A soft landing is becoming more complicated
By Andrea Siviero, Investment Strategist at Ethenea
The EU is at risk of recession, whereas the US, with a stronger economy and less affected by the conflict in Ukraine, is better equipped to withstand tighter financial conditions. A soft landing of the global economy is still possible but becoming more and more complicated.
The global economy is at a difficult juncture and uncertainty is very high. Against a background of slowing growth, persistent inflation and tighter economic policies, the war in Ukraine and the Covid outbreak in China are serious stagflationary shocks challenging policymakers and threatening economic growth.
The downside risks for the global economy have increased considerably since the first quarter. The baseline scenario for the global economy has been downgraded to reflect slower growth and higher inflationary pressures. The IMF has revised down its baseline scenario for global growth in 2022 from 4.4% in its January forecast to 3.6%. The inflation forecast is now at 5.7% for advanced economies and at 8.7% for emerging economies for 2022.
The war in Ukraine and consequent western sanctions and the Covid-related lockdowns in China represent a combined negative supply and demand shock resulting in higher energy and commodity prices, softening consumer and business confidence, supply chain constraints and international trade disruptions. Without a solution to these exogenous shocks, growth expectations could be revised further downwards in the coming months.
Purchasing Managers Indexes (PMIs) confirm the softening momentum for the second quarter of the year. The May global composite PMI rose marginally to 51.5 (from 51.2 in April) but remains close to the threshold of 50 that separates economic expansion to economic contraction. Supply chain constraints and price pressures remain elevated. Growth prospects are divergent across regions as a result of asynchronous cycles, divergent economic policies and because countries are differently affected by the conflict in Ukraine and the consequent energy shock.
The US economy is resilient
The US economy remains in good health but the latest data point to a softening second quarter. The labour market is very strong with unemployment at 3.8% and wages rapidly increasing. Consumer demand remains healthy and business investment is solid. Inflation is high and sticky with headline inflation at 8.6% and core inflation at 6% in May.
The Fed started an aggressive tightening cycle that will likely bring the Fed funds to the estimated neutral rate of approximately 2.5% by year end, and it just started its quantitative tightening. There is little doubt that the Fed will tighten its policy until inflation is brought under control.
The Eurozone: inflationary pressures are broadening
The Eurozone picture looks gloomier. The Eurozone’s economy grew during the first quarter of the year at a 0.6% pace quarter on quarter. As a result of the conflict in Ukraine, the European Commission revised its forecast for 2022 growth from 4% down to 2.7%. Lately, economic data have shown a mixed picture. PMIs have stabilised in May after a sharp fall in March. The labour market remains solid with the unemployment level at 6.8% and moderate increases in salaries. Below the surface, however, we are seeing the effects of the conflict in Ukraine and high energy prices. Economic confidence is eroding sharply, industrial production is plagued by supply chain disruptions and high energy prices, and orders are declining.
Inflation reached in May an all-time high of 8.1% as a result of higher energy and food prices , but inflation is now broadening to other sectors. Consequently, Core consumer price inflation (CPI) is also picking up at 3.8%.
The ECB has announced that it will conclude its asset purchase programme as of 1 July 2022 and will increase its policy rates in July with 0,25%. It also expects to raise the key ECB interest rates again in September and left the door open to a larger increase of 50 bp in case of worsening of the inflation situation. However with a slowing economy and elevated risks of market fragmentation (spreads between the centre and the periphery) the ECB will need to maintain a flexible approach.
Despite the optimism related to the economic reopening and the beginning of the tourism season, headwinds from the conflict in Ukraine, higher inflation, tighter monetary policy and the economic slowdown in China will continue to hamper economic performance in the Eurozone.
China : sharp contraction of the economy in April
In China the economy has been slowing for some time and has undergone a sharp contraction in April as a result of Covid related lockdown. The People's Bank of China (PBoC) is accelerating the provision of liquidity and reducing rates to support the economy. Fiscal policy continues to be very accommodative. We believe that policy support will progressively start to have an effect and will likely impact economic growth in the second half of 2022 at the earliest.
China is however struggling to combine its health policy aimed at strictly containing the Covid outbreaks with support for its flagging economy. While the authorities have been lately tentatively winding down their strict Covid related lockdowns, this tension may well continue to hamper growth in the coming months and the Chinese economy will struggle to achieve the official 5.5% GDP growth target for this year.
Can a recession be avoided?
Headwinds for the US and European economies are growing. Facing a major stagflationary shock and with greater dependence on Russian energy and little fiscal room, the EU is at risk of recession. With a stronger economy and less affected by the conflict in Ukraine, the US economy is better equipped to prevent a recession. The path for the Fed is however extremely narrow and the risk of policy misstep (excessive tightening) should not be underestimated.
