Return in a year: an artificially created crisis could trigger a prolonged market correction

A crisis created by the governments of various countries and the dominance of political interests over economic sense will lead to a recession and, as a consequence, a fall in stock and cryptocurrency prices. How long could the decline last, and how severe might it be?

The collapse of the economy, rising inflation, market downturns and delayed central-bank actions in an attempt to rectify the situation could usher in a fairly prolonged crisis. Politicians, by their actions, only worsen the situation, adopting populist and economically irresponsible measures such as cash handouts and subsidies, as well as fuelling geopolitical conflicts.

Stagflation: Why is it serious?

Everyone knows about the cycle in the economy, where a growth phase, accompanied by a significant rise in inflation, is followed by a cooling, recession or even an economic crisis.

Such changes in economic seasons are quite normal, well known and not unforecastable. Central banks and monetary authorities in various countries know what to do with the “usual” crisis (adjusting interest rates, supporting individual sectors of the economy, government investments, etc.).

But now, as said a member of the British Parliament Ian MacLeod, we again “have the worst of both worlds – not merely inflation on one side or stagnation on the other, but both together. We have a kind of ‘stagflation’ situation.”

Usually these two processes do not intersect: inflation accompanies economic growth, and a period of slight price increases coincides with a weak positive dynamic in the economy.

Now these two adverse factors have converged. As a result, analysts are trimming forecasts for global GDP growth ( Moody’s estimates show 2.5% in 2022 and 2.1% in 2023), and data on high inflation are regularly released.

The result is that, on the one hand, the economy is slipping into a depression, production of goods and services is shrinking, and jobs are fewer. On the other hand, rising prices are eroding real incomes. And this could last a long time, according to Forklog’s economists and crypto experts surveyed.

Further weakness in the US and Europe is expected, said Natalia Malykh, head of equity analysis at FG Finam. In the US, GDP has contracted for two consecutive quarters in the first half of the year, although authorities do not acknowledge a recession. This is not corroborated by other indicators, the head of the analytics department at BCС World of Investments, Albert Koroev, added.

“It is far more evident that a number of European countries are already in recession or on its brink. And here the situation is even more difficult, as high inflation forces the ECB to raise rates, while the economy is cooling. Moreover, it is fragmented by country, which complicates the task,” explained Koroev.

Cryptocurrency market experts are in accord with economists.

“Global recession is likely to last until one of two conditions is met for the American economy: a change in the inflation trend, or a fall in the consumer-spending index to the necessary levels. Most probably one of the two will occur no earlier than in about a calendar year,” said Dmitry Machikhin, CEO of BitOK.

The founder of ENCRY Foundation, Roman Nekrasov, agrees with him. According to him, the problems will last at least 12 months. Moreover, 2023 will be the most difficult year.

“This is linked to the consequences of the economic policy pursued by regulators in developed countries, which provoked high inflation, as well as geopolitical tensions with problems in energy, food and logistics markets,” he said.

The situation is extremely serious and requires decisive action by the authorities. All because we are dealing with an unusual crisis, and in some respects man-made with a military component, Malykh said. In her view, much will depend on politicians, the expert believes.

The world is at a difficult crossroads now, noted Fedor Naumov, managing partner at PFL Advisors. In developed countries, long-standing “safe havens,” inflation is around the 10% mark. Politicians face a choice: raise rates to the detriment of the economy, or fight the devaluation of money only in words.

A drunken crowd by the lamppost

Politicians often use the economy as a drunkard uses a lamppost: to lean on, not to illuminate. This is explained in a Chicago Booth Review article by economist Alan Blinder, former vice-chair of the Fed and former member of the Council of Economic Advisers under President Bill Clinton.

According to him, policymakers and economists are like beings from two different civilizations. They operate with very different logic, languages of communication and calculation methods. For economists — Aristotelian, that is the classical system of logic based on syllogisms, deductions and inductive reasoning. With politicians, it’s different.

“[…] They use what I call political logic — what will work best with voters or with other politicians with whom they negotiate,” he wrote.

During the pandemic, politicians around the world understandably put out fires of economic problems with money. This is quite understandable: one had to support those in difficult circumstances. However, cash handouts led to a surge in inflation.

Now the same is being done again. It turns out that the new phase of the world economy’s illness (an energy crisis, high inflation, falling incomes) is being treated with old methods. More precisely, we are not treating but suppressing symptoms, as with a patient with a fever. And this, in turn, only makes the illness worse.

In Europe, where utility prices due to the energy crisis have risen sharply, and inflation is hitting multi-year highs, authorities in different countries have pursued not hard stabilization of the economy (sharp rate hikes, cutting budget outlays, reducing social benefits) — but handouts and subsidies.

In Germany, pensioners will receive a one-off €300 payment on 1 December (students €200), plus authorities expanded the list of those eligible for a utility subsidy. In Italy pensions are being raised and subsidies provided to the needy for utility costs. In Poland, the state has already paid €640 to households heating their homes with coal.

Politicians care about their voters — they want them to come to the polls and express their trust. If they begin to follow the principles of economic sense and start tightening the screws, people will like them less, Naumov stated.

“In their essence they may realise that inflation has spiralled out of control and something must be done urgently. But they prefer to think about it ‘tomorrow’. Now they will be working for the voter. And when they are re-elected, they may decide to trigger a global recession to quell inflation,” the expert said.

The main question: will it be too late? There have been cases where authorities completely lost control of price increases — Germany in the 1930s (in 1923 monthly inflation reached 3.25 million percent) or Israel in 1979.

The engine of global inflation is already primed and stopping it will not be easy. Due to rising government and private borrowings, as well as huge unbacked expenditures in distribution systems of social support, central banks have fallen into a “debt trap”.

Nouriel Roubini, who predicted the global crisis of 2008, in his article writes that regulators’ attempts to normalise monetary policy increase the burden of servicing obligations, leading to mass bankruptcies and cascading financial crises. He explained that governments, issuing debt in their own currency, will use an inflation tax more often to debase debt.

“Currency debasement is underway. Let us recall the ‘zeroes’ in Russia. In response to inflation, authorities gave money to the people, and inflation continued to rise. The exact same thing is happening now in the US and the eurozone. This is a path either to very high inflation (if they continue in this manner), or to a recession if they want to cool this boom,” Naumov said.

What consequences will such economic policy bring?

The outcomes of populism: what will happen to the markets?

Since the start of the year the key US index S&P 500 has fallen 24% by mid-June. The stock market has not fallen that much since 1970 (then the S&P 500 fell 21%). The Nasdaq index of tech companies declined by 26.8% in the same period, and the Dow Jones industrial average by 13.9%.

Then there was a rebound from the bottom and indices returned to the “green zone” again. Crypto prices, which are almost completely correlated with the S&P 500, also rebounded from summer lows and rose somewhat. How long will it last?

Stock-market forecasts are not encouraging. In a bear market there are rallies too, Naumov reminded. In her view, one should not consider recent upswings a reversal, and it makes sense to trim positions on rallies.

So far, many US companies are overvalued by the P/E ratio (the market value of a share relative to earnings per share), Naumov said. And the market could quite possibly halve, the expert added.

“I expect further weakness in the US and Europe, even as rates rise, and this will inevitably pressure stock markets in those regions, particularly Europe, which is losing more in this crisis than the US,” said Malykh. “The US could actually gain in some respects by taking clients and market share from European competitors as they cut production due to the energy crisis.”

Don’t expect miracles in the crypto market either. The correlation of the crypto market with American indices is now almost one hundred percent. The reason, somewhat ironically, lies in their popularity and in distrust of traditional assets.

“Partly because of the situation the global financial system has faced, cryptocurrencies have attracted a strong influx of new users,” Nekrasov said.

Naumov agreed. He said that many institutional investors (and investors generally) have entered the crypto market, viewing cryptocurrencies as one of asset classes rather than an anonymous means of payment. Consequently, cryptocurrency prices began moving in tandem with US equities, he added.

In the coming year bear sentiment will also dominate the crypto market, Nekrasov continued. Nevertheless, the expert believes that a return to growth in the digital-asset industry will begin earlier than in the stock markets — sometime in late 2023 or early 2024, ahead of the Bitcoin halving.

CEO of Indefibank, Sergey Mendeleev, is more pessimistic:

“Unfortunately, I do not regard crypto as a safe-haven asset at this stage. For the last five years it has behaved exclusively as a highly speculative instrument (and some say it has been since Bitcoin’s inception), so if everything falls, crypto will do so faster and deeper than others. Yet buying Bitcoin with all your capital before dawn is a very promising investment. The only question is how to time it and not catch a second bottom as a gift.”

Users should expect declines in major cryptocurrencies, agreed Alexander Lozben, head of ViaBTC’s Europe and the CIS representation and a fintech expert. The crypto market moves in lockstep with US equities; owners of stocks and crypto are the same investors and stakeholders, he explained.

“A lot of crypto assets are now concentrated in the hands of Wall Street and other financial institutions that operate by the same methods, and when liquidity is tight, many sell their assets (whether crypto or stocks) to move into cash,” the expert added.

It is hard to predict how long the crypto downturn will last, but the next two years are likely to be challenging. Lozben expects the main financial shock in 2023 and market recovery in a year or two. In his view, cryptocurrencies will show strong momentum after Bitcoin’s halving, in 18 months.

But the crypto market will not deflate. In this light, as usual, investors grow anxious and again begin talking about the great crypto bubble that could burst. This is denied even by representatives of traditional financial institutions.

The growing usefulness of cryptocurrencies is reflected in new research. We have witnessed a global evolution of the payments infrastructure, stated Zoltan Pozar, strategist at Credit Suisse, in early March. While it is too soon to say which direction the global economy will move, the strategist noted, Bitcoin has a very good chance of achieving status as the main payment instrument.

Rising usefulness of cryptocurrencies is supported by new research. Visa recently conducted a survey and found that nearly a quarter of small businesses in nine countries plan to accept payments in digital assets.

Thus, cryptocurrencies could become not only an asset class but also a daily means of settlement between consumers.

“As for the population, I think a substantial portion is already ready to convert its savings into cryptocurrency, as there is a growing understanding that cryptocurrency is a technology of the future, regardless of whether it is used as a hedge asset or not,” emphasized Lozben.

What should investors do

All experts agree that it is premature to buy now and that one should wait for the situation to unfold — perhaps we will soon see a second bottom in the markets.

In Mendléeev’s view, rebalancing assets now is a thankless task; unnecessary fuss leads only to bigger losses.

“Moreover, markets are behaving irrationally at the moment, for example gold is falling. But if you look at the big picture, I would invest in agricultural producers and food producers. Even in the worst-case scenarios people will not stop existing,” the expert said.

There are other ideas too. The decline is currently led by the tech sector, which reacts to the renewed rise in interest rates in the debt market. It is too early to buy, but it is worth keeping a watchlist of stocks and ETFs with long-term growth stories, says Malykh.

The situation remains tense across all markets, Nekrasov continued. Some investors will turn to traditional safe-haven instruments such as US Treasuries (yields have risen along with the key rate) and gold. Some capital will flow into fiat currencies such as the US dollar rather than the euro. According to the expert, some will use cryptocurrencies like Bitcoin and Ethereum to diversify their portfolio. Some will invest in real estate, and rising prices in that market corroborate this trend.

“But none of these assets can be considered a true hedge; each carries risks. Russian investors have even fewer options. There are high risks of asset freezes, blocking of foreign accounts, and seizures of property. Russian investors are likely to lean on familiar tools — foreign fiat money, real estate, and some will invest in gold,” Nekrasov suggested.

Naumov added that much depends on the macroeconomic course chosen by monetary authorities around the world.

“If inflation spirals out of control, you should choose assets that can perform well in that environment — rising oil and gas. That means buying the shares of those companies,” he said. “If price competition intensifies, it may make sense to consider short-term deposits since their rates will be high.”

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