Developments in the US economy will have an impact not only in the US, but across the globe. While the stateside economy has proven reassuringly resilient until very recently, a recession now looks inevitable within the next twelve months. Against this backdrop, we believe that patience is the order of the day in equity markets. Meanwhile, rising interest rates are a source of opportunity for bond investors.
United States: a drawn-out fight against inflation
After climbing for two years, US inflation seems to have peaked. Lower fuel prices have allowed headline inflation to slow, while core inflation (excluding food and energy) has stabilised at around 6.0% year-on-year (Figure 1).
Core inflation is coming off the boil as goods prices return to normal (Figure 2). The overheating was a reflection of temporary price rises due to a mismatch between supply and demand prompted by the Covid-19 pandemic. Goods prices can be expected to continue to fall back to normal as production flows improve. That said, the consequences of the Covid-19 epidemic in China still need monitoring.
Meanwhile, services inflation remains high. Labour market tensions would need to ease markedly to enable a return to normal as wages heavily influence the prices charged for services (Figure 3).
In the past, labour market tensions have rarely eased without the onset of recession. Up until the ISM numbers were released for December 2022, the US economy had been proving remarkably resilient. Weekly jobless claims remain very low and we are not yet seeing the fall-off in corporate earnings that usually precedes a recession (Figure 4).
Against this backdrop, we see three possible scenarios. The first is a soft landing, where the economy slows down but avoids contraction. The scenario would enable labour market tensions to gradually ease. The second foresees a mid-2023 recession triggered by recent rate hikes to tighten monetary policy. The third scenario accounts for a more robust US economy that pushes the Fed to continue hiking rates into the second half of 2023. In this case, we place the onset of recession in early 2024. We believe the soft landing scenario to be unlikely (10% probability), and the two remaining scenarios to be equally likely (45% probability each).
Eurozone: resilient growth
Eurozone inflation remains stubbornly high. Unlike in the US, it is closely tied to rising food and energy prices, as shown by the large gap between headline and core inflation (Figure 5).
In all likelihood, headline inflation will slow sharply in the months ahead given that last spring’s energy price surge constitutes a very high basis for comparison. It would take another similar spike to reach previous inflation levels (Figure 6).
However, a slowdown in headline inflation does not mean that the problem has gone away. Core inflation remains high and without significant labour market easing, wage pressure could persist (Figure 7).
Governments have implemented various measures to support both households and businesses. Reduced gas consumption and efficient storage strategies helped to lessen the threat of winter rationing and ultimately led energy prices to fall (Figure 8).
In addition to lower gas consumption, massive LNG imports were key in avoiding shortages. Given thin capacity for LNG supply growth until 2025, lower Asian demand and especially Chinese demand has facilitated these higher import volumes. The reopening of the Chinese economy could result in a tighter gas market. All told, uncertainties persist and next winter could be challenging.
For this winter, the energy crisis threat appears to be receding and the ECB will probably have to push ahead with tightening its monetary policy. As usual, developments in the US will influence the outlook for the European economy.
China: the road to recovery
The decisions made by Chinese authorities in recent weeks indicate a pro-growth policy shift. The government has abruptly lifted the health restrictions that had been disrupting growth for three years. It also stepped up measures to support the property market.
Ironically, relaxing health restrictions initially prompted a growth slowdown (Chart 9) as people stopped travelling due to catching, or trying to avoid, Covid.
While the reopening will eventually translate into a spending recovery, the timing remains uncertain and depends on how the health situation develops, which is difficult to gauge. A rebound in mobility data suggests that a peak has passed, but further waves cannot be ruled out.
Questions also surround the scale and sustainability of the economic rebound. To what extent will consumers spend surplus savings accumulated during the pandemic? Could structural headwinds, such as population decline, limit the housing sector’s ability to recover? (Figure 10)
Conclusion: macroeconomic context
Once inflation has peaked, the problem has not necessarily been solved. Until wage growth slows significantly, or the conditions for such a slowdown are in place, central banks will not be convinced that they have won the battle against rising prices. As such, they view economic strength in the short term as problematic and are likely to remain hawkish.
Over the course of an economic cycle, it is difficult to significantly reduce labour market tensions without the dampening effects of an economic recession. We see the pathway to the most favourable scenario (soft landing and significant labour market easing) as being a very narrow one to tread. Chinese growth will gather pace following an initial hiccup, but probably not enough to compensate for the very likely recession in the West.
PMI / ISM indices: the PMI (Purchasing Manager’s Indices) and ISM (Institute for Supply Management) indices summarise confidence levels among surveyed business purchasing managers. A value above 50 indicates positive sentiment in the sector concerned (manufacturing or services) and below 50 indicates negative sentiment.
Risk premium (equities): the equity risk premium reflects the additional return offered by equity markets compared to the bond market risk-free rate (usually 10-year sovereign bonds). This additional yield compensates the investor for taking more risk.
Credit spread: the difference in yield between a bond and a risk-free loan with the same maturity. The term ‘spread’ therefore refers to a rate difference or rate differential. The better the perceived creditworthiness of the issuer, the lower the spread.
MSCI World: the MSCI World Index is a stock market index produced by MSCI to measure the performance of global equity markets.
EPS: earnings per share. 12-month forward EPS are the earnings per share expectations linked to earnings forecasts over the next 12 months.
€STR (euro short-term rate): the overnight eurozone interbank rate in the money market.
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See also : https://latribune.lazardfreresgestion.fr/en/fixed-income-in-2022/
The opinion expressed above is dated January 2023 and is liable to change. Latest available data as of publication date.
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