“Soft landing” is becoming increasingly difficult

The world economy is at a difficult stage when uncertainty is reaching a very high level.

Dr. Andrea Civiero, investment strategist

ETHENIA - Andrea CivieroBriefly about the basics

  • Global growth will slow with increasing risk of stagflation and recession.
  • Inflation will stay higher longer, threatening to take root and cause a second-round effect.
  • Monetary policy is being tightened (almost) around the world to curb inflation expectations and reduce the risk of a price / wage spiral. Fiscal policy can provide the desired incentive to avoid a recession.
  • The risks of political error are significant, especially in the United States.
  • Soft landing remains possible, but is becoming increasingly difficult.

“A strong economic recovery after the coronavirus is a thing of the past.”

The world economy is at a difficult stage when uncertainty is reaching a very high level. Against the backdrop of slowing growth, sustained inflation and tightening economic policies, the war in Ukraine and the Covid wave in China are creating serious stagflationary shocks that are straining politicians and threatening to expand.

The risks of a global economic downturn have increased significantly since the first quarter. The baseline scenario of the world economy has been revised downwards to take into account the slowdown and rising inflationary pressures. Thus, the IMF has revised its baseline scenario of global growth to 3.6% in 2022 against 4.4% expected in its January forecast. The IMF’s inflation forecast is currently 5.7% in developed countries and 8.7% in developing countries in 2022.

The war in Ukraine and related Western sanctions, combined with China’s blockade, create a cumulative negative supply and demand shock that raises energy and commodity prices, overshadows business and household confidence, restricts supply chains and disrupts international trade. If these exogenous shocks do not find a way out, growth expectations may still be revised downwards in the coming months.

Procurement Manager Indices (PMI) confirm the loss of momentum in the second quarter. The global consolidated PMI fell from 52.7 in March to 51 in April, with services even stronger. Supply chain constraints and cost pressures remain high. Growth prospects vary by region due to asynchronous cycles, differences in economic policy and disparities between the consequences of the Ukrainian conflict and the consequences of the energy shock.

Focus on: the US economy

Weakened by the widening trade deficit and low accumulated reserves, the US economy contracted by 1.4% year on year in the 1st quarter of 2022. Consumer demand and investment in business, however, remain stable. The labor market is also very well oriented: the unemployment rate is 3.8% and wages are rising rapidly. Inflation is high and gaining momentum. Core inflation in April was 8.3% and core inflation was 6.2%, but there are signs of a possible surge.

The Fed has embarked on an aggressive cycle of tight monetary policy, which is likely to bring Fed funds to a neutral rate of around 2.5% at the end of the year, on the sidelines of the quantitative strengthening that has just begun. Thanks to a strong economy and employment, the Fed is likely to achieve a soft landing, making sure it has room to maneuver to tighten its policies and curb overall demand without causing a recession.

It is not yet certain that the central bank will be able to return inflation to the target level without causing a recession. However, it is very likely that the Fed will tighten its policy until inflation is under control.

Emphasis on: the eurozone

In the eurozone, the situation looks less bright. The economy grew in the first quarter at a slow rate of 0.3 percent compared to the quarter. Following the conflict in Ukraine, the European Commission has revised its growth forecast for 2022 from 4% to 2.7%. Recent economic statistics paint a mixed picture. PMI stabilized at low levels in May after a sharp drop in March. The labor market remains strong, with an unemployment rate of 6.8% and moderate wage growth. But beneath the surface, the effects of the Ukrainian conflict and high energy prices are clearly being felt. Economic confidence is falling sharply, industrial production is hampered by supply chain disruptions and high energy prices, and orders are falling.

In May, inflation reached its highest level in history (8.1%), and core consumer price inflation (CPI) accelerated to 3.8%. Inflation is driven by energy and food prices, but is now spreading to other sectors. The ECB has stepped up its tone to curb inflation expectations, while fiscal policy should remain broadly moderate in 2022. The central bank will complete its asset purchase program in June 2022 and is likely to raise key rates in July to bring them to zero by the end of the year. However, there are significant risks to the world, as interest rates will rise amid a slowing economy, and this tightening will have little effect on inflationary pressures, as they are essentially derived from energy and commodity prices. Market fragmentation (the spread of profitability between the center and the periphery of the region) is an additional cause for concern, which will require a flexible approach by the ECB.

In our opinion, the European Central Bank will not raise rates as much as markets expect. Despite optimism about the economic recovery and the start of the tourist season, obstacles to the conflict in Ukraine, rising inflation and a slowdown in China are expected to continue to hamper the zone’s economic performance. .

Focus on: China

China’s economy has been slowing for some time. Despite a temporary surge during the first two months of 2022, Zero Covid’s policy of broad quarantine was imposed in the face of a new wave of Omicron, causing severe disruptions in economic activity. Thanks to a very strong start to the year and measures of state support, GDP growth reached 4.4% year on year, but the economy remains weak and declined sharply in April. The All-Ukrainian People’s Congress has launched large-scale stimulus initiatives, and the State Council of China has announced a number of impressive measures to prevent an excessive economic downturn.

As inflation is low and falling (the main CPI is 2.1%) and consumer demand is weakening, the People’s Bank of China (NSC) is accelerating liquidity inflows and lowering interest rates. Fiscal policy must remain very lenient. In our opinion, state aid should start to work gradually, and its impact on economic growth is likely to be seen no earlier than the second half of 2022.

But China is trying to reconcile its health policy, which aims to sternly contain Covid’s sources of infection, with support for its economy. With President Xi Jinping running for a third term as secretary general of the Chinese Communist Party, this state of tension is expected to persist through the fourth quarter, and China’s growth will be difficult to reach the official 5.5% target this year.

Will the developed economies of the United States and the eurozone be able to slow down gently to avoid a recession?

Negative trends are intensifying, increasing the risk of decline and reducing the chances of a soft landing. Several factors will help determine the course of events:

  1. The duration of the armed conflict in Ukraine and its impact on raw material prices, economic confidence, investment and production.
  2. The duration of the Covid wave in China and its impact on supply chains and domestic demand, as well as on inflation and global growth.
  3. Health of labor markets and consumer spending, whose real disposable income is under significant inflationary pressures.
  4. A combination of macroeconomic policies: in the context of tighter monetary policy everywhere, with the exception of Japan and China, will fiscal regimes prevent another recession?

Faced with severe stagflationary shocks, increased dependence on Russian energy and limited fiscal space, the EU is at risk of recession. With their economies stronger and better isolated from the Ukrainian conflict, the United States is better prepared to avoid this result. However, the Fed’s path is extremely short, and the risk of political error (in the form of excessive tightening) should not be underestimated.

More information about Ethna funds