01 Oct Cassandra Economics
“Will the 2020s be defined by recession, rising unemployment, crashing stock markets and instability?” – The Lonely Realist
Cassandra believes so but, then, she’s a catastrophist. Unfortunately, she’s not alone.
Nouriel Roubini – today’s “Doctor Doom” – is predicting that the world is at the very beginning of a deep economic downturn. “Even in a plain vanilla recession,” he says, “the S&P 500 can fall by 30%.” Roubini expects worse: “It’s not going to be a short and shallow recession. It’s going to be severe, long and ugly.” Then there’s permabear David Rosenberg, the famed former Chief Economist at Gluskin Sheff, who has stated that the Federal Reserve’s interest rate hikes “will kill the economy” …, and Michael Burry, renowned for his “Big Short” bet against the 2008 subprime mortgage bubble, who believes that the stock market is in the middle of a major crash …, and Mark Mobius, the respected former executive chairman of Templeton Emerging Markets Group, who has cautioned that “The picture looks very bad [and] I still think it’s going to get worse.”
Less pessimism characterizes investment bankers’ perspectives. Although Goldman Sachs, Morgan Stanley, and JP Morgan et al have cut their economic and growth targets for 2022 and 2023, each sees economic recovery by the middle of next year …, but isn’t that the buy-side’s perpetual mantra? “Stay the course.” “No one can time the markets?”
TLR has consistently relied on Cassandra for her prescient macroeconomic predictions (noting that the contents of TLR are not investment, legal or tax advice). In a recent conversation, when asked what she foresees, Cassandra provided a uniquely pessimistic perspective on today’s economic climate:
The Realist: Good afternoon, Cassandra. In a departure from our normal Q&A interchange, what I’d like to do today is turn the floor over to you to prophesize on economic direction. Would that be OK?
Cassandra: It would be my pleasure, Mr. Realist. Interestingly, you’ve chosen a particularly opportune time for me to do so. The economic climate is the clearest I’ve seen in the last 70 years. The fulcrum in 2022, you see, is energy. Economic direction therefore can be discerned by analyzing how energy will be impacting each country’s wealth. When I say energy, I’m talking only about crude oil and natural gas, not coal or green alternatives. The global economy today continues to depend on fossil fuels and is being radically altered by the rebalancing of energy suppliers and demanders. Energy suppliers Saudi Arabia, Oman, the UAE, the U.S. and Russia are the winners in this energy lottery. The biggest losers are the EU, Japan and the UK, the world’s hungriest energy importers. This rebalancing has come about through a combination of the Ukraine War – which has cut-off the West from Russia, the world’s largest oil and gas exporter –, Western sanctions against Russia, China and their Axis allies – which have struck deeply into global GDP –, and the end of cheap energy – prices hereafter will only be going up.
The immediate economic impact on the U.S. is positive. Longer term it is the opposite. The Dollar is at a 20-year high. It is rising at an unprecedented rate because the U.S. is both energy self-sufficient and the issuer of the world’s reserve currency. Denomination of crude oil and natural gas in Dollars is a cornerstone of America’s “exorbitant privilege,” making Dollars ever more precious because energy-starved countries are required to accumulate – and use – an increasing amount of Dollars. The need for Dollars has been exacerbated by (1) the Fed’s decision to raise interest rates (which I predict will top-out at 5%), creating more demand for Dollars by foreign investors (the U.S. today is the “safest haven”), (2) the Fed’s Quantitative Tightening (QT), which means that an additional $95 billion of Treasury securities must be issued each month, (3) America’s budget deficit, which requires the U.S. to finance its spending by selling increasing quantities of Treasury securities, (4) the increase in the interest rate payable by the U.S. on its Treasury securities, requiring the issuance of yet more Treasury securities, and (5) the increase in America’s entitlement obligations caused by inflation, baby boomer Social Security and Medicare obligations, forgiveness of student loan debt, etc. What this means is that the Fed is withdrawing Dollar liquidity (QT) at the same time that the U.S. government is overspending and foreigners are in need of more Dollars to purchase oil and gas, etc.
These stresses increased in September when the Fed confirmed that it will continue tightening … until something breaks. The British Pound broke shortly thereafter when the Truss Administration announced Reaganesque-like tax cuts without offsetting revenue raisers. UK bonds promptly crashed, pushing the Pound to an all-time low against the Dollar (the UK has the 3rd largest holding of U.S. Treasuries that, at some point, it may need to sell to raise Dollars). The Japanese Yen also is breaking with the Bank of Japan intervening to sell Dollars for the first time in 24 years (as the world’s largest holder, it too may have to start selling U.S. Treasuries; China is #2). The Euro could be next (with Italy as a flash point). And then…?
What the world is seeing, Mr. Realist, is a slow-motion pyramiding of energy, currency and U.S. Treasury (and other) crises (with geopolitical overtones) arising from excessive government debt accumulated over the last two decades. The UK and Japan have provided a preview: Energy-starved countries soon may be compelled to sell Dollar assets to pay for needed oil and gas or may need to pay for their energy using producers’ currencies (e.g., Rubles). Either would undermine the U.S. Treasury market and, ultimately, Dollar hegemony. An alternative would be for the U.S. to double down on Modern Monetary Theory by a Fed policy reversal with a renewal of Dollar printing. That would threaten hyperinflation.
For me, Mr. Realist, the spark that could ignite today’s risks is the Dollar, neatly framed by Societe Generale strategist Kit Juckes: “This has all the hallmarks of the start of the final stage of the dollar’s rally (a stage which has the capacity to be violent and volatile).” If so, the next number of years indeed are likely to be defined by recession, rising unemployment, crashing stock markets and instability.
The Realist (clearing his throat): Thank you, Cassandra. You’ve once again provided a chilling, cautionary reminder of what it means to be “a Cassandra.”
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Finally (from a good friend)
jeffcsiegel
Posted at 06:46h, 03 October5% sounds about right. It will be tough for the Fed to increase above 4% since our deficit & debt balloon with higher rates. I expect them to move back to 4% a year later when pressure forces them to. Larry Summer’s thinks we need 6% unemployment to kill inflation. I read his paper on it, and frankly didn’t understand all of it, but I still think he is probably correct. He usually is.
Some data points:
1) I don’t think we fully realized how much of the market asset bubble was fueled by corporate debt, and how hard that will be to handle at higher rates. Private equity has stopped purchasing companies, and public companies have enormous debts they build up to do stuff like acquire companies and buy-back their own stocks. At near zero % rates that leverage looked like a smart play. Add 4%, and it isn’t. Deleveraging will move us from hiring freezes to layoffs.
2) Manufacturing, particularly in Europe, is dead. The more than doubling of energy costs is crushing companies. The relatively cheap energy we have in the US is giving our manufacturers an advantage.
3) While Macro issues may break it, the market historically recovers from a 20% downturn in a year, 70% of the time with a 15% average gain. Post-midterms are also good for the market.