A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.
2022 witnessed the biggest inflation shock the world has seen in more than 40 years. Central banks responded with aggressive interest rate rises. Recession, or at best a period of sluggish growth, is in prospect for much of the industrialised world. This is a big subject and today’s briefing is roughly twice as long as usual.
The macro picture is not quite as bleak as it may sound. Inflation has probably already peaked and, helped by lower gas prices, should fall sharply this summer, paving the way for recovery before the end of this year. Recession risks are greatest in Europe, rather lower in the US and lower still in much of the rest of the world. The world’s second and third largest economies, China and Japan, are expected to post strong growth this year, as is India, the world’s most populous economy. The IMF’s widely reported forecast that one-third of the world economy will fall into recession in 2023 could more optimistically be expressed as meaning that two-third of the world economy will avoid recession. The reality is that the global economy will continue to grow this year, albeit at a slower pace than in 2022.
Inflation is the principal cause of the West’s problems. Russia’s invasion of Ukraine gave a big leg up to commodity prices, with European gas prices peaking in August at roughly fifteen times pre-invasion levels. Food, metals and other commodity prices also surged, though this also reflected a wider supply-demand imbalance in the wake of the pandemic. Lockdowns in China exacerbated supply disruptions in the world’s largest manufacturing economy, adding to pressures.
The scale of the inflation shock, and its persistence, triggered a change in thinking among central banks from the early summer of last year. Far from being a temporary phenomenon caused by recovery from the pandemic, central banks saw a growing risk that inflation was becoming embedded, above all in wage bargaining and price-setting behaviours. That triggered a bout of large interest rate rises, with the US Federal Reserve raising rates by 75bp at four consecutive meetings, the most aggressive tightening of US monetary policy since a previous Fed chairman, Paul Volcker, set out to crush runaway inflation in 1981.
The swift unwinding of over a decade of easy monetary policy has caused turmoil in financial markets. Last June US equities entered their eleventh bear market since the early 1950s. The US S&P index fell by 18% in 2022, similar to the decline in the global equity market. Riskier, highly valued or losing-making businesses suffered far larger losses. Bonds, supposedly a safe haven in difficult times, have been anything but safe, with inflation driving yields higher, and prices lower, on government and corporate bonds. Someone who invested in UK government bonds, or gilts, a year ago has lost almost 18% of their money. Our own measure of UK financial conditions shows levels of stress in financial markets running at the highest level since the financial crisis in 2009.
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Monetary policy famously operates with “long and variable lags”, but after nearly a year of rising interest rates, it is having an effect. With real incomes falling consumers have switched from the discretionary goods purchases they splurged on in the pandemic and where inflation has been high, towards essentials. This shift is seen in worldwide sales of PCs, which fell by 20% in the year to Q2 2022 or in the prices of second-hand cars that surged in the pandemic and are now falling. Weaker global demand has led to big declines in commodity prices. Mild weather has helped, with European gas prices halving in December and running 30% lower than a year earlier. Supply chain problems have eased significantly since the summer. Companies in the US and Europe struggled with stock shortages for much of the last 18 months but are now reporting much higher levels of stocks. The cost of shipping freight, which exploded in 2021, is now roughly one-tenth of the levels reached in August.
These factors are feeding through the system, with US inflation dropping from 9.1% in June to 7.1% in November. Euro area and UK inflation rates seem to have peaked, though are running at higher levels than in the US.
Yet inflation is far from beaten. Even stripping out soaring energy and food prices, core inflation is running at horrendously high levels by the standards of the last 20 years. Labour markets have proved resilient in the face of a massive tightening of monetary policy. The unemployment rate in the UK is close to a 50-year low and wage growth in the private sector is accelerating. Central banks believe they will need to raise rates still further to bring inflation back to their 2.0% targets. We see UK rates, which are currently 3.5%, peaking at 4.5% and euro area rates rising from 2.0% to 3.5%. The Fed moved further and faster and inflation has fallen more quickly than in Europe. US rates stand at 4.0%-4.25% and they now seem unlikely to rise much above 5.0%.
High inflation and high interest rates are traditional harbingers of recession, and most economists expect the UK, the euro area and the US to experience recessions this year. The tightening of policy in the last year has been unusually synchronised by the standards of the last 50 years and so, too, will be the dampening effects. The most obvious risks lie in the UK and Germany. The consensus view is that any US recession is likely to be mild, reflecting the strength of the job market, high levels of savings, easy fiscal policy and the fact that the US is insulated from the effects of the high gas prices that have hit Europe.
On average, economists expect the UK economy to contract by 1.0% this year. Our forecast is for a rather deeper downturn, with UK GDP shrinking by 1.4%. The consensus of economists sees Germany as the weakest major European economy, contracting by 0.7% in 2023, in part because of its reliance on natural gas. Expectation for euro area growth of -0.1% is bolstered by Spain, which is expected to grow by 0.8%. Economists see the US economy expanding only marginally in 2023, by 0.2%. Japan is expected to grow by 1.3% this year, well above its trend rate.
Why is the UK expected to underperform its peers when all industrialised economies have been beset by inflation, rising energy costs and higher interest rates? Several idiosyncratic factors are at work. The UK has lost over half a million workers to early retirement since the start of the pandemic, shrinking the productive capacity of an economy that also suffers from low investment. Brexit has reduced the supply of lower labour from the EU and, by adding costs and complexity, weakened trade with the EU. Finally, consumption plays a bigger role in the UK, relative to GDP, than in most European economies. The Office for Budget Responsibility expects UK real household disposable incomes to be 6.5% lower at the end of 2023 than at the end of 2021, a massive reduction in spending power which feeds through to weak consumption and GDP growth.
We expect the UK to return to growth in the fourth quarter of 2023 with the economy shrinking, from peak to trough, by 2.0%. This would be like the recession of the early 1990s, but less than half the reduction in GDP seen in the recessions of the ‘70s, ‘80s and the financial crisis.
Views vary widely on the scale of the downturn in the West this year, from brief and mild to long and deep. But there are some things on which there is much more consensus.
Labour markets have peaked, and we should expect unemployment rates to rise across Europe and the US. (Crucially, however, the expected peak in unemployment is likely to be far lower than in all the recessions of the last 50 years prior to the pandemic.) Consumers everywhere will feel the pinch from inflation, rising interest rates and higher unemployment. We’ll be hearing a lot more this year about the so-called Misery Index that gauges consumer welfare by summing inflation, interest rates and the unemployment rate. Selling non-essentials to consumers, especially those on the middle to lower incomes, will get harder. House price inflation is falling in Germany, the US and the UK, and prices have further to fall. In the UK we expect prices to decline by 15% from peak to trough.
Inflation and weak demand will push corporate profits down and increase the number of corporate bankruptcies. (In the first three quarters of 2022 UK company insolvencies were 76% higher than in the same period in 2021.) Credit is less available and more expensive, making it harder to raise finance for leveraged, higher-risk projects. Investors will put a premium on assets that deliver profits and protect against inflation.
The brightest spots in the global economy lie outside the old industrial economies of Europe and North America. The near abandonment of China’s zero-COVID policies has caused an overnight re-opening of the economy and pushed COVID cases to record levels. (One Western estimate suggests that 18% of the Chinese population may have COVID.) With low levels of acquired immunity in the population and low vaccination rates among older people the Chinese health system faces a severe test. But the re-opening will also drive growth that is widely expected to accelerate from 3.2% in 2022 to around the 4.5% mark this year. India is likely to be the world’s fastest-growing major economy for the third consecutive year, expanding by about 6.0%. Growth in Indonesia, Vietnam, Malaysia and the Philippines, with a joint population of over 500m, is expected to come in at over 5.0% this year. Growth in the energy-producing economies of the Middle East is slowing but should remain well above those in Western economies. Among other large economies, prospects are brightest in Japan, South Korea, Taiwan, Australia and Turkey. What is clear is that it would be very unwise to extrapolate from the weakness of, say the UK or German economies, to the rest of the world.
We see four major downside risks to the global economy.
Number one is that inflation proves more embedded than expected, forcing central banks to engineer deep recessions to crush price pressures. The odds on this outcome increase if labour markets and wage growth remain solid.
The second, and related risk, is of another spike in energy prices. Bad weather could yet send gas prices soaring. Europe is set to ban Russian imports of petrol and diesel from February reducing supply. Russia seems likely to do what it can to stoke energy prices, possibly by halting supplies of liquid natural gas to Europe or cutting remaining pipelines.
Third, a financial crisis could yet emerge from somewhere in the financial system. A recessionary, higher interest rate environment creates pressures across the economy and in financial markets. The turmoil in September in the UK gilt market in response to the government’s easing of fiscal policy – something that, without intervention by the Bank of England, could have turned into a deep financial crisis – demonstrates the risks. The banking system is more regulated and better capitalised than it was on the eve of the financial crisis, but the less regulated parts of the system where activity, debt accumulation and risk taking have boomed, are at greater risk.
Fourth, and it’s a catch-all category, is geopolitics. Economists are even worse at forecasting geopolitical events than economies (who, after all foresaw Brexit, Trump or the Russian invasion of Ukraine?). The continuation of a major war in Europe, involving one of the world’s military superpowers, carries with it innumerable uncertainties. Mr Putin’s invasion, together with more assertive rhetoric from the Chinese authorities, has stoked concerns that China may take a more aggressive approach to Taiwan. Military incursions by Chinese warships and aircraft into Taiwanese waters and airspace increased sharply after the visit, in August, by the speaker of the US House of Representatives, Nancy Pelosi. A full-scale invasion would be a huge risk for China, but it is possible to imagine lower-level measures, including blockades and other disruptions, that would materially raise tensions.
The hope for 2023 is that inflation falls sharply as demand softens and a myriad of one-off factors, from soaring energy prices, to disrupted supply chains and booming spending on goods, subside. But even if that comes to pass, the UK, the euro area and, quite possibly, the US, seem unlikely to avoid a period of recession or, at best, stagnation, as the effects of high inflation and tighter monetary policy feed through the system. As The Economist noted recently, in the world of monetary policy the mantra is that only hawks go to heaven. Central banks need to tame inflation, and if it doesn’t fall of its own volition, they will have to crush it – and growth.
That’s a sobering thought on which to end. To avoid the tag of pessimist or gloomster I want to conclude, in staccato form, with some positive thoughts: China rebound; India strength; Japanese growth; Europe’s rapid switch from Russia energy; sharply lower gas prices; falling inflation; unemployment rises less than in previous downturns. Let’s hope they win out in 2023.
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