Reversals, but recession without rescue

Falling inflation won’t prevent recession

Both headline and core inflation look set to fall a lot in developed markets this year as energy prices fall back and goods prices decline. But we don’t think inflation will settle right back down at central banks’ 2% targets. Going from over 9% to 4% will be the easy bit. Getting it to settle below 3% will likely be much harder, and is not a given.

• That’s because tight labor markets are creating wage pressures. In our view, labor market tightness is being misinterpreted as a sign of economic strength. Instead, it reflects constrained labor supply: in the U.S., an aging population has reduced labor participation; in Europe, an expanded public sector has reduced the pool of workers that private-sector companies can hire from. High wage pressure could only be eliminated with a serious recession. We will be in the unusual situation where recession does not result in subdued wage growth.
• It’s possible that inflation could come down further than we expect. Goods prices could fall faster than expected and companies might not have the pricing power to pass on higher wage costs. While this could be better news for inflation, it would be bad news for profitability.
• But contrary to market expectations, we don’t see central banks cutting rates at any point in 2023, even if inflation does fall faster than expected. They will need to be convinced that inflation is falling all the way to 2% before reversing course and won’t be able to declare victory for a long time.
• Markets are taking comfort from currently resilient growth in the U.S. But that near-term resilience won’t prevent a recession in developed markets, in our view. We expect a mild one this year as continuing rate hikes and the lagged effects of past hikes meet other drags. In the U.S., that is the depletion of consumers’ pandemic savings by the second half of the year. In the euro area, rate hikes will meet the energy shock that, although smaller than previously expected, is already dragging on activity.
• In China, we expect the lifting of Covid restrictions to power a temporary growth spurt this year, with 2023 calendar growth surpassing 6%. But that spurt won’t be as strong as might have been expected with reopening because fading developed market demand for Chinese goods exports are striking a huge blow to overall growth. Once the reopening has run its course, we expect future growth to average significantly below pre-pandemic rates given the country’s aging population.
• What does this mean for investors? Falling inflation increases our conviction that central banks have regained some control and will be able to stop hiking at some point. On a multi-year investment horizon, we are already constructive on risk assets. But on shorter investment horizons, we remain underweight developed market equities and prefer credit and short-duration fixed income assets. Falling inflation has spurred market hopes that it is already on its way to target without a recession, and yet central banks will still start an easing cycle. These hopes could persist in coming weeks. But getting inflation down close to target will require higher rates and recession. We think markets will be disappointed. As they adjust to this reality, the conditions will be created for a more constructive environment later in 2023, in our view.

Spending and energy

This year we see a series of reversals in some of the forces that weighed on markets in 2022: headline and core inflation are set to come down as U.S. consumers revert back to their pre-pandemic spending patterns and energy inflation falls.

During the pandemic, western consumers splurged on goods as they couldn’t or wouldn’t visit restaurants, museums and theatres. The sudden increase in goods demand created bottlenecks in supply. Goods prices shot up relative to other prices, driving a surge in inflation – even though overall spending and activity in the economy wasn’t high. The spending mix changed so quickly that the economy’s supply capacity couldn’t keep up: unused capacity in services production couldn’t easily be switched to produce and supply goods.

Consumer spending patterns are now normalizing again. See the chart below.

Spending rotates back to services
U.S. goods share of real consumer spending, 2008-2022

Goods prices fall in the U.S.

In the U.S. and Europe, goods prices have already stopped rising relative to other prices – in the U.S. they’ve started falling quite rapidly – and we expect that to continue. That means overall core inflation will come down materially from its current highs, though the journey could be somewhat of a rollercoaster.

Inflationary pressures ease in Europe

In the euro area, surging energy prices caused headline inflation to jump to historical highs in 2022. That bled through into higher costs for producers of many other goods and services – and higher core inflation. But wholesale gas prices have now fallen back to early-2022 levels. Energy price inflation is likely to turn negative later this year, causing core inflation to drop. That will likely drag both headline and core inflation down sharply in the euro area this year, we think to around 3%. As with the U.S., where inflation settles once the energy adjustment is complete depends on what happens to wages and their impact on core inflation.

China reopening

China has been rapidly lifting its Covid restrictions since the end of last year. Without that, 2023 growth would likely have been intolerably low from the authorities’ perspective: the U.S. spending shift away from goods means demand for Chinese exports is plummeting, following a massive pandemic boom. From mid-2020 to mid-2022, as China churned out goods to meet the west’s skyrocketing demand, the value of China’s exports surged by 21% on average each year, more than triple the average growth rate in the three years before the pandemic, according to data from China’s Customs Administration.

But in December 2022, export growth had plunged to -10% – and is likely to continue to struggle this year. That’s a serious hit to overall growth, since exports account for around a fifth of China’s GDP, according to China’s National Bureau of Statistics. We see exports going from being one of China’s biggest growth drivers to actually dragging it down this year – by around 1.3 percentage points, we estimate. See the chart below.

Exports: a positive becomes a negative
Actual and forecast contributions to real GDP, 2020-2023

Boost to global growth but challenges lie ahead

The initial impact of reopening on growth is likely to be negative, too. The virus has spread extremely rapidly since restrictions were lifted – weighing on mobility and economic activity. We expect further ups and downs in economic activity over coming weeks. But, given the speed of the reopening, we think infections could peak around the end of January and the economic impact of Covid subside fairly early this year.

After that, we see domestic consumption and investment picking up substantially, particularly since consumers will be ready to spend savings built up during Covid lockdowns. We estimate China will clock in economic growth of above 6% in 2023, providing some support to global growth.

it’s important to bear in mind that our forecast of above 6% growth in 2023 reflects the one-off effect of the reopening. Once that has run its course, we expect future growth to average significantly below pre-pandemic rates. We think the country’s potential growth rate might have fallen below 5% and could fall further to around 3% by the turn of the decade. Why? Most importantly, the working age population, having grown rapidly, is now shrinking. See the chart below right. Fewer workers mean the economy cannot produce as much without generating inflation, unless productivity growth accelerates. But we think international trade and tech restrictions, as well as tighter regulations on companies operating in China, will dampen productivity growth.

Mid-year contraction in the U.S.

We see the U.S. economy contracting by 1% cumulatively in the second and third quarter of this year, and total 2023 calendar-year growth coming in at just 0.3%. See chart below.

Gauging the U.S. recession
Forecast growth contributions, 2022-2023

A deceleration from 2% growth to 0.3% may seem large, but it’s actually smaller than the average 2.5 percentage-point deceleration in U.S. activity during the first year of every recession since 1950. And, as is typically the case, we expect the deceleration to be caused by falling investment and slower growth in consumer spending. Here’s how we see that deceleration playing out.

Assuming the Fed raises rates to a little above 5% this year, we estimate that only a fifth of the total impact has manifested so far. Much of the remaining economic damage is already baked in since interest rate changes work with a lag. Peak pain won’t come until around mid-2023: we estimate GDP will be nearly 2% lower in the second quarter of this year than it would have been if the Fed had left rates unchanged since last March.

The Fed’s rate hikes are already damaging economic activity. Multiple economic indicators are reaching levels of stress not seen since the global financial crisis. That’s particularly the case for the most interest-rate-sensitive parts of the economy, like housing: mortgage costs have surged to nearly 7%, the highest since before the financial crisis, and sales of new homes have cratered. As in past rate-hiking cycles, we expect the damage to spread across the economy. We think it will reach consumers just as their pandemic savings near depletion: consumer spending growth could be in negative territory by the end of the year.

Rate hikes add to Europe's energy shock

We believe recession is foretold in the euro area as well, as the European Central Bank’s (ECB’s) rate hikes add to an energy shock that is already playing out – albeit now set to be smaller than feared six months ago. We expect those two factors to lead to a similar cumulative fall in output of 1% in the euro area.

In fact, business surveys suggest the euro area economy already started contracting in late 2022. See the chart below. That is largely due to the energy shock: the rapid rise in energy prices last year as Europe began weaning itself off Russian oil and gas has squeezed real incomes and dragged down consumer spending, despite government support measures providing some cushion. Retail sales in the euro area fell in 2022, for example. The energy shock has also disrupted manufacturing activity, with manufacturing output falling throughout the second half of 2022, according to PMI surveys.

Business surveys suggest contraction
Change in business sentiment, 2018-2022

The ECB has already raised rates by 250 basis points and begun selling government bonds. We think it will raise rates further to above 3% – the highest level since August 2008. Together with its announced intention to reduce the amount of government bonds it holds, that has contributed to the widening of peripheral spreads, with the gap between yields on Italian and German 10-year government bonds now around 100 basis points wider than the low in 2021, according to January 2023 Refinitiv data. We expect the combined effect of these monetary policy measures to drag materially on euro area growth this year, prolonging the current contraction through the first half of the year. We expect overall calendar growth in 2023 to be -0.7%, the weakest outside the pandemic period since 2012.

New labor market dynamics

Low unemployment is usually paraded as a sign of strength. But firms are having to fight harder to hire now – most obviously by sharply upping pay offers – because so many people have left the labor force. Constrained labor supply is also likely to change the dynamics of the labor market during the recession. In past recessions, labor demand has fallen through a mix of reduced hiring (lower job vacancies) and letting people go (higher unemployment). See the chart below. Things could play out differently this time though. Companies might be more reluctant to let workers go given the labor shortage and fears about being able to hire in the future – and instead cut back more, and faster, on recruiting new workers. We may already be seeing signs of that “unemployment-less” recession. In the U.S., the number of open job vacancies has fallen, even in advance of entering recession and any sign of rising unemployment, as the chart shows. Unemployment alone could give a false sense of robust labor demand. It will be important to monitor both vacancies and unemployment to assess overall labor demand this year. 

Recruiting freeze over firing
Change in vacancies and unemployment from start of recession, 1950-2022

Recession likely not enough to get core inflation down to 2%

Labor shortages aren’t likely to ease by themselves anytime soon. So, the only way central banks can get wage pressures right down would be through serious recession, reducing labor demand to be in line with constrained labor supply. Based on past relationships, we estimate it would take a 2% fall in U.S. activity to get annual wage growth to a rate consistent with inflation settling at 2%. But we expect output to contract by only 1%. Given this, and the typical lags between reduced labor demand and lower wage pressure, we currently see U.S. core inflation still above 3% at year-end.

In the euro area, wage pressures aren’t currently as high as in the U.S. The recession we see unfolding now could have reduced labor demand by enough to eventually get inflation back to 2% – but we expect some further upward pressure on wages as workers seek to restore their spending power eroded by high inflation last year. We see core inflation lingering close to 3% in 2024 despite our recession outlook this year.

No central bank rescue

Faced with the need to reduce labor demand, we expect both the Fed and ECB to continue to raise rates until the resulting economic damage is clearer. That means further rate hikes in early 2023, likely to above 5% in the U.S. and above 3% in the euro area – and then a halt. If central banks want to get inflation down to 2%, we think they would need to go further, triggering a deeper recession than the one we see unfolding. But we don’t think they will: we think they will prefer to live with inflation lingering above target than cause additional economic damage. And we don’t see them coming to the economy’s rescue by cutting rates either, as they typically do in a recession: they are the ones actively crushing activity to bring down inflation and they won’t want to put that work at risk by cutting too soon.

We believe central banks will want clear evidence that inflation is on track to fall all the way to 2% before reversing course.