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Despite the evident weakness in manufacturing and freight, the service sector and labour market are displaying strong momentum in major economies
Published : 01 Mar 2023, 04:15 PM
Since the start of the year, prominent forecasters have become more confident the US Federal Reserve and other central banks can engineer a soft landing for the global economy or even avoid a cyclical slowdown altogether.
In this view, inflationary pressures will soon dissipate, allowing policymakers to stop raising interest rates and then start to lower them later in 2023 or early 2024, supporting a continued expansion in economic activity.
High levels of employment and nominal wage growth will support household and business expenditure in the interim while the global economy pulls through its recent softer patch.
And the much larger and more labour-intensive service sector will provide continued momentum while the smaller and more energy-intensive manufacturing sector goes through a cyclical adjustment to clear out excess inventories.
While this optimistic scenario is plausible, it remains less likely than the economy entering a significant and extended cyclical slowdown or full-blown recession in the course of 2023.
Global industrial output was no higher in December 2022 than it had been twelve months earlier in December 2021 as spending on merchandise buckled under pressure from high inflation and excess inventories.
The manufacturing slowdown is consistent with the onset of previous recessions in 2001, 2008 and 2020, but also mid-cycle slowdowns in 2013 and 2015, after which the economy re-accelerated.
The slowdown in global trade and freight has been more severe as manufacturers and distributors have tried to reduce excess inventories after over-ordering as a result of the supply chain disruptions in 2020 and 2021.
Global trade volumes were down almost 3% in December 2022 compared with December 2021, according to the Netherlands Bureau of Economic Policy Analysis (“World trade monitor”, CPB, Feb 24, 2023).
This abrupt downturn in trade has only ever been associated with the onset of a recession, as opposed to a mid-cycle slowdown, and illustrates the severity of the cyclical contraction on the merchandise side of the economy.
MONETARY TIGHTENING
In the past, the Federal Reserve and other major central banks have usually responded to a temporary “soft patch” by pausing interest rate rises or cutting them to support the level of activity.
In this instance, however, the US central bank is expected to continue raising rates for the next six months by another 75 basis points on top of the 450 basis points of increases already implemented over the last year.
Interest rates are rising from an exceptionally low base in this cycle, but cumulative rises of this magnitude have normally preceded a full-blown recession since the 1960s.
Rates are now expected to rise further and remain higher for longer in response to the persistent strength in the job market and service sector inflation.
Expectations for the end of 2023 are still trending higher as service sector inflation has continued rising faster than originally anticipated.
Rate traders are convinced increases on this scale will induce a very significant slowdown in inflation, business activity, or both.
The US Treasury yield curve between two-year and ten-year maturities is more inverted than at any time since September 1981, when the economy was entering the second part of an exceptionally severe double-dip recession.
The US S&P 500 broad equity index is down 13% compared with the same month in 2021, after adjusting for core inflation, which is also consistent with a severe cyclical slowdown.
UNDERLYING MOMENTUM
Despite the evident weakness in manufacturing and freight, the service sector and labour market are displaying strong momentum, especially in the United States.
US real personal incomes less transfer payments (PILT) increased by 1.1% in the three months from November to January compared with the same period a year earlier.
PILT growth, one of the key indicators used to identify the onset of recessions, accelerated from 0.8% in October-December and was rising at the fastest rate since February-April 2022.
The combination of rising employment, increasing wages and a slight slowdown in inflation, has reversed some of the previous slowdown in PILT and eased some of the squeeze on household incomes and spending.
Service sector activity levels also strengthened significantly in January according to business surveys conducted by the Institute for Supply Management.
Service sector prices excluding rent rose at an annualised rate of 5.24% over the three months to January, up from 3.10% in the three months to December, and were 7.24% above year-ago levels.
Similar strength in service sector activity and inflation has been visible across the Eurozone and other major economies.
The service sector’s enormous size and labour intensity provide a lot of ballast for the rest of the economy and could support it through a downturn in the manufacturing cycle.
In the United States, private-sector service businesses provide 107 million jobs compared with less than 13 million in manufacturing and less than 8 million in construction.
Provided the service sector continues to drive employment, income and spending gains it could be enough to carry the manufacturing sector through its own cyclical downturn.
The problem is service sector strength is also a potential source of persistent inflation, which risks spreading back into manufacturing as excess inventories are eliminated and demand for merchandise rises again.
In the ideal scenario, popular with prominent forecasters, the service sector maintains just enough momentum to pull manufacturing through, but not so much to entrench inflation.
It is possible, but a lot of factors would have to fall exactly into place in just the right sequence for this soft-landing or no-landing scenario to work.
It seems more likely that (a) household and business spending will buckle under pressure from prices rising faster than wages; or (b) persistent inflation in the service sector will force policymakers to tighten monetary conditions - with manufacturing activity as collateral damage.
John Kemp is a Reuters market analyst. The views expressed are his own.
