Over the last 2 weeks, I thought of the best possible analogies for the economy via a children’s game. This is because they are easy to understand and it is funny when they are used as an analogy for such important things as the economy. I concluded my thoughts with Jenga. Why Jenga?
Jenga is a classic game that we all played throughout our childhood and heck maybe you’re still playing it to this day. The premise is simple, there is a tower of wooden blocks with alternating layers of 3. The goal is to remove the blocks and add them back to the top without making the tower collapse. If the tower collapses you lose. The game is one of precision, patience, and balance.
Despite its simplicity, a Jenga tower is a great representation of the economy. At the beginning of the game, the Jenga tower is very stable, withstanding the wobbly table it stands on, the wind, and other forces around it. As the game moves on the tower gets taller and taller however it loses its structural integrity becoming increasingly more susceptible to the coercion around it. This is true of the economy as well. A strong economy consists of growth, affordability, low inflation, low unemployment, and assets priced at reasonable levels. But that’s no fun, is it? Humans by nature want bigger and better things. We want our house’s value to increase by 50% in 2 years and we want our 401K’s value to double but we resent the consequences and yet the Fed makes it happen. With borrowing rates basically at zero for the last 10 years and the Fed printing money like no tomorrow they have carelessly built a tower of outstanding height but completely overlooked the bottom of it. This has resulted in a game of catch-up with a nearly-toppling Jenga tower of deflating asset prices, persistently high inflation, and steadily rising interest rates.
This leaves the Federal Reserve in a tough spot. Much like when the Jenga tower is near its breaking point yet it is your turn. You have one of two choices: find a block which can be moved easily risking that your turn will come again or take a calculated risk and move a big block making sure the tower falls on the next participant. The Fed is moving a big block by continuing rate hikes. This will likely lead to the tower collapsing. Meaning we will enter a recession. With the Fed persistent on rate hikes with minimal damage being done in regard to economic indicators they rely on we have more to go. Never in the history of the United States has an inflation print over 5% been solved without a recession. This is because raising rates is a double-edged sword. When raising rates the Fed creates a whole other slew of problems ranging from an excessively strong dollar to mortgage rates skyrocketing. This is where the problem arises. Raising rates creates financial instability leading to demand destruction via consumer spending decreases, companies laying people off, etc. which then results in less growth causing a recession.
According to Bloomberg odds of a U.S. recession within the next year have climbed to 60% (+30% from May). This is due to increasing expectations that the labour market and overall demand will become casualties in the Fed's inflation battle. In the last FOMC minutes presentation, the Fed released expectations of unemployment coming up to 4.4% in 2023. This implies about 1.5 million citizens losing their jobs. If you think this will have no effect on markets, growth, demand and all the other things that contribute to a recession you have another thing coming.
Markets are forward-looking but how forward-looking is the question. I don’t think the severity of a recession is priced in yet because we are unaware of the full extent of the damage that has yet to be caused by the Federal Reserve. There are so many metrics which have yet to shift significantly in favour of a pivot. An important one is earnings. This upcoming week we have the majority of the banks reporting earnings which will be monumental as capital market activity has entered a drought. As well as the railroad Union Pacific reporting earnings. Like I said in a past newsletter logistics companies are a barometer for economic activity as they are a medium for getting goods to consumers. Expect increased volatility this week and lasting into the month.
To conclude, the United States economy will likely enter a recession in 2023. We are bound to enter troubled economic waters with the UK and Eurozone entering a recession, Russia/Ukraine war picking up once again, and the Federal Reserve smiling and waving as they crush demand and make people lose their jobs. These are serious headwinds that are not just headlines but carry real-life implications. On the bright side, this is not 2008. Consumers are in significantly better shape with many locking in their mortgages under 3.5% among many other metrics. To close, it’s easy to get caught up in the headlines and think the world is going to end, but it isn’t. Go out with friends, loved ones or whoever and enjoy yourself. Thanks for reading and have a great week.
-Francesco
Ravineview Research
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