2022: The Hangover?
2022: The Hangover?
Why a significant slowdown or even recession is likely next year. Plus an excursion to the German "Gründerzeit"-Boom from 1871-73
To start, I would like to apologize to my readers for the gloomy headline of this post. As many of you know, I am an optimist who believes the “good” side will, in the end, always win. I bought shares with both hands when the world seemed to end in March 2020 and believed in a successful COVID-19 vaccine early on when few did. However, two reasons let me put a high probability on a significant slowdown or recession next year, I am laying them out below
The first reason is inflation
To start, let’s recap briefly why we currently experience inflation:
In late 2020 and early 2021, the US government poured trillions of dollars into an economy that had already largely recovered from COVID-19. The chart below shows the size of new money provided in comparison to the damage caused by COVID-19
This excessive money is now moving around the economy, like an air bubble under a carpet. It causes price surges in used cars and hospital bills, in microchips and commodities, in sofas and Christmas trees
The price of lumber is a good example. It exploded in April 2021, to subsequently cool off. Some took that as prove for inflation to be transitory, but now it’s skyrocketing again
While the phenomenon originates from the US, in a globally interconnected economy, the effects are felt worldwide, in Germany, the Eurozone and the UK
The US-economy is overheating. Its red-hot labor market has set the dreaded price-wage spiral in motion
In this dynamic, inflation feeds on itself: Workers demand higher wages as their costs increase. Companies concede as they have no alternative. To protect their profit margins, they increase prices, which in turn creates more inflation and leads workers to demand more wage increases
There is strong evidence for this now happening in the US, from the emergence of COLA-clauses in contracts to record numbers quitting their jobs. The reduction in immigration also plays a role
It illustrates the biggest problem with inflation. It is not a constant. Once in the system, it’s accelerating as people change their behavior to anticipate rising prices
It also hurts the weakest members of society the most. They spend all of their income, and inflation in basic goods such as food or rent has been particularly bad
As discussed, the US government and the Federal Reserve have recognised this explosive dynamic and made fighting inflation priority number 1. This represents a dramatic U-turn from the easy-money policies. A recent interview with San Francisco Fed member Mary Dahl illustrates the change in tone1:
Ok, understood, the Fed will do something against inflation. But why the gloomy recession prognosis?
Here is why: Historically, inflation has never been defeated by a central bank without a recession
There have been several similar inflationary periods: After WWII, after the Korea War, during the 60s, the early 70s and again the early 80s. In all of them, the Federal Reserve intervened to bring inflation down, and in all cases a recession ensued (most prominently in 1981 when Paul Volcker famously defeated inflation with 12% interest rates and a two-year recession)
There is a strong logical reason for this relationship. In order to tame inflation, demand has to be reduced and the price-wage spiral has to be broken. For this to happen, unemployment needs to increase again, at the very least growth has to slow considerably
To summarise the first reason: There is too much inflation. The government and the Federal Reserve are committed to bringing inflation down as it creates political instability. Historically, such efforts have coincided with a recession
Where could I be wrong: Inflation could turn out to be transitory for whatever reason, irrespective of the logic above. Furthermore, the Fed could manage to engineer a so-called “soft-landing”, taking heat out of the economy without slowing it too much. Finally, inflation could turn out to be more politically acceptable than I assume and continue to run without intervention
The second reason is bad investments made due to easy money policies
With interest rates at zero percent, trillions of dollars traditionally parked in safe government debt were forced to look for a new home. Much of that money found its way into venture capital, cryptocurrencies, SPACs and other significantly more speculative areas, attracted by stellar gains (see “House Money”)
This strong sense of FOMO crept deeply even into institutionalised areas and highly sophisticated money managers, from pension funds to university endowments
We now find ourselves in a “emperor-with-no-clothes” moment, where many of the excessive valuations gradually become obvious to everyone, just as they did in the Spring of 2000, when the New Economy bubble burst
I want to highlight an exemplary company at the time, telecom services company Siebel Systems. Telecoms were the hot sector back then, and Siebel looked like many hot tech companies look today: Several years of exponential revenue growth of ~100% p.a. (see financials below) and a nosebleed valuation of 28x EV/Sales in the spring of 2000 (a bargain in comparison to some of today’s valuations)
However, in 2000 the bubble burst and not only did Siebel’s valuation fall, its revenues also stopped growing at the same pace. In fact, they declined. It turned out that most of its clients were were at the center of the bubble and had run out of money
I would expect similar circular effects in several (but not all) of today’s high growth tech areas
It’s important to note though, the New Economy era also brought rise to some of the most successful companies in the world, from Google to Netflix and Amazon. They survived the growth purgatory of 2001-3 and faced much less competition afterwards. The same will be true for today’s category winners
In April 2021, I wrote a post provocatively called “Is Tech the New Subprime”, looking at the structural risks to the economy from write downs in high-growth tech investments. Public market valuations for the sector have since halved, the conclusion remains the same as back then though:
In both the New Economy and the Subprime bubble, leverage was involved. This caused catastrophic losses when asset values were wiped out. This time around, leverage is much more limited
I therefore suspect the issue will mainly be psychological in nature. Losses would weigh on consumer confidence, but they won’t cause a structural crisis
To summarise the second reason: There is a significant amount of malinvestment in the economy. While the absence of leverage should limit the fallout, losses on these investments could weigh on consumer confidence, especially if they coincide with a central bank efforts to tame inflation
Where could I be wrong: As mentioned in “House Money”, technological progress in some companies could move so fast it overcompensates for bad investments elsewhere. Furthermore, I could overestimate the sums involved in bad investments
Conclusion:
Central banks will face a tremendous challenge next year in their attempt to slow inflation. History suggests it will be hard to achieve this without collateral damage. The task is made more difficult by the significant amount of malinvestments. For that reason, I assign a high probability to a significant slowdown or recession next year
For my readers, I would recommend to be mindful with investments, prioritise safety over risk and avoid anything speculative. Now, it may very well be that asset prices continue to climb from here. However, unless inflation recedes at the same time, this will simply create more pressure on Central Banks to react with more force, making the subsequent fall harder
Finally, there are always reasons to remain optimistic. It is the natural state of the economy to grow, and everyone is united in working towards that goal. Any correction, however severe it would be, should be followed by growth and if anything, provide great opportunities for the long run
ADDENDUM: A brief historical excursion - the German “Gründerzeit”-Boom from 1871-73
From 1871-73 the German economy experienced an unprecedent boom2, with a record number of company formations (=“Gründungen”, “Gründer” = Founder). I will very briefly walk through its stages, some similarities to today are staggering:
In 1870, the various German states defeated France in a short war. In the wake of the war, the states united to become one country, the predecessor of today’s Germany
France was mandated to pay 5 billion Goldfrancs reparations. This money flowed into the German economy without any offsetting productivity increase, leading to a 50% increase of money in circulation (cf. today’s American Rescue Plan?)
With this ample funding available, company creation mushroomed. Thousands of new corporations and banks were founded, and 10x more companies went public in 1871-73 than in the decade before (cf. today’s SPAC boom?)
The technology of mass fascination at the time was the railroad (cf. today’s cryptocurrencies?)
The boom ended with the Gründerkrach, a stock market crash in Vienna in 1873, that caused a cascading collapse of the overheated economy. The damage was huge, as ample leverage was involved and banking regulation was non-existent (today banks are strictly regulated)
While thousands went bust, several companies founded then became giants in the following century, e.g. Continental, AGFA, Schering or Hoesch, a predecessor of ThyssenKrupp (just like the New Economy bubble brought Google, Amazon and Netflix)
At the time, the monetary system rested on the gold standard. Therefore, the crash could not be softened by central bank intervention. It took almost a decade for the economy to recover (today central banks can intervene in a crash)
As Mark Twain said: History does not repeat itself, but it often rhymes. I wish everyone a happy, healthy and prosperous 2022!
On a side note, I would like to highlight the contrast to ECB-Chairwoman Christine Lagarde, who refuses to acknowledge the issue