As we look towards 2023, the COVID-19 overhang and related economic fallout will likely start to recede. However, the Russia-Ukraine conflict may have a lingering effect. While supply side issues are likely to improve, the recovery will assumedly be uneven. Goods are increasingly available, with select products still in short supply. Service, however, remains somewhat constricted due to the current robust labor markets.
In this piece, we will highlight our outlook for the global economy in 2023, centered around the following three themes:
- Pockets of inflation normalization
- Heightened interest rate environment, though some moderation
- Rising potential for sovereign distress
Theme 1: Pockets of Inflation Normalization
Inflation rose due to a combination of factors stemming from the pandemic and the Russia-Ukraine War.
Our core thesis on the catalyst for rising inflation in 2022 stems from events that came together to create a perfect storm. The story largely begins with COVID-19, which was then exacerbated by the Russia-Ukraine War.
When the COVID-19 lockdowns went into effect in 2020, personal savings rates rose sharply in many developed markets. In the U.S., personal savings rates as a portion of discretionary income increased from just under 9.0% in late 2019 to nearly 34% in the spring. The pent-up savings were quickly unleashed to procure goods (not services, because of lockdowns).
Concurrently, companies eased up on production as they anticipated protracted weakness in demand. This disruption in activity, coupled with the fact that COVID-19 affected countries at different times, led to a breakdown in production (supply-chain issues).
On top of this, maritime activity was affected due to a shortage of labor and containers scattered around the world. As a result, the cost to move a 40-foot container rose from around $1,500 USD to over $12,000. In the U.S., further labor disruptions made it challenging to remove containers from ships, leading to a backlog in ports and movement of goods inland due to a shortage of trucking jobs. These events led to high demand, coupled with limited availability of goods, which is inherently inflationary.
The Russia-Ukraine war further exacerbated the challenges as the price of energy and food rose. Natural gas prices rose sharply as Russia was a large provider of the product to mainland Europe. Oil prices also rose as many expected a significant portion of Russian oil supply to leave the markets. Furthermore, Russia and Ukraine accounted for 50% of the world's sunflower oil, 30% of barley, 25% of wheat and 16% of corn prior to the war. Shortages in these products and fertilizer affected the price of food.
As a result, the U.S. Consumer Price Index (CPI) rose on a sequential basis each month in 2021 and part of 2022 from 1.4% in January 2022 to a peak of 9.1% in June 2022. In other words, nearly 18 months of annualized increases in prices. By the summer of 2022, U.S. inflation had reached a 40-year high.
Inflation is starting to show some signs of moderation, but it's still too early to tell.
The U.S. savings rate has now dipped to 2.3%, well below its pre-pandemic level. This should have a moderating effect on demand. Meanwhile, many of the supply-chain logistics have improved as production capacity is ramping up and lockdowns have eased in many parts of the world. Issues persist, and some goods are still in short supply, but the situation has improved since last year.
On top of this, shipping costs have come back down. The same 40-foot container now costs less than $2,000 USD to move from Shanghai to Los Angeles.
For some goods, we are seeing a rapid decline in inflation readings. For example, the auto market may soon see oversupply, especially if the global economy slows in the coming year. In 2021 and 2022, a shortage of cars resulted in a saturated used car market, with used car inflation hitting 45% at one point. That number is now down to 2.0%. New car inflation has also moderated from double digits to around 8.0%. Auto prices may normalize early in 2023, especially as demand for used cars declines.
Many of the input materials for construction are also improving, potentially reducing the cost to build. Higher interest rates are expected to dampen housing demand, which we started to notice around May 2022. In October of this year, the annualized run rate of existing home sales (volume) was down 28% from the same month the previous year, while new homes sales are down almost 6.0%. New building permits are down 22% as activity slows. Housing starts are declining, but compared to last year, they are still up as builders continue with some of their projects. Overall, this should have a dampening effect on home prices and construction costs.
Starting in July 2022, U.S. inflation began to decline each month, dropping to 7.1% by the end of the year. While 7.1% is an improvement over 9.1% CPI, it's still an elevated figure. The Personal Consumption Expenditure (PCE) Index, which is the Fed's preferred inflation gauge, started to rise again in the late summer and fall after dropping earlier in the year.
Overall, the story is not yet fully clear. It seems that inflation is moderating, which should likely continue in the coming year—barring a few wild card events.
Some issues could persist, namely in energy and services.
Energy prices are a wild card and could continue to exhibit volatility. While the trend favors falling inflation, services and energy could be spoilers. Shocks to oil supplies are not out of the question given the deterioration in U.S.-Saudi Arabia ties. But growing oil demand from India and China (especially in India, which is set to be one of the fastest growing economies in the year) could continue to place upward pressure on energy prices.
Services could also remain under pressure, especially if labor markets continue to exhibit the same level of tightness.
These are the two issues to monitor as they could continue to place upward pressure on prices. However, barring any other unforeseen circumstances, the shortage in supply-induced inflation challenges may be set to normalize in the coming year.
Global inflation readings could remain elevated, but also may moderate slightly.
Meanwhile, select emerging markets also began to see some moderation in inflation. For example, India's inflation rate held relatively steady at 6.0% to 7.0% throughout 2022, below its developed market peers. Brazil rose sharply, hitting 12.00% early in 2022, only to be cut in half to 6.5% by the end of the year. And China's inflation was relatively muted throughout the year at less than 3.0%.
Granted, there were some emerging markets in Africa and Latin America that endured persistent inflation. The U.K. and Europe continue to see price pressures largely due to the cost of energy and the structure of their energy markets. They are largely dependent on natural gas, much of which they procured from Russia.
Collectively, global inflation should potentially hold or moderate slightly. With that said, inflation could remain above the average observed over the past 10 years, while also falling below the recent historic highs.
Theme 2: Elevated Interest Rates
Despite a potential decline in inflation, interest rates will likely remain elevated until inflation is firmly under control.
While we expect inflation to moderate in 2023, interest rates are likely to remain elevated. Most central banks will need to keep monetary conditions tight until either their domestic inflation rate falls back within their target rate or it is evident that price pressures are thoroughly eroding.
For the U.S., it's unlikely that the Federal Reserve can begin to ease until CPI falls back towards 2.0%, which could take many more months (unless the unemployment rate starts to rise, in which case the Fed may have to act, per its dual mandate).
At the moment, financial markets believe that the U.S. Fed will raise interest rates a few more times and then potentially cut rates later in 2023. That means that interest rates in 2023 will likely be above their 2022 average.
Developed market central banks have evolved structurally over the past 30 years.
This is an important point to note. Consider that between 1994 and 1999, U.S. inflation averaged 2.4%. However, the U.S. Fed Funds rate averaged 5.4%. During that era, the lowest the Fed cut rates to was 4.75%, and the highest was at 6.00% in 1995 when inflation was around 3.00%.
Yet in the past year, inflation rose to above 9.0% and the Fed only raised rates up to 4.00%. While more increases could be on the way, this points to how much the Fed's posture has changed. The era of extra vigilance and keeping interest rates well above inflation levels is likely over.
This is a point we highlighted in a publication we produced a few years ago articulating the evolution of central banks and the increased bias towards lower rates. That scheme will likely continue in 2023: Central banks may not aggressively raise interest rates further. But at the same time, they may be reluctant to ease rates quickly. At the moment, it feels like the Fed is aggressive in taming inflation. Yet, when looking back just 30 years ago, it's evident that the current framework is dovish.
If the unemployment rate starts to rise sharply or the economy contracts, the Fed may opt to cut sooner than later. The severity of those two factors could dictate how much the Fed cuts.
Ultimately, the Fed has a dual mandate of achieving price stability and maximizing employment. If the Fed loses control of the employment mandate, it will need to begin easing rates. Accordingly, while we anticipate rates to ease slightly but remain elevated, that expectation could change if the economic landscape deteriorates quickly.
Global rates could also remain elevated in the coming year.
Most other central banks have inflation mandates well below their current levels. These same central banks are still running negative real rates, which is the difference between inflation and the official interest rates.
From a textbook perspective, central banks should theoretically keep interest rates above inflation. Yet that's not the case. Even if inflation falls, we anticipate that most central banks will likely not move to cut aggressively for two reasons:
- Monetary conditions could theoretically be tighter as many countries continue to maintain negative real rates (the difference between inflation and interest rates – typically, interest rates should be above inflation). These markets will likely need to see lower inflation readings to be compliant with their mandates.
- There may be fear that inflation could turn around again. In order to avoid having to make quick policy reversals, central banks may wait until inflation appears to be firmly under control before an easing cycle begins.
Plus, most emerging and frontier central banks will likely take their cues from the U.S. Fed. In 2020, Fed tightening contributed to a strong dollar trend. A strong dollar, in turn, helped fuel inflation in many markets around the world due to the rising cost of imports. Thus, central banks will likely wait until the Fed starts to ease before they can do the same to prevent a compression in interest rate differentials. If their interest rates move lower and close to (or below) the U.S. rates, that could spell weakness for their domestic currency.
High interest rates could continue to weigh on risk assets and overall deal flow.
Anticipate elevated interest rates in 2023. On a historic basis, interest rates will be below their historic highs, at least in the developed world. It's unlikely that the U.S. will raise rates as aggressively as it did in the 1980s when the main policy rate reached double digits. Instead, it's far more likely that the Fed will cut rates later in 2023, which could give other markets the space they need to either keep rates flat or potentially reduce theirs too.
While we likely will not see a repeat of the 1980s, we will see rates that have not been observed over the past decade or more. For many risk participants, this will be new territory, as many have not endured a period of elevated interest rates. Of course, there are knock-on effects of this, including a higher cost of capital, a potential slowdown in deal flow as transactions become more expensive to finance, protracted weakness in risk assets (equities) and headwinds to housing.
To reiterate, the risk to elevated rates could mean ongoing headwinds to capital formation and asset prices. Overall credit conditions could tighten further, and delinquencies in certain sectors of the economy could rise. This could be the case for revolving credit that has variable rates and for assets that witnessed abnormally elevated prices in 2021 and 2022, such as automobiles.
This could also be a challenge for smaller companies that depend on lines of credit to maintain their operations, especially if margins compress or turn negative, or for companies that need to refinance their debt obligations.
Is there a risk that central banks induce a recession? A slowdown—even a potential recession in the global economy—is the more probable event. This in turn could lead to tighter credit.
Theme 3. Increased Sovereign Challenges
Debt accumulation remains a concern for some markets with a strong dollar; higher interest rate exacerbates these risks.
Collectively, high interest rates and a slowing global economy could lead to sovereign distress in some markets. Countries may find it increasingly challenging to access liquidity, while others may face rollover risk. As borrowing rates reset in the higher rate market, the cost to service debt will likely go up.
Debt-to-GDP levels rose on account of COVID-19 related government spending to support economies around the world. But most countries continue to maintain elevated spending, often to offset the price of higher energy expenses following the Russian invasion of Ukraine. The spending was often meant to subsidize household expenses. Thus, debt levels continue to rise in nominal terms, though they have fallen relative to GDP due to the economic growth that has transpired till now.
Furthermore, an aggressive Fed has enabled the dollar to strengthen. The DXY index, which is a broad dollar index, strengthened by 19% from January to September. It has since fallen but is almost 10% stronger since the start of the year. For countries that rely on dollar borrowings because they lack domestic savings or have underdeveloped local financial markets, the cost of servicing the dollar debt is higher in local currency terms. Plus, some of these same countries are earning fewer dollars via exports, which could fall further if the global economy slows in the coming year. This potentially weighs on their FX dollar reserves, further imperiling their ability to service dollar obligations.
This year, watch for the potential for more countries to face liquidity and sovereign challenges.
Select emerging markets could face ongoing challenges.
One such case is Egypt, which is one of the world's largest wheat importers, sourcing 80% of its wheat import volumes from Russia and Ukraine. While the government eliminated fuel subsidies in its budgetary plans, authorities increased food subsidies in the 2023 budget, likely to avert domestic political turmoil. As a result, the IMF projects Egypt's fiscal deficit to be in excess of 6.0% of GDP, while debt is expected to remain around 85% of GDP.
FX reserves at Egypt’s central bank remain somewhat healthy. But authorities opted to secure a $3 billion USD IMF program, likely due to worries that reserves could fall in the coming year as imports remain elevated and exports face headwinds if the global economy slows.
Tunisia, for its part, has faced economic difficulties including high unemployment since the 2011 revolution, which was then exacerbated by the pandemic. Tunisia's fiscal deficit is also above 6.0% of GDP with debt equaling almost 90% of GDP, per the IMF. To alleviate fiscal pressures, Tunisia agreed to key reforms—including the gradual removal of subsidies and a restructuring of state-owned companies—to access a $3 billion USD IMF support package. Similar to Egypt, dollar reserves are somewhat healthy for now. But the overall trend in debt alongside a dependence on agricultural and energy imports makes these two countries potentially vulnerable in an elevated interest rate environment.
Pakistan perhaps remains the most vulnerable. According to the Pakistan Bureau of Statistics, inflation has been hovering just around 25% while the trade deficit remains wide, resulting in dollar reserves dwindling to USD 6.7 billion, per the State Bank of Pakistan. This accounts for almost one month of import coverage, far less than the standard three-month requirement. Against this backdrop, debt levels remain elevated at nearly 78% of GDP. Given these dynamics, Pakistan will likely face ongoing headwinds with concerns about a potential default, particularly if nations like Saudi Arabia, China and the United Arab Emirates withhold ongoing financial assistance. In such a scenario, the risks to a balance of payments crisis and default could escalate.
But not all emerging markets are the same. India's debt-to-GDP surpassed 80% recently, but nearly all of this is locally funded in rupees through a fairly robust domestic capital market. Brazil's debt-to-GDP is nearly 90%, largely due to economic policies that continue to increase subsidies and government benefits. And while Brazil's sovereign stress levels are elevated, unlike others, it will likely be able to access capital markets.
Then there are markets such as Vietnam and Thailand, which have built up a war chest of dollar reserves through their booming export markets equaling over 3 and 6 months of import coverage, respectively. While both have also witnessed a rise in debt issuance, they are likely able to finance their borrowings.
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