Global economy: How far off recession?

Last month’s Purchasing Managers’ Index (PMI) business surveys were already consistent with the Chinese economy contracting, with social distancing measures and lockdowns restricting output.

The May flash PMIs in the past week suggest that recessions have moved at least a step closer in several major economies, with the UK and US composite PMIs seeing a notable deterioration. As of April, the global composite PMI business survey indicator had already fallen sufficiently to enter the ‘zone’ where global economic recession at least tends to become more widely discussed as a serious possibility.

It doesn’t require that much for an economy to be in ‘technical’ recession – just two consecutive quarters of even slightly negative Gross Domestic Product (GDP) growth would do it. What could that look like in practical terms? Consumer spending is a huge component of GDP in both the US and UK. Simplifying, but imagine that everyone bought 1% fewer ‘things’ (goods or services) in Q2 and did the same again in Q3 (perhaps in response to higher prices for things like food and energy). Keeping everything else steady (including, slightly unrealistically, imports), that would be more than enough to push either economy into technical recession.

The US economy already contracted in Q1 (through reflecting net trade rather than weak domestic demand). The UK economy hasn’t grown since January according to monthly GDP data to March (and contracted slightly in March). There are recessions and recessions though, and a more substantial downturn that included a significant rise in unemployment looks further away.

Focussing on the UK, in theory, the headline flash composite PMI reading of 51.8 in May is still consistent with tepid but positive activity growth and the employment PMI, alongside recent PAYE payroll data, suggests firms are still hiring at a relatively strong pace. However, the scale of deterioration in the UK PMI was striking in May and consumer confidence is also very weak. The more forward-looking bits of the PMI deteriorated too (e.g. business expectations) and there were some tentative indications from the output price indicator that companies are finding it harder/becoming more reluctant to pass on input costs to end consumers. My UK GDP forecasts have already assumed one quarter of negative growth this year.

Recession is not ‘inevitable’ yet in the UK, especially if we are talking about something more than a technical recession. Fiscal policy is an important variable on that front, as are energy bills and other commodity prices. Recent news has pointed in different directions here. On the fiscal policy front the UK government have just announced a further package of measures to alleviate the cost-of-living crisis, amounting to some £15bn (around 0.6% GDP) at headline level, though partly offset in overall stimulus terms by a windfall tax on oil and gas companies. The Institute of Fiscal Studies (IFS) calculate that a median earner will see roughly flat real take home income this (fiscal) year after the measures announced. However, 1) it is worth pointing out that this fiscal support makes further rate hikes more likely from the Bank of England – I already assume two more 25bp rate increases this year – but risks to that forecast are now firmly on the upside again and; 2) in the past week or so we have also heard from Ofgem’s Jonathon Brearley suggesting that another huge increase in energy bills (a 42% increase in the Ofgem price cap) now looks likely in October. So the announcement from the Chancellor needs to be seen in that context too. Plugging a 40% rise in October into my Consumer Price Index (CPI) forecasts would leave inflation not peaking until October at only a little below 10%Y (though the exact peak will partly depend on how the Office for National Statistics (ONS) decides to treat the energy bill rebate) and remaining above 8% year-on-year until next Spring, all of which still looks difficult for UK consumers to absorb, despite the additional help from the Chancellor.

As for the US, recent data has shown less resilience than I’d have expected and leaves me more worried about the prospect of a US recession within the next 12 months. Again, the May flash composite PMI fell sharply, in this case from 56.0 to 53.8, below expectations. Services providers indicated that increased selling prices were weighing on demand conditions, according to the press release. Some companies also reported challenges passing on further increase in input costs onto customers. Recent housing sector data has also been weak, presumably reflecting higher bond yields feeding through to higher mortgage interest rates. The US labour market still looks tight and Federal Reserve speakers continue to signal that they expect to hike rates a lot in a short space of time. Domash and Summers in their recent paper suggest that it is unrealistic to expect the Federal Reserve to be able to engineer a soft landing for the economy given the starting point of a very tight labour market. According to their research, in the case of the US at least, since 1955, there has never been a quarter with price inflation above 4% (currently 8.3% on the CPI measure) and unemployment below 5% (currently 3.6%) that was not followed by a recession within the next two years.

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