January 27, 2023

News in Charts: First-round effects in the past, but recession ahead

by Fathom Consulting.

With headline and core inflation now slowing, it seems as if the worst of the first-round inflationary shocks are probably over. Investors concur, with positive returns on bonds and equities so far this year, and lower market-implied risks of crises. Nevertheless, Fathom’s central forecast is still that the UK, euro area (EA) and the US will experience mild recessions in the coming year. In this post we explain why, and review the recent data.

Long-only portfolios, which are especially volatile during economic downturns, were hit badly in 2022, but have since recovered as markets have grown more optimistic about the future. This is based upon an expectation that we have now passed the worst of the trade-off between growth and the inflation that arose from COVID and the war in Ukraine.

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Fathom’s Financial Vulnerability Indicator, a comprehensive measure of financial risk across 176 countries, shows that the risk of a global outbreak of banking crises peaked in 2022 Q3. Credit default swap spreads are also narrowing, reflecting lower risk of default.

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Fathom’s economic sentiment indicators have improved too but remain at low levels. Furthermore, the euro area composite PMI was above 50 for the first time since last June (a level above 50 indicates an expansion in business activity).

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Fathom has in the past highlighted that a large symmetric shock to the euro area could trigger a reassessment of the asymmetric exposures to sovereign default. The probabilities of sovereign default, based on CDS market pricing, have peaked or decreased, without having been anywhere near the high levels of risk in 2012 and 2015.

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The optimistic news laid out above partly stems from lower oil and natural gas prices. Both remain elevated, but are decreasing. If European natural gas stocks hold, which according to Fathom’s central case they will, the worst of the first-round effects are now behind us. Indeed, the extent and speed of Europe’s substitution away from Russian gas generally exceeded expectations last year.

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Although inflation rates are elevated across the OECD, in Fathom’s central forecast both headline and core inflation will slow this year. Indeed, headline outturns in both the US and euro area have surprised to the downside compared to the Reuters poll of professional forecasters’ expectations for the last few months.

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However, the core CPI surprises indicator is still elevated in the euro area, with little sign of waning yet. This could indicate that second-round effects are greater than anticipated by forecasters, and it points to a risk that inflation may prove more persistent than many expect. If this proves true, then policy may have to be tightened by more than is currently priced in.

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There is a time lag of up to a year, or more, from when monetary tightening is implemented to the full effects being seen on economic activity; thus, monetary tightening in 2022 will still be acting as a brake on economic activity in 2023. Additionally, data suggest there is a chance of rising second-round effects through wages, profits and other nominal quantities, particularly in the euro area.

To summarise, the worst of the first-round effects seem to be in the past, market sentiments are looking brighter and inflation is slowing, but risks still persist. Fathom’s central case remains that the euro area will experience a recession within the coming two quarters, and the US later in the year. On the bright side, the downturn will not be near the levels seen during COVID.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG. 

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