Global Activity: Not Quite Dead Yet

The highly anticipated global recession has yet to arrive. The consensus view is that a sharp slowdown is all but inevitable, given the steepest rise in policy rates in four decades, ongoing geopolitical tensions, and energy supply constraints stemming from the Russia-Ukraine conflict. In line with this view, sentiment indicators such as purchasing managers' indices have been signaling a sharp slowdown for months. And an array of consumer and business confidence indicators have given similar signals.

However, activity data are not cooperating and third quarter GDP featured a swathe of upside surprises. The U.S. economy grew by 2.6% on an annualized basis as slowing but still positive consumption growth, especially in services, and exports offset weakness in the interest rate sensitive real estate sector. The Eurozone economy surprised by growing at all, with output expanding by 0.8% annualized in the flash estimate, with all major economies, including Germany, recording higher output. China surprised on the upside as well, growing 3.9% on a year-on-year basis, boosted by net exports and government spending. The property sector has remained weak due to restrictive housing sector policy and ongoing COVID-19 restrictions.

Inflation remains stubbornly high, especially in the advanced economies. While policy rates have been lifted this year by up to 300 basis points (in the U.S. and Canada, less so elsewhere), overall inflation has yet to peak. Supply-side inflation has recently begun to moderate as supply chains normalize and food and fuel prices have plateaued, at least for now. But demand-side inflation--most effected by central bank policy--has not. This suggests that more rate hikes are required.

Long and varying lags of monetary policy transmission cloud the picture. As we have argued previously, the U.S. has the largest macro imbalances of any major economy and emerging markets were generally quicker to respond to inflation pressures last year and rate cycle are near completion.

Labor markets remain resilient, and in our view remain key to the slowdown narrative. While employment growth has slowed in most economies as activity growth has eased, it remains sufficient to keep unemployment rates at or near four-decade lows. Some weakness has appeared in the more interest rate sensitive sectors such as real estate and durable goods, but services activity and employment remain robust and labor markets remain tight. The current unemployment rate in most regions remains inconsistent with low and stable inflation. And as long as economic agents have jobs – or think they will – they will continue to spend, perhaps more moderately, and support activity.

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We think this resilience is temporary. The determination of monetary policymakers to bring inflation (expectations) back to low and stable rates suggests that policy rates still need to go higher. And, given the big miss on correctly identifying last year's incipient inflation pressure as persistent means that policymakers will error on the side of doing too much rather than too little. As a result, the window for a soft, non-recession landing is closing fast: a meaningful slowdown is highly likely to come.

Inflation Fighting: Now Comes The Tricky Part

Inflation fighting has been straightforward this past year. In a perverse way this has been aided by many central banks being behind the curve. Large and frequent rate rises were needed to bring the monetary policy stance beyond neutral in order to slow activity, bring price pressures down and bolster credibility. The period of outsized rate hikes appears to be ending, but rate hikes are not finished. We are simply returning to the environment of the last few decades when central banks moved in 25 basis point increments.

The challenge now is when to stop hiking. Milton Friedman famously said that monetary policy works with long and variable lags. The implication is that policymakers should not be targeting current inflation (which they cannot influence); rather, they should be looking at forecast inflation in the second half of 2023 and expectations. If rate rises to date suggest that demand will slow sufficiently to bring inflation back to target over that forecast period, then there is no reason to continue hiking. With growth and demand remaining resilient and inflation forecast to remain above target, given current monetary policy settings (and financial conditions), the implication is that policy rates will need to rise further.

Complicating this challenge is the wedge between core and non-core inflation. Headline inflation (core plus non-core) has peaked or should be peaking in the coming months. However, core inflation continues to rise in many economies as labor markets remain strong and savings cushions are being deployed. Policymakers face a tricky environment where further monetary tightening is likely to be required at a time when growth and headline inflation are both falling.

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While inflation fighting is largely a domestic affair, there is an international spillover dimension as well. This involves the U.S. dollar as the main global safe haven and U.S. Treasury as the main global reserve asset. When a central bank lifts its policy rates, one of the channels through which monetary policy works is through strengthening the currency, which lowers import prices.

However, when the U.S. Federal Reserve is raising rates at the same time, perhaps combined with global risk aversion, then the U.S. dollar strengthens and other currencies depreciate, even when the local central bank is lifting rates. This means, in effect, that other countries import U.S. inflation through their weaker currencies and that local central banks need to do more to bring local inflation under control. On the real side, tighter monetary policy means lower output and inflation than would otherwise be required.

The macro policy mix will become an increasingly important issue as inflation remains elevated and output slows. Ideally, monetary and fiscal policy should generally be rowing in the same direction. However, with inflation still higher but employment starting to soften, monetary policy will need to remain tight while pressure will grow for fiscal policy to ease. Adding demand to the economy through fiscal stimulus will tend to push inflation higher and require more tightening by central banks. Governments will try to thread the needle and limit targeting support to the most vulnerable.

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Our Forecasts: Not Materially Different

Our updated GDP forecasts are not materially different from our previous round. The larger change is in 2022 since growth has held up better than we expected and upward revisions are widespread. We have marginally marked down 2023 growth, with the United Kingdom being an outlier as the recession there looks to be deeper than previously thought. Growth is unchanged for 2024-2025. Inflation forecasts are generally higher across the board because price pressures are more entrenched than before, meaning both higher rates for longer and a slower return to target rates.

U.S.

Growth momentum continues to moderate, although output in the third quarter rose at an unexpectedly high 2.6% annualized. Retail sales rebounded in October, but the latest reading for consumer and business sentiment continue to ease; both remain above the neutral level of 50. Job gains in October came in strong as well, with some pressure starting to emerge in interest rate sensitive sectors such as real estate. Inflation eased to 7.7% year over year in October, lower than expected; core inflation also came in lower at 6.3%. Nonetheless, the Fed continues to move aggressively, delivering its fourth consecutive 75 basis point rate increase in early November.

We are forecasting 1.8% growth in 2022 and fractionally negative growth in 2023 with a shallow recession in the first half of the year. Rising prices and interest rates will continue to eat away at household purchasing power and consumer confidence. Inflation should fall sharply from 8.1% this year to 4.3% in 2023 and continue toward 2% thereafter. We see the Fed Funds rate now peaking at 5.25%. For further details, see "Economic Outlook U.S. Q1 2023: Tipping Toward Recession."

Eurozone

Growth again surprised on the upside in Q3 with the Eurozone economy expanding by 0.8% on an annualized basis; all four major economies grew in the quarter. The labor market remains strong as employment expanded in the third quarter, and the unemployment rate stands at a record low 6.6%. Manufacturing production in the EU is at an all-time high, driven by a strong rebound in the automotive and the pharmaceutical sectors while energy-intensive sectors have curtailed activity due to high costs. Inflation remains extremely elevated at 10.6% in October, driven by energy price inflation of more than 40%. Core inflation remains lower than in the U.S. at 5.0% in light of smaller macroeconomic imbalances. In a similar vein, Eurozone construction in Q3 was only 2.4% below the record level reached in Q1, showing a less-depressed housing sector than in the U.S. Sentiment remains weak as the composite PMI remains below 50, but edged up in November.

We now forecast GDP growth for the Eurozone at 3.3% in 2022, falling to zero next year as sticky inflation, higher interest rates and stunted hiring sharply decelerate spending. High wage growth and public investment will provide support. Germany is the weakest of the major economies and is likely to see a shallow recession during the year; other major Eurozone economies will likely escape that fate. Inflation should fall from 8.5% this year to 6.1% next year. We see 75 basis points more from the ECB. For further details, see "Economic Outlook Eurozone Q1 2023: Reality Check."

Asia Pacific

China's recovery in Q3, driven in part by state-financed industrial production growth, masked underlying weaknesses. Organic growth remained soft and sentiment remained weak amid a broadly unchanged COVID stance and a property downturn. While the work report coming out of the Party Congress in October suggested a broadly unchanged approach to economic policymaking, the comprehensive package of property policy easing measures announced in November should help lay the foundation for an eventual recovery.

Growth in the rest of Asia is holding up well, with the more domestically oriented economies of India and Indonesia outperforming. Tight U.S. Fed policy remains a headache for the region's central banks, given imported inflation via currency depreciation. Japan remains an outlier.

We have raised our 2022 China growth forecast by 0.5 percentage point to 3.2% and growth should pick up in 2023 as the government eases its COVID stance and the property market stabilizes; the forecast for 2023-2025 remains unchanged. Elsewhere, India's forecast has been lowered by 0.5 percentage points for the next two fiscal years on slower global demand. Regional growth remains healthy overall. For further details, see "Economic Outlook Asia Pacific Q1 2023: Global Slowdown Will Hit, Not Halt, Asia-Pacific Growth."

Emerging Markets (EM)

EM growth is decelerating in line with our expectations, with broad divergence based on proximity to Europe, size of the domestic market, and the composition of the export basket. Headline inflation has likely passed its peak in most EMs, driven by energy prices and slowing demand, reflecting tightening financial conditions. EM central banks, which were quicker off the mark than their developed market (DM) counterparts, have in some cases stopped or paused their tightening cycles, particularly in Latin America and Eastern Europe (Brazil, Chile, Poland, Hungary). Turkey remains an outlier on the policy front. EM Asia has experienced less inflation pressures than other EMs, in line with the regional trend. High U.S. interest rates and a strong dollar pose outsized risks to EMs.

We have lowered our GDP growth forecasts for EMs to 3.8% in 2023 (from 4.1%). This revision comes from all EMs excluding China and Saudi Arabia. Most EM will expand below their trend rates in 2023. Forecasts for 2024 and 2025 remain broadly unchanged. Even as inflation should ease in most EMs next year from falls in food and fuel inflation, it's poised to remain above many EM central banks' targets. For further details, see "Economic Outlook Emerging Markets Q1 2023: Hanging In There, But Growth Prospects Remain Tough."

Main Risks: Stubborn Inflation, Geopolitics

Stubborn inflation requiring more than expected rate hikes remains our top risk. Indeed, we have already partly moved to this scenario from our previous forecast round. Policy rate projections in the U.S. are higher and the probability of a recession-free soft landing continues to decline. Higher rate hikes are not fully priced in and the higher-for-longer scenario implies a potentially sharper downturn and more pain in the interest-rate sensitive sectors of the economy.

Geopolitical developments comprise our second downside risk. The Russia-Ukraine conflict has entered its eighth month with a large degree of uncertainty around its duration. The impact on sentiment has been well documented and is a contributing factor in our forecast for a sharp growth slowdown. More directly, good and energy prices remain elevated although ongoing increases (inflation) have disappeared for now. Nonetheless, supply concerns remain for gas (heating) and food, beyond this winter for the former at least. Any escalation or broadening of the conflict would magnify this risk.

Higher Chinese growth stemming from a relaxation of COVID restrictions remains our main upside risk. Although growth has picked up recently on the back of government investment spending, the household sector is languishing and growth for the year will come in well below the official target of 5.5%. While the property sector correction is necessary in our view and will be a multi-year process, vigorous COVID-related restrictions are putting a large drag on growth. A move toward the health policy in place in most other countries would boost growth and, given China's large size, global sentiment.

Revelations And Non-Revelations In 2023

We wrap up with some likely macro revelations that are likely to occur in 2023, as well as some issues that will remain unresolved. Supply chain-related pressures that emerged as a result of the pandemic will likely be resolved in the first part of the year; however, the reconfiguration and rebalancing from efficiency to resilience will take years.

The bottom of the current economic and financial cycle will be reached, probably in the second half of the year; however, the rebound will differ across regions, complicated by nationalism and geopolitics. Finally, inflation will have peaked and will be on a downward path; however, getting inflation back down to "low and stable" and firmly re-anchoring expectations will be a long grinding. Putting the genie back in the bottle will not be easy.

Other issues will remain unresolved. The rise of geopolitics and nationalism is not transitory and will be with us for the foreseeable future; the era of "pure" textbook macroeconomics has clearly ended. The green transition will accelerate as we pay more attention to sustainability (and its proper definitions) and natural capital. In short, it is not just about economics, credit, and finance any more. We are living in a multidisciplinary world, and we are not going back to the simpler pre-COVID world of 2019.