A summary of our outlook for economies and markets.
Recession: a price worth paying?
The persistence of upside inflation surprises in 2022 has created a dynamic that has not been seen for decades. The combination of strong demand and weak supply has pushed headline inflation rates close to, or into, double digits across most of the world.
The precise mix of demand or supply factors does differ by region. Europe has been most heavily impacted by the supply shock to energy markets that has resulted from the war in Ukraine. Whereas in the United States, the demand pressures have been a more important factor, with household consumption continuing to be supported by robust household balance sheets and rising wage growth.
Central banks need restrictive policy
But whatever the underlying cause, the increase in inflation everywhere has led central banks to rapidly shift their policy stance into restrictive territory, abandoning the post- global financial crisis approach of gradually removing policy accommodation as economies recover.
The focus has shifted almost exclusively to bringing inflation down to target, to avoid a sustained period of realised high inflation, with the objective of preventing a rise in longer-term inflation expectations amongst households and businesses. For central banks, credibility that has been hard-won over a long period is at risk of being lost quickly.
The more singular focus of monetary policy on inflation is reflected in the expected worsening of trade-off between growth and inflation. Figure 1 shows the change in consensus expectations for both developed (DM) and emerging (EM) market calendar year growth and inflation since the start of this year. Growth projections, which were already expected to be on a slowing trend, have been revised down across both years and many regions.
Figure 1. An expected worsening in the growth and inflation trade-off - Change in consensus growth and inflation forecasts since the start of 2022
Meanwhile, inflation projections have been revised higher, reflecting both the surprises already seen this year, and the expected persistence of those shocks. This sets the global economy up for an extremely challenging period. Central banks are expected to tighten policy sufficiently to deliver positive real interest rates over the next few years.
The extent to which households and businesses are able to manage materially higher real rates is difficult to assess. Central banks need to see enough of a slowdown in demand to ease underlying inflationary pressures. Too much tightening could push economies into recession, while too little could result in a more persistent inflation problem.
At this stage we think the risk management decision for central banks will be more likely to result in the first of those two outcomes. As such, we expect growth in developed markets to be weak in 2023, with most experiencing some form of mild recession, characterised by little growth and rising unemployment. Growth in the emerging market economies is expected to be a little firmer, reflecting an improving situation in China.
Overall, we expect global growth to slow to around 3 per cent in 2022 and 2.25 per cent in 2023 (Figure 2).
Figure 2. Global growth projections - Recession the most likely outcome
The depth of recession is expected to be shallow, reflecting the relative strength of private sector balance sheets. Unlike deep recessions of the past, we do not expect a sustained period of deleveraging to act as a serious continuing headwind to growth. However, the potential for further negative supply shocks, particularly from global energy markets tilts the balance of risks to our central view to the downside.
Fiscal policy is once again providing extraordinary support
In response to the extraordinary increase in natural gas prices in Europe, governments across the region have taken significant fiscal actions. Many have moved to cap the increase in energy and electricity prices faced by consumers, absorbing that cost onto the government balance sheet. At current gas futures prices, the intervention might be worth upwards of 5-7 per cent of GDP. If that were to be the cost, it would exceed the direct support households and businesses in Europe received during COVID.
While the financial support is understandable given the magnitude and cause of the shock, the fact that most governments have chosen not to be more targeted creates yet another challenge for central banks. In the first instance the price caps will reduce headline inflation compared to what it otherwise would have been, but over the medium-term they are likely to sustain demand and result in greater underlying inflationary pressures.
Our central projection sees inflation ease back over 2023, but risks remain to the upside (Figure 3). Moreover, policies such as those recently announced by the government in the United Kingdom to introduce unfunded tax cuts, also come at an inopportune time.
Figure 3. CPI inflation projections - Decline expected through 2023
For the first time in recent memory, the fiscal accelerator is being used, while the monetary brake is applied at the same time. If handled poorly, this risks the type of systemic stress seen in the UK gilt market in late September, when the Bank of England was forced to intervene to stabilise the situation.
We think the policy mix of greater use of fiscal and more active monetary policy will be far more common over the coming years than it was in the decade between the global financial crisis and COVID.
That changing policy dynamic also comes at a time when three critical structural factors – deglobalisation, decarbonisation and demographics – are becoming more important drivers of the global economy. We think that the combination of these factors is likely to presage a period of increased economic and policy uncertainty, with greater variability and higher average level of interest rates.
Asset markets will need to adjust to the new policy mix
For asset markets that had become used to cheap money and unlimited liquidity, a period of adjustment will be necessary. That adjustment has begun, but we think will take some time to fully play out. That is not to say that there won’t be investment opportunities created. Indeed, the increase in market volatility and shifting correlations can create more opportunities.
We have a preference to be modestly underweight duration, with upside inflation risks outweighing the downside recession risks (Figure 4). However, the tipping point between those two may well be coming closer.
Figure 4. Asset allocation summary
We prefer to be broadly neutral in equities, with the rise in real yields putting further pressure on multiples, while at the same time expecting to see downward revisions to earnings expectations in coming quarters. We have a mild preference for the UK over Europe given the relative exposure to energy and resources.
We prefer to be neutral in credit, where we think pricing of high yield spreads is roughly fair in terms of recession risk, but with risks of further widening from here. On investment grade, the all-in yield on short-dated paper does make it relatively attractive.
Finally, we prefer to be long the US dollar against a range of currencies, reflecting the weakening global growth environment and the strength of underlying inflation in the United States.