Like a stereotypical romcom, the global economy appears to be in a will it, won’t it phase. Rather than being romantic entanglement, the subject of this particular situation is, of course, recession. The word of the hour is “resilience”, when applied to economic activity, although its use is definitely in a relative sense. Given inflation of 8-11% (higher in necessities such as food and energy), sharp rises in interest rates, declines in asset valuations and house prices, there was a greater expectation of a steeper decline in activity. Instead, activity has slowed, turning negative in some situations, but not falling off the proverbial cliff.
As an example in the UK, the Bank of England forecast GDP growth of -0.3% for Q4 2022 following an expectation of contraction of 0.5% in Q3. In the event, GDP fell 0.3% in Q3 and, following a surprising 0.1% expansion in November, could be flat in Q4. The expected technical recession would be shallower or possibly avoided altogether.
There are similar situations in the Eurozone and the US. Germany, expected to be severely affected by higher energy prices and lockdowns in China, is now also forecast to skirt a technical recession. The “soft landing” rhetoric in the US has resurfaced, after being somewhat discredited at points towards the end of 2022.
Principally, strength has been concentrated in labour markets, but a shallower decline in activity is being experienced in most areas, perhaps outside of retail spending on goods. Composite PMI figures are now broadly lower than 50, indicating a monthly contraction in activity, but many have also edged back to that level, indicating that the downturn in activity was relatively short and shallow. Employment balances within these surveys largely remain positive, despite the drop off in business, suggesting that businesses are reluctant to reduce headcount due to the difficulties experienced in finding new workers since the pandemic.
You can find reasons for this resilience. As noted earlier, employment has remained strong, which has supported spending. Households have resorted to credit and savings to maintain spending. Businesses have successfully passed higher costs onto consumers. Commodity prices have declined, particularly wholesale gas and energy prices. Financial conditions have loosened since tightening sharply in Q2 and Q3. Looking forward, China’s removal of tough COVID measures will possibly support global trade (and inflate commodity prices), as households there spend accumulated wealth saved over various lockdowns (although estimates of how much of the reported $2.5tn will actually be spent vary).
Some of these factors could be temporary. There is only so much saved in developed economies, and evidence suggests that savings growth is now slowing. Expanding employment while sales volume growth declines either suggests woeful productivity or indicates hoarding of staff due to prior recruitment difficulties (ONS figures indicates UK Q3 output per hour expanded just 0.1%). Consumer confidence remains very low, despite apparent willingness to spend on services, and business investment levels and intentions are declining. Housing market activity and prices have already experienced rather sharp changes in trajectory, but there is likely further to go.
So the data appears resilient, but does it harbour underlying weakness glossed over by some of the items above, simply delaying a sharper decline in activity? The US GDP data published last week is a case in point. At first glance, a consensus beating Q4 growth rate of an annualised 2.9% looks great. Looking at the detail, private sector final demand weakened considerably, with growth boosted by government spending, inventory growth and net trade (both the latter elements a symptom of the drop in domestic demand).
Underlying this is the fact that central bank monetary tightening is yet to be fully felt. In the UK, the ONS estimated that 1.4 million UK households will need to remortgage in 2023 as fixed term deals end, resulting in increased monthly payments of around £200. Higher savings rates will encourage those with savings not to spend. The Bank is also engaging in quantitative tightening, selling the gilts it bought under QE. This both drains liquidity out of the financial system, which may have been used for more productive things, and maintains gilt yields at higher levels than otherwise.
Looking at the monetarist MV=PQ equation, central banks around the world (with some exceptions) are acting in concert to rapidly reduce both M (money growth) and V (velocity of money). The hoped for consequences are a reduction in the growth of P (price levels), but it is difficult to see how this will avoid a dramatic impact on Q (quantity supplied).
Those temporary factors may be enough to see economies through current monetary tightening to the lower inflation sunlight hills policymakers are aiming for without sharp disinflationary declines in activity. Current data suggests as much and thus supports continued policymaker hawkishness, and let’s face it, economies have managed to weather both substantial rises in inflation and interest rates unbelievably well (too well from a policymaker’s perspective). Indeed, the Bank of England’s Monetary Policy Report this week is likely to forecast a shallower recession and lower short term inflation, at the expense of higher long-term inflation. This outlook, allied to strong wage growth and higher services inflation, is likely to embolden policymakers to deliver another forceful decision.
However, when businesses decide that they no longer need to hoard employees because spending is not picking up, house prices start falling more sharply due to both the continuing decline in real incomes and higher borrowing costs, and homeowners are forced to direct more money to servicing mortgages, we may see the tipping point reached. Current economic resilience may only be illusionary.
Inflation - Written in the Mars?