China Is Coming Back Online, And Inflation Proves To Be Far Stickier
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Mark, what’s your take on the flavor of potential recession?
Mark: This has been an unusual three years to say the least. And I always use the word “experiment” from the sense that the economy was down and out, almost in a depression. We saw extraordinary policy responses, monetary as well as fiscal. And because of that, we’ve seen a lot of dislocations. As we come back online and try to compare what’s going on now to before COVID-19, perhaps 2018, 2019, it’s difficult to apply probabilities. However, that’s what we do.
One of the reasons we believe in a diversified portfolio in 2023, even though that did not work at all in 2022, is because of some of the uncertainties that Gene and Sonal have highlighted. We would agree more so with Sonal than Gene when looking at the odds of recession. Working with our economists, our base case is for the United States to avoid a recession—let’s call it either side of unchanged.
While we have observed inverted yield curves, we have also seen fed funds move up from near zero to 4.5% in a year of volatility. Financial conditions have been tightening, and when you put that all together and you look at the various components of the economy, we see unchanged or around zero in terms of economic growth. There are some stress points to the economy that are more interest-rate sensitive—like housing—but a decline in interest rates should provide some relief.
The consumer is behaving very well, and very importantly, incomes, job growth and savings have offered support— at least so far. All in all, our base case is that the United States doesn’t have a deep recession. Our next highest probability is that unbeknownst to the Fed as well as other central banks globally, they are in the process of overdoing it. Real interest rates are as high as they’ve been for a long time. Policy is a big debate that we all have, and it seems that US fiscal policy is not extremely tight by any means, but is less than what we were used to in 2020 and 2021.
A lower probability for us would be a deeper US recession. The question we would ask is where is the stress in the economy? Where is the leverage? It’s not always obvious as we go through the cycles, but nonetheless, we think a deep recession is a lower probability. Finally, in terms of our
“ ...the question becomes will the Fed react fast enough? Given their history and their anxiety about maintaining their inflation credibility, my personal belief is that they prob ably are not going to react fast enough. There will be another “oh my God” moment, just like there was last year, but in a different direction.” Francis Scotland
probabilities, a potential tail risk is that the economy is doing just fine, the consumer is doing very well, China is coming back online, and inflation proves to be far stickier than the market is pricing in. We put a fairly low probability on that outcome as we go through 2023, which would have a whole different set of policy implications, particularly for the Fed.
And, finally Francis, your thoughts on recession?
Francis: Fed Chair Jerome Powell has gone to great lengths to prepare the market, business and people for the prospect of a recession. He’s drawn on references to the Fed Chair Paul Volcker era (1979–1987) when it took a severe recession to break the inflation psychology that existed in the early 1980s. In my opinion, a comparison of that era with today isn’t appropriate. We’ve seen an 18-month pickup in inflation that has largely reversed and is well on its way back to 2%. There’s just no comparison with what we’ve gone through to what took place in the 1970s and the 1980s. But if the Fed persists in sustaining monetary conditions where they are, we will get a recession.
And, you can see the underbelly of the labor market beginning to shift here. Temporary employment is already contracting. Average weekly hours have now fallen back to below pre-pandemic levels. Average weekly earnings grew only 3% over the last year, which is a dramatic retreat from post-pandemic levels. All of that suggests the wage disinflation the Fed is looking for is already in the pipeline. In addition, Harvard University’s high-frequency economic tracking service tracks job postings data—the data show there’s been a dramatic change in the job market in the last two months.
Job postings, according to this metric, went from 20% higher than January 2020, as recently as early November, to 22% below January 2020 levels, as of the end of last year.2 So that seems to rhyme with the weakness in average hourly earnings, which was posted in the last jobs report, as well as a lot of the job layoff announcements that we’re seeing in the newspapers from large marquee-type corporations. What’s missing so far has been a pickup in unemployment insurance (UI) claims. But what history shows is that when UI claims start to pick up, it coincides with a rise in the unemployment rate.
And all of that happens very, very quickly, and it’s not reversible—by the time that arrives, it’s too late. So, the question becomes will the Fed react fast enough? Given their history and their anxiety about maintaining their inflation credibility, my personal belief is that they probably are not going to react fast enough. There will be another “oh my God” moment, just like there was last year, but in a different direction. So, do I think that the Fed’s going to react fast enough? No.
