More Complicated From Here
If you thought this year was difficult, just wait. The good news is that the extreme outcomes investors worried about through most of 2022 look less likely for 2023.
Central bank tightening seems to be working. As supply chains normalize and demand cools, inflation is heading lower. Conversely, the odds of a serious recession seem to be moderating given the recent strength of labor markets, corporate profits and bank balance sheets. But there’s still plenty of uncertainty about an outlook that is neither boom nor bust. Three complicated sets of policy decisions loom in the coming months.
In China, the pace of relaxing COVID restrictions will determine just how strong a recovery to expect in the world’s second largest economy. In many ways imposing strict lockdowns looks like an easy choice compared to the much more uncertain process ahead. Local officials will have to decide which restrictions to remove even as they assess the risks of rising infections overwhelming the healthcare system. With a property market only now stabilized, consumer confidence may be slow to bounce back. But even a halting rebound counts as a recovery in the only major economy where growth will actually accelerate next year.
Europe’s most important decisions center around its energy needs as it ends oil and gas purchases from Russia. Again, this year’s scramble for alternative supplies was hardly simple. But the task ahead is to secure next winter’s supply at a reasonable price while minimizing the shock to what may be a much weaker economy. The outlook is not nearly as dire as it was just a few months ago when there was talk of energy rationing and rolling blackouts. But the European Central Bank will face difficult choices as it tries to weigh inflation risks that hinge largely on highly volatile energy prices.
In the United States, all eyes will remain on the Federal Reserve. Hiking rates sharply this year now looks obvious with consumer price inflation that peaked above 9% in June. The difficult judgements ahead will rest on cooling a hot jobs market without inflicting too much damage on the rest of the economy. Recent data show that labor demand has started to ease as both job openings and quit rates fall. But existing home sales are falling fast after the recent spike in mortgage rates. Prices need to settle in more affordable ranges, but there are worries that a rapid deterioration could undermine consumer demand and make the recession much more serious.
Our central scenario remains what we call ‘Stagflation Shock’ as higher rates and prices combine to cool global demand and bring inflation back under control. While a recession still looks likely in Europe, the U.S. downturn should be mild and relatively brief. We continue to watch for signs that inflation may remain more stubborn even as it falls, especially given the strong U.S. jobs market and high levels of consumer savings. If the U.S. economy ends up “Boiling Over,” the Fed would have to hike a lot more and the recession would be much deeper, long and variable transmission lags have played out. The risks of a “Steeper Slide” and sharp U.S. recession still look less likely given recent data.
Markets may deliver more volatility under these circumstances rather than a large move in either direction. These delicate choices will likely deliver mixed signals to markets amid a continuing stream of conflicting and contradictory data. Difficult decisions for policymakers mean difficult decisions for investors, too.