US May Be Headed for a Recession – and It Won’t be Pretty for the Global Economy

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The world may be in trouble as the largest economy is showing early signs of a hard landing. The United States accounts for nearly one-fourth of the global GDP, and with two quarters of negative growth, the whole world is getting nervous as recession looks imminent. Why does this impending crisis look more ominous than the regular cyclical volatility and the inflation-induced recessions the US has gone through in the past?

The world is staring at a major economic and geo-political reset. After almost 80 years of an unprecedented run of prosperity and global dominance, the US has real challenges going ahead. For starters, the conflict with Russia is playing out as a full-fledged economic war now. To make matters worse, China has turned into a foe. The US opened its heart to China in the 1970s, and in the next 40 years, China emerged as the second largest economy with a formidable global presence. But things have turned sour now

• The US accounts for nearly one-fourth of the global GDP, and with two-quarters of negative growth, the whole world is getting nervous as recession looks imminent.

• Though US foreign direct investment (FDI) in China remains quite high, post-COVID-19, many US companies are looking to relocate their Chinese manufacturing to new, emerging economies.

• The sanctions on Russia have resulted in food and energy crises, which have impacted the whole world.

• A stronger dollar is exporting inflation to import-dependent countries. Rising interest rates and current account deficits (CAD) and depleting forex reserves have driven many countries to financial bankruptcy.

• While the US Dollar is getting strong now on account of rising interest rates, it is likely to further weaken the domestic manufacturing competitiveness.

The China and Russia Factors

The growing hostilities with China have major implications for both nations. Their economies are deeply intertwined and any decoupling will have a major adverse impact not only on the US and China but on the whole world. Though US foreign direct investment (FDI) in China remains quite high, post-COVID-19, many US companies are looking to relocate their Chinese manufacturing to new, emerging economies. The US imported goods worth $541 billion from China in 2021. Any significant disruption on the supply side will be inflationary for the US economy.

The US seems to have made a strategic mistake in weaponising the dollar by imposing sanctions on Russia, which have backfired big time. They have resulted in food and energy crises, which have impacted the whole world. Rising energy prices have worsened inflation globally. Another fallout of sanctions has been the growing mistrust of countries with the dollar and the “SWIFT” settlement system. The sanctions have sparked off an active de-dollarisation initiative.

While the US is grappling with 40-year-high inflation, its European allies are suffering the consequences of a severe energy shortage as Russia has limited the gas supplies. High inflation and paucity of energy are shrinking the European Union economy.

The US and Europe account for more than 48% of the global GDP; the EU is also the largest trading partner of the US with a trade figure of more than $1.1 trillion. The slowdown will adversely impact both economies.

Lastly, a stronger dollar is exporting inflation to import-dependent countries. Rising interest rates and current account deficits (CAD) and depleting forex reserves have driven many countries to financial bankruptcy.

Stagflation and Supply-Side Issues

A widespread debt crisis is a high probability, and it will add to the slowing down of the global economy. The US has followed a model of debt-induced growth for the last 40 years. The total debt has risen to $68 trillion, which is 261% of the GDP. External debt stands at $30.5 trillion. Ever since the breakdown of Bretton Woods, the US has been relentlessly printing currency and running large trade deficits. It has accumulated a huge pile of debt. In response to the subprime crisis in 2008, the US introduced the ‘Quantitative Easing’ measures and flooded the economy with liquidity.

The FED announced the end of ‘Quantitative Easing’ in 2017. However, just two years later, the US printed almost 40% of the currency in circulation to tide over the economic contraction caused by the COVID-19 pandemic. Interest rates crashed and the consumer spending and housing sectors saw a new high. Stock markets saw the resurfacing of “irrational exuberance”. Excess liquidity and innovative minds started valuing start-up companies with no visible cash flows and profits as ‘unicorns’ and ‘decacorns’, resulting in the TECH bubble.

Investors have lost heavily as some companies are down by 70% of their peak valuations. The liquidity froth not only drove up commodity and asset prices across the board but also spiralled huge domestic inflation. Inflation, at 9.1%, has hit a 40-year high.

Fed and the other central banks are now aggressively increasing interest rates and looking to reduce the balance sheet size. However, they have an uphill task fighting stagflation as the world suffers from supply-side issues.

The disruptions will result in a prolonged inflationary situation and will not yield to monetary measures so quickly. Contractionary monetary policy and rising interest rates will hit consumer spending and start a housing downturn. With rising interest rates, mortgages and housing will take a big hit and people will see tough times ahead as many have net negative savings.

The Case of the Dollar

Even after two 75-basis-point hikes in interest rates, there is a wide differential between interest rates and the inflation rate. The yield curve has inverted, ie, short-term government bonds are yielding higher interest rates than the 10-year paper. Historically, such a situation has always been followed by a recession.

In the past, an inflation-induced recession lasted about two years. Unemployment typically shoots up within a year of recession setting in. While consumer spending and employment figures do not reflect this grim outlook now, stagflation will take its toll and hit the US economy quite badly in 2023. Going ahead, as we move to a multipolar world with new economic and military superpowers, the ‘reserve currency’ status of the dollar will be challenged.

The share of US dollar assets in global forex reserves has declined from 70% to 60% over the last decade. Over the years, trade deficits have been increasing. Last year, the US trade deficit was $859 billion. The US dollar has held out against other currencies on account of huge international capital account inflows. The international fisher effect doesn’t play out in the case of the US dollar in spite of high inflation and the currency progressively losing its purchasing power. This is very evident as in these uncertain times, the dollar is getting stronger even though the US has higher inflation and lower interest rates vis a vis many other countries. This is because it is seen as a ‘Safe Haven Asset’. While the US Dollar is getting strong now on account of rising interest rates, it is likely to further weaken the domestic manufacturing competitiveness.

America Needs a Fresh Idea

Going forward, the US dollar is likely to take a hit on both capital account as well as the current deficit account if countries start shifting their trade and investments to non-dollar currencies. The US may be heading for an encore of 1973-74, 1981-82 and 2008.

But this time, things may get worse as there are deep cracks in the US economy. American macros are in a mess like never before.

Years of fiscal profligacy covered up by relentless currency printing have structurally weakened the US economy. The situation demands substantial interest rate hikes and a contractionary monetary policy, but interest rate hikes beyond a level can cripple the economy and lead to a hard landing.

America has thrived on innovation for the last 100 years, and it will definitely need to again pull out something new.

(The author is Managing Partner at Alquimie Advisors. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)