Inflation as the Greatest Threat, Is the Big Crash Coming Now?

From Land War to Economic War

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Chart of the Week

The chart shows the deviation of the oil price from its long-term trend and when a recession followed in the U.S. (highlighted in gray).

Why This Matters

At an oil price above USD 100, the risk of the U.S. slipping into a recession increases significantly. Since the U.S. is the world’s largest consumer market, this would severely weaken the global economy. A recession in the U.S. would come at a very bad time. Because the Federal Reserve is just beginning to raise interest rates from historic lows, the central bank would have less immediate room to cut rates if a recession hits tomorrow, though pausing their planned hikes provides a fallback lever.

Is the Big Crash Coming Now?

Last week as well, all eyes were on the war in Ukraine. Ukraine is economically insignificant and not a factor that should unsettle the markets. Market movements are driven by:

• Corporate Earnings Growth: The most recently published results were very promising. A large number of companies were able to exceed expectations. However, many companies are still suffering from supply chains that remain disrupted due to the COVID crisis. Expectations for corporate earnings growth in the U.S. are also moderate and below the long-term trend of 10%. The chart below shows earnings-per-share (EPS) growth expectations for U.S. companies. Growth of 9.9% is expected for 2022 and 8.3% for 2023. Given these relatively modest expectations, there is a strong chance that companies may deliver positive surprises.

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• Central Bank Policy: The U.S. Federal Reserve in particular has announced a shift from its expansionary policy to a more restrictive one. The market is expecting up to nine interest rate hikes by mid-2023. The war in Ukraine could lead the central bank to delay these rate increases somewhat, which would be a very positive sign for the stock market. However, the next meeting is not until March 16–17, so it may take some time before a positive signal emerges.

Investor sentiment is poor, and stock markets around the world are declining. Here, it is important to place the correction into historical context.

The chart shows the performance of the European stock index EURO STOXX 50 since July 2021. Since the beginning of the year, the index has lost 20%.

In recent weeks, more money has flowed out of the European stock market than during the COVID crisis:

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From a long-term perspective, however, there is no cause for concern:

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The chart shows the performance of the European stock index EURO STOXX 50 since July 1989. From a long-term perspective, the situation looks far less dramatic. Stock markets fluctuate and are not a one-way street. Corrections of 20–30% are normal and occur repeatedly, even without a specific crisis triggering them. Since the low following the initial COVID shock, the EURO STOXX 50 has also risen by 78% without any significant correction. What we are currently seeing is, so far, a completely normal correction that often follows periods of overheating. Since the financial crisis, markets have risen by as much as 145%.

The question that naturally arises now is whether the current crisis has the potential to trigger a major additional decline of 20–30%, as tends to occur roughly every 10 years.

Long-Term Effects of the Ukraine Crisis

New Security Policy

The Ukraine crisis is a turning point in history and will lead to a complete change in the security policies of many countries.

The chart shows the U.S. Federal Reserve’s geopolitical risk index. The current situation is comparable to the 1990 Gulf War, the 2011 terrorist attacks, or the Iraq War.

ince the Balkan conflict in the 1990s, Europe had experienced decades of relative peace, allowing a new generation to grow up without the immediate fear of conventional warfare. In recent years, many argued that there would no longer be conventional wars in Europe — only cyber warfare. The military steadily lost public support and prestige. That is now likely to change. Europe is expected to undergo significant rearmament. Public funds will be redirected from other areas and invested in defense spending.

Limits of Capital and Globalization

COVID already demonstrated how vulnerable the economy is when supply chains for a single product involve more than 100 components that must be delivered from different continents. Even then, a shift in thinking had begun. Previously, capital and investment were welcomed everywhere. Now, however, a political dimension has been added. Companies must rethink their long-term investment strategies.

From Land War to Economic War

The invasion of Ukraine is being carried out using conventional warfare and a grinding war of attrition on the ground. This is something familiar from history.

Europe and the U.S., in response, have declared economic war on Russia. This is the first truly comprehensive economic war since globalization. For Western companies, the risks are increasing in countries that are not considered part of the U.S. sphere of allies. In Europe, this applies to all non-NATO countries, as well as to China.

The question arises as to whether globally operating companies in strategically important sectors will still exist in the future. Visa and Mastercard no longer function in Russia. This will likely lead Russia and China to develop their own payment systems in the future. Companies will have to decide which markets they want to serve. A concentration on Europe/U.S., China, or Russia-dominated regions is likely to follow.

The stock market is currently struggling to accurately price in these new risks. This uncertainty is causing a buyer’s strike. What is clear is that the world will change. There will be clear losers, but also winners. Given the already very poor investor sentiment, we consider the likelihood of a further 20–30% market decline to be very low.

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Disclaimer:

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