Buoyant balloons or burst bubbles?

Published: Mar 2023

Will Western consumers, companies, governments and investors succeed in pumping more heat in their economic balloons and keep them drifting higher or is a landing unavoidable, whether a soft landing or a crash?

Inflation has peaked and is expected to decline rapidly over the next few quarters. However, central banks are indicating that they will tighten monetary policy further to ensure that inflation declines to the 2% target. The question that has been preoccupying the markets is whether central banks will succeed in this or crash the economy in the process, or whether monetary policy makers can steer inflation down while also piloting a soft economic landing. Because labour markets remain tight and lower inflation gives purchasing power an additional boost, some have now even taken to the idea that a landing will not be necessary at all, arguing that we can keep flying along without having to touch the ground.

A soft landing

In the soft-landing scenario, the high inflation rate of recent years is seen as due to problems on the supply side and the shift in demand from services to goods during the lockdowns. Inflation will fall back of its own accord, as most supply side problems have evaporated and commodity prices have declined.

Also, in the soft-landing scenario, tighter monetary policy will slow down the economy enough to cool the labour market. This will not lead to a recession because consumers still have vast amounts of savings to spend, real incomes are being supported by declining inflation, governments are pursuing loose fiscal policies and Chinese economic growth will accelerate. Central banks will not have to raise their rates much further in this scenario and can lower them later this year, once inflation has declined significantly further.

A hard landing

In the hard-landing scenario, inflation can only be reduced to 2% with the help of a recession. The risk of a recession seems to have declined due to the better-than-expected economic data, but appearances can be deceiving. Several indicators that have proven to be reliable warning signals of a recession in the past (an inverted yield curve, a decline in leading economic indicators and credit supply contraction) point to a very high risk of recession. In addition, central banks have tightened monetary policy very quickly in a short period of time, to the point where this is almost bound to have a major negative effect on the economy, given the soaring debts and exceedingly high asset prices.

If, before the corona crisis, you had asked an economist what the effect would be of the rate hikes that the Fed and ECB have enacted in the last year, they would certainly have warned of a deep recession. However, it takes a long time for the impact of monetary tightening to become apparent in the real economy, so the negative effect of monetary tightening from mid-2022 still has to be largely reflected in the data.

Also, it remains to be seen how quickly inflation will decline as a result of weaker growth and tighter monetary policies. The war between Russia and the Ukraine will not be over any time soon and higher growth in China will boost commodity demand. As a result, commodity prices could easily rise again because commodity stock levels are relatively low and investment in resources has been lacking in recent years. Furthermore, labour markets have become permanently tighter due to less immigration, ageing populations and because more people left the labour market during the corona crisis. These factors are exerting additional upward pressure on wages. This means that central banks will only be able to properly contain inflation if unemployment rises by roughly two percentage points. In the past, such an increase was almost always accompanied by a recession.

No landing

In the third scenario, growth will pick up over the next few quarters. Chinese consumers can go out and about again because China has lifted its strict lockdown policy, while consumers in the US and in Europe will spend their large savings because tight labour markets and persistent high asset prices are positively influencing balance sheets and consumer confidence. Furthermore, tight labour markets cause wage incomes to increase considerably – a large part of which will be spent – and they ensure that companies will be more inclined to invest in labour-saving measures. Growth will also be supported by increased investment in sustainable energy. Finally, lower energy prices increase purchasing power and, in Europe in particular, lower gas prices make it more appealing for industrial companies to step up production. Higher economic growth will basically put inflation under more upward pressure and trigger even tighter monetary policy. However, this does not necessarily have to directly jeopardise improving economic growth:

  • In the coming months or quarters, the downward pressure on inflation due to improving supply chains and lower commodity prices is likely to remain far greater.
  • Central banks have already raised their rates considerably and will be cautious about stepping up the pace of rate hikes. They will first want to evaluate the delayed impact of previous rate hikes.
  • Equities will continue to perform well and credit spreads will decline further due to improving growth prospects combined with declining inflation. This will ease monetary conditions.

Spoiling party crasher

The markets have increasingly been pricing in a soft landing in recent months due to better-than-expected economic data, the reopening of China, lower energy prices and looser monetary conditions. And there’s even mounting speculation on a no-landing scenario. However, a hard-landing scenario is unfortunately the most likely.

Due to weak productivity growth and demographic developments, potential growth in the US and Europe is low and total debt-GDP ratios are very high. Furthermore, in recent years, a great deal has been invested in the expectation that interest rates would remain low. As a result, many asset prices were/are very sensitive to higher interest rates. Against this backdrop, the rapid hike in interest rates last year has significantly increased the risk of a profound recession. In our view, the fact that a recession is not (yet) evident is due to various factors that made the economy less sensitive to higher interest and kept economies humming along:

  • Because inflation was and is higher than the level of interest rates and wage increases, debts carry less weight in real terms, which has a positive effect on corporate earnings.
  • Loose fiscal policies.
  • In recent years, consumers and companies have borrowed more at low and fixed interest rates.
  • Spending of accumulating savings.
  • Catching up on production due to diminishing supply side problems.

However, the positive impact of high inflation will quickly disappear if diminishing supply side problems and lower commodity prices cause inflation to decline further, while central banks raise rates further and wage increases remain high. Also, we expect the economy to react more negatively to higher interest rates this year:

  • Many economists estimate that US households will have run out of their additional accumulated savings in the second half of this year. Moreover, it would not be surprising if households did not spend a large part of their remaining accumulated savings. A large part of these savings are held by wealthier households, which are less inclined to spend savings anyway. In addition, further declining house prices and diminishing job security may make people wary of spending more.
  • As most supply side problems have been resolved by now, the positive impact of improving supply side problems on production will become far smaller or could even reverse due to declining orders and because companies want to reduce overstocking.
  • Tensions surrounding the raising of the US debt ceiling could flare up by the summer. We also expect more speculation on tighter fiscal policies in the EU, as the suspension of fiscal rules ends by the end of this year.
  • Lower nominal growth, high stock levels and rising labour costs are likely to keep corporate earnings under downward pressure. As a result, companies will invest less and lay off more staff.
  • US economic data for January was surprisingly good. This was due to better weather conditions than in December and incorrect seasonal adjustments. Therefore, it is unlikely that last month’s strong data is the onset of a growth recovery.
  • The end of China’s zero-COVID policy will mainly boost the service sectors in China and surrounding countries. The positive effects on the rest of the global economy will likely be limited. Unlike US households, Chinese households will likely spend a relatively small proportion of their accumulated savings. Due to the ongoing crisis in the Chinese housing market, consumer confidence is under pressure and more households are seeking to pay off their mortgage debt.
  • Increased hopes of a soft-landing scenario have been partly fuelled by the sharp rise in equity prices and corporate bond prices. This was partly due to companies engaging in major share buybacks and investors reversing many short positions. A further decline in earnings and growing concerns about a hard landing will make companies more cautious about buybacks.

Because of the above, after Chinese and unknown balloons being blown to smithereens earlier this year, it could very well be that we will see some asset bubbles bursting too later in 2023. As financial markets adjust their radars to see what’s coming, prices of riskier assets will come under strong downward pressure, while government bond prices will rise due to investors seeking safe havens.

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