investment insights
Slowing or stalling? A cautious outlook for the global economy
War and pandemic have dealt twin blows to the global economy. Conflict in Ukraine and lockdowns in China have damaged growth and driven up prices worldwide. Much now depends on the fate of the US economy and domestic inflation. Can the Fed bring it to heel without causing a recession? We retain a cautious outlook, but are optimistic that growth will remain above-trend this year.
The year started well. The global economy was recovering from the pandemic and growing strongly. Consumers in the West were spending with abandon, boosted by generous fiscal support measures. Employment rose. Corporate profits – and margins – were at record highs, despite high inflation. Yet from this hopeful start, two events disrupted the prevailing growth and inflation mix.
Russia’s invasion of Ukraine was the first, and has altered some dynamics in the global economy forever. We see the war shaving 1% off global growth this year, primarily through higher commodity prices denting consumption. While the military confrontation has not escalated further and is now primarily concentrated in eastern Ukraine, it has implications that surpass the human tragedy and the hit to economic growth. Western support for Ukraine in weapons, intelligence, and funds has been substantial. We expect further energy supply disruptions ahead, with European sanctions expanding to Russian oil exports (as part of a now-inevitable shift from Russian energy dependence), and Russian retaliatory measures further disrupting supply. Denied access to the imports necessary to refine and process oil, Russia will find it difficult to sustain production. Meanwhile, it would take a severe reduction in demand or supply increases from other producers to offset the loss of Russian oil. We thus anticipate the yearly average oil price remaining above USD 120 per barrel for the remainder of the year – a figure that is above consensus estimates, and constitutes a major economic headwind.
The second source of pain is in China, where stringent Covid policies are applying the brakes to an economy that had still not caught up to pre-Covid growth rates. Cases are now falling nationally and a cautious re-opening has started, yet a full re-opening is unlikely before the end of June, and only if the virus remains under control – a ‘big ask’. Further relaxation will probably have to wait until the 20th Communist Party People’s Congress ends this autumn. In the interim, the authorities’ preference for incremental fiscal and monetary easing should only partly offset the hit to growth, while an under-vaccinated population suggests a robust consumption rebound is unlikely. We expect a second-quarter contraction, and growth falling far below the official 5.5% target this year, towards 4%. Trouble for the world’s largest goods exporter and delays at the world’s largest port have gummed up transport routes and global logistics networks. We do anticipate some improvement as Shanghai gradually reopens. However, it will take quite some time for supply chains and activity to recover to pre-Omicron levels.
Amid slowing growth and higher prices, developed market central banks face tough choices. Their decision has been squarely to sacrifice growth in the attempt to control inflation. The good news is that the vigorous post-pandemic rebound had built up a large growth buffer to absorb the slowdown. At the start of the year, growth expectations for the US and Europe were around 4%, more than double trend rates. Now we forecast around 2.9% and 2.5% respectively, and foresee little risk of recession before 2023. For now, the US economy looks strong: unemployment is close to record lows, and spending on goods and services – buoyed by fiscal handouts and pandemic-era savings – continues to soar. The obvious aim for monetary policy is to bring demand down to more sustainable levels in order to contain inflation, while trying to avoid choking it off entirely.
Here the Fed faces a tremendous challenge. It is starting much later, with inflation much higher and unemployment much lower than in past rate hiking cycles. In the post-World War II era, the US central bank has never successfully brought inflation down by four percentage points without causing a recession. Today, it also needs to shed around USD 2 trn of assets from its balance sheet simultaneously, entering fresh uncharted waters. The Fed’s aim will be to bring rates back to a neutral level (which we see at 2.5-3.0%) by Q1 2023, yet the risk is that it may go beyond this point to bring inflation to heel.
The trajectory of US inflation is thus key for the world’s growth outlook. For the Fed to step back from aggressive tightening, it must see clear evidence of inflation falling. The signs so far are mixed at best. Wage growth has moderated slightly. Base effects will be more helpful going forward. With luck, air fares, hotel rates, and used car prices should normalise in the coming months. Yet services inflation is running ever higher on remarkable domestic demand, and oil prices should stay elevated. However – and importantly – reduced fiscal support, combined with the monetary policy shift (bringing overall tighter financial conditions) should soften demand and bring inflation down. Fine-tuning the slowdown will also be tough. One area we will be watching closely is housing, where cooling demand would do much to take the heat out of the economy. With mortgage rates that recently flirted with 6%, affordability is declining and activity weakening. We foresee housing becoming a drag on growth this year and next, and note that a chronic supply shortage should help prevent any crashes ahead. What happens on the employment front (and more specifically, on earnings) will also be critical. And apart from the data, we will also be paying great attention to comments from the Fed.
Meanwhile, US rate rises are not just an issue domestically; they bring tighter financial conditions globally, in a world of stretched asset prices and high levels of dollar-denominated debt. Emerging markets face soaring food and fuel costs and a second inflationary shock, after many had already implemented large rate hikes. With geopolitics tense and supply disruptions abounding, companies are attempting to bring production nearer home, reducing the efficiencies of decades of globalisation. Overall, the outlook for the global economy has deteriorated as headwinds compound. The risks appear skewed for slower growth, with the probability of recession next year rising. Yet there are some factors that could make us turn more positive. A greater fiscal response to the war from the eurozone, the Fed pivoting to a more neutral stance, a ceasefire in Ukraine, or more encouraging data out of China, could all shift us to a more constructive stance. For now, however, we retain our cautious outlook.
To read our full second half 2022 outlook, with macroeconomic forecasts and views by country and asset class, please click on the pdf in the top right-hand corner of the screen.
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