The signals and the noise: Three-minute macro
With such a strong job market, how can a recession possibly be in the works? Our answer lies in some troubling leading indicators for growth. At the same time, we think oil’s importance in inflation means some reprieve for the Consumer Price Index in the future. Finally, we note that central banks’ bias toward rate hikes may mean more cuts down the road.
Leads, lags, and recession calls
“What’s with all the recession talk when the U.S. job market is so strong?”
That’s the number one question we get every day, and it’s absolutely a fair one. The United States is adding hundreds of thousands of jobs every month, there are nearly a million job openings, and businesses continue to bemoan near-record challenges filling open positions. How can we—and the majority of economists1—see a recession in this type of environment? The simple answer is that the economist’s job isn’t to tell us where we are now, it’s to explain where we’re heading next. To do so, we disaggregate our data into leading indicators (what’s ahead?), coincident indicators (where are we now?), and lagging indicators (where were we?). We tested some of the most cited economic data points and found a troubling trend: While lagging indicators, such as job growth, are still in strongly positive territory, the most useful indicators about where the economy will be in the next 6 to 12 months are flashing red—many of them, deeply red.
Moreover, we think it’s reasonable to expect that the traditional lags between job growth and the economy (wherein job cuts are the last shoe to fall in a recession) might be even larger in this post-COVID environment. Labor shortages are real and unlikely to be resolved in the near term; given companies’ persistent challenges in hiring, we’d expect them to be even more cautious in layoffs. This is also why we're looking at a broader (and more granular) set of job data such as number of hours worked, as opposed to the unemployment rate alone.
When we put this story together, we still see better-than-even odds of a recession hitting the U.S. economy around the fourth quarter of 2023 and a U.S. Federal Reserve (Fed) that has to pivot toward potential rate cuts as a result.
The signals (and the noise)
U.S. economic indicators
Source: Manulife Investment Management, as of March 6, 2023. Red represents a clearly negative signal, yellow a deteriorating signal, and green a still strong signal. C&I refers to commercial and industrial. ISM refers to Institute for Supply Management.
Past the inflationary peak: some comfort in oil prices
Good news: U.S. inflation is very firmly past its year-over-year (YoY) peak. After hitting a near-record 9.1% YoY increase in June 2022, the Consumer Price Index (CPI) has fallen for nine consecutive months and is now running at 5% YoY. We expect these declines to continue, with U.S. CPI to be in the mid-3% range by year end. There are, however, some concerns that inflation’s decline will stall out, even from the likes of certain central banks; for example, at its April meeting, the Bank of Canada (BoC) noted that getting inflation back to its 2% target “will be more challenging.” After all, central banks know that the bulk of the supply chain challenges have already unwound and that wage growth is still running hot. Services inflation, which tends to be stickier, isn’t showing many signs of letting up in any major developed-market economy.
But here’s one reason why we take comfort in our forecast that inflation in YoY terms will continue to unwind, even as some other factors remain uncertain: The base effects from lower energy prices are extremely powerful. A year ago, West Texas Intermediate (WTI) oil had climbed to over $100/barrel (from below $40 in early 2020). Today, it's stabilized around $80, running about 20% below its 2022 peak. Consensus expects WTI prices to remain around $85 to $90, which would be consistent with total inflation falling back toward 2% by the end of 2024. Amazingly, in order to prevent that ongoing decline in inflation from current levels, we have to model in a persistent $120 oil price through the remainder of 2023 and into 2024. Moreover, if we incorporate a more bearish oil outlook (around $60 oil for the next year), total inflation slips below 2% by the end of the second quarter. So, for all the talk of wages, supply chains, and geopolitics, one of the most important drivers of price pressures ahead remains oil prices. And all signs point to energy remaining a material drag on inflation.
Inflation's big dependence on oil
Actual and forecast CPI under various oil price scenarios, YoY change (%)
Source: Manulife Investment Management, as of April 13, 2023. The dashed lines represent forecasts. Base case represents WTI oil at $90/barrel, bear case at $60/barrel, and bull case at $120/barrel. YoY refers to year over year. No forecasts are guaranteed.
Rates: what goes up must come down
With all of the market’s recent uncertainties—from banking stress to China’s reopening—one question continues to nag us: Will central banks respond the same way to the coming (forecast) recession as they have in past cycles? The typical monetary policy response is to combat economic weakness with rate cuts that support growth, reduce the rise in unemployment, and get credit moving again. Indeed, markets have historically rallied when central banks have pivoted toward easing cycles; therefore, counterintuitively, a garden-variety recession and central bank response ahead might not be as gloomy as they sound.
But what if this time is different? Every major central bank has very weak growth (consistent, more or less, with recessions) and a rise in unemployment in their formal forecasts; nevertheless, they state that bias is toward future rate hikes as inflation remains high. And, in some respects, that might make sense. After all, inflation is substantially above target in just about every Western economy, and with such a significant labor shortage, central banks may see higher unemployment as a feature, not a bug.
Given it’s our job to state what central banks might do—and not what we think they should do—we’re still incorporating more rate hikes from the European Central Bank, the Bank of England, and the Fed in our outlook. And even if we don’t formally foresee hikes ahead from the BoC, it’s still an important possible outcome. As those additional rate hikes permeate the economic systems within our models, they tell us that every incremental increase will lead to a commensurate or larger decrease in rates in 2024. In other words, what goes up must come down.
But as always, we have to assess the risk to our outlook. And if we're to take central banks at their word, we also have to consider an environment in which the bar to cut rates is higher than it has been in the past and that, while rate hikes might be far off, rate cuts may not be as close as either we hope or have modeled for.
Major central banks' policy rates and forecast
Source: Manulife Investment Management and the specificed central banks, as of April 16, 2023. No forecasts are guaranteed.
1 The Bloomberg U.S. Recession Probability Forecast, an average of participating economist’ forecast, is at 65% as of the time of this writing.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management, nor any of its affiliates or representatives (collectively “Manulife Investment Management”) is providing tax, investment or legal advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
This material has not been reviewed by, and is not registered with, any securities or other regulatory authority, and may, where appropriate, be distributed by Manulife Investment Management and its subsidiaries and affiliates, which includes the John Hancock Investment Management brand.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.