The signals and the noise: Three-minute macro
With such a strong job market, how can a recession possibly be in the works? Our answer lies in some troubling leading indicators for growth. At the same time, we think oil’s importance in inflation means some reprieve for the Consumer Price Index in the future. Finally, we note that central banks’ bias toward rate hikes may mean more cuts down the road.
Leads, lags, and recession calls
“What’s with all the recession talk when the U.S. job market is so strong?”
That’s the number one question we get every day, and it’s absolutely a fair one. The United States is adding hundreds of thousands of jobs every month, there are nearly a million job openings, and businesses continue to bemoan near-record challenges filling open positions. How can we—and the majority of economists1—see a recession in this type of environment? The simple answer is that the economist’s job isn’t to tell us where we are now, it’s to explain where we’re heading next. To do so, we disaggregate our data into leading indicators (what’s ahead?), coincident indicators (where are we now?), and lagging indicators (where were we?). We tested some of the most cited economic data points and found a troubling trend: While lagging indicators, such as job growth, are still in strongly positive territory, the most useful indicators about where the economy will be in the next 6 to 12 months are flashing red—many of them, deeply red.
Moreover, we think it’s reasonable to expect that the traditional lags between job growth and the economy (wherein job cuts are the last shoe to fall in a recession) might be even larger in this post-COVID environment. Labor shortages are real and unlikely to be resolved in the near term; given companies’ persistent challenges in hiring, we’d expect them to be even more cautious in layoffs. This is also why we're looking at a broader (and more granular) set of job data such as number of hours worked, as opposed to the unemployment rate alone.
When we put this story together, we still see better-than-even odds of a recession hitting the U.S. economy around the fourth quarter of 2023 and a U.S. Federal Reserve (Fed) that has to pivot toward potential rate cuts as a result.
The signals (and the noise)
U.S. economic indicators
Source: Manulife Investment Management, as of March 6, 2023. Red represents a clearly negative signal, yellow a deteriorating signal, and green a still strong signal. C&I refers to commercial and industrial. ISM refers to Institute for Supply Management.
Past the inflationary peak: some comfort in oil prices
Good news: U.S. inflation is very firmly past its year-over-year (YoY) peak. After hitting a near-record 9.1% YoY increase in June 2022, the Consumer Price Index (CPI) has fallen for nine consecutive months and is now running at 5% YoY. We expect these declines to continue, with U.S. CPI to be in the mid-3% range by year end. There are, however, some concerns that inflation’s decline will stall out, even from the likes of certain central banks; for example, at its April meeting, the Bank of Canada (BoC) noted that getting inflation back to its 2% target “will be more challenging.” After all, central banks know that the bulk of the supply chain challenges have already unwound and that wage growth is still running hot. Services inflation, which tends to be stickier, isn’t showing many signs of letting up in any major developed-market economy.
But here’s one reason why we take comfort in our forecast that inflation in YoY terms will continue to unwind, even as some other factors remain uncertain: The base effects from lower energy prices are extremely powerful. A year ago, West Texas Intermediate (WTI) oil had climbed to over $100/barrel (from below $40 in early 2020).2 Today, it's stabilized around $80, running about 20% below its 2022 peak. Consensus expects WTI prices to remain around $85 to $90, which would be consistent with total inflation falling back toward 2% by the end of 2024. Amazingly, in order to prevent that ongoing decline in inflation from current levels, we have to model in a persistent $120 oil price through the remainder of 2023 and into 2024. Moreover, if we incorporate a more bearish oil outlook (around $60 oil for the next year), total inflation slips below 2% by the end of the second quarter. So, for all the talk of wages, supply chains, and geopolitics, one of the most important drivers of price pressures ahead remains oil prices. And all signs point to energy remaining a material drag on inflation.
Inflation's big dependence on oil
Actual and forecast CPI under various oil price scenarios, YoY change (%)
Source: Manulife Investment Management, as of April 13, 2023. The dashed lines represent forecasts. Base case represents WTI oil at $90/barrel, bear case at $60/barrel, and bull case at $120/barrel. YoY refers to year over year. No forecasts are guaranteed.
Rates: what goes up must come down
With all of the market’s recent uncertainties—from banking stress to China’s reopening—one question continues to nag us: Will central banks respond the same way to the coming (forecast) recession as they have in past cycles? The typical monetary policy response is to combat economic weakness with rate cuts that support growth, reduce the rise in unemployment, and get credit moving again. Indeed, markets have historically rallied when central banks have pivoted toward easing cycles; therefore, counterintuitively, a garden-variety recession and central bank response ahead might not be as gloomy as they sound.
But what if this time is different? Every major central bank has very weak growth (consistent, more or less, with recessions) and a rise in unemployment in their formal forecasts; nevertheless, they state that bias is toward future rate hikes as inflation remains high. And, in some respects, that might make sense. After all, inflation is substantially above target in just about every Western economy, and with such a significant labor shortage, central banks may see higher unemployment as a feature, not a bug.
Given it’s our job to state what central banks might do—and not what we think they should do—we’re still incorporating more rate hikes from the European Central Bank, the Bank of England, and the Fed in our outlook. And even if we don’t formally foresee hikes ahead from the BoC, it’s still an important possible outcome. As those additional rate hikes permeate the economic systems within our models, they tell us that every incremental increase will lead to a commensurate or larger decrease in rates in 2024. In other words, what goes up must come down.
But as always, we have to assess the risk to our outlook. And if we're to take central banks at their word, we also have to consider an environment in which the bar to cut rates is higher than it has been in the past and that, while rate hikes might be far off, rate cuts may not be as close as either we hope or have modeled for.
Major central banks' policy rates and forecast
Source: Manulife Investment Management and the specified central banks, as of April 16, 2023. No forecasts are guaranteed.
1 The Bloomberg U.S. Recession Probability Forecast, an average of participating economist’ forecast, is at 65% as of the time of this writing. 2 The West Texas Intermediate (WTI) Spot Price Index tracks the price of oil imports in domestic currency units using exchange rates. It is not possible to invest directly in an index.
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