How do these predictions stack up? First, Team Transitory clearly lost to Team Persistent in the inflation debate. On top of excessively loose monetary, fiscal and credit policies, negative supply shocks caused price growth to surge. Covid lockdowns led to supply bottlenecks, including for labour. China’s ‘zero-covid’ policy created even more problems for global supply chains. Russia’s invasion of Ukraine sent shock waves through energy and other commodity markets. And the broader sanctions regime, not least the weaponization of the US dollar and other currencies, has balkanized the global economy further, with ‘friend-shoring’ and trade and immigration restrictions accelerating the trend towards de-globalization.
Everyone now recognizes that these persistent negative supply shocks have contributed to inflation. The European Central Bank (ECB), Bank of England (BoE) and US Federal Reserve have begun to acknowledge that a soft landing is exceedingly difficult to pull off. Fed Chair Jerome Powell now speaks of a “softish landing" with at least “some pain." Meanwhile, a hard-landing scenario is becoming the consensus among market analysts, economists and investors.
It is much harder to achieve a soft landing under conditions of stagflationary negative supply shocks than it is when the economy is overheating because of excessive demand. Since World War II, there has never been a case where the Fed achieved a soft landing with inflation above 5% (it is currently above 8%) and unemployment below 5% (it is currently 3.7%). And if a hard landing is the baseline for the US, it is even more likely in Europe, owing to the Russian energy shock, China’s slowdown and the ECB falling even further behind the curve relative to the US Fed.
Are we already in a recession? Not yet, but the US did report negative growth in the first half of the year, and most forward-looking indicators of economic activity in advanced economies point to a sharp slowdown that will grow even worse with monetary-policy tightening. A hard landing by end 2022 should be regarded as the baseline scenario.
While many other analysts now agree, they seem to think that the coming recession will be short and shallow, whereas I have cautioned against such relative optimism, stressing the risk of a severe and protracted stagflationary debt crisis. And now, the latest distress in financial markets—including bond and credit markets—has reinforced my view that central banks’ efforts to bring inflation back down to target will cause both an economic and a financial crash.
I have also long argued that central banks, regardless of their tough talk, will feel immense pressure to reverse their tightening once the scenario of a hard economic landing and a financial crash materializes. Early signs of wimping out are already discernible in the UK. Faced with the market reaction to the government’s reckless fiscal stimulus, the BoE launched an emergency quantitative-easing (QE) programme to buy up government bonds [yields on which had spiked before a part rollback].
Monetary policy is increasingly subject to fiscal capture. Recall that a similar turnaround occurred in the first quarter of 2019, when the Fed stopped its quantitative-tightening (QT) programme and started pursuing a mix of back-door QE and policy-rate cuts—after previously signalling continued rate hikes and QT—at the first sign of mild financial pressures and a growth slowdown. Central banks will talk tough; but there is good reason to doubt their willingness to do “whatever it takes" to return inflation to its target rate in a world of excessive debt with risks of an economic and financial crash.
Moreover, there are early signs that the Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of slow-motion negative supply shocks. In addition to the disruptions mentioned above, these shocks could include societal ageing in many key economies (a problem made worse by immigration restrictions); Sino-American decoupling; a ‘geo- political depression’ and breakdown of multilateralism; new variants of covid and new outbreaks, such as monkeypox; the increasingly damaging consequences of climate change; cyberwarfare; and fiscal policies to boost wages and workers’ power.
Where does that leave the traditional 60/40 portfolio? I’d earlier argued that a negative correlation between bond and equity prices would break down as inflation rises, and indeed it has. Between January and June of this year, US (and global) equity indices fell by over 20% while long-term bond yields rose from 1.5% to 3.5%, leading to massive losses on both equities and bonds (i.e., a positive price correlation).
Moreover, bond yields fell during the market rally between July and mid-August (which I correctly predicted would be a dead-cat bounce), thus maintaining the positive price correlation; and since mid-August, equities have continued their sharp fall while bond yields have gone much higher. As higher inflation has led to tighter monetary policy, a balanced bear market for both equities and bonds has emerged.
But US and global equities have not yet fully priced in even a mild and short hard landing. Equities will fall by about 30% in a mild recession, and by 40% or more in the severe stagflationary debt crisis that I have predicted for the global economy. Signs of strain in debt markets are mounting: sovereign spreads and long-term bond rates are rising, and high-yield spreads are increasing sharply; leveraged-loan and collateralized-loan- obligation markets are shutting down; highly indebted firms, shadow banks, households, governments and countries are entering debt distress. The crisis is here. ©2022/Project Syndicate
Nouriel Roubini is professor emeritus of economics at New York University’s Stern School of Business, and author of the forthcoming ‘MegaThreats: Ten Dangerous Trends that Imperil Our Future, and How to Survive Them’
