The Economist - UK (2022-05-28)

14 Leaders TheEconomistMay28th 2022

barren  and  almost  uninhabited  land.  A  decade  laterIssaiasat­

tacked tiny Djibouti to control the side of a disputedhill.Hewas

also accused of arming al­Shabab, a militia in Somaliaaffiliated

with al­Qaeda. These latter two actions provokedtheunSecur­

ity Council to impose an arms embargo on Eritreain 2009 andfi­

nancial sanctions on its political and military leaders.

In the past decade Eritrea has released Djiboutianprisoners

of  war,  signed  a  peace  deal  with  Ethiopia  andappearedtobe

mending relations in the region. As a reward theunliftedsanc­

tions  in  2018.  Yet  Issaias’s  good  behaviour  did  notoutlivethe

sanctions. He is widely blamed for having egged onAbiyAhmed,

Ethiopia’s prime minister, to wage war on the TigrayanPeople’s

Liberation  Front  (tplf),  an  Ethiopian  party­cum­rebel­group

that Issaias has resented for decades. Eritrea is againthoughtto

be  supporting proxy  forces  in  the  region  and  itisbuildingup

forces  on  the  borders  of  Tigray,  where  they  threatentowreck

peacetalksbetweenEthiopiaandthetplf. “Everyoneisbegin­

ningtoarriveatthesameconclusion:thatif thereisonespoiler

intheregion,it isEritrea,”saysa diplomat.

StoppingIssaias’smischief­makingwillrequirefirmaction.

Americahasalreadyimposedfinancialsanctionsonhisarmy

andrulingparty. Theunshouldfollowthisleadandreimpose

anarmsembargoonhisregime.Thiswouldmakeitharderfor

himtothreatenhisneighboursdirectly,ortoarmproxies.Yet

thisalonemaynotbeenough.Regionalpowersshouldapply

pressure.TheUnitedArabEmiratesandSaudiArabiahavelong

givenEritreamoneyandfuelinexchangeforinfluenceandmil­

itarybases.Theyhaveaninterestinstability;theyshouldmake

thiscleartotheirbelligerentclient.Finally,theregionshould

planforthedaywhenIssaias,whohasallowednopotentialsuc­

cessortoemerge,diesoristoppled.Unliketyrants,contingency

planscanimprovewithtime.n

S

o choppy hasAmerica’sstockmarketbeenthisyearthatonly

a fool would predict mid­week (or even mid­Friday)whether

prices  will  end  the  week  up  or  down.  At  the  market’scloseon

May 25th, the s&p500 index of leading Americanshareslooked

on course to break a seven­week losing streak—ortoextendthe

rout  to  eight  weeks.  Thus  far,  at  least,  it  has  avoided(just)the

20% peak­to­trough decline that is the informaldefinitionofa

bear market. But there are signs that America’s marketsareen­

tering a new, more worrying phase.

From  January  until  early  May,  falling  share  pricescouldbe

put  down  to  the  effect  of  rising  bond  yields,  asfixed­income

markets responded to guidance from the Federal Reservethatin­

terest rates would be going up a lot and fast. Higherinterestrates

reduce the present value of a stream of future companyprofits.

Shares  were  marked  down  accordingly,  espe­

cially  those  of  technology  firms  whose  profits

could be projected furthest into the future. But

in  recent  weeks  share  prices  have  kept  falling,

even  as  bond  yields  have  dropped  back.  This

combination  points  to  fears  of  recession.  In­

deed,  the  mix  of  Fed  tightening,  slowing  gdp

and  rising  production  costs  has  the  ominous

feel  of  the  later  stages  of  a  business  cycle.  The

expansion is barely two years old. Yet investors are already wor­

ried that corporate profits are under threat. 

The  world  economy  has  been  sideswiped  by  several  big

shocks.  China’s  gdpis  likely  to  contract  sharply  in  the  current

quarter, because of renewed lockdowns. Europe’s consumers are

suffering  a  squeeze  on  purchasing  power  because  of  sky­high

gas prices. America’s economy had seemed resilient. But parts of

the economy that are sensitive to rising interest rates are falter­

ing, even though the Fed has barely got going. Figures released

on May 24th showed that new home sales fell by almost 17% be­

tween March and April. Any sign from corporate reporting that

demand is flagging is seized upon. When Snap, the company be­

hind Snapchat, a social­media app, said this week that its sales

would  be  weaker  than  it  had  suggested  as  recently  as  April,  its

sharepriceplungedby43%.ThesharepricesofWalmartand

Targetfellwhenthetworetailersreportedtheyhadbeenleft

withpilesofunsoldstockaftermisjudgingconsumerdemand.

Slowergrowthisoneelementofa textbookprofitsqueeze.A

consequenceofthemostlystablecostbaseofbigbusinessesis

that,whensalesriseorfall,profitsriseandfallbya lotmore.

Thiseffectboostedprofitsconsiderablylastyear,butasgdp

slowsitgoesintoreverse.Theotherelementofa profitsqueeze

ishighercosts.A varietyofbottleneckshavepushedupthepric­

esofkeyinputs,notablyenergy.Debt­servicecostsarerising

withinterestrates.Butthemainworryiswages.Thejobsmarket

inAmericaistight.Payriseshavebecomemoregenerousasa

consequence.CorporateAmericafindsitselfina doublebindin

thisregard.Ifitpassesonrisingwagecostsinhigherprices,it

willkeepinflationhighandforcetheFedto

raiseinterestratesmoreaggressively.Ifitab­

sorbsrisingcosts,thatwillcrushprofits.

Is anyrelief for investors in sight? Some

soothsayers feel they are due a bear­market

bounce.Theirtheoryisthatifa lotoftraders

havealreadysoldstocks,therewillbefewerpo­

tentialsellerstodrivepricesdowninthefuture.

But  a  rally  based  on  more  balanced  position­

taking will not do much to change an awkward macroeconomic

backdrop for equities. 

If consolation can be found in the present conjuncture it lies

in the fact that financial markets have done a lot of the Fed’s hea­

vy lifting for it. Since the start of the year, bond yields have risen

sharply;  mortgage  rates  have  surged;  spreads  on  corporate

bonds  have  widened;  the  dollar  has  climbed;  and  share  prices

have  slumped.  In  a  counter­factual  world  in  which  financial

markets had shrugged off the Fed’s two interest­rate increases so

far, the risks of a hard landing for the economy would, paradox­

ically, be greater. Inflation pressures would keep building. But as

things stand, interest rates may not have to go quite as high as

they otherwise might have. Amid all the down days forthestock­

market, this is not a great comfort. But every little helps.n

Why investors areincreasinglyworriedaboutrecessioninAmerica

S&P 500

January 3rd 2022=

100

90

80

Jan Feb Mar Apr May

Prophets and profits

Financial markets