Davos Mood Swing: Was It The Altitude?

The macro mood post-Davos has improved noticeably. This mainly reflects relief over the resilience of the European economy including gas availability, and optimism over China's surprising early (and abrupt) exit from its zero-COVID policy. While both developments are positive for the global economy, S&P Global Ratings believes they add fuel to the dominant macro risks: inflation and rate rises.

On the eurozone, we were not surprised by the resilience. Our out-of-consensus call had included a boost from the production side, as supply chain bottlenecks eased and firms began to clear order books. This despite the hit on growth from higher rates and tighter financial conditions. We could not have predicted Europe's mild winter, but this has also been helpful to economies.

On China, the timing and pace of the opening did surprise us. Our forecast assumed this would happen in a more gradual fashion (i.e., with Chinese characteristics) over the first part of the year. The earlier reopening keeps China on track for close to 5% growth this year despite a weak finish to 2022. But the demand spillover will be limited given that the recovery will be skewed toward consumer spending and, therefore, largely domestic.

China's reopening will add to global inflation pressures. Commodity prices are rising already. This will complicate macro policy in countries where the focus is already squarely on bringing down inflation.

As such, we are taking the Davos euphoria in stride. We explain why, and reaffirm our current macro view through the lens of the "big three" economies. Given what is currently moving the global macro needle, which have rearranged the usual ordering of our discussion to: first the eurozone, then China, and finally the U.S. and emerging markets.

Eurozone: Some Luck With The Weather, Some Supply-Side Support

Coming into the winter, the market reflected fears about gas shortages, rationing, and a material disruption in activity. These have not come to pass. On the policy front, the diversification of energy sources--including from liquefied natural gas imports--has helped fill inventories quickly. On the weather front, a mild winter and some moderation in industry gas demand have lowered gas drawdowns. As the winter winds down, the relief is tangible.

As we had forecast (out of consensus), the production side of the eurozone economy continues to perform strongly. Industrial production is at an all-time high despite soaring energy costs. Industry has begun to process the large backlog of orders coming out of the pandemic as supply bottlenecks ease. This led the microchip intensive sectors (including automotives) to strongly increase production in the second half of 2022 while energy intensive sectors (chemicals, metallurgy) curtailed activity.

This tailwind will likely continue for a while longer, and then fade. A European Commission survey suggests that industry has an additional five to six months of production to fill the current order book. Also on the production side, construction has boomed on the back of deeply negative real mortgage rates and a change in household preferences for housing. Construction is now 3% above its pre-COVID level.

Chart 1

As in other advanced economies, the labor market in the eurozone is tight. The unemployment rate remains near a multidecade low, and job openings are at a multidecade high. Some signs of moderation in hiring are showing in the data, but there is no sharp reversal in sight. Meanwhile, we see an acceleration in wages. This suggests that policymakers will find bringing employment and inflation down to sustainable paths will be more challenging than they expected.

Monetary policy tightening has started later in the eurozone than in the U.S. The European Central Bank now sees its benchmark deposit rate rising above 3% early this year and remaining there into 2024. We agree. Meanwhile, fiscal policy remains slightly expansive. Government support to households contributed to higher consumer spending in the third quarter, while real wage growth has been flat. The personal saving rate remained constant, contrasting with the drawdowns in the U.S.

Overall, we still see flat growth for the eurozone this year, with a slight recession in Germany toward the middle of the year. But the probability of recession has declined and there are upside risks to our 2023 growth forecast. We also expect upward revisions to 2022 growth given the strong finish to the year.

China: An Early Opening, But With Limited Spillover

The major development over the past two months has been China's surprising volte face on its zero-COVID policy. We were expecting a gradual unwind of the policy this year. The rapid rollback of almost all restrictions was not in our baseline.

China's reopening will not repeat the massive 2008 stimulus that accelerated investment growth and commodity demand during the global financial crisis. This time, China's recovery will be consumer and services led, with less spillover to the rest of the world.

High-frequency passenger road, subway and domestic air travel indicators are rising steadily. This is boosting consumption during the Lunar New Year holiday. Beyond the domestic consumption recovery, we also expect a pickup in outbound tourism, which will benefit neighboring countries. On the investment side we see less of an impact, although we expect property market activity to bottom out this year following a range of support measures in the past two months. But this will largely be a consumption led rebound, with modest demand spillover to the rest of the world.

Chart 2

We do expect some global impact, however, as is already reflected in commodity prices. Aviation fuel prices have begun to rise, and we see global oil potentially hitting $100 per barrel this year as the Chinese recovery builds. Industrial metals prices are also rising. These will result in positive terms of trade shocks for exporters of these commodities, many of which are emerging-market countries. This positive income shock will offset declining demand from the U.S. and the eurozone, varying by country.

United States: Continued Strong Services And Wage Growth

The U.S. is not at the center of the Davos debrief. However, the state of the world's largest economy obviously matters. While softening in the goods sectors of the economy has been clear from the data for months (especially in real estate and tech), the U.S. continues to experience strong services growth and a tight labor market. Wage growth remains strong--though negative in real terms--and the unemployment rate has dropped back to 3.5%, a 50-year low. This is well below its sustainable rate, which we see in the low to mid 4% range.

Chart 3

Powered by a tight labor market and a drawdown of COVID-era excess savings, the economy has continued to grow robustly. Fourth quarter GDP growth came in at 2.9% (down from 3.2% in the third quarter) led by consumer spending and inventory accumulation That all being said, higher rates and financial conditions will continue to bite. We expect a shallow U.S. recession beginning in the first part of the year, as high prices and rising borrowing costs squeeze U.S. households. Growth in 2023 will basically be zero. Still-healthy household balance sheets have kept the slowdown from turning into something more severe.

U.S. policymakers are focused on stubbornly high inflation--this remains the main policy challenge. While overall inflation has peaked and begun to decline, core inflation (personal consumption expenditure, the Fed's preferred measure) remains near 5%, well above the Fed's 2% target. We see the Fed raising its policy rate to above 5% in the first part of 2023, and keeping it there into 2024. The risk is that wage inflation turns out to be stickier than most now expect and that the Fed, still behind the curve, will need to go higher for longer. But while U.S. households continue to eat into their savings, there still may be enough cushion to absorb the impact of rate increases leaving open the possibility of a soft landing.

Emerging Markets Excluding China: Net Positive On Balance

China's earlier and speedier abandonment of stringent COVID policies should bring forward the growth impulse in emerging markets, especially through tourism channel. The main beneficiaries are in emerging-market Asia, which had significant inflows of tourists from China pre-COVID. In Vietnam, Thailand, and Malaysia tourism from China previously constituted a sizable portion of GDP. Elsewhere, even in destinations where Chinese arrivals have grown to become a sizable share of the tourism market, their contribution to GDP is generally small.

There could also be a positive net impact for emerging markets through the commodity price channel. The main beneficiaries will be the major commodity producers such as the Gulf countries (oil) and Latin America (metals and agricultural products). Chile and, to a lesser degree, Peru stand out given the importance of copper in their export share and, subsequently, the current account balance and GDP growth.

For other emerging markets commodity exporters, any improvement in terms of trade will only translate into stronger GDP growth if higher incomes result in more spending (versus saving). Our sense is that the revenue windfall will be a relief to external and fiscal pressures for many countries. China may need to see a more decisive improvement in its property sector for its reopening to help metals exporters in emerging markets. Meanwhile, higher oil prices will slow expected disinflation in 2023 at the margin, but not enough to shift the stance among central banks in emerging markets, which is to pause or even begin cutting this year.

Our Post-Davos Macro Affirmation And Risk Scenario Adjustment

The moderate macro euphoria coming out of Davos does not change our view. Rather, it underscores it. Our above-consensus view on the eurozone seems to have played out, and China's surprise reopening is still broadly consistent with our just-under 5% GDP growth forecast this year, despite the weak finish to 2022.

While a more resilient Europe and an earlier opening China are both positive developments, the global economy is certainly not out of the woods. Yes, recession risks may have declined, but the main macro challenge remains inflation. Specifically, how will policy rate increases--and tighter financial conditions--needed to bring inflation back to target play out in 2023 and beyond? Stronger momentum is a two-edged sword. It provides tailwinds to growth but raises the possibility that rates may need to go higher to rein in demand, and bring inflation back to target.

The bottom line is that we are affirming our baseline scenario. However, upward growth revisions risk higher rates for longer, and the associated negative effects on output over the medium term. We will provide a full set of forecast revisions in our upcoming report on credit conditions, in March.

Related Research

• Global Macro Update: Surprising Resilience Unlikely To Last Into 2023, Nov. 30. 2022
• Excess Savings Is A Double-Edged Sword, Nov. 23, 2022
• No Easy Way To Correct Outsized Dollar Strength, Oct. 6, 2022