There is a mild global recession coming

There are currently four scenarios for the global economic outlook. Three of these pose potentially serious risks with far-reaching consequences for the markets.

A more positive scenario is a “soft landing,” in which central banks in advanced economies manage to bring inflation back to their 2% targets without triggering a recession. There is also the option of a soft landing. Here the inflation target is achieved, but through a relatively mild (short and shallow) recession.

The third scenario is a hard landing, where a return to 2% inflation would require a prolonged stagnation with potentially serious financial instability (such as growing unrest between heavily indebted banks and agents having serious difficulties servicing debt). If efforts to contain inflation lead to severe economic and financial instability, a fourth scenario is possible: central banks relax and decide to allow above-target inflation, with the risk that inflation expectations will no longer be strengthened and that a continuing wage-price spiral develops.

Already in a technical doldrums

At this point, the Eurozone is already in a technical recession, with GDP falling in the fourth quarter of 2022 and the first quarter of 2023, and inflation still well above target (despite the recent decline). The UK is not yet in recession, but growth has slowed sharply and inflation remains stubbornly high (above the OECD average). And in the US, growth slowed sharply in the first quarter, while core inflation (excluding food and energy prices) remained high (although it was down, it was still above 5%).

Meanwhile, China’s post-coronavirus recovery appears to have stalled, calling into question the government’s relatively modest growth target of 5% for 2023. Other emerging economies are showing relatively weak growth relative to their potential (with the exception of India), with many economies still struggling. Very high inflation.

Difficulties in complying with the price stabilization mandate

Which of the four scenarios is most likely? And while inflation has fallen in most advanced economies, it has not been as fast as central banks had hoped, in part because tight labor markets and rapid wage increases have increased inflationary pressures in labour-intensive service sectors. In addition, expansionary fiscal policy continues to fuel demand and contribute to persistent inflation.

This has made it more difficult for central banks to fulfill their mandate of price stability. Market expectations that central banks will raise interest rates have been shattered and they will even start cutting rates in the second half of 2023. The US Federal Reserve, European Central Bank, Bank of England and most other major central banks will have to raise interest rates more before they can stop. If they do, the economic downturn will become more prolonged, raising the risks of economic downturn, new debt, and banking tensions.

Geopolitical developments are pushing the world towards instability

At the same time, geopolitical developments—some of which come suddenly, such as the Wagner Group’s failed march on Moscow—continue to push the world toward instability, deglobalisation, and further fragmentation. And as China’s recovery loses momentum, the country must pursue aggressive stimulus policies – with implications for global inflation – or risk falling sharply from its growth target.

On the plus side, the risk of a serious credit crunch has diminished since the failure of the banks in March and some commodity prices have fallen (due in part to recessionary expectations), leading to lower commodity inflation. So it seems that the risk of a hard landing (the third scenario) is lower than it was a few months ago. But with higher wage increases and core inflation determined to force central banks to raise interest rates, a short and shallow recession next year (second scenario) has become more likely.

The contraction is more severe and prolonged

Worse, if a mild recession occurs, it could further erode consumer and business sentiment, creating the conditions for a more severe and prolonged downturn and raising the risk of financial and credit stress. Faced with the possibility of the second scenario developing into the third scenario, central banks may close their eyes and allow inflation to remain well above 2%, rather than risk unleashing a severe economic and financial crisis.

Therefore, the monetary policy trinity in early 2020 still stands. Central banks face the very difficult task of achieving price stability, growth stability (not stagnation), and financial stability at the same time.

Archaeology

What are the implications for asset prices in these scenarios? So far, U.S. and global equities have reversed their 2022 bear market and bond yields have fallen slightly — a pattern consistent with a soft landing for the global economy, with inflation falling toward its target rate and avoiding deflation. In addition, US stocks – especially technology stocks – have been boosted by hype around generative AI.

But even a short and shallow recession – not to mention a deep downturn – would lead to significant declines in US and global equities. Then, if central banks backtrack, the resulting rise in inflation expectations would push up long-term bond yields and eventually hurt stock prices, because of the higher discount rate applied to dividends.

While a major hurricane for the global economy may seem less likely than it did a few months ago, there is still a good chance that we will encounter a tropical storm that could cause significant economic and financial damage.

Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business, chief economist on the Atlas Capital team, and author of Big Threats: Ten Dangerous Trends Holding Our Future, and How to Survive Them (Little, Brown and Company, 2022).

Copyright: Project Syndicate, 2023.
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