Recession fears have so far focused largely on the United States. However, the file note From Capital Economics to its clients anticipating that we are likely to see a recession in Europe.
Are US fears of recession really true?
Most US economists’ fears of a recession stemmed from last month’s short reversal in the spread between US 2-year and 10-year Treasury yields. Historically, this curve has inverted before every US recession in the past 50 years. In fact, there was only one significant false positive, and it came back again 1998.
As expected, economists warned that ignoring the yield curve would essentially be a “bet on history.” However, CE notes that large-scale central bank asset purchases over the past decade have distorted the dynamics driving the curve. In their opinion, this severed the relationship between short and long-term returns.
A closer look at the shapes
Consider a “short-term” 2-year chart rather than a 90-day chart. In doing so, it becomes clear that the relationship between the two-year chart and the 10-year chart doesn’t actually show any reversal. According to the logic of most economists, this does not indicate an upcoming recession. at least no distance.
The CE also advised that US household balances are extraordinarily strong from a historical point of view. They went on to point out that the Fed’s tightening policy is likely to soon mix with easing post-COVID supply chain frictions. This may cool the economy down a bit, but it should help avert an all-out recession.
Point stagnation fears across the pond
Unfortunately, the real red flags of recession are spreading in Europe. For one thing, trend growth is already much lower there (1% compared to 2% in the US). This leaves a much smaller margin of error. Second, Europe is a larger net importer of goods than the United States.
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Therefore, as commodity inflation moves into prices, inflation risks exceeding even the historically high estimates that are currently being discussed. If this happens, it will likely culminate in a decline in both consumer spending and investment.
Real Disposable Income of US Households and Eurozone (Q4 2019 = 100)
Chart courtesy of Capital Economics
And whether Europe falls into a mild technical recession or simply stagnates for 2 or 3 quarters, it may not make any appreciable difference in the long run. However, Europe’s poor performance will be a drag on global growth, no matter how easy or difficult the landing may be. Moreover, it is likely to be onset in later years of slower growth than we would have expected just 6-12 months ago.
Obviously a lot will depend on how aggressively the ECB raises rates. At the moment, markets are expecting 0.25% by the end of the year, but CE is less certain. Recently, they suggested that the first quarter could come as soon as July. Such aggressive narrowing can upset already fragile feelings. This is especially likely if it comes on top of declining real income compared to higher inflation this year.
Metal prices have already been affected by the dollar’s rally this week. There were also sharp sell-offs of aluminum, copper and palladium in particular. It is as if the markets have finally woken up to the changing fundamentals.
Written by Stuart Burns via AG Metal Miner
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