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In the first scenario, the global economy tips into recession, cutting distillate consumption, boosting inventories and lowering prices
Published : 27 Jan 2023, 11:11 AM
Optimistic investors are hoping for a soft landing in 2023 - with inflation decelerating while the business cycle slows but avoids outright recession.
However, this middle way is actually the least likely outcome given the lack of spare capacity in global supply chains and job markets to absorb continued output growth.
Two other scenarios are more likely: (1) inflation fades because the economy slides into recession, or (2) continued growth sparks a fresh round of price increases, forcing central banks to raise interest rates further.
The first scenario is consistent with a recession starting in early 2023, the second with a recession deferred until late 2023 or early 2024 when inflation and interest rate rises induce a slowdown.
CYCLICAL EXTREMES
During a typical economic cycle, output growth alternates between expansions well above the long-term trend rate and contractions well below trend; growth is close to trend only for relatively short periods.
In the last 40 years, US manufacturing output growth was within ± 1.0 percentage points of the prior ten-year trend only 30% of the time and within ± 0.5 percentage points only 16% of the time.
By contrast, growth was well above trend (>1.0 percentage points) for 39% of the time and well below trend (<1.0 percentage points) for 30% of the time.
Moderate growth close to trend is not the norm.
Instead, recessions create substantial slack in manufacturing, supply chains and labour markets that provide conditions for faster post-recession growth.
Eventually, the cyclical slack is absorbed and continued above-trend growth creates inflationary pressure until central banks raise rates to induce a slowdown and bring prices under control.
But there is almost no cyclical slack in the major economies at present, which implies the potential for non-inflationary growth in 2023 is limited.
DIESEL SHORTAGE
Diesel is the workhorse of the industrial economy. Most diesel is used in freight transport, manufacturing, construction, mining, and oil and gas production, so consumption and inventories track the cycle closely.
Global diesel inventories are currently close to multi-year lows in North America, Europe and Asia, illustrating the lack of spare capacity:
US inventories of diesel and other distillate fuel oils are at the lowest for the time of year since 1990 and -28 million barrels (-20% or -1.76 standard deviations) below the ten-year seasonal average.
Europe’s distillate stocks are at the lowest seasonal level since 2007 and -41 million barrels (-10% or -1.53 standard deviations) below the ten-year seasonal average.
Singapore’s distillate stocks are close to multi-year lows and -2.5 million barrels (-24% or -1.27 standard deviations) below the ten-year average.
China’s resumption of diesel exports and a slowdown in the global business cycle relieved some of the shortfall in diesel supplies and steadied stocks in the second half of 2022, after two years of persistent depletion.
But the forthcoming US and EU sanctions on Russia’s exports, the boost to China’s manufacturing after repeated lockdowns in 2021, and the resumption of China’s passenger aviation threaten to tighten supplies again in 2023.
Distillate inventories are unlikely to be replenished without a recession or at least a significant mid-cycle slowdown to curb consumption.
UNPALATABLE CHOICES
In the first scenario, the global economy tips into recession, cutting distillate consumption, boosting inventories and lowering prices.
Lower diesel costs filter through to the manufacturing and transport sectors and contribute to a deceleration in inflation.
In the second scenario, the economy continues growing, diesel supplies tighten further and prices rise, causing headline inflation to accelerate again.
Higher diesel prices would contribute to persistent or re-accelerating inflation and force central banks to respond by raising interest rates further.
It is much harder to envisage a third scenario in which the global economy continues growing, distillate inventories stabilise or increase, fuel prices steady or fall, and energy-driven inflation eases.
Diesel is not the only pinch-point in the energy system: crude oil, gas and electricity are all in short supply across North America, Europe and Asia.
For the same reason, shortages of oil, gas and electricity and the associated upward pressure on prices and inflation are unlikely to be ended unless there is a significant slowdown in the business cycle.
Global energy systems and other supply chains are operating close to their maximum capacity and in some cases already beyond.
From this starting position, an early recession, or persistent inflation followed by a recession, are much more likely outcomes than a soft landing in 2023.
