The global economy is on the precipice of recession. Indeed, recessions appear to have already begun in some economies. Leading indicators in the Eurozone are deep in contraction, and we expect GDP growth to turn negative from the fourth quarter of 2022.
Admittedly, energy rationing this winter now looks less likely, given the build-up in gas storage. But the mild weather and reduced Asian demand that have allowed Europe to secure large amounts of liquid natural gas cannot be relied upon to continue. Moreover, we see no immediate end to the Russia-Ukraine war, meaning no flows of pipeline gas. In any case, avoiding gas rationing this winter only makes Europe’s recession less severe, rather than preventing it.
In the UK, GDP contracted in the third quarter; the weakness of leading indicators, and the sharp rise in interest rates means a more fundamental recession is setting in, or will soon. While the US is slowing, growth remains positive, with consumer spending especially resilient. But we take a more leading signal from the contraction in housing indicators.
Despite signs that inflation is peaking, our analysis implies that taming core inflation requires a substantial rise in unemployment. And critically, we think the Fed is prepared to do what is necessary.
In China, despite excitement about a double pivot towards easing zero-Covid and property sector policies, rising Covid cases are contributing to a near-term worsening in growth. A forceful recovery in housing is unlikely with developer funding conditions tight, the pipeline of activity depressed, and a supply overhang.
Across broader emerging markets, macro prospects vary considerably. Asia is best placed, while parts of Latin America are close to easing monetary policy. Inflation is still too high in the central and eastern European countries, while many frontier emerging markets are in the midst of crisis.
Global headline inflation pressures are passing their peak. But core inflation will prove stickier, as labour markets are too tight and firms have too much pricing power.
This means we envisage more rate hikes in the near-term, including another 1.0% from the US Fed and European Central Bank, and 1.5% from the Bank of England, by the end of the first quarter of 2023. Risks are skewed towards even more.
But the demand destruction during the recessions should ultimately put significant downward pressure on core inflation.
The upshot is that we think central banks will be in rate cutting mode again by late 2023. We project US interest rates to return to the effective lower bound by late 2024 and both UK and Euro area interest rates to do the same.
Risks are skewed towards weaker growth but higher inflation than the consensus expects. We have introduced a “sticky inflation” scenario in which tightening triggers recession, but underlying inflation proves more persistent.
Even then though, the policy rate falls well below 2% across the mean of all scenarios. This is why we are bullish on duration heading into next year, as well as currency proxies like the yen and Swiss franc.
The outlook for risk assets on an excess return basis is poorer. After the recent rallies, a soft landing is increasingly priced into equites and credit spreads. In our opinion, a durable rally will need to wait until the recessions are established.
