Assessing a mixed bag of macro challenges
Investors are shifting their attention from how much higher inflation and interest rates might rise, to how deep the global slowdown will be and when policymakers will offer support
AGAINST the backdrop of an economic cycle plagued by the uneven recovery from the pandemic, the ongoing ripple effects from the war in Ukraine and the loss of inflation-fighting credibility among major central banks, the global economy has so far evolved as expected. Backward and forward-looking data show clear downward trends for goods-and-shelter inflation in the United States, while services inflation is beginning a gradual descent as wage growth shows nascent signs of moderation.
The unprecedented pace of monetary tightening by global central banks is slowing the momentum of the real economy, most visibly in the sectors most sensitive to interest rates, though the labour market and consumption remain more resilient than anticipated. Even more surprising has been the latest developments from China, where the exit from the “dynamic zero-Covid” policy has been faster and more wide-ranging than expected, perhaps offering the global economy a much-needed shot in the arm.
Collectively, the big question for investors worldwide is shifting from how much higher inflation and interest rates might go, to how deep the growth slowdown will be and when policymakers will offer their support.
Taking into consideration the challenging mix of headwinds described above, the risk of a US recession in 2023 remains elevated. Moreover, a contraction – if it materialises – will likely be larger than the “garden variety”. In the post-war period, the average peak-to-trough recession is 3.7 percentage points of Gross Domestic Product (GDP), and our base case is for a 4 per cent contraction.
In terms of monetary policy, the favourable developments on inflation validate the recent stepdown in the pace of tightening by the US Federal Reserve. From the current bound of 4.5 per cent, the Fed Funds Rate is expected to peak at 5 per cent by the March meeting. However, risks remain skewed to the upside if the labour market remains tight – and prices for services remain higher – for longer than currently expected.
Our base case is for the PCE (personal consumption expenditure) price index to fall to 2.5 per cent by the fourth quarter of 2023, allowing the Fed to pivot towards a more neutral posture amid the economic downturn by delivering 50-75 basis points of rate cuts by the end of 2023. However, the path back to the Fed’s 2 per cent inflation target may not be linear, as the structural forces described exert upward pressure on trend inflation and may keep policy rates near the peak for longer than envisioned.
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In contrast to the US, Europe faces a stark and very real possibility of stagflation. Euro-area GDP is expected to contract by 0.9 per cent by end-2023, compared to the median consensus of a 0.1 per cent decline, resulting in lower economic growth. While many analysts expect an economic rebound by the second half of next year, there is a high likelihood that the growth momentum will be sapped by a further curtailment of Russian energy imports to roughly 15 billion cubic meters (bcm) from around 70 bcm in 2022.
Across the English Channel, financial stability in the United Kingdom looks to have mostly recovered as institutional credibility is clawed back with a new government and a reset of fiscal policy. Despite the prospect of weak growth and high inflation, the central bank has managed to steer clear of actions that would further spook investors. While GDP will likely decline by 1.4 per cent in 2023, high inflation will necessitate the Bank of England raising the bank rate to around 5 per cent by year-end from 3.5 per cent currently.
Meanwhile, China has abandoned its dramatic zero-Covid restrictions much faster than expected. Despite this shift, the economic patterns associated with reopening in the rest of the world are unlikely to apply to China, as the country’s industrial sector never completely shut down production. For this reason, the industrial and manufacturing sectors should see only a limited reopening bounce. However, key services, such as restaurant and entertainment, as well as travel and tourism, which experienced a massive drop during the past three years, are expected to be the main beneficiaries of the economic reopening.
Overall, the reopening by itself is not expected to lift the country to a significantly higher growth trajectory. For that to happen, the free fall in the property sector – largely a result of the “Three Red Lines” policy enacted mid-2021 – has to be arrested. Since November and December last year, the policy has been actively reversed, and additional policy support is expected for the sector.
Besides the reopened economy, a stabilised property sector and fiscal stimulus in infrastructure should be sufficient for the economy to bounce back in 2023, and we’re sticking to our above-consensus forecast of 5.7 per cent annual average growth, which will attenuate the global growth drags emanating from developed markets to some degree.
Beyond the near term, however, nothing but headwinds are expected. Cyclically, external demand, China’s last remaining growth driver last year, is stalling as global consumers tighten their belts. Structural headwinds present even more challenges to growth in the long run. In the past, the debt-driven investment in properties was a key growth driver, which is not expected to return.
Furthermore, over-investment extends to many other sectors, making further capital accumulation an unlikely growth driver. If history is any guide, China’s total factor productivity increase has slowed to a pace that seems insufficient to escape the middle-income trap.
In sum, our fundamental framework for understanding the triggers of recession reinforces our downbeat outlook for the global economy in the year ahead. However, the probability of brighter scenarios – including a “soft landing” of growth back to trend levels in the US, or even a “nominal GDP” boom driven by the sizeable public investments legislated in the past year – has moved higher in recent months, particularly with inflation retreating from the recent peak.
These positive developments provide monetary policymakers with more flexibility to steer the global economy towards continued expansion, even in an environment of ongoing and persistent shocks. Our mindset will remain humble and open to a wide range of outcomes as the year unfolds.
The writer is chief global economist (fixed income), PGIM.
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