They currently exist four scenarios for the global economic outlook. Three of them are implied potentially serious risks with far-reaching implications for markets.
The most positive of them is one “soft landing”, where central banks in advanced economies manage to bring inflation back to their 2% targets without triggering a recession. There is also the possibility “less soft landing”. Here the inflation target is achieved, but through a relatively mild (short and shallow) recession.
The third scenario is a “hard landing”where a return to 2% inflation is achieved through a protracted recession with potentially severe financial instability (such as greater banking distress and highly leveraged actors experiencing severe debt servicing difficulties).
If the effort to moderate inflation triggers severe economic and financial instability, a fourth scenario becomes possible: central banks disappear and decide to allow inflation above target, risking the unwinding of inflation expectations and a persistent wage-price spiral.
As things stand, the eurozone is already in a technical recessionwith GDP having contracted in the fourth quarter of 2022 and the first quarter of 2023, and with inflation still well above target (despite its recent decline).
The UK is not yet in recession, but growth has slowed sharply and inflation remains stubbornly high (above the OECD average). And the United States suffered a sharp slowdown in the first quartereven as core inflation (which excludes food and energy prices) remained high (although falling, it remains above 5%).
In the meantime, China’s recovery from COVID-19 appears to have stalledcalling into question the government’s relatively modest 5% growth target for 2023. And other emerging and frontier market economies are showing relatively anemic growth relative to their potential (with the exception of India), with many still suffering from very high inflation.
Which of the four scenarios is most likely? While inflation has eased in most advanced economies, it has not done so as quickly as central banks had hoped, in part because a tight labor market and rapid wage growth have added to inflationary pressure in labor-intensive service sectors. In addition, expansionary fiscal policies continue to fuel demand and help keep inflation down.
This has made it more difficult for central banks to fulfill their mandate of price stability. Market expectations that central banks were done raising interest rates and would even start cutting rates in the second half of 2023 have been dashed.
The Federal Reserve, European Central Bank, Bank of England and most other major central banks will have to raise interest rates even further before they can stop. However they do, the economic slowdown will become more persistent, raising the risk of economic contraction and new debt and banking stress.
At the same time, geopolitical developments – some of them unexpected, such as the unsuccessful mutiny of the Wagner organization in Moscow – continue to push the world towards instability, de-globalisation and greater fragmentation. And now that China’s recovery is losing momentum, it must either pursue aggressive stimulus policies – with implications for inflation worldwide – or risk significantly undercutting its growth target.
On the positive side, the risk of a severe credit crunch has eased following the bank failures in March, and some commodity prices have softened (partly on recessionary expectations), helping to contain goods inflation. Therefore, the risk of a hard landing (scenario three) appears lower than a few months ago. But with persistently high wage growth and core inflation forcing central banks to make additional rate hikes, a short and shallow recession next year (scenario two) has become much more likely.
Worse, if a mild recession does materialize, it may further erode consumer and business sentiment, thereby setting the stage for a more severe and protracted recession and increasing the risk of financial and credit stress. Faced with the possibility that the second scenario could evolve into the third, central banks may blink and allow inflation to remain well above 2%, rather than risk triggering a serious economic and financial crisis.
So, the monetary policy trilemma of the early 2020s remains. Central banks face the extremely difficult task of achieving price stability, growth stability (without recession) and financial stability simultaneously.
What are the implications for asset prices in these scenarios? So far, US and global stocks have reversed their bear market for 2022 and bond yields have moved slightly lower – a pattern consistent with a soft landing for the global economy, where inflation is falling towards the target rate and stunting growth is avoided. Additionally, US stocks – mainly tech stocks – have been boosted by the hype surrounding artificial intelligence.
But even a short and shallow recession – let alone a hard landing – would cause US and global stocks to fall significantly. And if central banks then appear hesitant, the resulting rise in inflation expectations would raise long-term bond yields and ultimately hit stock prices, because of the higher discount factor applied to dividends.
While a major hurricane on the global economy looks less likely than it did a few months ago, it is still possible that we could face a tropical storm that could cause significant economic and financial damage.
- Article by the famous economist Nouriel RoubiniEmeritus Professor of Economics at New York University’s Stern School of Business, at Project Syndicate.
Source: News Beast
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