Developed markets are gradually converging towards their old, pre-COVID economic trends and, so far, appear to be successfully navigating the fastest monetary tightening cycle in decades. In the central scenario in Fathom’s Global Outlook, Spring 2024, which summarises our view for the world economy, financial markets and geopolitics, we no longer contemplate a recession across the major developed economies over the forecast horizon, and instead foresee a growing divergence in economic performance, with the US outperforming its peers — a trend we flagged up in previous Outlooks and which so far has been vindicated.
However, there are significant risks around this central scenario, which we name ‘Back to BC’ (Before Covid). This note focuses on an alternative scenario, which we call ‘Making up for lost time’, to which we ascribe a 40% probability. In this risk scenario, the global economy turns out to be stronger and more resilient than expected, particularly in the short term. Consumers still have substantial pandemic savings pots, and may be so intent on making up for lost time by spending them that the current, tight monetary policy may have less of an effect than usual. Moreover, if consumers’ expectations around inflation remain elevated, this spending could come in a hurry — though the fact that this hasn’t already happened makes this a risk rather than a central case. Higher asset prices could also offer further support for spending, particularly from high-income consumers who have seen significant positive wealth effects during COVID.
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If the increase in spending materialises at the same time as labour markets remain tight, this could reignite worries around inflation — especially if wage growth remains above levels consistent with productivity growth and the inflation target. No major western economy seems immune to this risk, and we believe people should keep a close eye on wage-growth trends. Anything persistently and significantly above 3% (a generous estimate for the sum of trend productivity growth and the 2% inflation target) could pose a risk that inflation is not under control after all. The UK seems the most exposed, where current levels of wage growth are hovering around 6% (although there are serious doubts about the reliability of these wage statistics, given the low number of respondents to the labour market survey). Meanwhile, alternative high-frequency wages data from Indeed, the job search company, suggest that the downward pressure on wage growth in the EA may have bottomed out.
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With inflation still discounted by investors to come back to around 2%, the risks embedded in Fathom’s ‘Making up for lost time’ scenario are benign in the short term, but much less so further out in our forecasting horizon. Complacency around inflation breeds complacency around rates. Given the recent hot CPI prints in the US, investors have already pared back significantly on Fed cut expectations. The risk is that expectations around any interest rate cuts all but disappear, with central banks subsequently forced to deliver further hikes to rein in inflation and demand. Assuming they have learned their lesson after failing to respond quickly enough to rising inflation during the pandemic, a monetary U-turn could materialise at short notice.
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Higher interest rates sustained for longer would increase the odds that pre-existing vulnerabilities might be tested and could start to unravel, particularly in the corporate sector. In the US, recent data point to improving average corporate balance sheets and, for now, debt-servicing costs in aggregate are manageable. However, a second wave of inflation which led to further increases in interest rates would take a toll on over-leveraged corporates, arguably leading to a surge in defaults. Fathom’s analysis shows that the situation is no rosier in the euro area than it is across the Atlantic. More specifically, the share of financially constrained firms has increased post-COVID to multi-decade highs. The evidence suggests that European firms are becoming less transparent as financial constraints bite.
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Finally, this year US elections will be taking place; and if Donald Trump is re-elected and Republicans control the House and Senate, there is a good chance that he will repeat the policy of his first presidential term of offering big tax cuts. While these would probably provide a short-term boost to growth, they would also exacerbate inflationary pressures, at a time when US fiscal policy is already expansionary. Overall, risks to US economic activity, inflation and rates are all to the upside relative to our central scenario in the short term, but to the downside further out. We see equities continuing to rise through 2024, but the risk of a correction next year is high as investors seem already to be fully pricing in a cycle close to our benign, central scenario. This leaves the market exposed to potential disappointment, particularly if risks materialise around rates and inflation.
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The views expressed in this article are the views of the author, not necessarily those of LSEG.
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