investment insights

    As IMF warns of “darkest hour,” how bad will it get for the global economy?

    As IMF warns of “darkest hour,” how bad will it get for the global economy?
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways

    • We expect a tough nine months ahead, with the Fed continuing its inflation fight with aggressive rate hikes this year, and 2023 growth in the US and eurozone just 1.4% and 0.4% respectively
    • If US unemployment remains lower than expected by mid-2023, the Fed could end up raising rates above our expected peak of around 4.5%, with more severe repercussions for growth and risk assets
    • A strong dollar and tightening global liquidity are already hurting low-income countries, as the IMF extends short-term credit and pushes for a more effective debt resolution mechanism
    • We retain a cautious stance on both equities and fixed income, and focus on quality across asset classes.

    The tone in Washington D.C. is sombre, our economist in the US capital notes. Policymakers’ annual meetings with the World Bank and IMF come as the fund downgrades 2023 global growth forecasts to 2.7% and warns of the “darkest hour” ahead, with output in countries accounting for around a third of the global economy contracting this year or next. Amid persistent inflation, rising interest rates, the Ukraine war and China slowdown, financial turmoil may well appear, the fund notes. 


    Fighting inflation – a marathon not a sprint

    We expect three tough quarters ahead. High and persistent inflation is leaving central banks around the world – and chief among them the Federal Reserve (Fed) – with little choice than to raise rates aggressively. Recession will be the unavoidable price. Restrictive monetary policy will slow growth, weakening the housing and labour markets, and ultimately bringing inflation back under control. But how far through this process are we? Investors are anxiously awaiting a ‘Fed pivot’ from relentless tightening to trigger a sustained rally in risk assets after several false starts.

    We expect three tough quarters ahead

    There is little to suggest we are there yet. While September’s US consumer price index (CPI) showed global measures, e.g. shipping costs easing, domestic ones are not. Services inflation, and notably rents, is rising, and will take time to normalise. Core inflation – stripping out food and energy costs – rose 6.6% on the previous year. We expect CPI to average 3.7% next year, well above the Fed’s 2% target; the Fed itself still sees core CPI above-target in 2025. Cooling the labour market will be hard. Job openings remain very high and unemployment around 50-year lows, meaning sustained upward pressure on wages. Annual wage growth of 5% needs to fall nearer 3.5% to be in line with the Fed’s inflation target.

    The Fed cannot yet afford to pivot. We forecast another 75bps US rate hike in November, and 50bps in December, with rates peaking around 4.5% next year, followed by a pause. Market expectations of cuts as soon as Q3 2023 look too hasty to us. Many of the meetings around this year’s IMF and World Bank events have reiterated the need to quash inflation, whatever the consequences for growth. The IMF’s new report urges central banks to “stay the course,” and warns against a repeat of the 1970s, when the Fed reversed course prematurely. Any such move might lead markets to rally sharply, as they did over the summer, in turn easing financial conditions and complicating the inflation fight.

    Many of the meetings around this year’s IMF and World Bank events have reiterated the need to quash inflation, whatever the consequences for growth

    2023 will feel like a recession

    Households and companies are already feeling the squeeze. Consumer confidence across developed nations is the lowest it has been in at least 50 years. Mortgage and other lending rates are spiralling. Purchasing Managers and manufacturing indices are approaching contractionary levels in the US, and below them in Europe and China. We think the US economy will grow just 1.4% next year, with unemployment rising to 5%, as a limited second half rebound follows a poor first six months. In the eurozone, we expect just 0.4% growth. As demand slows globally, the Organization of the Petroleum Exporting Countries plus key non-members (OPEC+) announced an aggressive cut to oil production from November. The cartel’s aim of keeping oil prices above USD 90/barrel will complicate the inflation fight. US President Joe Biden said there would be unspecified “consequences” for relations with Saudi Arabia over the decision; other Democrats are pushing for an end to arms sales and less security cooperation. 


    Will the Fed overtighten?

    Of all the major risks to the global economy – geopolitics and a Russia/Ukraine escalation, defaults at property developers causing a broader financial crunch in China, or the Fed ‘overtightening’ rates – markets are focussing squarely on the latter. The US labour market is the key factor to watch here. If unemployment remains lower than expected by mid-2023, the Fed could end up raising rates nearer 5.5%, with more severe repercussions for growth and risk assets.

    If unemployment remains lower than expected by mid-2023, the Fed could end up raising rates nearer 5.5%, with more severe repercussions for growth and risk assets

    Less discussed, perhaps, are the possible sources of good news. Here, we would highlight the potential for a Chinese growth rebound next year. China is the last major post-Covid reopening story, and we believe growth could recover to 5.5% in 2023 – above consensus estimates – on the back of a potential softening in its zero-Covid policy. Policy easing by China’s central bank and the Bank of Japan are also working against the rate tightening flow, helping the global economy avoid a deeper recession.

    Of course, tightening global liquidity has already crashed through many economies worldwide. A stronger dollar (up around 20% in trade-weighted terms over the past year) has increased dollar-denominated debt burdens. Rising US interest rates are exporting America’s domestic inflation, forcing more central banks across the world to raise rates, or hasten the pace of their own tightening. The IMF estimates that about 60% of low-income countries, including Chad, Ethiopia, Zambia and Sri Lanka are either in or at high risk of debt distress, causing huge problems for some of the world’s most vulnerable populations. The fund has launched a one-year programme to help those struggling with food and energy costs, and is urging creditors to consider a new debt resolution framework.

    Even high income countries face more financial instability and volatility ahead: witness the historic moves in gilt markets in recent weeks. Yet while the economic downturn will be acutely painful for many, we see little risk of a wider financial or solvency crisis in the developed world. Here, household debt levels and servicing costs as a percentage of income are generally below those seen before the Global Financial Crisis (GFC). Excess savings would act as a shock absorber: households still have some Covid savings, while corporate cash balances are around pre-pandemic averages. Countries’ current account positions and banks’ balance sheets also look healthier than pre-GFC.

    We remain cautious on both equities and fixed income and apply a quality tilt across asset classes

    Seeking out quality assets

    How should investors navigate this tough environment? In light of a deteriorating macroeconomic outlook, we have gradually lowered portfolio risk to more defensive levels. We remain cautious on both equities and fixed income, which have – unusually – suffered in tandem this year, stocks and bonds have only seen three years of combined negative returns since the 1920s. Stock markets could be hit by further cuts to earnings forecasts following the Q3 reporting season: earnings per share typically fall 15-20% during recessions, and analysts’ consensus is currently for 8% growth next year. We therefore apply a quality tilt across asset classes: in equities, companies with low earnings volatility and better ability to protect their margins; in fixed income, a preference for investment grade over high yield debt; and in currencies, a preference for havens against risk, such as the US dollar and Swiss franc.


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