Global Scenarios and Heat Map: Q3 2022 Update
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byAlex Ng
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- Our forecast of a global growth slowdown is starting to come to fruition, both as consumption and global trade slow. However, the driving forces differ between the U.S. (broad based inflation and tightening financial conditions) compared to EZ (real income shock from energy crisis) and China (zero COVID strategy impact on consumption and property developers deleveraging). The GDP slowdown at times will becoincidentalbut at other times into 2023 will differ and the EZ faces clearer recessionary risks before the U.S.
- We see some easing of immediate supply chain and post COVID reopening inflation pressures into 2023. Combined with the existing decline in commodity prices (outside of natural gas), plus some DM monetary policy normalization, this can help to bring down headline and core inflation into 2023.Wage inflation is a problem however for certain DM countries (e.g. U.S.) and this means a moderate alternative probability scenario of super aggressive Fed tightening (Figure 1). EZ gas prices will likely fall substantively in H1 2023, as Russia changes tactics and normalize gas exports to Europe (here).However, we do not see a peace deal between Ukraine and Russia over the next 18 months (here).
- EM countries have suffered less than DM currencies from USD strength, which has avoided a broad based tightening of EM financial conditions. Better current account positions than 2013, plus wider bond yields spreads for most big EM ex China have helped. Even so, a swing to restrictive Fed tightening can cause some tensions among weaker EM countries in the next 12 months and bring certain frontier economies close to default.
- Financial markets will see a final adjustment higher in government bond yields, but hopes of 2023 easing are being restrained as DM central banks struggle to get inflation back to target. This means technical recessions in EZ and UK and then the U.S., which will hurt equity markets through the next 6-9 months as an earnings recession is discounted. Hopes of a return to economic normality in 2024 can produce a 2nd half 2023 equity market recovery.
- Our 2022 and 2023 global growth forecast is now 2.9% and 3.0% (from 2.9% and 3.1% in the June Outlook here).
- Meanwhile, our research team sees some marginal reduction in trend growth rates in select DM and EM economies through to 2027 and more elevated inflation trajectories long-term. This will be a challenge to central banks as economies recover into the middle of the decade.
Figure 1: Scenario Assumptions for the Next 12 Months
Baseline—65% | Upside—10% | Downside—25% | |
Recovery from the Pandemic, with Ukraine War Spillover 65% probability | Cyclical and Structural Trends Align 10% probability | Aggressive Fed Tightening and Bigger Energy Shock 25% probability | |
Global Summary | Growth headwinds include food and energy supply problems hurt real incomes (amplified by the war in Ukraine) plus a scaling back of COVID fiscal support, causing slower growth and risks of recession into 2023 -- risks greater in U.S./UK/EZ. Headline inflation pressures greater given high energy prices due to Russia sanctions/restrictions, with second-round inflation effects for certain countries. Fed tightening to 3.75-4.0% along with other factors produces a U.S. technical recession into 2023. 2022 global growth: +2.9% 2023 global growth +3.0% | Core inflation pressures ebb more quickly than expected and central bank normalization becomes gradual and then stops. Lower inflation revives consumer spending. Investment also picks up strongly globally, helped by government investment to address climate change, energy and digitalization challenges. Supply chain problems ease noticeably in 2022/23. An end to the war in Ukraine via a peace deal would also help soothe a path away from energy problems. 2022 global growth: +3.0-3.25% 2023 global growth +3.5% | Inflation proves to be more persistent, with major second-round inflation effects. U.S. Federal Reserve has to tighten aggressively towards 5% Fed Funds, which produce a deeper U.S. recession. ECB has to push rates toward neutral faster. Other risks include widening of Ukraine/Russia war to other European countries via major malware cyberattack or military spillover. 2022 global growth: +2.5% to +2.75% 2023 global growth +2.25% to +2.50% |
U.S. | With positive gross domestic income contrasting negative GDP and employment growth still strong, the U.S. economy does not currently appear to be in recession. A recent sharp drop in gasoline prices, combined with continued employment growth, will give consumers near term support. Heading into 2023 Fed tightening, and a challenging global backdrop, is likely to push the economy into a technical recession, but not a deep one. Despite softer recent headline inflationary data the underlying picture remains firm and is likely to come down only slowly, seeing the Fed holding rates in restrictive territory even if unemployment moves modestly higher. Easing is likely to wait until inflation returns to target, we expect in 2024. | Despite headwinds from Fed tightening and the global backdrop, the U.S. economy maintains growth, led by consumers. This requires strong levels of pent-up demand built during the pandemic to lead to further declines in savings, and continued employment growth assisted by rising labor supply. This also requires inflation to fall despite strength in demand on improvements in supply. The Fed Funds target would then move well above 4% and remain above neutral for some time, with the economy sustaining GDP growth combined with moderate inflation. | Inflation proves stubborn to Fed tightening, ongoing supply problems and emergence of a wage-price spiral as inflationary expectations pick up. This forces the Fed to tighten well above neutral, bringing a sharp slowing in domestic demand. Slowing employment growth combined with persistent inflation bring further declines in real disposable income. Economy moves into a significant recession by early 2023, but Fed is slow to respond given persistent inflation, sustaining economic weakness through 2023. |
EZ/EU | The Ukraine war has radically changed the EZ's growth and inflation dynamics for the worse. Soaring costs and slumping confidence are already undermining the consumer, while supply problems have also seen net trade turn clearly negative. Most likely, price-induced slower demand will act to rein in inflation, helped by what is still a positive labor market backdrop. But recession risks are clear and mounting, as the current gas price surge (here) will hit the corporate sector markedly.Even so, this outlook will not deter the ECB continuing to raise rates further with around three more hikes this year likely to lead to a policy pause through 2023. | Helped by earlier end to Ukraine war, the inflation surge unwinds quickly and there is a further reversal in household savings rates, as consumers react well to a more positive health and wealth outlook and companies respond to the revival in demand. In addition, companies' output revives profitability and tourism enjoys a bounce into 2023, as vaccine usage underpins confidence. The EU largely unwinds the deterioration in the 2020 budget deficit into 2022, lowering risks of fiscal turmoil. Banking crisis avoided as banks' balance sheets in better state. | High EZ inflation causes a heavier headwind to growth via an even bigger drag on consumption and investment, especially if price pressures are fanned by more persistent supply problems and wage-price spiral. Risk of more persistent recession would be clear. ECB forced to raise interest rates more quickly, and possibly to a higher terminal rate amplifying the slowdown into 2023. Banks get reluctant about lending and this, alongside likely politically induced fiscal slippage, may increase risk of fresh sovereign debt problems. The latter risk would be amplified if inflation persistence led to nominal interest rates exceeding nominal growth rates. |
China | Property market slowdown and sporadic Covid outbreaks and lockdowns drag on the economy. Our central view remains for a soft landing in 2023 and 4.0% growth. The risk of harder landing is still real but the authorities will not allow a Lehman moment in the property sector. There could be more policy supports towards the property sector and even easing of Covid measures post Party Congress meeting in October. A moderate shift away from the zero-Covid approach is needed for the economic recovery to be in place, which could take place between the Party Congress meeting in October and next March. | More stimulus measures that allow a smoother adjustment in the property market are announced to ensure a transition to sustainable growth. In addition, substantial shift away from zero-Covid approach will eventually boost the economy. The upside case is brought about by policy mix ranging from easing of Covid restriction policies to property market related supporting measures and more aggressive fiscal spending in infrastructure projects as well as monetary easing. | Major endemic resurgences in COVID cause rolling lockdowns under the zero-tolerance policy and hurt quarterly growth profile, as the authorities refuse to move away from the zero-COVID approach even post Party Congress meeting in October. The authorities misjudge the development in the property developer debt crisis which results in delayed policy response that brings about harder landing in property sector. |
Source: Continuum Economics
Figure 2: Scenarios and Heat Map for Major Asset Classes over the Next 12 Months
Asset Type | Baseline | Upside | Downside |
DM Equities | P/E multiple derating for U.S. is now largely complete, as close to 5yr average. Corporate earnings growth worries take over and renew the selloff circa 3,500-3,700 for S&P500 (here) as the market is not discounting a recession. Core inflation slowdown eventually tempers aggressive rate hikes and opens the way to modest easing. S&P500 recovers to 4,300 by end-2023. Germany fails to outperform the U.S. as EZ hurt by gas energy crisis over the winter. Japan can outperform on continued ultra-easy monetary policy. | A quicker decline in core inflation pressures prompts optimism of gradual Fed tightening and rosy view of the economic cycle being sustained and recessions being avoided. The S&P 500 can rally to 4,500 by end-2023, while other DM equity markets only modestly outperform on better valuations vs. government bonds. | Aggressive Fed tightening towards 5% causes further multiple derating and a deeper recession and S&P500 ends 2022 at 3,300-3,500. EZ/Japan equity markets are hurt further by the U.S. equity market, but then outperform as wage inflation and tightening are less of a problem. Unresolved Ukraine war favors Japan more than EZ equity markets. |
EM Equities | EM equities' relative performance can be helped by no widespread EM currency crisis and cheap equity valuations. EM Asia can see 5% outperformance vs. U.S., but Brazil should outperform most as rate cuts arrive in 2023. | Global growth surprises on the upside helps commodities and EM growth, which prompts a rerating of EM equities alongside the U.S. EM LatAm can outperform on commodities and rate cuts. | EM LatAm, Europe and Asia all hurt alongside S&P500 on aggressive tightening, but then modest outperformance occurs for stronger EM Asia countries with better inflation control. |
DM Fixed Income and FX | U.S. 10yr yield climbs to 3.15% by end-2022, as the Fed hikes to moderately restrictive levels causes a shift to a technical recession that curtails the yield rise. EZ bond yields have scope for modest yield rise, as era of negative official rates is over. JGB yields capped by BoJ QE with YCC policy. USD uptrend peaks out, as Fed tightening slows then stops. Decline against EUR and JPY also due to USD overvaluation. | Short-dated DM government bond yields dip and cause yield curves to turn positive again or alternatively re-steepen. Long-dated yields marginally lower than the baseline scenario, as recession fears are tempered. | Aggressive Fed tightening in face of persistent inflation causes major bond selloff. 10yr U.S. yields to 3.65% by end-2022. Yield curve inverts more on hard landing fears. |
EM Fixed Income and FX | EM countries with high yield spreads vs. U.S. (e.g., Brazil/Mexico) should not see spillover from Fed tightening, but as Fed tightening moves to restrictive strains will increase for other EM currencies. China controlled devaluation also has further to run as well. Frontier countries with high external debt levels are vulnerable to a crisis and this can spill over to weaker EM countries. | Ebbing global inflation pressures allow more gradual Fed and other central bank tightening, which enhances economic expansion hopes. Risk-on rotates into EM for yield pickup (BRL) or undervaluation (ZAR). EM LatAm, Europe and Asia all see bond yield declines as more benign Fed and global outlook reduces risk premia. EM LatAm FI benefits most as shift occurs towards larger 2023 easing cycle. | Aggressive Fed tightening causes more tension among weaker EM countries, especially if spreads narrow on slower EM tightening than the Fed. EM Asia ex China forced to speed up tightening. |
Commodities | EU seaborne oil ban on Russia/end of SPR release pressures prices back up, with inventories at average rather than high levels. WTI oil prices end 2022 at $110.Lower demand feeds in more fully in 2023 and WTI end 2023 at $90. Copper prices are discounting slow global growth and mild recession in certain countries. This can help stabiles prices and we see the end-2022 price at $8,200. | Receding fears of recession prompts a recovery in oil demand forecasts and squeeze WTI to $120/bbl by end-2022 – Ukraine war adverse effects on supply will remain, as we do not see a peace deal in the next 12-18 months. | Aggressive monetary tightening would hurt the global economy and commodity demand. Supply growth would still be restrained and WTI falls to $80/bbl by end-2022. |
Source: Continuum Economics
Our forecast of weaker growth is appearing in major economies, with clear slowdown phases in the U.S./EZ and China.We do see some easing in current global supply chain pressures on inflation (here), but other inflation issues vary across countries. The causes of the economic slowdowns vary and these need to be assessed for the forward looking growth view. The U.S. is seeing a combination of a real wage squeeze on households, alongside tightening financial conditions slowing the growth trajectory. We see this come through more noticeable in late H2 22/H1 23, as employment growth slows and household savings stop filling in for the adverse real income picture. The U.S. also has a wage inflation problem, which means at a minimum that the Fed will move to restrictive policy of a 4% Fed Funds rate but with a clear alternative scenario that aggressive Fed tightening could be seen as far as 5% (Figure 1).We only see a technical U.S. recession on our baseline scenario.
The EZ CPI and growth shock is more dominated by food, gas and electricity prices, the latter two dependent on President Vladimir Putin's politically motivated restrictions on gas exports to Europe. The next couple of months will likely see Russia restraining gas to Europe to try to break EU support for Ukraine, but by early 2023 Russian tactics could change to more normal gas exports and this could mean a substantial reduction in gas prices and headline CPI (here).Wage inflation is less of a problem in EZ.This can mean a bleak H2 2022 for EZ, but some relief to very low growth into mid-2023 – though we do not see an early peace deal on the war in Ukraine (here).
China economic problems are home grown in the shape of the zero COVID policy (restraining consumption spending) and the crackdown on the property sector. While these have been fine-tuned, more substantive policy support for the economy is required to help growth recover into 2023. This is possible after the October party congress reelected President Xi, but is not certain.
Other DM and EM countries are impacted by the real income squeeze from the surge in commodity prices, but the impact is being diluted by government's support and also as most commodity prices have partially reversed – except natural gas. Slowing global trade growth is a headwind, while the retreat from globalization is producing losers and some winners due to reshoring and near shoring at the expense of Asia centric global supply chains. Asia has a better cyclical growth picture than Latam or EM Europe, both as interest rate normalization is gradual and as Asia is still getting benefits from a shift to an endemic COVID strategy (e.g. travel and consumer services).
Risks to Our View for the Next 12 Months
Most of our downside risks in the next 12 months are based on aggressive monetary policy tightening in the face of persistent inflation.
- The key risk is in the U.S. where wage inflation remains elevated and could cause the Fed to continue tightening towards a 5% Fed Funds rate, which would cause a deeper recession. Less risks in the EZ or China from monetary policy, but the importance of the U.S. economy and financial systems means it would have global ramifications via weak export prospects to the U.S. and tightening global financial market conditions.
- Global commodity prices could rebound on supply problems and produce more of a growth headwind/boost to headline inflation if the Ukraine war escalates. We see the use of tactical nuclear weapons by Russia as low probability (here), but would be a very high impact in geopolitical terms and a major hit to global business and consumer confidence. However, our baseline scenario (here) is for a prolonged war that keeps most commodity prices elevated, but does not mean materially higher commodity prices.
- A COVID mutation that dramatically reduces vaccine effectiveness against severe disease and hospitalization is an alternative low probability downside scenario for the winter (i.e. worse than omicron or delta). Major omicron waves in the north hemisphere winter could cause some disruption, but not lockdowns or severe restrictions.
For the upside scenario, the key is a quicker-than-expected slowdown in inflation pressures, but this remains only a 10% scenario with greater risks to the downside.
- If core inflation pressures subdue more quickly (especially wage and broad-based inflation), it could allow a more gradual Fed tightening and policy normalization elsewhere in DM. Additionally, less of a real income squeeze could help produce more support for consumption into 2023 and build confidence in the global economic expansion being sustained.
- Business investment could also surprise on the upside if the policy backdrop is not aggressive and expectations grow of the economic cycle being sustained, all helped by what seems to be a more solid banking sector in the DM world. Additionally, long-term climate change investment ignites and, alongside an accelerated wave of digitalization expenditure, could support business investment growth.
The 5-year View
- As well as the 12-month cyclical view, we take a long-term 5-year view out to 2027 to provide an outlook on the structural trajectory (Figure 3). Certain influences will likely be less important in the long run (e.g. China COVID lockdowns/immediate post-COVID supply pressures). Even so, it is clear that food and energy security will remain a long-term issue after the Ukraine war while climate change investment will likely cause some extra inflation pressures compared to the 2010-19 period and could complicate the political backdrop. Additionally, reshoring is occurring for certain goods after the COVID pandemic, while the Ukraine war is also shifting some supply chains to near-shoring in friendly countries. Thirdly, labor market tightness in certain DM countries will likely remain a medium- to long-term issue, due to labor market mismatches (labor supply, mobility and skills), aging populations and lower immigration to DM countries.
- Meanwhile, we will still see an acceleration of some positive structural developments in the aftermath of the crisis, in the shape of AI, Big Data and IOT enabled by 5G helping to boost growth, these also brings disinflationary influences. Fiscal policy will likely remain neutral into the mid-2020s, in contrast to the fiscal austerity seen after the GFC.
- Overall, our research team sees some marginal reduction in trend growth rates in select DM and EM economies through to 2027 and more elevated inflation trajectories long-term than the 2010-19 period. This will be a challenge to central banks as economies recover into the middle of the decade and will likely require a 2nd wave of interest rate normalization.
- The picture in EM economies remains more divergent on inflation, with some central banks having turned restrictive and likely to keep inflation anchored (e.g., Brazil/Mexico), but others facing higher inflation persistently (e.g., Russia).
- Our central, upside and downside scenarios vary (Figure 3) depending on the outcomes of inflation and policy responses, as well as on the structural themes of climate change and digitalization. In the downside scenario, policymakers will have less policy space, which raises a serious risk of a major financial crisis in some fundamentally weak countries.
Figure 3: Medium- to Long-term Scenarios (to end-2027)
Base Case—60% | Upside Case—10% | Downside Case—30% | |
A Tricky Economic Expansion | Global Cooperation on Climate and Technology | Aggressive DM tightening | |
Global Summary | DM countries face a challenge of some persistent inflation pressures that require neutral or a modestly restrictive monetary stances for longer into the middle of the decade. Combined with some de-globalization, headwinds exist to growth. Even so, fiscal policy will remain more supportive than the austerity seen after the GFC. Public and private investment should also benefit from climate change investment and increased digitalization. This will be enough to sustain the economic expansion, though with intermittent weak growth phases. The stance of EM monetary policy and fiscal policy changes are more varied, which could prompt continued GDP growth divergence, though without derailing overall global growth. Average global growth: 3% to 3.5% | Helped by the initiatives forced on them by the COVID crisis and Ukraine war, governments work cooperatively on innovation and investment in health, climate, energy transition and technology. A boom in business investment also occurs. Disinflation from technology and more dynamic labor market growth offsets inflation forces from climate change. China breaks through the middle-income gap and its growth spills over to other EM economies. The reversal of stimulative global policies is slow enough not to derail the macroeconomic momentum. Average global growth: 3.25% to 3.75% | DM central banks have to adhere to aggressive tightening stances in the face of persistently high core inflation, causing below-trend growth and intermittent recession in certain countries. More limited fiscal policy space means that fiscal policy cannot provide a partial offset. China/U.S. competition turns to a cold war and accelerates de-globalization, which raises inflation pressures. A war over Taiwan is less likely however (here). One final alternative scenario is an escalation of the Ukraine war to conflict between Russia and NATO countries that would severely impact European growth. Average global growth: 2.5% to 3% |
U.S. | The U.S. economy settles down to trend growth by 2024, which is marginally lower due to less intense globalization and a sustained reduction in immigration. Supply-and wage-generated inflationary pressures fade, with inflation trending near target. Reduced globalization prevents a return to the pre-Covid dynamic of persistently below target inflation. U.S. politics remains closely divided leaving fiscal policy ineffective, and demographic forces sustain a trajectory for wider budget deficits. Monetary policy moves back to neutral only gradually after remaining restrictive though 2023, while quantitative tightening adds to concerns over budget deficits | A new chapter of U.S. investment based on public/private partnerships helps to lift the economy. This spills over to jobs and consumption. Improved supply conditions helps return inflation to target despite a resilient economy into the mid of the decade, with a rebound in labor force participation preventing the emergence of a wage-price spiral. The Fed is able to move rates lower in 2024. Some fiscal tightening tempers fears over the debt trajectory. | A structurally slow U.S. growth trend into mid-decade, with curtailed consumption and low business investment, but the current supply-generated inflation bounce becomes ingrained into inflationary expectations, and a wage-price spiral develops. The U.S. debt trajectory constrains further major fiscal expansion. Growth is vulnerable to external shocks. Fed keeps policy tight to contain inflationary pressure despite a weak economy. Fiscal policy proves ineffective under a potentially divided government. |
Europe | EZ economic growth recovers back toward trend at 1.25% into mid-decade, but even this modest rate may court some upside risks on inflation given both supply-side problems persisting as well as the likely and intertwined impact of climate change policies. Fiscally, budget gaps continue to drop, but policy and nominal growth exceeding cost of debt servicing will aim to ensure a continued fall in government debt/GDP ratios as ECB rates rise to no higher than 1.5% neutral. Politically, populism remains confined to a few countries while anti-Russian zeal helps cement international cooperation. Already-damaged post-Brexit trade recovers, but the UK remains the clear casualty, economically and politically. | Above-trend growth, alongside only a modest return of inflation, helps EZ economies deleverage faster. A continued recovery in the housing sector and health spending, a fulfillment of pent-up demand and a predisposition toward climate change-related investment boost domestic activity. This possibly helps revive the transport and tourism sectors more discernibly and more rapidly. The ECB normalizes interest rates somewhat, but the refi rate is still expansionary at the end of the period and low enough to keep rates well below nominal growth. Post-Brexit political and economic relations with the UK recover, and fresh efforts are made to limit, if not mend, Brexit-related trade and political frictions. | Consumer fragility persists, exacerbated by high inflation, aging populations and voluntary social distancing as disease caution persists. The ensuing weaker real-growth backdrop relative to above-neutral ECB rates revives periodic EZ banking problems. These probably center on Italian fiscal woes, but issues in Spain and Portugal may also surface. Banks become more reluctant to lend, impairing capital expenditure growth. EU orthodoxy and populists clash regarding fiscal and climate-change priorities, causing widening differences between the core and the periphery and reviving existential risks to the EZ and even the EU. UK-EU tensions worsen as the former prioritizes domestic political goals, damaging all aspects of bilateral trade. |
China | Growth drivers switch from investment to consumption and a focus on fiscal and sector policies for more sustainable growth. High-tech manufacturing, new infrastructure and new urbanization also help maintain growth momentum post-COVID. Trend growth of around 5.0%-5.5%. Monetary policy is broadly neutral though, with sufficient central bank liquidity to support the deleveraging process for banks and property. Demographics start to weigh on medium-term growth, with a declining natural growth rate and aging population. The continued rural-urban migration and the accompanied improvement in labor productivity can lessen that trend, but this remedy is constrained by structural barriers such as the Hukou system. | China avoids the middle-income trap and sees higher potential output growth of around 5.5-6%. Common prosperity allows a reduction in precautionary savings. The economy also advances as China takes the lead in areas such as 5G, artificial intelligence, high-tech manufacturing and digital and green technologies. Rural-urban migration takes off for another round and helps salvage the demographic weaknesses. This upside scenario is realized when there are more reforms to the restrictions that currently limit internal migration. | The country remains stuck in the middle-income trap, with slow growth that is below trend due to excess debt levels and slowing productivity. Domestic consumption remains below trend and business investment is less of a growth driver. Financial risks and smaller fiscal space limit the government's ability to stimulate growth. New wave of urbanization and labor movement is hindered by lack of reform in the Hukou (household registration) system. Strategic U.S./China relations remain strained, despite better communications. Medium-term growth takes more of a hit from the demographic weaknesses, with rural-urban migration also slowing and the rebound in labor participation rate easing off again because of the COVID long-term impact on labor market. |
Source: Continuum Economics