wall of worries

Climbing the wall of worries - Summer Economic Outlook

June 2023

Some larger economies slipped into recession earlier this year amid a difficult global economic outlook, with GDP growth averaging at only +2.5% and +2.3% in 2023-24, respectively. The manufacturing and global trade recessions dragged several economies into a technical recession in Q1 2023 (Germany, Singapore, Taiwan). Residual effects of tighter monetary policy are set to shape a tempered 2023-24 growth scenario, with the US and Eurozone heading towards a soft landing and a subdued rebound in 2024, especially as Europe faces the prospect of a tighter financing landscape for longer. Most advanced economies are expected to avoid a full-fledged recession, but will remain in a low-growth environment. Emerging markets face mounting pressure due to internal and external imbalances. Social fatigue is also likely to unfold amid a general convergence towards lower growth rates  on the back of decelerating commodity prices, a higher USD, rising liquidity strains and delayed rate pivots.

Determined to fight inflation, central banks are expected to decelerate their hiking cycles throughout the summer but not pivot before spring 2024. Positive real interest rates will push non-payment risk higher. Given sticky core inflation, notably due to services prices, high interest rates will remain in advanced economies. The latter half of the year may bring about an increasingly politicized monetary stance as central banks prioritize inflation control over growth support. In the US, resilient economic activity and less acute financial stability concerns means tighter monetary policy. Following a pause in June, two final rate increases of 25bps each are likely in July and September, leading to a 5.75% terminal rate. The Eurozone continues to face a challenging monetary policy environment as persistent price pressures, particularly in services, reinforce the need for further rate hikes. We expect two additional hikes for July and September, resulting in a 4.0% terminal rate. This would imply that the ECB maintains a restrictive stance in 2023, despite an expected stagnation in growth until Q1 2024. The Bank of England is expected to be the last to pause with three more rate hikes at 5.5% by year-end. If interest rates rise by 200bps, we calculate that the share of fragile SMEs would rise to 18% in the UK, 14% in France, 7% in Germany and 10% in Italy, i.e. back to 2019 levels. The bounce back in insolvencies is spreading across sectors and to large firms: We expect them to increase by +21% in 2023 and +4% in 2024.

A lot of the economic resilience comes from the labor market; indeed, companies are hoarding labor despite the fall in margins. But this can’t last for too long. Global corporate revenues continued to increase in Q1 (+2.7% y/y) but much slower than in previous quarters (+4.0% in Q4 and +9.0% in Q3). Earnings fell for two quarters in a row. Wage pressures as a percentage of gross value added remain above average in the Eurozone, most notably in France, Germany and Italy. Since other costs excl. wages cannot be reduced indefinitely and pricing power has been fading in most sectors, we see margins squeezing in the coming quarters, increasing pressures on companies that scaled back hiring, but “hoarded” labor amid deteriorating demographic trends and the expectations for a short-lived moderate recession.

The prevailing fiscal stance remains supportive, yet a serious shift towards fiscal consolidation is expected next year as climbing interest rates limit flexibility. In Europe, the cyclically adjusted fiscal expenditure, representing the fiscal stance, lingers near peak levels. The structural deficit, inclusive of energy-related measures, is set to drop by around 0.5pp of GDP this year, correspondingly reducing GDP growth. Despite subdued growth, the cyclical impact of a more restrictive fiscal policy won't be substantial. Shrinkage in fiscal space may necessitate challenging policy compromises as governments strive to address key structural issues arising from the recent crisis, including green economy transitions and crucial pension and tax reforms. In the US, a debt-ceiling agreement between the White House and Congress Republicans proposes spending caps, focusing narrowly on federal non-defense discretionary spending. This limits the degree of fiscal policy tightening. Nonetheless, accelerated fiscal consolidation is anticipated in US states due to a soaring interest bill and probable federal transfer cutbacks. We expect a negative general government fiscal impulse amounting to 0.7% of GDP in 2024, and forecast a broadening fiscal deficit to -7.8% of GDP (from -7.3% in 2023) amid a weaker economy induced by Fed policies and interest payments rising above 4% of GDP.

Expectations of heightened monetary policy and stronger-than-anticipated economic resilience present short-term upside risks for long-term yields, while euphoric equity markets are heading towards challenges. Market participants are speculating on central banks' terminal rates, hence fluctuations in realized and projected policy paths significantly affect the long end of the yield curves. Our forecast, based on stronger economic performance in the US and Eurozone for 2023 and 2024, as well as inflation estimates exceeding consensus, suggests ongoing upward risks for long-term yields in the short run as the market adjusts to revised central bank expectations. However, valuation models suggest lower absolute yields in the mid to long term. Overall, we expect a gradual decline in long-term yields once central banks reach their terminal rate, with the 10-year UST ending at around 3.8% by the end of 2023 and then dropping to 3.3% in 2024, and similar patterns for the 10-year Bund. Despite their strong performance so far, equity markets should see downward pressures in the next few months. Weaker long-term growth, elevated short-term rates, falling inflationary pressures and deteriorating liquidity are poised to exert such pressures on valuations. The US and Eurozone are likely to exhibit regional divergences, with the US displaying a stark gap between economic leading indicators and current market pricing. Conversely, in the Eurozone, economic optimism aligns more with current market conditions, suggesting a more positive outlook if economic expectations are realized. This suggests a drop in margins before an anticipated rebound later in 2024.

What could go wrong? We are heading towards a very politically charged 2024 with elections upcoming in economies accounting : for close to 75% of global GDP: the US, EU elections, UK, Austria, Russia, Poland, Romania, South Africa, Taiwan, India, Mexico etc. Beyond politics and although a full-scale financial crisis has been dodged for now, the risk of further bank failures remains as efforts to reassure investors falter. Potential bailouts of bankers and tech start-ups might also have political implications in the run-up to the US 2024 Presidential campaign. Higher-for-longer inflation also increases the risk of a policy mistake by central banks, which will need to maintain a more restrictive monetary stance. U.S. monetary tightening and overshooting particularly by the Federal Reserve could prolong the current economic downturn and delay the recovery. Also renewed energy supply constraints in Europe, for instance as a result of a cold winter in 2023-24, could bring back the specter of gas rationing and push real growth in most countries into negative territory until mid-2024. However, a ceasefire between Russia and Ukraine would help reduce much of the prevailing uncertainty about the outlook and would allow for resources to be allocated more efficiently, including through strengthening strategic trade relationships that are currently under strain but critical to tackling important secular challenges (slowing globalization, rapid digitalization and effective de-carbonization). Also a more globally-oriented re-opening of China’s economy could revitalize flagging global trade and accelerate normalization of inflation.

Ludovic Subran

Allianz SE

Ano Kuhanathan

Allianz Trade