Global economy outlook:
Cloudy with sunny breaks
The market is forward-looking and is starting to believe the worst can be avoided
By Al Rizk
March 9, 2023
For the majority of 2022, market participants were convinced that the global economy was headed for disaster. A nasty cocktail of rising interest rates globally, a war in Europe and endless lockdowns in China would surely lead to economic doom. As we begin the new year, it seems at least for the moment, that the most dire scenarios have been averted. This has encouraged investors to look toward better days ahead.
For the majority of 2022, market participants were convinced that the global economy was headed for disaster.
The relentless rise in interest rates over the past year had most experts convinced that the U.S. economy was headed for recession. After all, history would suggest that a soft landing (a slowing economy but not a technical recession: two consecutive quarters of negative GDP growth) is very difficult to achieve. In fact, the last time the Fed achieved this was in 1994 under then-Chairman, Alan Greenspan.
Never the Same
However, no two scenarios are ever the same, this time around the world is emerging from a pandemic, which caused many disruptions to supply chains as well as labour shortages. In addition, we have been living through an extended period of easy monetary policy and the fear was, and still is, that either the Fed would overshoot on the tightening, chocking the economy into a recession and/or that inflation would be so persistent that central banks would need to take rates much higher, causing a sustained and deep recession.
‘It would appear today that the probability of a soft landing has increased.’
It would appear today that the probability of a soft landing has increased. Of course, we will not know for sure until the government releases the data many months from now, but the market is a forward-looking instrument, and it is increasingly starting to believe the worst can be avoided.
Crack a Smile
There are reasons for this optimism. First, the end to the hiking cycle is now in view, whether it’s another 25-basis point hike in March, then a pause or an additional 25-point hike in May, market participants can see the end game. Since markets are forward-looking, this has begun to reverse the relentless rise in the U.S. dollar.
For much of last year, the Greenback’s strength was a thorn in the side of investors as just about every other asset class was hammered against the all-mighty dollar. The dollar’s decline, if it continues, will become a tailwind instead of a headwind.
‘The dollar’s decline, if it continues, will become a tailwind instead of a headwind.’
Secondly, inflation is clearly trending downwards, while corporate earnings have been better than feared. Furthermore, supply chains have begun to unblock, reducing shortages and downtime. It would appear that a good chunk of the inflationary pressures was related to the pandemic and its aftereffects. Goods inflation is rapidly declining as the situation normalizes.
Services inflation is still elevated but is likely to subside
In addition, the job market has proven far more resilient than during other rate hiking cycles, the consumer remains relatively confident and corporate balance sheets are generally healthy. Of course, the full effects of the rate rises have yet to be fully felt. But at least for now, it would appear that economic activity has slowed but not collapsed.
Some may view the strength in the job market as a glass-half-empty scenario, as it implies that a still strong jobs market will lead to competition for workers thus higher wages, hence stickier inflation, thus forcing the hand of Mr. Powell to raise rates even further. One could also take a more positive view, noting that wage inflation is declining, and it is a good sign that the economy is far from contracting.
‘Inflation is clearly trending downwards, while corporate earnings have been better than feared.’
The Russian invasion of Ukraine convinced many investors (myself included) that Europe, due to its high dependence on Russia for energy, would be in for a disastrous economic period. In addition, Mr. Putin’s sabre rattling and weaponizing of energy appeared to have Europe at his mercy. How would they cope? How could the economy survive if people are freezing in their homes? Alas, a combination of good fortune and market forces helped to avoid the worst. Europe has avoided recession thus far and European markets are performing quite nicely.
Germany’s targeted 20% natural gas consumption reduction, coupled with an abnormally warm winter has helped tremendously. While the warm weather might be disappointing for winter sports enthusiasts and Alp resort operators, it has removed a lot of pressure on the continent. This will allow more time to secure resources before next winter.
Furthermore, the market has adapted, and liquified natural gas from the U.S. has been moving east to fill the void. Indeed, European prices for natural gas have declined precipitously from the initial spike immediately following Russia’s invasion last February. This rearranging of gas supplies to Europe will take years to work itself out, however, for now, it would appear things will be ok, alleviating the worst fears of market participants.
‘The job market has proven far more resilient than during other rate hiking cycles, the consumer remains relatively confident and corporate balance sheets are generally healthy.’
China’s Zero- Covid policy brought havoc and disruption to its economy and much of the global supply chain. Most western observers and no doubt many Chinese citizens felt this was an ill-advised way to handle the pandemic and its aftereffects. The opening of borders, ending the quarantine requirement for incoming travellers, mass lockdowns and removing curbs on movement will surely help to re-energize its economy. The reversal of this policy has been welcomed by investors around the world as the normalization of trade, manufacturing and travel in China will undoubtedly be a positive for the global economy.
For much of 2022, these issues plagued financial markets. While a lot can still go wrong, it seems that one by one these issues are being resolved and that finally there is light at the end of the tunnel. Nonetheless, I still suspect it’ll be a bumpy ride. As I mentioned, the economic data suggests a soft landing, however, a recession is still a possible outcome. In that case, equity prices would fall as markets are not currently pricing-in a recession into stock prices in my opinion. However, even if equity prices do fall, there will be a recovery on the other side as economic growth returns.
‘While a lot can still go wrong, it seems that one by one these issues are being resolved and that finally there is light at the end of the tunnel.’
Ultimately nobody knows with any certainty what the future holds, all our economic models and forecasts are simply best guesses. For this reason, I believe a diversified portfolio of sound businesses with reasonable valuations paying sustainable dividends and competent management teams, held for the long term is the best way to maintain and create wealth. Let’s keep our focus on the long term, not trying to get too cute and avoid shooting ourselves in the foot.
Al Rizk is an investment advisor and portfolio manager at BMO Nesbitt Burns. After earning his business degree, he entered the financial services industry in 1990 and has been with BMO Nesbitt Burns since 1999. Al is married and has two young boys. He is an avid fisherman and golfer.