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Hard landing is now our base case

Following last month’s surprisingly high US CPI print, and the subsequent 75bps hike from the Federal Reserve, discussion has swiftly moved on from whether a hard landing will happen at all, to when it will come and how severe it will be. The Fed’s growing hawkishness implies that it is now willing to inflict the pain necessary to bring inflation down. We believe the risk of a hard landing (we define it as global growth <1%) has risen sharply, from 35% before the CPI release to 60% today.

Inflation is peaking and should begin to fall over the summer. By hiking 75bps in June and opening the door to a further 75bps hike in July, the Fed is desperately trying to regain control of inflation and inflation expectations. Markets are expecting a Fed Funds rate of nearly 3.5% by the end of the year. We are on the dovish side of this, but uncertainty is high.

Chart 1: Market is pricing in a lot of hikes that may not materialise

Market implied Fed Fund Rate as of 27th of June. Number of hikes assumes 25bps hikes. Source: Fidelity International, Bloomberg, June 2022.

If the Fed is eager to get in front of the curve, the ECB is more of a reluctant hiker. Inflation in the euro zone is also high, and the ECB needs to raise rates to bring it down. However, the ECB must balance the additional risks of the fallout of the war in Ukraine and periphery spreads widening so much as to raise the cost of servicing the debt burdens of countries such as Italy, Spain and Portugal becoming a drag on growth. It looks likely that the ECB will combine hiking rates with a version of QE that focuses on periphery countries’ debt to ensure financial stability in the euro area.

Europe is also facing the exogenous shock of gas supply disruptions. European gas inventories are rising despite Russia severely limiting exports this year, indicating a combination of demand destruction and pre-emptive rationing. We are expecting further gas disruptions this year, which will pile more pressure on European industry and consumers. A recession in Europe is already our base case. The timing and severity of the coming slowdown will depend in large part on the amount of gas imported from Russia over the coming months.

Caution needed over hopes for China recovery

China is re-emerging from the strictest lockdown measures. Its economy has taken a terrific hit from the zero-Covid policy. Economic activity and output are now bouncing back, although still not to pre-lockdown levels. The property market, one of the main focusses of the reforms carried out in 2021, is still sluggish. Youth unemployment is nearly at 20%, a serious concern for policy makers who prize social stability. On the domestic policy front, the stance remains dovish with more easing on the way.

Along with tightening by the major central banks and the war in Ukraine, how fast China’s economy recovers will be a key determinant of global growth over the next 12 months. We would urge caution about the speed of China’s recovery. Retail sales are still struggling, and how consumers and corporates will react as they gradually return to life without Covid restrictions is highly uncertain. Policy might be gently easing, but internal politics can be unpredictable. Government bond issuance, a proxy for investment, remains lows.