Barely six weeks after U.S. Federal Reserve (Fed) Chair Jerome Powell noted that Fed officials weren’t actively considering a 75 basis points (bps) interest-rate hike, the FOMC delivered just that on June 15. Cryptically telegraphed to the markets a few days before the June Fed meeting, the key takeaway in our view is receiving confirmation—albeit indirectly—that the U.S. central bank will knowingly hike into a material economic growth slowdown to tame inflation. Make no mistake: We’re witnessing the Fed implement its most aggressive monetary policy tightening cycle in decades.
The Fed’s hardened stance meant that many economists and forecasters (ourselves included) have had to recalibrate their views. At the very least, the global growth outlook has become more challenging, and prospects of achieving a soft landing have dwindled.
Unsurprisingly, year-to-date losses¹ across many financial assets have reached double digits. Technology stocks led global equities lower, traditional safe-haven assets such as U.S. Treasuries have turned in their worst performance since 1980, and even cash—the most liquid form of an asset in any portfolio—has suffered due to elevated inflation. The last time bond and equity markets moved two standard deviations in the same direction was 30 years ago, in December 1991, when both markets rallied.²
Amid the upheaval, the U.S. dollar (USD), commodities, and commodity-linked assets have provided investors some shelter from the storm. That said, it’s worth noting that the positive correlation between the USD and the commodities complex is also an extraordinary occurrence by historical norms. In fact, commodities are on track to outperform the MSCI All Country World Index for the second consecutive year—a phenomenon that has only occurred three times since 1970: 1972/1974, 1976/1979, and 2007/2008. These are uncomfortable analogs and consistent with our assertion that important paradigm shifts in the global financial system are under way.
Are we there yet?
The question many investors are asking is whether the worst start for global markets in decades is behind us. Yet, as we enter the final half of 2022, the macroeconomic outlook remains extremely challenging, characterized by high inflation, weaker economic growth, and tighter financial conditions.
While our base case is that inflation will ease into 2023, at this point in time, we find ourselves preoccupied with emerging risks to that view.
1 Inflation, especially headline inflation, may prove sticky at elevated levels for longer
A multitude of factors are at play here: The surge in fertilizer prices (50%–200% appreciation over the past 18 months, depending on input) points to the intensifying food scarcity and food price inflation ahead; inflation is becoming geopolitically entrenched—the global economy is fragmenting, characterized by the weaponization of strategic resource commodities and the USD; and logistical issues are taking longer to address.
2 Concerns about economic growth are rising
For many economies, the question isn’t if there will be an economic slowdown, but how deep and how long it will be. Since recessions are measured in real terms, the hurdle rate to avoid a recession is especially high when inflation is elevated. Moreover, should the upside inflation risks mentioned earlier persist in 2022, it would imply that larger-scale demand destruction will be required to achieve aggregate disinflation.
Against that backdrop, we expect global policymakers to come under heightened pressure in the second half of the year to simultaneously break the back of supply-driven inflation and address the cost-of-living crisis enveloping many households. If policymakers are serious in that endeavor, it will be difficult for central banks to deliver a dovish pivot until they’ve witnessed a decline in commodity prices and a rise in wages expressed as a percentage share of real GDP.
From that perspective, policymakers aren’t likely to achieve their goal in H2 2022 and must forge ahead with policy that will—unsurprisingly—be unwelcome for financial asset prices. These risks were acknowledged in the latest global economic outlooks from the World Bank and the Organisation for Economic Co-operation and Development (OECD).
The World Bank cut its global GDP growth forecast for 2022 from 5.7% in 2021 to 2.9%, shaving nearly a third off its January 2022 forecast (4.1%). The downgrade is significant: It’s the bank’s biggest short-term global growth downgrade in 80 years. Crucially, the World Bank noted that “for many countries, recession will be hard to avoid … even if a global recession is averted, the pain of stagflation could persist for several years,” and noted that “subdued growth will likely persist throughout the decade.”
Meanwhile, the OECD observed that “the global economy is set to weaken sharply,” adding that despite having incorporated expectations of a moderation in demand growth and a reduction in supply chain and commodity price pressures, core inflation is likely to “remain at or above central bank objectives in many major economies” at the end of 2023. The intergovernmental organization also highlighted that “the cost-of-living crisis will cause hardship and risks famine and social unrest.”
"For many economies, the question isn’t if there will be an economic slowdown, but how deep and how long it will be."
In H2 2022, we expect to see a recession in the euro area, a weaker-than-expected economic recovery in China, and a material economic slowdown in the United States (a recession in early 2023 seems likely at this point). Given that these are the top three destinations for emerging-market (EM) exports, many emerging economies are likely to face reduced global trade volumes and increased capital outflows. Below-trend economic growth will also likely mean that corporate earnings growth disappoints analysts’ lofty expectations even as stronger underlying price pressures delay the end of the tightening cycle. Longer-dated U.S. Treasury yields typically don’t peak until just before the end of Fed tightening cycles.
A game of chicken
Despite the drawdown to date, we’re of the opinion that many markets aren’t fully priced for this challenging backdrop. This is partly due to what’s become commonly accepted wisdom in the post-global financial crisis (GFC) era that the Fed has its back—the belief that the Fed will always step in to limit the decline in asset prices beyond a certain threshold. In an era in which the unthinkable is occurring with ever-increasing frequency, however, banking on the continuation of the Fed put around asset prices—at least as investors have come to understand it—is a big gamble.
Historically, the specific asset market to which the central bank put applies differs around the world. For the Fed, it was understood to be equity and/or credit markets, for the European Central Bank (ECB), it was peripheral bond spreads. Where the People’s Bank of China and the Reserve Bank of Australia (RBA) are concerned, it was supposed to be the property market.
These policy puts have led to wider distortions in income distribution and, therefore, regressive outcomes in the real economy and greater economic, social, and geopolitical fragility. We’re seeing significant departures from this post-GFC regime.
William Dudley, highly influential former president of the Federal Reserve Bank of New York, argued that the Fed must “inflict more losses” on stock market investors to tame inflation. U.S. Treasury Secretary Janet Yellen has pivoted from her earlier opinion that the Fed might help the U.S. economy in a future downturn if it could buy stocks and corporate bonds and said in April 2022 that she was looking through stock market weakness and that the stock market wasn’t “a reflection of the underlying strength of the economy.”
On the other side of the Atlantic, the ECB signaled that monetary policy is in play and offered no detail on support mechanisms for the eurozone’s periphery bond markets, even as peripheral sovereign bond spreads keep widening. In China, despite its systemic importance, officials have systematically deflated the property market, while the RBA surprised with a larger-than-expected 50bps hike—the biggest interest-rate hike since 2001—even as property prices in most Australian cities are expected to fall by double digits over the next two years.
For years, the central bank policy put enabled the growth of financial assets to vastly exceed that of the real economy and critical investment and production needs, a policy choice that contributed to exposing the global economy to the stagflationary dynamics we see today. It therefore stands to reason that in order to reverse current stagflationary conditions, this central bank policy put must act in the opposite direction. While it’s an uncomfortable truth, the economic, social, and geopolitical costs of not acting now, we believe, will only be greater in the future. We can call it what we want—kicking the can down the road, or taking the path of least resistance—but, essentially, it’s just another way to describe a game of chicken.
1 As of 6/12/22. 2 Bloomberg, as of 6/12/22.
This is an excerpt of Manulife Investment Management's Q3 Global Macro Outlook. To read the full report, please click here.
Views are those of the authors and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.