Recession ahead – short and shallow o long and deep?
For many months, economists have warned that the world economy would enter at least a shallow recession in 2023, possibly a deep downturn. There is growing evidence that economic activity entered a weak period at the turn of the year, although the impact on bond markets was rather larger in the USA, and to a lesser extent in Europe, with little effect yet in the UK.
The fourth quarter started quite well in the USA. However, statisticians reported that retail sales fell 1.1% in December building on November’s 1% decline. This is quite understandable; a recent Fed survey, known as the Beige Book, outlined how “high inflation continued to reduce consumers’ purchasing power, particularly among low and moderate income households”. Companies are responding to this pullback; industrial production has fallen for three consecutive months, at an annualised rate above 5%. Capacity utilisation across businesses was the lowest for a year.
Bond yields reacted accordingly, with US yields down about 0.15% across most maturities. The fall was restrained by continued signals from Fed officials that they do not want to turn policy around quickly. After all, such weak data are hardly different to their own forecasts. Hence, St Louis Fed President James Bullard still sees rates rising to the 5.25% – 5.5% range, indeed policymakers should get it above 5% “as quickly as we can”. Philadelphia Fed President Patrick Harker sees “a few more” 0.25% increases before a pause. While Richmond Fed President Tom Barkin said the inflation news over the past 3 months has been “very encouraging”, he is not in favour of backing off too soon, not until it was certain inflation was falling “compellingly” towards the Fed’s 2% target.
The UK economy also remains weak. GDP fell 0.3% in the 3 months through November. Investment bank ING are looking for a peak-to-trough fall in GDP of about 1.5%, which would be close to the early 1990s recession in terms of scale. Retail sales were weak over Christmas and spending is 2% lower than its pre covid level. However, bank officials will worry that the labour market is flashing amber about future inflation. Average earnings excluding bonuses were 6.4% higher in the three months through November than a year earlier. That is the biggest increase since records began in 2001. Whilst companies are starting to lay-off staff, labour force supply has collapsed. On some estimates as many as 2 million people are affected by health issues and unable to work. Indeed, Andrew Bailey recently warned that that the combination of a shrinking UK labour force and China’s re-opening would keep upward pressure on Inflation. The Bank will also keep a watchful eye on the number of strikes and the danger of a spurt in public sector wage growth. It will also be well aware that productivity growth is slow, largely related to slack business investment since 2016. All this might explain the sticky inflation being seen in the UK. CPI eased to 10.5% in the year to December, helped by much lower petrol prices offsetting record price changes in many foodstuffs. Yet the core inflation rate remained steady at 6.3% underpinned by strong service sector inflation. Such data support the view that the Bank is more likely to move rates by 0.5% than 0.25% at its February meeting.
The latest survey of European economists suggests that the ECB’s deposit rate will be raised in three steps from its current 2% to a peak of 3.25%. The median prediction then envisages the rate sliding back to 3% at the start of the third quarter. Whether such an outcome appears partly depends on decisions made inside Europe but especially amongst its largest export partners. In particular, will China ease policy rapidly once the wave of Covid infections comes to an end, potentially leading to a sharp economic recovery, demand for imports and perhaps a surge in commodity prices in 2023. The International Energy Agency has already warned that oil demand in 2023 is set to rise to a new peak.
As far as ECB Governors are concerned, Francois Villeroy explicitly pushed back against recent reports suggesting a switch to 0.25% increases and said that President Christine Lagarde’s 0.5% guidance for March remains valid. Chief economist Philip Lane said the ECB needs to raise rates to a level that starts to restrict growth “Last year we could say that it’s clear that we need to bring rates up to more normal levels, and now we say, well, actually we need to bring them into restrictive territory” when rates are now “ballpark” neutral. He will be well aware that wages growth across the Eurozone is running about 4% a year, above levels which would be in line with the price target.
So the outlook for the bond market into 2023 will very much depend on the manner, depth and length of the approaching recession. It is quite understandable that a PricewaterhouseCoopers survey found 73% of business leaders predict that global growth will decline over the coming 12 months. How bad will it be though? About 40% of respondents expressed concern their own companies may not last a decade. How much is that driven by hard fact and how much by general sentiment? A key feature affecting all such surveys and economist forecasts will be the extent of the shifts in China towards easier policies to support the economy once the wave of Covid infections and deaths falls back.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.15 3.51 3.41
UK 3.47 3.26 3.32
Germany 2.51 2.12 2.06
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making