The Hunt for Red October

29/07

Inflation is back. It has been a relatively benign factor in our lives since the GFC. Now it’s here and getting ready to inflict a recession in a way not seen since the GFC and further back to the late eighties, early nineties. Inflation is, however, a symptom of a wide variety of inputs into the global economy. Like any symptom, the only way to deal with it is to understand the causes.

As things stand today there are parallels to the beginnings of every major recession back to the seventies oil crisis. This time, however, we are facing a combination of every major recessionary driver since those days, all at once. The circumstances and factors driving the forces of the coming recession are more complex, widely and deeply ingrained and harder to unwind than many can possibly imagine.

The global economy is more entwined and complex than at any time in history. Global trade, new economies, supply chains spread over multiple countries, reliance on unreliable and hostile energy suppliers, rogue states, and geopolitical confrontations reminiscent of the cold war are just the start of a puzzle causing the next recession.

The first major segment to become a victim of an impending recession and the biggest indicator is usually the property market. While the US real estate market is showing signs of severe stress, and was the indicator in the GFC, the recessionary property indicator that will and has, in fact, already started to flash red is the Chinese market. Due to the slow withdrawal of China from the world stage and its increasingly tight controls on its population and media, the extraordinary property bust and now runs on Chinese banks is being overlooked by western economists.

Since the Evergrande collapse the meltdown in the Chinese property market has not been widely reported or factored in as a risk to the global economy. Ukraine and Russia have distracted economists and politicians from the risks and impact of the Chinese bank defaults and runs as well as the domino effects of property company collapses. The supply chain disruption through ongoing covid lockdowns in China (more on this topic shortly) has also had the effect of distracting attention from the bigger issues in China. It would be easy to ignore the problems in that market as a domestic concern, however, the defaults in China are not small and they are typically starting with defaults to foreign creditors. In the latter half of this year $13.3 billion in US denominated debt will fall due to offshore lenders. Just a few weeks ago, the Shanghai-based developer Shimao Group joined the list of Chinese property groups defaulting on their offshore debt, when it was unable to pay $1.02 billion in principal and interest payments to creditors. The size of the Chinese offshore debt obligations is not insignificant and will have an impact on lenders.

China now has a runaway train of an economic crisis that will contribute to a global recession. The ongoing collapse on the real estate market is affecting consumer confidence, causing runs on Chinese banks and causing a near total collapse in new house and apartment purchases. This is a downward spiral that is almost impossible to stop in such a large economy. A cynic might argue the covid lockdowns are part of a central government attempt to quell civil unrest which is growing fast. However, the lockdowns are merely exacerbating an already disastrous set of circumstances. With the lockdowns comes a lack of exports as major port cities and manufacturers close. While the rest of the world is concerned with supply chain issues, internally this means the economy is sapped of foreign income adding to the major issues an already heavily strained financial system is facing.

For the rest of the world the Chinese export closures means more than just a supply chain problem. As importers cast around for replacements, competition for dwindling supplies increases prices rapidly contributing to inflationary pressures across most global economies. In normal circumstances a slowing or even closing of an economy the size of Chinas would influence oil and energy prices. We saw the effect the Covid shutdowns had on oil supplies and prices. This time we have the Ukraine war to more than offset any oversupply in oil or energy from China’s reduction in consumption.

With the Ukraine war comes a food price hike as one of the largest grain exporters in the world has seen its ability to supply all but shut down. Combine the food price hikes caused by Ukraine’s inability to supply with the knock-on effects of increasing oil and fuel costs and food and goods prices are even higher still pushing inflation higher again.

In normal circumstances consumers ability to keep up with such a sudden and dangerous spike in inflation would already have seen a sharp reduction in their spending habits. This time, however, we have the unusual situation where most major economies have consumers with reserves of cash left over from the covid crisis. This cash won't last long and the cost-of-living spike is already beginning to have an effect. As winter arrives and the cost of oil rises again, the combined circumstances of the reduction in cash in consumers’ pockets and a further spike in overall costs and inflation will see a marked effect on global economies. There is a reason most economic collapses have happened around October.

The factors above are only a few of those currently driving the global economy into what could be a very serious recession. The final one that should be looked at is domestic politics in some key nations. Election years make for poor environments to deal with economic crises. 2022 is the midterm elections in the US, France has just had their presidential elections with a very unsatisfactory outcome and the British government is in turmoil as the Prime Minister is ousted by his own party. Germany, while not facing an election this year, is still trying to come to terms with no Angela Merkel.

However, it’s the US midterms that cause the greatest concern. Politicians and the electorate's eyes are still distracted by the impact of the 2020 presidential election and the claims of fraud. The January 6th investigation, the concerns around election fraud and so many states changing electoral rules have all eyes on the wrong ball. The building housing crisis in the US is seen but not enough attention is being paid to it and the inevitable impact it will have. There is a housing bubble that has built up. The sudden increase in interest rates and substantial drop in consumer confidence and the rapid rise in fuel prices with the knock-on effect to cost of living across the board means US consumers will tighten their belts. With US elections in November, October becomes a very risky month.

The month of October is renowned for economic crises and 2022 could see yet another in the long line of historic economic downturns. With the summer holiday season distracting everyone, warm weather and children at home August is a very quiet month with trading floors and offices manned by juniors while families escape. August is also typically a high consumer spending month regardless of economic circumstances. The northern hemisphere is on holiday.

With September everyone returns to their desks, but most are still distracted for the first couple of weeks as children return or start school and others head off to university, some for the first time. Politicians return from long summer breaks but still take time to get up to speed on the detail of what’s been happening beyond their holiday homes and constituencies. This means true focus and concentration on what has been occurring and building during the summer months only starts in the back end of September. With the backward analysis finished by the end of September and winter looming, October is where reality sets in and forward-looking analysis sees the market react often rapidly and collapses begin. 2022 could well repeat the patterns of many historic collapses in October.