Don’t Be Fooled by Misleading Economic Signals

Mixed Economic Signals are making things harder than it is.

In most countries around the world in 2022, inflation was the primary economic signal and financial issue. This is particularly true for mature economies that significantly impacted the global economy and markets.

The consequences included lower living standards, rising inequality, higher borrowing costs, stock and bond market losses, and the occasional financial calamity (fortunately just small and contained until now).

In this new year, the actual and feared recession has joined inflation in the driver’s seat of the global economy and is set to supplant it.

It’s an evolution that exposes the global economy and investment portfolios to a broader range of potential outcomes, which a rising number of bond investors appear to understand better than their equities peers.

The IMF is likely to shortly revise its economic growth estimates again, believing that “recession will hit a third of the world this year”. What strikes me most about the world’s deteriorating economic prognosis is not only that the world’s three major economies — China, the EU, and the US — are slowing at the same time, but that they are doing so for distinct reasons.

The tortuous withdrawal from a misguided zero-Covid policy in China is hurting demand and producing more supply problems. Such impediments to local and global economic well-being will persist as long as China fails to improve vaccine coverage and effectiveness.

The strength and longevity of the future recovery will also necessitate a more aggressive revamping of a growth paradigm that can no longer rely on increased globalization.

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As Russia’s invasion of Ukraine proceeds, the EU continues to face energy supply interruptions. Many countries have made significant progress in improving inventory management and reorienting energy supplies. However, they are not enough to alleviate urgent growth limits, let alone address long-standing structural obstacles.

US Federal Reserve and Rates

The United States has the least concerning outlook. Its growth difficulties are the result of the Federal Reserve racing to limit inflation after badly mischaracterizing price increases as transient and then being too cautious in changing monetary policy.

The Fed’s shift to aggressive front-loading of interest rate hikes came too late to prevent inflationary pressures from spreading to the service sector and wages.

As a result, inflation is likely to remain stubbornly low at approximately 4%, be less sensitive to interest rate policies, and expose the economy to a higher risk of mishaps caused by additional policy errors hurting growth.

The uncertainties facing these three economic regions suggest that analysts should be more careful in promising us that recessionary pressures will be “brief and weak”. They should keep an open mind if only to avoid making the same mistake of dismissing inflation as temporary.

This is especially relevant because these various recession risk drivers make financial risks more dangerous and policy transitions more difficult, including Japan’s anticipated withdrawal from its interest rate control measures.

The range of possible outcomes is extraordinarily broad.

On the one hand, improved policy responses, such as improving supply responsiveness and protecting the most vulnerable portions of the population, can counteract the global economic downturn and, in the case of the United States, avert a recession.

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Policy Failures

Additional policy failures and market dislocations, on the other hand, might create self-reinforcing vicious cycles of high inflation and increasing interest rates, weakened credit and pressured earnings, and market functioning stress.

According to market pricing, more bond investors grasp this better, notably by refusing to follow the Fed’s interest rate guidance this year. They predict that recessionary factors will drive rate decreases later this year, rather than a continuous path of increasing rates through 2023. If correct, government bonds would provide the rewards and portfolio risk mitigation potential that was sorely lacking in 2022.

However, some parts of the stock market are still pricing in a soft landing. More than only investors are interested in understanding these many situations. Without improved alignment within markets and with economic signals, the desired economic and financial results will be less likely. The possibility of more unfavorable outcomes in reduced economic and human resilience will also challenge them.

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