Weekly global economic update

Week of March 6, 2023

• Is the global economy starting to recover?
• Eurozone inflation persists while unemployment remains low
• US productivity moves in a positive direction
• US investors revise inflation expectations based on recent data

Is the global economy starting to recover?

• At a moment when many observers expected a global downturn to begin, or already be under way, it appears that the global economy is modestly rebounding. The latest purchasing managers’ indices (PMIs) from IHS Markit suggest as much. PMIs are forward-looking indicators meant to signal the direction of activity in the broad manufacturing and services sectors of an economy. They are based on subindices such as output, new orders, export orders, employment, pricing, and sentiment. A reading above 50 indicates growing activity. And the higher number, the faster the growth.

Markit conducts surveys of purchasing managers in over 40 countries, gathering data that helps to paint a picture of the direction of the global economy. The latest data reflects input from 14 major countries. The global composite output PMI, which reflects both manufacturing and services, increased from 49.7 in January to 52.1 in February, a sharp turnaround and the first reading above 50 in seven months. The rebound, according to Markit, was led by the services sector and reinforced by growth in manufacturing. 

The global services PMI increased from 50.0 in January to 52.6 in February. Markit commented that the data “provides a convincing signal that the global expansion is gathering steam early in the year.” It also noted that strong performance “is filtering through to the labor market and business confidence. With reduced recession risks, improving supply chains, and the reopening of the Chinese economy likely to boost demand in the immediate future, further gains in output are expected in the coming months.”

Meanwhile, of the 14 countries surveyed, 12 registered expansions of economic activity in February. The principal data released this week involved the services PMIs for multiple countries. Services represents the lion’s share of economic activity and includes such industries as finance, telecoms, distribution, transportation, professional services, health care, and education. Services was substantially suppressed during the pandemic, but it is now recovering nicely and contributing to economic growth in many countries. Let’s take a look at some of them.

India was the star performer in February. The services PMI increased from 57.2 in January to 59.4 in February, a level reflecting very strong growth in activity and the highest in 12 years. Survey respondents reported strong growth of output and new orders. India has been successful in avoiding the headwinds facing other countries. This is because trade is a smaller share of GDP than in other countries and because India has had access to cheap Russian oil. Still, monetary policy is being tightened to fight inflation. Yet the economy has shown resilience.

In China, the services PMI increased from 52.9 in January to 55.0 in February, indicating rapid growth of services activity. The sharp increase reflects the reopening of the economy and the winding down of the latest outbreak of COVID-19. New orders increased more rapidly than at any time since April 2021. Job creation in the services sector was the fastest since November 2020. Notably, external demand for Chinese services surged, rising at the fastest pace since April 2019. This likely reflects increased travel to China. There remains a debate about how fast China will recover in 2023, with some observers predicting such rapid growth that global oil prices will likely rebound sharply, thereby leading to rising inflation and further tightening of monetary policy. Others, however, see significant headwinds for China that will keep growth at a more modest pace.

Japan’s services PMI also increased sharply in February. It went from 52.3 in January to 54.0 in February, a level indicating strong growth of activity and the highest since June 2022. Both domestic and external demand increased rapidly. The strong foreign demand likely reflects the revival of Japan’s tourism industry, which is especially awaiting a big influx of Chinese visitors. Employment in the services sector increased commensurately. Markit expects a strong overall economic environment for Japan, believing that the strength of services will more than offset a decline in manufacturing, which is due to weak external demand for Japan’s manufactured exports. 

In the United States, the services PMI rebounded sharply in February, but remained at a level indicating only modest growth. The PMI increased from 46.8 in January to 50.6 in February. This was the first time in eight months that the PMI was above 50. Markit commented that the growth of services more than offset a decline in manufacturing output, thereby setting the stage for likely positive GDP growth in the first quarter. Of course, there are other data indicating strength, including the stellar January reports on employment, retail sales, and consumer spending. Markit noted that the economic picture has brightened since a low in October. This, too, is also reflected in other data indicating an improvement in financial market conditions and a decline in risk spreads since October. Thus, the US economy appears to be on the edge. Either it continues to revive, or the Federal Reserve tightens further in response to positive economic news and, thereby, pushes the economy into recession. 

The services PMI for the Eurozone increased from 50.8 in January to 52.7 in February. There was especially strong growth of activity in Italy (52.2) and Spain (55.7) and slower growth in France (51.7) and Germany (50.7). For the Eurozone overall, new orders increased for the first time since May 2022 while output continued to rise. Export orders, however, declined. Business confidence rose sharply but remained lower than just prior to the war in Ukraine. While Markit commented that the favorable data reduces the immediate risk of recession, it said that “some of the February uplift appears to have been driven by temporary drivers, such as unseasonably warm weather and a marked improvement in supplier delivery times—likely linked in part to China’s recent reopening.” Finally, it said that “confidence has picked up from the lows seen late last year, buoyed by fewer energy market concerns, as well as signs that inflation has peaked while recession risks have eased.”

Finally, the services sector of the troubled British economy made a stunning comeback in February. The PMI increased from 48.7 in January to 53.5 in February. This was the best performance since May 2022. New orders were up and employment in the sector grew modestly. However, Markit said that “shortages of suitably skilled candidates to fill vacancies contributed to a renewed increase in backlogs of work across the service economy.” Since Brexit, this has been a persistent issue. Wage increases were substantial, contributing to rising input costs. Markit said that this report means a reduced risk of recession. Still, “elevated borrowing costs and stretched household finances remained constraints on growth.”

The significant rebound in service sector activity in India, China, Japan, the United States, Eurozone, and the United Kingdom paints a picture of a global economy on the mend. Whether this continues is difficult to predict and will, in part, be determined by the behavior of major central banks.

Eurozone inflation persists while unemployment remains low

• The Eurozone has an inflation problem. Although headline inflation has receded, this is mainly due to declining energy prices. Core inflation (which excludes the impact of volatile food and energy prices) continues to accelerate. This suggests that underlying inflation has not yet turned the corner and that the European Central Bank (ECB) will have to tighten monetary policy further. 

Here are the numbers: The European Union reports that, in February, consumer prices in the 20-member Eurozone were up 8.5% from a year earlier, down from 8.6% in January and higher than investors had expected. Prices were up 0.8% from the previous month. Headline inflation had peaked at 10.6% in October. The decline in headline inflation had largely to do with energy prices, which were up only 13.7% in February versus a year earlier, down from an increase of 41.5% in October. Moreover, energy prices were down 1.1% from the previous month. 

When volatile food and energy prices are excluded, core prices were up 5.6% in February from a year earlier. This is up from 5.3% in January. It is a record high since the euro was created. Core prices were up 0.8% from the previous month. Core prices have shown no sign of decelerating. 

By country, inflation varied. From a year earlier, prices were up 9.3% in Germany, 7.2% in France, 9.9% in Italy, 6.1% in Spain, 8.9% in the Netherlands, and 5.5% in Belgium. The highest inflation in the Eurozone was in Croatia (11.7%) and Austria (11%). The lowest was in Luxembourg (4.8%) and Belgium (5.5%). In six of the 20 Eurozone countries, inflation accelerated from January to February.

From the perspective of the ECB, this report is potentially troubling. While declining energy prices have brought headline inflation down, core inflation continues to accelerate, despite significant tightening of monetary policy. One problem is that labor markets have remained tight with rising wages. In addition, many governments within the Eurozone are providing subsidies to consumers and businesses to offset the impact of elevated energy prices. This is effectively a fiscal stimulus that boosts spending from what would otherwise be the case. We already know that the ECB intends to boost interest rates further. Yet recent news on economic resilience and persistent inflation may compel the ECB to tighten more and for longer than previously expected. 

• One of the factors that likely concerns the ECB is the tightness of Europe’s labor market. Unemployment has been historically low while the job-vacancy rate is relatively high. The European Union reports that, in January, the unemployment rate in the 20-member Eurozone remained steady at 6.7% for the third consecutive month. In fact, in nine of the past 10 months the rate was 6.7%. In October, it dropped to 6.6%, a record low. Evidently, unemployment has bottomed and stabilized. The question going forward is whether further tightening of monetary policy by the ECB will loosen the tight labor market and lead to a rise in unemployment. There is a consensus among economists that a rise in unemployment will be needed to bring inflation down to the target level. Tightness in the labor market will likely mean persistent increases in wages that will sustain high inflation.

By country, the unemployment rate in February was 3% in Germany, 7.1% in France, 7.9% in Italy, 13% in Spain, 3.6% in the Netherlands, and 5.8% in Belgium. 

US productivity moves in a positive direction

• An important contributor to economic growth is increasing productivity, which is output per hour worked. And productivity influences unit labor costs, which, in turn, influences inflation. The latest report from the US government indicates that, in the fourth quarter of 2022, productivity grew for the second consecutive quarter. Plus, unit labor costs grew at the slowest pace since the first quarter of 2021. This data points offer positive news regarding economic growth and regarding reducing inflation.

First, why is productivity important? The reason is that economic growth happens either because more workers are employed and/or because each worker produces more (increased productivity). The latter happens when businesses add capital to workers, create advancements in technology (innovation), or when workers become more skilled. Given that the US labor force is only growing at a very modest pace and that the United States is at full employment, further economic growth requires more productivity growth. From the third to the fourth quarter, output rose 3.1% while hours worked increased 1.4%. The result was a 1.7% increase in productivity. 

Meanwhile, an index of unit labor costs (ULC) measures the labor cost of producing each unit of output. It is determined by dividing labor compensation by productivity. If wage increases are offset by a similar increase in productivity, then ULC remains unchanged. This means a lack of inflationary pressure. That is, if productivity growth offsets wage gains, then the labor cost of producing an additional unit of output has remained unchanged, implying no need for businesses to raise prices. In the fourth quarter, hourly compensation was up 4.9% from the previous quarter while productivity was up 1.7%. The result was that ULC was up 3.2%. This was down from an increase of 6.9% in the previous quarter. From a year earlier, ULC was up 6.3% in the fourth quarter, roughly in line with the annual rate of inflation. Suppressing inflation will require that productivity rise and/or that wage increases be modest.

US investors revise inflation expectations based on recent data

• In the United States, recent favorable economic data, combined with evidence that the decline in inflation is slowing, has led many investors to reevaluate their future expectations of inflation. Although bond investors still expect inflation to return to a favorable level, they evidently expect the process to take a bit longer than previously anticipated. The breakeven rate (a measure of bond investor expectations of inflation, calculated by subtracting the yield on inflation-protected bonds from normal bond yields) for the five-year bond increased from 2.09% on January 18 to 2.71% on March 3. This means that investors now expect inflation to average 2.71% over the next five years. Given that the inflation rate was 6.4% in January, this still means many investors anticipate a quick decline in inflation—just not as quick as previously. 

The increase of 62 basis points (bps) in the breakeven rate was the biggest contributor to a 74-bps rise in the yield on the five-year bond. Meanwhile, equity prices are up slightly since mid-January, but are down from a peak reached in early February.

The big question now is what the Federal Reserve is going to do. Favorable economic data led to expectations of more persistent inflation. This implies that the Fed will have to tighten further and for longer than previously expected, thereby boosting the likelihood of a recession. On the other hand, we know from history that monetary policy acts with a lag of varying length. It could be the case that the Fed has gone far enough and should pause now and wait to see what happens. Some recessions in the past came about because the Fed overshot. The Fed has signaled that it will tighten more, but it remains unclear how much.