Recession has already begun in some major economies, yet markets have taken solace in increasing evidence of a peak in US inflation. This had led to bond yields and volatility falling, the dollar to weaken and US equities to rally. Recent speculation around the prospect of China reopening has helped to catalyse this move, particularly in emerging market (EM) and European equities.

We think this market reaction misses important details. Only the first part of the moderation in inflation – base effects and easing supply-chain bottlenecks – will be benign. As the driver of markets shifts next year from policy normalisation to demand destruction, corporate risk drawdowns may have further to go, while rates are likely to recover their diversifying attributes and rally.

Europe, UK probably in recession already…

In the Eurozone, leading indicators are deep in contraction, and we expect growth turned negative this quarter. Energy rationing looks less likely given the build-up in gas storage. But this only makes Europe’s recession less severe, rather than preventing one.

In the UK, gross domestic product (GDP) contracted in the third quarter, albeit in part due to a technical quirk. But the weakness of leading indicators and sharp rise in interest rates mean a more fundamental recession is setting in.

…and US to follow soon

The US is slowing, but growth remains positive for now. Consumer spending has been resilient, but we’re paying more attention to the contraction in housing activity and declining home prices.

Our research suggests that taming core inflation requires a rise in unemployment consistent with recession. With the fed funds rate still rising, and an inauspicious record of soft landings, we expect a US recession beginning in the second quarter next year, although it may start later in 2023.

Covid casts shadow on China

In China, the data make clear that rising Covid cases are driving a near-term worsening in growth. The zero-Covid policy is de facto ending, but with booster-vaccine coverage for the elderly still too low, a return to lockdowns cannot be ruled out.

Support for the property sector is welcome, but it won’t drive a robust recovery with developer funding and property activity so depressed, and a still-large overhang in housing supply.

Chinese equities have just about halved since their 2021 highs, and the risk-reward balance from these levels is better than for US stocks. But we would caution that reopening will be volatile amid high case numbers. Bond yields in China, conversely, are expected to trend higher, especially at longer maturities, in anticipation of policy tightening later in the cycle.

Mixed EM picture

Across emerging markets, the monetary-tightening cycle is drawing to a close, but the credibility of central bank policy pivots and macro prospects varies. The outlook is most challenging in Central and Eastern Europe, where inflation is elevated and the data signal a sharp economic contraction. Central banks in Poland and Hungary will need to hike further to bring inflation to heel.

In Latin America, Brazil will be among the first major economies to ease policy as headline inflation is dropping sharply. That said, the new president’s desire to increase social spending poses a threat to that policy pivot. Meanwhile, much of the region will face headwinds from lower commodity prices heading into a global recession, compounded by imbalances in places such as Chile and Colombia.

Emerging Asia is more resilient, given that core inflation has eased and an end to central bank-tightening cycles is within sight. External vulnerabilities are lower, although there are large current account deficits in the Philippines and Thailand. A global recession will still weigh on growth via lower trade and confidence, amid reduced demand from developed markets (DM).

Impact on stability, asset, currency prices

A DM recession is likely to reprice risk premia globally, partly through international-investor flows as capital is repatriated, something that typically generates US dollar appreciation.

Additionally, recent International Monetary Fund (IMF) analysis suggests a significant proportion of banks in developing countries are insufficiently capitalised to absorb a global recession.

Higher rates to follow

Global headline inflation is passing its peak. Oil prices are some 30% below recent highs, while European gas prices are down thanks partly to the warmer-than-usual weather.

But core inflation will prove stickier. Vacancy and quit rates remain elevated, while wage pressures are robust. Inflation expectations are higher now than before the pandemic.

That means we envisage more interest-rate hikes, including another 100 basis points (bps) from the US Fed and European Central Bank, and 150bps from the Bank of England, by the end of the first quarter next year.

But don’t ignore the rate cuts

Nevertheless, demand destruction during the recession should put downward pressure on core inflation. Higher unemployment will weigh on wage growth and inflation expectations.

Markets are discounting this normalisation to some extent, with US inflation swaps suggesting a fall down to 2.6% in 12 months, but then show remarkable stability over the next decade.

We think this is a low-probability outcome, best interpreted as an average of all possible scenarios. As typically occurs during a disinflationary recession, we think markets will over-extrapolate and inflation breakevens will fall below central bank mandate-consistent levels, at least at shorter maturities.

That means central banks will be in rate-cutting mode by late 2023. Our analysis points to US interest rates at the lower bound by late-2024. Even a probability weighting across our alternative scenarios – such as stickier inflation, a soft landing, or a demand-side recovery – suggests the fed fund rate could return to 2% by then.

Markets ignoring recession

This rate-cutting cycle is not fully reflected in asset prices. Either the market is pricing a very low probability of a 2023 recession, or it doesn’t expect the Fed to respond to one with rate cuts.

With implied corporate-default rates below the levels typically seen in a recession, forward-earnings expectations positive, and US equities having sold off in line with (but not in excess of) the rise in bond yields, we think the market is placing too small a probability on a recession.

The ‘bottom line’

All told, our forecasts envisage multiple overlapping headwinds driving global recession, a moderation in inflation, and interest rates back to the lower bound. Our 2023 (0.7%) and 2024 (1.5%) global GDP forecasts are below consensus.

When the recession kicks off next year we expect corporate risk will sell off, US Treasuries will rally, and the dollar will recover some strength. A durable rebound in equities, and a fall in corporate and sovereign credit spreads, will eventually come, but not until we are further through the recession.