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?
A soft landing
In the soft-landing scenario, the high inflation of recent years is seen as due to problems on the supply side and the shift in demand from services to goods during the pandemic. Inflation will fall back of its own accord, as many supply-side problems have evaporated and commodity prices have declined. In addition, prices in the coming months will be compared with the strongly increased prices of last year, which will also depress the inflation rate.
Moreover, in the soft-landing scenario, tighter monetary policy will slow down the economy enough to cool the labor 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 percent 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, weak 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 COVID crisis, you had asked an economist what the effect would be of the rate hikes enacted in the last year, they would certainly have warned of a deep recession. However, it takes a long time for the impact of hikes 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 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 production has been lacking in recent years. Furthermore, labor markets have become permanently tighter due to less immigration, aging and because more people left the labor market during the COVID 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 (further). Chinese consumers can go out and about again, while consumers in the U.S. and in Europe will spend their large savings because tight labor markets and persistent high asset prices are positively influencing balance sheets, wage increases and consumer confidence. 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 jeopardize growth:
- 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.
Calm before the storm
The markets have increasingly been pricing in a soft landing in recent months 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 U.S. 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 rate hikes have significantly increased the risk of a profound recession. The fact that a recession is not (yet) evident is due to various factors that 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, we expect mounting problems this year:
- Many economists estimate that U.S. households will run out of their additional accumulated savings. Moreover, it would not be surprising if households did not spend a large part of their remaining savings. A large part of these savings are held by wealthier households, which are less inclined to spend savings anyway. In addition, declining house prices and diminishing job security may make people wary of spending more.
- As many supply-side problems have been resolved by now, the positive impact of improving supply chains will become far smaller or could even reverse due to declining orders and because companies want to reduce overstocking.
- Tensions surrounding the U.S. debt ceiling could flare up by the summer. We also expect more speculation on tighter fiscal policies in the European Union, as the suspension of fiscal rules ends by the end of this year.
- Lower nominal growth, high stock levels and rising labor costs are likely to keep corporate earnings under downward pressure. As a result, companies will invest less and lay off more staff.
- U.S. economic data for January were surprisingly good. This was due to better weather conditions and incorrect seasonal adjustments. Therefore it is unlikely that last month’s strong data are 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. 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 fueled 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.
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.
Andy Langenkamp is senior political analyst at ECR Research which offers independent research on asset allocation, global financial markets, politics and FX & interest rates. Maarten Spak is a senior financial markets analyst at ECR Research.