Global economic growth is slowing as fiscal policy is becoming less accommodative (after two years of massive stimulus), high inflation in developed countries is crimping consumer spending and monetary policy is tightening to combat the breakout in inflation. A slowdown in economic growth is not necessarily bad after a period of heightened spending in 2021 (and the accompanying build-up in debt or other excesses). But, the concern is around the speed and magnitude of the slowdown which is leading to speculation about the chance of a recession. We go through our expectations for global growth in this Econosights.
High inflation is a constraint on global growth
The outlook for inflation is central to interest rate projections. The high inflation environment with US CPI at 8.6% over the year to May, Eurozone CPI at 8.1%, UK at 9%, Canada at 6.8% and Australia at 5.1% year on year to March means that interest rates will need to rise further from here (see the chart below).
The current inflation environment presents unique challenges to policymakers because of the significant upwards price pressure from Covid-related disruptions (e.g. supply chains, air freight, availability of staff) which will eventually resolve, but it could take another 6-12 months.
In the meantime, inflation expectations have risen and central banks are concerned that without significant interest rate rises to curb consumer demand, inflation expectaions will shift permanently higher. US 1-year inflation expectations have lifted sharply to 5.4%, the highest rate since the early 1980’s and 5-year inflation expectations have increased to 3.3%, the highest level since 1995/96 (but are no where near as high as in the high inflation period of the early 1980’s – see the chart below).
We expect global inflation to slow over the next 3-6 months, with central banks front-loading interest rate rises in 2022 before the chance of rate cuts in the second half of 2023 as monetary policy becomes too tight and growth slows.
Global growth expectations
We have revised down our global growth forecasts again for 2022 and 2023 after an initial downgrade in March with the start of the Ukraine war and the big lift in commodity prices. We expect global growth of around 3% in 2022 (in Purchasing Power Parity terms) and just under 3% in 2023. This is a big downgrade to expectations, given that global growth was expected to be over 4% at the start of the year.
Global GDP growth below 3% is considered low, but during global recessions, GDP growth tends to fall much further.
The lower economic growth outlook increases recession risks which is why some market signals have recently shown an increased chance of a recession including:
- Another inversion in the US yield curve with the 10-year government yield briefly moving below the 2-year yield after already inverting in March. An inverted yield curve (when the yield on long-dated bonds falls below short-dated bonds) can often be an early signal of a future recession (but it has also given false signals in the past) because it means that the central bank may need to cut interest rates in the future. However, the yield curve as measured by the 10 year yield less the US Fed Funds rate is firmly positive and is only likely to head towards negative if/when the US Fed Funds rate (currently at 1.50-1.75%) gets above 3% (likely in late 2022). Yields on the Australian 10-year less 2-year bond and 10-year less the cash rate have not inverted.
- The bear market in some sharemarkets with US shares down by 24% since early 2022 highs and Europe -21%. Australia is doing better at -15% along with Japan at -12%. Usually bear markets (when shares fall by 20% and keep falling) tend to be accompanied by recessions (although those share market downturns also tend to be worse than -20%).
In our view, the odds of a recession are larger in 2023 than in 2022 because central banks will need to take interest rates higher (and potentially too high) to get on top of elevated inflation which could cause the downturn.
The Australian economy
We see the cash rate reaching around 2.6% by early 2023, but the risk is that it ends up being higher. The 75 basis points worth of interest rate hikes so far have already started to dampen economic activity, with further declines in home prices (down by 0.7% since the first rate rise in May), a fall in consumer sentiment and some slowing in weekly consumer credit card spending. The high inflation environment (especially on essentials like electricity, gas, petrol and food) is also adding to weakness in consumer spending. A more aggressive profile for RBA interest rate hikes in the next six months has caused us to revise down our growth outlook. We now expect GDP growth to rise by ~2.7% over the year to December 2022 (well down from ~4% expected early this year) and 2.5% year on year to December 2023 and we see the unemployment rate rising back back over 4% in late 2023, after bottoming at 3.5% later this year.
But there are also still lots of positives that will keep growth from collapsing: consumers have a buffer of accumulated savings from the last 2½ years of fiscal and monetary stimulus and low spending on services (worth $250bn), the pipeline of residential construction work still to be done is ~40% above pre-Covid levels which will add to economic growth , the business investment outlook is the best that its been at for years with mining investment set to rise by +16% in 2023 and non-mining by +17%, the Federal and State governments are still pursuing growth-friendly policies (more spending on childcare in NSW and Vic and more infrastructure spending) and the outlook for exports (especially for commodities) is solid given the current commodity supply issues.
Clearly, the risk of an economic downturn have increased within the next 12-18 months. This means that the next few months could see more downside in sharemarkets, until inflation moderates and the growth outlook stabilises. We remain more optimistic on Australian shares versus US or Europe because of the higher exposure to commodities in our sharemarket (which remain in an uptrend) and less tech shares (which tend to perform worse as interest rates/bond yields rise).
Economist – Investment Strategy & Dynamic Markets