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Economic Research: Global Macro Update: Many Routes To The Bottom

The Direction Of Travel Is Clear

Global macro performance over the next few quarters is increasingly a one-way bet. Financial conditions are tightening as central banks raise rates quickly, foreshadowing slower growth. Most leading and sentiment indicators are pointing toward slower growth as well.

This may be the most anticipated economic slowdown on record, but the data have yet to fully fall in line. Gloomy survey-based indicators are weaker than the actual activity numbers, but they are both pointing in the same direction. The question is how low growth will go and for how long it will stay down.

Purchasing managers' indices (PMIs) and sentiment indicators have turned south in recent months and are sitting at levels normally associated with recessions. Some consumer surveys have recently turned up, reflecting lower petrol prices, but this is likely to be transitory. The downward trend mainly reflects rising inflation, higher policy and market interest rates, and uncertainty about the conflict in Ukraine.

Chart 1a

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Chart 1b

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While the survey-based indicators are pointing down, actual activity numbers are holding up reasonably well. Labor markets are strong, and spending on services from travel to hospitality remains upbeat. This is partly due to pent-up demand from two summers of COVID lockdowns. However, weakness is clearly visible in rate-sensitive sectors such as housing and durable goods.

Labor markets remain a bright spot. In the U.S., unemployment rates are near cyclical lows; in the eurozone, it's at an all-time low. Most other major economies are in a similar situation, with unemployment rates below those compatible with sustainable growth and inflation. Employment growth has eased in recent months but remains robust, and workers are returning to the labor force.

Consumer spending has moderated as well in response to declines in wealth and demand stemming from higher fuel and food prices, but generally remains buoyant. These indicators are not yet consistent with a recession scenario. Labor market developments will be a key determinant of whether economies can avoid a sharp downturn, or not.

Reining In Inflation Is Macro Policy Priority Number One

Inflation has consistently surprised on the upside over the past two years, leaving central banks behind the curve, particularly in the advanced economies. Emerging-market central banks started moving earlier and are now closer to their terminal rates. The inflation surprise happened across a wide swath of economies, with emerging Asia a notable exception.

Progress to date on lowering inflation has mostly been limited to improvements in the "second derivative"--simply, the rate of increase in inflation is slowing. But inflation itself is still rising. Supply-side inflation appears to have peaked, at least for now, as global supply-chain pressures ease and as petroleum and industrial commodity prices drop. However, demand-side inflation--which is more directly under the influence of central bank policy--remains high and rising.

Chart 2

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Central banks have raised the pace of rate hikes as 2022 has progressed (see chart 2 for the advanced economies). With its third consecutive 75 basis point hike in late September, the U.S. Federal Reserve is now at the forefront of central bank movers in advanced economies. Despite the pickup in the size and pace of rate hikes, a few central banks are at best only modestly above the neutral rate. Others are just at this rate, or below.

Moreover, given the elevated rates of inflation, real central bank policy rates are uniformly negative regardless of which inflation measure one decides to use. Announced terminal rates for the present cycle also appear to imply that real rates may not get into positive territory under current projections, raising questions as to whether more rate rises will be required.

The challenge for policymakers is to bring inflation (and expectations) back to target before they become entrenched, without causing a sharp downturn. This involves lowering demand through tighter monetary conditions. In the benign scenario this means raising unemployment to a sustainable rate, with perhaps only a modest overshoot. Central banks do not have a great record on soft landings when addressing inflation of the level now seen.

The job of soft landing the economy is tougher when faster and higher policy rate rises are required. Recent declines in inflation have come mainly from supply factors, not reductions in demand. Our confidence in the benign, soft-landing outcome continues to fall.

Our Revised Forecasts And Narratives

Over the past quarter we have cut our GDP forecasts for almost all countries and regions (see table 1). This reflects tightening financial conditions and rising geopolitical risks. Outside of China, the pandemic won't likely move the macroeconomic needle.

Table 1

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For 2022, the U.S. saw the largest reduction in forecast GDP growth, falling by a full percentage point from our June forecast. We marked down gains in China and Japan by around half a percentage point. We marked up eurozone growth, reflecting a stronger-than-expected performance in the first half of the year, although economic performance will likely be flat to negative for the remaining two quarters.

A handful of commodity-exporting countries remain notably outside our markdowns to global growth. India is also an outlier, having emerged from the pandemic which stronger corporate balance sheets and with structural tailwinds.

For 2023, we lowered growth expectations across the board with global GDP falling by over one full percentage point (to 2.4%) relative to our prior forecasts. The eurozone leads the way down, with Germany again falling more than the region as a whole. For 2024 and 2025, our forecasts are broadly unchanged. The eurozone and the U.K. are exceptions--both are lower.

Table 2

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U.S.

Activity continues to slow as high inflation and interest rates hit purchasing power and housing affordability. Inflation measures remain at or near four-decade highs, with the headline rate easing to 8.3% year on year in August, while the core rate rose to 6.3%. Sentiment is steady to higher on the most recent readings in light of lower gas prices and expanding orders.

The labor market remains strong, reflecting robust job gains and, more recently, rising participation, which should moderate wage growth. Despite two quarters of negative sequential GDP growth the country is not yet in a recession, in our view. However, a shallow recession in early 2023 is now our base case.

The Fed is aggressively raising rates. In September it lifted the policy rate by 75 basis points for the third straight meeting. The current rate of 3.00%-3.25% is above neutral for the first time since 2007. The Fed will likely raise rates by at least another 100 basis points by the first quarter of 2023.

We have marked down full-year 2022 GDP growth to 1.4%, from 2.4% in our previous round. We lowered 2023 growth to just 0.2%, from 1.4% previously. Our quarterly profile projects the economy will shrink in late 2022 and the first part of 2023 before recovering later in the year.

For further details, see "Economic Outlook U.S. Q4 2022: Teeter Totter," Sept. 26, 2022.

Eurozone

The eurozone economy entered the second half of the year in good shape. GDP growth in the first half was broad-based driven by consumer spending, including strong tourism; sequential second quarter growth was 3.2%.

The labor market was extremely strong with an all-time low unemployment rate of 6.6%. Job openings were at the highest level in decades. Headline consumer inflation stood at 9.1% in August, driven heavily by energy, while core was 4.3%.

A sharp slowdown is imminent due to the conflict in Ukraine causing a severe shock to terms of trade and confidence. The risk of a recession in 2023 is significant in the eurozone, approaching 50%.

The European Central Bank is also playing catch-up but faces a relatively moderate challenge. All three key interest rates were raised by a cumulative 125 basis points in the third quarter and the benchmark deposit rate now stands at 0.75%. The policy rate will peak at 2% in the first quarter of 2023, in our view.

We marked down growth in the eurozone more than other regions, and we marked down Germany more than other eurozone economies in light of rising tension with Russia. Growth in the eurozone in 2022 should be a very respectable 3.1%, but that reflects positive developments in the first half of the year.

The second half looks very weak. Next year, growth should fall to just 0.3%. The quarterly profile has growth flat to negative from mid-2022 to mid-2023 before returning to potential.

For further details, see "Economic Outlook Eurozone Q4 2022: Crunch Time," Sept. 26, 2022.

China

Momentum continues to be soft as new COVID outbreaks and the associated restrictions are hitting activity again, particularly in the services sector. Moreover, a weakening real estate sector and weakening sentiment constitute additional drags on growth.

Inflation has remained low in China--it was 2.5% in August, reflecting ongoing weak domestic demand. Net capital outflows have been strong in recent months and the renminbi continues to depreciate against the U.S. dollar--in line with the global trend--breaching the seven barrier in mid-September. Reserves have fallen modestly.

The People's Bank of China in August lowered its benchmark lending rate by 10 basis points to support growth. Balance-of-payment considerations constrain its capacity for further cuts. Fiscal support has so far been modest since the authorities seem uncharacteristically content to let growth slide well below the official target of 5.5% this year.

We now forecast growth of just 2.7% in 2022, half the official target. Beijing's zero-COVID policy continues to restrain growth and confidence and is compounding the downward pull on growth emanating from the slumping property sector. This policy will eventually be lifted--likely early next year--and growth should return to potential of about 4.8% from 2023.

For further details, see "Economic Outlook Asia-Pacific Q4 2022: Dealing With Higher Rates," Sept. 26, 2022.

Emerging markets

Growth eased in the second quarter across emerging markets as inflation reduced real household income, business confidence deteriorated, and the external environment became more complicated. Recent high-frequency indicators show a mixed picture with mobility for retail and recreation now 12% over pre-COVID levels, but PMIs have been declining on balance.

Inflation outside of emerging markets in Europe, Middle East, and Africa appears to be moderating while oil prices fall and supply-chain price pressures ease. Financial stress remains above trend reflecting higher interest rates and a stronger U.S. dollar.

Emerging-market central banks have been ahead of their advanced-country counterparts in hiking policy rates, and in Latin America they are now near the end of their tightening cycles. Elsewhere, core inflation continues to rise, suggesting there is more work to do. Large recent hikes by the Fed are exacerbating balance-of-payment strains across emerging markets.

For the 16 emerging economies that we cover excluding China, 2022 GDP growth will hit 5.2% this year, in our view. This forecast is up 30 basis points from our previous round. India is the star of this group with growth of 7.3% this fiscal year (ending in March 2023), while Brazil has been marked up by 1.3 percentage points to 2.5%. Next year growth should moderate to 3.6%, a decline of 40 basis points from our previous round.

For further details, see "Economic Outlook Emerging Markets Q4 2022: Further Growth Slowdown Amid Gloomy Global Prospects," Sept. 27, 2022.

Global Inflation And Europe's Geopolitics Pose The Main Risks

The risks to our baseline scenario remain on the downside on balance. The two main risks are more persistent than expected global inflation and a worsening of the European geopolitical landscape. Of note, China will not likely be a source of downside pressure to our forecasts. The negative effects of its zero-COVID policy are already in our baseline.

As noted above, in response to an unexpected outbreak of inflation in many economies, central bank policy rates have risen quickly and are expected to climb higher. Policy rates should surpass neutral if they have not done so already. The hope is that tighter financial conditions resulting from the expected policy rate paths will bring inflation--and expectations--back to target in the next year or so. This will allow central banks to return rates to neutral, laying the groundwork for a recovery.

However, this outcome is not guaranteed. Inflation could prove more difficult to bring down than we now assume. More virulent wage-price dynamics--particularly in the U.S.--could trigger even higher policy-rate increases and tighter financing conditions. That would drive growth lower for longer, worsening outcomes for households (lower income), firms (lower earnings) and governments (higher deficits).

A worsening of the geopolitical situation in Europe comprises the second main risk to our global baseline. Some of our previously identified downside risks have materialized with the indefinite closing of the Nordstream 1 gas pipeline, pushing up prices and raising the prospect of rationing.

The situation remains in flux. The disruption of trade with Europe stemming from the Russia-Ukraine conflict could broaden beyond energy to include industrial inputs into the pan-Germany manufacturing complex. Food deliveries could be disrupted again. The reconfiguration of gas supply away from Russia may not play out as planned. Ports that specialize in the handling of liquefied natural gas may not materialize. European political resolve could weaken. Any of these factors could materially dampen activity, prolonging a downturn.

A Multi-Flavored Downturn Complicates The Rebound Narrative

While the focus of most forecasters rightly remains on the imminent downturn in activity in the coming quarters, we should also start thinking about the contours of the rebound. Economies move in cycles. All downturns are followed by recoveries. What could the rebound from the 2022-2023 global (growth) recession look like?

The rebound narrative is complicated by the differing reasons for the slowdown across the major regions of the global economy. The U.S. is arguably the most straightforward since it is the closest to experiencing a classic overheating problem. Policy needs to be tightened to slow growth and bring inflation, and expectations, back to target.

Europe's story is complicated by the uncertainties around the length of the Russia-Ukraine conflict and how that maps into the economic risks outlined above. At present, the recovery time is not only less certain but potentially longer than in the U.S.

China's rebound story depends first and foremost on health policy. The timeline for moving away from a zero-COVID stance is a political calculation. This makes it hard to predict; for now, a gradual reversal is likely early next year. A reversal would certainly help growth, although the real estate sector remains a challenge. Potential growth has declined, in our opinion.

The other pieces of the recovery narrative are structural inflation strains and the path of global interest rates. Are we going back to the pre-COVID era of lower for longer with persistently low inflation and r* (the real interest rate that equilibrates savings an investment) near zero? There are a few reasons why this may not be so.

First, supply chains are being reconfigured to ensure economic and political resiliency rather than only cost-minimizing efficiency. The world of a singular focus on costs has come to an end. The new world means shorter, more redundant, geopolitically driven configurations that will cost more but provide better returns on a risk-adjusted basis. Global price strains could be correspondingly higher.

Second, green investment looks set to accelerate as climate awareness has risen among government and private actors. This investment boom for the necessary green transition has the potential to raise r* as well, even if the "savings glut" persists. A higher rate structure--real and nominal--will give more room for maneuver to monetary policymakers. Neutral rates will be farther from zero, and asset prices will be less distorted by persistently low rates. This may be a silver lining coming out of what is otherwise a painful economic period.

Editor: Jasper Moiseiwitsch

Digital designer: Evy Cheung

Related Research

This report does not constitute a rating action.

Global Chief Economist:Paul F Gruenwald, New York + 1 (212) 437 1710;
paul.gruenwald@spglobal.com

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