Morgan Stanley Chief Global Economist Seth Carpenter joins Yahoo Finance Live to discuss the European energy crisis, the Bank of England raising rates, global recessionary risks, and the outlook for the economy.

Video Transcript

- Seth Carpenter, Morgan Stanley Chief Global Economist is with us now to talk about the global goings on and the economic picture right now. It feels sort of like we're on a precipice globally. But it's not a sharp precipice, right? I mean, how are you thinking about the big picture right now?

SETH CARPENTER: I think right now less of a precipice, more the tide is going out. I think there had been for months now sort of these storm clouds of recession looming. And now is the time where I think the storm is really coming. If you think about the three key economies, the US, Europe, and China, not a great story on the outlook anywhere.

Europe, we think will still go into recession. We're pretty pessimistic there. High energy prices high food prices have hurt the consumer. And we think things are going down. And the ECB is just laser focused on headline inflation. So they're hiking.

China, they ended the contraction they had in Q2. But things have not really started to rebound. The housing sector is imploding. They still have strong COVID restrictions. It's going to be hard for them to get any traction, we think, by the end of this year and probably not even into Q2 of next year. So really weak growth, something with a two handle for China for this year, which is pretty dismal.

Which leaves us the US, where we are guardedly optimistic. We don't think there's a recession on the horizon for the US. But it's pretty clear. Chair Powell spoke yesterday. He spoke at Jackson Hole. They are trying to slow the US economy down a lot. How much? Well, well below potential GDP growth, which on their numbers is like 1 and 3/4%. So they want to get below that.

We can avoid a recession, no outright contraction, no sort of mass layoffs, but it's still not this happy picture of a booming economy. And once you have those three key economies going, it sort of sets the stage for the whole world.

- Given your pessimism on Europe, let's lock in on Europe for a second. How deep and how long a recession do you think could be seen over there?

SETH CARPENTER: Hard to say for sure right now. Part of it does depend on two things-- one, if the flow of natural gas from Russia stays cut off, and second, if the amount of inventories that have been built so far are going to be enough for the winter. And the winter could be quite cold, in which case things could be much worse. So we think Q4 of this year, on the edge of that right now, Q1 of next year, all in negative territory, quarter on quarter contraction. Could be pretty deep, though it could be as much as 1% contraction.

- Let's zero in on the UK for just a moment, given the news that we have there, obviously a lot of transition right now with both the death of the Queen, Liz Truss taking over as prime minister and introducing this energy plan. What are the implications of all of this for the UK economy right now amidst the energy crisis?

SETH CARPENTER: Absolutely. So the UK also in a very difficult circumstance. They left Europe, but they didn't escape some of the challenges just on the other side of the channel. And high food prices, high energy prices also hurting UK consumers. We also think the UK is going to go into recession.

The new energy package, though, is pretty complicated. And once all the details are clear and how the money's going to flow, it will matter. But it seems like maybe a bit of near term, lower inflation by capping some of the prices, but there's a transfer, so more money going to households. More spending means more underlying impetus for inflation.

So it makes the recession that we think they're going to have at the end of this year a little bit less severe. So nothing cataclysmic, but it also sustains that underlying spending so the Bank of England's just going to have to keep raising rates. So it doesn't fix things by any stretch of the imagination. They're in a very hard spot.

- When does growth start to reaccelerate around the world? And what would trigger that?

SETH CARPENTER: It's going to be-- it's going to be patchy. So Asia outside of China has actually been holding up a bit better than a lot of the rest of the world. I think we can look to some of the LATAM economies and wonder, they're sort of hitting the peak of their hiking cycles and the peak of inflation. Maybe we start to get a little bit of a pickup. But any acceleration next year, any acceleration in 2023 from this year is going to be quite grudging. And it's just not going to be broad-based.

- I want to circle back. We've been doing a little global tour. To come back to the US for a moment, I'm curious how high you think unemployment can get. There's been a lot of debates. There's been some alarms raised that we're going to get quite a high level of unemployment as the Fed tightens. Do you think so as well?

SETH CARPENTER: I'm not worried about, for now at least, a massive layoff where there's massive job destruction. I think there's an elevated risk of recession in the US. But I'm thinking that's more 2001 than 2008 kind of recession. So not great for people who lose their jobs but not the disastrous kind of recession. So that's the first point.

I think when we get to the specific numbers of the unemployment rate, things get that much more complicated, though. Because that number also reflects how many people are in the labor market. What we see every business cycle, especially among sort of prime age workers, 25 to 54, is once things have bottomed out, and the economy has started to grow again, we see labor force participation start to rise. And that's going to start to put upward pressure on the unemployment rate if you keep everything else constant.

The last jobs report we got showed a big recovery there. And we think that continues. And so we are looking for an increase in the unemployment rate, maybe on the order of a half a percentage point, which in any other business cycle would probably say, we're tipping over and going into recession. But this time, at the risk of using that phrase, this time feels different because we are coming out of COVID. We are coming out of a very, very dislocated labor market. And I think we can get slower growth, less job demand at the same time people coming back to the labor market.

- How do you think the Fed will respond to rising unemployment?

SETH CARPENTER: Well, this is one place where the Fed-- they've got an army of economists. I used to be one of the foot soldiers, as it were. And I think they will do the same sort of parsing-- what's causing the rise in the unemployment rate? And it's hard to get angry it's hard to be worried that the unemployment rate rises if it's because more people are coming into the labor force. It's clear it's a bad thing if the unemployment rate is rising because people lose their jobs.

But if it's from more people entering the labor market, then it's actually a sign of underlying resilience in the economy. It's a sign that some of those inflationary pressures from tight labor markets can ease without us going into recession. So I think in that scenario, if we're right, they'll actually welcome it.

- So I think something that Sozz and I are trying to grapple with, particularly on a company basis, is what is normal at this point? As we have this post-pandemic, we had the bounce back. Now we're having the revenge bounce. I don't know. So how do you think about, from a macro perspective, what normal means? I that's sort of a philosophical question at this point.

SETH CARPENTER: Hard to answer. We're not there right now. That I'm very highly convicted on. I think if you take it in the context of markets as well, this is a conversation that my colleague Mike Wilson and I have a lot. So he's our head of equity strategy.

- I wish I could be there when you guys have these conversations.

- Yes. Yes. Me too. Fantastic.

SETH CARPENTER: I love Mike. But the point is, we see a macroeconomic slowdown, a big macroeconomic slowdown. Now the market is not the economy. The economy is not the market. But as it turns out in this case, the parts that seem likely to slow down the most, the goods producing parts of the economy and things like that overweight in the S&P are probably going to slow down even more. And so as a result, Mike has been pounding the table that earnings expectations probably have to come down a fair bit more than they have so far.

And I think that part of normal is part of the catch up we have to get to. We have to, I think, have everyone internalize where the economy is going, what it means for earnings. And again, just to get back to the Fed, there's this kind of one-way risk here. If things turn out better than we thought and the economy is stronger, that's just going to cause Chair Powell and the others to say, you know what we need to do? We need to hike more so we can slow the economy down and get it back down to that slow growth rate.

And so the upside is very much capped in that regard. And I think that kind of normal, that alignment of where things really are going and what the central bank means when they say they're serious about bringing inflation down, I don't think we're there yet. But we're on our way.

- I don't know if I like the sound of normal, Julie. It sounds like really abnormal, not cool.

- It's the process of getting to normal that I think is the painful, the ice part, I guess is how Mike would put it.

- Yeah, right. Absolutely, all right. Well, I'll leave it there. Morgan Stanley Chief Global Economist Seth Carpenter, good to see you. Good to see you in person.

- Glad to be here.