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Global economic update: the root cause of the current crisis
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Global economic update: the root cause of the current crisis

Sydney investment advice | The information in this article is current as at 1 July 2022.

Part 1: Overview

At the start of 2020 the world was facing a pandemic that had the capacity to upend the lives and livelihoods of billions. The collapse of global share markets was ultimately averted thanks to both the rapid intervention of central banks providing support to financial markets in the form of cheap money and liquidity, and governments, in the form of stimulus payments to workers and businesses. Just as the world was learning to live with the virus, the war in Ukraine began to unfold in all its technicolour horror, creating an entirely different economic crisis.

To understand the root causes of the current crisis, we need to go back in time before the pandemic started. During this time the world was awash with cheap labour. Foreign workers on temporary visas readily filled unskilled roles. Companies offshored operations or outsourced roles to India, China and other South East Asian countries to take advantage of lower labour costs. This era of globalisation was arguably a windfall for both corporate profitability and humanity, by providing jobs and increasing the standard of living for more impoverished nations.

The pandemic fundamentally changed all of this. The labour market is now very different. Staff shortages and wage pressures are almost universally evident for a multitude of reasons.

First, at the onset of the pandemic, foreign workers made their way home fearing border closures would cut them off from their families. Many have not returned and may never return. Demand for unskilled workers, such as in hospitality and tourism in many developed nations far exceeds supply. Second, many companies found outsourced or offshore operations unreliable during the pandemic as COVID-19 forced staff, who were working overseas, into prolonged lockdowns without technology to work from home. This was exacerbated by supply chain disruptions that have prompted a wave of reshoring operations to improve control over the supply chain. Third, COVID-19 forced some workers, who either chose not to be vaccinated, or did not have access to vaccinations, to temporarily leave the workforce until the worst was over. Many have still not returned. Fourth, COVID-19 forced many countries to hit pause on their immigration programs. Fifth, the pandemic crossed over into the start of the retirement years for the baby boomer generation. This has seen an increase in early retirements for those who could afford to do so. The combination of these factors has led to labour shortages, putting upward pressure on wages for the first time in decades.

The pandemic was also causing a whole range of other problems. Reopening the economy caused a wave of pent-up demand as consumers unleashed surplus savings. The resumption of manufacturing production lines however was not universal, resulting in extended delays in accessing componentry. As a result, the cost of shipping containers, freight, electrical components such as microchips, among other things, all jumped sharply.

These factors were all evident well before the war in Ukraine started. Since then, cost pressures that had been building for 18 months, have ignited. Before the war, Russia supplied about a quarter of Europe’s oil and 40%1of its natural gas needs, so it is no surprise that energy prices have since soared. Food prices have also skyrocketed. Russia and Ukraine collectively supply around 28%2 of the world’s wheat, 26%2 of barley and over 60%2 of sunflower oil. Russia and Belarus also happen to be the world’s major supplier of fertiliser. The outcomes are now plain to see.

In the United States, headline inflation in May was at a 40 year high at 8.6%3. Core inflation, that excludes volatile energy prices, was still above 6%3, more than triple the Federal Reserve’s target. In the Eurozone, inflation is running at 8.1%4, the highest since records began in 1997. Energy prices were up 39%4 on the prior corresponding period in May 2021, while food was up 7.5%4.

Faced with inflation outcomes not seen for over 40 years, central banks have been slow to react. But from Washington to Germany, they are now aggressively lifting interest rates to try and reduce demand and tame inflation.

In June the US Federal Reserve increased its cash rate by 0.75% to 1.75%5, the largest single hike since 1994. The average rate on a 30-year mortgage is near 6%6, double what it was a year ago. Similarly, the European Central Bank (ECB) has outlined plans to continuously raise rates from July in order to get inflation back within its 2% target. Failing to increase rates would only serve to devalue the Euro, increasing the cost of imported products and only adding to inflationary pressures.

The problem is that interest rates are the bluntest of tools. By increasing the cost of money, they reduce demand for goods and services. It is hoped that this reduction will help alleviate price pressures without demand capitulating to the point where the economy goes into recession.
Growth, that was already well below trend in China, is now clearly slowing across the world, including the US and Europe. Surging energy prices, higher food prices and higher interest rates are conspiring to reduce disposable incomes and dent consumer confidence. March quarter growth in the Eurozone slowed to 0.2% but is likely to have slowed further since then. In the US, the economy fell by 0.2% in the March quarter. While the US is expected to avoid a technical recession, households are clearly struggling with higher costs. Growth in the US over the year has been revised down to 1.7%7 from 2.6%, and in Europe to 2.8%8 from 3.7% just three months earlier.

It is abundantly clear that demand is slowing, but the problem is that prices are not. This is because inflation has been driven by supply side shortages on necessities. Energy prices are high because supply is tight. Food prices are elevated because crops have been either destroyed or are unable to be brought through the war zones to market. This has been compounded by the shortage of fertilisers. Further, rent and the cost of accommodation (a significant component of the inflation index) has largely only increased.
We are left in an uncomfortable reality where higher interest rates are unlikely to rapidly suppress price pressures. Inflation will inevitably stay higher for longer until the war in Ukraine ends and more supply of food and energy ultimately becomes available.

Conclusion

Central banks across the globe face the difficult prospect of trying to tame inflation with higher interest rates, without inducing a recession. Higher rates will reduce demand. The latest Gross domestic product (GDP) forecasts see growth slowing to stall speed across most major economies, but they will do little to resolve the underlying supply-side food and energy shortages that prevail. These are factors beyond the control of bankers. In the meantime, not only are households grappling with higher living costs and mortgage repayments, but heavily indebted sovereign nations are struggling with weaker currencies and higher interest rates making it more difficult to repay US denominated debts. This is a backdrop where the probability of a global recession is increasing rapidly.

Part 2: Key economic indicators

United States

Economic snapshot Last reported result Comments
Growth (GDP)9 -1.5% (annualised) Q1’22 The US economy contracted in the first quarter of 2022, following a strong 6.9% expansion in the previous quarter. GDP was adversely affected by a wider trade gap and a slower restocking of goods in stores and warehouses.
Unemployment10 3.6% May’22 The unemployment rate remained unchanged in May as notable job gains in leisure and hospitality, professional and business services, and transportation and warehousing offset a fall in employment levels in retail trade.
Industrial production11 0.2% m/m May’22

5.8% y/y May’22

Industrial production increased slightly in May, supported by both higher mining and utilities output.
Manufacturing PMI12 56.1 May’22

58.6 Feb’22

May’s manufacturing Purchasing Managers Index (PMI) reading of 56.1 continues to signal a manufacturing sector in expansion for a 24th successive month.
Retail sales13 -0.4% m/m May’22

6.9% y/y May’22

Retail sales remain strong on a yearly view although cost pressures are starting to emerge.
Credit growth11 10.1% (annualised) Apr’22 Credit increased at an annualised rate of 10.1% and stands at $4.57 trillion.
Outlook The World Bank has cut its 2022 expected growth rate for the United States economy from 3.7% to 2.5%. This growth rate may come under further pressure as inflation remains stubbornly high and financial conditions continue to be aggressively tightened.

Eurozone

Economic snapshot Last reported result Comments
Growth (GDP)14 0.6% q/q Q1’22

5.4% y/y Q1’22

Growth rebounded in the first quarter as the reopening trade gathered momentum. We saw signs that it began to slow towards the end of the quarter as Russia invaded Ukraine and energy prices soared.
Unemployment14 6.8% Apr’22 The unemployment rate remained unchanged in April and remains the lowest jobless rate on record.
Industrial production14 0.4% m/m Apr’22

-2.0% y/y Apr’22

Industrial production rose in April, underpinned by strong energy production.
Manufacturing PMI15 54.6 May’22 The Manufacturing PMI confirmed the manufacturing sector expanded for a 23rd successive month, albeit the rate has weakened over the past year.
Retail sales14 -1.3% m/m Apr’22

3.9% y/y Apr’22

Retail sales decreased in April, primarily impacted by lower food sales.
Credit growth14 6.0% y/y Apr’22 The annual growth rate of total credit to euro area residents decelerated to 6.0% in April, compared with 6.3% the previous month. The annual growth rate of credit to general government decreased to 9.3% in April from 10.1% in March, while the annual growth rate of credit to the private sector increased to 4.8% in April from 4.3% in March.
Outlook According to the World Bank, growth in the Eurozone is projected to slow to 2.5% in 2022. The growth rate has been revised lower by 1.7 percentage points as the Russian-Ukraine war leads to higher energy prices, continued supply disruptions and tighter financial conditions.

China

Economic snapshot Last reported result Comments
Growth (GDP)16 1.3% q/q Q1’22 4.8% y/y Q1’22 China’s economy expanded solidly in the first quarter of 2022 but COVID-19 lockdowns across the country will impact the second quarter growth rate.
Unemployment16 6.7% Apr’22 The unemployment rate rose to a record high as big cities across the country were locked down. The youth unemployment rate continues to increase, and now stands at 18%.
Industrial production16 0.7% y/y May’22 Industrial production rose solidly in May as COVID-19 restrictions eased in some major cities while mining production continued to rise.
Manufacturing PMI17 49.6 May’22

50.2 Feb’22

China’s manufacturing PMI strengthened in May but continues to signal an economy in contraction.
Retail sales16 -6.7% y/y May’22 Sales continue to be affected by lockdowns across the nation.
Fixed asset (urban) investment16 6.2% y/y Jan-May’22 Fixed Asset Investment (FAI) remains reasonably solid over the first five months of 2022, supported by timely investment approvals by state planners.
Outlook The World Bank has sharply lowered its 2022 expected growth rate for China from 5.1% to 4.3%. We expect forecast growth rates to be further challenged should COVID-19 disruptions continue to impact production and disrupt supply chains.

Japan

Economic snapshot Last reported result Comments
Growth (GDP)18 -0.5% (annualised) Q1’22 The Japanese economy contracted by a lower-than-expected 0.5% in the first quarter, as private consumption remained resilient.
Unemployment19 2.5% Apr’22 The unemployment rate fell to a two-year low in April, as recommended curbs on business activity were lifted for the first time since the onset of the COVID-19 crisis.
Industrial production20 -1.5% m/m Apr’22

-4.9% y/y Apr’22

Japan’s industrial output fell 1.5% in April from the previous month, as supply chain disruptions caused by Chinese lockdowns impact the economy.
Manufacturing PMI21 53.3 May’22

52.7 Feb’22

The latest reading of 53.3 continues to signify an expanding manufacturing sector, despite a slowdown in new orders.
Retail sales22 2.9% y/y Apr’22 Japan’s retail sales rose strongly in April benefitting from the easing of COVID-19 restrictions.
Outlook According to the World Bank, growth in Japan is forecast to be 1.7% in 2022, sharply lower than the Bank’s forecast of 2.9% in January. Whilst the Japanese economy should benefit from the reopening of international travel, weaker exports as a result of a deteriorating global growth outlook will impact Japan’s growth outcomes.
1 J. Horton, ‘Russia sanctions: Can the world cope without its oil and gas?’ BBC News, https://www.bbc.com/news/58888451, (accessed 1 July 2022).
2 ‘Ukraine War Has Put World’s Food Security At Risk As Wheat, Fertiliser Supplies Are Hit’, Outlook India, https://www.outlookindia.com/international/ukraine-war-has-put-world-food-security-at-risk-as-wheat-fertiliser-supplies-are-hit-news-192060, (accessed 1 July 2022).
3 J. Bartash, ‘Rising rents, gas and food prices push U.S. inflation to 40-year high of 8.6%, CPI shows’, MarketWatch, https://www.marketwatch.com/story/coming-up-consumer-price-index-for-may-11654862886, (accessed 1 July 2022).
4 ‘Euro area inflation up to 8.1%’, Eurostat, https://ec.europa.eu/eurostat/documents/2995521/14636256/2-31052022-AP-EN.pdf/3ba84e21-80e6-fc2f-6354-2b83b1ec5d35, (accessed 1 July 2022).
5 J. Cox, ‘Fed hikes its benchmark interest rate by 0.75 percentage point, the biggest increase since 1994’, CNBC, https://www.cnbc.com/2022/06/15/fed-hikes-its-benchmark-interest-rate-by-three-quarters-of-a-point-the-biggest-increase-since-1994.html, (accessed 1 July 2022).
6 M. Strohm, ‘Current National Mortgage Rates: June 24, 2022–Mortgage Rates Fall’, Forbes Advisor https://www.forbes.com/advisor/mortgages/mortgage-rates-06-24-22/#:~:text=The%20average%20rate%20on%20a,with%20an%20APR%20of%205.78%25, (accessed 1 July 2022).
7 ‘The Conference Board Economic Forecast for the US Economy’, US Conference Board, https://www.conference-board.org/research/us-forecast, (accessed 1 July 2022).
8 ‘Eurosystem staff macroeconomic projections’ , European Central Bank’, https://www.ecb.europa.eu/pub/projections/html/ecb.projections202206_eurosystemstaff~2299e41f1e.en.html, (accessed 1 July 2022).
9 US Department of Commerce, ‘Bureau of Economic Analysis’, 2022, https://www.bea.gov/, (accessed 1 July 2022).
10 US Department of Labor, ‘Bureau of Labor Statistics’, 2022, https://www.bls.gov/, (accessed 1 July 2022).
11 United States Federal Reserve, 2022, https://www.federalreserve.gov/, (accessed 1 July 2022).
12 Institute of Supply Management (ISM), 2022 https://www.ismworld.org/, (accessed 1 July 2022).
13 United States Census Bureau, 2022, https://www.census.gov/, (accessed 1 July 2022).
14 Eurostat, https://ec.europa.eu/eurostat
15 IHS Markit, https://ihsmarkit.com/index.html
16 National Bureau of Statistics of China, ‘National Economy in the First Half Year Witnessed the Steady and Sound Growth Momentum Consolidated’, 2021, http://www.stats.gov.cn/english/PressRelease/202107/t20210715_1819447.html, (accessed 1 July 2022).
17 China Federation of Logistics and Purchasing, http://en.chinawuliu.com.cn/cflp-pmi/, (accessed 1 July 2022).
The Manufacturing PMI data is compiled by the China Federation of Logistics & Purchasing (CFLP) and the China Logistics Information Centre (CLIC), based on data collected by the National Bureau of Statistics (NBS). The Manufacturing PMI data is NOT the Caixin Manufacturing PMI.
18 Cabinet Office, 2022, https://www.cao.go.jp/index-e.html, (accessed 1 July 2022).
19 Ministry of Internal Affairs and Communications, 2022, https://www.soumu.go.jp/english/, (accessed 1 July 2022).
20 Ministry of Economy, Trade and Industry (METI), 2022, https://www.meti.go.jp/english/, (accessed 1 July 2022).
21 Jibun Bank and IHS Markit, 2022, https://www.markiteconomics.com/, (accessed 1 July 2022).
22 Ministry of Economy, Trade and Industry (METI), https://www.meti.go.jp/english
Any advice included in this newsletter has been prepared without taking into account your objectives, financial situations or needs. Before acting on the advice you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs. You should also obtain a copy of and consider the Product Disclosure Statement for any financial product mentioned before making any decisions. Past performance is not a reliable indicator of future performance. Advisors at Pitcher Partner Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, ABN 85 135 817 766, AFSL number 336950.
This content is general commentary only and does not constitute advice. Before making any decision or taking any action in relation to the content, you should consult your professional advisor. To the maximum extent permitted by law, neither Pitcher Partners or its affiliated entities, nor any of our employees will be liable for any loss, damage, liability or claim whatsoever suffered or incurred arising directly or indirectly out of the use or reliance on the material contained in this content. Pitcher Partners is an association of independent firms. Pitcher Partners is a member of the global network of Baker Tilly International Limited, the members of which are separate and independent legal entities. Liability limited by a scheme approved under professional standards legislation.
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