Shifting from supply to demand

Shifting from supply to demand


Graham McDevitt

  • Managing Director, Global Strategist
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Dean Stewart

  • Senior Managing Director, Head of Quantitative and Markets Research
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Patrick Er

  • Senior Manager, Senior Econometrician
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Executive Summary

The transition away from the “stagflation” of the past 1-2 years is well in progress as the supply disruptions that triggered those conditions are receding. In Issue 01 of the 2023 Macquarie Fixed Income Strategic Forum, we noted that this comes just as a significant deceleration in demand is emerging. Our research from the Forum suggests this is due to sustained negative stress on households and businesses, which is exacerbated by persistently tight economic policy settings. A deeper dive into the research in Issue 01 suggests that the trend of weakening demand in 2023 as supply slowly recovers will deliver lower inflation, perhaps even deflation, but also significantly raises the probability of recession. This will have a significant impact on investors’ decisions, and our analysis shows it to be a positive for global bond markets.


After more than two years of supply-disrupted stagflationary conditions, economies are now poised to move to the next stage of the cycle. Toward the end of 2022 (amid the short-lived economic improvement, when the worst effects of the Ukraine war did not materialise), we noted the emergence of decelerating demand and the continued steady easing of supply disruptions. As markets go deeper into 2023, it will be the interplay between these two opposing forces of supply recovery and demand deceleration that will be the key in determining the eventual macroeconomic outcomes. Where this transition from stagflation ends up will be crucial to investors’ decisions in the medium to longer term.

Shifting the focus from supply to demand

Since the pandemic erupted in the first quarter of 2020, supply issues have been the main determinants of macroeconomic outcomes. However, the first hint that this was about to change, and that demand factors would reassert their traditional dominance, was observed in the fourth quarter of 2022, when the pace of demand deceleration began to overtake the pace of supply recovery (see Figure 1). Today, a few months into 2023, this divergence has remained, with demand deceleration clearly the main driver of the gap.

Figure 1: Demand decelerating quicker than supply recovering

Sources: Macrobond, Macquarie, March 2023.

Intensifying demand deceleration due to negative income effects

Our analysis suggests that this shift was triggered by the prolonged lagging of household income growth behind inflation over the past two stagflationary years (see Figure 2). Persistent real income decline is now causing income growth expectations to revert to the long-term downward trend that first emerged in the 1990s (see Figure 3). If this negative income effect persists into 2023, spending will very likely decline further.

Figure 2: Real wage growth still contracting

Figure 3: US permanent income growth trend: disposable income per capita (10-month moving average)

Sources: Macrobond, Macquarie, March 2023.

It is true that strong labour market conditions1 should keep unemployment rates from rising significantly and therefore moderate the degree of demand deceleration. However, we should remember it is still income effects that mainly determine incremental spending. In the absence of significant real income growth, keeping one’s job alone will not encourage greater spending growth, especially in a tight monetary policy period when access to credit tends to be limited. In fact, the current tight policy environment (both fiscal and monetary), with potentially more tightening to come, will likely add to the prevailing negative income effects and further hasten the rate of spending declines (see Figure 4).

Figure 4: Policy impact on the economy

Sources: Macrobond, Macquarie, March 2023.

As a result, household stress (see Figure 5), measured by income growth relative to the rise in living costs plus the extent of interest rate burden (which accounts for the level of debt carried), has reached levels not seen in many years (about 40 years in the case of the US).2 It could well be that the breaking point that tips consumption into contraction, and thus demand deceleration into outright demand destruction, may not be too far off.

Figure 5: US household stress

Source: Macrobond, Macquarie, March 2023.

While negative income effects are not as severe for businesses, if households (who are the ultimate consumers) capitulate, business incomes will quickly follow suit. Despite businesses’ best efforts at protecting margins, profit growth will likely weaken significantly once spending contracts, and it will likely affect future expectations of profit growth. This in turn will dampen incentives for further capital expenditure by businesses, a prospect that has already dimmed considerably due to existing policy tightening moves.

Relatively steadier private balance positions unlikely to prevent further demand deceleration

Could the current state of private balance sheets, fortified by some of the biggest fiscal transfers in modern times, withstand these rising headwinds? When compared with recent history, households and businesses appear in relatively better financial shape (see Figures 6-8 below). In particular, debt ratios are at levels not traditionally considered a serious risk when compared with past crisis periods. But this does not mean financial positions will comfortably offset the current rising income stress. This is because net wealth is clearly retracing.3 Therefore, balance sheet effects could, at best, prevent a severe spending collapse but not likely adequately offset the prevailing (and increasingly) negative income effects.

Figure 6: Growth in net wealth

Figure 7: Household debt rising but still low

Figure 8: Corporate debt fairly contained by historical standards

Sources: Macrobond, Macquarie, March 2023.

The trends described above should apply to most investable economies. To different degrees, perhaps, but they are unlikely to be avoided. Note that the increasing rate of demand deceleration necessitates a significant shift away from our recommended emphasis (from the past two to three years) on supply-side issues. The supply recovery process, despite potential speed bumps along the way, will continue to proceed in the gradual, steady manner observed at the end of 2022. But it will be the intensifying of the forces of demand deceleration that will be crucial in determining macroeconomic outcomes, especially growth and inflation in 2023 and probably into 2024.

Implications from demand decelerating more than supply recovers

When supply recovery meets demand deceleration, the first unambiguous result is that inflation will ease. And that was our 2022 high conviction call: high inflation has peaked, and disinflation will emerge in the next 12 months.4 But the intensifying of demand deceleration suggests that inflation could also possibly overshoot to the downside. The probability would rise further if a recession outcome were to be worse than expected. Therefore, deflation in the longer term, for example, from 2024, cannot be ruled out.

Determining the likelihood of a recession, and its potential severity, is also clearly important. Once again, our demand-supply lens reminds us that economic growth can be higher if the forces of supply recovery dominate, but if the forces of demand deceleration are stronger, there is a greater likelihood that growth will be weaker. Since the intensifying of demand deceleration relative to supply recovery will be the main trend in 2023, we believe the focus should be on indicators of demand. By looking at how demand will turn out, the likelihood of recession and its potential severity can be better determined.

The key indicators to monitor in the transition from stagflation

This analysis on recession likelihood is guided by our in-house recession alert process. That process flagged that the necessary conditions for a recession – that is, the emergence of severe supply shocks – have been met, first at the onset of the pandemic and then again by the second Russia-Ukraine war supply shock in 2022.5

The next step in that process is to consider the extent of discretionary policy tightening. Currently, policy settings (both monetary and fiscal) in many countries are cyclically tight (see Figures 9 and 10). Although the rate of fiscal tightening has eased somewhat, partly in response to concerns about the war in Ukraine, this could change as political events change. For now, the full impact of monetary tightening via interest rate hikes has yet to play out, while the rhetoric on fiscal policy in many countries is still skewed to budget repair, which implies tightening in the works. Therefore, the need to closely monitor what policymakers do is obvious. What is less obvious is that policy tools mainly impact demand; justification for policy is usually based on demand-related outcomes.

Figure 9: Monetary policy tight and getting tighter

Figure 10: Fiscal policy tight but not getting tighter

Sources: Brookings Institution, Thomson Reuters, Macquarie, March 2023.

In keeping with our earlier findings that developments in demand will be the main determinant of macroeconomic outcomes, the final step in our alert process (which is to assess prevailing conditions) can be reduced to assessing the signals of demand. The following set of indicators was identified as most appropriate: the first two – the Conference Board Leading Economic Index® (LEI) and the Institute for Supply Management (ISM) New Orders Index – cover overall demand growth, while the other signals add additional emphasis on interest-rate-sensitive demand (housing construction, residential investment, and spending on durable goods). Prior analysis had determined that these indicators are most effective in delivering timely signals for a demand-driven recession (see Figures 11a-11e).

Figure 11a: Conference Board leading indicators signalling recession

Figure 11b: ISM New Orders on verge of pointing same

Figure 11c: Interest-rate-sensitive sectors: Construction

Figure 11d: Interest-rate-sensitive sectors: Residential investment

Figure 11e: Interest-rate-sensitive sectors: Durable goods spending

Sources: Thomson Reuters, Macrobond, Macquarie, March 2023.

Charts 11a-11e above do suggest a recession is reasonable as a base-case outcome, because current signals are getting into historical ranges that are consistent with either a recession or an impending one. Just as importantly, the signals are not at levels that suggest a severe recession (such as the one that followed the global financial crisis). These indicators suggest a recession that is closer to a cyclical recession along the lines of the 1991-1992 or 2001 recessions, or at worst, the one that followed the tightening by US Federal Reserve Chair Paul Volcker in 1979-1981. This is also consistent with our findings that while negative income effects are present, balance sheet effects are not negative (for now). The demand-side signals of whether a recession is imminent (in Figures 11a-11e above) can also be useful as a guide to whether current policy trajectories could change (for example, the oft-mentioned central bank “pivot”),6 given that recession expectations are a major influence on policy decisions.


The big picture macroeconomic outlook

The shift in 2023 will be the return of demand as the driver of macroeconomic outcomes with supply issues leaving centre stage. This is because negative income effects and neutral balance sheet effects will probably accelerate the pace of demand deceleration to the point of overtaking the positive impact of supply recovery. The tight policy environment also adds to the expected decline in demand.

This would imply a weaker GDP growth outlook to the point of recession, as well as continuing the disinflationary path that began in the fourth quarter of 2022. This pattern is likely to be generally repeated across most countries. At this stage, we believe a traditionally cyclical recession (-0.5% to -1% in the US, with a slightly more negative picture in Australia) is the likeliest outcome. We would add that the risk of disinflation (back to central bank ranges) turning into outright deflation is also materially possible. Whatever the result, the prospect of a transition from stagflation to more bullish conditions, which seemed possible at the end of 2022, is now an increasingly distant hope. The stage is being set for a likely return to a low-growth, low-yield world but with a stopover into recession and possibly deflation.

Implication for financial assets: Applying the outlook in a Regimes Framework

With the above macro picture in mind, what are the likely broad implications for financial assets? To answer this, we utilise our Regimes Framework, which is a recent addition to our macro strategy toolbox. This process starts by recognising that macroeconomic outcomes are, by nature, uncertain because of the multiple factors in play, the role of policymakers, and a host of other potential exogenous factors that may influence the outcome. Therefore, the Regimes Framework is underpinned by identifying a range of economic scenarios, with different assigned weights to represent our base case outlook and alternative possible outcomes. The next step is to input forecasts for each scenario for major financial asset variables (such as key yields and spreads) so that a range of portfolio outcomes can be generated. This process then provides a general big picture guide to how a typical portfolio may react and therefore provides signposts for risk management depending on how the outcome develops. Portfolio returns are attributed into rates and credit.

Application of Regimes Framework: Expect a positive bond return environment in 2023

The current Regimes Framework indicates that the outlook for 2023 should be positive for fixed income markets under each scenario. For the base-case scenario of a recession, bond yields are expected to fall, with a steeper yield curve as central banks pivot and deliver rate cuts. This generates positive returns for bond markets, from capital movements along with additional carry. The outlook for credit is negative with spreads forecasted to widen, but this will be more than offset by increased carry. The highest fixed income returns come from our harder-landing scenarios, which imply a higher momentum of central bank rate cuts, lower bond yields, and wider credit spreads.

To conclude, our research points toward 2023 being dominated by demand destruction as supply recovery continues. Tighter policy in the short term and lower inflation in the longer term pave the way for positive bond portfolio returns, even if that path seems unclear right now. The Regimes Framework notes that under the riskier, deeper recession scenarios, returns should also be positive, with high risk-free return and significant “rates” return given the larger falls in bond yields and more aggressive central bank action.


Both inflation and unemployment rates have historically been slow to respond to monetary policy rate hiking cycles. Inflation rates tend to be higher, rather lower, after the last rate hike than at the first rate hike. Meanwhile unemployment rates tend to increase significantly well after the last hike and attain a new cyclical peak well after a recession emerges. These empirical observations suggest neither inflation nor unemployment rates are accurate guides to calling the end of a monetary policy tightening cycle.

Figure 12: Inflation rates and Fed rate hike cycles

Figure 13: Unemployment rates and Fed rate hike cycles

Sources: Macrobond, Macquarie, March 2023.

1 Driven mainly by slower-than-expected re-entry into the workforce and resilient demand for workers.

2 This way of estimating household stress is especially relevant in more recent times as automatic adjustments to wages to compensate for inflation are generally no longer practiced.

3 In particular, households’ excess savings (accumulated from the COVID-19 fiscal support), while still positive, are also diminishing.

4 And that has indeed been the case with the first inflation prints of 2023, showing the lowest headline Consumer Price Index (CPI) annual rate in almost a year.

5 The US economy received a taste of that in the first half of 2022 when a technical recession emerged as a result of serious fiscal tightening followed by rapid rate hikes. Thanks to a significant turnaround in fiscal spending in the second half of 2022, partly due to Ukraine war-led spending, fiscal drag eased enough to prevent a full-blown recession.

6 They certainly do no worse than relying on the existing standard indicators such as inflation and unemployment rates in gauging the likelihood of a “pivot” in central bank policy stance. See Figures 12 and 13 in Appendix, which show that neither indicator provided much value add in determining the likelihood of a pause or a cut.


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Demand destruction is when persistently high prices for a certain good lead to less demand for that good.

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The ISM Manufacturing Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The Manufacturing PMI is a composite of five indices with equal weights: New Orders, Production, Employment, Supplier Deliveries, and Inventories. A Manufacturing PMI reading above 50% indicates that the manufacturing economy is generally expanding; below 50% indicates that it is generally contracting.

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