Global Economic Outlook 2022

Global economy and financial markets are in for a rather challenging 2022

Stock markets rallied globally on Tuesday (December 7, 2021) and the S&P 500 posted its biggest one day gain since March 2021 (i.e. in nine months), after concerns vis-à-vis the omnicron coronavirus variant’s ability to inflict harm on the global economy receded and investors were encouraged by Chinese policymakers willingness to ease macroeconomic policy to counter the marked slowdown in growth (the Chinese central bank announced on Monday (December 6, 2021) that it will reduce the required reserve ratio (RRR) by 50 bps to release liquidity to boost growth. Further, a more proactive fiscal policy is expected).

Earlier, over the past fortnight, stock markets were whipsawed globally. Fears over the spread of omnicron and expectations that the Federal Reserve could tighten monetary policy faster than expected sparked a wave of selling across financial markets from Asia to Europe, and the US. ?

Having stated the above, there is much to worry about. The strong rebound from Covid-19 witnessed earlier this year is flagging and the fastest pace of growth is now behind us. The global economy is slowing down, as the spread of omnicron is restricting trade, travel and economic activity worldwide, particularly in Europe. New restrictions to stem the spread of omnicrom are likely and geopolitical tensions (vis-à-vis US-China, and Russia) are resurfacing. As a result, global financial markets could be in for more turbulence over the coming months.

With reference to economic recovery, this new Covid variant is threatening to upend the same at a time when inflation is running uncomfortably high globally. Supply-side bottlenecks, higher than expected wage rates, rising energy and commodity prices, protectionism, and labour shortages have all been adding to cost pressures, and have resulted in higher than expected and persistent inflation in recent months. The future course of inflation will have a significant influence on central bank interest rate policy.

The US and the UK are already facing inflation way above their respective central bank’s inflation target. Inflation in the US rose by 6.8% y/y in November on the CPI measure (a 40-year high) and by 5.1% y/y in the same month on the CPI measure in the UK (a decade high).

Given the surge in inflation, I expect the Federal Reserve to go in for two rate hikes – probably in June and September 2022 and the Bank of England much earlier – probably February and May 2022. Despite the spread of this Covid-variant, both economies seem to be in a position to withstand two rate hikes over the next 12-month period.

Turning to growth, this ominous development (i.e. spread of omnicron across countries) could, via new restrictions and shutdowns, lead the global economy on a stagflationary path in 2022 – higher inflation and lower growth due to aggravation of supply-side disruption, more rapid rate hikes, labor shortages, high wage growth resulting in higher costs and prices, pandemic related closures, more pressure on corporate margins, and lower consumer demand. It is also a potential catalyst for market correction or pullback in 2022.

Financial markets, investors, and emerging markets should brace for the Federal Reserve possibly winding down its bond program?earlier than expected in 2022 (i.e. more speedy tapering) and raising rates twice, and a stronger dollar – with adverse consequences in particular for emerging markets which should reflect in slower growth, higher inflation, capital outflows, lower trade flows, marked slowdown in private investment, and weaker currencies at a time when these economies don’t have adequate fiscal space to counter an economic slowdown.

The global economy, after an exceptionally strong 2021, is likely to witness growth cooling over the next year, as the exceptional fiscal and monetary support during the pandemic begins to be scaled back. In the US and the UK, the massive fiscal stimulus is already winding down (In the US, excessive fiscal stimulus has led to the overheating of this economy). Except for the Eurozone, fiscal policy will be much less supportive of growth in 2022, relative to this year. According to the OECD’s latest projection, the global economy is likely to grow by 4.5% in 2022, compared to 5.6% this year. Due to reasons stated below, growth will probably be lower than 4.5% in 2022.

In addition to scaling back of excessive policy support in 2022, there are other factors too that are going to put downward pressure on global growth next year.

The US economy is facing several headwinds –possibility of persistence of high inflation, aggravation of supply chain disruption, labour shortages, prospects of higher wages, growing pressure on margins, and less supportive fiscal policy next year – which are all likely to result in lower than expected growth. Further, the Chinese economy seems set for a significant slowdown next year - notwithstanding policy support - due to gargantuan debt-related issues in its massive property sector (which accounts for around 30% of GDP) and the probability of very stringent controls being imposed to prevent spread of the new covid-variant.

Moreover, emerging markets, such as Brazil, Chile, Argentina, and Turkey among others (except India) will probably bear the brunt of tighter American monetary policy, marked slowdown of the Chinese economy and spread of omnicron at a time when they are highly fiscally constrained to boost growth (they are likely to witness supply-side disruption related inflationary pressures too).

Asia, particularly tourism and trade dependent countries in the South-East Asian region, and commodity exporting emerging economies, such as Brazil and Chile, are likely to bear the brunt of China’s economic slowdown. The economic outlook for Russia and South Africa too is disconcerting.

Turning to the six major risks that could adversely impact the global economy and investment returns (equities should provide more moderate returns (i.e. single-digit)) in 2022 are prospects of rising spread of omnicron across countries and related restrictions, worsening of US-China relations over contentious economic, political and technology issues, possible sanctions against Russia, higher inflation resulting in more than expected rise in interest rates in the US, the UK, and some other countries, a marked slowdown of the Chinese economy (which is a strong possibility), and central banks botching up vis-a-vis monetary policy normalization in their attempt to balance the inflation-growth trade-off next year.

In addition to the aforesaid risks, the world economy will also have to grapple with further rise in global debt (fast approaching US$ 300 trillion) at a time of slowing growth and possible rise in interest rates next year. This is likely to have downside implications for investments, productivity and growth over the short and medium-term. According to IIF, global debt rose to a new record high of nearly $300 trillion in the second quarter of 2021.

Turning to the US economic outlook, I expect this economy to grow by 3.9% in 2022, compared to 5.4% in 2021. The US economy will probably continue to grow above potential in 2022, due to ongoing supportive fiscal policies (though much less support than in 2021), improving health of the US consumer (debt servicing is at manageable levels and household debt to income ratio has come down) and positive wealth effects from financial markets. But growth will be well below 2022 levels, as elevated inflation – well above Federal Reserve’s inflation target of 2% - rate hikes, and rising tax rates will have a downside impact on corporate margins, investments, consumer demand, and consequently overall growth. Further, the ongoing squeeze on real earnings from higher inflation will also restrain consumer demand.

Next, turning to China, it faces more growth risk, and lower investment and industrial production in 2022, due to the new covid variant and lingering downturn in its property sector – whose outlook is negative. Stringent or draconian measures to control the spread of the pandemic are likely to adversely impact consumer sentiment and demand, reduce manufacturing output and markedly affect many service sector jobs.

Consumer spending will mainly support the Chinese economy next year. However, it is likely to decelerate rather sharply in 2022, relative to this year, due to likelihood of imposition of very stringent Covid related restrictions to prevent spread of the new covid variant. Real estate investment growth will probably slump next year, as a result of the simmering problems confronting this sector. Exports are likely to remain robust. However, contribution from the same will be much lower in 2022, relative to this year, as global demand is expected to decelerate with the spread of the new covid variant across countries and related restrictions. In 2022, growth could possibly fall below 5%, from a forecast 7.8% (my forecast) in 2021.

I doubt whether policy makers in China will let problems in its real estate sector ripple through the economy, as it could result in a hard landing of the economy. In early December, as stated before, policy makers have already announced certain policy measures to counter the economic downturn.

In 2022, I expect a 100-basis point reduction in the Reserve Required Ratio (RRR), a 25-basis point cut and other monetary policy measures, in addition to specific policies aimed at alleviating pain in China’s leviathan real estate sector. Fiscal policy might focus on higher local government borrowing and tax reduction to households and firms. However, macroeconomic policy is unlikely to be eased greatly or substantially, given China’s emphasis on containing leverage and financial risks at a time when its financial imbalances are already uncomfortably large and need to be checked to avoid turmoil in the markets.

Lastly, turning to India, it will probably be the fastest growing emerging market economy in 2022. Growth is likely to be on firmer or more durable footing next year, as an increasing percentage of the population becomes fully vaccinated – boosting consumer sentiment. The fiscal deficit is likely to fall too. However, elevated inflation and the possibility of the same rising over the coming months due to strong economic recovery, cyclical inflationary pressures, supply chain disruptions, shortages, and persistently high global inflation could result in the RBI raising rates in Q1 2022. But due to growth concerns and worries about the potential aftershocks from the impending American monetary policy normalization, the RBI is unlikely to raise rates more than once in 2022.

Private investment is likely to continue to languish, due to stressed banking and corporate balance sheets, and concerns about the strength and durability of the economic recovery. Moreover, weakness of fiscal response, spread of the new covid variant, persistently stressed balance sheets and net trade will continue to a drag on growth in 2022. Overall, I expect the Indian economy to grow by 7.8% in 2022, compared to 9.3% in 2021.

Next, India’s relatively strong economic outlook, a stable domestic currency and possible inclusion in some bond indices have bolstered investor confidence in India. Further, it is in a far better position to withstand normalization of American monetary policy than most emerging market economies, due to vast improvement in some of its external sector indicators such as foreign exchange reserves and current account balance, and its relatively strong economic outlook. However, the Indian economy is unlikely to remain unscathed. Moreover, one needs to worry about India’s high fiscal deficit, rising debt and persistent inflationary pressures. Having said this, the medium and long-term outlook of the Indian economy remains rather promising. The government’s macroeconomic management has been commendable.

Lastly, to conclude, with the tapering of bond buying programs next year and possibility of more than expected rate hikes by some major developed world central banks - due to the probability of persistence of high inflation - borrowing costs are going to go up and asset valuations will be impacted. As a result, stock and bond markets, and growth would be directly impacted.

Essentially, both financial markets and the global economy (and emerging economies in particular) are in for a rather challenging 2022.

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Article by: SHER SINHA MEHTA, Global Macroeconomist and Financial Market Economist, Virtuoso Economics, New Delhi, India, and London, UK

Website: https://www.virtuosoeconomics.com/media