Your Assumptions for 2023 and Coping with Change

What are your economic assumptions for 2023?

I have been asking this question ahead of each New Year for the last couple of years. What started out as a bit of fun has become a bit more serious.  After all, if a hobbyist and others find more value from the insight, it’s utility grows.  I find that estimating how the economy will behave helps understand how businesses operate and ultimately how IT is used.  Sometimes it’s the process itself that is more useful than the final estimates themselves.

A Look Back at 2022

Let’s look at the quality of of my estimates for 2022, as published December 16th, 2021:

• Estimate: GDP/Growth: USA to reach 5+% annually by end of year. Roaring growth; re-jiggered supply chains; China investing in more growth will keep demand plodding along.

Actual: Current‑dollar GDP increased 6.7 percent at an annual rate, or $414.8 billion, in the third quarter to a level of $25.66 trillion See BEA).

• Estimate: Interest rates: USA will need to ramp up faster than currently signaled by the Fed. Note the Bank of England raised its rates today. Year-end target:
  • 30-year fixed mortgage: 5-6% (currently under 3.0%)
  • 10-year treasury note rate: 3-4% (currently around 1.0%)

Actual: 6.42% for 30-year fixed mortgage (see FRED; St. Louis Fed)  and 3.75% for 10-year treasury note rate (see Ycharts).

• Estimate: Inflation: USA likely to peak middle of the year at an annualized 8-9% but then slowing in Q4. For the year-end I would look for a 6% number.

Actual: 7.1 as of November 2022 (See Statistica).

How did I do?

Frankly, I was pretty good but sometimes for the wrong reason. Much of US GDP has been driven by increased and continued public spending from COVID-19 and post-COVID-19 bills. China has its own economic challenges and it has not been spending significantly to help drove global growth.  The rate of inflation may have peaked around 9.1% in June then gradually moderated. My estimate looks pretty good.  My estimates for rates was pretty good, given my underlaying assumptions for growth and inflation.

What is most interesting to me here is that in December 2021 the vast majority of the market, including Jerome Powell of the Fed, where headed in a very different direction. I was in the very small minority who seemed to have guessed correctly.  Then again, I had offered that these conditions might have occurred in 2021, and I was wrong .  So let’s just say I was right with my forecast, but my timing was a little off.

Recession in 2023?

Pundits are still arguing over if, when and where recession will surface. My latest estimates align with others who suggest:

• USA recognizes a recession (effectively a double-dip) by Q2 2023. It will be mild (most likely) with a slight chance of a very painful contraction persisting for 9 months.
• EU follows US in Q3; wracked and split with managing debt, interest rates and spreads across the region.
• UK also experienced a short, sharp contraction in the middle of the year.
• Japan will experience a massive flight of capital by middle of the year, as its own interest rates have to grow notably to help neutralize the return Japanese capital can gain from foreign debt alternatives, thus ending the unique Japanese economic experience (See WSJ: Bank of Japan Blinked in Standoff With Markets).

What is Ahead of Us in 2023?

My actual day job is not related to researching economics; I am in our Data and Analytics team, and I have a specialization in things like business leadership roles such as Chief Data and Analytics Officers.  I also focus on China too.  However, I study economic data and apply my own insight in order to try to understand what is taking place around us all.   I am also what you might call a hawk. My main focus is in money supply and debt-to-GDP differentials across sovereign states. As such there are some major concerns for 2023.

With this backdrop, here are my estimates for 2023 for the most likely outcome:

• Estimate: GDP/Growth: USA to reach 3-4% annually by end of year. With recession behind it, and government spending still increasing, growth will recover (but it won’t be productive growth).
• Estimate: Interest rates Year-end target:
  • 30-year fixed mortgage: 6%(currently 6.42%
  • 10-year treasury note rate: 4-5% (currently around 3.75%)
• Estimate: Inflation: Around 5-6% by end of year (currently 7.1%)

Context for my Assumptions for 2023

The first six months will be driven by economic contraction, rising unemployment, wage pressure augmented by growing labor and union unrest. Rates will have to remain high in an attempt to wrestle inflation to the ground. S&P profits will not decline noticeably until the middle of the year. Government spending will continue even as the Fed tries to rein in spending in continued political conflict.

During the second quarter the natural forces dragging the economy down will achieve their goal. From here the cycle will revert direction. Gradual recovery will take place.  While inflation will be seen to be coming down, the question will shift.  The main question on everyone’s lips will be: Will inflation fall fast enough for the Fed to ease off?  And when?  For me, the answer is possibly by the end of Q3 but not likely before.

The Underlaying Challenge is Out of Reach

But there is a small chance that worse may take place. If, through political weakness, the Fed takes its feet off the pedal too soon; or if central government further increases transfer payments that again reduces working age opportunities and participation rates, more damage will be done, unintended and even intended. Even regulations and policies, sold to the press and public as efforts to alleviate pain and loss, will just shift the pain from one group in the economy to another.

The one irrefutable fact that plagues our economies is out of reach of the desire and intellectual grasp of our political leaders: we need productivity-enhancing economic growth, large and significant. And little is being done today by federal governments (See Economist’s Political Economy – First World Problems: How the West Fell Out of Love with Economic Growth).

Not All Growth Is Equal

Growth, producing more, is not the answer.  Productivity-enhancing growth is what is needed – where the economy creates more wealth and value but uses less resources in doing so.  Productivity has been in the doldrums for quite some time and it it is not showing any signs of changing at a macro level.

Even regulations, targeting one group or other to drive some positive behaviors, ends up conflicting with another groups’ behavior.  The industrial revolution and almost any other notable example of productivity-enhancing growth was not managed by regulation or central government.  It was unleashed by regular workers who sought to better themselves, and capital that was free to seek out the best returns.  The profits of that effort are what should be used to help those that were unable to create the growth, not fund pet projects by those in charge.

The High-Risk Low-Probability Assumption for 2023

There is a risk that politics will lead to additional policy mistakes, and the second half of 2023 will lead to a much worse situation. Here is my high-risk, low-probability scenario:

• Estimate: GDP/Growth: USA to reach 0-1% annually by end of year. Recession sucks the economy down and excessive government spending creates a maelstrom beyond stagflation
• Estimate: Interest rates Year-end target:
  • 30-year fixed mortgage: +10%(currently 6.42%)
  • 10-year treasury note rate: +7%(currently around 3.75%)
• Estimate: Inflation: Around 11-13% by end of year (currently 7.1%)

Analysis: The risk is that central government keeps spending just as the Fed continues to tighten. Central government keeps shuffling chairs around, paying of various voter-groups.  It does this to survive in office (after all, its called politics for a reason) but no such actions actually addresses the underlaying challenge. Unable to grow the size of the pie, and with fewer options to print dollars, the economy goes into free-fall. GDP collapses and inflation rages; interest rates race ahead of inflation levels continuously.

Why the High Risk Scenario is Possible

While some of you will refer to exorbitant privilege of being a reserve currency, the weight and responsibility of that role will be too much for the Fed. It is workable when the federal government acts with the same long-term goal in mind: stable economic conditions for the market to flourish. The Bank of England achieved this for many years. The US achieved similarly but for a much shorter period of time.

Since the 1950s the potential for a bifurcation between fiscal and monetary policy custodians has been building. It is staring at us in the face, and few even realize it See CNBC: Fed rate hikes won’t bring down inflation as long as government spending stays high, paper says. And in the midst’s of high inflation and rates still ascending, the US Federal Government just passed another $1.65tn dollar spending bill.

The fact is that the US federal government is not spending dollars to enable the market to flourish. It is spending dollars to help itself and its own supporters to flourish, at the expense of the wider market. At the heart of this is capital and where it flows.  Without capital we don’t have an opportunity for growth, and this brings us back to our current experience and Japan.  While central banks risk battles against foreign exchange and capital flow, Japan will prove the final answer to the question.

Japan Proves We Can Spend Our Way to Utopia

Japan has been held up as being a unique monetary phenomena. It’s public debt to GDP is at eye watering levels at over 260%; it’s inflation has been muted and growth anemic. But it has been relatively stable for one main reason: Capital, invested in Japanese bonds (by Japanese banks and firms) had few alternatives to realize higher returns.  As the rest of the world plays catch-up with Japan, that capital has more choices and the desire to hold onto Japanese debt will fall.  The BOJ will have to raise rates to try to keep capital interested See WSJ: Time Might Run Out on Japan’s Low-Rate Policy).

On top of this you then add how inflation can be globally triggered and you see that another element of the Japanese economic experience will give way.  Even now it is clear that inflation in Japan is finally rising (See WSJ: Japan Consumer Inflation Reaches Nearly 41-Year High).  This was predictable 9 months ago when one grasped the size of the mountain ahead of the Federal Reserve. It was clear in Q1 2022 that inflation was going to be triggered globally through the complex web of supply chains we all enjoy every day.

One Big Happy (or Unhappy) Family

The fact is that Japan’s economic condition has been stable for so long simply because capital had so few options to obtain higher returns. As of now, pundits are waking up to the idea that Japanese debt holders can see returns equalizing across the globe and those holders will realize there is more money to be had outside of Japan.  Capital will shift away from Japan’s debt, and that flight, once ignited, will be impossible to stop. Capital’s last flight could be public debts downfall, and a global economic collapse could engulf us all.

That’s the worse-case scenario. I give it today 5% chance. I remain a massive hawk.

Coping with Change

What this blog shows is that there are alternative outcomes that can be simulated and thought through.  How can a CIO, CFO and CEO plan to run their business given the different scenarios outlined above?  What plans can  you put on the shelf, just in case they are needed?  What capital investment strategies become more attractive?  Where will you get capital when you may need it, to recycle your debt or make those investments?  These are all delectable decisions.

There was one awesome article I read during the holidays that nicely captured the idea of scenario planning ahead of multiple possible futures.  It was this one: Qualcomm Confronts Decline in Demand. Qualcomm’s CFO is interviewed and he explains some of the actions and steps taken by the organization to help prepare for change and alternative scenarios through 2023.  The article explores how capital will be acquired, debt will be managed, and ultimately how spending – including on IT to drive productivity-enhancing growth – will be protected.

None of us really know what lays ahead, and estimates can help explore modes of operation and boundaries of success, and failure.  The process of thinking through such activities can be as useful since it leads us all to learn more about ourselves, and the models and systems we use to learn such things.  Its recommended.

Happy New Year.