These are unprecedented times as the world has never ever dealt with Global recession and an economic war simultaneously. Organization of the Petroleum Exporting Countries(OPEC) plus move to cut oil production and sending the oil prices northwards is seen as a calculated and determined move to keep the global inflation high.
Saudi Arabia is the new entrant, bringing its anti-American vibes out in the open and USA is not pleased at all! The concerted efforts by the European Union(EU) to cap the oil and gas prices have been destroyed in a swift move. This winter may test North Atlantic Treat Organization(NATO) and EU loyalties.
The world is already at war - Global economic war! The geo political headwinds and the macroeconomic imbalances are brewing a global financial crisis of Epic proportions.
First Signs of a Plunging Market
The world has not been so chaotic for a long time and the Financial markets are sensing an Armageddon coming their way but they just don’t know the scale and quantum of the blow out and the likely trigger. There are too many moving parts this time.
One thing is for sure, as and when the world comes out of this crisis, the world will have a very different order while heading for a reset. Relentless currency printing and the burgeoning debt has failed to spur productivity and instead, has led to a spiraling inflation, asset price distortion and an unprecedented concentration of wealth.
Central banks have a big fight ahead if they should work on Price stability i.e. Inflation or Financial stability in terms of Bonds. Currency, Equity markets. The big debate today is whether the Central banks should tighten the interest rates further or prevent the present slowdown from slipping into a long recession.
The first signs of a global recession setting in are already visible in the commodity prices, freight rates, inventory build up, housing sales slowdown and a shrinking global Gross Domestic Product(GDP). The financial markets and the real economy quite often have a lead and a lag.
Global equity markets have been tumbling since last December but the Real Economy is yet to fully manifest the impact of interest rate hikes, monetary tightening and financial instability.
How The Pandemic Affected The Economic Ecosystem
Post the pandemic recovery, the liquidity overhang has resulted in spewing a spiraling inflation which has been exacerbated by the Russia-Ukraine war. The zero interest rate Federal Reserve FED policy may have been good to revive the aggregate demand post pandemic shutdowns.
However, the supply-side disruptions failed to cater to the pent-up demand resulting in an inflationary build up. Moreover, it seriously killed the incentive to save, resulting in a huge debt pile-up. The world has not recovered since then as the Central banks chose to ignore the monstrous inflationary build up. Rising cost of living is threatening to bring down governments both in emerging as well as developed countries.
US Economy in a Fix in a Mix of Headwinds
The FED and the European Central banks are, therefore, under immense pressure to aggressively increase the interest rates as they are still way behind the inflation curve. This is leading to a lot of nervousness in the financial markets. The fund managers keep wishing for a FED pivot. Unfortunately, the world will have to live through a full economic downturn cycle and FED is unlikely to pivot this time!
The country-level risk of financial distress is increasing and this includes developed economies. Europe and USA are grappling with Stagflation, while China has serious problems with its Real Estate bubble which is now threatening a banking and economic collapse. China could very well deliver a nasty shock to the world economy!
Many of the emerging countries are already facing food and energy shortages and a debt crisis. Global debt has become the Frankenstein Sword, it is likely to create long term financial problems for many countries. Going ahead some of the developing and developed countries may join this list.
USA added another trillion dollar of debt in 2022 with two quarters of negative GDP. The country has pursued an easy monetary policy for far too long which was supported by global supply chains. With a sharp polarisation setting in, the low cost supplies from China are passé. USA will have to look for alternate supply chains or go back to Make in USA and for that to happen it will need to revisit its cost structures. “Services” constitute 80% of the American economy and industry is at 19%.
The economy is near full employment, however the high wages are not keeping up with the cost of living. America has been pursuing a liquidity-driven expansionary economy for the last 15 years by relentlessly currency printing. It is no longer increasing productivity rather it is resulting in inflation, asset price distortions and concentration of wealth.
Moreover, this cannot continue as we are moving to a multi-polar world and the world is no longer willing to accept US Dollar as a reserve currency. This has serious implications going forward.
Europe’s Energy Crisis To Throw a Wrench?
Europe is being pushed back to medieval times! The rising energy prices have reduced the discretionary spending of people and the non-availability of energy is shrinking the European manufacturing. It looks to be a bad fiscal story in the making.
To make matters worse, inflation is at a 40-year high and the interest rates are unrealistically low. Sooner or later the central banks will have to aggressively increase the interest rates. Expect a financial, banking and housing & mortgage crisis going ahead.
European banks are already on the radar! Credit Suisse in particular is at the edge of a cliff as it has had huge internal problems for many years now. Share price has fallen over 50 % in the last one year. The credit swap rate is at all time high of 2.75% , which reflects the nervousness of insurance companies to insure debt securities issued by Credit Suisse.
The new CEO is slated to unveil a new blueprint on the 27 October to turnaround the bank. However if it fails to enthuse the markets the bank will be in serious trouble and so would be European and Global banks.
On the currency front, the soaring US dollar has become a major headache for many emerging and developing countries. Not only are they facing a flight of capital and a debt crisis as the forex reserves are running low, they are also suffering on account of “imported inflation”. Aggressive Interest rate hikes by the FED will continue to depreciate the global currencies as Dollar is seen as a safe haven in the shorter term.
Dollar No Longer Idolised As the Capital Currency
The flip side is that the soaring Dollar may be committing hara-kiri as it may be the next bubble in making. More and more countries are in a hurry to delink their trade and economies from US dollar as the depreciating currencies are increasing domestic inflation and stressing the fiscal health. US committed the biggest mistake by weaponising the US dollar and post Russian sanctions, many countries including India are pacing up the process of 'de-dollarisation' as no one wants US domination anymore! Dollar may see a substantial depreciation over the next 3 to 5 years.
Most of the European and American markets are already at their 52-week lows having lost between 22- 35 % off their peaks in 2021. Equity valuations had become a function of liquidity and were totally out of sync with the underlying cash flows and profitability! So far the market correction has just brought back the sanity but markets do not seem to have priced in the hard landing as yet, more specifically – Quantitative tightening, Rising interest rates, and a prolonged recession! Expect the global equities to tumble another 15 – 20%.
With so many moving parts a financial accident of Epic proportions is just waiting to happen and the probability remains high! It could be a banking crisis, or a country-level debt crisis or a currency rout or a war-driven black swan event. This could be one of the longest bear markets in recent times.
More than the equities it is the debt – bonds and gilts , which can blow out the lid of the global economy as interest rates are unrealistically lower than the inflation, especially in Europe and USA. Sovereign treasury dumping could result in a huge financial instability. A single day crash in UK gilts saw Pound plummet to a historic low against the dollar and made Bank of England pivot from 'Quantitative tightening' to 'Quantitative easing'.
How Will India Combat Inflation Amid Recessive Trends
Expect the global headwinds to impact India as well. The World Bank has cut the GDP growth rate to 6.5% for the current year. India is likely to see a further slowdown until the world comes out of recession. Global slowdown, rising Current account & Fiscal deficit and falling forex reserves will negatively impact the Indian economy in the short run. The Reserve Bank Of India (RBI) is also likely to go for more interest rate hikes with the twin objectives of containing inflation and aligning interest rates with the FED hikes to prevent capital outflows.
Brazil, India, Indonesia have so far outperformed the global markets in 2022. However, the Indian equity market valuations remain very high and given the global headwinds and the domestic slowdown, they are likely to see a sharp value correction or a slow time correction.
International Portfolio Capital will not flow in Indian equities till then. Foreign institutional investors (FIIs) have resumed their selling. The domestic Systematic Investment Plan (SIP) flows are also declining. With the rising interest rates, 'debt' as an asset class is again looking attractive given the unfavorable risk-reward ratio of Indian equities at these levels (Nifty @17300). Expect Indian equities to underperform over the next 6 months..
(The author is Managing Partner at Alquimie Advisors. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)