Regimes, rates and recessions

Interest rates are rising at a rapid pace, as central banks admit that inflation is no longer just a series of transient shocks, but there is a risk that it becomes more ingrained.

Markets appear to have bought into the idea that the US Federal Reserve (Fed) is close to a ‘pivot’, after guidance from Fed chair Jerome Powell during the Federal Open Market Committee (FOMC) press conference held on 27 July. In reaction, equity markets rallied, and US Treasury yields fell (prices rose), as investors tempered their expectations of future rate rises, and began to look forward to potential rate cuts as early as spring 2023.

However, despite comments from Chair Powell, it may be too early to call for the ‘Fed pivot’. Our analysis on how far the economy has slowed during past cycles to lower inflation suggests that the US economy must enter a recession in order to defeat inflation pressures.

With monetary policy actively working to lower demand, fiscal policy is likely to be more active to support households. However, 2023 is likely to be a fiscally contractionary year, and without the tailwind of economies re-opening as there was in 2021, the world economy is likely to struggle as a result.

We now expect global growth of 2.6% for 2022, slowing to just 1.5% growth for 2023. Apart from the Covid-19 pandemic, this will be the weakest year for global growth since 2009. Recessions are now built in for the US, eurozone and UK in our Schroders baseline forecast, while most emerging markets will also see slower growth.

Global inflation is forecast to rise from 3.4% in 2021 to 7.2% in 2022, before moderating to 4.3% in 2023. This is helped by a fall in year-on-year energy inflation, but also higher interest rates which work to lower domestic pressures.

US GDP growth has been downgraded from 2.6% in May to 1.7% for 2022, significantly lower than consensus estimates of 2.1% growth. This is mostly driven by a higher inflation forecast (8% for the year vs. 6.9% previously) and also a more aggressive path for the Fed funds rate.

Higher interest rates, less generous fiscal policy, and higher inflation all work to reduce the spending power of households in the US, which are expected to eventually cut spending in a meaningful way. Companies are likely to respond to weaker demand by slowing production, and as such, also reducing demand for labour. Policy tightening is expected to be severe enough to drive the unemployment rate higher, which is required to see not only household demand to fall, but also inflation pressures to ease.

China’s core inflation remains low as the market recovers from Covid lockdowns

In China, recovery from the impact of Covid-related lockdowns is likely to continue, aided by policy support which is starting to have an impact. Leading indicators such as the credit impulse and the growth in real narrow money supply (M1) have been signalling for some time that the economy will stage a more sustained cyclical recovery from late to end of the third quarter onwards.

Problems in the real estate market remain a major obstacle. With the sector’s activity contributing to a fifth of the economy’s output, there has understandably been a serious hit to overall GDP growth. Moreover, the crisis has hit the confidence of households, which coupled with concerns over Covid, has pushed consumers to retrench.

Policymakers have indicated that support for the housing sector is forthcoming and have encouraged local governments to ensure the delivery of outstanding projects. Additional stimulus measures may eventually follow, but developers are likely to restructure their debt, particularly on debt owed to foreign creditors.

Meanwhile, China is likely to feel the pinch as most of the advanced world tips into recession in the months ahead. Manufactured exports, which have been the key driver of growth over the past two years, are set to slow as demand conditions soften and consumers reorientate spending to services.

We have adjusted the country’s GDP from 3.5% to 3.3% for 2022 (consensus of 4.2%) and from 5.5% to 5% for 2023 (consensus of 5.4%). Inflation is likely to trend higher on the back of higher food costs and a continued unwinding of the pork price shock. However, the key point is that, in contrast to the rest of the world, excess supply of goods means that core inflation remains extremely low at around 1%. China’s economy should stage some recovery as we head into 2023.