Are we heading towards a recession?

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In recent months we have often heard the words “approaching recession” being thrown around in the media. Although recessions occur naturally – on average, once every four years – they have a strong negative connotation for most of us. Let’s dig into this claim and see what to expect in the coming months.

Economic recessions are formally defined as two consecutive quarters of declining real GDP of a given country. It is important to note that recessions are a normal part of the business cycle and will be succeeded by periods of economic growth sooner or later. However, this “approaching recession” feels different. This is primarily because of the events that had happened since February 24, 2022, when Putin decided to start a war in Ukraine. The uncertainty and panic it brought to the markets is worse than what we had seen in March 2020, when Covid-19 began to spread across the world.

GDP continues to grow in the long run despite periods of recession in the short run (Image: Corporate Finance Institute)

The case of Europe

Starting off with the epicentre of difficulties, Europe is struggling to balance most of what is happening. The war in Ukraine has triggered a humanitarian crisis as well as an energy crisis.

The humanitarian crisis is a result of people being displaced and fleeing from war, with the primary destination being countries in the European Union. This is leading to unforeseen increases in government spending in these countries. Naturally, governments will seek to replenish their assets by either taking up more debt or increasing taxes on their own citizens.

The dependency of Europe on gas and oil from Russia is another reason why economic difficulties are approaching. When war broke out, and sanctions were imposed on Russia, the price of oil quickly headed north of $100 per barrel, with Brent Crude currently trading at over $110 (market data as of May 5, 2022). This will be leading to higher petrol prices for the entire world, increasing shipping costs, and increasing the final cost of goods that we see in stores. The threat of an energy embargo against Russia is also driving up the price of gas. Households are beginning to notice their monthly gas bill increasing.

Rising energy prices are the primary driver of inflation, as supply chains rely on fast shipping, which is mainly done by lorries. With increasing costs being passed onto the end consumer, it comes without surprise that inflation in Europe is heading towards 8% – a level that we have not seen in the past two decades.

With the European Central Bank (ECB) keeping interest rates low, inflation may continue to grow. Savings accounts have not been giving a return for a long time in Europe, so it is quite likely that unless the ECB tightens the monetary policy, we will continue to see rising inflation and perhaps even a path towards declining economic growth.

The case of the US

Looking at the United States, which is far away from the conflict zone, yet is also struggling with similar problems. Inflation in the US is primarily the result of immense money printing that occurred during the peak of the pandemic. As the world began to reopen, all of this excess money supply is starting to drive up inflation. This excess money supply is a result of unprecedented government stimulus packages that essentially devalued the money in terms of consumer goods. Petrol prices have also increased in the US, meaning that consumers will, once again, see an increase in the price of goods and services.

The United States Federal Reserve System (FRS) has reacted to this by increasing the rate by 50 basis points to 1%, with the possibility of further increasing the rate by another 50 basis points in the coming months. Essentially, the FRS is trying to catch up with the rising inflation.

Financial markets negatively react to such actions as it makes savings more attractive and investing less attractive. Loans will also become more expensive. The S&P 500 broad market index has dropped by 544 points (-11.36%) since the beginning of 2022. This is not only a result of the energy crisis and inflation but also the impact geopolitics has on the financial markets. Uncertainty and risk factors at the moment are very high, and uncertainty creates a very negative outlook for investors, incentivising them to sell rather than buy.

Also, an interesting event took place in the US Sovereign Debt market. The bond yield curve has inverted. Short-term US government bonds are now returning higher yields than long-term ones. This is usually not the case, as investors always expect higher risk levels over more extended periods of time. This factor alone is not a cause for recession. However, this event has signalled that a recession is approaching in the past.

The case of China

On the other side of the world, in China, we see a picture that is quite the opposite. The People’s Bank of China (PBOC) has recently decided to keep the rate unchanged at 3.7%, with only slight regulatory easing for banks. Since 2011 the PBOC continuously decreased the interest rate, making loans more affordable for its population, and incentivising business activity.

At the moment, China is having a massive crisis due to its zero-tolerance policy concerning Covid-19. With restrictions across the country and Shanghai being in lockdown for over a month, Chinese manufacturing and logistics are taking a huge toll. This toll will be passed on to countries that are buying Chinese imports, as they will now experience shipping delays, shortages, and perhaps rising prices for goods that were previously cheaper.

Once again, the ongoing struggles with Covid-19 in China are creating uncertainty, which is much disliked by the financial markets. This uncertainty may lead to fewer new contracts concluded with Chinese counterparties, as well as lower levels of foreign investment into Chinese business projects.

Any hope?

Looking at the positive side, Covid-19 now seems to be a thing of the past. With the exception of China, the rest of the world is learning to live with Covid-19 and is gradually returning to pre-pandemic life. This may indicate that more people will be employed, more goods will be produced, and there will be more incentives for people to spend money.

Still, with a very uncertain future and rising geopolitical tension, it is unlikely that post-Covid reopening alone will make up for the rising inflation and high energy prices.

Overall, it appears as if a recession is possible, but not today or tomorrow. If the war in Ukraine ends, there will be less pressure and uncertainty in Europe and the financial markets, but this will not necessarily help avoid a recession. The damage is already done. One possible way out could be tightening the monetary policy to slow down inflation. Yet, it is important to note that we have defined recessions as periods of declining real GDP. Slowing down inflation and keeping consumer prices under control does not indicate that a recession has been avoided. Hence, this method might only help treat the symptoms rather than the underlying cause. A complete energy transformation would be needed to decrease logistical expenses and restore broken supply chains; this is a prolonged and costly process. This once again reaffirms the idea that declining real GDP and a full-scale recession are possible.

To sum up, a recession is very much possible, and it is only a matter of time before it occurs. Most likely, Europe will be the first to experience it, as it is currently the epicentre of geopolitical and economic tension and relies on many other countries, including the US, Russia, and China. China could be next if its approach to Covid-19 is not reassessed. Still, it is crucial to understand that a recession is natural and will be shorter than the periods of growth that will follow.