Don’t pop the champagne just yet
Data year to date suggests that developed economies had a better start to the year than expected. At the time of writing, only the eurozone and New Zealand have slipped into recession (as defined by two consecutive quarters of negative growth).1 But don’t pop the champagne just yet: We see this as a case of recession postponed rather than canceled.
We highlight three factors that have unexpectedly underpinned economic activity.
1 A significant easing in financial conditions
Data from the U.S. Federal Reserve (Fed) shows that financial conditions remain looser than average given current levels of economic growth and inflation. Crucially, financial conditions are looser than before March’s banking turmoil and in March 2022, when the Fed started tightening.
2 Continued drawdown of excess savings
According to the Fed, pandemic-related fiscal support allowed U.S. consumers to accumulate excess savings—in nominal terms—of around US$2.1 trillion through August 2021. Conversely, cumulative drawdowns, which have been supporting household spending, reached US$1.6 trillion as of March 2023.
3 Rotation of spending from goods to services
During the pandemic, demand for services (e.g., restaurant, theaters, and travel) suffered disproportionately relative to demand for consumer goods such as televisions, furniture, and home-improvement-related items. When the economy reopened, pent-up demand was unleashed and consumption patterns rotated from goods to services, thanks in part to fiscal support. That said, expenditure on services in the United States in real terms has returned to long-term trend while inflation-adjusted consumer spending on goods remains well above long-term trend.¹
In our view, these tailwinds should dissipate as the lagged effects of monetary tightening filter through and the savings buffer that consumers have accumulated is run down. Indeed, the tightening of credit conditions and the slowdown in lending—developments that can be seen in the latest data from the United States, the eurozone, and the United Kingdom—suggest that we’ve so far managed to delay the impending recession as opposed to averting it altogether.
Recession or no recession: moving beyond binary discourse
Precision in forecasting where and when recessions will happen can be extremely difficult; however, as we’ve argued previously, whether a recession actually takes place is far less relevant than how long we could be stuck in a period of below-trend GDP growth. It’s also worth noting that recessions can have an uneven effect across geographies and sectors.
The consensus view is that global growth will come in at around 2.5% this year and next.¹ It’s difficult to see this as anything but a rather lackluster performance but, crucially, it’s significantly below 3%—a threshold that, if breached, could herald a global recession.² For context, if consensus forecasts are correct, it means that global GDP growth would come in 15.2% below trend, a scenario last seen during the pandemic in 2020 and, before that, in the 1940s.
Inflation remains too sticky for comfort
A steep run-up in goods prices was the main cause behind the surge in inflation over the past 2.5 years. From energy to food to shipping, many of the factors that drove inflation higher in 2021 and 2022 have eased considerably this year.
However, core inflation remains stubbornly high—an outcome of strong income growth and the resilience of economic activity, among other factors—pointing to intensifying upside risks to inflation in services driven by tight labor supply.
The latest data showed a renewed spike in core inflation in the United States and the United Kingdom and a fresh record (high) in the eurozone. While the rise in core inflation has more to do with higher prices in services as opposed to goods, the price momentum in core goods inflation appears to be inflecting higher again as favorable base effects³ are largely behind us.
Why interest rates are likely to stay higher for longer
Persistent price pressures have forced central banks around the world to extend their respective tightening cycles; however, they’re proving to be more hawkish than the market had hoped. In parts of Asia, policy pauses have been followed by further tightening, contrary to the market’s all-too-simple linear pricing model of tightening followed by pausing followed by easing followed by risk-on. It’s a model that—so far—has failed in this cycle. In our view, markets have adopted a pricing model appropriate for the last 20 to 30 years, but it’s no longer appropriate today.
We like to think of central banks as apolitical, independent agents but, in practice, it’s difficult to completely separate monetary policy from the political developments of the day. For better or worse, central banks do not and cannot operate in a vacuum. Indeed, the dominant political ideology in the West over the last 20 to 30 years, which informed policy, allocation of resources, and financial markets, was neoliberalism—one of many forms of a political economy.
But that’s ending: In our view, we’re entering a new regime.
An evolving geopolitical backdrop
This shift in ideology was flagged in April by two key speeches, one from European Central Bank (ECB) President Christine Lagarde and the other from U.S. National Security Advisor Jake Sullivan.
In her speech “Central banks in a fragmenting world,” Ms. Lagarde noted that competing global trading blocs are emerging and the ECB’s analysis suggests that if global value chains were to fragment along geopolitical lines, global Consumer Price Indexes could rise by between 5% in the short run to 1% in the long run; she also warned against repeating the 1970’s mistake of not hiking sufficiently in the face of persistent supply shocks. Ms. Lagarde went on to say that monetary policy must work with fiscal and structural policies to remove supply constraints, implying a need to deploy targeted stimulus to the supply side alongside higher rates.
Meanwhile, Mr. Sullivan pushed back on the notion that free markets are best at allocating capital in his speech “Renewing American Economic Leadership.” Notably, a new policy path was required to fend off emerging geopolitical and socioeconomic risks. He highlighted the need to identify and boost “specific sectors that are foundational to economic growth, strategic from a national security perspective, and where private industry on its own isn’t poised to make the investments needed to secure our national ambitions.”
If we were to take these two influential leaders at their words, the implications of what they’ve said are enormous. Our interpretation is that both leaders are signaling that Western governments have reweighed their priorities and will be allocating capital toward rebuilding domestic industrial capacity, narrowing the U.S. current account deficit, lifting labor’s share of income, and actively using capital to defend hegemony. In other words, they’re no longer pursuing neoliberalism. In our view, this change in regime will reinforce a zero-sum game global environment that will heighten geopolitical tensions.
"In our view, the market is premature in its pricing of dovish pivots from global central banks, both in terms of timing and magnitude."
The International Monetary Fund (IMF) also picked up on these developments. In a recent publication, the IMF warned that a rise in geopolitical tensions among what it called “partner countries” could lead to an abrupt reversal in cross-border capital flow. Unsurprisingly, such a development would affect emerging-market and developing economies more than their developed peers and could potentially morph into macro financial stability risks. Specifically, the IMF noted that “greater financial fragmentation stemming from geopolitical tensions could also exacerbate macro-financial volatility in the longer term by reducing international risk diversification opportunities in the face of adverse domestic and external shocks.”
To be forewarned is to be forearmed. We continue to believe:
- The market is premature in its pricing of dovish pivots from global central banks, both in terms of timing and magnitude.
- There’s a risk that even if the Fed pauses in the coming months, the next move could be more tightening, not easing.
- Markets need to reassess the central bank put for asset prices.
1 Bloomberg, as of 6/15/23. 2 "World Economic Outlook, 2008: Housing and the Business Cycle," International Monetary Fund, 4/9/08. 3 Although the pace in price rises in goods slowed in the months leading up to January 2023, this had been largely a result of base effects. For instance, one year ago, crude oil and wheat prices jumped nearly 60% on a year-over-year basis; they’re now about 20% and 45% lower, respectively. There is a limit to how much further the prices of critical commodity prices can fall going forward.
This is an excerpt of Manulife Investment Management's Q3 2023 Global Macro Outlook: navigating turbulence. Download the full 29-page report.
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