Is Economic Recession Around the Corner?
Introduction
The economy has underperformed during the first quarter of 2022. The only asset class that generates positive returns is commodities, such as energy stocks, oil, natural gas, copper, gold, wheat, etc. On the contrary, starting at all-time highs, the US equity market ultimately decreased by 4.6%. The European stock market also performed disappointingly, as its energy supplies were affected by the Russia-Ukraine war severely. Moreover, due to recent interest rate hikes, Fixed Income was among the worst asset with significant downturns in 2022, causing aggregate bonds to have the worst quarterly performance in 30 years.
Despite the underperforming global markets in the first quarter, more influencing global economic events are foreseen. The US Federal Reserve Chair Jerome Powell has announced that upcoming interest rate hikes are on the table to tackle the skyrocketing inflation in the US. Furthermore, global supply chain disruption continues as China has implemented lockdown measures in cities, including Beijing and Shanghai. Uncertainties about the Russia-Ukraine war also continue, leading to probable food and energy crisis. The potential economic events seem to be posing a menace to the world’s economy, but when will it arrive?
What are the Possible Global Economic Risks?
As mentioned, several economic events may push the economy into a global recession, and potential interest rate hikes will be the paramount factor. As the CPI has reached its 40-year highs, the Fed has announced that more contractionary monetary policies will be implemented. Thereby, the interest rate is expected to rise by 0.5% in the next 3 meetings, while a quarter-point rise is expected at the year’s 3 other sessions. Moreover, a $9 trillion balance sheet reduction is also expected in the foreseeable future. The inverted yield curve could also provide a pessimistic market signal for investors, that economic recession is just around the corner. The policies have given certain pressure on the stock and bond markets.
Apart from potential interest hikes to combat the skyrocketing inflation, the recent COVID-19 outbreak and lockdown in China may also pose a menace to the global supply chain. The zero-COVID policy in China has led to mass testing, border closures, and quarantines in different cities. As owning one of the largest manufacturing sectors around the globe, recent policies in China had worsened the complex supply chain. Prices of food, consumer goods, and commodities are surging. The stability of the global economy will be threatened if such a situation continues in China.
Geopolitical tension between Russia and Ukraine is also contributing to the potential economic recession. As the largest oil exporter to Europe, the military conflict has stopped its energy supply from Russia. As a result, prices of commodities have been rising significantly in the first quarter, especially oil and natural gas. To lower fuel prices, the US has announced that it would release 180 million barrels of oil from its strategic petroleum reserve in the coming six months. However, it is believed that energy supplies will still remain in shortage.
When will it arrive?
Economic recession is possible, but not probable. Though the incidents mentioned above have provided investors with the market signal of an economic recession, it is believed that we are transitioning from the middle stages to the later stages of the recession cycle. The time delay between an inversion and a recession will be between 6-12 months.
As shown in Figure 1, the top 3 contributions of CPI are Housing (42%), Transportation (18%), and Food & Drinks (14%). A continuous rise in interest rates may not tackle the inflation of these sectors directly. Moreover, the Fed also has to consider the market reaction after the implementation of contractionary monetary policies. Overtightened policies would only bring destruction to the economy. Hence, though interest rate hikes are foreseen, the frequency and the rising range are still uncertain.
Figure 1: Contribution of the US CPI in 2022
In terms of supply chain disruption, the number of COVID cases will reduce while cities will resume their operation after lockdowns. The disruption will not be continuous. Geopolitical tension between Russia and Ukraine also remains uncertain in the long term, and investors should not be too pessimistic regarding the recession ahead.
Strategies During Recession
Commodities are one of the best investments to combat inflation hikes. As the market supply for products such as gold, oil, agricultural inputs, and energy supply decreases due to supply chain disruption, prices of these products and related services would also increase, hence helping investors to hedge investment risks against economic downturn and inflation risks. Equity sectors with more consistent cash flows will also be a good option to invest in during this period, such as the healthcare and consumer staples sector. Foreign exchange such as buying the US Dollar may also be a good strategy. On the contrary, fixed income such as aggregate bonds should be avoided, as the inflation and interest rate hikes will expand investors’ capital loss with a lower bond price.
Takeaway
It is foreseen that the economy will remain volatile due to several macroeconomic events and will drag the economy into a downturn. However, the economy is still in the transition stages with several uncertainties. Though those events will undoubtedly push the economy into recession, the arrival time may be longer than expected. Therefore, investment decisions should be made carefully. Several asset classes that would depreciate during inflation should be avoided, such as aggregate bonds. Investors should use a more defensive approach during this difficult period.