Inflation in Europe and the US has continued to soften, while China has ditched its zero-Covid policy and shifted to re-opening its economy. However, these developments do not reduce stagflation risk for developed markets in the near term. For one thing, central banks look set to continue with their monetary tightening. And for another, China’s expected recovery will likely not be enough to pull global growth out of the doldrums.
Inflation down, but not by enough
While inflation in most major economies has continued to soften, it is still far above central bank targets (see Exhibit 1). Labour markets, too, have remained too tight for central banks to be able to relax.
A relatively warm winter so far in Europe has somewhat reduced market concerns over an energy crunch boosting inflation (further) and leading the ECB to tighten its monetary policy (further), potentially crushing what GDP growth there is. Still, while the headline inflation rate fell to 9.2% YoY in December after more than 10% in November, Europe’s core inflation rate actually rose to 5.2% YoY from 5.0%.
Europe’s access to energy remains fragile amid geopolitical tensions, meaning the downside risks to the economy linger. Furthermore, the ECB has warned that a mild recession might not be enough to tame inflationary pressures. Should the eurozone economy prove resilient this winter, the ECB may feel forced to raise rates yet more.
Similarly, in the US, headline consumer price inflation has cooled from the record high of over 9% YoY last June, but core inflation has been sticky. Dynamics in inflation and the labour market are pivotal in determining by how much and for how long the US Federal Reserve (Fed) may tighten.
The latest US jobs data gave no clear steer on what the Fed’s next decision could be. Both the ADP (Automatic Data Processing) private jobs and the official non-farm payroll reports for December showed stronger-than-expected growth. Average hourly earnings growth, although down from a peak of 5.6% in March 2022, held at 4.6% YoY. That is incompatible with the Fed hitting its 2% inflation target.
Stabilising prices needs tough stance
On balance, there has been some easing of labour market pressure on inflation. But it is still too hot for the Fed to pivot away from its tight policy bias. Indeed, Chair Jerome Powell noted at a Riksbank conference in Sweden on 10 January that stabilising prices would require some tough decisions that could be politically unpopular.
The point is clear to us. While inflation rates may be falling in the major economies, they are still way above official targets. The pace of tightening may slow, but the central banks cannot be expected to be done with raising rates yet.
Throughout most of 2022, we saw the negative correlation between stock and bond prices break down, as manifested in the more than 16% losses of a traditional 60-40 portfolio of equities and bonds.
If the recession risk rises to become a catalyst for a major market move in the coming months, we could see the negative stock-bond correlation return: Risk-off investors would exit stocks amid a profit recession (rather than over hawkish US rate expectations) – and move into bonds. Time will tell.
China’s recent shift to a ‘living with Covid’ policy and a reopening of the economy suggests to us that the country will generate less disruption for global supply chains. If China can unlock its economy, consumption should recover and augment the fiscal and investment drivers to boost annualised growth to above 5% this year.
Indeed, our research team raised its forecast for China GDP growth earlier this week to 5.5% YoY for 2023 from 4.8% earlier, based on such expectations. The U-turn in official credit policy to support the property sector should help improve public confidence significantly. It could spark a rebound in construction.
In our view, this is bullish for industrial commodities (see Exhibit 2), though it may only be a moderate boost because China is de-emphasising the role of property in economic growth. The country’s recovery will likely spill over to regional economies, especially in Asia, through trade (Sino-Asia trade now eclipses Sino-US trade).
Unlikely to avert recession
However, we do not expect China to save developed markets from recession.
Firstly, China accounts for about 20% of Asia’s total exports, which is less than the combined Europe-US share of 25%. Furthermore, the combined GDP of the US and the eurozone is 1.6 times that of China. The country’s demand growth is thus unlikely to suffice to offset the slowdown in these two economies, let alone in developed markets as a whole.
Secondly, China’s reopening will likely focus on the country’s own sectors and services first. Property sector growth is being moved down the priority list. Both these factors will limit China’s imports of consumer and capital goods and commodities.
Thirdly, there may be a lag between China’s recovery, which is expected to kick off in the second half of 2023, and the slowdown in developed markets, which has already started. This implies a growth mismatch between China and the developed markets in the first half of 2023.