As at 26 July 2023
Author: Gavyn Davies, Executive Chairman
- Flash PMI releases for the advanced economies in July indicate that service sectors are now generally slowing down, but there are encouraging signs that US manufacturing may be stabilising after months of weakness.
- Overall, the Advanced Economy (AE) PMIs remain consistent with slowing growth, but there are few signs of global recession up to now. However, the US is far more robust than the EU, where recession now looks to be a possibility, though we think it can probably be avoided.
- Core inflation now seems to be clearly headed downwards in the AEs and the recent monthly run rates are close to the central banks’ 2% targets (with the UK remaining an exception).
- With the Fed and European Central Bank (ECB) close to peak policy rates, the markets have continued to interpret these data releases as indicative that a soft landing is now the most likely path for the global economy in the next few months. This interpretation still seems justified.
- This note is written ahead of the major central bank meetings due on July 26-28. Although neither the Fed nor the ECB will declare that rates have peaked they are expected to emphasise data dependency in coming meetings. While they will stop short of unequivocally hawkish guidance about further rate hikes in the balance of 2023, following likely 25 bps policy rate increases this week, they may also emphasise that rate cuts early next year are far from certain.
- The main risk of a hawkish shock is that the Bank of Japan (BoJ) may alter its Yield Curve Control (YCC) programme and monetary policy mix at this week’s meeting. This is clearly a very live issue, though markets currently do not appear to be expecting concrete action until October or later.
July PMIs Raise Concerns
- In recent days, we have seen the publication of “flash” PMIs for July in the major economies. Although these releases are based on incomplete information from business surveys, they nevertheless provide the earliest information on the development of global activity in the current calendar month and are therefore widely followed in the financial markets. They also contain important incoming information for Fulcrum’s nowcast models, which often react significantly to their appearance.
- This month, the PMIs for the advanced economies have shown clear signs of slowdown in the service sectors, which have been the main expansionary force in the global economy this year. While this is concerning, there have been offsetting signs of a rebound in manufacturing, notably in the US, and composite PMIs do not appear consistent with recessionary conditions. Having said that, there are clear differences among the major geographical regions, notably between the very weak data from the EU and the firm data from the US.
- The EU is undoubtedly the main problem area. The EU composite PMI has fallen sharply since the spring, reaching 48.9 in July, about 5 points below the level reported in April, and now in mild recession territory. By far the weakest sector in the PMI and other similar surveys has been manufacturing, where the PMI has now dropped to 42.7, a level normally considered to indicate a deep recession in the goods sector. Most of the major EU economies (apart from Spain) have slowed sharply, but Germany has been the clear outlier on the weak side. The German manufacturing PMI has nose-dived to 38.7 in July, and this collapse is now dragging the services sector into recession.¹
- Some economists have argued that business surveys have become less reliable indicators in the EU during and after the pandemic and it is certainly true that surveys have been weaker than hard economic data in recent months, including in Germany. The Fulcrum nowcast uses inputs from both hard and survey data, and it confirms that EU activity is clearly headed downwards. The model estimates underlying activity growth is now -0.4%, which is 1.6% below the trend growth rate (see Figure 1). Once again, Germany stands out as the weakest economy, with activity growth now at -2.2%, or 3.2% below trend (see Figure 2).
- The latest nowcast results for EU activity are clearly below consensus forecasts for GDP growth in 2023Q3, and even further below the official ECB forecast which now looks entirely unrealistic. It seems very likely that this will be recognised in the ECB’s press conference on Thursday, but it may not be sufficient to trigger a significant change in longer term forecasts for GDP, which continue to suggest that a meaningful EU recession will be avoided, with the economy returning to trend growth in 2024.
- The immediate direction and outlook for the EU economy currently looks grim but there are several reasons for believing that any recession in the remainder of this year is likely to be mild:
- The EU’s major trading partners (China and the US) do not seem to be nearing a recession and EU export growth may accelerate if the recent announcement of extra policy support in China is confirmed.
- The EU’s overhang of excess private savings is still large and untapped, relative to that in the US, and European household balance sheets appear healthy.
- The slowdown in activity growth has not yet any significant impact on employment and real wages are set to accelerate markedly as lower gas prices bring down headline inflation. The labour market remains far too robust to be consistent with a deep recession.
- The decline in manufacturing has been caused in part by large declines in inventories, following excess stock building at the end of the pandemic. This negative force is likely to abate before the end of 2023, as it seems now to be doing in the US.
- Fiscal policy is approximately neutral this year but is likely to tighten by about 1% of GDP in 2024 as consolidation measures are implemented. However, the impact of monetary policy tightening on the economy may not be as large in 2024 as in 2023, so overall macro policy may be only modestly contractionary.
- It will be interesting to see whether President Lagarde places much emphasis on recent weak activity data in this week’s press conference. The overall message is likely to be that the economy faces some near-term downside risks but that a significant recession is not the base case. Furthermore, she is likely to reiterate her view that core inflation is not falling rapidly enough, especially in the services sector. This would leave a further rate hike in September to be entirely “data determined”. A final hike is already expected by the market, but Lagarde is also likely to emphasis that the rate cuts priced by the market early next year are not expected by the ECB.
- The US economy is also seeing a progressive slowdown in the services sector, but the July PMIs showed a welcome (and belated) rebound in the manufacturing sector, with indications that the inventory cycle may finally have bottomed out. The Fulcrum US nowcast (see Figure 3) has dipped slightly from last month’s readings, but underlying activity growth remains close to the 2-2.5% trend rate which is not consistent with near term recession risk in the economy. As a result, consensus forecasts about impending recession risks have also been dropping rapidly in the past few weeks, and now stand at 54%, the lowest reading seen this year.
Source: Fulcrum Asset Management, Goldman Sachs, and JP Morgan
Source: Fulcrum Asset Management
Source: Fulcrum Asset Management