August 07, 2023
At the beginning of the year, our analysis from Issue 01 of the Macquarie Fixed Income Strategic Forum 2023
included the prediction that demand deceleration would overtake supply recovery as the dominant factor affecting
macroeconomic environment. As we enter the second half of 2023, we conclude in Issue 02 of the Strategic Forum
series that we have seen that narrative largely play out. An array of economic data, including household
supply chain stress indicators, has reinforced our views and our resulting economic outlook of lower inflation
growth. Looking ahead, we use a critical lens on our outlook and identify the main factors that have the
change it: fiscal policy, monetary policy overtightening, and the deterioration of credit lending conditions.
note that the implications of these could be profound for investors, as the likelihood of a dislocation in
slowly creeps upwards.
As global economies began a transition away from “stagflationary” conditions at the start of 2023, we highlighted
we considered an important shift in the key forces affecting the big macro picture. We believed demand would
supply as the main driver of macroeconomic outcomes. In other words, the direction and magnitude of the broader
economy through 2023, and the resulting investment landscape, will likely be determined by slowing demand rather
than the rate of supply recovery. Investors should therefore emphasise demand-related developments, in our view.
Our key conclusions in Issue 01 of the Strategic Forum 2023 series were for inflation to fall and for a cyclical
to unfold in the second half of the year. With the second half of 2023 now in view, we believe it would be helpful
reassess our analysis and to identify the risk factors that could change this trajectory.
What has happened since the start of 2023?
The supply recovery that had been our core theme since 2H21 has broadened and deepened while remaining on a slow,
sustainable, positive trend (see Figure 1). Demand has weakened as we anticipated, with movements becoming more
pronounced, but not enough to give rise to outright demand destruction (see Figure 2). The other development worth
noting, in our view, was the unexpected banking crisis, centred in US regional banks – a sign of underlying economic
fragility implying that when rapid and significant monetary policy tightening is engaged, “things tend to break.”
Figure 1: Global Supply Chain Pressure Index
Source: Federal Reserve Bank of New York, July 2023.
Figure 2: Demand and supply since the COVID-19 shock
Source: Institute for Supply Management, July 2023.
Household spending growth in the US has moved to the downside since the year began, while business spending levels
remain muted, implying a lack of incentive to significantly expand operations (see Figure 3).
Figure 3: US household and business spending
Sources: US Bureau of Economic Analysis, Institute for Supply Management, July 2023. Personal
Consumption Expenditures Price Index (PCE).
This trend can also be observed globally: Growth in world trade (a proxy for global demand) decelerated into 2023
peaking in 3Q22, while global production (a proxy for global supply) remains on a steady but moderate growth
(see Figure 4). In short, the trend of intensifying demand deceleration is very much intact, and as we noted in
of the Strategic Forum 2023 series, should remain the main determinant of macro outcomes, while supply recovery
becomes less significant.
Figure 4: Global demand and supply indicators
Source: Refinitiv, July 2023.
So why hasn’t demand deceleration turned into outright destruction?
While better-than-expected winter weather in the Northern Hemisphere was helpful, we believe the most important
factor in preventing outright demand destruction was the continued easing of fiscal drag (see Figure 5). This was
due to a rise in government spending, as well as increased fiscal transfers from the highest cost-of-living
government support recipients in about 40 years. This (less obvious) hand of fiscal policy has worked to offset the
publicised and hence more obvious) action of tighter monetary policy. In addition, households and businesses
from starting the year with relatively more resilient financial balance sheets (see Figure 6).
Figure 5: US federal government budget deficits
Sources: US Treasury, US Bureau of Economic Analysis, Macquarie, July 2023.
Figure 6: Household and business net worth
Source: US Federal Reserve, July 2023.
While the demand trend has not turned into outright destruction, the risks are skewed to the downside. Why is this
the case? Perhaps the biggest legacy from the combined supply shocks of the pandemic and then the Russia-Ukraine
war has been the “inflation scar” imposed on all economies. Price levels have launched higher and historically do
generally retrace, so we all are left with “having to pay more, much more, for everything” (see Figure 7). This is
not to be
confused with inflation, which is price growth, now on a downward trend.
Figure 7: US Consumer Price Index (CPI) price levels and CPI price growth (inflation)
Source: US Bureau of Labor Statistics, July 2023.
This scarring comes at a time when permanent income was attempting to buck the long-term structural downward
trend on the back of massive government transfers that began during the pandemic. Negative income effects
accompanied by elevated cost-of-living pressures (especially in the things we all need such as food, energy,
medicine), and exacerbated by rapid interest rate rises, have resulted in a significant worsening of household
stress in a
fairly short period (see Figure 8). In short, the worsening economic fragility of both households and businesses set
scene where exogenous headwinds could tip demand deceleration into outright destruction.
Figure 8: Macquarie US household stress indicator
Sources: US Federal Reserve, US Bureau of Labor Statistics, Macquarie, July 2023.
What could change the current trajectory of the current demand-supply
At the time of Issue 02 of the Strategic Forum 2023 series, the uncertainty of the US debt ceiling outcome and risks
for a repeat of the fiscal tightening that followed the 2011 debt ceiling resolution loomed large on our radar. The
that the debt ceiling agreement had not imposed serious spending cuts for the rest of fiscal 2023, followed by
moderate spending caps in 2024, has been correctly viewed with relief by financial markets, in our view.
Figure 9 illustrates the contrasting approach to fiscal policy across countries, with Australia the most fiscally
conservative and the US and Japan taking a more liberal approach. Given the significant positive effect of easing
economic policy in the second half of 2022 and into 2023, we believe a reversal would certainly darken the outlook.
Therefore, we remain alert to any shift towards tighter fiscal policy, but for now investors should expect a neutral
modestly expansive fiscal policy in the US through 2023, in our view.
Figure 9: Fiscal policy levels across key global economies
Sources: Refinitiv, Macquarie, July 2023.
This has been the fastest and the largest rate hike cycle since the 1980s and, for many countries, it is not finished
History shows that rate hikes alone do not necessarily bring about a recession because rate hikes create winners
and lenders) and losers (borrowers). However, if credit quantity restrictions are being imposed on even
borrowers, everyone is a loser. Historically, when significantly tightened credit conditions have occurred at the
time as rate hikes, a recession has unfolded each time (see Figure 10).
Figure 10: Historical US rate hikes, credit restrictions, and recessions
Sources: US Federal Reserve, Macquarie, July 2023. SLOOS refers to the Fed’s Senior Loan Officer
Opinion Survey on Bank Lending Practices.
We should point out that even if sustained rate hiking cycles do not cause a recession, they almost always trigger
or create conditions that give rise to financial market dislocation. Depending on the severity, these could turn
a systemic financial crisis. For example, even though the sustained rate hiking cycles of 1983-1984 and 1994-1995
are considered benign episodes, resulting in “soft landing” economic outcomes, financial dislocations did emerge
adversely impacted markets.
At this stage, while tighter credit restrictions have started to emerge, conditions are not yet tightened
prolonged enough to adversely impact economic activity. This can be seen by the fact that loans growth is still
although clearly on a declining trend. However, rate hikes are now at magnitudes that would impact spending – our
rule of thumb on US interest rate overtightening2 has breached traditional thresholds, implying that US
policy is in
The risk of something “breaking” in financial markets is probably higher now than at any time since the global
crisis (GFC), even if economic activity has not slipped into demand destruction or recession yet. We would recommend
investors stay vigilant not just on interest rate policy but also on where credit conditions are headed for the rest
the year. In this regard, we use one of our proprietary signals – the Credit Access Thermometer – to help guide the
discussion (see Figure 11). The signal’s current message is that credit access is tightening, although not as
recent episodes where a recession transpired.
Figure 11: Loan growth and our Credit Access Thermometer
Sources: Macquarie, US Federal Reserve, July 2023.
Implications for inflation and growth in 2H23
Our analysis also shows that the balance of risks for any change leans more towards outright demand destruction
rather than for an about-turn into buoyant demand. Moreover, the rate of supply improvement has now reached a fairly
steady state that is unlikely to be reversible, in our view. However, we believe it is also unlikely to surpass the
demand deceleration and therefore unlikely to act as a meaningful counterweight.
This analysis reinforces our high conviction call of a significant disinflation trend. The only unknown is how low
will go, with the outlooks varying by country. For example, in the US, prolonged demand deceleration with the rising
probability of demand destruction raises the risk of disinflation turning into deflation. This is a key difference
previous analysis in Issue 01 of the Strategic Forum 2023 series, where we emphasised falling inflation without
on the possibility of deflation. On the other end of the spectrum, a unique emergence of record population growth in
Australia will likely keep inflation higher than central bank comfort levels.
The impact on economic growth is less definitive. A significant slowing of growth is certainly the likeliest outcome
since demand deceleration has not turned into outright destruction, a recession is not guaranteed. This is further
supported by the relatively less-aggressive fiscal stance generally implemented by governments globally. In the US,
example, the resolution of the debt ceiling has significantly reduced the risk of a fiscal policy headwind to
least for the rest of 2023. However, as mentioned above, the prolonging of demand deceleration tends to lead to
fragility, which raises the risks of adverse effects from other exogenous headwinds.
A clear and present headwind is the on-going central bank tightening, with monetary policy close to or in
mode in many developed markets. In fact, the easing path of fiscal policy has actually increased the burden on
policy to deliver the goal of bringing inflation back to target. The lack of evidence of outright demand destruction
that the threshold for an interest rate pause or a cut is even further off, in our view. This implies a higher
doing too much and “breaking something.” But what “breaks” may not be the traditional contraction in real economic
activity. It could very well be in financial markets where a systemic crisis erupts and spills over into the real
because of the increased fragility of the broader economy.
Therefore, our sense is that a financial market dislocation should, in our view, no longer be a
As the probability rises, the longer rate hikes continue, and credit restrictions should increase. We might not be
identify where the dislocation will likely manifest and which asset sectors it would involve, but if it is
and systemic, a recession will emerge.
While a recession in 2023 is not inevitable, it remains our base case call as we head to 2024. For
now, key leading
indicators of demand, such as the Conference Board Leading Economic Index® (LEI), continue to point in the direction
of a recession (see Figure 12). But they also do not signal that the potential recession will be serious – more a
crash recession of 2001 than a post-GFC recession of 2007-2009.
Figure 12: LEI and recessions
Sources: Macquarie, The Conference Board, July 2023.
Issue 02 of the Strategic Forum 2023 series revisited our key conclusions at the start of 2023, which were for
to fall and a cyclical recession to unfold in the second half of the year, with demand deceleration overtaking
recovery as the main driver of macroeconomic outcomes. As we go further into 2023, it is increasingly evident to us
that demand deceleration is dictating the direction of the broader economy even as aggregate supply rises slowly
but steadily. Financial markets are seeing evidence that inflation has peaked and a clear disinflation trend has
However, the “widely expected” economic recession has not yet manifested.
Our analysis had previously highlighted that prevailing conditions, namely more resilient balance sheet positions of
households and businesses along with easier-than-anticipated fiscal policy, were working against the forces driving
However, the prospect of overreliance on monetary policy suggests to us that the probability of financial risk is
than previously expected. Historically, sustained rate hike cycles always deliver a financial dislocation, if not
recession. This view is further enhanced by the fact that credit conditions have now tightened, with the prospect of
further restrictions in coming quarters. The combination of overtightening monetary policy and rising restrictions
credit access has delivered a recession every time in the past. This implies a greater probability that the root
a recession this time will stem from financial markets. Unless serious fiscal and monetary loosening emerges – and
threshold for that is high, in our view – all it takes is for distress to emerge in financial assets and a systemic
a recession could occur, given fragile households and an increasingly downbeat business sector.
History also suggests that risk markets never really adequately “price” a recession, and financial crisis-led
even more unpredictable. As a result, our updated base-case outlook is for the disinflationary trend to continue,
the possibility of deflation by the end of 2023 to early 2024, together with a cyclical recession that’s no worse
recession of 2001 that followed the tech crash.
Investor implications: A Regimes Framework update
Our Regimes Framework, a recent addition to our macro strategy toolbox, aims to provide a big picture guide to how
a typical portfolio may react in the expected upcoming economic environment. We recognise that macroeconomic
outcomes are, by nature, uncertain and hence the model utilises alternative economic scenarios with assigned weights
that represent our view on the likelihood of each.
After being refreshed with our updated views, our Regimes Framework model still recommends that investors stay
vigilant on risk and maintain a bias to overweight duration. If a recession manifests in coming quarters, we believe
bond yields will likely fall and yield curves steepen as market expectations move to anticipate central bank rate
cuts – a
positive result for bond markets. The outlook for credit is more reserved with spreads forecasted to widen,
for below-investment-grade credit. However, for investment grade credit, the current high levels of absolute yield
help offset some of the capital loss. If continued central bank tightening delivers a harder landing for the
portfolio returns should be positive, with significant returns for bond markets, as we believe even larger falls in
yields and more aggressive central bank easing are likely to follow eventually.
1 Index shows the number of standard deviations from the long-term average.
2 Rule of thumb: overtightening is attained when policy interest rates exceed a
three-month moving average of household spending by more than 2.5%.