Our macro house view : soft landing is becoming more complicate
Key points at a glance
- Growth will moderate globally with an increased risk of stagflation and recession.
- Inflation to remain higher for longer with risk of entrenched inflation and second round effects.
- Tighter monetary policy (almost) worldwide in the attempt to keep the lid on inflationary expectations and reduce the risk of price-wage spirals. Fiscal policy could provide useful support to avoid recession.
- Risks of policy mistakes are elevated, particularly in the US.
- Soft landing still possible but becoming more and more complicated.
“The strong post-Covid recovery is history.”
The global economy is at a difficult juncture and uncertainty is very high. Against a background of slowing growth, persistent inflation and tighter economic policies, the war in Ukraine and the Covid outbreak in China are serious stagflationary shocks challenging policymakers and threatening economic growth.
The downside risks for the global economy have increased considerably since the first quarter. The baseline scenario for the global economy has been downgraded to reflect slower growth and higher inflationary pressures. The IMF has revised down its baseline scenario for global growth in 2022 from 4.4% in its January forecast to 3.6%. The inflation forecast is now at 5.7% for advanced economies and at 8.7% for emerging economies for 2022.
The war in Ukraine and consequent western sanctions and the Covid-related lockdowns in China represent a combined negative supply and demand shock resulting in higher energy and commodity prices, softening consumer and business confidence, supply chain constraints and international trade disruptions. Without a solution to these exogenous shocks, growth expectations could be revised further downwards in the coming months.
Purchasing Managers Indexes (PMIs) confirm the softening momentum for the second quarter of the year. The April global composite PMI fell to 51 (from 52.7 in March) with an even bigger drop in the services sector. Supply chain constraints and price pressures remain elevated. Growth prospects are divergent across regions as a result of asynchronous cycles, divergent economic policies and because countries are differently affected by the conflict in Ukraine and the consequent energy shock.
Focus: the US economy
Due to the widening trade deficit and weak inventory accumulation, the US economy contracted -1.4% annualised during Q1 2022. However, consumer demand and business investments remain solid. The labour market is very strong with unemployment at 3.8% and wages rapidly increasing. Inflation is high and sticky with headline inflation at 8.3% and core inflation at 6.2% in April but there are tentative signs that it may be close to peaking.
The Fed started an aggressive tightening cycle that will likely bring the Fed funds to the estimated neutral rate of approximately 2.5% by year end, and it just started its quantitative tightening. With a solid economy and strong employment, the Fed sees the possibility of a soft landing and it is convinced that it has room to tighten policy and reduce aggregate demand without causing a recession.
It is still unclear whether the Fed will be able to bring inflation to its target without causing a recession. However, there is little doubt that the Fed will tighten its policy until inflation is brought under control.
Focus: the Eurozone
The Eurozone picture looks gloomier. The Eurozone’s economy grew during the first quarter of the year at a slow pace of +0.3% quarter on quarter. As a result of the conflict in Ukraine, the European Commission revised its forecast for 2022 growth from 4% down to 2.7%. Lately, economic data have shown a mixed picture. PMIs have stabilised at a low level in May after a sharp fall in March. The labour market remains solid with the unemployment level at 6.8% and moderate increases in salaries. Below the surface, however, we are seeing the effects of the conflict in Ukraine and high energy prices. Economic confidence is eroding sharply, industrial production is plagued by supply chain disruptions and high energy prices, and orders are declining.
Inflation reached in May an all-time high of 8.1% and core consumer price inflation (CPI) is picking up at 3.8%. Energy and food prices are pushing inflation higher but inflation is now broadening to other sectors. The ECB turned more hawkish to keep the lid on inflationary expectations while fiscal policy will remain broadly accommodative in 2022. The ECB will conclude its asset purchase programme in June 2022 and will very likely increase its policy rates in July with the aim of bringing its policy rate to zero by year end. There are however considerable risks that the ECB will raise rates in a slowing economy and that tighter policy will have little effect on inflationary pressures as they are emanating primarily from high energy and commodity prices. Market fragmentation (spreads between the centre and the periphery) is an additional worry for the ECB, which will necessitate a flexible approach.
We think that the ECB will likely not be able to raise rates as much as currently expected by the markets. Despite the optimism related to the economic reopening and the beginning of the tourism season, headwinds from the conflict in Ukraine, higher inflation, and the economic slowdown in China will continue to hamper economic performance in the Eurozone.
In China the economy has been slowing for some time. Despite a temporary rebound during the first couple of months of 2022, the new outbreak of Omicron and the zero-Covid policy have caused widespread lockdowns. As a consequence, economic activity has been greatly disrupted. Thanks to a strong beginning of the year and policy support GDP expanded +4.4% y/y, but the economy remains on a weakening trend and has undergone a sharp contraction in April. The National People’s Congress has pledged strong policy support and the China State Council has announced an impressive set of measures to prevent an excessive economic slowdown.
With inflation low and moderating (headline CPI at 2.1%) and soft consumer demand the People's Bank of China (PBoC) is accelerating the provision of liquidity and reducing rates to support the economy. Fiscal policy will continue to be very accommodative. We believe that policy support will progressively start to have an effect and will likely impact economic growth in the second half of 2022 at the earliest.
China is however struggling to combine its health policy aimed at strictly containing the Covid outbreaks with support for its flagging economy. With President Xi Jinping aiming for a third term as General Secretary of the Chinese Communist Party, we expect this tension to continue until the fourth quarter of the year and the Chinese economy to struggle to achieve the official 5.5% GDP growth target for this year.
Will the advanced economies in the US and the Eurozone be able to achieve a soft landing and avoid a recession?
Headwinds for the economies are growing, increasing the downside risks and narrowing the path to a soft landing. Several factors will play a role in determining the course of events:
- The duration of the armed conflict in Ukraine and its effect on commodity prices, economic confidence, investments, and production.
- The effects and duration of the Covid situation in China with respect to supply chain issues and domestic demand as well as their effects on inflation and global growth.
- Labour markets and consumer spending, as consumers are feeling a significant squeeze on their real disposable income due to rising inflation.
- The macroeconomic policy mix: with tighter monetary policies worldwide (notable exceptions are China and Japan), will fiscal policies help to prevent a further recession?
Facing a major stagflationary shock and with greater dependence on Russian energy and little fiscal room, the EU is at risk of recession. With a stronger economy and less affected by the conflict in Ukraine, the US economy is better equipped to prevent a recession. The path for the Fed is however extremely narrow and the risk of policy misstep (excessive tightening) should not be underestimated.
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