The key themes and risks our House View team expect to drive financial markets.
Shallow recessions expected
Global growth projections for 2023 are still being revised lower (Figure 1), but the pace of revisions might be slowing, suggesting that analysts believe we are getting close to “peak pessimism”.
Figure 1. Gloomy growth forecasts for 2023 - Bloomberg consensus for GDP growth in 2023
As importantly, differences are appearing across regions and countries. The implication is that we may be evolving from an environment in which every nation is feeling the impact of the same shock in a similar manner, to one where outlooks diverge.
Three generic areas of such differences spring to mind. First, the energy shock is being felt disproportionately by Europe, where it alone has been sufficient to usher in strong (supply-side) recessionary downdraughts. The US has not been unaffected, but the impact has been far smaller (Figure 2). Moreover, momentum in the US economy has been significantly stronger, implying that demand is having more of an effect on the inflation impulse.
Figure 2. Natural gas prices, September 2022 - (March 2021 = 100)
Secondly, downgrades for emerging and developing economies have been lower than for the major developed nations. One explanation is that many such countries hiked rates sooner and more aggressively, meaning the policy-induced element of downturn may be more complete. Outside of Europe, emerging markets are also not being as impacted by the energy shock. And finally, China continues to be affected greatly by COVID cases and resulting lockdowns.
But even with these differences, the global outlook overall is still pretty poor. World GDP growth may struggle to reach 2.5 per cent in 2023, close to the pace at which a global recession is declared. Outright declines in world GDP are very rare. Many regions and countries will experience recession over the coming year and even if some manage to avoid it, the threat will hang heavy throughout 2023 and quite possibly beyond.
There is less need for cathartic periods of adjustment and correction currently
We have stressed previously that, unlike many previous recessions, there is less need for cathartic periods of adjustment and correction currently: private sector balance sheets (household and corporate) are generally in good shape and banking systems are well-capitalised and functioning properly.
In theory, therefore, downturns and/or recessions can be shallow by historical standards. That’s about as far as the good news goes. Global central banks all believe that weaker or negative growth is a price worth paying to get inflation back under control.
More immediately, the pain of what has been termed in many places a “cost-of-living” crisis, is very real for many and there will be more difficult times to come.
The squeeze on (real) household incomes over the next year or two is unprecedented in the post-war period. Figure 3 shows the history of real household income growth in the UK along with the latest projections. It is this, rather than the behaviour of any fiscal aggregate, that shows what real austerity looks like. And the pattern will be very similar elsewhere across Europe.
Figure 3. UK real disposable income, y/y
Inflation persistence and uncertainty
Ultimately, inflation is still always about supply and demand. The inflation outcomes of 2020-2022 represent a stark contrast to the experience of the previous 20 or 30 years (Figure 4).
Figure 4. Inflation is back - Consumer price inflation in major nations
Visually at least, this picture offers compelling evidence that something has gone badly wrong. Surely the spike in inflation rates to 10 per cent or more is clear evidence of policy failure? The truth is more complicated, although it has to be conceded that, with the benefit of hindsight, some of the actions – or inactions – of central banks have probably contributed to the problem.
In fact, there has been a unique confluence of factors – supply and demand – that have contributed to higher inflation. Each one in isolation might have resulted in a temporary inflation spike not dissimilar to those seen in 2008 or 2012. But taken together (or in very quick succession), they have combined to push inflation up to the very high rates which prevail today.
Historical context is important here too. The tides of globalisation, including the emergence of China as a world heavyweight, released powerful deflationary forces around the world, pushing down the prices of tradeable goods. The assumed success of central banks in bringing inflation to target helped anchor inflationary expectations and created a virtuous circle for prices and wages.
In the wake of the GFC, central banks were able to cash in on this credibility by loosening monetary policy dramatically and it seemed, without inflationary consequence. This resulted in some complacency about inflation being “yesterday’s problem”. Ironically, loose policy settings probably started to get more meaningful traction just as other factors also started adding to the inflation impulse.
With globalisation now slowing or reversing, the world has also been hit by two massive supply shocks. First COVID, then the energy shock. Many global trade flows simply stopped, and a range of frictions, disruptions and shortages meant that restarting them has been a lengthy process which is not yet complete. Higher energy prices have contributed directly to rising inflation (Figure 5). They have also boosted food prices because much of food production is energy intensive.
Figure 5. Energy a key driver of high inflation - Euro zone: contributions to HICP inflation
As and when these prices stabilise or fall back, overall inflation rates should fall. However, inflation has also become much more broad-based (Figure 6), pointing to some other underlying drivers.
Figure 6. Inflation is much more broad-based now - Proportion of CPI basket with inflation rate above 6%
In simple terms supply constraint was being felt, while demand was being sustained or boosted directly by COVID support and energy packages. It should be no surprise that price pressures emerged. Rather late in the piece, central banks have realised that underlying inflation can only be tamed by deliberately suppressing demand.
More fundamentally, the inflation regime that eventually emerges may be different from the one we have got used to over the last 20 or 30 years. Inflation is set to be both higher and more persistent.
Underlying the supply and demand issues which we have already highlighted, there are a number of deep-rooted structural trends which will push inflation higher and, perhaps, make it more volatile. We have mentioned de-globalisation. Two others are demographics and climate change.
Shrinking workforces and efforts to de-carbonise are both likely to add to inflation. The bottom line is that while inflation should drop back significantly, where it eventually settles is less certain. In statistical terms, the mean of its future distribution may well be higher than we had got used to. But also, the range of outcomes is likely to be greater than in the past and skewed more to the right-hand tail of the probability distribution (higher inflation outcomes).
The relative importance of fiscal and monetary policy has ebbed and flowed in the post-war period, with each enjoying a position of comparative dominance for extended periods at certain times or in certain places.
In general terms more activist fiscal policies have been associated more with left-leaning political parties (notably in parts of Europe), while monetary policy was linked with more closely with right of centre parties, most of which favoured greater adherence to free market principles (the US is probably the best example).
In the 1980s, 1990s and 2000s, monetary policy was more prominent, but after the global financial crisis, the dial moved back to fiscal, with initiatives related more to rescue packages (banking systems) and political imperatives (Eurozone sovereign crisis). But only a few years later, even the fiscally conservative US was embarking on ambitious stimulus programmes.
In the wake of the COVID pandemic and in response to the present energy shock, most nations have leaned more heavily on fiscal programmes to sustain demand (Figure 7). In short, fiscal seems back in fashion.
Figure 7. Huge energy support packages - Cost of energy-related fiscal support, per cent GDP
However, this does not mean that expansionary fiscal initiatives can be pursued indiscriminately. As the risks section (see below) makes clear, the rules of fiscal sustainability have not been abandoned. In recent years public sector budgets have been helped by robust growth, high inflation and low (government borrowing) rates. All of those are now moving in less helpful directions.
Looking ahead, it seems very unlikely that the fiscal stance will transition to anything remotely resembling “Austerity 2.0”, especially across Europe where the pain of the 2010-14 period is still fresh in the memory. In the US, political stalemate in the two-year period after the mid-terms means it is unlikely that any fiscal measures of significance will be adopted.
One issue which now feels much more relevant is the greater possibility of crowding out of private spending. Public borrowing has to compete for the finite pool of savings resource that is available. If government borrowing is “excessive”, then real interest rates will move higher, choking off private investment.
The calamitous (though thankfully short-lived) fiscal experiment in the UK under Prime Minister Truss and Chancellor Kwarteng served as a timely reminder that financial markets can still act as de facto fiscal police if governments go too far or too fast.
The OECD recently stated that fiscal support will still be needed in response to the energy crisis, but also argued that such measures will need to be less extensive and more targeted. It is difficult to make cross-country comparisons as the fiscal aggregates still reflect a lot of pandemic measures, many of which will run off automatically.
In terms of headline numbers, the forecasts project moderate fiscal consolidation in both 2023 and 2024 for the OECD overall, with underlying primary budget balances improving by around 0.4 per cent of GDP next year and 0.6 per cent the year after (Figure 8). These are modest by historical standards and reflect a delicate balancing act. Governments will not want fiscal policy to pull in the opposite direction from the monetary stance if that results in central banks having to tighten more aggressively.
Figure 8. Fiscal consolidation to be moderate and uneven - Change in primary budget balance, per cent GDP
At a more micro level, they will (or should) also wish to ensure that energy support measures do not weaken incentives to reduce energy consumption or prevent reallocation to less energy-intensive activities.
The IMF was set up at the Bretton Woods conference in the 1940s to end the beggar-my- neighbour policies of the 1930s, to encourage greater openness and to prevent countries exporting deflation. In the immediate post-war period progress was slow, but incrementally the world became more open.
The transformation accelerated from the 1970s and the next three decades are rightly characterised as the golden age of globalisation.
But as we have noted before, that period now seems to be coming to an end. The last 10 or 15 years have seen attitudes change in many fields including trade and politics. As Figure 9 shows, there have been a number of global trade regimes over the last 200 years and it seems as if we have entered a new one since the global financial crisis.
Figure 9. Have we entered a new global trade era - World exports as per cent of world GDP
It is unlikely that we will return to the damaging era of protectionism of the 1920s and 1930s, but the risk of a less cooperative global environment is probably greater now than it has been for several decades. It is to be hoped that what will actually evolve is a “redefinition” of globalisation based more on security than cost-cutting efficiencies.
The overriding message from the annual Washington meetings hosted by the IMF in October was that we now live in a more fractured, less open world. There were some testy exchanges between nations, and not just those involving Russia or China. The Americans were unhappy at Saudi Arabia’s oil production cuts. India expressed concerns about the global ramifications of aggressive US interest rate hikes and Britain was heavily criticised after the disastrous mini-budget.
The managing director of the IMF, Kristalina Georgieva, expressed concerns over de-globalisation trends: “Fragmentation in the world economy means that we might see shifts in supply chains that impact on cost structures on a more permanent basis."
Geopolitical tensions are just one example of a more fragmented world
She also suggested that we are moving from a world of relative predictability and stability to one with greater uncertainty and volatility. The present tensions between Russia and the West and between the US and China are the most important, but they also belong to the broader category of geopolitical and social frictions of recent years such as the Brexit vote, right-wing populism in Europe and the election of Donald Trump. In some ways, the pandemic and energy price shock have brought such issues more out into the open.
The Russian invasion of Ukraine is obviously an extreme example of this theme and it will have permanently damaged Russia’s place in any new world order.
But there are many other geo-political tensions around the world, and these generate risks for global trade and international capital flows and threaten to erode the pillars of multilateral cooperation frameworks that were built up in earlier decades.
Sanctions on Russia have been effective and are unlikely to be reversed or even relaxed any time soon.
Meanwhile the Biden administration’s sweeping restrictions on China using US-produced semiconductor chips is an overt attempt to slow Beijing’s technological and, presumably, military advances (Figure 10). The latest measures represent an extension to earlier initiatives that halted shipments of equipment to Chinese factories. But their severity and bluntness are a reflection of how poor Sino-US relations have become. This is unlikely to be the last such episode.
Figure 10. China rising - Semiconductor sales, global market share, per cent
There may well be a further ratcheting up such measures in the future, with China likely to retaliate with its own partisan actions. It is impossible to predict the exact nature of these skirmishes, but it is not entirely inaccurate to describe them as a new “cold war”. This time around, stand-offs will relate to commerce more than weapons, but the two are not unrelated, especially when it comes to technology.
Energy security, commodities and decarbonisation
The conflict in Ukraine has reminded everyone that national security should not be taken for granted. Moreover, the devastating impact on energy prices that has resulted has refocused attention on other issues, including energy security and the transition to cleaner and renewable sources of energy.
Russia's invasion of Ukraine is changing attitudes towards energy
Even if the war were to end soon or come to some form of resolution – neither of which looks imminent – it has permanently changed the geo-political, energy and, more debatably, economic landscape in Europe and elsewhere.
Fears that Russian restrictions on natural gas supplies would lead to shortages and rationing over the winter have receded, helped by the astonishingly rapid substitution into coal and oil, an equally swift build-up of energy inventories and, at least at the time of writing, mild weather.
Absent an unusually large and enduring cold snap (which can’t be ruled out), the consensus view is that Europe has sufficient energy stocks to get through winter without major problems. However, rebuilding stocks to a similar “safe” level before the 2023/24 winter will be more difficult.
Long term, as the IMF points out, the geopolitical realignment of energy supplies in the wake of the invasion is broad and permanent. Europe and others will reduce or eliminate their dependence on Russian energy supplies. But that transition will take longer than a year. In the meantime, further disruptions and energy price spikes should not be ruled out.
Wholesale natural gas prices are still very elevated by the standards of the last ten years, but they are well below the recent spikes when it looked as if shortages could be sizeable (Figure 11). It is also noteworthy that commodity prices more generally, which had recovered significantly after the COVID episode and then spiked higher after the invasion, have also fallen back meaningfully (Figure 12).
Figure 11. Natural gas prices off highs - European natural gas price (one month forward)
Figure 12. Commodity prices have fallen back - World commodity indices
Looking further ahead, the OECD highlights how the Ukraine has changed things: “Governments will need to ensure that the goals of energy security and climate change mitigation are aligned. Efforts to safeguard near-term energy security and affordability through fiscal support, supply diversification and lower energy consumption should be accompanied by stronger policy measures to enhance investment in clean technologies and energy efficiency."
In the short term, some tensions have emerged between energy independence and the green transition – some European nations are burning more coal to make up for reduced imports of oil and gas, while some nations in Asia are also using more coal because LNG supplies have been diverted to Europe.
In any event, the best response to the crisis must surely be to speed up the transition to net zero carbon emissions. In time this should reduce costs, improve energy security and enhance prospects of meeting climate objectives.
More generally, if these issues are to be addressed properly, ongoing global cooperation and coordination will be needed. COP26 and COP27 have seen some progress, but it is still far too slow. If our global fragmentation theme is correct, this may become progressively more difficult and expensive.
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.
The energy shock may lead to beneficial change over the longer run
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.
Changing market structures
In most recessions, fragilities that were previously overlooked are often exposed as unstable, and depending on feedback loops and spillovers, can lead to damaging market implosions, or even more severe depressions.
As asset values decrease in market downturns, illiquidity and difficulties funding leveraged structures, problems rolling over debt, and margin calls requiring forced selling, are all to be expected. Fraud and what economist JK Galbraith termed “bezzle” (phony wealth bordering on the criminal) flourish during periods of plentiful liquidity and risk appetite, and the assumed asset values are vaporised when liquidity is withdrawn.
This should be expected to be a theme in coming quarters, just as Enron, Madoff and subprime CDOs were exposed in previous cycles. We don’t list this as a risk factor but a theme because the serial defaults and insolvencies of Chinese real estate developers, the British LDI conflagration and the FTX bankruptcy already show that such fears are not a possibility, but a reality. There will almost certainly be more to come.
The fiscal sustainability and global hard landing risks would of course intensify and reinforce this theme. After 12 years of ultra-accommodative monetary policy (Figure 13) and generally suppressed volatility, the sudden shift to aggressively tight central bank stances and a global slowdown are certainly sufficient.
Figure 13. Monetary policy has been exceptionally loose - GDP-weighted G7 policy interest rate
An important change, which we discuss in the Markets Outlook and elsewhere, is that cash is no longer a drag on portfolios: negative yields are a thing of the past (outside of Japan), and thus TARA – “there are real alternatives” to risky assets – is the appropriate viewpoint.
The positive correlation of government bonds and equity markets is another significant change in market structure, making balanced funds and risk-parity approaches more challenging, and, we argue, supporting higher risk premia across all asset classes.
Moritz Schularick and Alan M. Taylor’s analysis of “Monetary Policy, Leverage Cycles, and Financial Crises” shows that credit booms typically precede financial crises, and that whether or not a recession is accompanied by such a disaster is predictive to a large degree of whether the subsequent recovery is quick and “V-shaped”, or prolonged and “L-shaped”, with permanent damage (hysteresis or scarring). COVID unleashed a huge wave of essential fiscal and monetary support, but as Figure 14 shows, it was short-lived compared to previous booms.
Figure 14. Recent credit “bubble” was short-lived - US credit to private sector as per cent of GDP (relative to trend)
The hope that the coming recessions and slowdowns will be “mild” rests in large part on market structure adjusting to a new and harsher reality without too much disruption. As we have highlighted elsewhere, there is much less need for retrenchment and private sector deleveraging, implying there is justified hope in the present episode being painful, but comparatively brief and shallow.
Inflation becomes more entrenched
Even if headline inflation has peaked or is peaking, high inflation rates have now been around for long enough to cause more lasting damage.
As we have shown elsewhere, although higher energy prices are a major reason for elevated inflation (directly and indirectly), other components are now contributing too (Figure 6 & Figure 15). The Fed, the ECB and the Bank of England all – to varying degrees – now state explicitly that the aggressive policy tightening they are all delivering is required to slow demand growth deliberately by pushing the policy stance into restrictive territory.
Figure 15. Core inflation has risen everywhere - Core inflation, y/y per cent
All believe that the cost now, in terms of reduced output and demand, is a necessary evil. The alternative would in the longer run be worse: allowing inflation to continue unchecked would require an even more severe tightening and an even greater loss of output in the future. Time will tell if they have acted early and boldly enough. But it might be too late already: there is a risk that the inflation genie is already out of its bottle.
The key relationship is that between wages and prices. The inflationary disasters of the 1970s and 80s had several things in common. But one was critical – increases in consumer prices inflation were accommodated and followed by commensurate increases in wages. This process meant that wage-price spirals developed and that inflation became deeply embedded and self-reinforcing.
One of the most encouraging aspects of the current episode is that longer-term inflation expectations have not taken off. They are nothing like as high as present realised rates of inflation, indicating that there is still a belief that current inflation rates are not normal and that they will decline again.
Central banks must take advantage of this hard- won credibility to help prevent those dangerous second round effects. The risk is that they fail: underlying wage growth of 5 per cent or 6 per cent in the US and UK, for example, is already too high to be consistent with inflation targets (Figure 16).
Figure 16. COVID distortions, but wage growth too high - Wage growth in the US and UK, 3m mavg
As we described in the themes section, fiscal policy has moved back into the limelight in the last 15 years or so, both for explicit and targeted support and for more refined demand management. The era of exceptionally low interest rates added importantly to the attraction of using fiscal policy and also contributed significantly to a reassessment of what constitutes a prudent and sensible limit for Government debts and deficits.
As macroeconomic circumstances change (higher rates, lower inflation, weaker growth), those judgements are likely to be revisited.
More fundamentally, and another point that we have made regularly, the rules of fiscal sustainability have not been re-written. There is still a well-known and well- understood relationship between key variables which determines whether public finance plans in any country are sustainable or not in the long run.
And, as the debacle in the UK recently showed, if governments present irresponsible fiscal intentions, the reaction from financial markets can be violent (Figure 17). There is no doubt that the sharp moves in gilt yields and the currency led quickly to the abandonment of the UK’s plans for unfunded tax cuts.
Figure 17. Violent market reactions to UK mini-budget - UK gilt yield and the currency in 2022
So, while attitudes towards expansionary fiscal policy have arguably become more enlightened after GFC, the pandemic and the energy crisis, there are still limits.
Both the OECD and the IMF have recently begun to steer their commentary and guidance back towards notions of fiscal prudence. The latest OECD Economic Outlook stated that “credible fiscal frameworks would help to provide clear guidance about the medium-term trajectory of the public finances and mitigate concerns about debt sustainability at a time of rising spending pressures and higher future payments on public debt".
The IMF has pointed out, rightly, that fiscal vulnerabilities may be greater for some nations: the war in Ukraine has helped to precipitate a surge in sovereign spreads for some emerging and developing markets.
Higher rates in developed economies are likely to add pressure to borrowing costs for many. Some are well-placed to deal with this, but others, including those hardest hit by energy and food price shocks, will be less able.
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, sharp contractions can be driven by changes in either fiscal or 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 arguably some elements have already materialised: it is clear that parts of the world (Europe, primarily) are 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 18).
Figure 18. Global growth continues to slow sharply - Estimates of global GDP growth
The dynamic which has added to the hard landing risk more forcefully this year has been the aggressive rate hikes by the major central banks. This evolution, magnified by market expectations, has increased the chances of a sharper recession being brought about as a result 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. The higher the risk that inflation is a more fundamental problem, the greater the possibility of a harder landing.
It is still true that the world economy does not have anything like the scale of vulnerability from over-leveraged private balance sheets and under-capitalised banks which have characterised previous recessions and that means that any downswing can be short-lived. But that is far from certain.