Executive summary

Inflation fight raises recession risk

The dominant driver of global macroeconomic and financial market developments right now is inflation, and the way central banks are responding to its rise.

The impact of COVID lockdowns depressed activity and inflation in 2020. But from mid-2021, a combination of the surprising strength of consumer demand – especially for goods – alongside constrained supply led to an acceleration in the price of global manufactured goods. That was exacerbated by a rapid increase in demand for raw commodities, in particular energy and industrial metals, which were also supply constrained, leading to sharp increases in input costs for businesses and prices for consumers.

Many expected these effects on inflation to be temporary. However, inflation continued to build through 2021 and 2022 due to a subsequent series of supply disruptions.

These disruptions followed several rounds of COVID-related restrictions on activities globally through to 2021 Q4 and continued through 2022 with China’s pursuit of a Zero-COVID Policy (ZCP) and the resulting ongoing lockdowns. This has meant that important components, such as semi-conductor chips that are used in a wide range of manufactured goods, remain difficult to source and are therefore constraining supply (Figure 1).

Further supply challenges arose with the Russian invasion of Ukraine in February, and the subsequent sanctions imposed by the West, with uncertainty about future supply from one of the world’s largest energy producers.

Figure 1. US supplier delivery times
Supply chains have only recently begun to improve

But even outside those areas where there might be explicit supply disruption, rising demand has seen only a limited supply response. That is unusual, as the price signal would usually be sufficient to increase supply and limit further price increases.

However, it appears that supply curves have become more inelastic in several areas. For example, commodity producers, especially oil and gas majors, have been restrained in new investment spending outside of renewables for many years.

With climate change policies being set to deliver on countries’ Net Zero emissions targets set under the Paris Climate Agreement, and reinforced at the Glasgow summit in 2021, project financing has become more challenged and the future of fossil fuels uncertain. But the ability of renewable energy sources to rapidly increase is also constrained, by the need for raw materials, such as copper, where under-investment in new capacity has also been a major issue.

In other sectors, such as hospitality and travel, that have enjoyed a rapid recovery on reopening, labour has become a significant challenge. There has been a relatively slow labour market supply response to the strong rise in vacancies and rising wages. In particular, older cohorts and prime-age women have not returned to the workforce as quickly following the COVID lockdowns. These factors have led to the broadening in inflation pressures beyond just energy and other commodities (Figure 2).

Figure 2. Increase in inflation since start of 2020
Energy the single largest contributor, but increase in core also shows breadth of increase

These additional global inflationary pressures come at a time when the strong global recovery from the COVID pandemic had already seen underlying inflation rising quickly, with shortages in global manufactured goods, and already elevated energy prices, contributing to multi-decade highs in both headline and core inflation.

Heading into 2022, we expected another year of well above trend growth across all the major economies. While the magnitude of the shock to global energy and other commodities is still evolving, we have marked down global growth this year by around 0.5 percentage points, to a little below four per cent.

The impact of higher energy prices on household disposable income will be felt globally, but will be even more acute in the UK and euro zone, where natural gas prices will be impacted by uncertainty of Russian supply.

Moreover, income and activity will be affected more heavily in those economies that are net importers of oil and gas (again, among the larger advanced economies that would include the UK and euro zone), while potentially being modestly beneficial to the larger net exporters (Canada and Australia amongst the advanced economies).

However, even with the larger impact on the euro zone, we still expect growth of around 2.5 per cent this year. There are risks on both sides of that projection, but they are skewed to the downside given the risk of higher energy prices. Growth projections for the major economies are shown in Figure 3.

Figure 3. Policy rates
Market pricing reflects expectation of further rate increases

The impact of higher inflation on household real disposable income will be significant this year. Most economies will experience a decline similar to what might be expected in a recession. That said, overall household balance sheets are in a relatively strong position to withstand such a shock, due to the savings accumulated during 2020/21 when income support policies were used to offset the impact of COVID on household income. But just how far households are prepared to utilise those saving buffers given an uncertain outlook is hard to judge.

Sentiment readings across all the major economies do not provide much comfort. Alongside the tightening in monetary policy and associated financial conditions, this has led us to revise down our growth projections for both 2022 and 2023.

We now expect global growth to be below trend in both years (Figure 4), with the risk of recession rising to close to 50 per cent. That said, we think any such recession would be relatively modest in scale, with little or no financial deleveraging required, and therefore with scope for economies to bounce back quite quickly.

Figure 4.  Global growth projections
Slowing to below trend

We now expect inflation to peak in most economies during 2022H2, reaching around ten per cent, before falling back quickly through 2023, albeit remaining above target throughout (Figure 5). For the reasons highlighted above, the risks to inflation remain to the upside in the near term.

Figure 5. CPI inflation projections
Peaking in 2022

The new macroeconomic environment, the monetary policy response to it and the changing views on a range of longer-term structural factors have resulted in an extremely challenging year in financial markets.

Global rates markets have re-priced sharply in the face of persistently strong inflation, while risk assets, such as global equities and credit have performed particularly poorly.

The increase in uncertainty about the outlook has raised both implied and realised volatility across all asset classes. As such we prefer to have relatively light exposure at this time, as reflected in the asset allocation table (Figure 6).

We continue to have a preference to be modestly underweight duration, with upside inflation risks outweighing the downside recession risks. However, the tipping point between those two may well be coming closer.

Given the sharp fall in equity multiples this year, we prefer a small overweight, apart from in Europe, where the growth risks are more pronounced. That said, we are cognisant of the risks of further downside in equity markets should margins decline meaningfully from here.

We prefer to be neutral in credit, where we think pricing of spreads is roughly fair in terms of recession risk. Finally, we prefer to be modestly long the US dollar against the euro given the relative outlook for the two economies.

Figure 6.  Asset allocation summary
Currently limited risk appetite