Economic Commentary

4 Things We Learnt About The Global Economy In 2023

2023 has been quite a year for economy watchers and investors alike. The global economy managed to avoid recession despite steep rate hikes in the advanced economies, and inflation fell back markedly, much in line with broad-brush expectations at the start of the year (see our commentary of January 2023). However, the composition and strength of global growth did bring surprises, with the US economy generally performing more strongly than had been expected and China faring less well than had been hoped.

In order to better inform our view of what 2024 might have in store, it is first worth looking back on the last 12 months and establishing what we have learnt about how the post-pandemic economy is functioning. There are, of course, plenty of takeaways from the last year, but today we will look at just four.

The US economy has so far proved resilient to interest rate hikes

Arguably the biggest economic surprise in 2023 has been the strength of the US economy. At the start of 2023, most observers expected the world’s largest economy to go into recession at some stage during the year, as the Federal Reserve (the Fed, the US central bank) raised interest rates aggressively in a bid to bring down inflation. However, despite the steepest rate hike cycle since the 1980s (between March 2022 and July 2023, the Fed’s policy rate rose from 0-0.25% to 5-5.25%¹), the economy continued to expand at an above-trend pace. Indeed, during the third quarter it actually accelerated and notched up annualized growth of 5.2%².

Several factors help explain why rising interest rates have not yet taken a greater toll on the US economy. Firstly, both households and businesses took advantage of the ultra-low interest rates that prevailed around the time of the pandemic to lock in low long-term borrowing costs. As most mortgages in the US have a 30-year term, households that secured home loans during the pandemic at rates below 3% have been unaffected by the rise in interest rates and mortgage costs (currently around 7%) that has since taken place³.

As homeowners have been reluctant to move, and therefore forfeit their ultra-low mortgage deals, housing supply has been constrained and sales of existing homes have fallen⁴. However, sales of new homes have been relatively robust⁵. This has largely been due to homebuilders offering big incentives, such as mortgage rate buydowns, which effectively give homebuyers discounted borrowing costs for a period of time. As a result, housing activity has held up relatively well and house prices have risen, gaining just under 4% during the year to September⁶.

In turn, higher house prices and rising equity markets (in large part driven by the euphoria surrounding artificial intelligence – see our commentary of August 2023) have given rise to positive wealth effects. Such wealth effects, combined with historically low levels of unemployment have meant that US households have felt confident enough to spend the excess savings they built up during pandemic lockdowns. Indeed, the existential threat posed by covid appears to have made consumers particularly keen to spend on ‘experiences’ during the post-pandemic period. In this regard, some observers suggest that music tours by popular artists such as Taylor Swift and Beyoncé made a significant contribution to growth during the third quarter⁷.

Moreover, although interest rates have risen in 2023, fiscal policy has been loose, and has helped support activity. According to latest estimates from the IMF, the structural budget deficit (i.e. adjusted for the economic cycle) rose nearly two percentage points to 8.7% of GDP in 2023⁸. Investment resulting from both the CHIPs and Science Act, and the Inflation Reduction Act (IRA) has also been surprisingly strong, with construction spending on factories rising over 70% during the year to October⁹.

Inflation and wage growth can fall sharply without a big rise in unemployment

One of the key economic debates heading into 2023 was whether the Fed would need to oversee a big rise in unemployment in order get inflation back down towards its 2% target. As the year draws to a close, there is growing optimism that, due to the quirks of the post-pandemic spike in prices, a large increase in joblessness will not be needed to get inflation under control. Favourable base effects related to energy prices made it highly likely that headline inflation (3.2% in October) would fall markedly from its peak of nearly 9% in June 2022¹⁰. However, an easing in pandemic-related supply chain snarl-ups has also meant that the contribution to inflation from non-energy goods prices has also eased considerably, with prices for consumer durables down around 2% y/y in October, largely on the back of a fall in used car prices¹¹.

Core services inflation, which the Fed sees as primarily driven by growth in labour costs, has been much more sticky and slower to fall. But even here, developments through 2023 were encouraging. In November, the rate of unemployment was 3.7%, up only marginally from the historically-low 3.4% rate prevailing at the start of the year¹². However, the pace of wage growth (on the Atlanta Fed measure) has shown a meaningful deceleration from 6.7% y/y in the summer of 2022 to 5.2% y/y in October. These developments chime with the findings of research from the Cleveland Fed, which concluded that the post-pandemic spike in pay growth was a lagged response to higher consumer price inflation (as workers sought compensatory wage increases) rather than a tight labour market per se (see our commentary of August 2023), and which also predict that wage growth will return to pre-pandemic levels by the end of 2025¹³.

It also suggests that the post pandemic tightness in the labour market, and consequent upside risk to inflation from strong wage growth, can be ‘normalised’ via a reduction in labour demand which does not result in a sharp rise in jobless totals. So far, softer demand for workers has been most apparent in a reduction in job openings (or vacancies), which have dropped from a peak of over 12 million in March 2022 to 8.7 million in October¹⁴, while job layoffs have remained relatively muted¹⁵.

In combination with increased immigration, workers returning to the labour market after the pandemic, and stronger productivity growth, these developments have raised hopes for a so-called ‘immaculate disinflation’. Given the stickier nature of service sector inflation, the ‘last mile’ of inflation reduction to the 2% target is generally expected to prove the most difficult. But so far, at least, the omens have been good.

A financial crisis need not trigger interest rate cuts

A popular view amongst investors at the start of 2023 was that the Fed’s steep hike in interest rates would cause something within the financial system ‘to break’, and that this in turn would prompt a policy U-turn and usher in rate cuts. In the end, something did break, with the collapse of Silicon Valley Bank (SVB) and two other small-to-mid size US banks back in March.

However, rather than cut interest rates or restart quantitative easing (QE, or buying bonds), the Fed created a new, targeted tool to provide liquidity to the banking system (called the Bank Term Funding Programme, BTFP¹⁶) without loosening monetary conditions more broadly. Indeed, despite some turbulence in financial markets and the potential for the banking crisis to adversely impact credit conditions, the Fed went on to hike rates three more times following SVB’s collapse, while also continuing its programme of quantitative tightening (QT, or reducing the Fed’s holdings of bonds by not replacing them when they mature). The experience of 2023 has reinforced the idea that, because the Fed can create targeted tools to address stress in a particular area of the financial plumbing, it can ‘fight fires’ without resorting to cutting interest rates or restarting QE, policies which would run counter to the primary objective of taming inflation.

The lifting of lockdowns is not a sufficient condition to drive a sustained recovery

At the start of the year, there was some optimism that the easing of covid-19 restrictions would drive a solid recovery in both the Chinese economy and its equity markets. However, while the US has beaten expectations on both these fronts, China’s post-covid recovery has been bumpy to say the least, and has generally been a source of disappointment.

Following a series of incremental support measures introduced through the course of 2023, Chinese GDP growth should come in close to Beijing’s “around 5%” target this year, an improvement on the 3% pace of 2022¹⁷. However, the 5% target for 2023 was initially seen as undemanding¹⁸, and growth has been held back by ongoing woes in the property sector (which in broad terms account for around one fifth of GDP¹⁹) and the authorities’ reluctance to provide more forceful stimulus. Falling house prices, negative wealth effects and worries about job security have undermined consumer confidence, making households wary of splurging out.

Meanwhile, business confidence has been undermined by weak demand, ongoing regulatory uncertainty and strained US-China relations. These headwinds have meant that, despite the Peoples Bank of China (PBOC) injecting liquidity and expanding its balance sheet this year²⁰, Chinese equities (as tracked by the iShares MSCI China ETF) have performed poorly, falling around 15% since the start of 2023²¹.

An uncertain world

All in all, 2023 had its fair share of economic and financial market surprises, which left large swathes of the forecasting community somewhat humbled - a consideration which underlines the need for diversification in investment portfolios. As has come to be expected, we shall start the New Year with a look ahead to the issues that will face investors during the next 12 months. However, the experience of 2023 has provided a reminder of an uncertain world’s capacity to upend analysts’ unfeasibly precise projections, and that any forecast should be treated with a healthy degree of scepticism.

12th December 2023