Another Strange Recession

March 13, 2022
  • That Seventies Show
  • Toxic Brew
  • Misery Index
  • Velocity, Banks, and the Dollar
  • Incomplete Homework and Speech Recognition

Back in the good old days, recessions were simply the unpleasant part of the business cycle. Consumer choices, exuberant businesses, and monetary policy would periodically generate growth contractions. We debated the timing, but recessions didn’t come out of the blue.

Then in 2020, a recession did come out of the blue, or nearly so, when COVID unexpectedly changed behavior. Working from home, avoiding travel, etc., caused a sudden drop in services demand, and thus recession. This wasn’t part of the business cycle.

Now it’s 2022 and another strange recession looms. That’s right, I’m calling it: Recession is here, or will be soon. And unfortunately, it will be a global recession. Like the COVID recession, this one has little to do with the business cycle. It’s a recession of choice—not your choice or mine, but Vladimir Putin’s. He clearly miscalculated how hard capturing Ukraine would be and how the West would react.

Most recessions are preceded by an inverted yield curve, when long bond rates drop below short bond rates. Further, the inversion had to go relatively deep and last for some time to really be reliable as a recession predictor. When I called a recession in 2001 and in 2007, those conditions existed. Like a fever indicates something is wrong in your body, an inverted yield curve tells us there is something wrong in our economic body.

In this case, the economy was already slowing down and at stall speed. We’ll look at some data to demonstrate that. But this war will make it worse and the longer it goes the worse it will get. I don’t see the sanctions ending as long as Putin stays in power. Further, I think Western countries will change who they rely upon for energy in any event.

We always get through recessions and there will be a recovery. It’s not the end of the world, just a readjustment. But regardless, we’re here. And I think we’ll be here for quite some time.

That Seventies Show

This recession is strange for another reason, too. Most recessions are de flationary. Negative growth and rising prices don’t normally occur together. Unemployed people have little choice but to reduce spending, so most businesses lack pricing power.

However, a recession can be inflationary when accompanied by a supply shock in essential goods. Then you get falling growth and rising prices at the same time—an especially miserable combination. We call this stagflation : stagnation + inflation, and it last occurred in the 1970s. And for similar reasons: higher energy prices. In that case they came from the Arab oil embargo. This time it’s a buyer’s embargo as Western countries stop trade with Russia. Since most of that trade is energy-related, energy prices are rising.

But it won’t be just energy prices. Benchmarks like the Consumer Price Index report something called “core inflation.” This is the full index minus the food and energy categories. We laugh at it because actual consumers don’t have the option of omitting food and energy spending. But this figure actually has a point.

Food and energy are the starting point for almost everything else. (Food is a kind of energy; it just powers humans instead of machines.) Louis Gave likes to say all economic activity is simply “energy transformed.” We pull coal, oil, etc., out of the ground, process them, and after several steps we have cars, computers, and all other goods. Without energy it never gets that far.

We expect volatility in food and energy prices. At some point, it seeps into the price of other goods and services. That is a sign of more serious inflation, which is why the Fed watches core PCE. We have a problem beyond just normal volatility if it’s rising.

Functionally, higher energy prices are similar to a tax increase. Yes, we can do things to reduce the burden, but it’s hard to escape. We have to keep the lights and heat on, have fuel to drive to work and so on. On a percentage basis, a 1 cent rise in gasoline costs the US economy $1.4 billion. That means we have the equivalent of a $200 billion tax increase hitting the economy this year. That’s not including the food costs and other energy increases that work their way through the market. By the way, the $4.19 gas price this chart shows is a national average. My eight kids in Texas, Oklahoma, Colorado, and Florida tell me they see much higher.

Source: YCharts

The macro effects of all this take time. At first people just grumble. But eventually, they start changing their behavior. They stop taking the boat out on weekends, don’t drive to the beach as often, look for jobs closer to home. Maybe they try to sell the giant SUV and find it’s not worth as much as they thought. This affects their confidence so they reduce other spending. And because inflation is higher than their wage increases, they feel even more pressure.

Businesses experience similar changes. Those in fuel-intensive segments (airlines, delivery, construction) see their costs rise quickly. At some point they have to raise prices, which makes their customers look for alternatives—or stop buying.

All this continues until something ends the supply/demand imbalance that caused the initial energy shock. That could be new supply, reduced demand, or a combination of both. One thing that makes commodities different from other goods is their fungibility. Oil is oil, wheat is wheat, regardless of origin. (Yes, I know there are different grades and varieties. They matter but we’re talking macro here.)

So if, as happened this week, the US and UK ban imported Russian oil, the global oil supply may not change much. Russia will sell that oil to someone else while the US and UK find other sellers. Everyone typically is still buying and selling the same amounts they were before, just from different counterparties.

But it’s not clear this will go that way. The economic sanctions disrupt the financial mechanisms that permit Russian trade. And even if they didn’t, it may not be possible to deliver the oil to other buyers. Pipeline and shipping capacity have limits. China buys a lot of Russian oil now, but they get it from eastern Russia. The oil produced further north and west? There are no pipelines to get it to China cheaply. It will take years to build the infrastructure to redirect not just Russian oil but grain and everything else.

Another open question is how long Russia can sustain oil and gas production at the current amounts. Much of it is (was) operated by Western companies that have now left, using equipment and technology that sooner or later will need maintenance and spare parts.

Balancing that is the possibility of increased production from elsewhere. OPEC has unused capacity it could bring online fairly soon. US officials are reportedly talking to Iran and Venezuela. Some US shale companies might be able to produce more. All those would help, but we don’t know how much or for how long. Fully replacing Russian energy exports seems unlikely—which means energy prices will stay elevated for some time.

Long story short? Energy spikes preceded almost every recession for the last 80 years. We now have another one.

Source: Pictet Asset Management

Toxic Brew

The other aspect of this, not yet getting as much attention as it should, is the very real possibility of global food shortages. Russia and Ukraine are both major grain exporters. Spring planting season will be difficult for farmers in the battle zones. Meanwhile the same economic sanctions that hinder Russian energy exports will have a similar effect on agricultural goods. That’s why wheat futures prices have been hitting their daily limit. This next chart shows you the importance of Ukraine and Russia to important grains and oils.

Source: Geopolitical Futures

Last week we sent Over My Shoulder members a fascinating and somewhat terrifying report about Egypt’s food crisis. The staple diet in that nation of 105 million people relies on large imports of wheat and sunflower oil. Some 85% of the wheat comes from Russia and Ukraine, and 73% of the sunflower oil.

No surprise, Egypt’s government is not aboard the sanctions train. It has no choice. Food is first, particularly in a country where food inflation has brought down more than one regime. The opposite is more normal; Cairo heavily subsidizes food prices to maintain order.

How is that going to work now, with dramatically higher import prices and a worldwide recession to boot? If Egypt continues subsidizing food, which is likely, it will cost the country multiple billions of dollars that it really doesn’t have.

Now, multiply this challenge by dozens of other developing countries. On top of the human suffering and possible starvation, the economic effects could be giant. Governments that have to subsidize food prices may have to skimp on servicing foreign debts. Lenders could receive rude surprises, which leads nowhere good when financial markets are already overleveraged and overvalued.

Look at how important Ukraine and Russia are to these Mediterranean countries:

Source: Geopolitical Futures

It gets worse. The money governments redirect to basic needs is money that won’t be spent on infrastructure, education, and other productivity-enhancing projects. This will further reduce growth.

Now imagine you are a US tech giant that does business in all these markets, and has been counting on growth there to justify your stock valuation. How will that go? You can see the toxic brew before us.

And there’s yet more. “Normal” recessions end when consumers and businesses make adjustments sufficient to restore growth. That hope is slim this time, at least in the short term. As I noted last week, this is change squared. The entire world order is experiencing a shock adjustment—economically, geopolitically, and otherwise. We are not going back to January 2022. That world is gone—even if Putin and Zelensky reach some kind of cease-fire agreement soon.

My friend Vitaliy Katsenelsen (whose Coming to America story I sent you in December) has been following Russian media and talking to friends who still live there. He is not optimistic about Putin losing power. More the opposite: In a chilling tweet , he said “They are preparing to turn Russia into North Korea.”

That parallel, if accurate, is economically problematic. North Korea has been cut off from most of the world economy for decades, yet the regime survives. The sanctions we have placed on Russia, while necessary (and certainly preferable to a wider war), could last a long, long time.

I think we can adjust to a world split between two blocs with limited interaction. I don’t see how we complete the adjustment this year, though. Shifting supply chains takes time, and creating new production facilities takes even more time and money.


The symbol for silver ‘AG’ comes from the Latin word ‘agentum’ meaning silver.

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