Three forces shaping growth, inflation, and markets in 2023

SINCE the pandemic, our view of the medium-term outlook has shifted to become more pessimistic on inflation and equity market returns while maintaining our overall thesis that the world economy will eventually be characterised by low growth and low inflation once again.

Three very different forces are shaping the three key regions of the global economy: US excess demand and the associated aggressive monetary tightening; the European energy crunch triggered by the Ukraine-Russia war; and China’s broken growth model. How the different forces will combine adds uncertainty to our outlook.

In normal times, each shock would have been significant enough to dominate our global research. Now, we are analysing the implications of all three factors for growth, inflation, and markets as each shock works its way through the global economy over 2023 and beyond.

Our baseline encompasses the idea that, combined, these shocks will produce an era of low growth, elevated inflation in the short term, low medium-term inflation, and average returns in financial markets. Compared to our pre-Covid medium-term view, both inflation and bond market returns are set to surprise on the upside, while global growth is still likely to struggle

This marks a significant shift in our outlook and in the level of conviction we can have about the medium-term outlook because it is facing large and sometimes opposing forces.

US: Excess demand will give way to tighter policy

It may seem odd to talk about excess demand when real GDP growth in the United States and other advanced economies was so weak by historical standards in 2022. But such is the impact of bottlenecks in product and labour markets that it has been sufficient to keep inflation elevated in an environment of weak growth. Undoubtedly, some of these supply disruptions are temporary in nature but others, such as a worsening demographic situation, are key elements of our weak longer-term forecast.

While we expect that inflation will start to fall back in 2023, the legacy of this high inflation episode is likely to be tighter macroeconomic policy in the US and, by extension, the rest of the world. The comparative resilience of the labour market and consumer spending in the US towards the end of 2022 further the case for tighter macroeconomic policy.

The Federal Reserve has declared war on inflation and, with its credibility riding on bringing it down, any return to an easing bias in monetary policy is unlikely until inflation is close to the target. Our baseline doesn’t foresee this happening until 2024 at the earliest. If the resilience of activity and inflation continues, then the risk of further tightening or a delayed pivot will rise.

Although inflation in the rest of the world is broadly more of a supply than demand issue, the Fed is forcing other central banks into keeping monetary policy tight via the strength of the dollar.

At one level, dollar strength (and currency weakness in the rest of the world) is an unhelpful inflationary impulse, but it is also limiting central banks’ room to manoeuvre in case they make the problem worse. Until US inflation is tamed, dollar strength will remain a problem for the rest of the world.

Tighter monetary policy is nothing new, but 2023 will see it combined with a lack of active fiscal policy support resulting in the most restrictive stance for overall macroeconomic policy in years. For example, the stalemate resulting from the US midterm elections will likely focus the fiscal debate on the debt ceiling rather than making a meaningful contribution to the progress of the US economy.

Meanwhile, the United Kingdom’s brief and spectacular failure to adopt an expansive fiscal policy will provide a cautionary tale for other European economies.

Europe: Supply will remain constrained and volatile

All else being equal, a weak growth outlook might be considered the death knell for inflation. As Milton Friedman famously pointed out, it is only really governments (or economic policymakers more generally) that can generate inflation, not the private sector. This might be a bit extreme, but the idea that understanding the direction of policy is critical to the inflation outlook is certainly true.

While authorities are likely to bear down on inflation in one sense, the broader geopolitical landscape is keeping the inflation impulse alive. The Russia-Ukraine war and resulting European energy crunch is an obvious example.

While it might be tempting to see this as a near-term issue only, there is a significant risk this will again be an issue in winter 2023/2024 and will continue until European energy infrastructure can be reoriented towards more secure energy sources.

The consequence for European consumers is dire. The hit to household real incomes in Europe is greater than in any other region of the world, ensuring the outlook for consumer spending is also the weakest.

More generally, there are good reasons to be sceptical of the idea that supply disruptions are a thing of the past. The gradual retrenchment of globalisation is likely to add to the vulnerability of supply chains. Geopolitical tensions between the US and China are already beginning to exert an influence on higher value add sectors such as semiconductors.

Furthermore, it is easy to imagine ways that authorities’ actions (either intentionally or unintentionally) might generate new supply shocks. For example, China’s rapid reopening should improve the immediate growth outlook, but it also raises the prospect of disruptions from the reopening.

In addition, hard rationing of gas supplies in Europe would likely lead to unintended consequences for industry and global supply chains, particularly given Germany’s exposure to Russian gas. Finally, the European Union’s price cap on Russia oil exports could reduce global oil supplies even further and lead to unintended consequences for the supply side of the economy.

While we expect tight monetary and fiscal policy to eventually return inflation back to target or even below, lingering supply shocks may mean that the full disinflationary force of policy is not felt until 2024.

China: Demand of last resort lost, but will the world import inflation?

For the past couple of decades, the global economy has been able to rely on two key supports – the Fed “put” on markets and China as a last resort source of demand. Both are now gone.

Chinese stimulus has successfully offset weakness in advanced economies several times in the past, including in 2009, 2011, and 2016. But since those episodes the effectiveness of Chinese stimulus in financing new investment has declined markedly.

The natural alternative to investment-led growth is a bigger role for the consumer. But this is a long-term structural change that will take years (at a minimum) to deliver growth dividends, assuming it can work. After all, China has been pursuing a more balanced and sustainable way of growing for more than a decade without much success.

That task will be made even more difficult while the housing market – an important source of wealth for households – continues to deflate, which was highlighted by the weakness in consumer spending at the end of 2022.

We still think that a housing crash is unlikely thanks to government policy, but if past international evidence is anything to go by, it would be a stretch to think that China is going to raise global growth prospects while the housing market is correcting.

Aside from growth, China has also had a significant influence on global inflation through the export of comparatively cheap goods. Many academic studies have found the spillover effects on inflation in other economies to be significant, ranging from a 0.2-0.8 per cent reduction in annual inflation.

But should we expect China to continue to export deflation over the medium term or turn into an inflationary impulse for the global economy?

In the near term, it seems likely that China will continue to be a deflationary force for the world economy. The near-term reliance on the “old” growth model of export competitiveness, weak currency, investment, and measures to support the housing market imply maintaining the status quo.

In the longer term, if China is to start adding to global inflation, then it will most likely be the result of a successful growth model transition. A greater role for private consumption would imply higher demand for more complex goods imports, thereby raising global input prices.

More generally, a successful growth transition would imply a very sharp increase in productivity to offset a very poor demographic outlook. Our projections for China’s working age population show a comparable rate of decline to that of Japan in the lost decade and significantly worse than other key economies. This is a huge obstacle to Chinese growth and to offset it would require a productivity miracle.

If that rise in relative productivity were to occur, it would lead to rises in wages, price levels, and the real exchange rate vis-a-vis the rest of the world. Our baseline forecast sees China struggling to undertake this transformation, meaning that China will remain far from becoming a source of global inflation in the medium term.

Market returns to be met with economic reality

In the past decade, weak economic growth has not been a barrier to stellar market and, in particular, equity returns. But looking ahead, economic realities are likely to provide more of an obstacle over the medium term.

The key difference is the higher discount rate environment. In the past decade, falling rates enabled equity multiple expansion and capital gains for fixed income.

But with rates set to remain high, returns should be more closely linked to economic fundamentals. Furthermore, valuations are still not compellingly cheap after adjusting for this new discount rate reality, particularly in the US.

Portfolio rebalancing over the next year is also likely to create a difficult environment for risk assets. Not only will quantitative tightening start to bite via lower levels of bank reserves and liquidity, but higher issuance by governments will raise the supply of safe assets and, at the margin, keep yields relatively high.

One positive for 2023 and beyond is that, although inflation will remain elevated in the near term, it will fall back as the economic cycle worsens. Given that re-emergence of weakly pro-cyclical inflation, we should expect that a negative stock-bond returns correlation will reassert itself further out in that investment horizon.

This will prove a welcome respite for investors after one of the worst years in living memory for the traditional 60:40 portfolio.

Innes McFee is chief global economist at Oxford Economics