The key themes and risks our House View team expect to drive financial markets.
Growth projections are being revised lower everywhere (Figure 1). The combination of much higher inflation, war in Ukraine, ongoing energy (and other commodity) price shock and tighter monetary policy is not a growth-friendly one.
Recession risk is elevated, although such an outcome is not yet our central scenario. Moreover, the nature of the risk is subtly different in different geographies as the comparative influence of the drivers listed above varies.
Recession risks are elevated, but vary in nature
There have been supply-side and demand-side drivers in all places, but the balance is different.
In broad summary, the additional supply-side shock from the Russian invasion has been felt most in Europe, where energy dependence and trade linkages are greater. The US, by way of contrast, has experienced a greater weight of demand-led inflation, and as a result probably needs more of a slowdown to bring it down again. Policy prescriptions also vary from country to country, although almost all nations are set to tighten monetary policy over the next year.
Figure 1. Growth is being revised lower again
GDP growth projections for 2023
In its June World Economic Outlook, the OECD downgraded its growth forecasts substantially.
World GDP is now expected to increase by 3 per cent this year (previously 4.75 per cent) and 2.75 per cent in 2023 (previously 3.25 per cent). Some of the growth numbers for next year now look notably weak: euro zone 1.6 per cent, US 1.2 per cent and UK 0.0 per cent.
Our own growth projections are similar, with outright stagnation risk greatest in the UK and parts of Europe. High inflation is eroding real incomes for households, lowering consumption, elevated uncertainty is hurting investment, while global supply chains continue to be disrupted by post-COVID adjustments, war in Ukraine and China’s ill-advised approach to the pandemic.
Sentiment measures, especially among households, are very depressed
All are acting as hindrances to growth. Whenever growth slows or is deliberately slowed, there are always risks that the slowdown intensifies and becomes self-perpetuating. This is perhaps especially true in a world where information and opinion are shared so quickly and comprehensively.
Consumer confidence readings around the world are touching new lows (Figure 2). The recession “meme” is circulating widely: Google Trends indicates that the term is today being used in searches just as much as it was at the peak of the COVID downturn and during the Global Financial Crisis.
Figure 2. Households are gloomier than during COVID
OECD consumer confidence, standardised measure
But whether recession is evaded or not is hardly the point. Even if it is, the next year or so is going to feel pretty downbeat. Slowing growth is always a worry and concerns over runaway inflation, higher interest rates and war in Ukraine mean risks are biased to the downside.
Having said that, there are also good reasons not to overdo the gloom.
Unlike previous deep recessions, there are far fewer imbalances today that require painful adjustments, with both household and corporate balance sheets (in aggregate) in very good health by historical standards. The impact of the various supply-side shocks will eventually fade, and inflation should fall back as they do.
Whether recession is avoided or not, the next year or so will feel tough going
There is greater risk of overheating in the US, which will require tighter policy for longer, while the unique set of circumstances in China imply that growth there will also be constrained.
Overall, the coming 12 to 18 months look likely to be a period of modest growth, and we continue to believe that a globally coordinated recession will be avoided.
Although it is still a relatively recent phenomenon, high and rising inflation has now been with us for long enough for it to be described as a breakout.
There are several well-known reasons for why inflation (almost everywhere) has become detached from the anchors which, with some minor exceptions, had prevailed for much of the last 30 years. And it remains true that many of these – perhaps even most – could unwind over the next year or two, resulting in inflation falling back to “acceptable” levels.
High inflation cannot all be attributed to special factors; loose monetary policy has also contributed
However, the recent experience cannot all be put down to one-offs. When economic history eventually documents this period, it is very likely that it will describe central bank actions (or rather, inactions) in the post-GFC period as inadequate or complacent.
While there is considerable debate about the future risk of overzealous monetary tightening resulting in a policy mistake, the more pertinent judgement is probably that it was the earlier policy mistake of not withdrawing extreme policy stimulus more quickly that is the one which will result in any lasting scarring.
Yes, energy and other commodity prices, as well as the post-COVID disruptions have driven inflation higher. But it is still the case that the latest “core” rates of inflation are well above the averages that have prevailed for the previous 20 years (Figure 3).
Figure 3. Core CPI inflation is well above historical averages
Core CPI inflation: latest vs history
If energy prices stabilise and if global supply chain disruptions ease, as we expect, then price pressures which have resulted from those earlier trends will fall or even reverse, driving inflation back down again, although this will primarily be a story for 2023.
Futures markets don’t always get it right, but if they do prove accurate, the oil price will fall below $90 a barrel by the end of next year.
On historical patterns, energy prices would then be detracting from overall inflation to the tune of 1 percentage point, rather than adding 4 to 5 percentage points as they are now. That turnaround would on its own be enough to bring inflation back much closer to target.
If energy prices moderate, inflation will fall back significantly in 2023
The problem is that recent experience may have let the inflation genie out of the bottle, and that underlying inflation pressures and/or second-round effects take firmer root. There is plenty of evidence that this is happening, especially in the US, where domestically generated price pressures have become an important part of the overall inflation impulse (Figure 4).
It is for this reason that the Fed has adopted such a hawkish stance – they recognise that they need to deliberately slow growth to address the inflation problem. Hence the explicit references to a policy rate move to restrictive territory (see below).
Figure 4. US inflation has become broad-based
US contributions to CPI inflation
Such “conventional” inflationary overheating is less prevalent in most other developed nations but is far from absent.
Labour markets are tight, housing markets are bubbly and as household spending continues to transition back from goods to services, then underlying inflation pressures could start to increase more noticeably.
This is the main concern for inflation-fighting central banks. They are only too well aware that if higher inflation becomes more embedded in expectations, then it can be tough to shift.
Inflation has become more broad-based in 2022, with services contributing more
Figure 5 shows recent inflation trends for non-energy goods and services for the euro zone, although the pattern is broadly similar across all developed (and many developing) nations.
It is very early days, but it may be that goods price inflation now moderates if some normality returns, economies reopen more fully and trade flows resume. But services price inflation, largely linked to wage trends, is both less volatile and more sticky. It typically accounts for about half of consumer price index baskets, so if it settles at, for example 3 per cent, then goods price inflation will need to fall to 1 per cent for overall inflation targets to be met. This does not look imminent.
Figure 5. Services inflation is now on the rise
Eurozone CPI inflation
Moving to restrictive
In December 2021 we stated in our 2022 Outlook that it would be sensible and appropriate for financial markets to prepare for tighter monetary policy. At that time such a view was bordering on the controversial, with many market participants and commentators believing that policy rates would be stuck near zero (or even below it) for a while yet.
Six months on, virtually all central banks around the world have raised policy interest rates (some significantly) or signalled their intention to do so.
Tighter monetary policy is now a given. The relevant issue now is how far and how fast hikes are delivered. And given the underlying and dangerous inflation pressures that we have described above, it is far more appropriate to modify the theme to highlight how several central banks – the Fed being the most important – now accept that monetary policy needs to move into restrictive territory to prevent an even worse inflation problem.
The adjustment to policy rate expectations so far in 2022 (Figure 6) has been one of the major drivers of recent financial market volatility.
Figure 6. Assessment of likely tightening has moved up significantly
Policy rate expectations for end-2022
Moreover, while the concept of the neutral (or equilibrium) interest rate is well-defined in theory, in reality it is much more difficult to pin down. It varies over time (and across countries) and the cold truth is that we, along with central bankers, do not know where exactly it is.
The only real-world option is to raise rates until the tightening has the desired impact. Of course, this task is further complicated by the fact that interest rate policy takes a long time to fully affect behaviour. What has become increasingly clear is that the Fed (and presumably quite a few others, including in several EM geographies) now believe they have to move above neutral as soon as possible, while at the same time trying to make sure that they do not cause financial markets (or the economy) to collapse. Some have perhaps already moved above neutral.
Rates are going to have to go beyond neutral in some places, wherever that is
It is not out of the question that, if growth does slow and inflation falls back to target, that modest policy rate cuts are possible within our investment horizon of one to two years. Indeed, that is effectively what financial markets have priced in and also what the Fed has acknowledged as plausible, given their infamous dot plot projections. Hence these show a median forecast of just under 4 per cent for the Fed Funds rate at the end of 2023, in contrast to their “longer run” projection (presumably a decent estimate of where they think “neutral” is) of 2.5 per cent (Figure 7).
Forecasting the peak in Fed Funds is difficult enough. To then forecast subsequent cuts might just be a bit too cute.
Figure 7. The Fed expects to move well above neutral
FOMC assessment of policy rate
Having had such an extended period of ultra-low policy interest rates since the Global Financial Crisis, it is perhaps unsurprising that adjusting to a world (the old world) which anticipates policy rates of 1, 2 even 3 per cent or more has not been easy.
Looking ahead, there is certainly more monetary tightening to come. And with inflation unlikely to move convincingly back towards target until later in 2023, a period of monetary policy restriction is to be expected.
The conflict in Ukraine has refocussed attention more closely on the broader issue of changing political and economic tides around the world. But, seismic as the Russian invasion has been, it is really only the latest example of more deep-rooted trends towards increased nationalism and self-interest that have emerged over the last ten or 15 years.
Cracks have been growing in the cosy global consensus in recent years
There are lots of discrete components within these matters and they may progress (or not) at different speeds and in different ways around the world. But they are linked by underlying themes of greater independence, autonomy and self-determination.
Over the years we have tried to capture some of the key elements of this theme under broad umbrella headings such as populism or de-globalisation. The blanket term we are adopting now is borrowed from the ECB lexicon: fragmentation; it looks set to influence global politics and economics for years to come. And as it does so, it will impact financial markets too.
As we have stressed in previous House Views, momentum in global integration had already been slowing noticeably in recent years – even reversing in some cases – after decades of continuous increases.
But since 2008, governments and companies have wrestled with a global financial crisis, an existential euro zone disaster, growing revolt against open borders, Trump’s trade war and a global pandemic. Attitudes have changed and are likely to change further. Strains in global supply chains have escalated worryingly since the pandemic (Figure 8).
Figure 8. Attitudes towards openness are changing
Global supply chain pressures have intensified
As the leader in the Economist (June 18th-24th issue) highlights, “the lodestar of globalisation was efficiency. Companies located where costs were lowest, while investors deployed capital where returns were highest. Governments aspired to treat firms equally, regardless of their nationality, and to strike trade deals with democracies and autocracies alike”.
Openness was the name of the game. Webs of intricate global supply chains developed, and ever leaner just-in-time inventory management became the norm.
But as the KOF Swiss Economic Institute reports, indices of globalisation are peaking out (Figure 9). It remains to be seen whether recent events tip the world into more outright de-globalisation or whether, as the free-market Economist advocates, globalisation can be reinvented.
Any new type of globalisation looks set to be based more on security than efficiency, with companies endeavouring to do business with reliable counterparties in countries with which your government is friendly. The danger is that such approaches could descend into protectionism, government interference and, arguably, higher inflation.
Figure 9. Indices of globalisation have stopped rising World, social & political indicators, globalisation indices, total
It seems inevitable that there will be moves towards home-shoring and a more just-in-case approach to inventories.
To the extent that globalisation was a key part in the emergence of low inflation in the 1980s, 1990s and 2000s, any changes in this direction look likely to 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.
More generally, the changing global mood may also be reflected in a different direction for politics and social attitudes. Populism, Trump and Brexit were all examples of this. The liberal Swedish think-tank, Timbro, compiles various indices of populism around Europe. The political right is rising steadily in support and representation (Figure 10). The recent rejection in France of Macron’s centrist government at the parliamentary level, and the alarming rise of the far right (even if it is not as extreme as it was), is another sign of these forces.
Figure 10. Right-wing populism still on the up
Based on election results and polling
Commodity prices, energy security and decarbonisation
The conflict in Ukraine has continued to put upward price pressure on several global commodities, most notably energy, which is contributing significantly to the current outbreak of high inflation around the world.
Although Russia and Ukraine actually account in aggregate for only about two to three per cent of global GDP, and also of global trade, their relative importance is greater in certain areas (Figure 11 & Figure 12). It is also true that the “shock” of the invasion and the disruption which it has caused have had a disproportionate effect on some prices. There is now a risk of severe food shortages in many developing economies if wheat exports, in particular, are badly affected.
The conflict in Ukraine has many implications for fossil fuels usage, energy security and the green transition
More generally, and as we said three months ago, events in Ukraine have refocussed attention very strongly on the issues of energy security in general, dependence on Russia in particular, but also on the whole subject of energy transition away from fossil fuels.
Between March and June, various sanctions have been imposed on Russia, and Europe has agreed an embargo on coal imports from August and sea-borne oil imports from next year. The dependence on imported gas is more difficult, with Russia needing the revenue and Europe needing the product, at least until they can find alternatives. Longer term, European dependence will be reduced, but now there is an uncomfortable rapprochement.
Figure 11. Commodity prices have surged this year
% change from January 2022 average
Figure 12. Russian production is important in some key areas
% share of world trade in 2020
It looks likely that the Russian invasion will accelerate the energy transition, even if there are some perverse short-term increases in reliance on older fossil fuel sources – and nuclear – while adjustments are made.
One major concern here is that massive investment will be needed to help the longer-term transition and the adoption of new technologies for renewable energy including wind, water and solar. Even if accelerated, these adaptations are neither quick nor cheap. In the interim, there is every prospect of at least some energy prices staying high or moving higher still, sustaining the present inflation impulse and providing ongoing support to that theme for longer.
Greater use of renewable energy sources should eventually lead to lower prices, but the transition will be neither cheap nor immediate
Eventually, households and businesses should be able to benefit from lower costs of electricity generation from renewable sources, but that moment looks a long way off. Most believe that the high costs of energy transitions are a price worth paying, but that does not make the process any less financially painful, especially at a time when everyone is feeling the pinch anyway.
Historical parallels are often dangerous, but the current energy upset 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.
Today, short-term pain is certain and here already. Those longer-term aspirations are hugely appealing and, we hope, realistic. But they will not inevitably be achieved.
Energy transitions in the past meant short-term pain, but longer-term benefits; we hope for the same payoff this time
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.
Some global political cooperation is probably warranted, but that is no guarantee that it will be forthcoming. 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 deepen
Many would argue that inflation is already out of control, but it could still get a lot worse. The risk of even more damaging inflation outcomes than the misfortunes we have already seen has probably not been higher any time in the last 30 or 40 years.
The longer the current inflation spike lasts, the greater the danger it becomes more entrenched
The almost unique confluence of factors that have pushed inflation higher – COVID pandemic, energy price spike, global supply-demand imbalances, war in Europe – may persist for a while yet, as we have described elsewhere. And the longer that high inflation hangs about, the greater the danger that it becomes ever more entrenched in the minds of households, companies and investors. Inflation expectations underpin a large number of key behaviours and if these become unanchored, then inflation can swiftly spiral alarmingly.
The most important of these linkages is that between wages and prices. If workers attempt to respond to high consumer price inflation with escalating wage demands, while companies protect margins from increasing wage costs by raising prices, then all the elements are in place for destructive wage price spirals.
A convincing case can perhaps be made that this is already happening in some places – the US being the prime example. And that is why it is the Fed that is acting most aggressively and signalling the greatest hawkishness. They know they need to slow demand and try to prevent additional inflationary dislocation.
But overall, it remains the case that medium-term inflation expectations are still reasonably well-behaved in most places and that wage inflation does not look likely to explode higher.
Even in the US, high inflation is expected to be temporary – the influential University of Michigan survey records one-year expectations at over 5 per cent, but the five-year measure at “only” 3 per cent. In Europe, expectations have risen too but only to around 2.75 per cent over the next year (Figure 13 & Figure 14).
There is still a reassuring faith that central banks will be able to rein inflation in. The risk is that they fail in this endeavour and that the inflation anchor is lost. The grim history of the 1970s and 1980s shows that it can be a very long and difficult grind to get it back.
Figure 13. Longer-term inflation expectations are still contained
US: expected inflation rates
Figure 14. European inflation expectations up sharply…
…but still much lower than recorded CPI inflation
During the pandemic it was quickly accepted that expansive fiscal policy was the right thing to do. We would go further and argue that it was absolutely essential. It was already coming back into vogue before COVID struck, with even the fiscally conservative US getting in on the act, first with Trump’s many initiatives and subsequently with Biden and the new Democratic administration.
In COVID times, unhindered fiscal policy did most of the heavy lifting and arguably prevented the downturn morphing into the next Great Depression. But despite this, the rules of fiscal sustainability have not been rewritten.
Fiscal policy came back into vogue during COVID, but debt sustainability is still relevant
Without delving into the minutiae of the algebra of prudence, the key comparison was that the real rate of interest (which governments pay on their debt) fell well below the growth rate of the economy. It was this that provided the latitude for fiscal largesse. High inflation also helps – indeed that is really why real interest rates have stayed low.
However, growth is now slowing and (nominal) interest rates are rising. If central banks are successful in getting inflation back under control, then the issue of fiscal sustainability could come back. It has already done so in a number of emerging markets; now there are fears that such worries could return in the developed market universe, especially Italy.
Sri Lanka is in a fiscal mess and has defaulted on a multi-million dollar foreign debt repayment. When real rates move above underlying economic growth rates, countries must run primary budget surpluses to keep public finances under control. Italy has net public debt exceeding 140 per cent of GDP and currently pays a little under 3.5 per cent on its 10-year bond.
Public debt-to-GDP ratios are high in several European countries (Figure 15). They are projected to fall, but it would not need much to change for debt dynamics to verge onto an explosive path. As the IMF has pointed out, even with more enlightened approaches to policies, a credible medium-term fiscal framework will still be needed everywhere. COVID and now the war already meant that any equilibrium the world had achieved was fragile at best. It would not take much to change the delicate balance on fiscal sustainability for many countries.
Figure 15. Public debt is high almost everywhere
IMF net public debt as % of GDP and projections
Global hard landing
As with inflation and China policy mistakes, there are elements of this risk which have already materialised.
Growth has slowed in many places and is set to slow further over at least the rest of this year. Whenever that happens, but especially so when monetary policy is being actively and aggressively tightened, there are risks that the growth deceleration picks up speed, feeds on itself and a “hard landing” ensues.
Those risks have increased further over the last three months (Figure 10) in most parts of the world, boosted by higher rates, an escalation of parts of the energy price shock, the ongoing impact of war in Ukraine, the inflation squeeze on real incomes and worries about the effect of the zero-COVID policy in China.
Global imbalances and/or excesses are less marked than in the past, but the unique set of negative drivers has increased the risk of a hard landing in places
On the upside, the world economy does not have anything like scale of vulnerability from over-leveraged private sector balance sheets which characterised and intensified the Global Financial Crisis. And banks are well-capitalised and following much stricter lending standards.
Every crisis is different of course, and there is evidence of froth in some areas: crypto-currencies are an obvious example – but hopefully of very limited overall macroeconomic significance.
Bubbly real estate markets are perhaps more of a concern, although higher borrowing rates should help take the steam out, without undermining them excessively.
The biggest concern is probably stubbornly high inflation which would oblige global central banks to keep the hiking pressure on, or even increase it to deliberately slow demand growth. Arguably hard landings in the past have almost been necessary in order to address inflation problems properly.
We do not believe current conditions merit economic pain such as the Volcker remedies of the early 1980s. But with inflation currently so high, it is entirely understandable that such comparisons are being made.
Today’s Fed is not really projecting such an outcome, but they are saying unemployment will rise (Figure 16). It is very rare that they do this and is probably as close as they will come to a “hard landing” scenario. Hard landings can happen because they have to, or because central banks make policy misjudgements. Both are possible in today’s circumstances.
Figure 16. Downturn risk rising, but not yet alarming
US: composite leading indicator of recession
China policy mistakes continue
Several accidents and errors have already hit China’s economy in the past 6-12 months, so in important aspects this risk – delineated in previous House Views – has become a reality.
Yet, it remains possible that future actions taken by policymakers to alleviate the damage are ineffective or, worse, that new plans or decisions hurt confidence or cause further distress.
The Zero-COVID Policy looks certain to hurt activity recurrently, and Xi cannot afford to admit an error of approach
This may play out in (i) how frequently, for how long, and where “dynamic” Zero-COVID Policy (ZCP) is applied, (ii) how aid to banks, corporates, households and local governments is meted out, (iii) whether regulatory adjustments or Common Prosperity are put on hold or not, (iv) decisions made with respect to currency or debt markets, and (v) geopolitics and trade, in particular the unbounded support for Russia as it becomes an international pariah.
The two main ‘known unknowns’ are real estate and ZCP. The property market recession has been worse than expected, with developer defaults continuing and activity falling off.
This has created a new problem, as falling land sales mean that local government revenues and their financing vehicles have become cash-starved, though special local bond quotas have been raised to plug the gap.
Mounting debt problems would most likely be borne by SOEs and state banks, and the losses ultimately would be backstopped by the government; much slower growth and Japanification seem more likely than a classic sovereign debt crisis. China’s COVID experience in the face of Omicron has been very different (Figure 18) and eradication efforts have been a disaster for economic activity in Q2; in the near term (H2 and into 2023), the risk is that more outbreaks will cause new lockdowns, and a policy “defeat” is unacceptable for President Xi ahead of the October Party Congress. What new policy directions on regulatory, social and international affairs emerge in Xi’s third term are unpredictable, but it won’t be the status quo.