Global recession risks are growing by the day
Bottom Line:
- Inflation remains the main theme at the moment and central banks have committed to tightening monetary policy as much as is necessary to reign in inflation. It has been a coordinated and aggressive tightening by most central banks around the world that have collectively resolved to contain price pressures. The result will be painful and could result in a global recession. While central banks will be mindful of the negative impact aggressive tightening will have, they will also be mindful of the devastating impact that a prolonged period of inflation will do to the poor.
- Slowing the economy appears to be a necessary evil to contain inflationary pressures and there is now a growing body of evidence to suggest that the central banks efforts are starting to influence the performance of the global economy. Increasingly it appears as though the risks of a global recession are growing. The chances of this happening will continue to rise for so long as inflation remains stubbornly high.
- The relevance of this for emerging markets is two-fold. On one hand it could induce financial market volatility and a rotation to safety. However, on the other it will help re-establish the attraction of emerging market rates if the developed economy central banks suddenly turn more sensitive to the growth outlook and become less hawkish that they are at the moment.
Baseline View:
A global recession might induce financial market volatility, but it would also scale back the incentive for DM central banks to persist with an aggressive tightening in monetary policy. The likes of the USD that has so much hiking already priced into it would be left vulnerable, something the ZAR might capitalise on should equity markets hold up.
Leading indicators declining, with more to come
A debate around whether the global economy is headed for a recession is raging. Although some central banks would have us believe that the global economy is headed for a soft landing, other data suggest that the risk of a deeper global recession is growing by the day.
Leading indicators provided by the OECD make this point clear as they collectively head towards levels historically synonymous with recessionary conditions. There are simply too many headwinds to navigate that are constraints to growth, including the cost-of-living crisis, energy prices, food inflation, rising interest rates and the fallout of the war in Ukraine. Supply chains are normalising, but not to the extent that it could offset all the headwinds that persist.
The business cycle is therefore heading lower, and in the short to medium term, it seems unlikely that there will be much respite. On the contrary the situation may become that much worse through the northern hemisphere winter when the demand for energy will rise further and where the scarcity of supply will impact on households and the productivity of companies.
Inflation has yet to reverse
The overriding theme at the moment is inflation. Although there are early signs that inflation could reverse, there is no definite proof that this has begun. On the contrary, the accompanying chart shows that inflation rates remain sky-high, with the potential of rising still further.
Such inflation shocks require much adjustment within the economy.
Households and businesses need to adjust to the weaker levels of disposable income and the rapidly rising production costs. Until the adjustment is fully absorbed, the adjustment can be painful and detract from GDP growth.
Beyond just the direct impact of inflation on the cost of production and households, the central banks are committed to lifting rates to avoid a situation where the second-round effects of inflation drag on
and impose even more damage on the economy. The idea is to accept pain now, to avoid even more pain down the line. It is not popular, but it is necessary.
Demand will weaken, the credit cycle will moderate, and the monetary space for inflation to take hold will moderate. The implication, however, is that a recession follows.
The number of central banks hiking aggressively has spiked
What makes this phase of tightening quite different is not only the amazing coordination in tightening by several influential central banks but the aggression with which they are tightening. The accompanying chart highlights very clearly just how outsized the aggression is.
Contrast that, with global debt levels that exploded through the Covid pandemic and the economy’s sensitivity to monetary tightening, is heightened. It implies that the feedback into the economy could be a lot more severe, albeit with a slight lag, before the full effects of the tightening manifest, first, the ultra-loose monetary policy needs to unwind. That will take time.
In the interim, with central bank policymakers questioning the response function of the economy to their monetary policy, it seems as though they are defaulting to responding to the inflation data as it
gets released rather than their model-driven forecasts of inflation.
More on that front will be covered this weekend at the Jackson Hole symposium and the guidance that the central banks offer.
Yield curves flashing danger
US yield curve has inverted as has the UK yield curve. Other bond markets are facing similar prospects, which is neatly reflected in the accompanying chart showing the aggregated yield curves of five major economies.
The aggregated yield curve has flattened to levels last seen in late 2019, when a global slowdown was underway and feared. This was rekindled at the start of the pandemic and preceded a recession. The previous time this happened was in 2007 and 2008, which preceded the global financial crisis of 2009, and prior to that similar flattening was witnessed in 2000.
In all these cases, the flattening of the yield curve heralded a significant reversal in the business cycle and levels of strain intensified. Given the numerous headwinds impacting economic growth, it would be brave to dismiss the possibility because this time is different. In some instances, it is. In others, it is very similar, given how modern-day economies are heavily influenced by the credit cycle
and the credit cycle in your major economies are under severe pressure as central banks seek to lift rates further.
Financial markets offer corroborating evidence
As all this information becomes public and both households and businesses experience the stresses and strains synonymous with a slowing economy, one would expect that to reflect in corporate earnings eventually.
Waning CEO confidence levels is another red flag, and, notably, the collapse in sentiment is borne out of their direct experience.
Meanwhile, major US retailers such as Walmart and Target have chosen to start discounting products. This preceded news earlier this week that Gap posted an 8% decline in earnings due to the more challenging environment.
Although that has not yet manifested in a job-loss induced recession, persistent inflation and interest rate hikes will take their toll over time.
It will only be a matter of time before these same CEOs consider cost rationalisation strategies to try and shield corporate profitability and share prices.
In the interim, this is another indicator that alludes to a recession when such a sharp drop in confidence is seen.
China cannot be relied on to bail out the world
Those who believe China could still come to the rescue should think again. China is an economy riddled with high levels of debt that have impacted the property market very directly. Balance sheets in China are contracting as the property market corrects, which has a negative feedback loop for the rest of the economy.
The PBoC is one of the only central banks, save for Turkey, that have reduced interest rates in the face of persistent inflation, highlighting just how concerned the central banking authorities are over the outlook for the Chinese economy.
Although China’s Citi economic surprise index has turned marginally positive, consumer confidence in China has collapsed. This kind of collapse portends tough times ahead and a dip in domestic demand.
The central bank is aware of this and aware of the systemic problems this will cause for the banks as the property market corrects and have opted to try and support the economy through the credit cycle.
Nonetheless, the message is that the Chinese economy is also facing strong headwinds which will detract from global growth.
Global production is under considerable pressure
Another sure way of gauging global demand is through the assessment of the productive sectors of the major economies. The accompanying chart shows that the productive sectors of China and the EU are already contracting, while the US PMI data is heading lower.
Most of these measures will be below the 50.0 breakeven level and contracting in the next two months.
Such phases of coordinated contraction suggest that the weaker global demand is permeating all corners of the globe. These economies are heavily integrated into global trade and for them all to be below 50.0 suggests there has been a material contraction in demand.
Productive sectors are facing several threats ranging from high input costs, rising interest rates, scarcity in securing energy needs and the geopolitical risks for those close to the war in Ukraine. It is an ugly cocktail that impacts broadly. The further these indicators decline, the greater the probability that the global economy will experience a broad-based recession.
Central banks have a lot to do to normalise
Central banks have paused their quantitative easing and are focusing instead on quantitative tightening. The objective would be to try and normalise monetary policy and to extract from their respective economies the excess levels of liquidity they injected through the pandemic to try and prop up economic growth.
The US Fed was the biggest contributor to the build-up in the aggregated balance sheet reflected in the accompanying chart as it bought some $5.0trln worth of bonds (corporate and sovereign) in the
space of two years. The rest was built by the remaining central banks.
The result, is that collectively, these central banks created the monetary space for inflation to take hold. That has contributed in part to the current inflation episode and needs to be unwound to some
degree. However, in unwinding this stimulus, it necessarily impacts the credit cycle negatively, which will contribute to the negative credit forces that will play a role determining economic growth.