February 2023 Peter Hall
Senior Advisor Elevate Export Finance Corp
CEO of Econosphere &
Former Chief Economist EDC
A Tale of Two Economies Thoughts on the near-term economic outlook
Here we slow again. Didn’t we just have a recession in 2020? Surely we can’t be in for another so soon. Yet for most pundits it’s no longer a matter of whether, but how deep and long the recession is going to be. Meanwhile, prominent analysts question anyone’s ability to really forecast, given all the mayhem of today’s market served up by climatic disturbance, neo-protectionism, technology, corporate malfeasance, terrorism, populism, pandemics, unreliable news, and a host of other recent happenings. Sure, many things have changed, but many other features of the economy are the same as they were. What awaits us in the coming two years?
One look at key leading indicators is shocking. Housing markets are swooning; purchasing managers’ indexes are in the red; equity indexes are turbulent; consumer confidence is shaky. Composite leading indexes are down for a vast swath of the world economy. Other indicators seem to be exhibiting late-cycle levels. The unemployment rate is at or near record lows in most countries. Capacity utilization rates are hovering close to pre-pandemic highs in both the U.S. and Canada. All seem to cry out that recession is imminent.
Then consider ongoing inflation-fighting interest rate increases, which could only be called radical. The effects of these measures will be felt at least into early 2024, given the predictable pattern of near-term mortgage resets. And the effects will be magnified by home prices, which were inflated by the long stretch of ultra-low interest rates and ample pandemic-era liquidity. If the whole economy sidesteps recession, recent homebuyers in Canada certainly won’t.
So far, this sounds like the consensus view: demand is too hot, so it needs to cool off; soft landing preferred. While it seems the description fits Canada, in this case one size does not fit all. Rising above the high-frequency cacophony, a different picture emerges. Most seem to disagree, but a strong case can be made for the U.S. economy not being structurally ready for recession. Many of the same arguments apply to Western Europe. At this point, attention is usually rapt: “Do tell!”
Multiple factors point to surge of underlying U.S. demand. First, there was the long, slow growth phase following the global financial crisis (GFC) of 2008. Some sluggishness is to be expected following a recession, but in this case it persisted and was then labelled a ‘new normal’ – suggesting that the economy could only sustain growth at this new, lower level. Once the general public is convinced, lower growth becomes a self-fulfilling prophecy: consumers rein in spending, save more, and companies in turn produce less, invest less and indefinitely delay true recovery.
If so, this is exactly what frustrated John Maynard Keynes about the economy of the mid-1930s. Crudely put, he observed that the economy should have reset, having worked off the excesses of the 1920s. However, working down those excesses took so long that new, lower patterns of economic activity set in. This led to his proposal of a public-deficit-financed reboot of the macroeconomy, a revolutionary idea at the time.
Fiscal pump-priming is almost routine now. Trouble is, post-GFC we engaged in a massive reboot, but arguably far too soon in the process. At the time, massive public spending was not lifting a beleaguered economy; it was desperately trying to keep a bubble inflated. Keynes was rolling in his grave, I’m sure. Sadly, this strategy prolonged the agony. But here’s the good news: despite the chaos and confusion, at a particular point in time – likely around mid-2012 – excesses were used up, and that hidden groundswell of demand started to form. It started to really show its face about two years before the pandemic. It was as plain as day immediately following the initial pandemic shutdowns, in the sharpest global V-shaped recovery history has likely ever seen. And according to regular rules-of-thumb, this pent-up demand is far from exhausted.
There’s more. A second potent source of pent-up pressure occurred – of all things – during the pandemic. How? Most people still had incomes, or income supplements. Yet there were many things we could not do during the pandemic: restaurant meals, concerts, sporting events, travel and so much more. It turns out we saved all that money, and put a lot of it into chequing accounts – meaning we intend on spending it. That money – here and in the U.S. economy – is quite significant as a share of GDP, and has already begun to make itself known. There’s actually enough there to boost spending for a good few years.
A third factor is the leverage position of the average American. By one key measure, gone are the days of the wildly profligate consumer of 2007. According to the OECD, American thrift from then until now has lowered the debt-to-disposable income ratio from over 150% to 100%, a remarkable achievement. This lowers the impact higher interest rates will have on personal cash flow considerably in the coming months. Even if the debt ratio just flattens out from here on, it will provide a nice – and needed – boost to the economy.
The list could go on, but one final factor for the moment is employment. Against the early predictions of many and the prolonged closure of certain industries, U.S. employment came roaring back, and fast. Despite a recent bout of layoff announcements, job growth continues to beat expectations. The unemployment rate is still hovering in record-low territory, and one of the top complaints of business leaders is a lack of available labour. Add to this somewhat higher wage settlements, and income growth looks to be in good shape.
Small wonder, then, that there are supply issues. The swift rebound in demand caught businesses unawares. Prolonged post-GFC under-investment ensured that existing capacity was used up quickly. Cutbacks to capacity to preserve mid-pandemic cash flows were rapidly regretted. Supply chain issues then compromised already-tight capacity, thinning out available inventories. This was largely due to asynchronous COVID infections at the country level. Suddenly, our well-orchestrated, global just-in-time logistics system had a serious problem.
Put significantly constrained supply together with resurgent demand and capacity to pay, and you get inflation. Not just transitory inflation, as initially promised; the first significant runup in global prices in 31 years. It wasn’t foreseen by most, but it was predictable. Now what? Some say that this is a demand issue – there’s simply too much of it, and it has to be brought under control. That would be relatively easy to do, but demand isn’t the problem; people aren’t that irrationally exuberant in the immediate wake of a crisis.
This is pretty clearly a supply-side issue. Would that there were a simple fix, but it just isn’t so. There’s a deficit of labour. Supply chains remain snarled. A lot of catch-up investment is needed, and that’s not easy to do quickly at the best of times – let alone in a hobbled-supply-chain world. Infrastructure, particularly transportation networks, is also a constraint. It’s hard to believe, but there’s actually a whole lot more growth than we can handle. So if we want stable prices, the only quick option is to use interest rates to cool demand.
In the case of the U.S. economy, monetary tightening shouldn’t be seen as tromping on the brake. The Fed is easing off the gas, which has been pedal-to-the-metal since the pandemic hit. Put in business terms, the Fed’s task is to accommodate growth without snuffing it out. Fundamentals suggest this is possible, although given the aggressive rate hikes of 2022, it’s a delicate dance. Doubtless, there will be an immediate negative reaction to sharply higher borrowing costs, but pent-up pressures should ensure a few rounds of upward revisions to U.S. economic forecasts for this year and next in the coming months.
Believe it or not, much of this underlying rationale is also true for Europe. Sadly, monetary policy has been slower to react, and is quite likely to be in aggressive catch-up mode this year. Adding the additional inflationary impacts of the war-related energy crisis puts growth on a lower track than underlying conditions would have served up. Even so, assuming some resolution to the Russia-Ukraine conflict, growth will rebound nicely in 2024.
Would that Canada were as resilient as America. For most of our history, we have run in lock-step with our southern neighbours. Thankfully, this will still remain true for Canada’s exporters. Not so for the domestic economy. Since the 1990s, this hefty part of our economy has pulled away from U.S. trends, charting our own course. While the U.S. economy is, in certain critical ways, quite balanced at present, Canada is dealing with a sizable domestic bubble of excessive activity. This is clearest in our housing markets, where the bursting bubble is most obvious in plunging sale prices of existing homes.
At this juncture, it’s a waiting game. Aggressive rate hikes have brought recent monthly consumer price growth in line with the Bank of Canada target rate. Core inflation in Canada is not far behind. Stateside, recent movements in the all-items Consumer Price Index (CPI) are well below the 2% target, which would be alarming were it not for core CPI, which in recent months is also falling, but still at the 3% level. From this data it seems that tightening to date is sufficient to cool prices; little further tightening is necessary.
What remains is the response of the economy. Technical recession for most, if not all, developed economies is almost unavoidable at this point. The depth and breadth of recessions will not be the same everywhere. This forecast calls for a short and shallow dip in U.S. output. In Canada, it will depend where you play. Exporters should have an experience that mirrors the U.S. growth path. Everyone else is in for a deeper drubbing.
We’ve actually seen this before – although the tables were turned. Back in 2008-09, the U.S. economy took the big hit. So did we, to the extent that demand south of the border pummeled Canadian exports. But our more balanced domestic economy saw a shorter and shallower impact, and important sectors were up and running far sooner than in the U.S. It’s a role reversal that’s likely to produce a torrent of dramatic headlines this year. It also creates a golden opportunity for exporters – and those who support them – to be the heroes of this turn of the economic cycle.
_________________________________________________________________________
Elevate Export Finance Corp. | 3001 – 1 Adelaide Street East, Toronto, Ontario, Canada M5C 2V9 | peter@elevatefinance.ca