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Rocky stock and bond markets are struggling to price in this spring’s three biggest economic shocks: commodity price spikes from Russia sanctions, slowing Chinese demand amid fresh lockdowns and the Federal Reserve’s sharp, hawkish turn.
But deeper cracks in the world’s economic and political order are visible too. Long-term inflation expectations, expansive European spending and fresh threats to trade integration could make the next business cycle very different from the last.
Central bankers will likely tame prices without a U.S. recession as supply chains normalize and demand moderates. But listen closely. After four decades of deflationary pressures from aging demographics, relentless technological progress, and global trade integration, there are worrying background noises that threaten to unleash more price increases than we have seen since Jimmy Carter was president.
On current numbers, the U.S. economy still looks robust with workers enjoying good wage growth and ample savings buffers. Spending still looks healthy, and the latest PMI surveys record strong activity even if they reflect some worries over rising prices.
The last month brought increasingly determined rhetoric from the Federal Reserve, however, with markets expecting policy rates well above 2.5% by the end of the year. Consumer spending will surely cool as food, fuel, and housing costs all move higher, but growth looks likely to slow without triggering a recession.
There is a deeper worry, of course, that markets
SPX,
are not yet pricing in any slip in long-term inflation expectations. The St. Louis Fed’s survey has prices rising in five years and still well within historical ranges at 2.48% on the latest reading, but that number has jumped from 1.92% in mid-January.
The longer the Fed takes to bring prices under control, the greater the risk of higher wages driving higher prices in an upward spiral. Tight commodity markets and slow normalization of supply chains predate the Ukraine invasion and may signal something more enduring is afoot.
In Europe, the shocks from war are visible everywhere. The labor market is strong, but consumers are bracing for worse times ahead. Lining up alternative energy suppliers may come over a few years, but a rapid transition will add to the continent’s costs. A very hasty transition, triggered by gas cutoffs like Poland and Bulgaria now face, raises the odds of a recession significantly.
Here, too, there are deeper shifts that could drive prices higher for longer as the continent digs in on its commitment to Kyiv and isolation of Moscow. This will mean finding new and likely more-expensive trading partners to replace Russia, higher spending on defense as Sweden and Finland consider NATO membership, and a long-term commitment to the reconstruction of Ukraine. This comes on top of large spending promises to accelerate the green transition and a fresh attempt to rethink the iconic spending limits within the Maastricht Treaty.
Market expectations about long-term European spending discipline—and euro area price stability—could easily slip, too.
In Asia, China’s latest COVID-19 outbreak has triggered lockdowns that cover nearly one-third of the population and scuppered the recovery in domestic consumption. The impact on production appears limited so far, but it’s hard to see how the government will impose strict pandemic restrictions and meet its ambitious 5.2% growth target this year.
There is a much more significant shift underway in Asia, however, as Russia’s “Special Operation” grinds ahead and forces major regional economies to choose sides. Treasury Secretary Janet Yellen issued as sharp a warning as we have heard from Washington that the U.S. intends to enforce its sanctions vigorously. Japan, Korea, and Australia are among those who are firmly lined up against Russia, but China and India are clearly not. Others are trying to avoid taking sides.
As the Ukrainian death toll mounts, so will the pressure for secondary sanctions on firms that continue doing business with Russia. The risks are rising rapidly for a much more difficult set of trade and finance relationships in the world’s fastest-growing region. This includes the prospect of higher tariffs, more discriminatory rules and sudden retaliatory sanctions.
It has been a long time since investors have seen headwinds this stiff from rising prices and rates, but it has also been a long time since investors have seen a U.S. economy with consumers and companies in such good shape. While the base case remains that demand cools without a U.S. recession next year, these deeper tectonic shifts in foundational assumptions put this “happy ending” at risk.
If it feels like the ground beneath your feet is shifting, it is.
Christopher Smart is chief global strategist and head of the Barings Investment Institute. Follow him on Twitter @csmart.
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