Economic Growth, outlook 4th quarter 2022

Summary

  • Near-term, inflation will remain elevated. We anticipate at least another 100–150 b.p. of tightening from major central banks in the next few months.
  • There are already signs of an economic slowdown globally, but household finances are robust, corporate balance sheets are strong, and the global financial system does not seem particularly vulnerable to asset price bubbles.
  • We also expect the Chinese economy to rebound in 2023 after a poor performance in 2022 – another reason to expect the coming downturn to be milder rather than more severe.
  • In financial markets, higher interest rates, lower equity prices and wider credit spreads are, unfortunately, part of the solution to the inflation problem. Much of the work has already been done, but we think it is nonetheless premature to sound the all-clear.

The Macro Picture

Inflation remains persistently high, dominating everything else in the macro outlook. Because inflation is too high, real growth is slowing; the probability of a near-term recession has risen sharply; monetary policy is rapidly tightening; and financial markets have been repeatedly buffeted by volatility. Inflation is the key variable going forward.

The primacy of inflation poses a massive challenge, because no inflation model is sufficient to give investors or policymakers a high degree of confidence in the future path of prices. While broad brushstroke observations about inflation are reasonably reliable over time, they tend to work across decades, not months.

For example, we have argued for years that rising populism and deglobalization would drive inflation higher in future – but is today’s inflation what we anticipated? Not at all. We expected, and continue to expect, inflation to be slightly above pre-pandemic levels in the future, but we certainly did not anticipate the recent massive spike in prices, nor would we attribute that spike primarily to populism or to deglobalization.

Central bankers rely on a relationship between the labor market and inflation, correctly observing that tighter labor markets generally drive inflation higher. But models based on that premise badly underestimated the magnitude of the current price shock as well. The net result is that central bankers are, to paraphrase one of Federal Reserve Chair Powell’s speeches, stumbling around in the dark, trying to avoid running into the furniture in their efforts to set policy.

As we see it, the near-term picture suggests that inflation will remain elevated. In the US, core inflation (excluding energy and food) is set to outpace headline inflation, driven largely by increasing shelter costs. We believe that the roughly 20% rise in home prices over the last year has yet to be fully felt in the inflation data.

In the 2007/2008 cycle it wasn’t until 15 months after home prices peaked that shelter inflation began to move lower. If that experience repeats in this cycle, it won’t be until next summer before shelter inflation moves lower, and shelter is the largest category within the inflation basket.

The labor market remains strong as well, and that should keep services prices elevated. We expect price pressure from services to be sufficient to keep overall core inflation elevated even though goods prices are decelerating as global supply chains reboot and energy prices decline.

In Europe and the UK, soaring natural gas prices mean that inflation will stay close to 10% for the remainder of the year. It is alarming that European natural gas prices remain almost 10 times their precrisis levels as the winter heating season approaches.

This is clearly a result of the Russian invasion of Ukraine, and inflated prices may not be the worst of it: if supplies are limited owing to the war, energy rationing may be necessary this winter, which would very likely throw the European economy into a sharp recession rather than the milder version we anticipate.

Smaller developed-market economies, too, are suffering from high inflation. In Australia, New Zealand and Canada robust housing markets have pushed prices higher. And in Scandinavian countries commodity prices have pushed inflation higher as well. Simply put, there are no western developed economies immune to rising inflation.

It is often observed that the best cure for rising prices is rising prices. The logic is that, if left alone long enough, rising prices will eventually hurt consumers to the extent that they pull back on purchases, reducing demand and rebalancing the system.

While that may be true, it would be a brave central banker indeed who chose to try that particular experiment in the current environment. Even if this laissez-faire approach did work, “eventually” would very likely be an intolerably long time to wait.

As a result, central bankers are not relying on high prices to self-correct, and we are in the midst of a very aggressive cycle of rate hikes. Policymakers around the world are moving rates by 50, 75 or even 100 basis points (b.p.) at a clip, scrambling to slow demand enough to bring inflation under control.

We believe that process has significant room yet to run and anticipate at least another 100–150 b.p. of tightening from major central banks in the next few months.

The tightening that has already taken place is beginning to have an impact—there are signs of an economic slowdown globally. Housing markets are cooling sharply as mortgage rates rise, and tighter financial conditions are dampening growth in general.

We think there is much more economic pain to come. It will simply not be possible for central banks to bring inflation under control without slowing growth and weakening labor markets. While in “normal” times, market participants might view a central bank raising rates into an economic recession as a policy mistake, in this environment we think it may be necessary to do just that.

We expect a recession in both the eurozone and in the UK, with growth likely to be consistently negative for several quarters. In the US, we forecast growth to be at or near zero for several quarters: better certainly than in Europe, but not good in any absolute sense.

Whether that is officially determined to be a recession or not is a semantic question rather than a substantive one – the outlook is gloomy, no matter what words one wishes to use to describe it.

That said, it’s important to put our expectations in context. While inflation is putting immense pressure on the global economy, we believe that this too shall pass. Central bankers are taking the appropriate steps to bring inflation down.

While that process will be painful, we believe that it will eventually be successful. Even during what will be challenging months to come, there are reasons to expect that the coming downturn will be minor compared with past recessions. Household finances, buoyed by pandemic-era stimulus, are robust, corporate balance sheets are strong, and the global financial system does not seem particularly vulnerable to asset price bubbles.

That means that rather than a sharp downturn, we expect a milder, grinding slowdown that persists for several quarters but does not cause the same economic and social dislocation as the last two recessions.

We also expect the Chinese economy to rebound in 2023 after a poor performance in 2022. This year’s growth was plagued by repeated bouts of COVID-related shutdowns and bottlenecks in global trade. Both seem to be fading, and the political imperative to keep growth on its medium-term upward trajectory should lead to increasing support as 2022 turns into 2023. While that won’t be enough to push the global economy onto a faster growth path, it is another reason to expect the coming downturn to be milder rather than more severe.

What does this mean for financial markets? Until inflation is declining in a sustainable way, investors should not expect support from central banks. Quite the contrary: one of the primary ways that monetary policy transmits to the economy is through financial markets.

Higher interest rates, lower equity prices and wider credit spreads are, unfortunately, part of the solution to the inflation problem. Much of the work has already been done, but we think it is nonetheless premature to sound the all-clear. We expect market volatility to be with us for the next several months at least.

Outlook

  • Inflation remains too high, but the primary driver has switched from goods to services. Because services prices tend to be more persistent than goods prices, that rotation means inflation is likely to stay higher for longer.
  • Rate hikes from earlier this cycle are already weighing on activity, most notably in the housing market. We expect that impact to persist and for the slowdown to broaden into other sectors of the economy.
  • Rate hikes are set to continue, and the rapid pace of monetary tightening is yet another reason to expect growth to slow.

Risk Factors

  • If inflation does not fall as expected the Fed’s plan to raise rates to only moderately above neutral will be at risk – and every rate hike increases the odds of a hard landing.
  • Commodity prices pose two-sided risks. Falling gasoline prices were a welcome relief over the summer, but geopolitics remain uncertain, and prices could go either up or down from here.