By Daleep Singh, Chief Global Economist and Head of Global Macroeconomic Research, PGIM Fixed Income
The first half of 2023 was just the latest reminder that we have entered a period of elevated macroeconomic volatility where regime shifts are likely to occur with greater frequency and consequence than experienced in recent memory.
In the US, the economy seemingly lurched from one crisis to another in the first half of the year. However, the regional bank failures did not spark a systemic reckoning, nor did the debt-ceiling drama produce a sizeable fiscal drag. With the prospect of balance returning to the labor market, we see a path for core Personal Consumption Expenditures inflation to decelerate to less than 3.0% by year end. Clear and sustained evidence of a downshift on inflation, coupled with below trend growth, should be enough for the Fed to pause its rate hike campaign at 5.5%, prior to initiating a 50-75 bps “fine-tuning” campaign of cuts as early as Q4 2023.
Putting it together, our modal case (35% probability) calls for “weakflation” in the US over the coming 12 months, the product of low, but positive, growth and declining, but still above target, inflation. As alternative scenarios, we see equal probabilities (25% each) for a recession and soft landing, followed by slimmer probabilities for a “nominal GDP boom” (10%) in which growth accelerates above trend and inflation remains too high or a “roaring 2020s” scenario (5%), reminiscent of the late 1990s when a productivity boost lifted growth above the previous trend and kept inflation in check.
Two tail risks for the U.S. economy—pointing in opposite directions—loom especially large to our watchful eyes. First, we’ll continue to monitor for signs of distress within the commercial real estate sector (especially office) and the non-bank financial sector that could take on a life of their own as the Fed presses further into restrictive territory.
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Conversely, we are respectful of the potentially game-changing consequences to the supply side of the economy from public investments. To the extent that the parabolic increase of construction spending in manufacturing is a harbinger of things to come in business spending, it would have highly favorable consequences for productivity, trend growth, and financial returns across asset classes.
Turning to Europe, our outlook points to weak growth. Although more resilient than expected, Europe’s growth backdrop is beginning to show signs of structural headwinds and a key aspect to watch will be the extent to which headline inflation decelerates over the summer months with the only positive contribution to Euro Area GDP growth in Q1 coming from net exports, which face increasing challenges. As a result, our Euro Area GDP projections remain well below trend and, at this point, appear set to dip below consensus estimates in the second half of 2023 and throughout 2024.
Regional and sectoral dispersion is also clouding the picture. Ultimately waning domestic demand for services, coupled with weaker global demand for manufactured exports, will translate into stagnant growth against a backdrop of elevated inflation. These factors feed into a weakflation base case (40%) for Europe. The inflation dynamic is expected to compel the ECB to lift its deposit rate to 3.75% at its July meeting with the risk of further rate increases in the second half of the year. We place the probability of European recession at 25%, followed by a soft landing at 15%, and nominal GDP boom and stagflation scenarios at 10% each.
Our outlook for China is bifurcated between a relatively sanguine short-term forecast – supported by additional monetary stimulus and an expected revival in fiscal stimulus – and a less constructive medium- to long-term picture given the country’s considerable structural hurdles. China’s current recovery is unlike others as it is relying on consumer-led growth following years of credit fueled investment in property and infrastructure.
However, the consumer already appears to be losing momentum. Moreover, there is no evidence as of yet that the property slump is bottoming out, and in order to prevent the recovery from stalling and GDP growth from missing its target for the second consecutive year, we anticipate that fiscal stimulus will focus on local governments.
As such, over the coming 12 months, our base case (50%) for China is for a soft-landing/moderation that consists of growth around 4.5-5.5% and inflation of 1.5%. This is followed by scenarios of strong nominal GDP (25%), weakflation (15%) as well as recession and roaring 2020s at 5% each.
However, fiscal stimulus across local governments risks lack of coordination. It could result in larger stimulus than warranted., underscoring China’s persistent need to de-lever, which is one of the key risks weighing on China’s medium- to long-term growth prospects. Other key risks include deteriorating demographics amid a historically low level of births in 2022 as its dependent population grows and de-risking as it faces export uncertainty as well as a more contentious relationship with the US and its allies.
Given that the key drivers of China’s medium-term growth are weakening, our GDP forecast for 2024 indicates a moderation that will likely continue in subsequent years. Over a five-year period, the country’s growth may approach its potential at slightly less than 4%, and its growth potential may subsequently moderate to less than 3% over the coming 10 years.
In addition to intensified competition between great global powers, the evolving structural changes include heightened political polarization, the bumpy transition from fossil fuels to renewables, the de-risking of supply chains, and increasingly distinct technological ecosystems. This de-anchoring of what was the status quo implies that shocks will continue to rattle major economies, likely leading to an end of the period of great moderation that characterized the last few decades.
