Has the global economy weathered the worst of the storm?

Key points 

• With inflation finally easing in advanced economies, and the end of the relentless interest rate-hiking cycle now in sight, there are signs that the global economy may avoid a prolonged recession
• While advanced economies may struggle to post solid growth numbers this year, a resurgent China – after the rapid reopening of its economy – and fast-growing India, are both expected to offset weaknesses elsewhere, driving global growth prospects
• In the US, the heavy-lifting to counter inflation seems to have been done – but America is still expected to experience subdued growth in 2023
• The outlook remains difficult for the UK, with its economy likely to endure the highest inflation rate among advanced nations – and sluggish growth is expected into 2024

After a tough year for the global economy, this year looks like being equally as challenging. However, with US and European inflation showing signs of easing in the US and Europe and China reopening its economy after COVID-19 restrictions, will more positive economic news improve the mood among investors?

This year looks set to be another challenging one for the global economy. The combination of heightened geopolitical tensions, tighter financial conditions and the impact of elevated inflation on consumption, are likely to weigh on growth prospects. Further risks to output could also emanate from the prolonged period of price pressures generated by wage increases, an extended energy shock and a flare up of the pandemic. 

Given the probability of slowing activity in both Europe and the UK, and flat performance from the US, we expect advanced economies to struggle to generate much growth this year. At a global level, we forecast that expansion will remain positive, albeit at just 2.2%, as China recovers from a depressed 2022 while the Indian economy grows at an impressive 5.2%.

If global gross domestic product (GDP) increases as we expect this year, it would be the third weakest result for the economy in the past thirty years, outside of the contractions of 2009 and 2020. 

While growth forecasts remain constrained, activity has been more resilient than expected in recent months. Household output has been cushioned by excess savings and robust labour markets. Consumer, corporate and financial balance sheets still look healthy while the service sector has been recovering as the bounce back from the pandemic continues. China’s decision to abandon its zero-COVID strategy late last year should also boost domestic activity and improve global supply chains.

Inflation set to become more digestible

The trajectory of inflation will be a big driver of sentiment, activity and policy this year. We believe that the peak in global price pressures is now behind us and inflation will continue to moderate over the coming months.

Hikes in goods prices have now eased as a result of elevated inventory levels, the relaxation of COVID restrictions and rising capacity. Further disinflationary pressures should emerge from weaker demand (higher interest rates), improving labour market conditions and stabilising commodity prices.

While we expect inflation to remain above targeted levels in many regions in 2023, the data is likely to become increasingly digestible over the next couple of years. We forecast that the global consumer price index (CPI) will average 4.4% this year, and 2.9% in 2024, compared to the 7% surge registered in 2022. 

The end of the hiking cycle is within sight

With leading central banks having instigated the steepest tightening cycle in four decades last year, much of the heavy interest rate lifting appears to have been done. If, as expected, inflation moderates, it should take some of the pressure off central bankers to continue to push rates deeper into restrictive territory, thereby reducing the risk of a policy-induced harsh recession. 

US growth to remain subdued

Slowing consumer demand, a softening housing market and depressed levels of confidence are expected to lead to a subdued growth profile for the US economy in 2023. We expect private consumption growth to weaken to 1.3% as unemployment rises and consumer purchasing power continues to be eroded by higher interest rates and inflation. We forecast that US unemployment will rise steadily from its current low base, of 3.5%, to finish the year at 4.8%.

On a positive note, US inflation is moderating. December’s CPI data was down by 0.1% month-on-month, the first decline in two and half years. While the annual 6.5% reading continues to be more than three times the target, it has decelerated for six consecutive months and is back to its lowest level since October 2021. We expect the moderation trend to continue, with US CPI averaging 2.4% in the final quarter of this year. 

The US Federal Reserve (Fed) hiked by 25 basis points (bp) at the start of February, following a string of 75bp hikes and a 50bp increase in December. The fed funds target range now stands at 4.5%-4.75%, the highest rate since December 2007. Having raised rates for eight consecutive meetings, and by an astonishing 425bp last year, we predict that the Federal Open Markets Committee (FOMC) will conclude the hiking cycle this year.

We forecast a string of 25bp increases (March and May) after which we anticipate the central bank will maintain the policy rate of 5%-5.25% through much of the year. Towards the very end of this year, there is the potential for a pivot to an easing stance as inflation continues to moderate, the labour market cools and growth weakens. 

China looks to kickstart growth

China had a miserable 2022 by its own standards. Its growth profile slumped due to the rigorous enforcement of COVID-19 restrictions, a collapsing property market and weaker external demand. The world’s second largest economy officially grew at just 3% last year, its second lowest rate in half a century, and well short of the official 5.5% growth target. 

In contrast to a lacklustre 2022, this year is forecast to be one of recovery. Officials have dramatically reopened the economy, implemented a compressive plan to shore up the housing market and boosted stimulus measures.

In the short term, we expect the world’s largest COVID wave to continue to disrupt activity. The peak of infections looks like being in February, following China’s Lunar New Year celebrations, and subsequently the economy is likely to gradually recover through the first half of this year. 

The earlier than expected reopening of the economy shows that China’s new leadership are refocusing on the growth agenda. The expected recovery in consumption and improvement in investment should both help the Chinese economy to grow at 4.8% this year, up from our forecast of 2.2% in November.

Europe looks to tame inflation

European economic data held up better than expected in the last three months of 2022. The mild winter weather, high levels of gas storage (84%)¹ and importing of liquified natural gas (LNG) have helped to reduced fears of an immediate energy supply shock impacting the region. That said, medium-term energy risks persist as we look into the supply and demand dynamic for winter 2023/24. 

More broadly, the outlook for European growth is anticipated to be affected by weaker domestic demand, reduced levels of industrial output and lower levels of investment. We expect eurozone GDP to contract by 0.1% this year and that the rate of unemployment will rise to 6.9% by December.

Eurozone inflation decelerated to 9.1% in December and is back into single digits for the first time since August. We forecast that price pressures in the bloc will continue to slowly moderate because of government intervention in energy markets along with weaker gas and electricity prices. Nevertheless, we estimate that price pressures will remain elevated this year (with CPI averaging 5%), as increases in minimum wages and higher pay demands by powerful trade unions create upward pressure on employee compensation.

Despite the weakening backdrop, the European Central Bank (ECB) remains determined to tame inflation and normalise policy. The Governing Council has increased the deposit rate from negative territory (in early summer last year) to 2.5% (at the February meeting). The ECB recently guided that rates will still have to rise significantly, and at a steady pace, to reach levels that are sufficiently restrictive. Therefore, we look for 50bp increases at the March meeting, and forecast a terminal deposit rate of 3%, though risks remain skewed to the upside.

UK economy feels the heat

The biggest cost-of-living squeeze in decades, political turmoil and policy confusion have created a particularly negative backdrop for the UK economy. Household consumption has slumped, the manufacturing purchasing managers’ index (PMI) is now in contraction territory and the recovery in the service sector is fizzling out.

The UK labour market continues to be restrictively tight with unemployment rates hovering around the lows of the 1970’s and vacancy rates remain above the one million mark². The constricted labour market, caused by a decline in participation rates following the pandemic and a reduced supply of workers, because of Brexit, is infringing on staffing needs and pushing up wages. 

Cost-of-living squeeze

The outlook for the UK economy remains gloomy as households are forced to confront a plethora of pressures including higher interest rates, rising energy bills and elevated and persistent levels of inflation. While average earnings rose at a record 6.4% in the quarter to the end of November, real wages (adjusted for inflation) fell 2.6% .

The Office for Budget Responsibility expects real wages to fall 7% in the two financial years up until 2023/24, which would represent the biggest drop on record, wiping out eight years of growth. The significant increase in taxes announced as part of the Autumn Statement will also weigh on disposable incomes. We expect private consumption will contract by 0.7% in 2023, compared to growth of 4.4% in 2022. 

UK inflation remains in double-digit territory (10.5% in December) and is forecast to moderate at a slower pace than other advanced economies. This is in part due to the impact of higher energy bills, lower levels of government assistance and the ongoing disruption to the supply of labour and goods. We forecast that UK CPI will average 7.3% this year. 

Higher rates and a pronounced UK recession

The Bank of England increased interest rates by 50bp in February, pushing the base rate up to 4.0%, the highest in 15 years. We forecast two further hikes (25bp in both March and May) taking the terminal rate to 4.5%. We predict that the UK economy will experience an interrupted recession, with a peak to trough decline of 1%, including a 0.7% contraction in this calendar year, followed by a sluggish 0.4% recovery in 2024.

Muted global growth prospects

Given the pressures facing the global economy, growth prospects are expected to remain muted over the next twelve months. The depth of the recession, however, is still expected to be a relatively shallow one. Economic sentiment is likely to improve as inflation eases, central banks eventually turn dovish and growth troughs.