A recession postponed, but the good times cannot last
Interest rates have peaked and inflation is easing, but debt service costs continue to rise. Governments will have to tighten their belts, and it’s sure to cause pain
Over the past three years, despite a global pandemic, resurgent inflation and a series of brutal wars, the most remarkable thing about the global economy has been its resilience.
One year ago, in this column, I was in line with consensus by predicting a protracted slowdown or even global recession by the final quarter of 2023. I could not have been more wrong.
The US economy enjoyed yet another stellar third quarter, roaring along at an annualised pace of 4.9%. As the post-pandemic supply chain bottlenecks open up and the Ukraine energy crisis dissipates, inflation is easing at last.
Unemployment, at least in the US and Europe, has almost never been this low. Central banks have ended their relentless tightening and are contemplating easing, with the first rate cuts expected (potentially even in South Africa) in the second quarter of 2024. And even China, as beset as it is with economic woes, will hopefully benefit from an upcoming stimulus package.
To paraphrase Harold Macmillan, we have “never had it so good”. Yet, peering into 2024, it becomes clear that the foundations of this growth are less solid than one might have hoped for.
Rates will stay higher for longer
Once again the critical variable for 2024 will be interest rates. After central banks around the world tightened aggressively to quash inflation from early 2022 until mid-2023, the discussion has turned to when they will start easing.
Economic resilience has increased the likelihood that rates will be kept higher for longer than previously expected. In the parlance, the interest rate profile may look less like Mount Everest – aggressive hikes up and then equally aggressive cuts down in line with fading inflation – and more like Table Mountain.
With risks of a disastrous resurgence of inflation outweighing any perceived chance of a recession, central banks are likely to err on the side of caution. The worst mistake, in this analysis, would be to ease too early.
Bond yields have reacted accordingly. Despite recent softening, the US government must still pay an extra 1% to borrow for 30 years compared with a year ago, with yields now at almost 4.3%. The 10-year benchmark US treasury is roughly the same. In the depths of the pandemic, this was as low as 1.2%.
South Africa is having to pay up about 1% too, with 10-year borrowing costs being almost 12%. Even economies that seemed stuck with negative interest rates have seen their bond yields spike: Germany is paying over 2% and Japan almost 1%.
As the global economy has remained relatively resilient through 2023, if only because of the voracious US consumer, these higher interest rates have been seen as a good thing – a “normalisation” after the strange distortions of quantitative easing during the ultralow years.
So goes the consensus argument. If last year the overwhelming view among economists was that high rates will lead to a recession in 2023, that mood has shifted, given the unpredictably resilient performance of the economy. Now the consensus is one of a “soft landing”; high rates have done enough to quash inflation, but they have not produced rampant unemployment and a collapse in aggregate demand.
The consumer, flush with post-pandemic savings, has ensured that the economy has remained buoyant amid spiralling borrowing costs. As soon as stress starts to be felt in the broader economy, particularly in the jobs market, so the theory goes, central banks can simply start easing monetary conditions and cut interest rates.
Why the consensus may be incorrect
This capitulation of bearish sentiment may well be missing a few critical factors. To see why the “Goldilocks” conditions of today cannot continue, it is worth considering in more detail the savings leftover from the pandemic.
US consumers have been spending the cash accumulated from handout
cheques and staying at home. It is true that we expected those savings already to have run out, but they have persisted. Recent data from the Financial Times suggest households in the US still have $1-trillion left, which explains why they can get away with saving less out of their incomes than at any point since 2010.
But at some point in 2024 they will run out. Then, higher interest rates on credit cards and home loans will start to bite and the consumer will have to rein in spending.
In anticipation of this pain
for the consumer, in Europe and the US bankruptcies are already rising; even companies that locked in ultra-low borrowing costs during the recession will have to refinance eventually. House prices will have to fall as a result of more expensive financing costs.
Banks that have managed to plug shortterm gaps in their capital structure after the losses incurred in their government bond portfolios will, finally, have to resort to raising more expensive long-term capital. The costs of this will once again accrue to the ultimate borrower, the consumer, in the form of higher interest rates.
As we have seen with the tightening cycle, monetary policy acts with a lag. Given some of the distortionary factors of the post-covid economy, it seems these lags have got longer.
Similarly, by the time economic stress starts to be seen in the employment data, it may well be too late for rate cuts to make a difference. And recent data out of the US jobs market which show that job openings are at a two-year already happening.
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Effects on the public sector
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If these are the effects of higher rates on the private sector, the effects on the public sector are likely to be even more profound. Fiscal policy since the pandemic has been illogically generous.
According to the International Monetary Fund, Britain, France, Italy and Japan are all likely to run deficits in the region of 5% of GDP in 2023. In the 12 months to September, the US’S deficit was a staggering $2-trillion, or 7.5% of GDP after adjusting for accounting distortions – about double what was expected in mid-2022.
At a time of record low unemployment, such borrowing is mind-blowingly irresponsible. According to The Economist, government debt in the rich world is now higher, as a share of GDP, than at any time since after the Napoleonic Wars.
When interest rates were low, even towering debts were manageable. Now that rates have risen, interest bills are draining budgets. There are already signs that sharply higher interest rate expenses are bleeding state coffers.
The EU is in the midst of a debate to increase its budget, with member states having to pay in once again, after (among other things) the borrowing costs of its bonds have simply been much higher than forecast.
Italy’s government blames the European Central Bank for hiking rates and increasing its borrowing costs to the detriment of nurses’ and teachers’ salaries. But shooting the messenger does not balance the budget.
In South Africa, debt service costs as a percentage of budget revenue have doubled to almost 20% from 10% in 2016. These are funds that will either have to be borrowed or diverted from spending on the economy.
In Japan, when government bond yields were a paltry 0.8% last year, 8% of its budget went on interest payments. Imagine the strain if yields reached even Germany’s relatively modest levels. Even in the US, the Republican Party is finally starting to acknowledge the importance of getting on top of runaway federal spending.
Tightening the belt to afford these costs will bring economic and social pain.
The paradox of the global economy
Such a paradox makes it hard to see how the global economy can possibly accomplish the three things that economists now seem to expect of it: evade recession, get back to low inflation and manage enormous debts under high interest rates.
It is more likely that the higher-for-longer era resolves itself through economic weakness, quite possibly a recession, which lowers bond yields organically without inflation rebounding.
For this reason, this columnist has not changed his tune like so many other forecasters have, from recession in 2023 to an idyllic soft landing in 2024. Instead, confronted with a global economy beset with contradictions, I am doubling down.