Volatility threatens to put the brakes on growth
As the global economy has emerged from the disruption of the pandemic, legacy constraints have persisted. At the same time, inflationary pressure, banking instability and geopolitical risks have shifted into sharper focus. However, the recessions which many markets have feared have not yet materialised.
There are even signs emerging of supply chains recalibrating and inflation beginning to soften. Although this is welcome news for the global construction industry, these improvements predominantly stem from symptoms of cooling demand, rather than a cure for logistical ailments.
The extent to which the inflation story has evolved in such a short space of time can’t be underplayed. Over the last decade, consumer price inflation rates in advanced economies had remained closely anchored to many central banks' targets – typically 2.0 percent.
Even in emerging and developing economies, inflation has often been stable. Albeit with some key omissions – such as Argentina and Turkey – which have suffered from a rapid expansion in money supply and continue to experience political challenges. That general trend first began to change in 2021 as the global economy started to emerge from the COVID-19 pandemic. The outbreak of conflict in Ukraine at the start of 2022 and the resulting squeeze on energy costs and materials availability then set inflation rates on a rapid upward trajectory.
Since the start of 2023, momentum began to shift again and reasons for optimism around the pace of inflation have materialised. Many markets have seen an encouraging decrease in the growth of headline inflation since January 2023. The Consumer Price Index (CPI) in the European Union and the UK has fallen slightly to 8.1 and 7.8 percent, respectively, as of April 2023. Meanwhile, the United States and Canada are seeing inflation soften to 4.9 and 4.4 percent on the year, respectively.
While these falling rates provide some comfort for consumers and for business, the picture is complex. Core inflation – that excluding food and energy costs – continues to rise in many markets, boosted by growing costs in the service sector.
Figure 1:
G7 CPI growth, month on year (%) – Headline and core inflation
Source: Organisation for Economic Co-operation and Development (OECD)
Source: Organisation for Economic Co-operation and Development (OECD)
Central banks grapple with inflation rates
Central banks are working hard to grasp a hold of inflation, principally by adjusting interest rates to slow and restrain growth by dampening spending. Throughout 2022, and well into 2023, nearly every major economy has committed to rate hikes to limit expenditure and control inflation.
Source: International Monetary Fund
This approach, while universal in trend, hasn’t been extensively coordinated across markets, with advanced economies overwhelmingly tilting to more frequent interest rate rises over emerging and developing economies. The timing and efficacy of rate hikes is also different.
In June 2023, the Federal Reserve raised the United States’ federal funds target rate to 5.00-5.25 percent, despite easing inflation. The Bank of Canada has followed a similar trajectory, raising its rate to 4.75 percent. This proactive approach to maintaining or gradually rising interest rates despite softening CPI is likely contributing to the greater easing of inflation in the two major North American markets.
With rate hikes less frequent and slower to rise in emerging and developing economies, they potentially offer more room for economic growth, but at the same time, could see inflation remain unstable. Nonetheless, the tightening of monetary policy across central banks is likely to help rein in inflation globally in the coming year as it begins to soften demand and, as a consequence, costs. However, those effects will be gradual in filtering through.
Central banks will need to tread a monetary tightrope until they have greater confidence that inflation is under control. This means making difficult decisions on when to alter interest rates and by how much. If rates rise too much, there is a risk that increased borrowing costs will curb domestic spending, triggering the recession that banks and governments are working so carefully to avoid. On the other hand, should interest rates remain too low, high inflation could persist, risking a choke on investment.
Key price indicators are stabilising
There are promising signs of inflation stabilising and supply chains are beginning to recalibrate, enhanced by the reopening of the Chinese economy with the relaxation of its zero-COVID-19 policy in January 2023, with bottlenecks beginning to lessen.
With that, the cost of energy, commodities and freight are settling. Oil prices, for example, have dropped by 36.5 percent as of May 2023, compared with their peak in June 2022. Even in Europe, an anticipated energy shortfall following the outbreak of conflict in Russia-Ukraine has been successfully avoided through a combination of a warmer winter and national policies to suppress demand. Energy supply agreements with other countries such as Qatar have also helped the region to wean itself off Russian gas and oil while managing costs.
For commodities, prices have now largely in fact returned to pre-conflict levels. Aluminium, copper and lead have fallen by 19.8 percent, 12.4 percent and 2.7 percent, respectively, on the year to May 2023. That said, prices are proving more sensitive to the continued volatility across global economies and ripple effects following the pandemic continue to impact markets.
The shift towards “near-shoring”, boosted by the pandemic, has bedded in. A greater reliance on local supply chains has helped to alleviate disruption to materials and commodity delivery. The downside to this ongoing trend of deglobalisation is that it is causing stickiness in costs, and in some cases even accelerating price growth. Goods production may no longer occur in the cheapest regions and domestic supply chains are often more limited in their ability to benefit from economies of scale.
Freight prices have seen the most significant realignment, with most of the world’s ports now reopened after COVID-19-related closures and more local supply chains reducing demand for shipping. The cost of moving goods by sea – catering for around 90.0 percent of global freight – is now approaching pre-pandemic levels of around US$1,400, compared with an extraordinary peak in 2021 of around US$11,000.
Figure 3:
Energy, commodity and sea freight price escalation
Source: World Bank and Freightos
Source: World Bank and Freightos
Growth begins to falter
Ultimately, while higher interest rates should start to dampen inflation – helped by stabilising costs – they are also putting the brakes on growth. Global growth in Gross Domestic Product (GDP) is softening with the International Monetary Fund’s April forecast for 2023 sitting at 2.8 percent, down from 3.4 percent in 2022. Additionally, in June 2022, the Organisation for Economic Co-operation and Development (OECD) has suggested that the global economy may only grow by 2.7 percent, the lowest annual rate since the Global Financial Crisis.
However, the outlook may not be as pessimistic as many thought. Government funding and policy is buoying economic performance in some markets, such as the Biden administration’s Inflation Reduction Act in the United States.
Currently, there are only two G20 markets expected to contract in 2023, the foremost of which is Russia. Despite the contribution of conflict-related expenditure to GDP, Russia’s economy outside of military spending is being hit by strict international sanctions and a reduced labour force following the introduction of conscription. The other market is Argentina, suffering from rampant inflation and tighter fiscal policy to curb inflation, restricting growth.
Emerging and developing markets in particular, where there is more scope to develop industry and production and where labour and material costs are often much cheaper, may prosper this year – the top five performing OECD economies are expected to be among this group of countries.
Source: Organisation for Economic Co-operation and Development
With the reopening of its economy, all eyes are back on China. Its Government Work Report has set a target for GDP growth of around 5.4 percent in 2023, following its 3.0 percent in 2022. While the OECD expects China to meet that target and return to its position as the global engine of growth, India is also in the wings on its own rapid trajectory.
Last year, India was the fastest growing economy at 7.2 percent and remains on a strong footing with 6.0 percent forecasted for 2023. Its population is set to overtake China’s as early as this year, putting the country on a long-term path to benefit from a high birth rate and a younger population. Cheaper labour, as well as India’s strengths in IT and financial systems, will likely attract greater investment in manufacturing.
Competition for skills remains fierce
Labour shortages remain one of the main strains for businesses and economies. Early retirement and career changes during and following the pandemic have caused a shortage of talent which continues to dog economies the world over. Unemployment rates are close to historic lows in many markets. Meanwhile, recovering from the initial economic shock of COVID-19, firms have returned to hiring with renewed enthusiasm and vacancy rates have soared in the past two years.
In the United States, employment has recovered quickly following a dip of 13.3 percent in the two months following the outbreak of the pandemic. With its unemployment rate currently sitting at 3.6 percent – the lowest in 50 years – there are two vacancies for every unemployed person.
The UK also faces an acute struggle with talent shortages following the pandemic and the country’s exit from the European Union. The loss of workers to early retirement and the more limited access to overseas talent from the EU have been felt across all industries, from construction and distribution to healthcare, education, retail and hospitality.
The picture is similar across the G7, with Japan the only market to have seen vacancies fall, with the rate 6.3 percent lower in Q4 2022 compared to Q4 2019.
Source: Statistics Canada, Istituto Nazionale di Statistica, Federal Employment Agency, Ministere du Travail, Bureau of Labor Statistics, Office for National Statistics and Ministry of Health, Labour & Welfare
Note: Figures for Italy have been calculated using data from Istituto Nazionale di Statistica
While vacancies may have peaked across most markets, these won’t necessarily come down significantly any time soon. Such low unemployment across the board will likely see shortages persist.
It will also push labour costs upwards as workers – and in many cases their unions – negotiate higher wages. Greater investment in automation and digitisation must continue to be a focus across major industrial sectors to redress labour shortages.
There is a silver lining to these high vacancies – in the event of a softening or contraction in an economy – labour markets should withstand a tempering of investment before the rate of unemployment notably increases.
Cracks begin to show in banking
Having considered these major trends from interest rates to the stubborn shortage of skills, a remaining issue to grasp is the impact of banking stability.
An unwanted side effect of higher interest rates has been the falling of yields in the bond market. Banks use bond yields to shore up their lending portfolios and, with the shrinking value of those yields, there is a reduced cash flow capacity to withstand a potential run on the banks.
Silicon Valley Bank in the United States marked the first of a number of failures as a result, while Credit Suisse in Europe avoided a similar fate only through a buyout by rival UBS Group. Though it is yet to become critical, there is a risk of knock-on defaults.
Increasing concerns about the health of the global banking system and of banks defaulting may also cause volatility in exchange rates to persist. Coupled with contractionary monetary policy, this volatility is impacting the affordability of many countries’ imports and exports, limiting trade and economic growth as a result.
Throughout COVID-19, the US dollar saw a steady appreciation, reaching a peak during the conflict in Ukraine. Banking concerns and increased caution around investing in US dollars have brought the US dollar exchange rate down slightly, however, it still dominates in terms of its impact on economies abroad. The US dollar remains strong though it has weakened of late and it is likely to see sustained variability for some time in response to monetary policy both domestically and from abroad.
Source: Bank of England
Causes for optimism are emerging
The global economy faces several headwinds including high inflation, slowing growth, the higher cost of finance and the possibility of further banking defaults. It is safe to say that uncertainty will continue to plague markets in all corners of the globe in the short term at least.
However, the picture is not as pessimistic as many had expected. Inflation is showing signs of easing and being brought under control by careful management of monetary and fiscal policy by central banks and governments. Costs of commodities, energy and freight are beginning to stabilise, though patches of stubborn prices remain.
As a result, the vast majority of markets are not expected to contract this year and for emerging markets recovering from the impacts of COVID-19 restrictions, there is a particular opportunity to come to the fore and generate global growth.
Future economic stability will depend on whether the careful balancing act can continue – getting a handle on inflation through monetary tightening without dampening growth.
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