Serdar Kucukakin (pictured), senior sovereign research analyst at Aegon Asset Management
Markets are guilty of ‘cherry thinking’ - picking the narrative that best suits a positive outlook.
Disagreement on the economic narrative is a good sign of a balance in the overall picture.
There is always a case in economics for good and bad outcome.
Regardless of the phase in the cycle, there are always positive and negative factors to consider.
But looking at the current market sentiment this balance has vanished.
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There are no pessimists left, just optimists and ‘super optimists.'
Super optimists advocate central banks, especially the Fed, will manufacture an economic soft landing. Inflation will come down significantly, they say, without pushing economies into negative territory.
This will halt the rise in interest rates, while equities will get a boost. Looking into 2024 this will supposedly create a tailwind for economic revival.
Meanwhile the ‘normal' optimists accept there will be a hard landing, i.e. a recession.
But they are convinced that it will be shallow. This ‘mild recession' is even seen as welcome, because it will lead to much-needed loosening in the labour market.
This scenario, while less good, is still a reasonably desirable outcome for markets.
In this scenario, asset classes such as equities would experience a setback, but a mild one.
While both scenarios are perfectly possible, they are not the only ones. But discussion of other scenarios seems to have vanished.
This is the first time in my career that I have heard other economists talking dismissively about an upcoming recession. I even heard one commentator enthusiastically say: "Don't worry about it.
We are very well placed to deal with the upcoming mild recession."
For starters, what is mild about a recession that, according to Eurozone consensus, could last a whole year?
The technical definition of a recession is just two quarters of economic contraction.
Cherry thinking
Looking at high frequency data economists and markets are reliant on for their decision-making, it is easy to cherry pick information that confirms biases.
Let us call it 'cherry thinking'.
For example in the US, manufacturing and services PMIs have dropped into contraction territory.
This gives a clear signal about future economic developments.
But at the same time the unemployment rate has not shown the same negative developments and remains quite tight.
While the labour market will probably loosen up eventually, this is still open to discussion.
According to optimists, this loosening is necessary and an expected outcome of rate hiking which will correct itself, thus avoiding a hard landing.
With no sign of labour market loosening, GDP forecasting models such as that of the Atlanta Fed is supportive of this view.
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Putting the survey, labour market and GDP-model outcomes next to each other is a perfect way to apply cherry thinking, because any of these views make sense.
Europe seems more straightforward on whether there will be a recession or not.
Yes, it will, is the consensus view. But depending on what you want to emphasise, cherry thinking is still possible.
In Germany for example, the significant drop in the sentiment indicators last year was a clear omen of what to expect this year.
The enormous fallback in factory orders (-11% YOY in November 2022) just solidified this view.
But the recent easing in sentiment indicators has allowed cherry thinking to creep back in.
Realist scenario
Looking at what fundamentally could drive economic developments this year, a step back from the data and a degree of realism is needed.
Inflation was higher than nominal wage growth last year, and could well persist this year.
This negative interaction between wage growth and inflation is a clear problem for the purchasing power of consumers.
Consumer spending is the most important pillar of economic growth.
The tight labour market only plays, at best, a neutral role.
If the labour market stays tight, then it won't aggravate weakening purchasing power.
But if it loosens, it will definitely worsen weakening purchasing power.
There is another development that will have a negative impact.
Central banks have already significantly hiked rates. But more is to come.
Even the super optimists would agree higher rates cause a drag on consumer and business spending.
Hypothetically, nominal wage growth could exceed inflation this year, correcting some of the loss of purchasing power.
But what would happen in this scenario with underlying core inflation already at elevated levels in the Eurozone and US?
In this case, the realistic scenario then turns very pessimistic, with economies galloping to stagflation.
The problem with a ‘this time is different' narrative is it rarely is different when you look in the rear mirror.
When was the last time we experienced a mild - or no - recession despite of a significant erosion of consumer purchasing power, while central banks aggressively hiked rates?
Serdar Kucukakin is senior sovereign research analyst at Aegon Asset Management
