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Throughout the post-war period there have been a number of external shocks that have affected the world economy and markets and are discussed in my book Global Shocks.[1] The most important development since then is the Covid-19 pandemic and people have asked me how I see it.
The short answer is: The current situation is unique. For the first time in the post-war period, the world economy was hit by two shocks – the worst public health disaster in a century, combined with Russia’s invasion of Ukraine. Together they have weakened the global economy and pushed global inflation to the highest rate in four decades. This creates a very challenging environment for policy makers.
Last week, the US Federal Reserve raised interest rates by 75 basis points for the second straight month to signal its determination to bring inflation back to its 2% target. The release of GDP data then showed a second consecutive quarter of negative growth, dubbed a “technical recession” as labor markets are still resilient. However, a slowdown in the labor market could signal the start of a recession later this year or next.
Meanwhile, the European Central Bank hiked interest rates by 50 basis points at its July meeting to combat euro-zone inflation, which rose to 8.9%. The move marks the first tightening since 2011. It comes even as consumer confidence has fallen to a record low and the EU economy is vulnerable to cuts in natural gas supplies from Russia.
The IMF is concerned about the outlook for the global economy, calling it a “dimmer and more uncertain outlook”. Its updated forecast (see table below) sees global growth slowing to 3.2% this year and 2.9% next year from 6.1% last year, down 0.4% and 0% respectively. 7 percentage points compared to April.
Latest IMF projections on the world economic outlook (baseline)
2021 2022 2023
Global Growth 6.1% 3.2% 2.9%
Higher economics 5.2 2.5 1.4
US 5.7 2.3 1.0
EU 5.4 2.6 1.2
Emerging Markets 6.8 3.6 3.9
China 8.1 3.3 4.6
Source: IMF Blog
The IMF sees the main risk in a sudden halt to Russian natural gas exports to Europe. In that case, inflation would rise and global growth would slow to 2.6 percent this year and 2.0 percent next year – a pace exceeded just five times since 1970.
While financial markets rallied over the past month on the back of falling oil prices, this may not last if there are prolonged supply disruptions. Last week, for example, Russia’s state gas company Gazprom announced that it would halve natural gas supplies to Germany to 20% of capacity. This threat was previously hinted at by Daniel Yergin, a recognized energy expert, in an op-ed stating that today’s energy crisis is likely to be worse than the oil shock of the 1970s.
My own assessment is that there are some parallels with the 1970s, but also important differences. The main differences are that inflation expectations are now much lower and the dollar is strong, suggesting investors have not lost confidence in the Fed.
However, some developments have surprised policymakers and investors alike. One is the way the Covid pandemic has transformed the US job market. Although the unemployment rate steadily declined from mid-2020, the labor force participation rate also fell as millions of people were unable or reluctant to return to their previous jobs. This contributed to tightening jobs and upward pressure on wages as the Fed moved to a ‘maximum employment’ stance.
Another surprise is the global supply chain bottlenecks that emerged in 2021. The Fed tried to reassure investors that the rise in inflation would be temporary, and investors agreed, given that inflation had been low since the 1990s and the measures put in place after the 2008 global financial crisis failed to reignite it. However, due to the protracted Russia-Ukraine conflict and China’s zero-tolerance Covid policy, shortages persist with no end in sight.
When the Fed hiked rates in March this year, it was obvious that they had miscalculated and needed to catch up. The Fed’s message now is that controlling inflation is now its top priority. The reason: it doesn’t want to repeat the mistakes of the 1970s, when it adopted a “stop-and-go” policy that allowed inflation to build up over time.
While many people fear the Fed will overreact and trigger a recession, bond investors believe the Fed will ultimately prevail in fighting inflation. As a result, the spread between government bond yields and TIPS (inflation-protected securities of government bonds) has narrowed, suggesting that inflation expectations have moderated recently. The bond market, in turn, is pricing in monetary easing next year.
One risk, however, is that core inflation could remain elevated even if headline inflation falls. The reason: The cost of housing, which makes up a third of the core CPI index, will continue to rise due to the sharp rise in mortgage rates this year and the 30 percent rise in house prices over the past two years. As a result, the Fed could be forced to raise interest rates above what markets are currently pricing in.
So what should investors do in the face of heightened uncertainty?
In my opinion, this is not the right time for bold moves in investment portfolios. In the US, there are no large sector imbalances, household balance sheets are strong and financial institutions are well capitalized. Therefore, should a recession develop, it would likely be mild.
However, global risks must also be taken into account. These include an ongoing conflict between Russia and Ukraine, which could lead to escalating food and energy prices, and China’s zero-tolerance policy, which could prolong supply chain disruptions and weaken its economy.
Balancing these considerations, the most likely outcome is a return to a world of stagflation – albeit less severe and protracted than in the 1970s.
[1] Nicholas P Sargen, Global Shocks: An Investment Guide for Turbulent Markets, Palgrave Macmillan, 2016.
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