What’s Next for the Economy in 2023?
The global economy will likely slow from the upper-2% range in 2022 down to the mid-1% range in 2023. Much depends on China’s growth path. An important aspect for investors is that the U.S. appears to have fewer headwinds to growth compared with Europe and other developed economies. The divergence between the domestic and international economies is most obvious in the inflation regime. Germany, for example, is still experiencing accelerating rates of inflation, whereas the U.S. has likely moved past the peak. The longer inflation is uncontained, the riskier the growth prospects.
If the U.S. falls into a recession, the chances are that it would occur during the first half of 2023 and will likely not be as deep as the 2008 recession, which was initiated by a fundamentally flawed financial market.
More clarity on potential for U.S. recession
There are three factors for defining a recession: depth, diffusion, and duration—conveniently referred to as the “three Ds.” Depth refers to declining economic activity that is greater than any relatively small change. Diffusion describes an economy that has experienced a contraction in a wide range of sectors, such as trade, business activity, and consumer spending. Duration, likely the least important of the three Ds, measures the time between the previous business cycle peak and the following trough. Since World War II, the average recession has lasted just over 10 months (down from an average of 17 months if you date back to 1854), according to the National Bureau of Economic Research. Given the unique cause of the 2020 recession, the time between peak and trough was the shortest on record—only two months.
One reason we’re currently seeing a healthy debate on the likelihood of a recession is that for most of 2022, not all of the metrics were flashing warning signs. However, recent data may give us more clarity. The Conference Board’s Leading Economic Index (LEI) has declined for seven of the last nine months, showing that the economy could enter a period of significant and broad-based contraction. The decline is predictable as many sectors, such as housing, started slowing months ago. Since the inception of the index, a decline of this magnitude over a six-month period has always foreshadowed a recession in subsequent quarters. As such, we think recession risks appear more probable by the beginning of 2023. If the economy does fall into a recession, the cause will likely be from the consumer sector retrenching after years of inflationary pressures, high housing costs, and slow real wage growth.
Even though investors are tempted to say “this time is different,” we all can take note of general principles about business cycles and the markets. The Fed has warned that the current inflation fight will be painful, so a dip into a recession should not be that surprising.
Readjustments in the job market could lessen pain
The Fed has repeatedly warned investors about the potential for pain from the fight with inflation. That pain is mostly likely associated with an expected increase in unemployment as the job market cools from a slowing economy. The Job Openings and Labor Turnover report was hardly on center stage, until Fed Chair Jerome Powell used a press conference to highlight the number of job openings in the economy. The pandemic caused these three metrics to become off balance: the ratio of openings to unemployed, the number of those not in the labor force, and the percent of firms having difficulty finding qualified workers. Investors should watch these metrics throughout 2023 as the economy leads to a more balanced labor market.
We expect the ratio of openings to unemployed to fall as the economy slows and firms cut their number of job openings. Firms often quickly respond to a slowing economy: during the 2008 financial crisis, the number of openings fell by 50% in roughly 16 months, so this metric could revert quickly. The persistent problem of individuals out of the labor force has kept the labor market tight, but a potential improvement in labor force participation in the prime age population (25–54 year olds) with improved productivity would be a powerful remedy. And in terms of firms’ struggle to find qualified workers, the coming year will reveal how firms are responding to current labor market conditions and any potential impact this may have on businesses. If the labor force grows back to its pre-pandemic trend, many of these near-term conditions would improve.
Housing market should begin to normalize
The housing market is still normalizing in response to an economy under pressure from higher borrowing costs, nagging inflation, and uncertainty about future Fed activity. Slowing residential investment will create a drag on economic growth at the start of 2023, but demographics of Millennials and Generation Z could provide some support for housing demand later in the year. Nevertheless, in the near term, housing demand will likely fall further in the coming months, putting downward pressure on median prices. Housing plays a significant role in consumer spending and investors should monitor the housing market as a bellwether for the health of the consumer. Consumers spend roughly 34% of their total spending on housing, so a decline in housing-related costs should give consumers more for discretionary spending.
The hybrid work environment and the corresponding interest to move to areas with lower cost of living created an imbalance in the housing market, especially during the trough in mortgage rates. Regional variations will likely remain as geographic reshuffling continues. In 2023, the potential for more multi-family dwellings should help bring the demand and supply for rentals into balance, while more rentals and normalizing house prices should ease inflation.
Inflation should become convincingly softer
Investors and central bankers will likely enter 2023 with a slightly different trajectory for inflation, particularly services inflation. In recent months, durable goods prices have clearly decelerated—and in some cases, outright declined—but services prices have been stubbornly accelerating as rent prices and health services rose. We could potentially be entering a new regime as rents across the country are showing signs of abating. During this transition period for services prices, the coming year could be the time when inflation is convincingly decelerating closer to the Fed’s long-run target of 2%. If inflation in 2022 was about supply constraints, then inflation in 2023 could center on demand constraints. For the past year, supply-related problems contributed more to inflation than demand-related imbalances. China’s zero-COVID-19 policy was one of the biggest glitches in supply chains as metro areas and ports were shuttered by the Chinese government.
However, things may be on the verge of changing as supply and demand get into balance throughout 2023, and as inflation likely becomes more demand driven and less supply driven. This is positive for policymakers because monetary policy tools do not work on supply shocks but rather, only on demand; thus, these tools are now more relevant than they were when inflation was primarily from supply bottlenecks. So as supply constraints ease and as Fed tools become more impactful, we could see the rate of inflation decelerating further in 2023.