Global Outlook

We believe the effects of Federal Reserve (Fed) rate hikes to date are accumulating, albeit remarkably slowly and diffusely. Inflation is moderating across the economy, most clearly in goods prices, but also in services prices and in housing costs (home prices and rents); the latter effects, however, have yet to show up in the Consumer Price Index (CPI) for technical reasons. We expect this moderation to continue. We think month-to-month inflation will be within the Fed’s target ranges before the middle of 2023. While year-over-year (YoY) measures won’t show this improvement as quickly, the “perception lags” arising from looking at YoY measures are well understood by any trained economist, and we believe the Fed will be astute enough to make this deduction as well.

The US construction industry has been in recession for some time, even while construction companies continue to replenish staffing. Lately, we are seeing similar developments in manufacturing, where both production and production hours worked have begun to decline, even as factory worker counts continue to recover. Understaffing is most acute in service industries, but even there job growth has slowed substantially except in those industries that were hardest hit by Covid restrictions (and where job counts are hundreds of thousands below pre-Covid levels). Even as service jobs continue to rebound, service-related workweeks are being cut enough that total production hours worked are decelerating or even declining.

We take these trends as clear evidence that either Fed rate hikes are taking their toll or that economic growth is slowing on its own, even while residual understaffing in the wake of Covid restrictions has meant further job growth. With these conditions, and given the progress made on inflation, it makes little sense and is likely counterproductive for the Fed to continue to tighten aggressively, and we think a change in its policy slant will be coming soon.

The combination of clement winter weather and voluntary demand reduction from both households and firms has led to a sharp fall in natural gas prices in Europe. Thus, the fear that growth would take a marked hit in the last quarter of 2022 has been avoided. Growth has also been aided by easing supply-chain problems such that production has been running quite strong, particularly in the auto sector. But this is a production boost from past demand and from a survey perspective, backlogs have come down sharply and future order indications are low. Hence, going forward growth will begin to weaken as production will reflect current weak demand.

The fall in energy prices is very important in terms of inflation. From a first-order standpoint this will lower energy prices; slowing the impact on actual inflation will be the energy price shields (government policies to offset the costs to both households and firms). Second-order impacts are likely just as important. Inflation expectations should begin to turn lower and the pass-through of energy price rises into both goods and service prices should recede. European Central Bank (ECB) Economist Phillip Lane suggests that half of eurozone inflation comes from energy cost pass-through. Last, lower energy prices will lower the cost of government support policies and likely result in less bond supply than previously expected over 2023. We anticipate that core goods prices will begin to turn lower this quarter; we can already see this in surveys, the Producer Price Index (PPI) and wholesale prices. Core services should begin to shift lower later in the first quarter as wage demands in new job postings are beginning to fall. Energy price declines will begin to recede gently at first, but later in the year the base effects will lead to sharper falls in headline inflation.

The ECB has posited a series of 50-basis-point (bp) hikes over the next two meetings and most members see the peak rate being reached in the summer. The market is pricing in a peak rate of 3.50%, thus another 150 bps of hikes in 1H23. With inflation expectations and future wage demands no longer rising (and in some cases gently falling), the hawkish argument is weakening a little at the margin. Both measures remain elevated, so there is clearly more to do. We, however, remain in the camp that the peak rate will be lower than that which is currently priced by the market.

Gilts significantly outperformed DM peers as UK domestic markets recovered from the unprecedented volatility that followed the ill-fated “Mini Budget” at the end of September. This was aided by the resignation of both the Chancellor and the Prime Minister, with their respective successors quickly reversing many of the fiscal plans and pledging to ensure that debt would fall as a share of GDP in the medium term. With market stability reinstated, the Bank of England (BoE) was able to proceed with its active quantitative easing program after an initial delay while the market was still stressed. A further test of market functioning and investor demand for gilts came as the BoE began to unwind its portfolio of long-dated securities via reverse enquiry operations. This was completed early in January. We believe that the BoE will raise the Bank Rate further during 1Q23, but quite possibly at a slower pace and to a lower peak than the market has currently priced. Data has shown further evidence of slowing economic activity, natural gas prices and inflation expectations have both fallen materially and hiring intentions have been declining for a number of months, loosening the job market and easing concerns over the risk of a wage-price spiral.

China continues to grapple with its Covid exit, a reopening that poses risks to the health care system and that may see people staying at home for fear of infection. That stated, the authorities are moving full speed ahead with their reopening plans. At the Central Economic Work Conference, China’s senior leadership committed to regaining economic confidence by adopting a policy package to turn around the economy in 2023. Specifically, the meeting highlighted five key areas of focus for next year’s economic agenda: expanding domestic demand, building a modern industrial system, strengthening support for state-owned enterprises (SOEs) and for private companies, increasing efforts to attract foreign direct investment, and diffusing economic and financial risks. The People’s Bank of China (PBoC) at its 4Q22 Monetary Policy Committee (MPC) meeting remained cautious on the growth outlook by stating that “the foundation for achieving economic recovery needs to be further consolidated.” The PBoC also reiterated a pro-growth stance and called for greater support for the economy, and in particular for the property sector. We believe the PBoC is likely to maintain its current accommodative stance in 1Q23, but posture for normalization if inflation risks rise after reopening in 2Q23, specifically from service price pressures on the back of low base effects. Though reflation will be manageable, it will take time to close the negative output gap in China and absorb significant labor market slack. Unlike the reopening supply disruptions faced by other economies in 2021, China does not face similar supply constraints. However, any pickup in China’s growth is unlikely going to be of the magnitude or extent that it would meaningfully lift the global economy. China’s reopening will act as a demand-push shock to the economy, but this push will be mostly driven by pent-up services demand with more limited goods spillover demand.