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August 14, 2022

Why Global Recession Is Still Likely

Michael J. Donoghue
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.

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