Why recession is threatening the developed world – Asset Management

Around the world, interest rates are rising at an alarming rate as central banks recognize that inflation is taking root, rather than just a series of transitory shocks. For many, this looks like the dawn of a new regime in monetary policy and financial markets.

At its July meeting, the US Federal Open Market Committee (FOMC) raised the federal funds rate by 75 basis points (bps) to 2.25%-2.50%. This means that the most important interest rate for the global economy has quintupled in the space of just three months. This had a very negative impact on both government bonds around the world (with rising yields and falling prices), but also on risky assets, such as stock prices.

In Europe, the European Central Bank (ECB) raised all of its major interest rates by 50 basis points, ending eight years of negative interest rates. Even the UK’s Bank of England (BoE) surprised the market by raising rates more than expected.

The era of zero or even negative interest rates is over. A definitive regime change has occurred, taking us into a new era. That said, more experienced investors might see this as a throwback to more normal times, akin to the run-up to the 2008 global financial crisis. However, that remains to be seen. Perhaps the stagflation (a period of consistently high inflation combined with high unemployment and stagnant demand) experienced in the late 1970s and early 1980s is the most appropriate comparison.

Recessions expected next year

The new interest rate regime means that we now expect the US, UK and Eurozone economies to enter recession (defined as two successive quarters of declining economic output) at next year. All three of these markets will experience significant production declines over the next year, and the outlook for the global economy is bleak.

Inflation is now one of the top concerns for households when looking at their own financial situation. Politicians are finding they are not immune from blame as voters, who have grown accustomed to government help in the difficult times of recent years, now expect government support once again. As central banks seek to rein in high inflation, monetary policy is constrained, leaving governments to dull the pain of higher inflation wherever possible.

In the UK, rising inflation has been dubbed the “cost of living crisis” as household energy bills are expected to triple in as little as two years. Europe faces an even more acute crisis, with Russia’s energy supply threatened amid war in Ukraine. Governments in the region are struggling to find ways to help households, especially low-income ones.

World economy faces worst year since 2009

We have downgraded global economic growth significantly in Schroders’ new baseline forecast, with recessions now forecast for the US, Eurozone and UK, while most emerging markets will also see slower growth . Global growth is now expected to slow from 5.9% to 2.6% this year (revised down from 2.7%) and slow to 1.5% in 2023 (previously 2.7%). Barring the height of the Covid-19 pandemic, it would be the worst year for the global economy since 2009.

We lowered US economic growth from 2.6% in May to 1.7% for 2022, significantly below market estimates of 2.1% growth. This is mainly due to our higher inflation forecast (8% for the year vs. 6.9% previously) and also a more aggressive trajectory for the fed funds rate.

We expect the US Federal Reserve (Fed) to moderate the pace of hikes, but rates will hit 4% by early 2023, compared to market expectations of 3.65%. Higher interest rates, less generous public spending and higher inflation all contribute to reducing the purchasing power of households, which should eventually reduce their spending significantly. Businesses are likely to react to weaker demand by slowing down production and therefore also reducing the demand for labour. The policy tightening should be severe enough to drive up the unemployment rate, which is necessary to see not only household demand decline, but also inflationary pressures ease.

Soaring energy prices will lead to lower European production

We expect the US economy to slip into recession in the first three quarters of 2023, with economic output expected to contract by 1.9%, before returning to growth. To underscore how negative this forecast is, the fall in output means the country’s economy will contract by 1.1% for all of 2023, compared to consensus estimates of positive growth of 1%.

Unlike the United States, the recession in Europe will not be caused by domestically generated inflation and rising interest rates. Instead, spiraling energy costs related to the war in Ukraine are now severe enough to drive down production.

Compared to the United States and the Eurozone, the United Kingdom seems to be somewhere in between. Economic growth has been more resilient lately, and inflationary pressures are building up more and more. However, the UK is also being forced to endure high energy prices in Europe, which will hit households with a lag due to government energy price caps.

About Meredith Campagna

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