How the World Dodged a Recession
- Many observers predicted the tight fiscal policies following the COVID-19 pandemic would induce a recession, but economist Dario Perkins says the traditional rate cycle is the wrong model for the current global environment.
- Labor shortages, deglobalization and government bailouts are three factors that may entrench inflation with a 2% floor, rather than the Fed’s target 2% ceiling.
- In the coming years, governments will likely favor both expansionary fiscal policies and tight monetary policies. In such an environment, high-growth stocks are unlikely to outpace value investments.
As inflation soared and central banks hiked interest rates following the COVID-19 pandemic, most economists predicted a recession in 2023. As we near the end of the year and the global economy seems largely intact, we might wonder why the consensus was wrong.
In a March 2023 survey, more than two-thirds of the National Association for Business Economics (NABE) membership predicted inflation would stay above 4%, and the majority of NABE survey respondents forecast an American recession before the end of the year. Yet the October Consumer Price Index pegged inflation at only 3.2%, and the Federal Reserve is increasingly optimistic about its so-called soft landing to avoid a national recession.
“There's been this continuous attempt to impose a business cycle framework,” Dario says, referring to the idea that economies alternate between periods of expansion and recession. In a textbook scenario, a pullback in spending due to rising interest rates should coincide with decreases in employment and income. The last three years, however, have been anything but a natural economic course.
“We shut down the global economy,” Dario explains. “We created enormous amounts of pent-up demand, we put in enormous one-off fiscal stimulus and we created massive disruption in global supply chains. None of this was a sort of normal, organic business cycle.”
For that reason, Dario believes the present global economic situation does not fit into the usual deterministic, cyclical models of growth and contraction. To explain his perspective on the current global economic outlook, Dario joined Alan Dunne on a Global Macro edition of Top Traders Unplugged. In their discussion, Dario highlighted the structural shifts in both industry and politics that are likely to entrench higher inflation without driving a global recession.
The unemployment myth
Economists are familiar with the Phillips curve, a theory that inflation moves inversely to unemployment. In essence, if the Fed’s rate hikes are successful in decreasing inflation, we should expect an increase in unemployment.
For Dario, however, the Phillips curve model doesn’t fit for one key reason — the heavy post-lockdown inflation was artificial. Supply chain and production delays created shortages, which raised prices, but consumers had stimulus money to spend. Recall how much the average consumer might have spent on a pack of toilet paper at the height of the pandemic. Yet those transitory factors would have subsided on their own, Dario says, meaning inflation would likely have cooled without any central bank intervention.
Of course, politically speaking, the Fed would never consider a hands-off approach. “If you’re a central banker and you’re seeing inflation at the highest levels in 40 years, and you don’t do anything about it, there is a very good chance that you’re going to go down in history looking like a complete joker,” Dario explains. Central banks had no choice but to clamp down.
So as interest rates have skyrocketed, why hasn’t unemployment followed? In many countries, labor supply dropped during the pandemic. In the U.S., labor force participation fell to its lowest level since the early 1970s, meaning many job openings went unfilled.
“What’s happened is central banks have managed to destroy demand in the labor market [with interest rate hikes], but a lot of that demand wasn’t being realized anyway. It was job openings and job vacancies,” Dario says.
Practically, if 2021 was the Great Resignation when workers could easily quit one job and find another, 2023 has removed some of that mobility. The effect of a tight monetary policy has been that workers have fewer options, but not that they don’t have jobs.
Low-rate household debt
Another factor holding back a recession: Many consumers have little financial exposure to rising interest rates. While higher lending costs are bad news for corporate development, household debt can largely avoid the brunt of the Fed’s rate hikes.
“If you think about the last decade,” Dario says, “you basically had deleveraging across all of the developed world. Private sector debt levels, particularly on the household side, are down substantially since 2008.”
Home mortgages — the largest personal debt for most Americans — are overwhelmingly fixed-rate loans. In 2021, nearly 90% of U.S. home mortgages were on fixed-rate terms, with many homeowners either buying or refinancing during the rock-bottom interest rates of the pandemic. This means that even if the Fed were to continue raising rates now, current homeowners will not see their monthly payments change.
Not all consumer debt is so sheltered, of course, with credit card debt in particular being susceptible to interest rate swings. But during the pandemic, there was an artificial backstop to prevent personal bankruptcies.
“We had a two-year period where central banks and governments basically put the credit cycle into complete hibernation,” Dario says. “You couldn’t default or go bankrupt in that period because governments wouldn’t allow you.”
Yet like the moratoriums on evictions and student loan payments, these government protections are no longer in place, and the credit market is playing catch-up on overdue defaults. For all the talk of a soft landing in the U.S., a sudden rush of loan failures could plunge the nation headfirst into a recession. That is, unless the government intervenes again.
Stock and flow
A tight monetary policy has two effects on credit. The first is a cutoff of credit flow, a hard turn for the cash spigot that makes new loans for construction or vehicles prohibitively expensive. Consumers sit tight on what they have, and overall spending goes down.
Meanwhile, a “stock effect,” or a sudden change in price, hits existing debt holders with variable-rate loans. Any short-term floating rate will get squeezed, with commercial and home mortgage loans hitting the hardest. Yet, as mentioned, the U.S. largely operates on fixed-rate mortgages. This means other countries will feel the stock effect first.
The Bank of England, for instance, favors two-year fixed rates. After 24 months, the loan can revert to a higher rate, making a clamp-down monetary policy highly uncomfortable for the average consumer. Additionally, Portugal, Spain and France are among the EU nations with a high sensitivity to floating-rate corporate debt. Dario says, “Europe is much closer [than the U.S.] to a situation where central banks have overtightened already.”
This presents a scenario where the European Central Bank (ECB) and Bank of England may want to loosen their monetary policies before the U.S. does, which could lead to a quick devaluing of their currencies. According to Dario, it’s a lose-lose situation.
“If you cut interest rates while the Fed is on hold, your currency is going to go down. If you just ignore the fact that your economy is deteriorating, your currency is still going to go down,” he says.
When governments are backed into a corner, their financial policies become not just an economic issue, but a political one.
The inflation supercycle
The 2010s saw low variability and economic growth. Alan asks, “Can we go back there, or has COVID and the [tight monetary] policy experiment knocked everything out of equilibrium?”
For Dario, the world has forever changed — but, macroeconomically speaking, the difference is subtle. What used to be a 2% ceiling on inflation, the Fed’s target in the 2010s, is now a floor. “From now on,” Dario says, “the whole bias in monetary policy shifts.” He predicts the prevailing tendency of inflation will be to run high, and central banks will frequently have to restrain it. Economists call a prolonged period of expansion a supercycle.
What’s driving the new inflation supercycle? Ironically, as much as governments are trying to suppress inflation, they’re most responsible for propping it up.
“We now have this sort of bailout culture,” Dario explains. “Any problem in the world can be solved with fiscal policy. So you have an energy crisis or cost of living crisis or, as the politicians call it, an inflation crisis. What do we do? We throw fiscal spending at it.”
For the average consumer, a loose fiscal policy may not always seem like welfare. A strategic industrial policy, for instance, is a geopolitical move against foreign manufacturing dependence, but it ultimately amounts to heavy government investment as a means to deglobalization. Building factories and creating jobs may be a strong political platform, but it pumps money into the economy that ultimately balloons inflation instead of controlling it.
Death to austerity
A tight monetary policy is a stark contrast to the neoliberal attitudes of the 1990s and 2000s — when the U.S. and Europe took on broad free trade agreements and an opening of labor markets to immigration. Back then, central banks had explicit inflation targets, and free-market capitalism ruled the day as governments tried to pull back on their expenditures.
Now, under a rise of nationalist politics and reconsidered strategic industrial policies, it seems as if deglobalization will be a driving macroeconomic force for the foreseeable future. The U.S. and China have already leaned heavily into domestic industrial investments, and Dario predicts they’ll soon force Europe’s hand as well.
“China's basically decimating Europe’s car industry over the past 18 months,” he says. “Strategic industrial policy is working in China. It’s working in the US. So what are the Europeans going to do? Well, they’re gonna have to do the same thing.”
These movements require a shift in how investors think about financial markets. Instead of jumping into a hot, high-growth tech stock, investors will likely look more to commodities and industrial sectors that benefit most from deglobalization. Dario also adds that hedging against a stock crash will have to involve a different strategy than bonds, as the bond and equity markets are losing their negative correlation.
Notably, we’re in a historic bear market for U.S. Treasury bonds — when the Fed raises interest rates, existing bonds with fixed yields become less attractive and plummet in price. So in 2022, when growth stocks crashed, the bond market didn’t fare much better.
Meanwhile, an expansionary fiscal policy could prop up the economy, similar to how big public spending in the 1960s fueled productivity growth and rapid scientific advancements. “The government took over a lot of investment in new technologies related to the space industry, and those filtered through into the rest of the economy,” Dario explains. “So it isn’t true that fiscal policy is necessarily bad.” A growth stock and bond portfolio will just need to adjust.
So is a recession still possible?
Even with so many signs pointing to a soft landing, Dario cautions that we aren’t out of the woods yet. Ironically, he says, the risk of recession is higher now than it was twelve months ago when economic forecasters were most concerned.
But he’s quick to add: “It may not even feel like a recession for a lot of people.” Perhaps as soon as the labor markets start to break down, central banks will loosen their grips on interest rates. The future could be defined by high inflation but also high investment in domestic economies that drives consistent returns for value stocks. In any case, we aren’t caught in a traditional rate cycle.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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