Global - Weekly Market Report

The global economy is expected to experience a gradual recovery, but there are potential challenges that could derail the advance, according to the latest International Monetary Fund’s (IMF) World Economic Outlook, released last week. The forecast for world economic expansion has been tempered for both this and next year by 0.1 percentage points. World output is on track for a steady recovery from the pandemic and Russia’s war on Ukraine, with China’s economy rebounding strongly, and supply chain disruptions unwinding. The IMF predicts that global growth will bottom out at 2.8% this year before rising modestly to 3% next year, while inflation is expected to ease, although more slowly than initially anticipated, from 8.7% last year to 7% this year and 4.9% next year.

The slowdown is concentrated in advanced economies, where growth is expected to fall to 1.3% this year before increasing modestly next year. By contrast, emerging market and developing economies are already pushing ahead, with fourth quarter growth expected to accelerate to 4.5% from 2.8% last year. China and India are both earmarked for steep rebounds in the last quarter for the year, expanding by 5.8% and 6.2% respectively compared to the same quarter last year. Not all emerging economies will experience the same tailwinds as South Africa will effectively flatline this year because of ongoing loadshedding with a modest recovery off a low base of 1.8% by the fourth quarter of 2024.

Serious financial stability-related downside risks have emerged, and the situation remains fragile. The first downside risk is that inflation is much stickier than anticipated even a few months ago. While global inflation has declined, this reflects mostly the sharp reversal in energy and food prices. Core inflation, which excludes energy and food prices, has still not peaked in many countries. It is expected to decline to 6.2% this year, still well above target. At this stage in an interest rate tightening cycle, the IMF would expect to see more signs of output and employment softening. Instead, both output and inflation estimates have been revised upwards for the last two quarters, suggesting stronger-than-expected global demand. This may call for further monetary policy tightening or to stay tighter for longer than currently anticipated.

There is little evidence of an uncontrolled wage-price spiral. Nominal wage inflation continues to lag price inflation, implying a decline in real wages. But labour markets are still very tight in many countries, suggesting real wages should increase, and the IMF expects they will. Corporate margins have surged in recent years. This is the flip side of steeply higher prices coupled with only modestly higher wages and firms should be able to absorb much of the rising labour costs on average. If inflation expectations remain well anchored, as they are now, that process should not spiral out of control.

More worrisome are the side effects that the sharp policy tightening of the last 12 months is starting to have on the financial sector. The financial sector had become too complacent towards maturity and liquidity mismatches following a prolonged period of muted inflation and low interest rates. Last year’s rapid policy tightening triggered sizable losses on long-term fixed income assets and increased bank funding costs. The brief instability last autumn in the United Kingdom’s gilt market and the recent banking turbulence in the United States illustrate that significant vulnerabilities do exist, both among banks and non-bank financial institutions.

In both cases, financial and monetary authorities took quick and strong action, and so far, have prevented further instability. Broader markets have remained calm, and volatility has been contained, including for emerging and developing economies. Increasing funding costs and the need to act more prudently, however, may push banks to cut down lending further. The IMF explored such a scenario and found that it would lead to an additional 0.3 percentage point reduction in output this year.

The financial system may well be tested even more. Nervous investors often look for the next weakest link, as they did with Credit Suisse (SIX: CSGN ). A sharp tightening in global liquidity followed by a risk-off event could also have detrimental implications for emerging market and developing economies’ public debt and stock markets as capital flows to safe havens. The corresponding dollar appreciation and decline in global activity in such a scenario will knock down global output to a meagre 1% this year, although the probability of such a scenario remains low at this stage. Policy makers will need a steady hand and clear communication to bring inflation down, but also stand ready to respond quickly if financial stability demands actions. The silverling in such a scenario is that policy rates could come down sooner than previously thought which would be a fillip to global equity markets.

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