U.S. recession outlook as China reopens

U.S. recession outlook as China reopens

Amid hopes for a soft landing even as some leading indicators point toward recession, we assess the probabilities for the economic cycle in the next 12 months.

  • The slowing U.S. economy and the reopening Chinese economy are shaping the trajectory of growth and inflation.
  • We believe this economic expansion most likely will end in a recession, but in 2024, not 2023.
  • A soft landing, an earlier downturn, or even a reaccelerating inflation are possible but less likely.

Below, we outline possible scenarios for the year ahead and how global forces will contribute to them.

Strong labor market prolongs expansion: Our base case is a delayed recession

Job losses have always been key in determining recessions and will be especially important in this cycle. Initial jobless claims are the best and timeliest indicator of job losses: They start rising and gather momentum ahead of recessions. It is 10 months, on average, from the bottom in initial jobless claims to the recession start date. In this cycle, initial jobless claims bottomed in March 2022, but the pickup since then has been sluggish. Despite some high profile layoff announcements, small businesses continue to hire at a decent pace. Almost nine months after the bottom, initial jobless claims are still low, as corporate profitability has been holding up.

Today’s environment has similarities to the early 2000s in terms of high asset valuations and strong household balance sheets. It also has similarities to the late 1970s in terms of high inflation and lack of layoff momentum. In both cases, high interest rates eventually hit corporate margins and resulted in layoffs. The 2000 “dot-com recession” required a significant drop in profits to start the process of mass layoffs; profits peaked about two years before the recession. In the late 1970s, initial jobless claims bottomed about 1.5 years before the recession. These parallels to the current cycle put a recession start date in early 2024.

A mid-year recession at the earliest

In another scenario, it is possible that household consumption could lose steam early in 2023. Households might become more price sensitive even if their wages rise. In this case, profitability would quickly become a problem and result in layoffs. By the middle of the year, the U.S. could be in a recession. In this alternative scenario, typical recession dynamics would play out in markets with a large sell-off in risk assets and a rally in bonds.

Figure 1. Corporate profits are peaking in real (inflation-adjusted) terms

U.S. corporate profits (seasonally adjusted annual rate in billions of dollars)

Corporate profits are peaking in real terms

Sources: The National Bureau of Economic Research, Bureau of Economic Analysis, as of 9/30/22.

China’s rapid reopening could push up inflation

Although U.S. core inflation has been trending down, it is really only a commodity shock away from reaccelerating. The shock could come from China’s reopening, since the decline in commodity — especially oil — prices in late 2022 was largely because of China’s economic weakness. And China now seems to be accelerating its exit from its zero-Covid policies. Authorities eased restrictions across major cities on January 8, lifting quarantine requirements on infected people as well as inbound foreign travelers. A large share of the population is getting infected and will recover in a short period of time. Mobility will likely increase after the Chinese New Year (January 22).

Inflation’s effect on profits and rates

In an environment of rising inflation, corporate profitability could persist longer, but rates would rise. The federal funds rate could go up to 6%, and the 10-year Treasury yield could touch 5% this year. The 10-year U.S. Treasury yield can go higher due to global capital flows, too, even while the front end of the Treasury curve is anchored by the Federal Reserve. The global yield curve could move up, for example, if Japanese corporations bring capital back to Japan. Higher rates would later slow the economy — in this case, again, making a 2024 recession probable.

Soft landing possibility

The keys to a soft landing are goods prices and wage pressures. Should the price of goods come down, there is a chance that higher wage demands of workers might ease while some job losses occur. The unemployment rate can go up but stabilize without job losses broadening across sectors. A feature of the soft-landing scenario is that the Fed would cut rates as inflation drops. However, the data would be ambiguous, and only toward the end of the year would the Fed be convinced that inflation is returning to its 2% target sustainably. Policy easing would be unlikely in 2023.

Why China looks strong

Following China’s Central Economic Work Conference (CEWC) in December, senior Chinese officials declared a consensus on increased policy support for economic development and rapid recovery in 2023. The policymakers attending the CEWC meeting talked about an accelerated recovery in the first half of the year through a combination of fiscal, monetary, and industrial policies. The People’s Bank of China (PBoC) Deputy Governor Liu Guoqiang said that fiscal stimulus will be at least equal to 2022’s stimulus and will be targeted to focus on weak sectors. Some consumption-boosting measures can be announced; local governments have already ramped up issuance of consumption vouchers.

Stabilization in the property sector is likely to add to momentum in China. There are already early signs of that. New home price depreciation in China seems to be slowing while new home sales in top cities are bottoming out. If the measures announced in the last few months can raise household confidence, which seems to be the policymakers’ objective, housing activity might indeed bottom in the first half of 2023. Meanwhile, the easing measures announced in October and November seems to have had a positive impact on corporate credit demand. Long-term corporate loans have been gaining steam, as continuing infrastructure projects along with the recent fiscal easing likely increased credit growth to corporates and to local governments.

Figure 2. China real estate may be poised for recovery as home price depreciation slows

China real estate indicators, year-over-year percentage change

China real estate may be poised for recovery

Sources: National Bureau of Statistics of China, Bloomberg, as of 12/31/22.

Data to watch

Economic data in the next few months is likely to be confusing and give credence to different outcomes. Only in the near-term recession scenario is it likely that consumer spending and corporate profitability would rapidly fall and job losses quickly rise. It is more probable that the Fed and the market can remain convinced of the soft-landing scenario for a period. In the background, data showing a strong China recovery, persistent inflation, and waning U.S. corporate profits would be consistent with a 2024 recession.

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