The debate in the forefront on investors' minds these days is when will the recession hit the global economy, with the timeline ranging anywhere from as early as 2023 to perhaps mid 2024. As economists try to debate the merits of a recession, what most fail to realize is we are in fact already in the midst of one.
Such is the behavior of markets and asset prices that they tend to weaken first and then the data prints to confirm it after the fact. But by then, it is too late.
US government officials including the Fed are working very hard to mask the fact that we are indeed in the midst of a recession per se, even though the textbook definition qualifies it as such. Two consecutive quarters of negative GDP growth will be possibly followed by another one judging by the way Q3 is shaping up to be.
Investors often tend to focus on the US economy, but it is far more resilient than Europe and rest of the world, not to mention the US central bank is one of the most important and powerful ones that dictate price action for a host of economies and currencies.
After the Covid induced demand surge, all economies suffered from high consumer and producer prices and faced the same trend of lower disposable wage income growth against a rising cost of living. That puts a serious dampener to the average consumer and hence GDP for that country. As central banks tighten, these prices are coming down, easing some of the inflationary pressures, but make no mistake, we are still averaging inflation closer to 8% year over year.
Europe's Systemic Problem
The problem with Europe is in addition to these trends, they face a more systemic problem, i.e. one of extremely high debt and no end in sight to rising gas and electricity prices. Europe is so dependent on Russian gas that its Ukraine invasion has really torn the countries between those wanting to sanction Russia for their actions and those that cannot given how reliant their county is on those gas flows.
Europe plans to end oil and gas imports from Russia towards end of the year, but that is still a few months away, even though it has been soaking up a lot more LNG from the US. Given the pricing arbitrage and difference between US, UK and Europe, US LNG players are able to take advantage of the massive price difference and reroute their cargoes to Europe. The EU imported 21.36 million tonnes of LNG in the first half of 2022, up from 8.21 million tonnes in the same period a year ago, according to ICIS.
Over the past few months, Europe has managed to build up gas storage steadily by curbing demand, and switching from gas to coal for some power plants. All that was talked about in COP26 has been reversed as China and rest of the world are cranking up coal production to meet their power and gas needs.
Today, European gas storage levels are 70.54% full, surpassing the 5-year average of 70.32%, according to data from Gas Infrastructure Europe (GIE) released on Thursday. The levels were also not far from a 10-year average of around 71.40%. The market is still nervous going into the winter given the surge in heating demand but the situation is a lot less dire now than it was months ago.
European gas prices have moved from 75 Euro/mwh to north of 200 Euro/mwh, since the start of this year. Gas and Power is not like Oil, there is a limited amount that needs to be stored ahead of any season to pre-empt the demand surge. Given the extent of Russian flows or winter demand, prices could very well stay elevated for a long time despite the economy going into a manufacturing recession as Chinese demand slows.
For the time being, the Fed is able to raise rates to combat this inflation, but we know the ECB is no position to raise rates given the extent of their debt and lack of productivity. It cannot even afford more than 50 bps of rate rises. This is witnessed in their balance sheet, the fact that the ECB has not even managed to trim it even in the good times.
It is easy to look at market moves over the summer and try to fit a narrative to justify the move. But beware the lack of liquidity and extreme bearish positioning does tend to cause oversold rallies. To claim that the Fed is now dovish, is a different matter altogether.
Global growth is coming off a cliff and central banks are no longer able to print their way out of their dilemma, at least not until inflation comes down fast. Even if the US manages to engineer a soft landing, the Fed still has about 250-300 bps to cut if need be. Europe does not even have 50 bps room. Commodities are all about timing, and the US being energy independent allows it to weather the storm a lot better than Europe that will be forced to pay higher prices for the goods it needs and consumes.