Mon, Jun 26, 2023

2023: Surprising Economic Resilience

The global economic outlook has improved significantly since the beginning of the year, for completely different reasons in different regions. The labor market remains particularly strong in the U.S. despite aggressive rate hikes; a mild winter mitigated the impact of the energy shock on Europe; and China managed its sudden abandonment of Zero COVID successfully.

Our last outlook in December 2022 forecasted a recession in the U.S. by the middle of this year. We still expect a recession, but not until the end of the year or the beginning of 2024. The U.S. economy has held up shockingly well in the face of over 500 basis points of rate hikes in just over a year. Part of this is policy driven: the Inflation Reduction Act (IRA), Bipartisan Infrastructure Law and CHIPS and Science Act have fuelled significant manufacturing construction spending after years of underinvestment. Consumption, which accounts for just over two-thirds of U.S. GDP growth, has remained robust thanks to a significant cash cushion among U.S. households and the strength of the labor market. The labor market has remained robust in part owing to labor hoarding—firms are reticent to lay off workers given how difficult recruitment has been since the pandemic. We do not have a good way to measure labor hoarding, therefore there is no easy way to identify inflection points. As corporate profits dwindle in a tighter rate environment, firms might capitulate and let workers go. A sudden deterioration in the labor market is likely to impact consumption even more than the state of household bank accounts, and we expect this will be the trigger for the recession.

There had been concerns that financial instability in March would cause a downturn, but they seem to have mostly blown over so far. Consumer and business confidence have held up well since the banking wobbles. The Federal Reserve’s Senior Loan Officer Opinion Survey (SLOOS) shows that lending standards have tightened since March, but they have been tightening since last year. On the margin, financial instability will weigh mildly on loan extension in the U.S.—but we do not expect a significant credit crunch.

The U.S. labor market has remained very tight, but there are signs it is slowly easing. Wage growth is decelerating and job openings and the quits rate are slowly falling. This suggests the Fed does not need to worry about a wage/price spiral. Nevertheless, inflation has remained stubbornly above the Fed’s target of an average of 2% and the path for the stickiest part of inflation—core services inflation ex-shelter—has been bumpy. The Fed held rates at 5.25% at its meeting in June, but a majority of Federal Open Market Committee (FOMC) officials expect the Fed will hike rates twice more this year. The Fed will base its rate path on the data, but we believe the Fed’s work in leaning against inflation is not done. It will likely hike rates by another 50 basis points in the second half of the year before keeping rates steady through the end of 2023. We expect gradual rate cuts in early 2024 as it becomes clear the U.S. is in recession.

The eurozone is technically already in recession, with quarter-on-quarter output just barely contracting in the past two quarters. The downturn is led by Germany, which is also in recession off the back of falling consumption. Given strong consumer confidence data in Germany, we expect consumption and growth to rebound. The recession in the eurozone is much milder than expected six months ago thanks largely to the energy picture. Energy was expensive but still in good supply, thanks partly to a mild winter and partly to policies implemented in some eurozone countries to curb energy demand. EU energy storage levels are much higher than they have been off the back of previous winters and oil and gas prices have come way down from the highs over the past year.

The European Central Bank (ECB) was relatively late to begin hiking interest rates and shrinking its balance sheet and so rates in the eurozone remain lower than in the U.S. and the UK. The eurozone has probably only just hit peak core inflation in the second quarter of this year, whereas the U.S. saw core inflation begin to decelerate already late last year. At its most recent rate setting meeting, the ECB decided to hike rates by 25 basis points and signalled at least one more rate hike is likely. A tight labor market has kept upward pressure on inflation, but in the second half of last year corporate pricing power was also a significant component of inflation. It is difficult for a central bank to address firms rebuilding their margins after a tough 2022; ultimately consumers may have to be the disciplining factor.

Chinese growth rebounded robustly at the beginning of 2023 after the government suddenly scrapped its Zero COVID policy at the end of 2022. Following lackluster growth of only around 3% last year, we expect Chinese growth to accelerate to just over 5.5% growth this year—well above the government’s target of 5%. This recovery will look different from previous Chinese booms in that it will be consumption rather than investment led. The government has stepped in to support the real estate sector without reflating it, and property prices and property sales have rebounded this year. Consumer confidence has recovered significantly since the end of 2022 as well. Industrial production and fixed asset investment have lagged in recent months, causing some to worry that the Chinese recovery is losing steam. However, we never expected the recovery to be investment or goods led. Furthermore, consumer price inflation remains muted in China, so there is significant room for additional stimulus. The People’s Bank of China (PBoC) has already loosened monetary policy, and we expect it to continue to do so over the next few months to support the recovery.

Because this Chinese recovery will be driven by demand for domestic services rather than capital goods from abroad, the spill overs should be muted relative to previous booms. This means that demand from China is unlikely to drag the rest of the global economy out of the doldrums this year. On the bright side, it also means that the impact of Chinese demand on inflation in the developed world is likely to be relatively muted, though commodity prices will face upward pressure.

A key risk to the economic outlook is further financial instability impacting either the banking or the non-banking sector. As major central banks are tightening monetary policy and shrinking their balance sheets, liquidity is waning and we are likely to hit additional pockets of market dislocation. A second risk is that labor hoarding stops abruptly. This is a bigger phenomenon in the U.S. than elsewhere because of the structure of the U.S. labor market (employers laid off workers during the pandemic, whereas in Europe there was more of an effort to maintain a connection between workers and employers through furlough and short time working schemes). A sharp deterioration in the labor market would cause consumer confidence and consumption to suffer significantly. A third risk is that a significant escalation in geoeconomic fragmentation could drag on trade, foreign direct investment and capital flows. This would reduce potential growth and push inflation up. While there has been fragmentation across a few industries deemed to be of national strategic importance (i.e.: semiconductors), we expect that the vast majority of sectors will remain plugged into global supply chains (albeit with contingency plans). Finally, an upside risk is that the AI revolution advances exponentially and boosts potential growth. The development of AI is likely to be non-linear, but we expect the impact on productivity and potential growth to take at least a few years to materialize.


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