The key themes and risks our House View team expect to drive financial markets.
The COVID-19 pandemic led to wild swings in output and demand around the world as waves of infection were countered by enforced lockdowns or other, slightly more limited, containment measures. These alternated with swift rebounds as restrictions were lifted.
Impressive adaptation by businesses and households meant that outbreaks had successively less overall impact, although the actual changes in GDP were still incredibly large by the standards of history.
The virus is still with us, having its presence felt significantly in some regions, and the Omicron variant most recently led to limited further disruptions, albeit not as bad as had been feared. It had looked as if 2022 would finally see a smoother return to pre-COVID trends as economies reopened more fully (Figure 1). And although that remains the most likely eventual prospect in our central scenario, the path required to get there now looks less clear.
Figure 1. G7 nations GDP growth
Expected to slow but remain robust
The most obvious issue, of course, is the dreadful war in Ukraine which has roiled global sentiment and financial markets as well as greatly exacerbated the already-disruptive impact from energy – prices and supply. The outcome of the conflict is latently unpredictable.
Even before the invasion, it had become increasingly appropriate to characterise the spike in energy (and some other commodity) prices as another major supplyside shock that would have a detrimental effect on underlying growth. The war has magnified that shock, but even if the impact fades as we expect, the longer-term hit to effective real incomes could well persist for a while.
For energy importers, especially those who rely most directly on Russian supplies, the combination of sanctions and spiralling prices will slow growth, even while the post-COVID rebound continues. Europe is the most obvious instance, with large parts of the euro zone closely integrated into Russian supply chains. It is plausible, therefore, that European economies experience a sharper slowdown in the middle quarters of 2022, before recovering once more later in the year (Figure 2).
Figure 2. Eurozone GDP, quarterly growth
European growth pause, but rebound is expected
It is very hard to quantify the size of any such effect, especially when GDP data are still distorted by pandemic effects. But it is not unreasonable to postulate a stall in growth in Q2 and Q3 in Europe followed by another rebound, a similar pattern to the COVID experience. Other areas, the US for example, should be less impacted but higher energy prices and any war-related dent to sentiment could still slow growth moderately in coming quarters.
Overall, most regions should still see above-trend rates of GDP growth in 2022 largely because of the earlier momentum. The post-pandemic catch-up will continue to be supported by reopening and by accumulated savings. However, greater challenges may emerge in 2023 as the reality of lower real income growth feeds through. The longer the spike in energy prices lasts, the greater will be that hit.
Higher inflation is causing a major squeeze on real household incomes
Although we expect the current exceptionally high inflation rates in Europe and the US to fall back later in 2022, for now they are already hurting real incomes significantly. The squeeze on households (and businesses) has been described as the most severe since the 1970s and 1980s and it is hard to argue with that reasoning.
Moreover, even if inflation does decline, it is in our view unlikely to return any time soon to the one to two per cent range that characterised much of the last two decades, implying that the pinch on real incomes will continue. If workers try and offset this through higher nominal wage increases, central banks are set to respond with more aggressive monetary tightening as they have warned (see below).
High and rising inflation has only actually been with us for a year (so far), but that has been long enough, and the spike extreme enough, to invalidate the usefulness of any debate about transitory versus permanent.
Inflation is here and it is dangerous. It is having a significant impact on behaviours now and is generating a major squeeze on spending power (real incomes) that will be felt for some time yet.
The shock of sharply higher inflation is all the more stark, coming as it has after an extended period of quiescence. Between 1992 and 2007 CPI inflation in the G7 averaged a whisker over 2 per cent (Figure 3). After the inflationary disasters of the 1970s and 1980s, this was an achievement for which central banks were quick to claim responsibility.
Figure 3. G7 nations: annual CPI inflation
Highest since 1982
And while there is some justification in that, there were a lot of other moving parts which contributed, including labour market and other structural reforms and the beneficial impact of globalisation and low-cost China. In the decade and a half which followed the Global Financial Crisis (GFC), inflation was more volatile, but actually averaged a little lower again (1.5 per cent) in the G7. It really has only been the last 12 months that have witnessed an apparent regime change.
Whatever the proximate cause – and there are many candidates (see below) – inflation-fighting central banks still have to deal with the issue.
Monetary policy normalisation has been a long time coming. After the GFC a period of accommodative healing was required – only the US attempted to tighten meaningfully. Next came the euro zone deflationary threat and finally the pandemic.
High inflation – if it persists – implies very low real rates currently (Figure 4). But the tightening process has now finally begun in several jurisdictions. History books pronounce that inflation persistence in the 1970s was in significant part attributable to central banks doing too little, too late. Inflation pessimists fear that something similar may be happening today.
Figure 4. Real interest rate approximation
High inflation means very low real rates
We do not share quite such a pessimistic view, believing that inflation will fall back later this year and in 2023. But it would be seriously complacent not to acknowledge that the risks of a damaging inflation outbreak are probably greater now than at any time in the last 30 years at least.
Arguably more important, even if some of the current drivers of higher prices do retreat or reverse, it is very likely that inflation will settle at rates significantly above the averages which have generally prevailed for the last 20 years. That would be a very different environment for both economies and financial markets, which could make for some grating adjustments.
Having said that, it is still important to recognise that there are at least two aspects of the present inflation impulse that are unusual and may not continue, irrespective of the monetary policy reaction.
First, higher energy prices – recently exacerbated by events in Ukraine – account for much of the increase. For example, over half of the 5.9 per cent CPI inflation rate in the euro zone is accounted for by energy alone (Figure 5). Undeniably a genuine price rise and major hit to households and businesses, it will only be sustained if energy prices continue to rise as they have over the last year. Not impossible, but unlikely, we would suggest. The average contribution to euro zone inflation over the last 20 years has been 0.3 percentage points, a huge contrast to the present 3.2 percentage points.
Figure 5. Eurozone: contributions to CPI inflation
Broad-based increases, but energy the dominant component
Secondly, the unique experience of post-pandemic reopening resulted in a wide range of imbalances between supply and demand that squeezed prices (mainly non-energy goods) sharply higher. The war may well add temporarily to such frictions for a while, but eventually supply will respond more completely, easing such pressures and restoring lower goods price inflation.
Tighter monetary policy
In December we suggested that it was sensible and appropriate for financial markets to prepare for tighter monetary policy. The pandemic – and the Omicron variant in particular – was influencing the exact form of the exit route for global central banks from emergency policy settings, but in the absence of any “extraneous influences”, we stated then that this would become more clearly the direction of travel.
Three months on, there has obviously been an extreme such “event”, but despite this, the actual and likely future path for monetary policy in most geographies seems clearer today and is far more aggressive than anticipated at the end of 2021.
Policy interest rates are going up over the next two years, although the timing, pace and extent will vary across regions. Many emerging economies had not been able to afford the luxury of the “wait-and-see” approach adopted by most developed market central banks, as inflation rose in the wake of the pandemic. But now those developed market equivalents are following suit.
In most cases, financial markets moved before they did, but now they are pretty much aligned. And what is expected is rather different from three months ago (Figure 6).
Figure 6. Policy rate expectations for end-2022
After brief Ukraine dip, expectations have moved sharply higher
In the middle of December last year, financial markets were discounting a Fed Funds rate at the end of 2022 of 0.75 per cent – a little under three 25 basis point hikes. The Fed has now achieved lift off and that expectation has risen to 2.5 per cent. An additional 50 basis points of tightening is expected in 2023 and the Fed’s own dot-plot projections are now almost perfectly aligned with that forecast.
The shift in the UK has been similar, with end-2022 expectations for the Bank rate now around two per cent, up from under one per cent three months ago.
Recent moves in the euro zone have been understandably more subdued, with markets shifting from an expected policy rate of -0.5 per cent (where it is currently) to just above zero per cent most recently.
Fed messaging has understandably been the most hawkish, with Powell and others acknowledging that it is probably inappropriate for them to be as relaxed about monetary tightening as they were in the last two hiking cycles. Specifically, near-term 50 basis point hikes are quite plausible in order to address the present inflation problem (Figure 7).
Figure 7. US measures of core inflation
However you measure it, US inflation is high and rising
The BoE is slightly more relaxed, but still expected to raise rates further in coming months. Meanwhile, a hike in the euro zone may be a step too far for this year, but the ECB is content with the market view that higher rates – perhaps even to positive territory – are at least now on the forecast horizon.
The timing of the ECB’s actions may yet be influenced by events in Ukraine, but it is impossible to resist the conclusion that macro-economic conditions today warrant tighter monetary policy. Inflation is alarmingly high, underlying demand growth appears robust and the post-pandemic rebound looks secure.
Central banks – and everyone else – may be uncertain about exactly where neutral or normal policy interest rates are. But they can be reasonably confident that they are well above present settings. Moreover, in the Fed’s case, conviction is growing that they may need to go beyond neutral. Bond yields have risen sharply higher in anticipation (Figure 8).
Figure 8. 10-year sovereign bond yields
Yields have moved up swiftly in early 2022
Absent major new shocks, tighter monetary policy looks inevitable in most places. For several places, this will be a major change from conditions which have prevailed since the GFC. This will be a headwind for economies and financial markets alike. It is a path that central banks will need to traverse both cautiously and determinedly.
Global economic and financial fragmentation
Well before the COVID pandemic and Russian invasion of Ukraine, the tide of globalisation which had swept the world between the 1970s and the 2000s, was already changing (Figure 9).
Figure 9. Annual growth of world trade and world GDP
World trade has grown more slowly than global GDP in recent years
Most economies in the world had continued to maintain close links, even in the face of global shocks such as 9/11, the Global Financial Crisis and the sovereign debt crisis in Europe. But momentum towards ever-closer integration was already slowing and several elements of economic, social, commercial and political theatre had started to resist that tide and move in different directions.
In the past we have included aspects of these matters within our House View themes or risks under such headings as geopolitics, nationalism/populism and de-globalisation. Recent events have acted as a further accelerant to such change, so it now seems reasonable to group them under a single heading, even though it encompasses a diverse range of issues. It seems plausible that we are entering a new era (Figure 10).
Figure 10. World exports as percentage of GDP
Could we be entering a new de-globalisation era?
Transitions associated with these shifts suggest that the extended era of low inflation (too low much of the time) suppressed economic and market volatility and easy financial conditions may be coming to an end. This could result in supply shocks, such as those which have become more familiar in recent years, becoming as widespread as demand shocks. Their nature implies higher and more variable inflation but also the likely need for larger risk premia to compensate investors more appropriately.
Comparisons with the two oil shocks of the 1970s are perhaps slightly overdramatic. But just as those hastened lasting changes in the world and led to difficult macro conditions – growth and inflation – today’s circumstances will also catalyse change and have macro-economic consequences.
Net zero and the energy transition (see below) form part of this new world – this will impact all sectors and geographies.
Moves towards more reshoring will also contribute to greater fragmentation compared with the past and will mean reduced flexibility for global supply chains.
Higher – and more volatile – inflation in the future seems likely
In the wake of the GFC there were genuine fears over “Japanification” and the threat of deflation (especially in Europe). Central banks responded with an extended period of super- accommodation. Those days are now over. Just as globalisation was associated with low and falling inflation – even the outright threat of deflation – then the new environment must surely push the other way, obliging central banks to be more active and aggressive. In this world, higher inflation risk premia seem entirely reasonable.
The Ukraine conflict has also refocused attention on high-level global geopolitics. While treading a fine diplomatic line, China has not distanced itself excessively from Russia. Whatever the resolution of the war, Russia is certain to be more isolated from the rest of the world, but their shared antipathy towards the US could yet lead to closer ties between them and China, with energy and commodity trade being the most obvious areas of potential common interest.
It will hopefully be premature to conclude that the “peace dividend” has gone forever, but the quick response of Germany – almost doubling its defence spending to two per cent of GDP – is a clear indication of a major change of mood. The prospect of a “new world order” with divided spheres of influence is not unrealistic. China and Russia have a common rival in the form of the Western alliance and both are keen to ensure that the world is safe for autocracy.
Commodity prices, energy security and decarbonisation
The world’s dependence on fossil fuel energy has been an uncomfortable truth for several decades, but at least momentum had been building in recent years towards the vital transition to renewables.
The war in Ukraine has refocused attention on energy usage
The war in Ukraine has starkly exposed the duplicity of Western nations who have relied heavily on imports of energy from Russia. Sanctions that have been swiftly imposed have bypassed large parts of the energy complex for the short term, while cynics point out that the longer-term aspirations to replace Russian imports totally have something in common with well-documented ambitions to decarbonise. As ECB board member Isabel Schnabel put it in a recent speech: “today, our dependence on fossil energy sources is not only considered a peril to our planet, it is also increasingly seen as a threat to national security and our values of liberty, freedom and democracy”.
In the shorter term, the recent spike in energy prices (Figure 11) will have a major impact on households across the world and is being countered in many places by government actions to ease the pain.
Figure 11. Oil and natural gas prices
Prices have risen sharply over the last year
Much of expenditure on energy is effectively non-discretionary, but the huge increases in cost are creating a massive squeeze on living standards. Energy prices remain elevated and with the inflation impulse now expected to last for longer, these forces will be felt for some time yet. But it is possible that these longer-term drivers – climate change, energy transition and decarbonisation – also have an extended upward push to inflation.
It is now inevitable that energy security will become a critically important policy aim for all nations in both a short and a longer-term context.
Perversely, the Ukraine conflict and resulting sanctions may lead to a temporary increased reliance on some of the old, fossil fuel sources – and nuclear – as countries try and adapt to reduced Russian supplies. But it has also served to concentrate focus on the future. Later in the same speech, Schnabel states that investment in new technologies and facilities for renewable energy, including wind, water and solar, must be the way forward. And with costs of electricity from many renewables significantly lower than conventional power plants, households and businesses will eventually benefit from lower prices.
This transition does not come for free, but it is a price worth paying, reflecting the twin goals of “safeguarding both our planet and our right to self-determination”. The ECB estimates that the energy transformation will require a doubling of global annual investments (Figure 12). Some have gone as far as to describe such policies as the third pillar of macro (alongside monetary and fiscal).
Figure 12. Actual and required global annual investment in energy
Investment spending needs to double to fund transformation
Correctly managed, the transition can be smoothed, and the growth-inflation mix maintained or even improved in time. But if it is uncoordinated, erratic or lacks credibility, it could have seriously adverse macro-economic consequences.
Bluntly, events in Ukraine have drawn attention to, and perhaps accelerated momentum towards, energy transition. Navigating through this period will require solidarity and global political cooperation that will not necessarily be automatically forthcoming.
It will also be a process that is almost certain to result in higher rates of inflation while it takes place. Both monetary and fiscal policies will need to recognise these trends and adapt dynamically to them, making sure that incentives to accelerate the green transition are not compromised or otherwise undermined.
Against the backdrop of inflation rates that have not been seen for 20 or 30 years, it might seem perverse NOT to characterise recent outcomes as a serious outbreak of inflation. And in one sense, of course, they are.
There has been a unique confluence of factors that have contrived to drive inflation sharply higher over the last year, many of which should fade or reverse in the future, helping to push inflation lower again. But the risk that high inflation becomes more engrained and self-perpetuating has not been higher at any time over the last 30 years.
Figure 13. CPI inflation compared with decade averages
Two particular aspects worry us most. First, much of what has happened recently can (rightly) be described as supply shocks. But there have been a sequence of them, and an argument can be made that they are now more likely in the future. If supply overall is constrained on an ongoing basis, then demand growth may have to be more deliberately restricted by policy to address or prevent excessive inflation.
But the main worry is that the inflationary impulse broadens and widens as expectations adapt upwards to the higher inflationary backdrop, leading to a more widespread acceleration in inflation.
The post-COVID landscape has confused interpretation here: as labour markets reopened, wage growth adjusted higher because of base effects and transient imbalances. Differentiating this effect from more conventional overheating (which would merit a more aggressive policy response) is difficult. Many indicators suggest that there are labour shortages in some areas. This is especially true in the US, where it can be reasonably argued that demand already exceeds supply potential.
The UK is also experiencing higher wage growth, but such pressures seem more limited across much of the rest of Europe. If such wage trends were to deteriorate more generally – in a worst-case scenario leading to wage-price spirals – then central banks would have to move more quickly into restrictive territory.
Figure 14. Wage trends in major nations
The role and importance of fiscal policy has fluctuated over time and across countries.
As attitudes to state intervention changed and after the inflationary disasters of the 1970s, it was largely usurped by monetary policy and relegated to deal mainly with distributional matters. With monetary policy believed to be approaching some limits, fiscal policy had already been making a bit of a comeback before COVID. But during the pandemic it was fiscal efforts which really did most of the heavy lifting, resulting in a renewed faith in its potential.
Even so, there has always been a recognition that there are limits, with fiscal sustainability depending on well-known relationships between growth, inflation, interest rates, budget deficits and debt levels. There has been a distinct and welcome change in attitudes towards the effectiveness of fiscal policy in recent times, but the algebra still applies. There are risks that extra strains put on the public purse in some countries will push them onto unsustainable paths.
Already it has become apparent that several emerging market economies do not have the luxury of engaging in the sort of fiscal largesse that their developed market contemporaries have been able to do, without serious consequences for their bond markets and currencies. Public borrowing and debt rose steeply during the pandemic and the impact of the war in Ukraine is almost certain to result in further calls on public spending.
Figure 15. Public borrowing as percentage of GDP – IMF Fiscal Monitor
Small improvements, but Ukraine war may lead to further borrowing
The limits for fiscal sustainability must therefore be significantly closer than they were for others now, or even more dependent on some of those key variables not moving out of acceptable ranges. 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.
Global hard landing
Economies have always moved in cycles.
Downswings have generally been caused by significant shocks or policy errors. In the past the average length of cycle was much shorter, suggesting that there were either more shocks or more policy mistakes. There were also several episodes where inflation had got out of control as a result of an overheating economy (positive output gap) and where the central bank had to raise interest rates to slow demand in order to choke inflation out of the system.
There are several aspects of the current macro-economic environment that might lead to an observer highlighting recession risk: fragile economies, fractious global geopolitics, rising inflation and a severe commodity price spike and central banks raising rates. Keen observers of history will draw attention to the marked flattening of the yield curve that has happened in the last six months. Every US recession since the 1950s has been preceded by an inversion of the 2s/10s yield curve in the previous year (Figure 16).
Figure 16. US yield curve, 10s – 2s spread
Inversions have preceded previous US recessions
The old warning that correlation is not the same thing as causation is relevant here and we are quite prepared to concede that we are closer to the next recession than we were three months ago. About three months closer in fact.
However, it would also be complacent not to acknowledge the risk that a hard landing for some of the world’s most important economies is possible. Granted, it would always be possible to have this as a risk in any economic outlook, but present circumstances are especially concerning.
It is not difficult to outline a scenario where geopolitical tensions escalate, energy and commodity prices ramp even higher, central banks tighten monetary policy aggressively because they perceive serious overheating risks and fiscal authorities feel unable to step in. It is quite possible that you would not need all of those ingredients – a selection could be sufficient to usher in a hard landing in 2023 or later.
China policy mistake
China’s policy-induced problems, including zero-COVID aims, and the ongoing property recession, are not yet fully played out.
China is facing a number of headwinds
In March, renewed pressure on the economy and markets emerged from continued woes of real estate firms, a spate of Omicron outbreaks and lockdowns, and a new slew of tax and regulatory penalties for large tech firms. The Financial Stability and Development Committee responded by acknowledging the need to “boost the economy”, to cease the regulatory harassment, and “actively introduce policies that benefit markets” while not letting COVID policy overly hamper growth by moving to a less strict “dynamic zero COVID policy”.
Credit was front-loaded in January but turned sharply down in February – China’s credit impulse is only stabilising slowly and we will watch this critical indicator closely, along with the breakdown of fixed asset investment and how fiscal support materialises.
Usually, such a tightening in financial condition has resulted in policymakers turning on the credit spigots (Figure 17), though leverage is now too high to risk a repeat binge. But just as these policy assurances reduce the risk of a disruptive scenario, the fallout from China’s pledge of unlimited support for Russia and growing energy imports financing Putin’s war machine raise the risk that Western sanctions are extended to China; the cost of energy is itself a headwind.
Figure 17. A tightening in China’s financial conditions typically induces a policy response
In the shorter term, China’s zero-COVID approach to the pandemic remains a problem. The lack of protection, from both previous infection and poor vaccines, obliges them to adopt lockdowns regularly. Although the authorities are allegedly adopting strategies to minimise economic disruptions, policies appear piecemeal and haphazard.
Mistakes are likely and hits to economic activity certain. Overall, the ambitious 5.5 per cent growth target notwithstanding, a more severe downturn remains a real possibility (Figure 18).