In recent years, the effects of climate change have increased in intensity and frequency: repeated droughts, storms, heat waves and floods are just a few of the consequences we are suffering. Just as global warming has seriously complicated weather predictability, the COVID-19 pandemic has led to unprecedented economic events and a more uncertain environment.
In 2020, the global economy came to a standstill, calling for uncharted central bank and fiscal stimuli. The recovery was just as exceptional, starting with a boom in goods consumption followed by a sharp recovery in the services sector as economies reopened and consumers were allowed out. The first phase caused supply chain disruptions, the second tight labour markets, and inflation soared to levels not seen in decades and was further aggravated by the war in Ukraine and an energy crisis. Consequently, central banks eventually hiked official rates — by 525 bp in the US in less than a year and a half. Surprisingly, the US economy has remained remarkably resilient, evidence of US exceptionalism which has been further propelled by the takeoff in artificial intelligence as AI superstars are almost all American.
Last year, the vast majority of economic experts were convinced that the sharp increase in interest rates would lead to an economic recession in the US. Since then, their view has radically shifted. In line with the strong data, they are now convinced central banks will manage a soft landing, or rather a no-landing along with immaculate disinflation. As the Canadian educator and author, Lauren J. Peter, astutely stated, “an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today”. Forecasting is a futile exercise, and it is often more useful to question pundits’ opinions and to look at what could go wrong.
A few signals are already pointing to a slowdown. The Citigroup Economic Surprise Index has been trending down all year, reversing the upward trend we saw throughout last year. More importantly, consumer data is softening after having led the recovery and growing way above trend. Retail sales year to date look weak. Although still at very low levels, the unemployment rate has been ticking up for the past year and credit delinquencies are on the rise. With respect to government spending, US debt appears to be on an unsustainable path and the next president will be obliged to rein in fiscal spending. Finally, although Artificial Intelligence has boosted investment spending and US growth, it has not yet led to an increase in productivity, which would be necessary to set economic growth on a solid structural upward trend.
As for inflation, looking at historical data, after periods of high inflation, it is always the last mile down that is the most difficult to accomplish. The easy part of the work has been done as supply chain disruptions have been resolved and energy prices have fallen. However, wages continue to pose a problem and structural trends, such as the energy transition and increasing tariffs, are putting upward pressure on prices. Even if there was a slowdown in economic growth, inflation would be sticky. And that’s the problem. Consensus is discounting that inflation will resume its downward trend, allowing the Fed to cut rates rapidly even though this forecast has been pushed out on numerous occasions in the past. Higher for longer rates will also put pressure on the consumer and the economy in general.
As Mark Twain said, “whenever you find yourself on the side of the majority, it is time to pause and reflect”. The consensus’ call for disinflation, no landing and the Fed cutting interest rates beholds quite a few incongruencies. Bear in mind that personal consumption expenditures represent close to 70% of GDP and if the consumer slowdown is confirmed, the consensus outlook could change rather radically.