The US Q2 GDP data released last week signals a technical recession in the world's largest economy. GDP shrank 0.9% Q/Q following last quarter's 1.6% contraction. Weak housing investment on the back of the Fed's aggressive rate hikes and easing consumer demand drove the contraction.
With supply chain bottlenecks persisting and the war in Ukraine keeping energy prices elevated, it seems unlikely that this growth slowdown stops anytime soon. Case in point is the Eurozone where manufacturing purchasing managers' index (PMI) fell into contraction territory in July for the first time since June 2020 due to easing global demand. Consumer confidence is at a record low and consumers are cutting back on spending amid broad based inflation.
We can think about the upcoming recession by taking cues from previous episodes of high inflation, supply chain bottlenecks and subsequent hit to consumer demand.
The 1973-75 oil price shock and early 1990s gulf war are good examples of similar economic conditions.
1973-75 oil shock: Arabic oil producers imposed an oil embargo against (primarily) Western economies for supporting Israel in the Yom Kippur War. The lack of oil imports and production cuts imposed by the Organization of Arab Petroleum Exporting Countries (OPAEC) drove a 300% rally in the price of oil between October 1973 and March 1974.
Severe oil shortage raised US CPI towards 12% by 1974 and 14% by 1980 leading Fed chair Paul Volcker to raise rates towards a record high 20% in the early 1980s!
During this shock, US GDP contracted in 5 quarters (on a quarter-on-quarter basis) and it took 10 quarters for GDP to revert to pre-recession period.
By gross value added, capital markets (-37%), chemicals (-20%), automotives (-11%) and natural resources (-10.3%) were the worst affected sectors.
The unemployment rate rose from 4.6% in October 1973 to 9% in May 1975.
During the 70s, the global economy was facing crop failures, strong consumer demand and cuts to oil supply, quite similar to the current scenario. The challenge with supply-side shocks is that there is very little the central bank can do to control prices aside from controlling demand through interest rate hikes. The Fed chose to implement the latter in the early 80s, plunging the US (and global economy) in a recession.
Early 1990s gulf war: Iraq's invasion of Kuwait resulted in lower oil production in the two oil producing economies and a rally in oil prices. Crude oil rose from USD 18 per barrel pre crisis towards USD 40 at its peak.
US GDP contracted in 2 quarters and it took 6 quarters for GDP to reach to pre-crisis level. US CPI inflation rose towards 6-7% in 1991. The airlines sector was hard hit given rising oil prices as well as a decline in travel spending.
By GVA, automotive (-23%) and energy (-11%) sectors were hard hit. By employment, industrial (-10%), aerospace and defense (7%) and automotive (-5%) were adversely impacted.
These are sectors highly correlated to economic activity through government and discretionary consumer spending.
Imagining the upcoming recession:
In thinking about the upcoming recession, it is important to identify the potential sources of economic pressure and how these differ from previous recessions. Similar to 1973-75 and early 1990s, this recession is likely to be triggered by elevated oil prices, transport and logistical bottlenecks and financial market tightening. What differentiates the current period is the prevalence of a global pandemic which may detract from GDP through lockdowns and restrictions.
Another differentiating factor is the relative inability of governments and central banks to shield their economies through traditional tools today. The entrenched nature of inflation in the US, Europe and Asia will prevent central banks from cutting rates. Secondly, governments globally threw the kitchen sink at the economy during COVID. This resulted in much weaker fiscal profiles post pandemic and several government institutions are currently implementing fiscal consolidation to appease the rating agencies.
Governments will need to engineer some degree of demand destruction to improve the supply-demand mismatch in all markets globally. Indeed, the aggressive pace of rate hikes by the Fed (inspired by Volcker's courageous fight against inflation) is likely to depress business investment and consumer spending in the quarters to come.
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