2023 H2: Assessing this year's second-half economic outlook

Historically, the best prerequisites for new and prolonged equity bull markets (and economic booms) have been high levels of unemployment, below-target inflation, depressed capacity utilisation, low equity and credit valuations and elevated risk premiums.  

As the following charts show, today we have the reverse: low unemployment, inflation still above target, relatively high-capacity utilisation, valuations near historical averages and low equity/high yield risk premiums when compared to risk-free rates.

If developed economies avoid recession, there will be less leeway for employment to rise without renewed wage pressures; less room for economic capacity to expand without triggering inflation pressures; and limited potential for multiples to expand (unless earnings growth accelerates).

In such a scenario, there will also be less room for central banks to cut rates and provide a tailwind for equity valuations and risk tolerance. If there is no recession in the second half of 2023, markets could be stuck in a trading range – with economic activity and earnings growth remaining volatile and more difficult to predict than usual.  

We should be careful what we wish for. But for investors with long-term investment horizons, a recession that includes a period of significant risk aversion might be the necessary evil needed to clear the way for the next period of strong returns in financial markets.  

The overarching theme for both the global real economy and the financial markets for the past few months — and even looking forward into the rest of 2023 — has been the tectonic shift from a world of abundant (we may even call it excessive) liquidity to one where liquidity in all its various forms is now being drained at an unprecedented speed and intensity. One need not be a die-hard monetarist to believe that the surge in money supply following the initial COVID-19 shock had something to do with the intensity of the subsequent inflation surge. Evidently, other factors such as supply constraints played a key role themselves, but their inflationary impact would not have been nearly as pronounced if not for the liquidity-driven surge in demand.

Looking forward, the relevant question is what comes next? Overall, nothing easy or pleasant is usually associated with episodes of liquidity withdrawal as intense as the one that the global economy is now experiencing (see Figure 1). Consequently, we would argue that — aside from inflation — nothing really gets better from here on the macroeconomic side in the near term. Our projection is that global growth slows, though a US recession still remains a more compelling argument for 2024 than for 2023. For 2023, we now forecast growth of around 1% in the United States, and only incrementally lower in the eurozone.

Disinflation deepens and broadens going forward. Disinflation is the one silver lining in the outlook. It is also the key factor that can establish a floor under the growth deceleration by allowing the much-anticipated monetary policy pivot toward lower rates to actually begin in the United States at the end of 2023, and to broaden and accelerate globally in 2024. Against this downside protection mechanism, fading reopening effects in China, intensifying fiscal headwinds in the United States, and the delayed impact of higher interest rates keep global growth low and risks to growth elevated in 2024.  

Given the vital role disinflation plays in limiting an approaching economic slowdown, it is worth discussing the inflation outlook in greater detail. We consider the inflation debate along three dimensions: cyclical momentum, medium-term equilibrium levels, and inflation volatility. The first is truly what our disinflation call is anchored on: Following the post-COVID surge, the next stage in the cyclical inflation journey is lower. Reaching 2 percent (or close enough that the difference will not matter) in 2024 is not such an impossible hurdle as the general opinion seems to imply. Not in a world where price competition likely re-emerges as backlogs shrink, demand slows, and base effects work in one’s favour. We believe that the inflation surge of the past year incorporated a fair amount of opportunistic price increases that made the inflation spike not only high in amplitude but also broad-based. Part of our more constructive view on inflation embeds an anticipation that as the demand-supply imbalance shifts from not enough to too much supply, those behaviours will simultaneously correct.

We share the belief that the medium-term equilibrium level for inflation over the next 10 years will be higher than it was in the 10 years before COVID when both globalization and deleveraging were in force. However, we are not convinced that it will be necessarily higher than the rate that prevailed in the 2000–08 period (when only globalization was in play). Globally, the green transition and deglobalization are inflationary forces, yet technology, demographics, and debt levels all suggest powerful disinflationary forces remain. Admittedly, deleveraging may now be more of a factor on the public side given the surge in fiscal stimulus and public debt levels post-pandemic. However, there are many economies — for example, Canada and Australia — where household finances appear stretched thin. Even in the United States, we suspect there is a correction coming for consumer spending following the abandon of the transfer-fed frenzy of 2021–22. China, too, is no longer in a position to deploy debt to fuel growth. Hence, we would argue that the shift in the equilibrium inflation rate is a sub-one percentage point move. Implicitly, this means that following more than a decade of sub-target inflation, we may well be entering a period where modestly above-target inflation is sustained for more than a decade.  

Finally, inflation volatility may be the part of the medium-term inflation story that is most troubling to us. The combination of the green transition, deglobalisation, and intensifying geopolitical risk speaks to an environment of more frequent potential shocks, with associated spikes and subsequent sharp declines in inflation whose timing is increasingly difficult and nearly impossible to predict. Such an environment would require ongoing and fairly dramatic adjustments to both business planning and investment portfolio allocations to navigate successfully. Indeed, a high volatility inflation scenario might present more challenges than sustained but steady 3 percent inflation.

Global stocks’ double-digit gains may make it easy to forget the drama in the first half of 2023 that included spy balloons, failed banks, hiked interest rates, and a debt ceiling showdown. The second half may see less drama, but milder returns for investors as the Cardboard Box Recession broadens. We will sum up what we learned in the first half and what we believe the second half of the year may hold for investors.

The Cardboard Box Recession

During the typical global recession, all areas of the economy (like manufacturing, services, retail, construction, and trade) tend to turn down around the same time. Yet, over much of the past year, only manufacturing and trade seem to be in a global recession, according to indicators such as industrial production, worldwide trade volumes, job growth by industry, surveys of purchasing managers at manufacturing companies, and many others.

We’re referring to this phenomenon as a Cardboard Box Recession, because items that are made (manufacturing) and shipped (trade) tend to go in a box. Demand for corrugated linerboard, what most cardboard boxes are made from, has fallen similar to past recessions, as per data from the Fibre Box Association. The latest drop is reminiscent of the demand behaviour during those shaded periods on the chart below denoting global recessions. Note that while the drop in 2012 on the chart isn’t matched with a global recession, both Europe and Japan did suffer recessions at that time, softening global demand for boxes.

In contrast, services industries, which make up the largest share of output among developed economies, have continued to grow. The global services Purchasing Managers’ Index (PMI) remains well above 50–the threshold between contraction and growth. As consumers have turned to shopping for experiences over goods, travel and entertainment remains in high demand. As an example, the airline industry’s main organisation, the International Air Transport Association, said on June 5th that it is doubling its estimate for global net profit in 2023 on the surge in flying in North America and Europe.

Earnings recession

Evidence of the Cardboard Box Recession suggests the mild recession in corporate earnings may continue. Historically, the global manufacturing PMI leads earnings growth for global companies by a quarter. It currently continues to point to low-to-mid single-digit year-over-year percentage declines for earnings per share. While falling earnings are never great news, the drop is barely noticeable when compared with prior recessions where they fell 20 percent or more.

Looking further ahead, the gap between earnings expectations for cardboard box-type industries and services industries is double-digit. Over the coming year, the FactSet-tracked consensus of analysts’ earnings growth forecasts for companies in manufacturing industries is +3.8 percent versus +14.9 percent for services. While these forecasts by analysts often tend to be overly optimistic, the wide gap between them highlights how the economists and analysts are aligned on the nature of the current economic environment.

Shortages to gluts

The change from shortages to gluts in the global market for goods that took place in mid-2022 may now be shifting to the global labour market of 2023. Company communications on earnings calls and shareholder presentations reveal a rising trend of mentions of job cuts (including phrases like reduction in force, layoffs, headcount reduction, employees furloughed, downsizing, personnel reductions) along with a falling trend in mentions of labour shortages (including phrases like labour shortages, inability to hire, difficulty in hiring, struggling to fill positions, driver shortages).

Lending conditions may also contribute to the weaker jobs outlook. There is a clear and intuitive leading relationship between banks’ lending standards and job growth. The magnitude of the recent tightening in lending standards from banks in the US and Europe points to a potential shift from job growth to job contraction in the coming quarters.

It has been a bumpy ride for the Chinese economy since its reopening in December. A stronger-than-anticipated rebound in the first quarter of 2023 was followed by a decline in activity in April and May in both manufacturing activity and home sales. The service sector is still holding up, though.

The rapid loss of momentum in housing and manufacturing has come as a surprise – and as a consequence, has reversed the early rally in metals prices and Chinese equities. It also leaves us with a question: where we go from here?

My baseline scenario is moderate growth in the second half at an annualised pace of about 4 to 5 percent, with PMI manufacturing rising modestly back to around 51 by the autumn. Private consumption should hum along, primarily driven by service consumption, which in turn supports jobs and household income growth. Savings also provide a buffer for consumers.

The housing market outlook is uncertain. It seems that pent-up demand was unleashed faster than expected, leaving activity from here more dependent on fundamentals. But if needed, the government is set to deliver more policy support – such as lowering mortgage rates and reducing requirements for down payments. It will take a while before this feeds through to construction, though, as developers struggle to meet debt payments.

Exports are likely to remain soft. But I expect to see a mild recovery in private manufacturing investment – up from low levels after the pandemic.

Although I’m still cautiously optimistic, risks are skewed to the downside. Far from all clouds of uncertainty have lifted. Recent developments point to a more fragile recovery than expected. Equity and metals markets are already pricing in a high probability of a further Chinese downturn.

However, this pessimism looks excessive in my view. Policy makers are likely to launch further stimulus in order to keep the economy on a growth path of 4 to 5 percent – not least in order to create more jobs. The issue is especially acute for young people, whose unemployment rate is uncomfortably high (above 20 percent).

Economic data has consistently outperformed pessimistic predictions over the past year.  

In the United States, despite more than 500 basis points of rate hikes, the labour market is robust, and inflation is decelerating. Wage growth is a key piece of the US inflation narrative, and non-household services wages are decelerating, which should further feed into core disinflation over the next 6-10 months.  

In Europe, core inflation also seems to have turned a corner, raising hopes that both the US and the Eurozone can tackle inflation without experiencing rising unemployment.  

While China’s reopening has stalled – with youth unemployment now over 20 percent, and consumer confidence low – its economy will still grow this year. The question is by how much. In conjunction with resilient US and European demand, there are structural shifts in the Chinese economy, such as its emergence as the largest global electric vehicle exporter.  

Major economies do face critical challenges. Consistent with higher rates, manufacturing is showing weakness in the US, China and Europe, as the next chart shows – meaning global growth in 2023 is highly likely to be weaker than 2022. Meanwhile, lower-income countries face painful increases in the cost of borrowing, threatening their recoveries.  

Yet, the longer that recession projections are delayed, the better the outlook for the global economy becomes. The picture is not rosy, but the outlook is improving with each data release.  

As was the case in many countries, house prices rose rapidly in Norway during the pandemic. From March 2020 to the peak in August 2022, sale prices for existing homes rose 20 percent nominally and 11.5 percent in real terms as mortgage rates reached record lows.  

In 2023, prices have continued to rise – despite interest rates rising to their highest level since 2008. But there are signs of weakness ahead.  

The Norwegian central bank was one of the world’s first to raise rates after Covid restrictions were eased. From September 2021 to May 2023, the key policy rate was raised from zero to 3.25 percent.

Norwegian households are particularly vulnerable to rate hikes as they are heavily indebted, with a debt-income ratio of around 240 percent. Some 80 percent of Norwegian households own their own homes, and 95 percent of Norwegian mortgage borrowers have loans with floating interest rates.

As a result, sale prices for existing homes in Norway are normally very sensitive to higher mortgage rates. Calculations from Housing Lab at Oslo Metropolitan University show that a one-percentage-point increase to mortgage rates has historically resulted in a price drop of nearly 14 percent, all else being equal.  

This time has been different. Housing prices have increased by 7.7 percent nominally and 1.8 percent on a seasonally adjusted basis from December 2022 to May 2023. There are several factors that explain this.

One reason is that households have more access to credit than they used to. Regulations say banks must consider whether households can withstand an interest-rate surcharge on the current market rate. This stress test is intended to ensure that borrowers have a buffer in case they lose their income or their expenses rise.  

Before this year, that stress test was 5 percentage points. From Jan. 1, it was cut to 3 percentage points, provided that the borrower can service a home loan interest rate of at least 7 percent. In practice, this meant an interest-rate reduction from about 9 to 7 percent. In addition, the special requirement for equity when buying secondary homes in Oslo was reduced from 40 to 15 percent.  

Other factors include a strong labour market, very low unemployment and savings buffers built up during the pandemic.  

There have also been few homes for sale, both existing and new. The number of transactions in the market for existing homes versus the number of such homes put up for sale has been high for several months.  

The situation for new homes is different. Housebuilders offered slightly above 2,500 homes for sale from Dec. 15 to April 15¹ –, down from about 6,000 in the same period  in 2021 and 2022 and from about 4,000 in 2020 and 2019  

The decline can be explained by weak sales and higher construction costs, including financing. New home starts are also at a record low: the first quarter of 2023 was the weakest since 1999, according to the housing producers’ association Boligprodusentenes Forening. New home starts were less than 20,000 over the past 12 months, clearly lower than the number of building permits issued – suggesting projects are being postponed or cancelled.

Looking ahead, there are many indications that seasonally adjusted housing prices will flatten out over the next few months and fall somewhat into autumn as interest rates hit harder. Most likely, the key policy rate will reach 3.75-4 percent by September, and mortgage rates should approach 5.25-5.5 percent.

Lending regulations will gradually tighten credit access and reduce housing demand. Unemployment is expected to increase somewhat.  

However, this is not expected to trigger a sharp fall in housing prices. There are still many job vacancies, even though the number of new advertised positions is trending downwards. Even if unemployment reaches pre-pandemic levels, it will still be low.  

There are other factors that will help limit a fall in house prices. Households have become more optimistic, and an increasing proportion expect housing prices to rise. All else being equal, this pulls up demand and prices.  

Demographic trends are also a factor. Norway’s population grew by 63,700 last year, or about 1.2 percent, amid high net immigration – especially from Ukraine. High population growth is also expected in 2023. This reinforces pressure in the rental market and may stimulate interest in buying existing homes.

The lack of homebuilding and the greater expense of new-builds  could also push up demand for existing properties. With new home starts running at half the level of a year earlier, that implies few homes being completed in 2024-25. This is especially the case for Oslo, where population growth and increased household formation is far outstripping new construction starts, leading to a large housing deficit over the past decade.  

Purchases of new homes are thus expected to remain low for some time to come. Many home buyers are also concerned that a soft market for the home they will sell might affect their home equity for their next purchase.  

Demand may pick up somewhat once it becomes clear that interest rates have peaked and inflation is on its way down, lessening uncertainty for households. Thus, we expect demand for new builds to increase somewhat in 2024 and normalise in 2025 – when the central bank may be lowering rates again. At that time, very few homes for sale will also push prices up.

Recent macro releases have been painting us a picture of broad disinflation in the United States. While the US economy has held up reasonably well against the banking crisis and tightening shock, some pockets of weakness have started to appear.  

The supply side – normalisation of supply chains and falling commodity prices – will probably be enough on its own to continue producing downward pressure on CPI going into the second half of the year. The Fed's supply chain pressure index (a leading indicator, as the next chart shows) is falling at a record pace, and both the shortening of delivery times and buildup in inventories suggest that broader price pressures are easing.

Slowing headline inflation will start impacting elevated core rates with a time lag. However, the stickiest, demand-driven parts of the consumer basket have already peaked and are slowly coming down from the past decade’s highs. The three-month annualised rate of inflation in services excluding shelter, for example, has fallen into negative territory for the first time since the pandemic. Furthermore, the ISM purchasing manager survey for the services sector already suggests lower willingness of companies to pass on costs to the consumers, which should continue putting downward pressure on services inflation in the second half of 2023.  

It remains true that the higher-for-longer narrative and surprise rate increases in Australia and Canada – coupled with stronger-than-expected British inflation and labour market reports – have spilled into Fed pricing. Markets don't expect any rate cuts in 2023 from the US central bank.  

However, a look at wage growth across these four countries clearly dampens speculation about the implications that these rate surprises and data might have for the Fed. The US is the only one where wage growth and has peaked and continues to come down. While individual data surprises still have the potential to shape market pricing in the short term, the medium-term trend remains in place.

The reelection of Turkish President Recep Tayyip Erdogan has been followed by the appointment of a new economic policy team. Mehmet Simsek takes over as finance minister, and Hafize Gaye Erkan is the new central bank chief.

They’re taking over after a period where Turkey’s consumer price inflation has accelerated to match that of Zimbabwe, as the first chart shows. Central bank governor Naci Agbal was dismissed in early 2021, and a highly unorthodox set of economic policies followed – as did a more or less unfiltered implementation of regulations and capital controls bearing the stamp of President Erdogan himself. These have caused severe distortions in the Turkish economy.  

The de-instrumentalisation of the policy rate as an economic policy tool has meant that authorities have had to spend reserves propping up the lira, while inflation has soared, reaching a peak of 80 percent year-on-year in October.  

When central banks around the world raised rates to prevent runaway inflation following the end of the pandemic, Turkey’s economic policymakers – effectively, the president – chose instead to cut rates, causing a severe cost-of-living crisis. On the expenditure side, this set in motion a record private consumption boom dwarfing anything else in other major emerging markets during the same time, as the next chart shows.  

The purpose was likely to boost the economy ahead of May’s elections – a strategy that may have paid off politically, but at great economic expense.

The cumulative current account deficit as a share of GDP is the widest at this point in a calendar year since 2011, as the next chart shows. In the first three months of this year, the accumulated deficit was more than half of what the IMF forecasts for this entire year.  

A combination of real appreciation reducing export competitiveness, high energy imports and increased demand for gold as an inflation hedge contributed to the imbalance – and these trends can all be linked in some way to the economic policies of President Erdogan.

As Simsek and Erkan consider the economic environment, one of the focus areas will be the rate hikes needed. Average deposit rates rose far above commercial lending rates during the spring, standing at almost 27 percent at the time of writing. But even raising the policy rate to that level would not put the real rate in positive territory, given that inflation for the next one to two years is forecast to stay above 30 percent. And even a barely positive real policy rate may still not be enough to durably boost the central bank’s credibility.  

It is useful to recall the lessons of the 2001 crisis. The newly independent central bank sought to boost its credibility by setting a high real policy rate – on average, 8.4 percent between 2003 and 2008. Over the next decade, the average real rate fell to 0.7 percent. There were periodic upticks following the 2018 crisis, as well as during Agbal’s tenure as central bank governor.  

As the final chart shows, the real policy rate bottomed at negative 75 percent in October of last year, when inflation surpassed 85 percent. The real rate is about negative 30 percent today.  

Given President Erdogan’s preferences, the probability that the economic duumvirate of Erkan and Simsek will be allowed to repeat the harsh but effective reputation-building exercise of the 2000s is unlikely.  

It then follows that markets can at best expect a marginal shift in policy. And even if global interest rates fall somewhat in the coming year, the interest-rate environment facing Turkey is different than it has been for most of the past decade. Other emerging markets’ policy rates are significantly higher.  

The combination of lost monetary policy credibility and competition from higher rates in other EM countries creates a significant challenge for Turkey’s incoming policymakers. Whether they will be allowed the scale, scope, and time needed to right previous policy wrongs will ultimately be a political decision. And recent Turkish political history shows that short-term political gains have too often trumped long-term economic progress.

Despite the widespread anticipation of a recession by the fourth quarter, economic activity has not yet conformed to this pessimistic sentiment.  

Based on the red flags in the data and our models, we still believe that a slowdown is imminent. But regardless of the outcome, it is clear to us that recession fear will continue to be the primary concern in the markets in the next few quarters. Our focus will shift away from the inflation ghost, and we will be more concerned about a potential negative growth scare.  

While the services sector has been performing well, we see this coming to an end in the second half. As our chart shows, trends in service sector PPI are pointing in a negative direction.

If this does come to pass, how fast will the labour market respond? If the rate of change is similar, it could get ugly.

Economic activity in the past few months has surprised on the upside, particularly in the US, while core inflation rates have remained stubbornly high in most developed countries.  

US core inflation appears to be stuck between 4-5%

<p class="blog-chart-link">Source: Macrobond, Bank J. Safra Sarasin, 08.06.2023</p>

Still, some of the tailwinds that have supported global growth appear to be fading.  

We expect that the most aggressive rate-hike cycle in decades will increasingly weigh on economic activity, as the yield-curve inversion suggests – even if that might take more time than usual. The US and UK economies should fall into a recession by the fourth quarter of this year.

Economic surprises are turning negative in the US and Europe

<p class="blog-chart-link">Source: Macrobond, Bank J. Safra Sarasin, 08.06.2023</p>

In the euro zone, revisions to past data suggest that the bloc was already in recession last winter. Pent-up demand for travel means that growth should pick up somewhat over the summer, but overall, stagflation continues to be the most adequate description of the European environment. As our next chart shows, weak manufacturing data in Europe likely augurs weakness in the euro.  

Relative cyclical dynamics argue for a weaker euro ahead

We think that policy rates are close to their peak in the US and Europe, and that the Bank of Japan will start adjusting yield curve control later this year. The deteriorating economic backdrop is generally favourable for high quality fixed-income instruments, with the prospect of lower bond yields over the next six to 12 months.  

We are particularly positive on emerging-market local currency debt. The difficult economic environment should also be positive for the US dollar, the Swiss franc and the Japanese yen. Finally, on equities, we prefer defensive regions and markets.

Tighter monetary policy means weaker economic growth  

We expect the Australian economy to slow over the course of 2023, driven by our expectation that real household consumption is essentially flat. Against a backdrop of 2.0%/yr population growth that implies a solid negative fall in consumption per capita. Indeed it would not surprise us to see a quarter or two of negative growth in total household consumption.  

Monetary policy works with a lag. Only around half of the RBA’s already delivered 400bps of policy tightening have hit the household sector. As the lagged impact of rate rises continues to hit home borrowers mortgage repayments will rise to a record high as a share of household income (see facing chart). This will have a negative impact on household consumption.  

Nominal income growth will continue to be supported by wages growth, which we expect will lift to 3.9%/yr in Q3 23. But this will not be enough to offset the ongoing drag on the consumer from rising mortgage repayments.  

An expectation that rental inflation will continue to lift will also hit the large number of households that rent. While rents are effectively a transfer payment within the household sector, many investors will be faced with higher mortgage repayments. So a good chunk of the money transferred from tenants to landlords will exit the household sector (note that the Government also taxes rent as it is considered income to the landlord).  

What about the savings?

Households as a collective tend to draw down on savings when they are feeling positive about the economic outlook. That is not the case right now. The anxiety being felt in the household sector as a whole is showing up in very weak readings of consumer sentiment – historically consistent with a major negative economic shock or recession.  

The savings rate fell to a below-average 3.7% in Q1 23. It can fall further. Based on our forecast profile for household consumption and household disposable income, we expect the savings rate will hit a floor of ~2.5% in H2 23.  

Weaker growth means higher unemployment  

Our downgraded assessment of economic growth means we mechanically upwardly revise our forecast for the unemployment rate. We see the unemployment rate increasing to 4.4% by end-2023.  

It is likely that measured productivity growth will stay weak over coming quarters as there is a lag between slowing economic activity and rising unemployment.  

Initially firms will keep workers on the books as demand slows. This weighs on measured output per hour worked. Output (i.e. production) slows faster than the demand for inputs (i.e. labour). So productivity remains weak and unit labour costs stay elevated for a period of time. But this dynamic does not last indefinitely.  

Once demand has slowed for a sufficient period of time some firms will respond by decreasing the hours they require their staff to work. A reduction in headcount also occurs. This is expected to happen in the discretionary parts of the economy where spending is forecast to contract. These outcomes are being engineered by restrictive monetary policy in order to drop the rate of inflation.  

Our home price call is unchanged  

According to CoreLogic, Australian property prices rose for a third consecutive month in May. The 1.4% increase in the 8 capital city benchmark index over the month followed a 0.7% increase in April and a 0.8% lift in March (see here).  

The turnaround in property prices over the last three months has been nothing short of remarkable given the RBA has continued to lift the cash rate over that period.  

In April we upgraded our home price forecasts. Our point forecast is for home prices to lift by 3% in 2023 and a further 5% rise in 2024. We have not changed this forecast despite the change in our RBA call.  

The RBA recently cited home prices as feeding into their decision to lift the cash rate “services price inflation is proving persistent here and overseas, and the recent data on inflation, wages and housing prices were higher than had been factored into the forecasts. Given this shift in risks and the already fairly drawn-out return of inflation to target, the Board judged that a further increase in interest rates was warranted.” (our emphasis in bold).  

But the RBA is facing an uphill battle to change the outlook for home prices by lifting the cash rate as monetary policy tightening is behind the big drop in building approvals.  

Further rate hikes reduce borrower capacity, which should by itself put downward pressure on home prices. But rate hikes also decrease the rate at which new homes will be built. This further exacerbates the mismatch between the underlying demand for housing and supply. The circularity here means we do not think our change of RBA call for a higher terminal rate alters the outlook for home prices.  

There is light at the end of the tunnel  

Readers may feel like there is a pessimistic tone to this note. That is understandable. Economists don’t take pleasure in downgrading the outlook for economic growth and upwardly revising their forecasts for unemployment. But there is light at the end of the tunnel.  

Once the proverbial ‘inflation dragon’ is slayed monetary policy will be able to move away from a deeply restrictive setting to a more neutral one. Rate relief will arrive to the household sector in the future and we expect that to happen in early 2024.

As interest rates are cut it will free up cash for those borrowers that have a mortgage. And the demand for credit will begin to lift. As this happens economic momentum will start to pick up and the upward trend in the unemployment rate will wane. Consumer sentiment and spending will lift.  

Our expectation is that the unemployment rate will peak at 4.7% in mid-2024 before grinding back down to 4.5% in late-2024. This is below the pre-pandemic level of ~5.0%.  

Ultimately we will not be able to hold onto all of the gains we made in employment over the pandemic. And the RBA readily acknowledges this as they see some lift in the unemployment rate as a necessary condition to return inflation to target.  

But if we end up with inflation back to target, unemployment at ~4.5% and wages growth at ~3.5% by the end of 2024 then Australia will have done a lot better over the period ahead than many other economies.  

There are risks of course in both directions. And the economic data coupled with the decisions of the RBA Board over coming months will give us a better sense of the balance of these risks.

US rents are on the rise: forecasting shelter CPI using spot data  

In a previous article, “Forecasting the Future of CPI Shelter” I discussed the relationships among the CPI Owners Equivalent Rent, CPI Rent and other more current data series that track the cost of housing.  

One should be able to use spot rent data to forecast CPI shelter metrics, which reflect the average rent paid – which itself tends to be a moving average of spot rent. I also mentioned the paper “The Coming Rise in Residential Inflation” by Marijn A. Bolhuis, Judd N. L. Cramer and Lawrence H. Summers, who employed an analytical technique to forecast CPI shelter metrics.

Hybrid Data Series

Both my initial model and the model used in the Summers et. al. paper materially underestimated actual CPI shelter growth, but the forecasting process enabled me to learn which metrics are best at forecasting CPI shelter.  

Specifically, I found that Zillow’s Observed Rent Index (ZORI) better captured the large increases in rents that later showed up in the CPI shelter component. Another advantage of the ZORI is that it is monthly, and Zillow publishes hundreds of these indices for markets across the country.  

The downside is that the data set started in 2011, so we cannot learn the relationship between the ZORI and the CPI shelter component during the global financial crisis of 2008.  

However, the Zillow data series and similar data from CoStar (that I used initially) track each other quite well between 2012 and 2021, so I decided to create a hybrid data series  comprised of the Costar data series between 2001 and 2011 and the Zillow data series from 2011 onward.

Historical Forecast with Hybrid Data Series

Employing this spliced data series, recreating the approach described in the Summers et. al. paper, greatly improves the forecast. Note that actual CPI rent growth stayed within the 95 percent confidence interval through October 2022. As of June 2023, the actual CPI growth rate was less than 1 percent above the 95 percent confidence band.

Updated Zillow Data

I then updated this improved forecasting methodology using the most current available data. Examining the monthly returns on the Zillow Home Value Index and the ZORI, we find that rent growth was largely flat last November, December, and January – a sharp departure from the dramatic run-up in monthly rent increases in 2021, which peaked at around 2 percent monthly or 24 percent annualized.  

However, February through May of 2023 saw monthly rent growth return to around 0.3 percent monthly (3.6 percent annualised). This is encouraging news for apartment investors, who had feared the large number of units currently under construction would put downward pressure on rent growth as these properties are delivered and absorbed.

Current Forecast

Using the forecasting method employed to replicate the Summers paper and Zillow data through May 2023, my latest forecast suggests that annual CPI rent growth will ease somewhat to 2.12 percent in June 2024. The confidence intervals indicate that there is a 95 percent probability that the actual CPI rent growth will be between 1.5 percent and 2.5 percent.  

What is interesting to observe is that the forecast falls slightly below 2 percent, then returns to 2 percent. This movement reflects no material growth for three months, then a return to 3 percent to 4 percent growth over the past four months.  

What is also notable is that the confidence interval starts to expand at a more rapid rate as the forecast period exceeds one year. This confidence interval is calculated based upon the historical ability of this model to forecast actual CPI rent growth, and this expansion of the confidence interval indicates that the CPI Rent metric reflects an approximately one-year moving window of spot rent: for forecast horizons longer than a year, the movement in spot rent has much less predictive power than it does for forecast horizons of less than a year.

The possibility that rents might re-accelerate

The CPI rent forecast indicates that we will likely return to 2 percent rent growth by the middle of 2024. If CPI rent follows a 75th percentile path, though, the 2 percent target may not be achieved if rents re-accelerate. We saw that actual growth for CPI rent exceeded the 95th percentile forecast made in February of 2022, so this is not without precedent.  

We will continue to track the actual CPI rent versus our model in the future and re-forecast CPI rent as new data becomes available.

Investors don’t have enough history to make casual claims about the relationship between liquidity and equity market performance. But so far this cycle, the relationship is tight; the surges and withdrawals of liquidity from monetary and fiscal policy are impacting markets.  

For this reason, the latest debt-ceiling debacle may yet prove itself a market risk. How the Treasury’s upcoming debt issuance is absorbed may greatly impact liquidity, triggering a risk-off environment. (See the top panel of the chart below).

Early 2023 saw a revival in the stock market, but this may have been strengthened by liquidity support in the form of Treasury General Account (TGA) spending and emergency funding programs from the Fed. However, the liquidity outlook for the back half of the year may be different.

Now that the debt ceiling has been suspended, the Treasury is free to issue new debt. It is targeting a net issuance of USD 600 billion by the end of September, and an estimated additional USD 400 billion by the end of the year. (See the middle panel of the chart below).

The refilling of the TGA has the potential to become a whirlpool of liquidity and wipe away 2023 year-to-date gains, or it could turn out to be relatively liquidity-neutral. Which outcome plays out depends on who absorbs the new issuance – households or money market funds (MMFs).  

Households have been major buyers of Treasuries during the Fed's interest-rate hiking cycle, but whether MMFs step in to absorb the debt before households may depend on the spread between the 1-month Treasury yield and the overnight reverse repurchase agreement (RRP) yield. (See the bottom panel of the chart below).

Should this spread widen, MMFs, which significantly increased their overnight RRP participation amid uncertainty about the future path of interest rates and elevated rate volatility for most of 2022, may find it attractive to shift money from overnight RRP to Treasuries.  

This would reduce reverse repo funds while increasing the TGA, which is net-neutral to liquidity. Alternatively, in the absence of such a spread, households are expected to remain the primary buyers of the debt sourcing their purchases from bank reserves, which would result in a drain of liquidity.  

If the relationship between liquidity and the stock market holds, this scenario has the potential to be challenging for the stock market.

Which geographies are most vulnerable to a crisis in the Taiwan Strait—and why should firms and governments care?  

While EIU’s forecast is not for China to attempt in the coming years to claim Taiwan with military force, deepening tensions encompassing China, Taiwan and the US mean that risks have risen to the point that they are influencing operational decisions.

To provide companies with a broad overview of their exposure to a potential crisis, while also offering policymakers insight into their own country’s economic and diplomatic vulnerabilities— and those of others – we have developed a bespoke model to evaluate the exposure of different economies in Asia to a hypothetical conflict in the Taiwan Strait, drawing on a range of quantitative and qualitative indicators. (More on our approach and analysis can be read in our white paper, Conflict over Taiwan: assessing exposure in Asia.)

A conflict in the Taiwan Strait would clearly be devastating for Asia, but we find that the region’s economies have differing a range of vulnerabilities.  

Outside those we assume would be immediately directly involved in the crisis - China, Taiwan and the US - our model shows the Philippines, Japan and South Korea to have the highest exposure. Their geographic proximity to the Taiwan Strait, alongside their roles as important US treaty allies, suggests a high risk that they will be drawn into a conflict. In addition, they have heavy reliance on trade with China.  

Hong Kong, Vietnam, Thailand, Australia and Malaysia also fall within our list of severely exposed markets.  

We assess the exposure of South Asia, some parts of South-east Asia and the Pacific to be lower. Geography partly explains this; the most exposed markets in our model are in close proximity to the Taiwan Strait, suggesting a high risk of being drawn into a conflict. The further away a country is from the Taiwan Strait, the more shallow its exposure. Stances of diplomatic non-alignment also mean a relatively low geopolitical exposure.  

The exposure of India and Indonesia, both strategic emerging markets, is high but less than for regional economies of a similar scale. Indonesia has a stronger trade reliance on China than India, suggesting higher economic vulnerabilities. However, we assess its geopolitical exposure to be lower, as —– unlike India —– Indonesia does not have a major territorial dispute with China, which could influence how its government (or its population) reacts to a cross-Strait crisis.  

While no market in Asia would be a “winner” from a cross-Strait conflict, these geopolitical swing states that are large enough to limit some of the economic repercussions and to avoid being drawn directly into the conflict stand out as the less exposed among Asia’s biggest economies.  

The possibility of conflict in the Taiwan Strait risks dimming Asia’s appeal in favour of other regions, but we believe most organisations will focus on strategies to mitigate risk rather than avoid it altogether.  

EIU’s forecast posits Asia as the world’s fastest-growing region in the coming decade, and its central status in the global trade landscape remains underpinned by its competitiveness in production, logistics and transportation networks.  

Our model can be helpful in terms of identifying areas of vulnerability and guiding reviews of asset allocation strategies, sourcing procedures, inventory accumulation designs and business contingency planning (including with regard to asset and employee safety).  

The Bank of Canada's decision to abandon its wait-and-see stance and resume interest-rate hikes was primarily driven by "excess demand" in the economy. This phrase, absent during the three-month pause in rate hikes, reappeared in this month's rate announcement.  

Initial GDP reports revealed first-quarter growth was 3.1 percent, significantly above the bank's estimate of 2.3 percent and suggesting a demand imbalance.  
Although the bank previously predicted that inflation would retreat to a 2 percent target by 2024, it now believes that excess demand is more persistent than anticipated – necessitating urgent action.

Canadian consumer spending surged in the first quarter, fueled by purchases of vehicles, clothing, restaurant meals and foreign travel. However, this increased spending was funded by savings – raising concerns about whether it can be sustained.

While GDP and retail sales patterns indicate temporary strength, the full impact of higher rates has yet to be realised: two-thirds of mortgage borrowers have not yet experienced increased payments. Moreover, the output gap points towards output being 0.2 percent above potential as of the fourth quarter of this year, as the first chart shows.

And as the second chart shows, recent employment figures are also concerning. Canada lost 17,000 jobs in May, and the unemployment rate rose to 5.2 percent. This increase raises questions about the Bank of Canada's future rate-hike strategy.

Capital investment by Japanese companies continues to be strong. As the first chart shows, both manufacturing and non-manufacturing capital expenditures are currently at high levels, according to Japanese corporate statistics. Last year, this high growth partly reflected capital investment that had been postponed due to the pandemic. Some of this postponed demand are expected to continue through 2023 – as is capital investment related to labour saving, digitalisation, and decarbonisation. Various surveys show that companies' capital investment plans for FY2023 remain at a high level.

In addition, corporate earnings are solid. Terms of trade, which had been deteriorating, are now improving due to lower import prices, as the second chart shows. Non-manufacturing sectors are expected to continue to perform well as a result of economic normalisation, while manufacturing is expected to be supported by improved terms of trade, despite the impact of the overseas economic slowdown.  

Given this background, capital investment is expected to increase steadily in the second half of the year.  

As this year began, expectations pointed towards a weakening US dollar due to an anticipated pause in US interest-rate hikes. However, sentiment shifted amid stubborn inflation, and the market revised its view. The “pause” is now likely to be delayed.  

The dollar indeed weakened after mid-March as the US and European authorities moved swiftly to contain banking risks, improving market sentiment. However, the greenback began appreciating again in May. Despite these fluctuations, the US dollar index remained broadly unchanged compared to its 2022 year-end level.

Meanwhile, the Malaysian ringgit emerged as one of the weakest-performing currencies, following closely behind the Japanese yen. Amid the Fed’s delayed pause and concerns about global economic growth, the ringgit reversed its appreciation and touched its lowest level since November 2022.  

Weaker-than-expected economic data and low commodity prices further hurt Malaysia’s currency. Additionally, the widened interest-rate differential between the US federal funds rate and Malaysia's overnight policy rate (OPR) resulted in capital outflows.

Nevertheless, the Malaysian ringgit appeared undervalued as measured by the real effective exchange rate (REER), which adjusts for inflation. As our chart shows, this measure remains below 100, despite the two-year post-pandemic recovery.  

In contrast, analyzing the ringgit's effective exchange rate on a nominal basis (NEER) revealed relative stability in the currency's valuation, despite its fluctuations and weakening against select currencies.

Looking ahead, with the expectation that the Fed’s “pause” will truly arrive later in 2023, fund flows are likely to return to emerging markets. This positive outlook supports the potential for improved performance in emerging-market currencies, including the Malaysian ringgit.  

However, this scenario assumes no further widening of interest rate differentials – and suggests that Malaysia's OPR would need to be raised to match the remaining US rate hikes.

Covid-19 exposed the fragility of global supply chains, leading to speculation that retail, industrial and manufacturing occupiers would prioritise resilience in the future by holding more stock domestically – even if it is more expensive to do so.  

Supply-chain pressures have abated significantly since then, and the cost of shipping has plummeted, as the first chart shows.  

However, there is unlikely to be complacency amongst occupiers. They will probably still execute on stock-building plans, which will drive logistics demand for a sustained period. We think this for two reasons.

Firstly, it takes time to rebuild inventory. European Commission data shows that the quantity of stock held by European retail, industrial and manufacturing businesses has only recently returned to pre-pandemic levels, as the next chart shows.  

A sustained period of over-compensation will be needed to build resilience – rather than simply offset pandemic-era stock depletion.  

Secondly, trade uncertainty is rising again. This is a result of several factors, including worsening climate risk, geopolitical tensions that are accelerating a retreat from globalisation, and rising interest rates – all of which feed into the index in the next chart. These factors increase supply-chain vulnerability.

The upshot is that the stock-building trend in Europe is only just starting to gather momentum, and it will be a source of demand for logistics real estate for some time.  

It will also be inflationary, driving up the cost of goods as a knock-on consequence of businesses valuing supply-chain security over cost. This suggests the recent bout of high inflation has some distance to run. We think that Consensus Economics’ June prediction that euro zone inflation will fall below 2.4 percent next year is optimistic.

Major macro risks are gradually receding, leading to a handoff from beta to alpha as the main driver of market performance. Recent correlations between bonds and stocks turning negative underscore this shift, in contrast to most of 2022, when accelerating inflation and central bank tightening dominated the market narrative, putting pressure on both asset classes.  

While uncertainty persists, the range of potential outcomes to the main macro challenges is much narrower today: peak U.S. hawkishness is behind even if the timing of a pivot isn’t clear, China is delivering stimuli to keep the recovery on track, and the risk of more extreme scenarios from the war appear remote.  

A global backdrop where extreme macro scenarios appear more distant, and volatility lower, makes emerging markets – with their asynchronous business cycles and policy mixes – a compelling vehicle for capitalizing on idiosyncratic opportunities.  

In this environment, one of our preferred axes of differentiation is exposure to high-carry strategies through local EM government debt. Many higher-yielding EM opportunities, importantly, are in countries with solid fundamentals, which may offer some degree of downside protection in case of renewed bouts of global jitters. Historically, moreover, high-carry strategies tend to perform well after the Fed pauses.      

Whilst interest rates have been and continue to be normalised, this is anything but a normal cycle. Amid the fastest rate hiking cycle in almost 50 years, economies have remained surprisingly resilient. Will this change in the second half?

We expect a mild US recession late this year, though ongoing economic resilience could delay the downturn into 2024. The cumulative tightening of rate hikes and reduced credit growth are expected to lead to an economic slowdown in advanced economies from the second half onwards.  

Inflation remains the key risk, as we recently outlined. If headline inflation drops below core inflation for many economies in the near term, that might create the illusion that inflation has been conquered -- when it has not been.  

Core inflation momentum remains significant and persistent in most economies. This persistence is underpinned by very tight labour markets in several countries, as the ratios of job vacancies to unemployed persons in the following chart shows.  

What's interesting is that the monetary policy transmission to labour markets has so far been muted. In prior hiking cycles, the negative effect of higher rates was more quickly reflected by increases in the unemployment rate. This time is different, at least so far – as the following chart shows.

Although monetary-policy lags are famously “long and variable," ongoing labour market resilience ultimately means that interest rates need to remain restrictive for a prolonged period.  

Whilst we do believe that the Fed is close to the end of its hiking cycle, the bar for rate cuts is higher than the bar for additional monetary tightening at this point. In our view, this assessment will only change once we see sustained and broad-based disinflation and/or substantial labour-market weakness.  

The ongoing war in Ukraine plays no major role in our economic forecasts. After 16 months, the conflict no longer weighs on sentiment and activity in western and central Europe. The EU has learned to live with minimal imports from and few exports to Russia.  

Our forecasts implicitly assume that the war drags on at least until next year. It’s possible, but not likely, that the war ends on mostly Ukrainian terms this year, according to many military experts.  

If it were to happen nonetheless, it would be a positive surprise. If so, it could lead to modestly stronger growth with lower inflation – lifting confidence and reducing prices for energy and some key foodstuffs. For the eurozone, we expect slow growth in 2023 (0.3 percent) and a solid rebound for 2024 (1.2 percent).

The US economy has remained resilient in the first half of 2023, and credit tightening has so far been more modest than expected. The labour market is still in good shape, with the unemployment rate remaining near historically low levels, as the following chart shows.  

As a result, we have raised our forecasts for US real GDP growth to 1.5 percent in 2023 and to 0.6 percent for 2024, largely due to a less negative outlook for residential construction and business fixed investment. Housing market activity (particularly for new homes) appears to have bottomed, while business investment in structures is firming up, due in part to fiscal incentives from the Inflation Reduction and CHIPS acts.  

We still expect the US economy to contract slightly in the second half. But the cumulative (non-annualised) drop in real GDP of a mere 0.3 percent – versus our previous call for shrinkage of 0.6 percent for the third and fourth quarters taken together – barely merits the label “recession.” “Temporary stagnation” may be the better description.  

Despite HICP inflation having fallen from a peak of 10.6 percent, it remains elevated and is set to keep the European Central Bank on a tightening path in the near term.  

Our own view is for another 25 basis point hike in July, taking the deposit rate to 3.75 percent, as the following chart shows. Given tentative signs that core inflation may be beginning to slowly turn lower, September’s Governing Council meeting will offer the chance for a reassessment of the inflation risks and outlook – and ultimately, to our minds, a pause, although we do anticipate the debate to be lively.  

However, alongside the ECB’s main tightening effort sits the withdrawal of non-standard policy measures: the run-off of its Asset Purchase Programme bond holdings and the phased end to targeted longer-term refinancing operations, TLTRO-III.  

With respect to the latter, given the expected pace of repayments through the rest of this year, only about EUR 400 billion is likely to be left of the original EUR 2.3 trillion TLTRO-III allotment, and by the end of 2024 it will be repaid entirely.  

At the aggregate level, the impact on Eurosystem liquidity is likely to be only modest, given that excess liquidity stands at EUR 4.1 trillion. However, at the national level, the impact may be more nuanced.  

At the end of May, banks in Northern European countries such as Germany and France were awash with surplus liquidity, as the next chart shows – on average holding 30 times more liquidity than their reserve requirements. By contrast, their Southern European counterparts’ coverage was half of that – with balances averaging only 15 times requirements.  

These banks were also typically the largest recipients of TLTRO funds. For example, the latest data show that Italian banks account for a third of all Eurosystem LTRO borrowing. On that basis Italian banks are likely to have seen their levels of excess liquidity severely depleted at the end of June, given the EUR 507 billion of TLTRO funds EU20 banks repaid.  

That’s not to say that Italian banks are in any real trouble. But TLTRO-III repayments will impact bank funding conditions given that cheap TLTRO funding (which, at its most favourable, was indexed to the average deposit rate minus 50 basis points) will be replaced by shorter-term, more expensive funding.  

For example, the ECB’s weekly main refinancing operation, has provided some insight into shifting funding patterns around the June TLTRO repayment, with borrowing seeing a jump to an average EUR 16 billion in the last two weeks. That’s the highest level of usage since 2017, and exceeds the EUR 1 billion 2023 average.  

Consequently, the withdrawal of such liquidity provision is likely to have a more detrimental impact on Southern Europe – once again raising the question of fragmentation risks.  

The global economy has reached a critical and perilous juncture. True, it withstood strong headwinds better than expected over the past year. Inflation edged down, as disruptions in global supply chains and commodity markets waned. Growth slowed, but it proved remarkably resilient.

At the same time, signs of strains emerged in the financial system. They engulfed both banks and non-bank financial intermediaries and prompted a forceful policy response to limit contagion. The strains share a common cause: the system is under stress following the era of low-for-long interest rates. 

Several strategies adopted to take advantage of that era are now proving ill-suited to the new environment. The strains are also a reminder of the tight monetary-fiscal-financial nexus, as the increase in government bond yields played a key role.

Looking ahead, two hazards stand out: persistent inflation and financial instability.

The next phase of disinflation is likely to be more difficult, as discussed in detail in Chapter I of the BIS Annual Economic Report. Mechanically, base effects are fading away. Substantively, inflation is increasingly driven by stickier components, particularly services, as the following chart shows.

The longer inflation lasts, the more likely it is that households and firms will adjust their behaviour and reinforce it.

There are widespread macro-financial vulnerabilities in the system. Private and public debt levels are historically high. Asset prices, notably those of real estate, have rich valuations. Interest rates may need to stay higher and for longer than financial markets are pricing in. The strains that have emerged so far reflect interest rate risk, but credit losses are still to come. 

Four major policy challenges deserve immediate attention. 

First, monetary policy needs to travel the last mile, bringing inflation back to target. Second, fiscal policy needs to support short-term stabilisation and ensure sustainability. Third, prudential and supervisory policies need to safeguard financial stability, thereby supporting the macroeconomic adjustment. 

Last but not least, policymakers need to wean growth away from excessive reliance on macro-stabilisation policies and bring monetary and fiscal policies firmly back into a "region of stability" (Chapter II of the report takes a closer look at this challenge).

The Tour de France might be underway, but as recent job data indicates, the nation’s economy is hardly racing ahead.

In economic forecasting, it’s practically impossible to predict the exact timing of a cyclical turning point, even if fundamental developments have been correctly analysed. However, the high-frequency data series we can analyse today suggest that a slowdown started in mid-May. 

Since then – according to Indeed, the online employment advertising platform – the volume of job adverts has started to decline more rapidly across all sectors. Most importantly, job postings for the construction sector are at their lowest in almost a year, as the following chart shows.

Furthermore, scores from the most highly regarded business surveys have continued to deteriorate in recent weeks. The economic tailwind from China anticipated at the start of the year is proving to be less pronounced, and that impacts the luxury-goods industry as well as hospitality. 

Finally, the continued tightening of monetary policy by the ECB is causing noticeable headwinds for industry. The “order intake” component of the purchasing managers’ index (PMI) for manufacturing fell to its lowest level for 2023 in June – not a good sign for the second half of the year. Meanwhile, PMI for the services sector also fell below the 50-point growth threshold in June.

Disinflation has been ongoing since last year. However, we keep hearing about scenarios of sticky inflation and high interest rates lasting for longer. The fact that inflation is most often reported on a year-on-year basis blurs the picture, given that base effects can be quite deceiving.  

To clarify the situation, we like to look into seasonally adjusted, annualised, three-month moving average, month-on-month inflation. That’s quite a mouthful, yet it’s simple.  

Usually, people focus on year-on-year figures, given the seasonality of month-on-month inflation. However, we can deal with that via seasonal adjustment. Then, we annualise the data to make it comparable with year-on-year figures. And finally, we use three-month moving averages because otherwise, the figure would still be too volatile.  

As a result, we have a gauge of inflation momentum that better reflects current pressures and is not distorted by any particular year-earlier comparison.  

Seen from that point of view – let’s call this measure “inflation momentum” – disinflation has come a long way in the US, as the next chart shows. (Follow the aquamarine line.)

Inflation momentum is not yet hovering around the 2 percent target, as was the case pre-pandemic; it’s still consistently above that threshold. But it is closer to the target than year-on-year figures suggest. The measure provides a glimpse of where inflation could be if the momentum is maintained over the next 12 months.

Inflation momentum in the eurozone remains somewhat higher than it is in the US, despite the weaker economy. But it’s also no longer that far from the 2 percent target. In the UK, however, inflation momentum remains very high.  

The same conclusions can be reached when looking at core inflation and other metrics, but we’ll keep it simple here.  

Using these same metrics, we can show that the disinflationary process is also very well-advanced across emerging markets. We show a selection of large EMs from each region in the chart below. Inflation momentum has been converging to national targets quite rapidly. (We chose a line at 3 percent to represent the modal target of the chart’s various countries.)  

In the case of central and eastern European countries (using Poland’s purple line as a proxy in this chart), inflation momentum suggests a rapid pace of disinflation is coming: from elevated double-digit rates, Poland will probably come very close to its 2.5 percent target next year.  

Brazil has the lowest inflation rate among Latin America’s large countries, coming in at 3.2 percent year on year in June. But this figure is flattered by base effects. The inflation momentum is around 4.4 percent, still far from the 3 percent mid-point of the inflation target range set for 2024. That may explain why the central bank has not rushed to cut its double-digit policy rate yet, despite the impressive progress on disinflation.

We can also use the inflation momentum metric to assess the level of real interest rates across many countries. Traditionally, 12-month inflation expectations are used to measure the level of ex-ante real interest rates, but inflation expectations aren’t available for all countries. And in many cases, what the different surveys measure is not the same across countries, making it difficult to make comparisons.  

Suppose we subtract inflation momentum (as defined above) from central bank policy rates. In that case, as the next chart shows, we find that the Fed has hiked rates significantly into positive territory, which is not the case for other developed-market central banks.  

That’s not to say that other central banks should hike as much as the Fed.  The neutral real rate is different in each country, and real rates can go up by a combination of nominal rates rising and/or inflation coming down. Moreover, if the economy decelerates, as consensus estimates predict, we should expect lower inflationary pressures – and therefore higher real rates – even if the Fed were to stay put.  

Moving back to EMs, it's not surprising that we find the highest real rates in Latin America, where central banks hiked rates earlier and more aggressively, starting in 2021. Perhaps less obvious is the fact that real rates increased meaningfully in the last two months, despite the unchanged policy rates, because month-on-month inflation rates were significantly lower.  

If the disinflationary momentum continues as expected, then real policy rates in the region will be too restrictive to be sustained – and rate cuts are likely to follow. This was already the case for smaller countries, such as the Dominican Republic, Costa Rica, and Uruguay. And it is likely to be the case in larger countries, beginning with Brazil, and possibly as early as next month.

Eastern Europe is another interesting region to look at from this angle. These nations faced the steepest inflationary pressures in 2022, probably due to their higher exposure to the gas, food and fertiliser price shocks that followed the Russia-Ukraine war. The velocity of the disinflation in Central and Eastern European countries is already evident in the year-on-year figures shown in the first graph.

This strong disinflation has translated into a very sudden increase in real interest rates. CEE nations had the most negative real rates globally, but now their positive real rates are second only to Latin America -- even though their central banks stopped hiking rates several months ago.  

In conclusion, global inflation figures provide an encouraging picture. The world has come a long way in the ongoing disinflationary process, and inflation may be a lot less sticky than some may fear.  

The effects of the monetary tightening central banks implemented to fight inflation are becoming more apparent – especially in the banking sector.  

There was the turmoil during the spring that saw the demise of US regional banks and Credit Suisse. But banks have also tightened their lending standards considerably, and demand for bank loans has declined significantly as well. This holds for both the US and the Eurozone, and is especially pronounced in business lending, as the next chart shows.  

The outlook for investment and, to a lesser extent, consumer spending, is therefore muted. This translates into a subdued economic outlook. The stagnation in the Eurozone that started during the winter is expected to continue, and the US economy is expected to stagnate as well.  

With growth rates hovering around zero over the coming quarters, there is an outsized chance of a mild (technical) recession in both economies. However, a large drop in economic activity seems unlikely.  

Both the US and the Eurozone benefit from strong labour markets, as the final chart shows. Unemployment is low, and employers are likely to be reluctant to let go of workers they struggled to hire. Furthermore, European households are set to see some purchasing-power gains due to the drop in energy prices and higher wage growth. In the corporate sector, strong balance sheets reduce the chances of a forced deleveraging.

These expectations imply that we believe central banks will be able to achieve a soft landing. This rests on the assumption that inflation will continue to fall. Consequently, we believe the main risk to our outlook is that disinflation stalls, leading to further rate hikes and a (deeper) recession.

We started 2023 with a mantra from Goethe: “Enjoy what you can, endure what you must.” After a roaring rally in equities and a much-improved showing from fixed income compared to 2022’s weakness, 2023 has been a year of far more enjoyment than enduring.

As we turn our attention to the second half of 2023 and beyond, we call upon another zinger from Goethe with his assertion that “few people have the imagination for reality.”

When we assess our expectations going into 2023, we had the imagination for a reality of a stronger U.S. economy compared to consensus estimates that were calling for an imminent recession.  

We expected this growth to keep upward pressure on both Fed policy tightening and interest rates. We thought this would create an environment that could be supportive for equity earnings, compared to dire forecasts for an earnings collapse, but present a headwind for equity valuations, as interest rates and tight policy kept a lid on multiple expansion, resulting in muted returns for equity indices.

Of course, 2023 has not experienced muted returns in major capitalization-weighted indices thus far, revealing where we have, instead, lacked the imagination for reality.

Instead of higher yields and tighterpolicy being a headwind for equities, other dynamics have mattered far more. Factors such as much-improved liquidity versus 2022 (despite continued policy tightening), highly concentrated performance, a positioning chase as investors were pulled from underweight to overweight equities, and a surge in optimism and fervour around the benefits of exciting technologies, have all contributed to surging valuations.

In fact, all the S&P 500’s 2023 gains have come from valuation expansion, while earnings have been a slight detractor from price gains.

Looking to the remainder of the year, we present the attached charts and analysis as a way to help us imagine various realities. At risk of oversimplifying a complicated market and economy, we summarize the views in the attached outlook as follows:

We expect:

• A stronger, more resilient economy than consensus expects, with low risk of a recession beginning in 2023, but watching closely for yet-to-be-seen cracks into 2024
• Tighter-for-longer Federal Reserve policy than what the bond market has currently priced into rates  
• Upward pressure on, or at least a floor under, interest rates as long as the U.S. economy remains resilient, with full-year fixed income returns continuing to be driven more by yield than price appreciation until yields begin to fall more substantially  
• Equity returns in 2H23 are lower than 1H23 after valuations have already re-rated to the high-end of prior ranges, positioning has normalized, and liquidity fades as a headwind, while upside to earnings estimates for 2023 is possible given better economic growth and near-term technical price momentum remains strong
• Continued, yet selective, opportunities within diverse alternative asset classes, as the disruptions from 2022 continue to weigh on and create opportunities in these asset classes.

There is always potential for surprise, both to the upside and the downside, which is why we encourage investors to employ a long-term perspective, mostly in times of great uncertainty. Controlling what you can in terms of maintaining a long-term strategic asset allocation and wealth strategy is critical. In this way, regardless of market vagaries, the goals of our imagination can become a reality.