The global economy is on the precipice of recession.

Aggressive monetary tightening led by the US Federal Reserve (Fed), an enormous energy price and terms-of-trade shock in Europe, and the disruptions from exiting zero-Covid measures and property sector weakness in China, will combine to push the economy over the edge.

Although our global recession call is now shared by many forecasters, the consensus is still missing the depth and severity of the downturn.

Moreover, the large interest-rate cutting cycle that we think will occur during the latter stage of this recession is not yet appreciated by the market.

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Figure 1: Global forecast summary

Global forecast summary

Source: abrdn, November 2022

Recession is here…

Recessions appear to have already begun in some of the major economies. The Eurozone is experiencing a huge terms-of-trade, real income and energy shock. Leading indicators there are deep in contraction, and we expect gross domestic product (GDP) growth to turn negative within this quarter.

Admittedly, energy rationing for this northern hemisphere winter looks less likely given the build-up in gas storage. But the tailwinds of mild weather and reduced Asian demand that has allowed Europe to secure large amounts of liquified natural gas (LNG) cannot be relied upon to continue.

Moreover, our Russia-Ukraine scenarios can see no immediate end to the war. This means no gas flows from Russia. In any case, avoiding gas rationing this winter only makes Europe’s recession less severe, rather than preventing it.

In the UK, GDP contracted during the July-September quarter, albeit in part due to a technical quirk. But the weakness of leading indicators and the sharp rise in interest rates mean a more fundamental recession is setting in.

Real estate is a problem for the US…

Meanwhile, the US economy is clearly slowing, but growth remains just about positive for now. Consumer spending and retail sales have been resilient. But we’re paying attention to the contraction in housing activity and house prices. Real estate, an interest-rate sensitive sector with a long track record of leading the economic cycle, is in a deepening downturn.

More broadly, our belief continues to be that taming core inflationary pressures requires a rise in unemployment that is consistent with a US recession.

With the fed funds rate above neutral and likely to rise further, and an inauspicious track record when it comes to engineering soft landings, we expect a US recession beginning in the second quarter of next year. That said, we have more conviction in the recession’s inevitability than its timing, given the ‘long and variable’ lags of monetary policy.

…as well as for China

China’s economic outlook is also downbeat, despite the excitement around easing zero-Covid and property sector support, following the recent 20th National Congress of China’s Communist Party.

Recent activity data make clear that rising Covid cases are contributing to a near-term worsening in growth.

The transition to endemic living is likely to see further disruption to activity over the next 6 months as the government periodically tightens restrictions to stop the healthcare system from being overwhelmed

Steps to support the property sector and a looser stance on financial conditions are welcome. But we don’t think they’ll support a robust recovery with developer-funding conditions, and the pipeline of property activity, as depressed as they are.

Mixed EM picture

Across the broader emerging markets (EMs), the monetary policy-tightening cycle is gradually drawing to a close, but the credibility of central bank-policy pivots varies considerably, as do the broader macro prospects and vulnerabilities.

Many frontier EMs are either in the midst of a crisis or teetering on the brink. These include Sri Lanka, Zambia, Pakistan, El Salvador, Ghana, Egypt, Tunisia and Lebanon. The drop in global risk appetite and capital flows will only complicate debt servicing and restructuring.

The outlook is also very challenging for Central and Eastern Europe, where inflation is exceptionally elevated and the activity data signal a sharp economic contraction. Central banks in Poland and Hungary, in particular, will need to hike interest rates further to help bring inflation to heel.

However, over in Latin America, Brazil is likely to be among the first major economies to ease policy as headline inflation is dropping sharply. But much of this region faces headwinds from lower commodity prices heading into a global recession, compounded by imbalances in places such as Chile and Colombia.

Emerging Asia is probably more resilient, given that core inflation has eased notably (except in Malaysia) and an end to central bank-tightening cycles is within sight.

External vulnerabilities are generally lower, although there are exceptions, such as large current account deficits in the Philippines and Thailand.

Even so, a global recession will weigh on regional growth via trade and confidence channels. Unlike during the 2007/08 global financial crisis, we don’t expect China to come to the rescue.

Peak inflation?

Global headline inflationary pressures have either already passed, or are very close to passing, their peak. Oil prices are some 20%-30% below recent highs, and annual base effects are now turning negative.

This downwards pressure on inflation should become even stronger over 2023 as our global recession forecast plays out, even with a relatively high price-floor set by the Organization of the Petroleum Exporting Countries (OPEC) amid supply cuts. European gas prices are also substantially below recent peaks.

But core inflation will prove much stickier. Across labour markets, vacancy and quit rates remain elevated, while wage pressures are robust.

Inflation expectations are also much higher now than before Covid, especially over shorter time horizons, with a high degree of expectation-anchoring on recent inflation experiences.

Admittedly, recent somewhat lower US core inflation numbers are encouraging, driven by moderating goods prices as demand continues to pivot back to services. But core services inflation, which is more tied to the tightness of the labour market, has increased.

Higher rates to follow…

That means we envisage a number of additional interest-rate hikes in the near term, 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.

The likelihood of the next Federal Open Market Committee (FOMC) dot plot – which provides official projections for short-term rates – revising up the terminal rate, means that near-term risks are to the upside. That would especially be the case if US economic activity holds up better than expected.

But the key point is that, rather than allowing the US to avoid a recession, interest rates would have to be pushed even higher to bring about the necessary economic rebalancing to restore price stability.

Demand destruction during the US and European recessions should, ultimately, put significant downwards pressure on core inflation – higher unemployment will weigh on wage growth and inflation expectations, and the core services component of inflation should weaken.

…until late 2023

Central banks will be in rate-cutting mode again by late 2023. Indeed, we think the speed and extent of these eventual rate cuts is underestimated.

Running a range of monetary policy rules using our baseline activity and inflation forecasts points to US interest rates returning to the effective lower bound by late 2024. Even a probability weighting across all our scenarios suggests the fed fund rate could return to 2% by that time.

Admittedly, policy rules are far from an infallible guide – they don’t reflect the many discretionary judgements in policymaking. But they are a good way of systematically gauging the trade-off policymakers face between activity and inflation.

This suggests the market isn’t anticipating the big rate-cutting cycle we think is coming.

Weaker growth, inflation focus

All told, our baseline 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 well below consensus.

But this is only one of several plausible scenarios. Other scenarios include ‘sticky inflation’ – monetary tightening triggers recession but underlying inflation proves more persistent, leading to a more cautious pace of rate cuts; ‘China stress and slowdown’; ‘European political and sovereign crisis’ and ‘vaccine escape’. All lead to global recession.

The most likely upside scenario is ‘Fed walks the tightrope’ – there is still a path to a soft landing for economies. This scenario is probably closest to what’s priced into financial markets. But it will require a lot to go right.