The short-term effect on the population and financial markets
“We live in a time of paradox and uncertainty. It is a paradox that, in a period of economic growth and low unemployment, households face a cost-of-living crisis and poverty is on the rise.” – His Majesty King Willem-Alexander of the Netherlands Speech from the Throne 2022
Throughout the spring and summer of 2022, most countries in the world were struggling to implement economic policies to control rising inflation and meet their growth targets following the aftermath of Covid-19, and the war in Ukraine.
Unfortunately, not only did the war in Ukraine not end, new points of conflict arose during the summer.
At the moment, rising energy prices are contributing to rising inflation in Europe and the United States, which in turn decreases the population’s demand for goods and services.
The United States Federal Reserve System (FRS) decided to jump into action by incrementally, yet confidently, increasing the interest rate. At the time of writing, the FRS benchmark interest rate is at 3.00–3.25%, with the latest hike being 75 basis points. The FRS is trying to chase inflation, which is already at 8.50%. This is already the third incremental increase by the FRS. The past two increases have also been in 75-basis-point increments at FRS meetings in June and July. This is a significant change compared to the beginning of 2022 when the interest rate was at 0.08%.
The US Bureau of Economic Analysis (BEA) has released the real GDP data for the first and second quarters of 2022. The US real GDP has decreased by 1.60% and 0.90% respectively. According to the most common definition of an economic recession, the US is already in one, since it has shown two consecutive quarters of negative growth. However, the White House refuses to call the current state of economic affairs a recession, citing “record unemployment of 3.60%” and large volumes of institutional investment coming into the US. Nevertheless, according to a survey of 750 CEOs and other C-suite executives by the Conference Board, “more than 60 percent of CEOs globally say they expect a recession in their primary region of operations before the end of 2023 or earlier”. With many large corporations being headquartered and/or targeting the US market, a full-scale recession in the US will mean bad news for the businesses.
The European Central Bank (ECB) has increased its interest rate by 50 basis points for the first time since 2016, with another 75-basis-point hike this September. The current ECB rate for refinancing operations is just 1.25%. Although this is a big step in the eyes of the ECB, it still keeps the rate far below inflation. The European Union inflation rate is currently at 9.80%, with food inflation being even higher at 12.82%. However, the EU is currently maintaining positive economic growth with the GDP up by 0.6% in the EU. The French economy grew by 0.5%, Germany showed no growth, and the Netherlands outperformed other EU members with a GDP growth rate of 2.6% in the second quarter.
What does this mean for consumers?
Higher inflation and higher interest rates typically make consumers less willing to spend their money and rather save in hopes of receiving interest. However, it is not always possible for consumers to cut down on spending. As we saw in the example with Europe, food inflation is higher than the overall inflation, and it is hard to spend less money on necessities such as food. Consumers might begin to avoid dining out as much, which may, in turn, hurt the restaurant industry.
Private consumers are most impacted by petrol and heating prices. As petrol remains expensive due to high oil prices, it will be expensive to drive and supply chains will continue to experience disruption and increasing costs. Natural gas is an even more comprehensive issue. Gas is used for heating and electricity in many European homes. As winter approaches, the question of central heating and hot water is becoming more and more serious, with some Germans looking at options to spend the winter on the Mediterranean coast and avoid a large gas bill this season.
The war in Ukraine has become a real wake-up call for Europe, and Putin’s aggression is likely to be yet another reason for the EU to focus on developing green energy projects that the EU can rely on. Yet, for now, Europe will have to urgently seek other sources of gas and oil imports, or use other forms of energy, such as nuclear power.
In December, the embargo on Russian oil is scheduled to come into effect. Depending on whether new suppliers enter the European market, and at what volumes, we may see petrol prices being confidently above €2 per litre in the Netherlands.
Risks of recession, high inflation and interest rates are all negative factors for the financial markets. As the FRS continues to increase its benchmark interest rate, the economy will continue to be under pressure, and eventually slow down. There is speculation that this is the beginning of a great recession in the United States.
Under these circumstances, it remains clear that stocks are taking the largest hit, with the S&P 500® index being down almost 20% year-to-date at the time of writing. The index was at its lowest point in June when it fell below 3700 points.
In fear of high interest rates and an approaching global recession, investors are becoming more risk-averse and exiting the stock market in favour of bonds and cash.
The recent escalation in Taiwan tensions between China and the US after the visit of Nancy Pelosi to the island has also had an impact on the Chinese financial markets. Institutional investors are now viewing Chinese government and corporate bonds, as well as other securities as higher-risk, due to the unpredictable nature of China’s foreign and domestic policy.
The Shanghai Composite is already down almost 15% year-to-date, and Hong Kong’s Hang Seng Index is down by over 20% year-to-date with a strong downward trend. The Chinese economy is projected to slow down and grow by only 3%, according to a forecast by Goldman Sachs.
Should Taiwan tensions escalate further, the trilemma à la De Ruijter is bound to create even more uncertainty for China and its trading partners. In case the EU and US impose sanctions on Chinese exports and financial systems, this may also backfire with shortages of various goods and raw materials.
In terms of domestic policy, the excessively strict approach to Covid-containment and quarantine as part of China’s zero-Covid policy often leads to logistical failures and entire factories shutting down. This usually results in additional costs for everyone involved, including the end-consumer somewhere on the other side of the world.
All in all, the world economy and financial markets are at a very uncertain point as we approach the end of the third quarter of 2022. However, the short-term goal of central banks will be chasing inflation and trying to slow down the economy and the financial markets as a consequence.
Consumers can continue to expect high (or even increasing) prices going into the fourth quarter. For Europeans, the energy crisis is likely to be the hardest part, though national governments and the EU are working on various solutions.
Troubles for financial markets may mean a loss for some, but an opportunity to enter for others. It is likely that both institutional and private investors are eyeing strategies for their free cash or retirement accounts. In case interest rates become more or less fixed in the future, and there will be more confidence in countries’ monetary policies, financial markets may show some growth. However, geopolitics remains the main driver of confidence attrition for now.