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Key investment themes and risks

The key themes and risks our House View team expect to drive financial markets.

Monetary policy-induced recession

2023 GDP growth projections around the world continue to be revised lower (Figure 5). Aviva Investors now expect world growth of 2.25 per cent next year, down from 3 per cent just three months ago. Outright falls in global GDP are extremely rare – the COVID experience of 2020 was an exception (a decline of 2.6 per cent) – but anything below 21/4 per cent world growth is generally considered as bordering on global recession, so risks are clearly magnified.

Figure 5. Growth projections revised steadily lower - Consensus forecasts for global GDP growth
Figure 5. Growth projections revised steadily lower
Source: Aviva Investors, Bloomberg, Macrobond as at 3 October 2022

As we have highlighted previously, there are several well-documented elements of the current downswing which relate directly to the shock following Russia’s invasion of Ukraine and the energy price hike and supply disruption which followed.

Neither central banks nor governments can do much to prevent such supply-side impacts (although they can try to offset them), but if the shock fades or disappears, as is hoped, then so too will the negative effects. But as the OECD made clear in its updated September assessment of global prospects, “[a] key factor slowing global growth is the generalised tightening of monetary policy, driven by the greater-than-expected overshoot of inflation targets”.

In other words, part of the slowdown can be now attributed to central bank actions which have been – and are expected to remain – more aggressive than previously thought (Figure 6). Although they shy away from such language, some central banks probably now believe a downturn or recession is almost necessary in order to address the more fundamental rise in inflation than that driven by energy prices alone.

Figure 6. Rate expectations have ramped higher in the last two months - Policy rate expectations for middle of 2023
Figure 6. Rate expectations have ramped higher in the last two months
Source: Aviva Investors, Macrobond as at 3 October 2022

Recessions are not inevitable (as they were, for example, during the pandemic). But they now look likely in several parts of the world (Figure 7). Although governments have strived to relieve the real economic distress from spiralling inflation for households and businesses through an array of fiscal assistance, that pain is still being felt and is being reflected in plunging sentiment and retrenchments in discretionary spending.

Figure 7. Deeper cyclical downturns are now likely - OECD composite leading indicators
Figure 7. Deeper cyclical downturns are now likely
Source: Aviva Investors, Macrobond as at 3 October 2022

The mood will be further affected by energy rationing over the winter months, should it be required (and worries about that even if it is not) and sharply higher borrowing costs. This will impact all businesses and households with debts, most notably mortgage borrowers on variable rates or those who have to refinance.

The huge uncertainties regarding the conflict in Ukraine, alongside prospects for inflation and interest rates are not a backdrop conducive to higher investment spending, while weaker labour markets – an inevitable consequence of slower growth – will hold back consumer spending.

Risks to growth are skewed to the downside over the next six to nine months

Risks to growth in the short term appear skewed to the downside for the reasons outlined above. In addition, the more specific and localised worries in China, including the impact of zero-COVID policies, property market strains and possibly misguided policy responses are adding to those downside risks in a nation of increasing importance in the world and still a hugely significant global exporter and importer.

It is important, however, not to get too gloomy. The next six months or so are going to be tough, but if inflation does start to fall back decisively, if fiscal policy remains sensibly supportive and – more speculatively – if some sort of resolution to the war in Ukraine becomes more plausible, then any recession could be both shallow and short-lived by historical comparison.

In particular, there are far fewer global imbalances (either private or public) which require cathartic and painful adjustments that generally take place during recessions. Both household and corporate balance sheets are in good health by historical standards.

Inflation breakout

It remains to be seen whether history will judge that the present inflationary outbreak was the result of irresponsible monetary policy errors or of the unique confluence of an extraordinary range of factors, about which central banks could have done very little.

In our view, it is likely to be a combination of the two. But the key point here is inflation was supposed to be yesterday’s problem. We’re all aware of the inflationary disasters of the 1960s, 1970s and 1980s. But harsh lessons had been learned and inflation as a severe macroeconomic problem seemed to have been beaten, partly because of a better understanding of the inflation generation process and partly because of the increased prevalence of inflation-fighting central banks.

The period which became known as ‘The Great Moderation’ (basically 1992-2007) was characterised by low and stable inflation across most of the developed world (Figure 8). G7 CPI inflation averaged just a whisker above 2 per cent during this period.

Figure 8. We thought inflation had been beaten - G7 countries: annual CPI inflation
Figure 8. We thought inflation had been beaten
Source: Aviva Investors, Macrobond as at 3 October 2022

After the global financial crisis, there was a little more volatility and some more noticeable inflation spikes, but it always fell back quickly and actually spent more time below than above the typical central bank target of 2 per cent.

Visually at least, the recent inflation experience represents a stark change to those patterns and prima facie evidence that something has gone very wrong and/or that policy mistakes have been made.

Of course, we know that there are some specific reasons for the latest spike in inflation which relate to post-COVID supply chain disruptions and the conflict in Ukraine. These can be largely bracketed as supply-side shocks which central banks have to accommodate, but their influence should pass in time.

As we have stated previously, we believe that any judgement on policy error is more likely to be applied to the long period of exceptionally loose monetary settings that existed between 2008 and 2020 than to the current episode of aggressive tightening. And that includes not just very low – even below-zero – policy rates, but also the array of unconventional policy instruments, collectively known as QE.

Higher energy prices are a key part of the inflation impulse, but not the whole story

But the latest inflation upsurge is not all about energy prices and pandemic-related global supply imbalances. There are demand factors at work too.

Figure 9 shows the inflation breakdown for the UK, but the picture is similar everywhere. And that means that central banks are right to respond forcefully to higher inflation. In many, perhaps even most, places, they now more firmly believe that they have to suppress the growth of demand to bring it into line with constrained supply to get the more fundamental underlying inflation impulse back under control. If that ushers in a period of weak – even negative – growth, then so be it.

Figure 9. Inflation has become markedly more broad-based - Contributions to UK CPI inflation
Figure 9. Inflation has become markedly more broad-based
Source: Aviva Investors, Macrobond as at 3 October 2022

The clear lessons from the past are that the alternative would be worse: by not addressing the issue now, inflation would become even more engrained in behaviours and the eventual demand and output adjustment needed to bring it back to target would be even more painful.

We believe that central bank efforts – and a reduction in those supply-side shocks – mean that inflation will fall back in 2023. But even if it does, it will be some time before policy-makers can relax and consider first a pause and then a reduction in policy rates.

Fiscal backstops

The role of fiscal policy as an active demand management tool has varied greatly over the decades. During its most influential periods, such as the New Deal of the 1930s, the post-WW2 recovery and the 1970s expansion of the social safety net (Figure 10), it has been a powerful force on growth and inflation. But for long periods it has largely been left to tackle other issues, such as redistribution.

Figure 10. Is fiscal dominance making a comeback? - UK government spending as per cent of GDP
Figure 10. Is fiscal dominance making a comeback?
Source: Aviva Investors, Macrobond as at 3 October 2022

The emergence of fiscal rules in the 1990s arguably led to a smaller demand management role, handing that responsibility to central banks. Following the huge fiscal costs of global financial crisis, governments quickly moved to austerity measures to rein in deficits.

The fiscal response to the COVID crisis appears to have emboldened governments to once again turn to fiscal policy for active demand management.

During the pandemic, it was fiscal policy which essentially did most of the heavy lifting, providing vast, immediate and open-ended assistance which, it is generally judged, prevented the onset of the second Great Depression, but added significantly to public debt burdens (Figure 11). Monetary policy was (and is) far from impotent, but the focus has changed again.

Figure 11. Public debt rose significantly during pandemic - IMF estimates for increase in public debt as a per cent of GDP (2019-21)
Figure 11. Public debt rose significantly during pandemic
Source: Aviva Investors, IMF, Macrobond as at 3 October 2022

To be fair, the tide had already been shifting: liberal Europe was already focussing on more active fiscal interventions, the UK had learned to love fiscal again and Japan was providing the clearest illustration how old guidelines on ‘safe’ levels for public deficits and debts were changing. Even the previously fiscally conservative US was embarking on huge tax-cutting and public spending programmes. Those old rules of thumb were swiftly abandoned.

The key point is that in a growing number of countries we now seem to be at a point where the marginal policy instrument of choice for providing stimulus is fiscal not monetary.

The various energy support packages across Europe are a case in point (Figure 12). Many of these numbers are comparable to the direct assistance provided during the pandemic. Gone are the days when the main ambition of fiscal policy was to exercise ‘prudence’, keep deficits contained (generally 3 per cent of GDP or less) and public debt sustainable (typically 60 per cent to 70 per cent of GDP as an arbitrary upper limit).

Figure 12. Support to help households has been extensive - (allocated funding, Sep ‘21 - Sep ‘22, % of GDP)
Figure 12. Support to help households has been extensive
Source: Aviva Investors, Bruegel, Macrobond as at 3 October 2022

The COVID experience has convinced many that expansionary fiscal policy can be actively pursued without as much need to worry too much about adverse financial market reactions. In the fairly recent past, any perception of fiscal profligacy might well have been met with scepticism, unhelpful market reactions and crowding out of private sector spending.

That said, it remains the case that the guidelines for longer-term fiscal sustainability have not been abandoned completely (see risks section). They are simply being interpreted in a rather different and arguably more enlightened manner.

But just as there were limits to monetary policy, there will be confines for fiscal policy too. The recent experience in the UK with their September ‘fiscal event’ has demonstrated the pre-eminence of fiscal initiatives today but has also highlighted that measures considered inappropriate or misguided cannot just be adopted freely.

Judgements will still be made, whether by private agents and financial markets, central banks or august bodies such as the IMF. All will have consequences.

Global fragmentation

As we have stressed in previous House Views, momentum in global integration had already been slowing noticeably in recent years after decades of continuous increases.

In the three decades from the mid-1970s, the world became steadily more closely connected and many seemed to benefit (Figure 13). Openness, free trade, specialisation, technology transfer, shared knowledge. These were all illustrations of the international attitudes to trade and development.

Figure 13. Trade openness has stopped increasing since the GFC - World exports as per cent of world GDP
Figure 13. Trade openness has stopped increasing since the GFC
Source: Aviva Investors, Macrobond estimates as at 3 October 2022

It would be naïve to suggest that there was no self-interest – of course there was. But those driving forces were contained within a globally accepted ideology that encouraged cooperation and shared goals. This coincided with the enlargement of middle classes across many nations.

But since 2008, governments, companies and people have wrestled with a global financial crisis, an existential Eurozone disaster, growing revolt against open borders, Trump’s trade war and a global pandemic and now a war on European soil. Attitudes have already changed, and they are likely to alter further in coming years.

These changes were probably underway well before 2008 – there had already been an increase in greater self-interest, in nationalism and a reaction towards wealth and income inequalities that had been getting wider for many years.

Attitudes continue to shift towards greater autonomy and self-determination

But in the wake of the global financial crisis, attitudes hardened and became much more visible. They showed themselves in many different ways including right-wing and other ‘populist’ parties across Europe and moves towards greater independence, autonomy and self-determination in many different arenas.

Brexit was another sign. The set-in-stone political system in the US prevented sudden transitions there, but even so, similar trends were visible: first the Tea Party, then more of lurch to the right, then Trump. Attitudes towards free trade have shifted, advanced technologies inspire fear as well as admiration and large elements of the middle classes feel squeezed and poorly treated.

On a broader scale, we seem to be witnessing geopolitical fractures between the West and Russia and between the US and China. These trends look as if they will frame the next 10 or 20 years.

Three months ago, we suggested that globalisation based on efficiency was yesterday’s story. Today, we seem to be evolving towards interactions based more on security. It seems inevitable that there will be moves towards home-shoring and a more just-in-case approach to inventories (rather than just-in-time).

To the extent that globalisation was a key part of the emergence of low inflation in the 1980s, 1990s and 2000s, any reversal may support a generally higher inflation impulse around the world. If supply shocks do now become as common as demand shocks, then inflation is also likely to be more volatile, meaning that investors may demand higher risk premia to compensate.

Meanwhile, politics continues to move with these times. Italy has recently elected an unashamedly far-right government (Figure 14). The main governing party has tried to re- position itself but has its roots in the fascism of Mussolini.

Figure 14. A further lurch to the right in Italy - Italian election results
Figure 14. A further lurch to the right in Italy
Source: Source: BBC, Wikipedia, Aviva Investors estimates as at 3 October 2022

The realities of social democracy in the Eurozone today mean that the new government is highly unlikely to make too many extremist demands, but their agenda will concentrate on areas which reflect their base: immigration, self-governance, increased access to the Recovery Fund. It is unlikely that the new administration will repeat the mistakes of Salvini and pick a fight with the EU. But some clashes in time look entirely plausible.

Closer to home, the shambles in UK politics is also a result of these shifting sands: a right-wing agenda and drive to supply-side reforms has precipitated a mini crisis that could yet become a maxi one.

Commodity prices, energy security and decarbonisation

Russia’s ongoing restrictions of natural gas flows to Europe have continued to support prices at levels far above those which prevailed before their invasion of Ukraine. Of course, their actions are all related to the complex dynamics of the new ‘cold war’ and will influence the parameters of the post-conflict landscape. Any such settlement does not appear an imminent development. Nevertheless, some things will never be the same again.

One certainty is that Europe – and others – will reduce their reliance on Russian energy as soon as they can. Russia is only too well aware of this and is determined to maximise the time-limited leverage that they have. As the International Energy Agency’s (IEA) Director of Energy Markets and Security recently stated, “The outlook for gas markets remains clouded, not least because of Russia’s reckless and unpredictable conduct, which has shattered its reputation as a reliable supplier.

But all the signs point to markets remaining very tight well into 2023”. More generally, commodity prices are still high by the standards of recent years, but have very clearly come off the boil in 2022 as growth prospects have been revised lower (Figure 15).

Figure 15. Commodity spike has cooled - Commodity price inflation
Figure 15. Commodity spike has cooled
Source: Aviva Investors, Macrobond as at 3 October 2022

The current experience has also injected greater uncertainty into longer-term prospects for natural gas where its use had been expected to increase as it replaced other high-emission fossil fuels.

Europe has attempted to offset at least some of the impact of reduced Russian supplies by alternative sources such as Norway, as well as boosting LNG imports significantly. At the end of September, it is estimated that EU storage facilities were almost 90 per cent full (Figure 16).

Figure 16. Gas inventories are high for now - Natural gas inventory in Europe
Figure 16. Gas inventories are high for now
Source: Gas Infrastructure Europe (GIE) as at 3 October 2022

The IEA further concluded that if Russian supplies remain frozen and, in the absence of demand reductions, EU gas storage would be less than 20 per cent full by February as long as LNG supplies continue. This would imply a significant risk of supply disruptions if the late winter is especially cold. Moreover, even if they get through this winter relatively unscathed, rebuilding inventory to safe levels in 2023 will be a major task. In other words, while medium-term dependence on Russian gas supplies declines, the impact of deliberately restricted supplies will be felt for a while yet.

The drive towards cleaner forms of energy will continue. But it may be interrupted by more pressing short-term considerations which leans on other sources, including dirtier fossil fuels and nuclear.

Different times, but some relevance of comparisons to the 1970s

The current energy shock does bear some comparison to the twin crises in the 1970s. Those events inflicted short-term pain but led to far-reaching changes to the energy industry that were in the end beneficial.

Longer-term aspirations for green energy are appealing and, we hope, realistic. But they will not inevitably be achieved. Governments are being pulled both ways – ease and speed the transition but keep prices low. They will not all do the right thing. Some may prioritise short-term relief through increased fossil fuel production or distorting subsidies, potentially exacerbating the climate crisis.

The green transition remains a laudable ambition. Recent events may both help and hinder, but care needs to be taken to ensure that macroeconomic policy adapts dynamically to present circumstances and continues to smooth the path to cleaner energy and less pollution.


Inflation problems spread

With headline inflation rates of close to 10 per cent in most of the developed world, and core inflation rates two to three times above target, it is difficult not to characterise the current experience as a disaster. And in the context of the last 30 or 40 years it is, even though, as we described in the earlier themes section, there are a number of unique factors driving inflation higher. Many – even most – of these should reduce or reverse over the coming 12 months or more, pushing inflation down again.

If that happens, then there is a chance that this inflation crisis will pass. But this needs to start happening now, or the problem could easily start getting worse in far more damaging ways. Both headline and core inflation rates moved decisively above the 2 per cent mark in the spring and summer of last year (a little later in Europe and Japan – Figure 17. Since then, of course, both have risen relentlessly and even if they are peaking now (not entirely certain), they are all far too high for comfort.

Figure 17. Core inflation high and rising - Core inflation, y/y per cent
Figure 17. Core inflation high and rising
Source: Aviva Investors, Macrobond as at 3 October 2022

The key point is that high and rising inflation has now been around for long enough to have a permanent impact. That is what central banks are worried about.

The key relationship is that between prices and wages. In the past, wage increases followed price inflation spikes much more immediately, leading to destructive wage-price spirals. High inflation became expected and built into wage bargaining processes.

Today that link is more tenuous because of the reduced power of collective labour, but more fundamentally because the hard-won inflation successes since the 1980s became reflected in inflationary expectations which, with minor exceptions, became anchored at or very close to official inflation targets.

The longer that high inflation continues – whatever the root cause or causes – the greater the risk of those anchors being lost. For now, most measures of expectations are cashing in on the credibility that had previously been established and are remaining contained. But unless actual inflation measures do now start to fall back, that faith will fade.

Some small cracks are already appearing in the form of expectations edging higher. But they are nothing like as high as actual inflation rates today (Figure 18). If those widen again and form the basis of successful higher wage demands and other second round effects, then the inflation problem will broaden, deepen and endure.

Figure 18. Inflation expectations are still reasonably contained - Euro zone: core inflation and inflation expectations
Figure 18. Inflation expectations are still reasonably contained
Source: Aviva Investors, Macrobond as at 3 October 2022

Global hard landing

There is no official textbook definition of an economic ‘hard landing’, but most believe that they would recognise one. It may be easier to characterise the ‘soft landing’ alternative, which is generally considered to be the successful transition from a bubbly, potentially overheating economy to a slower but more sustainable pace via a nudge or two on the policy brakes.

The less palatable alternative is of a more jarring adjustment, requiring painfully tighter policy settings and bringing about big drops in sentiment and retrenchments in activity. Sometimes these are necessary; sometimes they can happen by accident. Moreover, there are both supply-side and demand-side elements to this fine-tuning. Finally, they can be driven by changes in either fiscal and monetary policies, which are often motivated by very different considerations and can pull in different directions.

In the last three months, the risks of a hard landing have risen again, and you can persuasively argue that some elements have already materialised: it is clear that parts of the world (Europe, primarily) are already experiencing a difficult adjustment to the energy price and supply shock, while others (China et al) are still coping with disruption related to COVID policy (Figure 19).

Figure 19. Global growth has already slowed sharply - Estimates of global GDP growth
Figure 19. Global growth has already slowed sharply
Source: Aviva Investors, Macrobond as at 3 October 2022

The dynamic which has added to the hard landing risk more forcefully since the summer, has been the increasingly more hawkish stance adopted by global central banks in the face of persistent and broad-based inflation.

This evolution, magnified by market expectations, has increased the chances of a hard landing being brought about by the ‘tough love’ of dealing with the inflation problem now, rather than run the risk of an even worse problem further down the line. In other words, as central banks attempt to suppress demand growth, they increase the chances of the downturn gathering its own momentum. Any intensification of supply shocks (for example, a harsh winter and additional Russian supply restrictions) over this period would add to this risk.

Three months ago, we talked down the idea that parts of the world almost “needed” a downturn in order to deal with inflation. Today, that element of inflation risk is higher and so too, therefore, is the possibility of a harder landing. The Bank of England was already projecting marked increases in unemployment (Figure 20). The Fed has recently moved more in this direction.

Figure 20. The Fed and Bank of England project higher unemployment - Central bank projection for unemployment rate
Figure 20. The Fed and Bank of England project higher unemployment
Source: Aviva Investors, Macrobond as at 3 October 2022

It is still true that the world economy does not have anything like scale of vulnerability from over-leveraged private balance sheets and under- capitalised banks which have characterised previous recessions, and that means that any downswing could, in theory, be short-lived. But that is far from certain.

Fiscal sustainability

Fiscal policy was already moving towards the ascendency before the pandemic, but the COVID experience really accelerated that journey. In response to that crisis, it had to be vast, immediate and open-ended. And by and large, it was.

Greater acceptance of fiscal policy does not mean the rules of sustainability have been rewritten

As countries now struggle with the impact of the energy price shock and the cost-of-living crisis, fiscal initiatives to provide support and protection are once again front and centre. These are undoubtedly merited, but the reaction to them reveals very different attitudes to issues of fiscal sustainability than those which prevailed for decades.

There is now a more widespread acceptance that changes to tax and spending aggregates, often on a massive scale, are the appropriate policy response to challenging circumstances, such as those which exist today. However, there is still a danger that the high regard in which fast and flexible fiscal programmes are held now obscures some of the realities of their longer-term consequences.

Bluntly, the rules of fiscal sustainability have not been rewritten. The algebra of prudence is reasonably straightforward even if it does involve several variables. But perhaps the key relationship is between the real rate of interest which governments pay on their debt and the growth rate of the economy.

During COVID, and in its aftermath, the former fell well below the latter which helped generate ample room for fiscal latitude. Since then, high inflation has also helped the arithmetic. But growth is now slowing, inflation may have peaked and should fall significantly next year and beyond whilst interest rates are rising quite rapidly.

Public sector debt is now more than 100 per cent of GDP in most G7 nations (Figure 21). It would not take a lot for the fiscal maths to put countries on an unsustainable path. Japan may provide some visual comfort, but can other nations expect to keep borrowing rates close to zero?

Figure 21. Public debts now worryingly high in most places - Central government debt as a per cent of GDP in the G7
Figure 21. Public debts now worryingly high in most places
Source: Aviva Investors, Bloomberg, Macrobond, IMF as at 3 October 2022

Unsurprisingly, the IMF recently acknowledged that while fiscal support in the face of the energy shock was warranted, it “should be temporary, concentrated on the most vulnerable, preserve incentives to reduce energy consumption and be withdrawn as energy price pressures wane”.

China rebound

China’s economy is at a weak point as Xi’s second term draws to a close, with policy errors destroying the promises of ‘stability’ and the 5.5 per cent growth target missed for the second time in three years. While our base case is that the damage is difficult to reverse, there are several ‘known unknowns’ that also point to potential upside risks.

Zero-COVID policies continue to hurt growth in China

The first and arguably most important is Zero-COVID Policy (ZCP) which has been modified but is still exerting a severe negative influence through 2022, as lockdowns move from city to city and sharply curtail activity. After admitting in May that the economic situation was “worse than in 2020”, Premier Li Keqiang rolled out policies that were touted as “more forceful” than two years ago – but the dampened confidence caused by lockdowns means many transmission mechanisms are broken.

If China exits ZCP, even in a bumpy fashion with some health issues and reversals, it could unleash some pent-up demand and vastly improve confidence, though the rebound will not be as big as after Western economies reopened from extremely depressed levels.

Another huge benefit of reopening will be tourism, both for China’s domestic hospitality sector (Figure 22), but also the rest of the world, which will again have millions of visitors spending money at restaurants and hotels, losing money at casinos, and buying various entertainment services.

Figure 22. Tourism is still being hit hard - Tourism data
Figure 22. Tourism is still being hit hard
Source: Aviva Investors, Macrobond as at 3 October 2022

A second possible upside is that the effort to stabilise the property sector works better than in other real estate busts, in the UK and US for example, where 20-30 per cent declines in house price indices and collapses in housing starts were followed by L-shaped recoveries that took 5-6 years to regain an upward trajectory. China is helped thus far by GDP that is still growing, prices that haven’t collapsed, a smaller supply overhang, and well-capitalised banks that have avoided a crisis despite widespread developer distress.

Finally, the political cycle is perhaps underestimated, but has probably acted as a constraint on SOEs and local governments, which are afraid of mistakes and corruption probes ahead of possibilities for career advancement. Following October’s Party Conference and the March 2023 implementation at the National People’s Congress, more aggressive investment projects may be deployed, and if this happens (a big if) the private sector may also see a more pro-business stance by the ruling party, after years of harsh new rules and insecurity.

Read more of the House View

Executive Summary

A summary of our outlook for economies and markets.

Macro forecasts: charts and commentary

Our round-up of major economies; featuring charts and commentary.

Global market outlook and asset allocation

What our House View means for asset allocation and portfolio construction.

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