The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
The mix of tight fiscal and ultra-loose monetary policy that followed the Global Financial Crisis (GFC) meant that the global economy never recovered to its pre-GFC trend — particularly as quantitative easing was focused on purchasing government debt, implying the exchange of one safe asset for another. Policymakers appear to have absorbed this lesson, as when the next big global shock came round in the form of the COVID pandemic, their response was ultra-loose in both fiscal and monetary policy. That mix has got the world back to its pre-COVID trend, but at the cost of much higher inflation, at least for now.
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Soaring inflation has hit consumer confidence, suggesting a consumer-led downturn could already be under way in the euro area, UK and US.
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The odds of a consumer-led downturn that results in a Q2 contraction are highest in the euro area and the UK, which suffer from lower excess savings than the US and much higher reliance on Russian gas (directly and indirectly). Despite a lot of talk of an immediate US recession, we judge the world’s largest economy to be more resilient.
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Even if Europe escapes a Q2 contraction it is likely to be pain deferred rather than avoided, with a contraction close to inevitable over the coming twelve months as the European Central Bank and the Bank of England face a higher-for-longer bout of inflation than the US. The US central bank has increased its credibility by taking a stronger stance on inflation. Its chair Jay Powell has said that combatting inflation is the FOMC’s number one priority; and two 50-basis point hikes are close to nailed on for June and July.
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The situation is more tricky in Europe, where the growth outlook is weaker, but the inflation outlook is higher. The Bank of England and the ECB have signalled relatively modest interest rate increases, which is understandable given the weak outlook for demand. But both risk losing credibility, with wage growth already high in the UK.
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Meanwhile, the ECB is stuck between a rock and a hard place: it can hike rates now to prevent second-round effects on inflation, but at the risk of driving peripheral bond yields higher, thus increasing the risk of a currency bloc breakup; or it can maintain relatively loose policy but at the risk of de-anchored expectations. Fathom judges a recession is overwhelmingly likely in the EU in the coming 12 months.
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China faces a similarly unenviable dilemma: persisting with its ‘zero-COVID’ policy versus a stronger economy. At present, Beijing judges the cost to economic growth from zero-COVID to be less of a political risk than letting the virus spread more widely in a relatively vulnerable population. The result of China’s approach is an economy that is likely to shrink in Q2, and faces persistent headwinds through the year as Omicron poses an ever-present threat. Further ahead, structural imbalances and a reluctance to enact meaningful policy reform mean that growth will continue to grind slower.
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Against a backdrop of high inflation and slowing growth, risk assets have started the year poorly. Our proprietary Fathom Risk-Off Gauge (FROG) index shows markets are in a decisively risk-off mood, with history suggesting they could stay that way for some time. A separate Fathom indicator that measures global liquidity has stuttered, and remains under pressure from hawkish Fed rhetoric in particular. We are watching this measure closely for signs of a bottom, which would cause us to adopt a more constructive approach to risk assets. The outlook for US short rates will be critical in this regard. It is possible that the biggest surprises in the coming months relative to the median FOMC March forecasts will be on growth and to the downside, rather than on inflation and to the upside, as has been the custom in recent quarters.
A natural implication is that the FOMC may pivot towards focusing on the labour market side of its dual mandate, with downside risks to interest rates. Indeed, our mean expectation for the federal funds rate is below that of market pricing for the first time since the pandemic began. The same cannot be said for UK Bank Rate. With a tight labour market, and sustained external shocks, the likelihood of expectations slipping their anchor is higher in the UK than in any other developed market. So while the Old Lady has guided towards a very shallow rate-hiking cycle, she may be forced into something steeper than what is currently priced into markets.
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