The global economy is at an inflection point, as governments unwind their Covid-19 relief programmes, political tensions ratchet up and inflation hits double-digits in many countries. Is there a crisis in the making? James King reports.
In the final months of 2022, the Organization of the Petroleum Exporting Countries (OPEC) cut oil production by two million barrels per day, the US Department of Commerce introduced export controls on semiconductors bound for China, and a string of central banks tightened monetary policy to tame inflation. Taken together, these events form part of a wider step-change to a new economic era of resurgent geopolitics, the end of cheap money, and rising energy and resource insecurity.
The next 12 months will expose the emerging trends in this new global political economy, though it will be coloured by a deteriorating economic backdrop. “For the global economy, we’re going to see various degrees of recession. We think there’s a 70% chance of the US sliding into a mild recession. [It is likely] to be a more severe [scenario] for the UK and the euro area. Next year will be challenging,” says Lin Li, MUFG’s head of global markets research for Asia.
But, even as recession stalks some of the world’s largest markets, great power politics will inject itself into the lifeblood of international trade, investment and finance in a way not seen since the days of the Soviet Union. As a result, geopolitical risk will emerge as the most visible feature of this emerging landscape.
“We’re in a new epoch, and the channels of trust and volatility [in the global economy] now incorporate so many additional elements. The role of geopolitics is going to be amplified on a structural basis over the coming years,” says Goolam Ballim, chief economist at Standard Bank, Africa’s largest lender by total assets.
Russia’s invasion of Ukraine and the accelerated decoupling of the US and Chinese economies are the most obvious examples of this trend. But evidence of this shift exists elsewhere. From Riyadh to Jakarta, a growing number of emerging market powers are charting their own course across this new political terrain by projecting their ambitions onto the global economy. In October, Indonesia’s investment minister announced that south-east Asia’s largest economy was looking into the creation of an OPEC-style cartel for producers of key battery metals.
Similarly, Saudi Arabia’s crown prince Mohammed bin Salman rebuffed US calls to increase oil production in October and instead advanced — in partnership with Russian deputy prime minister Alexander Novak — sweeping oil production cuts as part of the OPEC+ group of countries. These moves, and others, also mirror the growing energy and resource insecurity that will afflict the world over the near-to-medium term.
Rising pressure
While the war in Ukraine has strained energy markets across Europe and severed the supply of Moscow’s hydrocarbons to the West, pressures have been mounting elsewhere in commodity markets. This is due to the huge underinvestment in new sources of metals, as well as oil and gas fields, and is a trend that shows little sign of changing over the coming year. Fears are mounting that with limited new supplies of key commodities and fuels, prices could spike into 2023 and beyond.
These dynamics are colliding with political tensions, climate change pressures and the green energy transition, among other issues, to spur a deeper and more structural inflationary impulse across the global economy. “There’s a realisation that we are probably entering an era where inflation is going to be higher than what it has been over the past 40 years, basically since the mid-1980s,” says Chua Hak Bin, regional co-head of macro research at Maybank.
We are probably entering an era where inflation is going to be higher than what it has been over the past 40 years, basically since the mid-1980s
What is more, the demise of the global economic system developed around Chinese export-based economic growth and US consumption — coined “Chimerica” by economists Moritz Schularick and Niall Ferguson — which helped to keep a lid on global inflation, is coming to an end. This can be seen in the gradual reconfiguration of production and supply chains, as companies vote with their feet amid rising US-China tensions and Beijing’s strict response to the Covid-19 pandemic.
A process of ‘friendshoring’, in which manufacturing and supply operations are gradually being diversified to mitigate political risk, is expected to accelerate in 2023. Several markets, most notably India, are emerging as beneficiaries of this trend. A range of large international companies, including the US’s Alphabet, have signed manufacturing agreements with Indian electronics producers, in what is being described as a bet against political risks stemming from China.
“China has been the factory of the world since it joined the World Trade Organization [in 2001]; there have been stories and articles about China exporting deflation to the rest of the world,” says Mr Chua. “Now there’s a reversal of that. We’re seeing a breakup of those supply chains. Factories are being invested in and relocated to not where it’s cheapest, but where it’s most resilient. It’s a process of friendshoring and it’s [about diversification. Manufacturing operations] are being moved to where it’s sensible on national security grounds, for example.
“That’s one big part of the [inflation] story, this bifurcation of the global economy [means] everything will become a bit more expensive. The peace dividend is [also] over,” he adds.
Inflation jumps
But these structural changes are not the only driver of inflation in some of the world’s largest markets. In the US, demand-driven pressures are also playing a sizeable role, according to research from the Federal Reserve Bank of New York. Headline and core inflation was stubbornly high in September, at 8.2% and 6.6%, respectively — well beyond the Fed’s target range.
Despite the great inflation debate shifting from discussions of these trends being “transitory” to whether inflation has “peaked” moving into 2023, several market voices are sceptical that US inflation will normalise quickly. Former US treasury secretary, Lawrence Summers, who has been sounding the alarm on inflation with striking accuracy over the past few years, recently observed: “History suggests that once generated, high inflation is very hard to stop. The vast majority of efforts to stop inflation have failed in industrial economies.”
Mr Summers’s perspective on the US’s inflationary outlook, as well as that of some other advanced economies, is shared by Ms Li. “I think that next year, inflation could prove to be quite stubborn [in some markets],” she says. “And in terms of the effectiveness of monetary policy in containing inflation, there is also a question mark there because there are supply shortage issues and structural factors that complicate the issue.”
In the euro area, inflation smashed forecasts in October, reaching 10.7% from 9.9% in September, the highest level in the history of the single currency. For the most part, this can be attributed to supply shocks stemming from the war in Ukraine, a crisis that will probably continue well into 2023. Elsewhere, including in the UK and Australia, surging inflation seems to be emerging from a mix of supply and demand-based factors.
Tightening policies
This inflationary outlook for advanced economies will present monetary policy decision-makers with a tough set of choices in 2023. Interest rate futures suggest that the Fed could hike its key policy rate close to 5%, while market forecasts put the European Central Bank’s terminal rate between 2% and 3% in 2023. In Australia, cash-rate futures suggest the Reserve Bank of Australia’s policy rate will hit 4% by the closing stages of the year.
The implications of this changing policy stance — combined in some cases with quantitative tightening — will have far-reaching implications. For one, it underscores that the era of ‘cheap money’ has come to an end, with 2023 marking the definitive turning point. Leading central banks will, in all probability, reach their terminal rates over the course of the year and hold them there for longer. Though financial markets expect interest rates to then decline in 2024, barring a catastrophic economic or market event, it seems unlikely that a return to the ultra-loose conditions of recent years will materialise.
For some countries, there will be a heavy price to pay for these changing monetary policy conditions. In particular, the outlook for key housing markets in 2023 is a cause for concern. The example of Australia illustrates this point well. In the second quarter of 2022, the total value of Australia’s residential dwellings market was just over A$10tn ($6.46tn), based on data from the country’s statistical bureau, set against the size of the national economy of just over A$2.5tn.
In order for valuations to reach these dizzying heights, Australians have saddled themselves with the second-highest household debt levels in the world, which will now be subject to a far higher interest rate environment. Similar trends will play out in Canada, the UK, the US, South Korea and parts of the eurozone, as mortgage markets more accustomed to rock-bottom interest rate environments contend with a rapid spike in borrowing costs. The real-world implications of this are already clear: Wells Fargo’s mortgage originations were down 90% in the fourth quarter of 2022, according to a report from CNBC.
Strong dollar
Meanwhile, the strength of the US dollar is likely to be maintained over 2023 as the Fed remains committed to fighting inflation. The effects of this tighter policy stance, coupled with the country’s status as a net energy exporter, will ensure that the dollar continues to have an outsized impact on the global economy over the next 12 months. It could also force central banks around the world to defend their currencies as the Fed continues to hike.
“The Fed is increasing interest rates quickly and the dollar is appreciating very quickly, which is forcing other countries to follow the Fed to implicitly defend their currencies,” says Grégory Claeys, senior fellow at Brussels-based economic think tank Bruegel. “So, one of my fears is that the world as a whole is tightening monetary policy too far.”
The dollar is appreciating very quickly, which is forcing other countries to follow the Fed to implicitly defend their currencies
Research from the Bank for International Settlements (BIS) shows that the Real US Dollar Index in 2022 was the highest it had been since the 1980s. But, as the organisation notes, the key difference over the coming months will be that commodity prices will also be high. A strong dollar and elevated commodity prices will be something of a double blow for many energy importing markets, according to the BIS.
For the world’s frontier economies, this could spell trouble. Research from ING suggests that the number of these markets with dollar-denominated sovereign bonds trading at distressed levels — spreads that are, on average, 1000 basis points over US Treasuries — climbed from eight at the start of 2022 to 17 in the latter stages of the year.
Faced with continued US dollar strength and higher commodity prices, there is scope for several frontier market debt crises to emerge in 2023. “We’re less likely to see a crisis or a default from a larger emerging market,” says James Wilson, emerging market sovereign strategist at ING. “Having said that, there is still kind of the broader risk [stemming from frontier markets] where a lot of weaker and higher yielding sovereigns don’t have access to international bond markets because it’s prohibitively expensive, and they’re struggling to issue new bonds and roll over existing debt.”
Growth potential
But if 2023 has the potential to bring strife to some of these jurisdictions, it could have the opposite effect for more established peers. In particular, the next 12 months could underscore the growing importance of the world’s largest emerging markets, particularly in Asia. Indeed, the wider region will be the bright spot for the global economy in 2023.
“For Asia, I think the outlook is relatively brighter,” says Ms Li. “Several things will play out across Asian markets next year, one of which will be a reopening [from Covid-related restrictions], even if this reopening will be cautious. This will see tourists returning in greater numbers.
“The good thing for Asia is that the region is further away from the energy crisis. Some countries may suffer from rising prices; but, overall, the impact on Asian countries will be much less than on Europe.”
Ms Li expects China’s economy to expand by 5.1% over 2023, thanks in part to a government investment-led recovery and a gradual improvement in housing market conditions over the year. In addition, an incremental loosening of Covid-related restrictions — an issue that is front of mind for most investors — could also play a role. “[I anticipate] a gradual relaxation of Covid-19 measures. It’s not a removal of these measures or a U-turn; it’s more of a relaxation on the organisation and implementation side,” she adds.
Meanwhile, the Asian Development Bank reckons that south-east Asia will achieve economic growth, in aggregate, of 5% for the year. This reflects the strength of big-hitting markets like Indonesia which, as a commodity exporter, is reaping some benefits from the changing nature of the global economy. Moreover, the Association of Southeast Asian Nations countries could also enjoy some positive spill-over effects from the US and China’s rising trade and investment tensions, as well as China’s domestic governance and approach to Hong Kong.
“The other story is the huge capital flows coming in from China and Hong Kong, because of the lockdowns and the national security laws. That’s the most obvious for Singapore. As an indicator we use the number of family offices being set up — it’s just ballooning. There are signs that Hong Kong is losing its status as an international financial centre and becoming more of a Chinese financial centre,” says Maybank’s Mr Chua.
Markets in east Africa will represent another growth centre for the global economy in 2023. With a surprise and tentative peace deal emerging in Ethiopia in November, coupled with the robust performance of markets including Kenya, Tanzania and Mozambique, the region offers several compelling long-term growth and development opportunities, according to Standard Bank’s Mr Ballim.
However, the prospects are not uniformly spread across the continent. “Just in terms of relative opportunity, which is what a lot of investors ask me, I’d say you want to be probably cautious on west Africa,” he says. “If you are trigger-ready, there’s opportunities in east Africa now. East Africa is outperforming and west Africa is underperforming.”
Stuttering steps
But if parts of Africa and Asia will emerge as the standard bearers for global economic growth in 2023, then the UK and the EU — caught once more between two world superpowers — will move in the other direction. In November, the Bank of England warned the UK was facing its longest recession in 100 years, with the central bank predicting the downturn would last until the middle of 2024. In the euro area, meanwhile, the pressures stemming from the Russian invasion of Ukraine have upended some of the core assumptions of the bloc’s growth model.
“Europe generally, and Germany in particular, has developed an economic model that is reliant on access to Russian gas and exports to China. So, Europe needs to rethink its business model. And it’s going to be difficult because now we hear a lot of noise coming from companies saying Europe is not a safe place to do business [and] energy is going to be more expensive in the next few years,” says Mr Claeys.
“Europe thought it could count on trade in terms of the import of energy and the export of manufactured goods, but when you’re doing business with Russia and China, geopolitical issues are going to come up at some point,” he adds.
If the next 12 months represent the embryonic start-point of a new structure for the global economy, principally characterised by the resurgence of geopolitics, it will also be the moment when real and meaningful concerns over this uncertain future are voiced more often.
“A lot of things can break — that’s really worrying me right now,” says Mr Ballim. “There’s a lot of big things that can break.”
