The world’s long-anticipated stagflation crisis has begun

How do these predictions stack up? First, the team clearly lost to Team Persistent in the transitory inflation debate. On top of overly lax monetary, fiscal and credit policies, negative supply shocks pushed up prices. The Covid lockdown created supply constraints including 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 widespread sanctions regime, the weaponization of not least the US dollar and other currencies further weakening the global economy, ‘friend-shoring’ and trade and immigration sanctions has accelerated the trend of de-globalisation.

Everyone now believes that these persistent negative supply shocks have contributed to inflation. The European Central Bank (ECB), the Bank of England (BOE) and the US Federal Reserve have begun to recognize that it is extremely difficult to pull off a soft landing. Fed Chair Jerome Powell now talks of a “soft landing” with at least “some pain.” Meanwhile, a tougher scenario is becoming a consensus among market analysts, economists and investors.

It is much harder to achieve a soft landing in conditions of stagflation negative supply shocks than when the economy is overheating due to excessive demand. Since World War II, there has been no case where the Fed achieved a soft landing with inflation above 5% (it’s currently above 8%) and unemployment below 5% (it’s currently 3.7%). . And if the hard landing is the baseline for the US, it is likely even more so in Europe, thanks to Russian energy shocks, China’s slowdown and the ECB falling even further behind the curve relative to the US Fed.

Are we already in recession? Not now, but the US has posted 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 worsen with monetary-policy tightening. Hard landing should be considered as a baseline scenario by the end of 2022.

While many other analysts now agree, they think the impending recession will be short and shallow, while I caution against such relative optimism, emphasizing the risk of a severe and prolonged stable debt crisis. And now, the latest crisis in financial markets – including the bond and credit markets – has reinforced my view that central banks’ efforts to get inflation back on target will lead to both economic and financial crashes.

I have also argued for a long time that the scenario of a hard economic landing and a financial crash unfolding would make central banks, regardless of their harsh words, feel immense pressure to reverse their rigors. Early signs of wimping out can already be seen in the UK. Faced with market reaction to the government’s reckless fiscal stimulus, the BoE launched an emergency quantitative-easing (QE) program to buy government bonds. [yields on which had spiked before a part rollback],

Monetary policy is increasingly subject to fiscal capture. Recall that a similar change occurred in the first quarter of 2019, when the Fed discontinued its quantitative-tightening (QT) program and began pursuing a mix of back-door QE and policy-rate cuts. Given — first followed by signs of sustained rate hikes and QT — at the first signs of mild financial pressure and a slowdown in growth. Central banks will talk tough; But in a world of extreme debt coupled with the risk of an economic and financial crash, there is good reason to doubt their willingness to “do whatever it takes” to bring inflation back to its target rate.

Furthermore, there are early signs that the Great Moderation has given way to the Great Stagflation, which will be characterized by a confluence of volatility and slow-moving negative supply shocks. In addition to the disruptions mentioned above, these shocks could include social aging in many major economies (a problem made worse by immigration restrictions); Sino-American decoupling; a ‘geopolitical depression’ and the breakdown of multilateralism; new forms of covid and new outbreaks, such as monkeypox; The increasingly harmful consequences of climate change; Cyber ​​warfare; and fiscal policies to boost wages and workers’ power.

Where does that leave the traditional 60/40 portfolio? I previously argued that a negative correlation between bond and equity prices would break down as inflation rises, and in fact it is. Between January and June this year, US (and global) equity indices fell more than 20%, while long-term bond yields rose from 1.5% to 3.5%, leading to heavy losses on both equities and bonds (ie. , a positive price correlation) )

In addition, bond yields fell during the market rally between July and mid-August (which I correctly predicted would be a dead-cat boom), thus maintaining a positive price correlation; And since mid-August, equities have continued to fall sharply, while bond yields have risen significantly. As high inflation has led to tighter monetary policy, a balanced bear market has emerged for both equities and bonds.

But US and global equities have yet to fully price in even light and short hard landings. Equities would fall by about 30% in a mild recession, and the severe inflationary debt crisis I predicted for the global economy would fall by 40% or more. Signs of tension are rising in debt markets: sovereign spreads and long-term bond rates are rising, and high-yield spreads are rising rapidly; The leveraged-loan and collateralized-debt-obligation markets are closing in; Highly indebted firms, shadow banks, families, governments and countries are entering a debt crisis. The crisis is here. ©2022/Project Syndicate

Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business, and the author of the forthcoming ‘Mega Threats: Ten Dangerous Trends That Imperfect Our Future, and How to Survive Them’.