By Seth Carpenter, Global Chief Economist of Morgan Stanley
How Close To The Edge
Fears of a global recession abound, and in the past three months we have revised our global growth forecast down 170bp while inflationary pressures have risen.
We live in the most chaotic, hard-to-predict macroeconomic times in decades. The ingredients for a global recession are on the table. My colleague Mike Wilson is calling for a substantial further selloff in US equities, even in the base case of no recession. Consider that the recovery from Covid means companies that have over-earned – especially those producing consumer goods whose demand has soared – will face a reversal of fortune. What's more, higher rates and falling growth are never good for valuations. Avoiding a recession is our base case, but markets will have to confront the rising probability of one regardless.
China’s sharp slowdown is clear. Last year, the Chinese government embarked on a regulatory reset that caused a marked downshift in the economy. Then successive waves of Covid buffeted the country. The Covid-zero policy has throttled household spending and has not left the productive side of the economy unscathed. Critically large cities like Shanghai and Shenzhen have been locked down, and cases in other major cities have been rising. The risk of an extended contraction is plain to see.
For Europe, the slowdown is more prospective because recent PMIs and confidence surveys suggest continued momentum. But since Russia’s invasion of Ukraine started, downside macroeconomic risks have risen. The sharp spike in energy and food prices will impose a tax on the European consumer. And as the Russian invasion of Ukraine continues, the prospect of an embargo on oil imports from Russia is becoming more certain. The second half of the year looks decidedly worse for euro area growth than the first half. Accompanying these headwinds, high inflation has spurred the ECB to normalize policy. While ending QE and bringing the depo rate to zero are highly unlikely to pitch Europe into recession, markets are forward looking, and the selloff in euro area sovereigns is likely just the start of tightening financial conditions.
In the US, GDP contracted in 1Q. To be sure, domestic final spending was solid, and the culprits were inventories and exports. Weak exports, however, warn of softening global growth. Nonfarm payrolls for April rose by 428k, extending a string of very strong job gains. But just as in Europe, we have yet to see the hit to consumer spending from the surge in food and energy prices, and our recent work shows that the drag can be noticeable (see Slower Growth Ahead). Moreover, mortgage rates have gone above 5% for the first time in 12 years, and with a shortage of new homes driving prices higher and higher, home affordability is the worst in decades. And of course, the Fed has signaled a fairly aggressive set of rate hikes that we see taking the federal funds rate past 2.5% this year as the balance sheet starts to shrink. The direction of travel for the US economy is clear, though for now it remains strong.
So why not call for a global recession? For now, even if Chinese GDP sees a modest sequential contraction in 2Q, mounting fiscal policy and receding Covid should allow for a subsequent rebound. A European embargo on Russian oil is likely to be manageable, while for a recession, we would need a scenario where all energy imports from Russia including natural gas are cut off abruptly. And the Fed is feeling its way with policy, trying to slow the economy to rein in inflation but willing to reverse course at the first sign of doing too much. We would need a European contraction to hit the US economy after enough front-loaded policy tightening is in train to trigger a recession. The alignment of those unlucky stars is possible, hence the rising risk, but it is not something I would count on.