More of the same

Our base case for the global economy the rest of the year should have a familiar ring to investors as we expect growth to continue to slow, largely on two key themes that dominated 2022. We see inflation staying elevated (albeit moderating), eroding real disposable incomes, and monetary policy remaining constrictive as the past year’s policy-rate increases carry a deeper sting this year. 

Add the two together and we expect real global GDP growth to slow to about 2.5% in 2023 from just below 3% in 2022—well below the prevailing 3.5% trend in the three decades before the Covid recession. This forecast incorporates significant slowdowns in major advanced economies, including a short and mild recession in the U.S., and a Chinese reopening after exiting its zero-Covid policy that’s unlikely to significantly lift global growth. 

We do see risks skewed to the upside, in light of the faster-than-expected reopening of the Chinese economy, the sharp decline in energy prices (in Europe, notably) and the easing in financial conditions at the turn of the new year. However, risks can quickly change and there is a non-negligible probability of a sharper slowdown occurring later this year or in 2024. Indeed, in an era of high leverage, monetary tightening could end up having a larger-than-expected impact as policy changes can take up to 18 months to fully affect the real economy. 

Diving into the details 

Inflation probably peaked in the second half of 2022 across major advanced economies and should remain on a downward trend in 2023. Even so, we expect it to stabilize somewhat above target (3-3.5%) in the second half of the year. Whether inflation takes a further step down and converges to target depends on economic activity and, crucially, labor markets. If labor markets stay tight and inflation proves stickier than expected, central banks may have to tighten conditions more aggressively. That would likely lead to a sharper recession down the line—if not this year, then in 2024.

Our above-trend inflation outlook is why we think monetary and fiscal policies are likely to remain broadly restrictive. Central banks may be close to their peak rates, but if inflation is stubborn, they are unlikely to embark on an easing cycle in the back half of the year despite markets’ expectations to the contrary. Meanwhile, monetary tightening also is coming from the correction of central banks’ balance sheets as they allow Covid-infused assets to roll off, adding to overtightening risks. Such an environment of higher rates could expose fragilities in some niches of financial markets.

Of course, geopolitics seems certain to remain a driver of economic dynamics across emerging and developed countries. The implications of the Russian invasion of Ukraine will weigh on the economic outlook for years to come, notably in Europe given its historical reliance on energy from its neighbor to the north. More fundamentally, the conflict has been both a manifestation and an accelerator of pre-existing geopolitical trends, pointing toward a more fragmented and unstable international regime. The economic consequences from a more unstable geopolitical backdrop—crucially including the increasingly tense relationship between the U.S. and China—will play out over extended horizons. In particular, the prospects for globalization, the main source of worldwide productivity gains in the last several decades, are now uncertain. 

So goes the U.S.?

Despite the large shock from 2022’s surge in energy prices, the eurozone economy performed much better than expected toward the end of the year, avoiding an outright contraction in the fourth quarter, according to preliminary data.  Recent survey developments, including January’s eurozone composite PMI that tipped over into expansion territory after troughing at 47.3 in October 2022, suggest stagnation is more likely than recession in the year’s first half. For the year, we expect anemic growth of 0.6%. Granted, good luck has played a role as winter temperatures were seasonally mild. But preparedness and the long tail of post-Covid recovery dynamics have underpinned economic resilience. Fiscal support partially absorbed the hit to households from higher energy prices, and governments made sure gas storages were plentiful at the beginning of the winter. In addition, the eurozone is well positioned to benefit from spillover from a consumer-driven recovery in China, which has a stronger economic relationship with the continent compared to the U.S. 

In the U.S., by contrast, conflicting data (weakening manufacturing and housing, slowing consumer spending versus January’s rebound in services and blowout in jobs), along with the Federal Reserve’s hawkish persistence have markets going back and forth on recession prospects. Layoff announcements are rising, especially in technology industries that expanded rapidly during Covid, but jobless claims continue to hover near record lows. Hard to read. But it does appear recession risks are more pronounced for the U.S.  than for the euro area, as reflected in business and economic surveys and the heavily inverted yield curve, with the gaps between 3-month/10-year Treasuries and 2-/10-year Treasuries at levels that have signaled recession a year out 50% of the time.

If the U.S. does fall into a recession later this year, the rest of the world is unlikely to decouple. Historically, the U.S. cycle has tended to lead the eurozone by a few quarters, though the lag could be shorter given significant challenges the euro area is facing, most notably structurally higher energy prices and aggressive European Central Bank tightening. In many ways, what happens in the U.S. comes down to what we began this piece with: inflation and monetary policy. If the former surprises and moderates more quickly than we expect, it’s possible the Fed may surprise, too, by taking its foot off the brakes sooner. That’s not our base case, however, which is why we think this year may feel a lot like last year, only potentially a little worse in the U.S. and a little better in Europe.