Is a global recession on the cards?
Growth in the global economy is likely to slow in 2023 with the US and parts of Europe at risk of periods of outright contraction, as real incomes are squeezed and the lagged impact of last year’s synchronized monetary tightening takes its toll. However, a full-blown global recession should be avoided given the prospect of a reopening recovery in China later this year following the recent easing of covid restrictions and a shift towards more growth-friendly policies in Beijing (see our commentary of December 2022).
Economic activity in Europe and the US has held up somewhat better than some observers had feared in recent months, as softer energy prices and a run-down of the excess savings built up during the pandemic have supported consumption. However, some estimates suggest that excess savings balances will be exhausted by mid-year, removing a key driver of recent post-pandemic spending1. With house prices now falling in response to higher borrowing costs in many advanced economies, negative wealth effects are also likely to weigh on consumer confidence.
A key issue for investors in 2023 will be whether the world’s largest economy, the US, will enter a recession. The omens are not good on this front. Several leading indicators, which during past economic cycles have provided advance warning that a downturn is on the horizon, are flashing red. The yield curve (the spread between short-term and long-term yields – see our commentary of April 2022) has inverted, a phenomenon which has occurred prior to every US recession in recent history2. Building permits have fallen sharply as higher interest rates have hit the construction sector3. Survey data has shown that demand in the traded goods sector is falling and more recently also indicate that the hitherto robust service sector (a beneficiary of post-covid pent-up demand) is now faltering4.
One reason that the risk of recession is high is the suspicion that the US central bank, the Federal Reserve (or Fed), will want to see some increased slack in the labour market (i.e., a higher rate of unemployment) before it is convinced that inflation is truly under control. According to the Fed’s latest forecasts, unemployment in the US is seen rising to an average 4.6% in fourth quarter of next year, up from the 3.5% rate recorded in December 20225.
Although the Fed does not see GDP growth turning negative this year, such a rise in the unemployment rate has historically been associated with the US economy falling into recession. According to the so-called “Sahm Rule”, a rise in the unemployment rate of 0.5 percentage points above the low of the previous 12 months is indicative of a downturn. The implication is that a recession might be the price the economy needs to pay in order to rein in inflation on a sustained basis. Similar reasoning might also be applied to the UK economy, which, like the US, is also experiencing a tight labour market which poses upside risks to price stability.
While many observers had penciled in an outright contraction in the eurozone economy for 2023, the outlook has improved somewhat in recent weeks. An unusually warm winter has triggered a sharp fall in wholesale gas prices and allowed utility companies to keep gas storage at elevated levels, thereby reducing the threat of energy rationing. Although the outlook for Europe’s energy security remains hostage to geopolitics and the weather, the worst fears of businesses and consumers have not come to pass, and economic sentiment has improved of late6.
In addition, the reopening of the Chinese economy should provide a welcome boost to the region’s tourist industry and exporters of manufactured goods. This suggests that consensus forecasts for the eurozone could be revised up during the coming weeks.
Will inflation fall back in 2023?
The dominant economic narrative of 2022 was one of inflation surprising on the upside, triggering sharp interest rate hikes by central banks around the world. Precise price dynamics vary from country to country. However, there were several common factors which contributed to rising inflation in the advanced economies: higher energy and food costs following Russia’s invasion of Ukraine; stimulus-fueled pent-up demand; disrupted global supply chains; and strong corporate pricing power.
In the US and the UK, tight labour markets played a significant role in driving prices up, reflected in core rates of inflation (i.e., excluding food and energy prices) generally being higher than in the Eurozone. With the shelter (i.e., housing) component accounting for nearly a third of the CPI basket in the US, the lagged impact of rising house prices and rents was a key factor behind the upward march in services prices last year7.
Through this year, inflation in the developed world is on course to fall markedly as a result of favourable base effects and softer economic activity. Energy prices are something of a wildcard, with the impact on CPIs dependent not only on the weather and geopolitics, but also changes in government subsidies to households. However, with prices for natural gas and oil having fallen back from their 2022 highs, it is a fair assumption that last year’s outsized hikes will not be repeated, suggesting the energy contribution will fall, and in some categories (e.g., petrol) turn negative8.
An easing of global supply chain disruptions, along with softer demand also bodes well for a deceleration in core goods inflation. After the steep rise seen during 2020-21, transportation costs have fallen sharply, with the Drewry shipping container price index currently down 79% from the peak in September 20219.
A post-pandemic shift in spending towards services and away from goods has also resulted in a build-up of excess inventories, which has led to discounting by retailers in some countries. This has been most notable in the US, where prices for durable goods are now falling in absolute terms10.
Services inflation tends to be stickier than goods inflation and remains uncomfortably high in developed market economies. However, given the prospect of a softening in economic activity and cooling labour markets, services inflation should also moderate. In the US, where the labour market is probably tightest, wage growth is showing signs of decelerating and survey data points to easing cost pressures11. Similarly, the lagged impact of recent falls in market rents (the ApartmentList indicator of rents fell for a fourth consecutive month in December12) should start to show up in moderating shelter inflation in the US CPI during the second half of this year.
All of this suggests that, while services inflation is likely to remain quite stubborn in the near-term, there is a good chance that headline inflation rates in the US and the eurozone could fall back towards central banks’ 2% inflation targets quite quickly, and potentially faster than policymakers expect if recession strikes. The reopening of the Chinese economy poses upside risks to global inflation given potential upward pressure on commodity prices. And further out, longer-term factors such as deglobalisation, an ageing population and the transition to clean energy threaten to shift inflation up to a ‘structurally’ higher gear. For now though, disinflation should be a key macro theme of 2023.
Where are interest rates headed in 2023?
2022 saw the major central banks hike their policy rates sharply in a bid to bear down on higher-than-expected inflation. The US Fed lifted rates seven times by a cumulative 425 basis points to 4.25-4.5%13. This side of the Atlantic, the European Central Bank (ECB) raised its main refinancing rate four times by a cumulative 250 basis points to 2.5%14, while the Bank of England (BoE) hiked its Bank Rate eight times by a cumulative 325 basis points to 3.5%15.
In 2023, the general expectation is that policy interest rates will top out. Weakening economic activity, an elevated risk of recession and moderating inflation argue for a slower pace of rate hikes in the early part of the year and an eventual pause in the hiking cycle.
Given its outsized influence on global financial markets, the policy machinations of the US Fed will be the key focus for investors. As it stands, there is a marked divergence between what policymakers project as the most likely path of rates (i.e., rising to 5.1% and staying at this level until the end of 202316) and that which financial markets expect (i.e., an increase to a peak of 4.9% in May before being cut to 4.4% by the end of the year17).
The markets appear to anticipate that a combination of falling inflation, rising unemployment and/or a period of financial market stress will prompt the Fed to start cutting rates during the second half of the year. However, Fed officials, keen to establish their inflation-fighting credibility and wary that premature rate cuts could spark a resurgence of price increases, have pushed back against the idea that rates will come down as soon as markets expect18.
The reaction of Fed policymakers is understandable given that lower rate expectations risk loosening financial conditions (i.e., causing bond yields to fall, equity markets to rise and the US dollar to weaken), which in turn could make it more difficult to cool demand and bring inflation down. Given Fed Chair Jerome Powell’s concern that wages have been “growing at a pace well above what would be consistent with 2% inflation over time”19, policymakers might be reluctant to loosen policy until the unemployment rate has moved significantly higher (a development which would probably take longer than six months considering the current high level of job openings).
Moreover, a period of stress in part of the financial market plumbing might not result in a broad easing of monetary policy; the Fed might choose to address the issue with a targeted lending facility, rather than resorting to the relatively blunt tool of interest rate cuts (see our commentary of August 2022). There is obviously a great deal of uncertainty and the Fed has performed dramatic U-turns in the past. However, there is a clear risk that investors’ hopes for a significant cut in US rates later this year will be disappointed.
In the UK, a 3-way split on the BoE’s monetary policy committee in December – when six members voted for a 50 basis point increase, while one member preferred a hike of 75 basis points and two others preferred to leave bank rate unchanged at 3.0%20 - has raised uncertainty about the rate outlook. Recent data for both GDP and wage growth has come in stronger than the BoE had anticipated in its November forecasts21, suggesting that further rate hikes will be needed to bear down on underlying price pressures. However, the emergence of dovish sentiment in Threadneedle Street casts doubt on whether policymakers will have the fortitude to raise rates as high as the 4.4% financial markets expect by mid-2023.
Having started tightening policy later than both the Fed and the BoE, the European Central Bank has turned decidedly more hawkish of late as core inflation has picked up and policymakers have started to worry about stronger wage growth leading to price increases becoming entrenched22. Current market expectations suggest the ECB will raise rates close to 3.5% by the summer before falling back marginally by the end of the year.
Like in the US, European policymakers increasing focus on elevated levels of wage growth (a lagging indicator) suggests that lower headline inflation might not be a sufficient condition to trigger the rate cuts that markets are penciling in for later in the year. Although there is growing optimism amongst some observers that recessions in the US and Europe can be avoided, from a policymaker perspective, things might need to get worse before they get better.
17th January 2023
1 https://www.ft.com/content/5ccae267-3069-47e1-accd-9250b12538a7
2 https://fred.stlouisfed.org/series/T10Y2Y
3 https://fred.stlouisfed.org/series/PERMIT
4 https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/december/
5 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
6 https://economy-finance.ec.europa.eu/economic-forecast-and-surveys/business-and-consumer-surveys/latest-business-and-consumer-surveys_en
7 https://www.investopedia.com/terms/c/consumerpriceindex.asp
8 https://tradingeconomics.com/commodity/brent-crude-oil
9 https://www.drewry.co.uk/supply-chain-advisors/supply-chain-expertise/world-container-index-assessed-by-drewry
10 https://fred.stlouisfed.org/series/CUSR0000SAD
11 https://www.atlantafed.org/chcs/wage-growth-tracker
12 https://www.globest.com/2023/01/10/apartment-rents-dropped-again-in-december/
13 https://fred.stlouisfed.org/series/DFEDTARU
https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html
14 https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
15 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
16 https://www.chathamfinancial.com/technology/us-forward-curves
17 https://economictimes.indiatimes.com/markets/stocks/news/markets-arent-buying-feds-mantra-of-not-cutting-rates/articleshow/96924810.cms?from=mdr
18 https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm
19 https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2022/december-2022
20 https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2022/december-2022
21 https://www.reuters.com/markets/europe/ecb-must-stop-quick-wage-growth-fuelling-inflation-lagarde-says-2022-12-31/