Analysis Remains More Certain In The View That Headwinds Persist; Whether This Results In A Recession Is Probably Less Important
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The mood music changes
The first month of 2023 was quite the contrast to the dismal financial market returns posted last year. We have seen a growing belief form in markets that inflation—the prime driver of last year’s pain—has not just peaked but is finally moderating. This has been complemented by optimism relating to China’s reopening and economic data in Europe that suggest near-term recession risks have been averted. You might say the “mood music has changed.”
As we discussed in last month’s Allocation Views, this is perhaps a case of markets having already discounted the likely pause in developed market growth. In addition, the relatively mild winter in Europe, which has led to unusually full reserves of natural gas (and sharply lower prices), can be viewed through an economic lens as one of the more extreme tail risks having been dodged. But has the outlook actually improved noticeably? Or is it just a matter of the phasing of periods of slightly more, or slightly less, sluggish growth. We continue to anticipate that the cumulative effect of monetary policy tightening will have a dampening effect on economic activity. We also believe the consequences of the cost-of-living crisis have not been evaded and that corporate profit margins may have further to fall if wages attempt to catch up with prices. This is likely to see growth slow—not just to below trend levels, but toward a standstill. However, with a more optimistic background, and listening to a happy tune being played by market participants, it would be easy to get carried away and believe that all was well.
One area where this optimism perhaps sits on more solid foundations is in Asia. The reopening of China’s economy and rising demand for regional travel may help to support China’s neighbors. The health consequences of a slightly chaotic relaxation in China’s COVID restrictions have not been as bad as some might have feared, and the domestic service sector should continue to benefit from the follow through into sustained acceleration in growth. However, the Chinese authorities continue to balance a desire to promote growth with a need to maintain stability. Neither housing market risks nor fears of further regulatory action have gone away. We have seen that the change in tune regarding China’s zero-COVID policy has improved the mood of equity investors, especially locally, but we would be less certain that China will drive any appreciable improvement in gross domestic product (GDP) for the rest of the world or lessen the risk of recession in the western developed economies to a meaningful extent.
The trough in economic activity is likely still ahead of us, as leading indicators suggest a period of weak growth (see Exhibit 1), even where current activity has held up reasonably well thus far. If the full impact of ongoing monetary policy tightening remains to be felt, then it is unlikely financial markets can post a sustained rebound at this time. Our analysis remains more certain in the view that headwinds persist; whether this results in a recession is probably less important than the direction of travel. This is reflected in our primary theme that is revised to note that “Growth Is Below Trend” and recession risks are high globally, but increasingly bifurcated between East and West.
Inflation has peaked
Part of the improving sentiment in markets, as we noted above, is due to inflation appearing to have peaked. This is true globally at the headline level, including the direct effects of energy prices. One of the areas that has received particular attention is European natural gas prices (see Exhibit 2), but broader measures of commodities have also reversed substantially all of their gains since the invasion of Ukraine in February 2022. As this round trip in prices recedes into the past, it will provide easy comparisons against which current Consumer Price Index (CPI) levels will be judged. This will result in expectations of an ongoing drop in headline CPI inflation being realized, unless other components rise to offset it.
However, with labor markets tight — especially in the United States, but also in the United Kingdom — wage pressures remain the dominant concern of policymakers. So long as job openings remain elevated and employers struggle to fill vacancies with appropriately skilled applicants, core measures of inflation will be slow to normalize. These pressures are particularly acute in the service sector, where productivity gains can be harder to come by and automation is more problematic. As a result, many central bankers continue to have a laser focus on developments in employment and the labor force. Even as we become more certain that headline inflation has peaked, it is too early to sound the “all clear” from a policymaker’s perspective.
Although supply push inflation is reversing, we believe demand destruction will increasingly be the dominant force as the economic cycle slows. These developments reinforce our view that companies will face softer demand, just as the lagged impacts of wage gains and interestrate rises are felt. A continued drag on profit margins is likely to drive weaker employment trends and a deceleration in core inflation. This will be a catalyst for central bank policy to change, but it is not in place yet. We believe the current focus on inflation and the debate around the rate of policy normalization will be the key determinants of monetary policy actions as the year progresses. However, we do see movement in a more constructive direction and have revised our second theme to reflect “Inflation Risks Are Now More Balanced.”
