The global economy seems on an inevitable march towards recession. The causes are well known: central banks aggressively raising policy rates to reduce inflation, an energy shock in Europe, zero-Covid policies (ZCP) and a shaky property market in China. Chief market strategist Daniel Morris explains.
Much of Europe is already in recession. We expect one to begin in the US in the third quarter of 2023, and while China’s growth will likely not turn negative, it will be below historic levels.
One can easily think of ways in which the situation could yet worsen: a breakdown in a key financial market due to the rapid rise in interest rates, a cold winter and blackouts in Europe, or a flare-up in geopolitical tensions between the US and China.
Given the strength of the US labour market, reflected not only in a low unemployment rate, but also in high (nominal) wage gains, declines in non-farm payrolls in 2023 will likely be necessary. Consumer demand will weaken, even though households still have a large amount of ‘excess’ savings. These savings are falling and, we should note, are concentrated among high-income/low-consumption households.
A deterioration of the labour market will be key to bringing services inflation under control. Goods inflation should drop thanks to base effects and lower demand, while shelter costs will eventually reflect the ongoing slowdown in the housing market. We anticipate the inflation rate for core personal consumption expenditures (PCE) will fall below 3% by the end of 2023.
One open question is whether wage inflation can be reduced without a large increase in unemployment. The number of job vacancies relative to the size of the labour force is still about twice the long-run average1, meaning companies are forced to raise wages to attract workers (see Exhibit 1). Historically, vacancies only decline significantly when the unemployment rate rises. The US Federal Reserve believes that the currently high number of vacancies reflects the reorganisation of the labour market and the economy following the pandemic. As that process ends, vacancies could fall without the unemployment rate necessarily rising.
There is another reason to believe the unemployment rate may not rise very much. US companies have learned from the lockdown recession that firing employees may reduce costs in the short term, but it creates problems later on. They may move towards a more European model, where employees are kept on the payroll through a recession, allowing for a swifter and smoother recovery later.
Offsetting the drag from higher policy rates will be the ongoing investments triggered by the Infrastructure Investment and Jobs Act, and the Inflation Reduction Act, which will direct nearly USD 400 billion in tax credits and subsidies for numerous clean energy programs.
Europe is facing an energy shock unlike anything the region has seen since the OPEC price increases in the 1970s. Even though gas prices have moderated of late, they are still 10 times higher than the average in 2019.
Inflation is in double digits in some countries, consumer sentiment has collapsed, and demand is weakening along with disposable income. Nonetheless, we believe headline inflation has peaked and will return to the ECB’s 2% target in 2024.
The response of governments to economic shocks has changed since the pandemic. Instead of counting on automatic stabilisers such as unemployment insurance to tide households through the downturn, governments have resorted to more direct support to mitigate any decline in income (or corporate profits).
This strategy was comparatively easy during the pandemic as policy rates and inflation were low and central banks were purchasing government debt. The recent experience of the UK, however, shows the limits of these policies now that inflation is well above target and central banks are looking to reduce the size of their balance sheets. While Germany can afford a EUR 200 billion support package, other countries may not. When Italian government bond yields were above 4% prior to the global financial crisis, the country’s debt was a few percentage points less than its GDP. It is now 40% greater. In 2022, debt-GDP ratios nonetheless improved, but in 2023, they will likely see a deterioration. Governments will need to ensure further expenditure is targeted to avoid a countervailing response to any stimulus from the ECB.
The two factors that were dragging on Chinese growth in 2022 — its zero-Covid policies (ZCP) and an unsteady property market — should moderate in 2023, allowing the economy to rebound, though growth will likely remain below pre-pandemic levels.
Covid infections in China have spiked again. Nevertheless, the government has reiterated its commitment to ZCP. At the same time, work on an mRNA vaccine is progressing and it should eventually be rolled out. We now know from experience that economic activity can rebound quickly once restrictions are lifted.
The problems in the property market will likely take longer to address. The recent Communist Party Congress signalled there would be longer-term policies to develop a housing system that ensures supply from multiple sources and the development of both rental and property sales markets. In the near term, the government is looking to targeted policies to support the recovery of the sector.
President Xi’s Party Congress speech was also notable for its emphasis on speeding up the transition to green development and meeting carbon emissions goals. This should be another source of long-term demand for companies in the relevant industries.
A key distinction between China and the US and Europe is the scope the government has to stimulate the economy, through either fiscal or monetary measures. While core inflation is running at over 4% in the eurozone and over 6% in the US, in China, it is at just 0.4%.2
Also read our China article in the Investment themes in the long run section below.