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More hawks than doves

Generali Investments’ outlook: in a global scenario that has radically changed compared to the recovery in 2021, Central banks in Europe and the US aim to curb inflation, which is at the highest level in forty years, as countries face the consequences of the war in Ukraine

The rising costs of raw materials, food and energy are a result of the conflict in Ukraine and have rapidly changed the outlook for the global economy, which in 2022 was recovering from the 2020 crisis caused by the Covid-19 pandemic. Global output decreased in the second quarter of 2022 due to declines in the Chinese and Russian economies, while consumer spending in the United States fell short of expectations. The world economy, which had already been weakened by the pandemic, has been hit with several further blows, mainly:

  • higher-than-expected global inflation – especially in the United States and the major European economies – which triggered more restrictive financial conditions;
  • a worse-than-predicted slowdown in China, due to new outbreaks of Covid and the subsequent lockdowns to contain the virus, in addition to further negative repercussions arising from the continuing conflict in Ukraine.


Drawing a hard line against inflation

As highlighted in Generali Investment’s September 2022 report “Market Perspectives – Tightening pain, at the Federal Reserve’s summit held in Jackson Hole, Wyoming, on the 26th of August, representatives of the world’s most important central banks reiterated the need to put up a common fight against inflation. They called for the implementation of a restrictive monetary policy to increase general interest rates, regardless of the consequences for families and businesses, in what Fed Chairman Jerome Powell called “the unfortunate price of reducing inflation”.

On top of the expected 75 bps rate hike, the September meeting showed that the Fed is determined to tighten monetary condition at an even faster pace and plans to keep rates at a restrictive level for longer, reaching 4.5% in December, with a further 25bps increase in 2023. A very hawkish message aimed at dispelling market’s perception that the Fed may give up keeping rates high for long for fears of a recession.

With the Fed and the European Central Bank (ECB) upholding their commitment to reducing inflation, it is highly unlikely that there will be a change in strategy in the short term. Following in the Fed’s footsteps, in fact, the ECB also raised interest rates by 75 points on the 8th of September, bringing the benchmark deposit rate to 0.75%. This followed a previous increase at the end of July of 0.5%. The ECB also revised up its inflation expectations to an average of 8.1% in 2022.


What are the scenarios for the global economy?

In its Investment View “Waiting for Godot pivot”, Generali Investments points to the fast-track monetary tightening and the EU energy crisis as powerful headwinds for the global economy, leading to the growth of recession forces over the turn of the year.

The US economy – now self-sufficient – is relatively insulated from the energy crisis. But the fast-track monetary tightening has led to a sharp deterioration of financial conditions, which will inevitably hurt growth following the short-leave Q3 rebound. A manufacturing recession is all but certain, though a better resilience of the broader economy is expected (+0.3% in 2023).

Conversely, Europe’s energy crisis will leave long-lasting marks. With EU power prices tightly correlated to gas prices, Europe has turned much less competitive. Energy-intensive sectors, such Aluminium/Steel, Glass, Chemicals, Agro-Food etc. are seeing production cuts and/or delocalisation outside the continent. The energy supply chain has been quickly reshuffled, and gas reserves have built up quickly; but the price effect remains, and rationing may still happen in case of a harsh winter. Europe has suffered a large terms of trade shocks, causing a spectacular deterioration of its trade balance. As the current account turns negative too, the excess domestic savings will vanish, and Europe will become more dependent on foreign investors - which may cause a relative increase in long-term real interest rates. A mild recession is predicted (-0.3% in 2023) but macro simulations of adverse natural gas scenarios indicate a potentially much larger drawdown (3% or more).


Is inflation here to stay?


The euro area’s high pre-war reliance on cheap Russian energy makes it particularly vulnerable not only to energy shortages but also to the energy-induced price shock. Headline inflation soared to 10.0% yoy by September. Elevated inflation averaging 8.2% in 2022 and 5.0% in 2023 will dent real incomes. Encouragingly, EU gas storage has currently reached a level of about 88% of capacity, covering energy needs for about two winter months. Gas demand will need to be curtailed further, but with average weather conditions the euro area may be able to just muddle through winter amid curtailed gas supply from Russia.


On the other hand, elevated uncertainty will further drag on confidence and investment spending. Especially energy-intensive firms will suffer sharply from higher input costs. Notwithstanding a solid labour market and government measures to cushion the fallout from high energy prices, the euro area economy is expected to fall into recession from Q3/22 to Q1/23. Unlike with previous downturns, the ECB will not come to the rescue. With about 75% of the items in the ECB’s consumer price index reporting inflation rates above 2.5% and ongoing strong pressure in the pipeline, the focus has narrowed on bringing inflation down.


As for the US, after a weak first quarter and a tentative rebound in Q3, growth is set to slow markedly starting from the last months of the year, with a higher than 60% probability of a recession in the first half of 2023. Despite a still solid labour market and wage gains, the surge in energy prices will dampen consumption and the most interest rate-sensitive parts of the economy are already feeling the pinch from tighter monetary conditions.


The level of core inflation reached (6% yoy in August) is only in part offset by the decline in goods prices inflation, as demand decline and global supply bottlenecks start unclogging. While the headline rate has already peaked and is moderating thanks to lower oil prices, core inflation will remain sticky. It is unlikely to fall below 5% before the first months of 2023. And this is precisely the outlook that has pushed the Fed to the September meeting’s hawkish twist mentioned above.


Despite acknowledging that this vastly increases the risk of a hard landing, the Fed flagged that the policy rate is set to remain well above the neutral level by around 200 bps until 2024, as a prolonged period of below trend growth is the price to pay to rein in inflation. The tension between the Fed’s tightening and a slowing economy will be a key theme over the coming months, when a rebalancing will be sought between pushing inflation downward and preventing too big a spike in unemployment. But a pivot seems unlikely in the near future.