If this period feels more chaotic than any in recent memory, it is because many of our previous assumptions are being challenged.
The mixed signals from the economy right now show that we're facing higher risks than we have in recent decades.
I t was the best of times, it was the worst of times, it was the age of maximum employment, it was the age of abysmal recession, it was the epoch of crypto beliefs, it was the epoch of SPAC visions, it was the season of inflation, it was the season of war, it was the spring of stocks, it was the winter of bonds, we had Covid behind us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way — in short, this period has so far been like nothing ever seen before, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only (with gratitude to Charles Dickens).
These conflicting narratives give a new meaning to Harry Truman’s quip that he wished for a one-handed economist because his own always qualified their advice to him with “on the other hand.”
On the other hand, the job of forecasting is extremely difficult. Anyone who claims to predict the next economic figure with certainty is either young, overly confident, or a quack. Since most of us are none of these things, we have to think in rational probabilities when considering any and all economic outcomes. And we should remember that the chosen outcome is not assured by any means; it merely has in our view a higher probability than other outcomes.
And so, that said, looking at the state of the economy and of the markets today, where do we stand? The U.S. stock market is down 12 percent year-to-date, but it was down 22 percent YTD in mid June. Oil and gasoline are up 20 and 36 percent YTD, but they were up 74 and 94 percent YTD two months ago. (All performance figures are as of midday on August 10.) The Fed has started to tighten, but real interest rates remain solidly negative. Official inflation is near a 40-year record per the CPI, but other indicators have rolled over, suggesting that CPI itself will soon break decisively on the downside.
Commodities have sold off since mid June, giving optimists some reassurance that the worst has passed and that markets are headed toward a genuine recovery, instead of just a bear-market rally. The price of WTI crude oil peaked in March at $130 per barrel and made a more recent high of $123 on June 8th, but it is now near $90. Copper, said to be the “commodity with a PhD in economics” because its fluctuations often predict the course of the economy, was at $4.6 per pound in June, and it is now at $3.6. The same declines were seen in other energy (gasoline), metals, and agricultural commodities. This wholesale retrenchment has resulted in new hopes that inflation may also have crested and that the market can now go back to the business of pricing companies on their own fundamentals.
But if we look at inflation in December 2021, the CPI was already at 7 percent, before the large acceleration in commodity prices in 2022. This means that the fall in commodities could, and probably will, result in lower inflation. But it also means that inflation could remain uncomfortably high, and high enough to warrant more Fed rate hikes.
Looking at a somewhat bigger picture, consider the factors facing the economy that are inflationary (in the non-technical sense of the word, that they contribute to higher prices). Budget deficits are inflationary. As is full employment. Deterring investments in fossil fuels is inflationary. A reversal of globalization is undoubtedly inflationary. Reshoring of manufacturing that was outsourced to other countries is not only inflationary, but also negative for corporate gross margins, a potential double whammy for stocks.
The tragedy of war should never be weighed in only economic terms, but a China-Taiwan war would also be highly inflationary because trade would be greatly disrupted. We would see something far worse than the post-pandemic mess in supply lines. Consider that U.S. imports from China totaled $542 billion in 2021, of which $135 billion were in electric and electronic equipment. Replacing these imports from domestic sources would cost more and would take time.
Due to a confluence of events in 2020–2022 starting with the pandemic and culminating now with Taiwan-related tensions, we face a higher risk of price pressures from all of these factors.
Of course, there is the scenario of recession by which demand declines to such an extent that inflation fades quickly. While this would “solve” inflation, it would lead to many other problems. And that is the reason that economists at the Fed are hoping that they can engineer a soft landing, a slowdown in inflation without recession.
If this period feels more chaotic than any in recent memory, it is because many of our previous assumptions are being challenged: that other large powers will exercise restraint in war; that a rules-based order benefits everyone; that open trade raises every country’s standard of living; that democracy is gaining ground; that as a result of all the above the geopolitical risk premium will remain low. These are the foundations upon which the low inflation and bull market of decades was built. Are we now experiencing a brief pause or the start of a major unwind?