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History says the Federal Reserve’s high-speed hikes in interest rates could push the US into recession in 2023. Few will be surprised if rising natural gas prices do the same for Europe. The double whammy of Covid Zero and a real estate slump threaten to bring the Chinese economy almost to a standstill.
And in an extreme bearish scenario, all of these things happen at once. This could wipe out about $ 5 trillion in global manufacturing, compared to the most optimistic forecasts earlier this year, according to Bloomberg Economics.
The fact that such a bleak outlook is far from implausible suggests that big things have gone wrong with the world economy. There was a lot of evidence of this in 2022.
Cheap money, overloaded demand from China, and low-friction geopolitics – ingredients of the secret sauce that produced decades of mostly steady growth and stable prices – have disappeared, leaving inflation at its highest for many decades and financial market losses colliding with the trillion.
There are positive surprises that could stop the rot next year. The Fed could complete the legendary soft landing with the job market proving resilient. Warm weather could save Europe from a recession. China could opt for an early exit from the blocs. Some of these possibilities surfaced last week as markets rallied amid lower-than-expected US inflation and indications of a Chinese move away from Covid Zero.
And even if these turn out to be false dawns, investors who see a high for interest rates and a low for growth could start betting on the upcoming recovery. However, after years of plague, war and scarcity, it is difficult to be optimistic.
Here is a guide to the biggest economic risks for the coming year.
The large rate cut is active
The Fed’s benchmark interest rate is set to hit 5% in early 2023, up from zero earlier this year. The most aggressive monetary tightening of recent decades is already hurting the US and world economies. There is more pain coming.
With higher financing costs hammering rate-sensitive sectors from real estate to automobiles, Bloomberg Economics predicts a US recession in the second half of 2023. More than 2 million Americans are likely to lose their jobs.
Things could get better than that if inflation disappeared as quickly and mysteriously as it came. But they are more likely to get worse. The pandemic has disrupted labor markets, pushing what economists call the natural unemployment rate – the level of unemployment required to keep inflation in check – above where it has been in recent years.
If that happens in the United States, and President Jerome Powell says it’s a possibility, the Fed may have to raise rates by up to 6%, leading the world’s largest economy into a longer and deeper recession.
Terminal customers can use Bloomberg’s SHOK feature to see how the US recession could be anticipated and deeper.
The risk replicates around the world, as most countries share the US inflation problem and their central banks are following the same path to solving it. And economies looking to reverse the trend don’t have a card to get out of jail. Japan remained with negative rates but paid a heavy price on the currency markets, with the yen losing more than 15% of its dollar value.
The debt risks are back
As long as growth rates were higher than borrowing costs, public debt was cheap. Governments have accumulated it. The total owed by the developed economies of the Group of Seven has risen to 128% of GDP this year, from 81% in 2007.
Now, with economies slowing and interest rates rising, the calculation is changing and the bill is due. Several large economies could find themselves on an unsustainable debt trajectory unless they make painful fiscal adjustments.
Investors are watching Italy, where debt service costs are expected to rise to 7% of GDP by 2030, from 3% in 2019. Italy is likely not to default. But avoiding this result may require a solution at the European level, usually a difficult process.
UK bond markets have pulled back from the brink after former Prime Minister Liz Truss’s failed attempt at fiscal madness. But closing the public finance gap and maintaining credibility with investors will require a period of painful fiscal austerity.
The United States is not quite in the same category. Even so, a looming debt ceiling debate – amplified by Republicans’ medium-term gains – will keep markets focused.
The architect of Japan’s low rate strategy, central bank governor Haruhiko Kuroda, reaches the end of his term in April. His successor faces a difficult choice: stay with cheap money, risking a further collapse of the currency, or follow the Fed and destabilize one of the largest debt heaps in the world.
Terminal customers can use SHOK to see how UK austerity could impact Bank of England policy
In some emerging markets, the dilemma is more acute. Sri Lanka followed Lebanon and Zambia with a historic non-payment. For now, at least, the problem appears contained.
Bloomberg Economics’ model suggests that impending insolvency risks are concentrated in small economies which account for only 3% of global GDP, while larger developing countries are likely to be spared from a debt crisis.
Turkey could be an exception. The elections in June are likely to induce President Recep Tayyip Erdogan to pursue even more unorthodox policies to fuel growth, with the lira – and perhaps debt sustainability – paying the price.
Housing looks vulnerable
Tight money means it is the pivotal time for real estate markets around the world. Countries like Canada and New Zealand, which rank among the foamy real estate markets based on parameters such as price / income, may be at the forefront.
The United States is not at the top of the risk chart, but it is not far behind. It will take a 15% drop in prices nationwide to bring mortgage payments in line with household incomes, Bloomberg Economics estimates.
China’s problems are everyone’s problems
For China, the basic case is that the reopening of the economy after Covid Zero – a process that has already begun and is likely to gain momentum after the National People’s Assembly in March – will offset the continued resistance of the real estate sector, with the net effect of slightly stronger growth. Bloomberg Economics predicts 5.7% for 2023.
The risks are strongly oriented to the downside. When and how the government will end Covid Zero is unclear. Calculations by Bloomberg Economics suggest that real estate construction must decline by 25% to realign to the contraction in supply.
Furthermore, the looming withdrawal of top economic officials could leave President Xi Jinping with a team that has no experience in fighting the crisis.
Failure on both these fronts could drive Chinese growth up to 2.2%. If the housing crash turns into a financial crisis, that number will also be out of reach.
Such a strong slowdown would send shockwaves around the world. The biggest blow would fall on China’s Asian neighbors, from Korea to Vietnam, and on major commodity producers like Australia and Brazil.
The tightrope of energy in Europe
The final piece of the global risk puzzle is the polarization of the world into rival fields, which is already imposing high costs on Europe.
Support for Ukraine after the Russian invasion left the continent with a shortage of natural gas and rising energy prices. Bloomberg Economics’ basic assumption is that high energy costs and rate hikes by the European Central Bank will drop the bloc into recession, with GDP down 0.1% in 2023.
With a little luck (good weather) and skills (policies that channel scarce gas to the right places), Europe could avoid a downturn. Without neither, the economy could plummet into a contraction comparable to that seen in the global financial crisis.
Crude oil fell from a war-caused peak of nearly $ 130 a barrel in the first half of this year. A combination of new sanctions on Russia, boosting demand in China, and OPEC supply cuts could push it back next year, opening another front in the energy crisis – in Europe and beyond – and adding fuel to the fire of ‘ inflation.
Global ties are wearing out
The stalemate with Russia leaving Europe short of energy is just one example of a geopolitical rift. Relations between the United States and China also continue to deteriorate.
President Joe Biden maintained the tariffs imposed by his predecessor Donald Trump and took it one step further with an embargo on the sale of cutting-edge semiconductors, a move that threatens to turn China into something of an Amish community, with its frozen technological development.
The breaking of trade ties is a slow brake on growth in both countries, with China paying the highest price.
Taiwan is the tipping point where slow burning could turn into a sudden fire. The delicate balance that has preserved peace across the strait now appears to be shattered, along with trust between Washington and Beijing, largely due to China’s growing political and economic clout.
The consequences of a misstep could be extreme. Suppose the US is exaggerating with a step towards recognizing Taiwan’s independence. China responds with a blockade of the island. The United States and allies impose a blitz of sanctions. Even if conflict is averted, Taiwan’s pivotal role in semiconductor manufacturing – and China’s pivotal role in manufacturing everything – could mean a supply chain growl to rival the worst of the Covid era.
Fortunately, military conflict remains a low probability. And for some countries, the growing rift between China and the United States presents an opportunity. Apple’s decision to start manufacturing the iPhone 14 in India is a sign that the business giants are hedging their exposure to geopolitical risk. Countries like Vietnam and Mexico will benefit.
Other things may also go wrong or right
Of course, there are risks that won’t fit any of these buckets perfectly.
A new, more lethal variant of Covid-19 would be a devastating blow. The recent floods in Pakistan, which affected 33 million people and caused the economy to contract sharply, show the impact of extreme weather events that are expected to become more frequent as global temperatures rise.
One potential benefit, at least for financial assets, is that investors are looking ahead. If they can discern a spike for Fed interest rates and a low for Chinese growth, they could drive market rallies by betting on a brighter future, even if the present looks bleak.
Which is likely to happen next year.
– With the assistance of Anna Wong, Bjorn Van Roye, Maeva Cousin, Ziad Daoud, Eric Zhu, Chang Shu, Scott Johnson and Jamie Rush.
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