The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Inflation was the dominant economic and financial issue of 2022 for most countries around the world, particularly for those advanced economies that have consequential impact on the global economy and markets.
The effects were felt in worsening living standards, higher inequality, increased borrowing costs, stock and bond market losses and the occasional financial accident (fortunately small and contained until now).
In this new year, recession, actual and feared, has joined inflation in the driver seat of the global economy and is likely to displace it. It’s an evolution that makes the global economy and investment portfolios subject to a wider range of potential outcomes — something that a growing number of bond investors seem to realise more than many equity counterparts.
The IMF is likely to soon revise down its economic growth projections again, expecting that “recession will hit a third of the world this year”. What is particularly notable to me in this deteriorating global outlook is not just that the world’s three main economic areas — China, the EU, and the US — are slowing down together, but also that this is happening for different reasons.
In China, the messy exit from a misconceived zero-Covid policy is undermining demand and causing more supply disruptions. Such headwinds to domestic and global economic wellbeing will continue as long as China fails to improve the coverage and effectiveness of its vaccination efforts. The strength and sustainability of the subsequent recovery will also require that the country more aggressively revamps a growth model that can no longer piggyback on greater globalisation.
The EU continues to deal with energy supply disruptions as Russia’s invasion of Ukraine persists. Strengthened inventory management and the reorientation of energy supplies are well advanced in many countries. However, they are not yet sufficient to lift the immediate constraints on growth let alone resolve longstanding structural headwinds.
The US has the least problematic outlook. Its growth headwinds are due to the Federal Reserve’s scrambling to contain inflation after having grossly mischaracterised price increases as transitory and then been initially too timid in adjusting monetary policy.
The Fed’s shift to an aggressive front-loading of interest rate hikes came too late to prevent the spread of inflation into the service sector and wages. As such, inflation is likely to remain stubborn at around 4 per cent, be less sensitive to interest rate policies and expose the economy to a higher risk of accidents induced by additional policy mistakes undermining growth.
The uncertainties facing each of these three economic areas suggest that analysts should be more cautious in assuring us that recessionary pressures will just be “short and shallow”. They should keep an open mind, if only to avoid repeating the mistake of prematurely dismissing inflation as transitory.
This is particularly important as these diverse drivers of recession risk make financial fragilities more threatening and policy transitions harder, including Japan’s likely exit from its interest rate control policies. The range of potential outcomes is unusually large.
On the one hand, a better policy response, including to improve supply responsiveness and protect the most vulnerable segments of the population, can counter the global economic slowdown and, in the case of the US, avoid a recession.
On the other hand, additional policy errors and market dislocations can lead to self-reinforcing vicious cycles with high inflation and rising interest rates, weakening credit and pressured earnings, and market functioning stress.
Judging from market pricing, more bond investors are understanding this better, including by refusing to follow Fed’s guidance on interest rates this year. Rather than a sustained path of higher rates for 2023, they believe that recessionary pressures will lead to cuts later this year. If right, government bonds would offer the returns and portfolio risk mitigation potential sorely missed in 2022.
Parts of the equity market, however, are still pricing in a soft landing. The reconciliation of these different scenarios is of importance to more than investors. Without better alignment within markets and with policy signals, the favourable economic and financial outcomes we all desire will prove not just less likely. They will also be challenged by the risk of more unpleasant outcomes at a time of lower economic and human resilience.
