• William Bourne

Are we in for a global recession in 2023? | Linchpin

Peering into the future direction of markets is never easy. The Russian invasion of Ukraine makes it even more difficult than usual; decision-makers on all sides are driven by considerations other than those which the market might consider rational. However, that said, let me extricate my night vision goggles and try to look into the future.

The first “certainty” is that consumer spending power is going to take a huge hit everywhere over the next six months from the higher cost of food and energy. The closest comparator is probably the 1973 oil embargo when OPEC nations refused to export to countries which had supported Israel in the Yom Kippur war. The price of oil rose by 300% between October and December 1973 and triggered a global recession. Today fossil fuels are less important, though they still account for around 80% of energy generation, but the quantums involved are far greater.

Food matters more than energy

Food seems to me to matter more than energy because it is harder to replace and even more essential. Russia and the Ukraine account for 33% of all corn exports and 28% of wheat. Sanctions will limit Russian and Belarussian exports and it is clear that the Ukraine planting season will be missed. Russia and Belarus are also the second and third largest potash exporters, which is an important fertiliser, and that may extend the problems.

There is sufficient energy in the world to replace Russian gas exports. The immediate issue is that it is either dirtier and clashes with the West’s net zero carbon agenda, or it takes some time to bring on stream (e.g. nuclear). As one quick example, if Japan were to restart all its idle nuclear power stations, it might take a year but would generate enough energy to replace about one third of Russian gas exports to Europe.

In the longer term, higher energy prices will stimulate the renewable energy industry and lessen the West’s dependence on Russian (and fossil fuel) energy. It may happen sooner rather than later, as much of Russia’s gas reserves sit in Siberia, where they need western technology to extract it.

Refinancing and debt service are two pressure points

The second fact is that there is a great deal of debt built up in the world after 13 years of virtually free money. The two pressure points here, if interest rates and bond yields rise, are borrowers’ ability first to service their debt and secondly to refinance it.

Government debt tends to have a long maturity and be fixed rate, but is only refinanced over time as historic bonds mature. Refinancing and servicing difficulties therefore emerge gradually. Consumer debt tends to be lumpier and, at least in the U.K., floating rate. Debt service is therefore more likely to be the immediate problem.

Corporate debt can differ greatly in terms of maturity and is more likely to be fixed rate. However, there is a wide swathe of US corporates who depend on very short-term repo markets for their finance. Both in 2008/9 and in 2018 these markets seized up and refinancing was a problem. There has to be a big question-mark how far corporates and consumers can stand a rise in interest rates.

Against the background of these two hard constraints, most else depends on how decision-makers react to events, and in particular the flare-up of inflation. First and foremost, of course, are the central banks. They are now clearly reducing their balance sheets almost everywhere and at least in the West talking tough about interest rate rises. They may be looking at the aftermath of the Second World War when they were successful in depowering a supply-side inflationary surge by shrinking their balance sheets.

Central banks almost always make policy errors, simply because they are driving down the road with limited tools to alter direction. It is no great surprise that they often verge off it either to right or left. In my view the odds today are high that in the west make another one by tightening policy too much at exactly the time when consumers are being hit by higher food and energy prices.

Over the years I have encouraged investors to see China as an influence on macro-economic trends just as important as the United States. Given the travails of Evergrande, it is tempting to look to the PBOC to provide some stimulus. However, the evidence for that is simply not there. As data from our friends at CrossBorder Capital shows, the Chinese authorities have been withdrawing liquidity for much of the past nine months since the Evergrande problems first came to the world’s attention.

A global recession in 2023? | Linchpin

If we put all this together, a global recession seems to me much more likely than equity markets are suggesting. Evidence from the bond and credit markets is certainly pointing in this direction. The U.S. bond market yield curve is inverting as the short end rises, volatility in fixed interest markets is the highest for over a decade, and credit spreads are widening. It is not the first time they have pointed in a different direction to equity markets, but the combination of these signals with high inflation should be frightening the life out of investors.

The only reason I can see why it isn’t, is that investors are expecting central banks at some point to reverse course and start easing again. That may yet happen on the back of geo-political fragility or a slowing economy ahead of the next electoral cycle in the U.K. and the U.S., but to invest on the basis of that seems to me to be looking round one too many corners.

Please contact Linchpin here if you would like to hear more.