Real consumer outlays were still rising at a healthy 2% pace at the end of 2022 compared to the year before, Gregory Daco writes.
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About the author: Gregory Daco is the chief economist at EY and former chief US economist at Oxford Economics. Views expressed in this article are those of the author and do not necessarily represent the views of Ernst & Young LLP or other members of the global EY organization.
The global economy is getting trickier to decipher as we enter 2023, and the consensus view for a mild recession will be challenged in the coming months. The reason is simple. While a mild recession represents a good median forecast, it’s by no means the most likely one.
In one scenario, the ongoing war in Ukraine and sanctions on Russia, multi-year-high interest rates, depressed global equity prices, elevated financial market volatility, and a synchronized slowdown in Europe, Latin America, North America, and Asia will push the global economy into a recession in 2023. In this environment, deteriorating trade, investment, and financial-market conditions would amplify the shock so that a global recession would be greater than the sum of individual regional recessions.
Alternatively, in a soft-landing scenario—where economic activity cools just enough to allow for inflation to fall back toward central banks’ targets—the global economy navigates a period of slower growth in the first half of the year but emerges with stronger momentum over the summer and into 2024.
Much ink has already been poured over the downside risks to the outlook, so it’s important to highlight three key factors that could lead the more optimistic scenario to materialize. Doing so isn’t about putting on rose-shaded glasses, but instead observing recent global developments with a curious eye toward the probable.
The three factors to monitor closely are the relative resilience in business and consumer activity in the U.S., the extremely mild winter in Europe, and the sudden abandonment of the zero-Covid policy in mainland China.
In the U.S., final demand is now visibly softening. Tighter financial and credit conditions brought on by the Federal Reserve’s aggressive tightening cycle are forcing business executives to re-evaluate their investment decisions and talent needs for 2023. But, with so much effort having gone into hiring and training over the last 18 months, executives are reluctant to let go of their prized talent pool. As such, layoffs remain low, and instead, companies are considering reduced hiring along with wage-growth compression to keep a lid on labor costs.
The December jobs report reflected this gentle easing of labor demand. The three-month moving average of job gains softened to a respectable 247,000, hours worked fell back to their prepandemic level, and temporary employment contracted for the fifth consecutive month. With the economy adding 4.5 million jobs in 2022 and the unemployment rate sitting at a 50-year low of 3.5%, the labor market remains quite robust.
Consumer spending activity has also showed signs of resilience. That’s true even as households—especially lower- to median-income families—are exercising more discretion with their purchases and making increased use of savings and credit in the face of persistently elevated inflation. Real consumer outlays were still rising at a healthy 2% pace at the end of 2022 compared to the year before.
The December reading on average hourly earnings for private-sector workers will no doubt come as a welcome development for Fed policy makers seeking evidence that their battle against inflation is successful. The combination of softer monthly momentum in wages along with the lowest postpandemic wage-growth reading at 4.6% year over year should reassure the Fed that an ongoing slowdown in the pace of monetary policy tightening—featuring a likely quarter-point rate hike in early February—is warranted.
Evidence of softening inflationary pressure in the coming months would likely further challenge the Fed’s hawkish narrative. It could even open the door to a recalibration of monetary policy, featuring rate cuts before the end of the year—another growth stimulant. This could happen despite the recent Federal Open Market Committee minutes statement that “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.”
Meanwhile, Europe has been dealt an unexpected free pass with one of the warmest starts to the winter in years, if not decades. While these conditions are certain to amplify climate concerns, the warmer temperatures are alleviating worries of an imminent energy crisis as gas storage across Europe remains at high levels. Lower prices for natural gas, oil, and electricity are easing cost-of-living strains on families across Europe and will support consumer spending and manufacturing activity.
Purchasing manager indices across the euro zone also point to a tentative rebound in service-sector activity. With consumers and business executives becoming less pessimistic about the outlook and regional economies finishing the year on a better note than expected, activity may be less subdued in 2023. Still, the aggressive tightening of monetary policy and hawkish communication by the European Central Bank, along with weak income growth, argue against any premature celebration as they point to constrained economic prospects for the region.
With authorities in China having apparently decided that the economic benefits of a rapid abandonment of the zero-Covid policy outweigh the cost of a health crisis, the country has been experiencing an unprecedented surge in the number of Covid infections and fatalities. In the near term, this will severely constrain economic activity in China. But, while the hit to growth will likely be significant in the near term, the government’s increased resolve to favor pro-growth policies along with increased population immunity will likely support a rebound in employment, consumer spending, and manufacturing activity in the spring and summer.
Overall, the implication for forward-looking financial markets is that while volatility is likely to remain ubiquitous in the first half of the year, better market conditions may prevail once the uncertainty regarding the immediate economic outlook dissipates.
And, if the more optimistic scenario materializes, the realization that a higher interest-rate environment is likely to persist along with reset market valuations and stabilized foreign exchange markets should be conducive to greater transactions activity.
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