabia have further worsened matters. After many meetings with the Biden administration, OPEC has only agreed to raise oil output by a minuscule amount, which would practically do nothing in preventing recession or reducing inflation. Therefore to tame the oil prices the US will have to take decisive steps to boost shale oil production in the US, by removing restrictions previously placed on the same, and by resuming the resale of leases for drilling on public land. If the US gets back into action and starts producing oil like never before, they can increase the supply to a large extent and reduce oil prices. But yeah, fracking is really expensive and can be profitable only if oil prices are above 60 dollars, but still, 60 dollars is 40% below the 100 dollar levels( For context it costs Saudi Arabia about 4 to 5 dollars per barrel to drill whereas it costs between 25 to 50 dollars per barrel for the US to frack). Nonetheless, it is not something that can’t be done. In 2017, the US was projected to produce more oil than four OPEC nations combined. If it comes down to the question of preventing a recession, the US can definitely outnumber OPEC, if they really get down to it. Forcibly reducing oil prices by enormously increasing production will definitely be on the cards in the coming months.

The situation today definitely looks grim, and with many indicators suggesting opposite things it is really difficult to predict with certainty whether a recession would occur in the coming months.