The global economy is facing multiple, mutually-reinforcing headwinds – a scenario which is likely to lead to a deeper global recession sooner than we’d previously forecast.
We now expect the Fed’s rapid policy tightening to tip the US into recession by Q2 next year. The UK and EU economies are facing a huge, commodity-price induced real-income squeeze, amplified by central bank actions.
In China, the rebound from the Shanghai lockdown is petering out, with the prolonging of a ‘zero-Covid’ policy and property sector weakness weighing on the outlook. Meanwhile, many emerging and frontier economies are caught between their own imbalances and these external shocks.
The compounding effect of these various shocks means that what once looked like a series of distinct headwinds emanating from different places at different times, are now coming together into something that looks like a perfect storm for the global economy.
Figure 1: Global forecast summary
Source: abrdn, as of September 2022
*Forecasts are offered as opinion and are not reflective of potential performance. Forecasts are not guaranteed and actual events or results may differ materially.
No US recession this year…
US economic activity experienced a sharp, commodity-price driven, slowdown in the second quarter, with the economy posting two consecutive quarters of contraction in the first half of this year.
While some observers insist on describing this as a ‘technical recession’, this is neither the formal definition of a ‘recession’ nor was what we saw the phenomenon we have in mind when identifying a US recession.
With employment growth throughout the first half of the year running well in excess of the rate required to keep unemployment steady, it’s not credible to believe the US was experiencing the breadth and depth of downturn that would be consistent with a recession.
If anything, underlying demand was still too strong, with imbalances continuing to build – especially in the labour market. In the very near term the economy looks set to accelerate, boosted by the recent fall in many commodity prices.
…but we expect it to happen earlier next year
Despite this ‘mini recovery’, we now forecast the US economy to enter a recession two quarters earlier than we’d originally anticipated.
The second quarter of 2023 is now expected to mark the formal end of the current economic cycle, due to more rapid and sustained monetary tightening by the Federal Reserve (Fed), and its transmission through asset prices.
But we have more conviction in the recession’s inevitability than its timing given the ‘long and variable’ lags of central bank monetary policy.
Powell at Jackson Hole
Granted, financial conditions eased following the July meeting of the Federal Open Market Committee (FOMC), which suppressed our short-term recession indicators.
But this development predictably proved unsustainable as it reflected a misunderstanding of the Fed’s reaction function.
Fed Chairman Jerome Powell hammered this point home in his hawkish speech last month at Jackson Hole, the annual gathering of economic policymakers from around the world.
That’s why the Fed is likely to keep rates elevated, even as the US economy enters a recession, as it awaits convincing evidence that core inflation pressures have moderated (see Figure 2).
Figure 2: Elevated core services inflation will keep rates high for longer
Source: Haver, abrdn, as at September 2022
What this means for the rest of the world
This will tend to exacerbate the global spill-overs, with the Fed continuing to export tight financial conditions to the rest of the world through the dollar-based financial system.
Emerging market (EM) countries with large external imbalances are likely to be especially vulnerable given the risk of capital flight and currency crises.
Even in EMs where external vulnerabilities are low, the global recession will weigh on growth via trade, financial and confidence channels.
China’s slowdown…
China’s 2022 growth target is out of reach while headwinds for next year are intensifying. Monetary policy may be easing, but it’s difficult to gain traction while structural headwinds from Covid restrictions and the property slump remain in place.
While an exit strategy for the country’s ‘zero-Covid’ policy may be revealed during the 20th Party Congress in October, we now think an actual exit may have to wait until the third quarter of 2023.
The ramping up of infrastructure spending will help to shore up growth and reduce the risks of a hard landing. However, there are limits to how much this will help.
…Europe has its own problems
Even before the US recession hits, Europe faces the prospect of huge terms-of-trade, real income and energy shocks pushing the Eurozone economy into recession by the fourth quarter of this year.
Our European gas-supply scenarios envisage further energy rationing to be phased in across various sectors, particularly in Germany. The risks may materialise into even more severe outcomes.
Inflation is everyone’s problem (for now)
Near-term energy supply shortages should keep headline inflation elevated throughout the northern hemisphere winter, especially in Europe.
Beyond the short term, however, the global recession will weigh heavily on commodity demand. Supply-chain bottlenecks continue to improve despite the effects of China’s zero-Covid policies.
As central bank monetary tightening starts to restrict product and labour demand, the scene will be set for significant disinflation – a slowing of price rises – throughout 2023 and especially 2024.
With falling headline and core inflation likely to help re-anchor inflation expectations, monetary policy can return to supporting economic growth from the second half of next year.
We anticipate the appropriate path for policy, given the likely increase in unemployment and fall in inflation, will see rates once again reach the effective lower bound for much of the developed world.
Political change
The US Inflation Reduction Act demonstrates the kind of constructive, albeit modest, and market-moving legislation that can be passed should the Democrats keep hold of both houses of Congress in November’s mid-term elections. However, a Republican victory would usher in another period of stasis.
Elsewhere, the upcoming Italian election is likely to result in a new right-wing government, which may exacerbate tensions with the rest of the European Union.
In another sign of the impact of inflation on politics, the new UK government of Prime Minister Liz Truss has significantly shaken up the policy mix, with large macroeconomic and market implications. Similar moves are possible in other European countries.
Meanwhile, the war in Ukraine will roll on, and sharpen the widening divide between the West and a more closely-aligned Russia-China pairing.
Most-likely scenarios lead to recession…
Not only does our base-case scenario involve a global recession (see Figure 3), but adding up the probabilities of all the scenarios consistent with recession gives a combined 55% probability.
This means a global recession in one form or another is more likely than not, most probably within the next two years.
Figure 3: We expect an even deeper, and earlier, global recession than we had previously forecast
Source: abrdn, as of September 2022
We’re still concerned about imbalances in the Chinese property sector on top of those already included in our base case, motivating our ‘China stress and slowdown’ scenario.
We also think a Covid ‘vaccine escape’ scenario is still plausible given what we know about viral mutations. Both these scenarios remain consistent with a global recession, but with quite different drivers than in our base case.
Meanwhile, we’ve recalibrated our ‘stagflationary shock’ scenario – based on expectations of European energy shortages and EM crises – so that it also leads to global recession.
That said, another, more positive, scenario – ‘Fed walks the tightrope’ – may deliver a soft-landing for the global economy. But it would require a lot to go right for this to happen.