We believe data in the first half of 2023 may offer evidence for both a soft landing and a near-term recession, while high interest rates gradually wear down corporate profits and the labor market.
- Our base case is a U.S. recession, but in 2024, not 2023.
- Global growth is likely to rise when economic activity in China increases over the next few months.
- Inflation has slowed but could reverse course in the U.S. given signs that housing is stabilizing.
Mixed signals of recession
Several well-known sentiment indicators — such as the University of Michigan Consumer Sentiment Index and the NFIB Small Business Optimism Index, among others — are at or near recession levels. The same is true for some semisoft indicators, including the Chicago PMI, which is known to have predicted all U.S. recessions. However, final consumption has been holding up and might stay resilient for some time.
Although the gap between hard and soft data cannot stay forever, it can stay long enough to extend the cycle. Households start retrenching expenses only after losing their jobs. In the U.S., jobless claims reached a bottom in March 2022 and started rising, but they have not gathered speed, as usually happens ahead of recessions.
Profits as a leading indicator
Declining profitability is the main driver of job losses, which means the change in corporate profits can be a leading indicator, although it can also produce some false positives. Typically, earnings start decreasing before recessions and continue to decrease for a period after the end. In the current cycle, nominal profits peaked about six months ago; real profits have been flat for over a year and have been coming down for about six months.
Soft landing possibility
Given the trends in profits and job losses, is a soft landing attainable? We believe the rapid tightening in 2022 has not hit the real economy yet. Strong household balance sheets and a tight labor market have been supporting consumption and reducing consumers' sensitivity to prices. Similarly, corporate sector refinancing needs were low in 2022 and will likely remain low in 2023. Many firms extended the maturity profile of their debt during the low-rate environment in the decade after the 2008 global financial crisis.
In this cycle, it might take longer for rising-interest-rate costs to impact corporate margins and household spending than in a typical recession. Our base case is growth can stay positive in 2023, but the U.S. is heading toward a recession in early 2024.
The Treasury curve inverted further during Q4
Source: U.S. Treasury Department. Past performance is not indicative of future results.
China's reopening can accelerate global growth
In China, authorities have eased Covid-19 pandemic restrictions across major cities. With the Lunar New Year on January 22 behind us, mobility can start to rise and economic activity can gain momentum. We believe China's growth is likely to surprise to the upside in 2023. Senior Chinese officials have announced a consensus on increased policy support for economic development and rapid recovery. Their focus is on an accelerated recovery in the first half of the year through a combination of fiscal, monetary, and industrial policies.
As in the rest of the world, households in China have accumulated savings during lockdowns. Although a part of those large savings can fuel consumption, consumer confidence (especially confidence in housing) might need to be restored for a type of recovery the West had in 2020 and 2021. Recovery in household credit is likely to take time due to low housing demand and weak consumption amid elevated Covid cases. We believe Chinese household loan growth can be a second-half story in 2023.
Also, the largest change in demand for oil in 2023 is likely to come from China. China's implied crude oil consumption stagnated in 2022 due to recurring lockdowns.
Monetary policy outlook
The December U.S. CPI (released in January) showed a change of –0.1% (headline) and +0.3% (core), and the Federal Reserve slowed its pace of hiking to 25 bps at its February 1 meeting. However, we believe the "inflation is slowing" narrative is beginning to fade. Housing has shown signs of stabilizing at recent low activity levels, and retail sales have not been that disappointing. The Fed is expecting economic weakness in the second quarter, but if that does not come, we could see Fed surprises.
Europe is likely to benefit more than the U.S. from the disinflation story in the near term. Although the ECB has made 50-bp increases in recent moves, the March decision could be a struggle between the hawks favoring another 50 bps and the doves favoring 25 bps.
Meanwhile, the market is looking ahead to rate cuts everywhere. If inflation is going to surprise to the upside, we believe it is going to surprise first in the U.S., even while inflation in Europe continues to come down.
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The rapid interest-rate tightening in 2022 has not hit the real economy yet.