By Seth Carpenter, chief global economist at Morgan Stanley
The clouds of recession are gathering globally. The Chinese economy contracted in 2Q. The US notched a “technical recession.” The flow of natural gas to Western Europe is restricted. In the past three months, we have revised down our forecast for global growth to 2.5%Y in 2022, which is about 50bp below consensus and 40bp lower than in May. We are edging closer to the bear scenario from our May Mid-year Outlook. Is a global recession upon us?
Recession is our baseline view for the euro area. The flow of natural gas from Russia has been restricted, prices have surged, and we see weak growth through the end of the year. We expect a recession by 4Q, but the data will be noisy. While 2Q GDP surprised to the upside because of the timing of the European post-Covid rebound, PMIs were already negative for July. A complete gas cut-off is the worst-case scenario and remains possible, but normalization of gas flows would bring only modest relief. Winter price levels are already partially baked in. And with the ECB almost single-mindedly focused on inflation, more hikes are likely until there are hard data that show economic contraction or normalized inflation. Inflation and rate headwinds are not dissipating any time soon.
I am only slightly more optimistic about growth in the US. The negative GDP prints in the first two quarters clearly cast a pall, but those readings are misleading. To be sure, the weakness in residential and business investment will not be reversing course with monetary policy continuing to tighten. But consumption spending was slammed by surging food and energy prices, a pullback from a year of goods overconsumption, and the rollover of the housing market. Nevertheless, household spending – the key driver of the economy averaged 1.4% at an annual rate in the first half. Indeed, the bright side of the negative 2Q print was the whopping 2 percentage point drag from inventories, correcting an overbuild. The inventory drag is now in the rearview mirror, and the July jobs report printed a massive 528k jobs. That pace of job creation almost certainly cannot last, however, and the Fed’s drag on the economy – and therefore jobs – is both substantial and intentional. But since the 1970s the US has never had a recession within a year of printing so many jobs. So what is the plan? As Chair Powell noted at the July press conference (and as we have repeatedly argued), the Fed’s strategy is to slow the economy enough that inflation pressures abate, but then to pivot. To be “nimble,” as Powell has said. A soft landing is by no means assured – again, we are only slightly more optimistic on the US than we are on Europe – but with the help of some good luck, the Fed’s plan has a chance.
China’s situation is completely different. The economy contracted in 2Q amid stringent Covid controls, but real-time data show that we have now bottomed. The question is no longer whether we get a rebound, but how much of one. Covid-zero policies are slowly easing and we think more relaxation will follow the Party Congress in October. But will freedom of mobility be enough to reverse the challenges of the housing market? Recent policy action to address the housing crisis will help, but I fully expect that a much larger package will be needed. Ultimately consumer and property confidence will need to make a rapid recovery if the rebound can take shape.
The world has been simultaneously hit by supply, commodity, and dollar shocks. Central banks are pulling back on demand to contain inflation. But even as we start to glimpse the other side of the inflation peak, the full effects of rate hikes are not yet manifest in the economy. Even if we avoid a global recession, it is hard to see economic activity getting back to its pre-Covid trend. I hope it is sunny where you are…you can worry about this storm tomorrow.