Economic Cycle Graphic Book

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The Russian invasion of Ukraine and retaliatory sanctions are creating economic uncertainty and a supply shock on commodity prices (notably oil/gas, wheat and nickel). Soaring oil prices increase the risk of recession.

The sanctions have created a financial crisis in Russia but may not have much impact on Russia’s position vis-à-vis Ukraine. A negotiated peace would probably be the best development for economic prospects. This seems unlikely in the short term. And yet, the West’s massive voluntary cancellation of Russia could be permanent, with lingering effects for global supply chains.

While the market is focused solely on Russia/Ukraine, it is important to note that Covid cases continue to decline rapidly – and containment measures are being lifted. In New York, restaurants no longer require proof of vaccination and the mask mandate has been lifted. The easing of restrictions should allow an accelerated return on the supply side.

Last week’s jobs report was strong, showing significant gains in the leisure and hospitality and health and education sectors. And the activity rate in the prime of life has increased. A direct reading of the consistent set of business cycle indicators suggests that near-term recession risk is low. But the exogenous shock of the past two weeks (not yet apparent in monthly economic data) could be large enough to push the economy into recession.

Interest rate markets predict the Fed will tighten excessively next year, then cut rates in 2024. As the saying goes: economic expansions don’t die of old age – they are killed by the Fed. The Fed could very well weaken and try to fight inflation by causing a recession. Inflation has been fueled on the demand side by overzealous fiscal policy “which has gone far beyond what is necessary according to even Larry Summers, and on the supply side by negative supply shocks related to Covid, and now war-related gasoline prices will likely dampen the economy and limit consumer spending.

The last two recessions, GFC and Covid, have been exceptionally deep, one long and one short in terms of duration. If the recession materializes in the next few quarters, it could resemble that of the early 1990s – which was partly precipitated by a spike in oil prices due to the Iraqi invasion of Kuwait.

For historical reference, the current expansion has 22 months, the three shortest expansions over the last hundred years were: 12 months, 21 months and 24 months. Based on pure historical data, in any given state of expansion, the probability that the economy will enter a recession within the next year is about 20%, or a one in five chance. Currently, I would say the probability is at least one in three.

However, not all recessions are associated with bear markets. 5 of the last 15 recessions (1/3) have not had a bear market. The 1990 recession is an example.

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