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Why Global Recession Is Still Likely

On Friday this past week, the United Kingdom’s Office for National Statistics released the latest reports on the UK’s Gross Domestic Product (GDP), a means of measuring economic output. It was revealed that their economy grew by -0.6% month-over-month, and -0.1% quarter-over-quarter, which entails a contraction for both timeframes. Although these numbers are less disastrous than had been forecast, they are unfortunately part of a trend: New Zealand has also suffered a contraction in GDP, while the United States has experienced two consecutive quarters of contraction, a technical recession. While these declines in output are historically strange, seemingly contradicting recent phenomena like relatively high levels of employment and stock market rallies, they ought to be taken into account by traders nonetheless. Let’s explore some of the root causes of these contractions as well as factors exacerbating them as we discuss why global recession is still likely.

1) Restricted Supply

Often when inflation occurs, it is because demand for a product or service is rising at a faster rate than the supply of the product or service itself. However, this is not always the case; sometimes, inflation is caused primarily by a decrease in the supply of a thing, rather than growing demand alone. We are experiencing this phenomenon today with high food and energy prices, which explains why CPI has far outpaced core CPI (which excludes volatile food and energy prices) in many countries.

Because commodities like oil and commodity crops are scarce resources that consumers rely on to live, geopolitical problems like the invasion of Ukraine and resulting sanctions, as well as environmental problems such as heatwaves, droughts, and famines, restrict available supply. Many of these problems either are or can become chronic and near-ubiquitous, leading to persistent inflation from shortages that cannot be resolved through contractionary monetary policy.

2) Interest Rate Hikes

While interest rate hikes are a crucial monetary policy tool for curbing inflation and cooling an overheating economy, they also come with a nasty side effect: slower growth. This is because rising interest rate are designed to stifle growth by limiting consumers’ and businesses’ ability and desire to borrow money, restricting spending and thus the chances of inflation.

While lower GDP growth, even a contraction, does not necessarily create a recession, it is nonetheless playing with fire by taking steps in that direction. This is especially relevant considering that many central banks, such as the Federal Reserve and the Bank of Canada, have begun fully embracing hawkishness through unusually aggressive rate hikes.

3) Trade Deficits

Another economic factor that often quite literally detracts from a country’s GDP is trade balance. Some wealthy countries have negative trade balances, or trade deficits, created by their imports exceeding their exports. While a trade deficit might grant consumers more access to lower priced goods from other countries, it also results in a net loss of economic output that is subtracted from GDP. When trade deficits are frequent, as in the case of the US, this can theoretically severely impede economic growth, which likely contributed to the country’s technical recession. Both the UK and New Zealand have recently been reporting trade deficits as well, which is unsurprising.

4) Underfunded Pensions

Across the developed world, underfunded pension programs are proving to be a difficult problem to contend with. With large percentages of many countries’ workforces retiring, public pension systems such as Germany’s are struggling to keep up, with the German government bailing out the program with €100bn in 2021. Likewise, Social Security in the US is expected to be trillions of dollars behind in long-term funding, despite the average annual benefit amounting to less than $20,000 per recipient. Failure to improve pensions severely limits demand and growth within an economy, since a large chunk of many countries’ populations are retired adults who still spend.

5) Real Pay Cuts

Some economists worry about the possibility of high inflation combined with hot labor markets creating a ‘wage-price spiral’ where inflation persists uncontrollably due to rising employee earnings. However, the truth appears to be less fanciful, and grimmer. Even with today’s historically high rates of increasing incomes for working people, year-over-year inflation completely negates these raises in most circumstances. For example, with average hourly earnings increasing over 5% in the US, when we account for 8.5% year-over-year CPI, this implies a real pay cut of approximately 3% for working people. This entails a net loss in consumer spending, which means less revenue for businesses, and thus lower GDP growth.

6) Self-Fulfilling Prophecy

For better or for worse, market sentiment has a hand in creating fundamentals (by allocating capital), not just the other way around. Thus, if dread about a global recession continues to loom in the public consciousness, traders and investors may respond by buying and selling accordingly, potentially accelerating a coming recession with stock market and forex selloffs. In this way, the general perception of an impending global recession alone can play a large role in creating one.

Consequences for Pairs?

Lately, much of traders’ fundamental analysis has focused on how central banks respond to inflation as the primary economic threat. However, if global recession becomes a reality, there is a chance we could see central banks return to their dovish ways, which may warrant reassessing pair biases from scratch. It is also worth noting that these hypothetical dovish pivots may not occur in the face of stagflation, which unfortunately seems possible given supply concerns.

Key Takeaways

• A number of countries are currently experiencing negative GDP growth, i.e., contractions in economic output, which traders should take into account while gauging the likelihood of global recession.
• One aspect of each contraction likely involves the potentially dwindling supply of scarce resources such as crops and oil due to war, sanctions, droughts, and other potentially chronic problems. This lowers the amount of ‘stuff’ there is to buy, shrinking output.
• While interest rate hikes curb inflation within a currency’s host country, they also disincentivize consumers and businesses from borrowing money, restricting GDP growth.
• Economies prone to trade deficits, i.e., spending more on imports than they receive selling exports, impair their GDP growth by net losing output in the trade process.
• Underfunded pension systems, which cause lower benefits for elderly consumers, are proving to be an international problem, limiting consumer demand and GDP accordingly.
• Although wage growth is rising at the fastest rate in years, it still often pales in comparison to high rates of inflation, limiting consumer demand and GDP accordingly.
• Fear of impending recession can become a self-fulfilling prophecy by spooking investors and speculators, encouraging mass selloffs that create the catastrophes they were afraid of in the first place.
• If a massive event such as global recession, or even stagflation, becomes reality, this could warrant a complete reevaluation of pair biases and fundamentals.

Has Everything Changed for Major Pairs?

This week the public received startling news: on Wednesday morning, month-over-month CPI (a proxy for inflation) in the United States had unexpectedly remained static, clocking in at 0% whereas a moderate 0.2% increase had been forecast. Core CPI (which excludes food and energy prices) likewise came in lower than anticipated at 0.3% month-over-month, while Thursday saw the Producer Price Index surprisingly decline 0.5% month-over-month. This prompted a mass selloff of USD across major pairs on Wednesday and Thursday, with the US Dollar Index (DXY) temporarily plummeting by 1.8% from the start of the week while stock indices soared. While demand for USD has recovered a bit since, with the DXY now down only 0.87% from Sunday, it is worth asking: has everything changed for major pairs?

Argument A: The Bearish Case for USD

A 0% month-over-month inflation rate may signal that the worst of price increases is finally over in the US. Annual inflation might have peaked, and consumers can breathe a sigh of relief now that three key events have occurred: 1) energy prices have dropped significantly due to a dip in demand, while US natural gas storage and oil barrel inventories also exceed expectations. 2) The Federal Reserve has embraced monetary policy hawkishness, and their rapid 50-75 bp rate hikes have worked, successfully restricting borrowing and thus curbing demand. 3) Despite a tight labor market, the US unemployment rate consistently hovers around 3.5%, granting a subtle degree of price stability.

Argument B: The Bullish Case for USD

Unfortunately, despite 0% month-over-month inflation being a welcome respite from high inflation, this one piece of data does not capture the full economic picture. Here are three reasons to expect high inflation to continue in the US: 1) though having fallen, energy prices could likely remain volatile and high because underlying global energy supply problems (e.g., mutual sanctions on Russian exports, OPEC’s unreliable output, energy dependence) have not been resolved. 2) Considering the scale of monetary stimulus over the course of the pandemic, and the double-digit federal funds rate that was historically implemented to stamp out high inflation, it would be shocking if these past few rate hikes were enough for the Fed to bring 40-year highs to an end. 3) The hot labor market may cause wages to further play catch-up, contributing to core inflation.

My Bias: Bullish (With a Grain of Salt)

Despite this particular cooling CPI report, I am retaining my bullish bias on USD, though admittedly with less confidence than before. The international and domestic economic conditions at work do not appear to have changed in a significant fashion as consumers still grapple with the consequences of an unprecedented money supply, labor shortages, and energy instability. However, if US inflation data continues to fall behind market expectations, I will certainly reassess this bias.

Best Pairs to Trade

According to the EdgeFinder, A1 Trading’s market scanner that helps traders conduct economic and sentiment analysis, here are two optimal pairs to trade for USD bulls: 1) GBP/USD, which has a score of -7, earning a ‘strong sell’ signal; and 2) USD/TRY, which has a score of 4, earning a ‘buy’ signal.

Could the US Senate's New Bill Reduce Inflation?

What is the Inflation Reduction Act in the US?

On Sunday, August 7th, the US Senate narrowly passed a budget reconciliation bill, coined the ‘Inflation Reduction Act’, by a vote of 51-50, with Vice President Kamala Harris breaking a tie. It primarily focuses on three goals: combatting climate change, expanding health insurance coverage, and reforming the tax code to reduce deficit spending. A heavily pared down incarnation of the discarded Build Back Better Act, it is expected to pass in the House of Representatives by the end of this week before being signed into effect by President Biden.

Provisions That Would Supposedly Curb Inflation

The legislation has been particularly marketed by Senator Joe Manchin (D-WV), one of its sponsors, as a means of subduing the 40-year high inflation rates currently gripping the US. The bill would allegedly do this by creating a new 15% corporate minimum tax to close existing loopholes, increasing funding for the IRS to enable higher auditing capacity, and introducing a 1% excise tax for stock buybacks. Between these measures, as well as enabling Medicare to eventually negotiate lower prices for a selection of prescription drugs, an estimated $700+ billion in additional revenue will be raised over a ten-year period. Of these funds, $300 billion will be used in lieu of current deficit spending, theoretically reducing the anticipated national debt increases as well.

Merits and Criticisms of These Claims

An optimistic outlook regarding the possible efficacy of these provisions in curbing inflation rates could highlight the reduction in capital that larger corporations would have available to allocate (for example, Amazon, FedEx, Unum, and many more companies have paid effective corporate income tax rates either at or below 0% in recent years). Net corporate subsidies stimulate the economy, increasing growth and thus inflation, while net corporate taxes restrict it.

However, a more skeptical outlook confronts the likely insignificance of these decreases in the deficit over a ten-year period. Given the United States’ $25 trillion GDP, penchant for trillion-dollar federal budget deficits, $30+ trillion national debt, and the effects of $8.9 trillion in mid-pandemic quantitative easing, a $300 billion promise in federal savings over a ten-year period is rather negligible. Slowing additions to the money supply by a fraction of a percent of GDP will likely not have much of an effect on slowing year-over-year inflation nearing double digits.

Potential Effects on Major Pairs

While it is difficult to say for certain, I am anticipating that if this legislation is signed into law, it will have either a minimal or virtually no effect on inflation and most USD fundamentals. I am personally maintaining my bullish bias on USD, and currently have open positions selling AUD/USD, NZD/USD, and buying USD/CHF. For those who are interested in finding supplemental analysis tools for gauging pair fundamentals and sentiment, consider investing in the EdgeFinder, a robust market scanner from A1 Trading.

Why the Stock Market Rally Is a Mirage

US stock market bulls experienced a month of respite as major indices have rebounded from their mid-June lows over the following five weeks. The Dow Jones Industrial Average crossed above 31,800 on July 19th after finding support upon dipping below 30,000 in June, and the S&P 500 likewise nearly hit the 4000 level on July 20th after having touched 3650 in June. Even with mixed earnings reports and a surprise 50 basis point rate hike from the European Central Bank seemingly prompting US stocks to take a tumble intraday on Thursday, July 21, investors were treated to another ultimately positive day as indices closed higher. However, despite over a month’s worth of restored buying pressure, this recent indices-wide leap is likely not as optimistic as it seems. Let’s explore fundamentals as we discuss why the stock market rally is a mirage, as well as what investors could expect timeline-wise.

Why the Stock Market Rally Is a Mirage

USD Trade Complications

Although a soaring USD in the foreign exchange market enables American consumers to indulge in lower priced imported goods, the flip side is that it comes at a cost for many US businesses. For those corporations that have historically sold goods and services internationally, these prices overseas are now far higher than in years past, limiting foreign demand. Thus, a highly valued USD makes US exports (approximately 13% of US GDP) less enticing for trade partners, which can substantially limit revenue for these businesses in the US, disincentivizing potential investors by theoretically limiting their earnings and share prices. Considering that USD looks primed to continue its bullish trajectory into the near future, this could be bad news for US indices overall, and by extension GDP growth as well.

Why the Stock Market Rally Is a Mirage

Ill-Fated Consumer Demand

As is the case in every market or mixed economy, corporate earnings in the US are predicated on demand for the products and services that companies are selling. High inflation is happening in America because, as in much of the world, demand for products and services has significantly outpaced their supply; this has resulted in today’s uncomfortably high prices and a hot labor market, bolstering corporate profits to a degree.

However, this strong demand is quite unlikely to remain. Factors such as US employees’ wages and salaries failing to rise at the rate of inflation (with average hourly earnings having increased only 5.1% over the past 12 months, compared to 9.1% inflation), as well as a hawkish Federal Reserve intent on aggressively cooling the economy through raising interest rates, will impair consumer spending. This will mean less income for US businesses by extension, as well as far less money spent buying stocks speculatively as in recent years.

Why the Stock Market Rally Is a Mirage

Global Economic Conditions

Although the US economy is currently the largest economy in the world in terms of its $25 trillion GDP and vast net wealth, much of this growth has been due to its relationship with the global economy. By relying heavily on free trade agreements, as well as foreign direct and portfolio investment, markets in the US have been transformed by globalized supply chains and reinforced by an ongoing influx of new capital.

While this approach to prosperity ostensibly comes with benefits, such as cheap imported goods and huge financing possibilities, it also comes with liabilities, such as those we are encountering today. Globalized supply chains aren’t conducive to flourishing if the world’s economies are in a tailspin while supply is unusually limited. Likewise, US businesses can’t rely on buying pressure from foreign investors if these investors have less capital to work with themselves. Thus, the US stock market is in double jeopardy, as it must endure both global and domestic economic hardships.

Why the Stock Market Rally Is a Mirage

No More Deus Ex Machina Fed

The Federal Reserve, the central bank for the United States, has established a unique role for itself over the past fifteen years as the lender of last resort. During the financial crisis of 2008, as well as the pandemic-induced crash in 2020, the Federal Reserve undertook unprecedented measures to save the US economy through monetary stimulus. By implementing quantitative easing as well as low interest rates to escape recession via emergency expansion, the Fed made history by being willing to spend its way out of any economic crisis, stabilizing markets and causing stocks to rapidly appreciate in value.

However, with potential for recession and stagflation around the corner in the US economy, the Fed’s ability to play monetary savior is now severely restricted. With annual inflation over 9%, at 40-year highs, the Federal Reserve is forced to confront hyperinflation threats, even at the expense of consumers and businesses. The Fed won’t be able to rescue the markets with its usual dovish tricks because this time the contraction is of their own making, as a sort of necessary evil. This is incredibly bearish for US indices, because there will likely be no multi-trillion-dollar last-ditch effort to prop up corporate share prices this time.

Why the Stock Market Rally Is a Mirage

How Long Will This Last?

Unfortunately, it appears that both the US’ and the global battles against high inflation are just beginning. With the Federal Funds Rate currently hovering around 1.75% as inflation surpasses market forecasts, and the Federal Reserve reportedly considering a full 1% rate hike with many more hikes left to go, US indices are seemingly destined for a prolonged bear market. While it is virtually impossible to know when the stock market will hit bottom, with much disappointment for short-term bulls likely ahead, long-term investors can take heart, knowing that this can also mean myriad discounted buying opportunities over the next few years.

Key Takeaways

Warning: Stock Market Looking Bleak

This morning US investors were greeted to yet another unwelcome, though perhaps not unexpected, decline in the stock market. At the time of writing, the Dow Jones Industrial Average has slid over 300 points today, or over 1%, after recovering slightly from dropping over 500 points earlier this morning. The Nasdaq and S&P 500 have likewise dropped over 1% intraday. While these events are disappointing in themselves, they are part of a recent disturbing downtrend of significant proportions, including a brief dip into bear market territory and the worst performing first half for the S&P 500 in fifty years. Unfortunately, there only appear to be several possible paths forward, with none of them favorable to stock market bulls. Let’s explore what this means for traders and investors as we issue a warning: stock market looking bleak.

Path #1: Selloff by Further Rate Hikes

One likely possibility for the US economy is that the Federal Reserve continues implementing further rate hikes to curb hyperinflation. This seems quite plausible for three reasons: a) high inflation in the US has thus far persisted, with the most recent CPI data for May reflecting a 1% increase in inflation month-over-month, and an 8.6% increase year-over-year; b) historically, high inflation seems likely to continue, considering cooling the similarly overheated US economy forty years ago required double-digit target interest rates; c) Jerome Powell, Chair of the Federal Reserve, has already signaled that the Fed is willing to continue rate hikes as necessary, perhaps even resorting to more 75 basis point ones if needed.

If this comes to fruition, it would likely be bearish for the stock market since the Fed’s past several aggressive moves have ultimately prompted increased selling pressure for stocks. The Fed’s hawkishness particularly affects the stock market because its recent highs were due in large part to COVID-era dovish monetary policy, which shareholders ostensibly can’t rely on anymore.

Path #2: Selloff by Impending Recession

Another plausible possibility for the US economy is that it continues its descent into full-blown recession. Such features include recurring contractions in gross domestic product, higher unemployment rates, and lower consumer spending from the lack of work or decent income. This would likewise be a disaster for the stock market, since its performance is often interpreted as, and anticipated to be, a proxy for the health of the US economy. Low consumer spending equates to less money spent purchasing goods and services from businesses, as well as dwindling confidence and spare capital from potential buyers, sending share prices lower and forcing even more layoffs.

While a recession can theoretically cause low inflation via lower demand, and thus no more need for further interest rate hikes, the stock market would nonetheless be caught in the crossfire. While many economists anticipate recession being likely, if not imminent, even the Federal Reserve acknowledges the risks as they forecast higher unemployment and slower economic growth as unfortunate sacrifices for having stopped hyperinflation via contractionary monetary policy. The US stock market would thus be a central casualty if a recession is induced.

Path #3: Selloff by Stagflation

One particularly disturbing possibility for the US economy is the chance of stagflation, a nightmarish fusion of both recession and hyperinflation. This would entail most aspects of both paths 1 and 2 playing out simultaneously: economic activity would contract as consumers and businesses lose money in a vicious cycle, while prices remain unusually high, exacerbating the effects of recession. This unfortunately seems possible in the US because of how current global supply chain bottlenecks are contributing to inflation by restricting supply, causing the price of oil and other commodities to soar. Thus, there is a significant chance that this tragic phenomenon could occur, which would be doubly disastrous for the stock market.

The Bad News

Unfortunately, it is difficult to imagine a probable scenario in which the US stock market doesn’t plunge deeper into selling pressure. Continued bearishness over the next few years seems incredibly likely regardless of what exact problems deal these next few blows to the US economy. Thus, for any traders who are short-term stock market bulls, please know that the chances of a prolonged, near-future rally for equities seem slim. The US is no outlier, either; the global economy is currently afflicted with these same issues. We will have to weather this economic storm altogether.

Some Good News

However, for those who are long-term investors, any stock market selloffs can be understood as optimal buying opportunities. This is because the US economy, like other market or mixed economies, experiences business cycles: periods of expansion, followed by contraction, rinse and repeat. Due to the US’ abundance of natural resources, huge population, international influence, and more, the US economy is incredibly resilient and able to rebound from recession long-term.

This means that even if fundamentals don’t currently look good for the stock market, they are still promising through the decades, which net favors long-term shareholders and bulls. So long as investors stick to a thoroughly diversified portfolio, investing regularly in historically reliable funds such as index funds and other trustworthy ETFs, and abstain from premature selling due to worries and disappointment, bear markets present bargains for future wealth building.

Key Takeaways

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