2023 is looming ominously

As the year draws to an end, evidence of a more pronounced slowdown in global economic growth is piling up.??

In the United States, the yield curve inversion - an accurate predictor of timing and depth of recessions1 - is the most impressive in 40 years (Chart I). In essence, the yield curve is the difference between projected returns on debt instruments of the same credit quality over different time scales. In normal circumstances, long-term rates on bonds will be higher than short-term ones and the premium arises from investors demanding a higher return for tying up their savings for longer periods, thus also facing higher risks: inflation pick-up, monetary policy changes and so forth. On the other hand, an inverted yield curve speaks of significant changes in market behavior, especially about expected economic growth. When long-term returns on government bonds fall below short-term ones, investors are typically pricing in the central bank having to cut the policy rate sooner than later to fight a substantial downturn.

To a great extent this phenomenon results from recent monetary policy actions, notably the sharp hike in the Fed funds rate (375 bps since last March), along with a downsizing of the Federal Reserve’s balance sheet. The latter, also known as quantitative tightening, started to reduce market liquidity at a pace of US $45 billion per month last June and then stepped up to US $90 billion since September. Arguably, markets are turning pessimistic about the impact of this stabilization strategy on economic activity, a quite reasonable concern in a context of high indebtedness and more vulnerable capital structures.2 By the way, none of this is incompatible with a labor market that is cooling only slowly, for the latter is a notoriously laggard indicator of the business cycle. Therefore, the further tightening monetary policy unfolds in late 2022, the more inverted the yield curve will be and the most likely is the recession scenario in the forthcoming quarters.

As for other key geographies, the Euro Zone is less advanced on monetary tightening actions - policy rates began to rise in July and thus far the ECB has hiked the marginal lending facility by 200 bps, while quantitative tightening should start only in 2023. However, the region is coping with other challenges, notably a protracted geopolitical conflict between Ukraine and Russia, a shortage of natural gas as a collateral effect of this strife, and escalating energy costs. In China, problems arise from the zero-COVID strategy, which signifies lockdowns, quarantines and mass testing that have upended everyday life, thus provoking widespread protests along with disruptions in production and distribution of several products across the country. In addition to exacerbating domestic sociopolitical tensions, these troubles are also a severe blow to the Chinese status as a global powerhouse. Different causes, same consequences: leading indicators for economic activity suggest a synchronized downturn towards the year-end (Chart II).

Against this backdrop, it is not surprising that the U.S. dollar is trading at the most overvalued level since the mid 1980s (Chart III). According to the Bank for International Settlements (BIS) data for real effective exchange rates, America’s currency is 22% more expensive than its long-term average. Global slowing, growing geopolitical tensions and supply disruptions fuel risk aversion, thus a bent toward “safer assets” and the prominence of the greenbacks in international investors’ portfolios. That contrasts with the performance of its Latin American neighbor, the Mexican peso. Even with a recovery of late, it is still 11% undervalued using the same metric. What is even less intuitive is the behavior of commodity prices.?

To be sure, prices of primary products are off from their recent peaks earlier this year. Yet, there was no slump. Despite slower global growth, the only group of commodities that seems to be underperforming is minerals, which are more closely associated with the business cycle in Asia. But even in this case prices of iron ore and copper, for example, are above their 10-year average by double digits (Chart IV). As for food, oil, and raw materials, both short-term and long-term movements speak of an upward direction. While temporary supply bottlenecks may account for some of this price stickiness, there are structural issues at stake, particularly several years of underinvestment in production.3

Without doubt, it is better to be on the export than on the import side of this commodity story and that is one of the reasons of Latin America’s economic outperformance over the past quarters. But there is no dismissing the importance of domestic factors. Indeed, prescient fiscal and monetary policies - short-term interest rates shot up and fiscal deficits went down faster than in any other geography - had a powerful stabilizing effect post-pandemic, which paved the way for a solid recovery. And this is still true, or perhaps even truer, when unfavorable events happen.

In that regard, Chile, Latin America’s most developed nation, provides useful lessons. The headline fiscal balance should reach a surplus of 1.6% of GDP this year, a remarkable turnaround from a deficit of 7.7% of GDP last year, whereas policy rates jumped to 11 ?% p.a. from 0.5% in the period. However, real economic growth, which is expected to total 14% in 2021-22, will turn negative in 2023 (the Chilean central bank estimated range is -0.5 to -1.5%). To a great extent the downturn results from President Boric’s ill-fated decision to connect his reform program with a badly flawed constitutional draft that was rejected by nearly two-thirds of the population. The ensuing institutional quandary undermined business confidence, dragged down investment and is now weighing on the economy.

1 See, for instance “Information in the Yield Curve about Future Recessions” by Bauer, M. D. and Mertens, T. M., Federal Reserve Bank of San Francisco Economic Letter, 2018-20, 27-Aug-2018.?

2 See, for instance, “The Next Financial Crisis” Long-Term Asset Return Study, Deutsche Bank Markets Research, 18-Sep-2017.?

3 See, for instance, “Five reasons to believe in a new commodity super-cycle” in Schroders Perspective, 15-Mar-2021.?

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