Economic outlook: Recession risk and implications for emerging markets
Globally, inflation remains high and rising, becoming more persistent and affecting more markets. This has prompted monetary authorities to take a more hawkish stance, raising the likelihood of a technical recession in the near future. We believe emerging markets are particularly vulnerable to this round of quantitative tightening.
Persistent Inflation
Recent economic readings show limited progress in taming the pace of price increases, and inflation is broadening and becoming more entrenched. In the United States, CPI inflation eased to 8.3% in April from 8.5% in March before rebounding to a 40-year high of 8.6% in May. Meanwhile, a tight labour market is increasing wage pressure (see Figure 1). The emergence of price-wage spirals could render inflation more sticky and difficult to contain.
Figure 1: U.S. Wage Growth Tracker, %
Source: U.S. Federal Reserve Bank of Atlanta
Inflation in the euro area reached 8.1% in May, up from 7.4% in April, after energy prices rose by nearly 40% year-on-year. Meanwhile, pressures are building on wage-setting negotiations across the region, particularly in view of rising minimum wage rates and a 4.3% annual increase in Germany’s negotiated wages in the first quarter of this year. In China, retail price inflation was modest at 2.1% in May, but producer price inflation has surged to 6.4%. Overall, more countries have reported higher inflation over the past months.[1] Moreover, with global food, commodity and energy prices remaining elevated, price pressure is likely to persist.[2]
In response to rising inflation, monetary policies have turned hawkish. For example, on June 7, the Reserve Bank of Australia surprised the market with the most significant hike since early 2000, by 50 basis points (bps). In India, the Reserve Bank of India raised the policy repo rate on June 8 by 50 bps to 4.9%. Finally, on June 15, the U.S. Fed announced its biggest rate increase since 1994, by 75 bps. Since April 2022, 22 OECD or G20 countries have raised interest rates. None has opted to lower rates.
These actions show central banks prioritising fighting inflation, even at the expense of economic growth. It should be noted that tightening monetary policies and raising interest rates are best adopted to combat demand-pull inflation, i.e. when prices increase due to a rise in demand outstripping the availability of goods and services. However, currently, price pressures stem mainly from supply-side disruptions. Apart from unwinding supply-chain bottlenecks, demand destruction would be required to regain equilibrium, with commensurate recession risks. Here, we will focus on the risk of recession and the implications for emerging markets.
Recession Signals
Projecting recession is difficult, if not impossible, but some useful indicators exist. Here we will focus on the recession risk of the U.S., as a recession there will have domino effects on the rest of the world. Traditional leading economic indicators, including the Conference Board Leading Economic Indicator (LEI), are deemed accurate in the near term and up to nine months in advance.[3] The latest reading shows a 0.3% decrease in the LEI in April, after a marginal 0.1% increase in March (see Figure 2). Overall, the index is up 0.9% over the six months from October 2021 to April 2022, pointing to moderating growth in the near-term but not a recession.
Figure 2: Conference Board U.S. Leading Economic Index
Source: CEIC. Shaded areas represent recessions as determined by the NBER
The bond market is sending a similar signal that the U.S. is not in an imminent recession, but neither is it clear of such an outcome. The inversion of the U.S. yield curve, which started in early 2021, accelerated in late 2021 and temporary dipped into the negative territory in early April. The retreat of short-term rates in May/early June brought the yield curve back to positively sloping (see Figure 3). However, it should be noted that the yield curve predicts recessions up to two years. The recent jittery in the financial market upon the May inflation rate has flattened the yield curve tangibly again.
Figure 3: U.S. 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity, %
Source: U.S. Federal Reserve Bank of St. Louis
Other financial market indicators are less consistent in predicting recessions. For example, stock indexes plummeted in early 2022 (and again in mid-June) but are generally considered poor leading economic performance indicators.[4]
Inflationary Recession
In summary, the risk of a recession in the U.S. in the near term (within 6 months) is small though increasing. On the other hand, a recession in 2023 is now a high-risk factor to consider. Furthermore, recession risk in other major markets, mainly the UK and the Eurozone, is also rising. In its June update on the global economic outlook, the World Bank warned of “a protracted period of feeble growth and elevated inflation… [raising] the risk of stagflation, with potentially harmful consequences for middle- and low-income economies alike.”[5]
The Bank is pointing to testing times ahead, given a confluence of factors, including high energy and commodity prices, rising geopolitical tensions, the withdrawal of pandemic stimulus and rising debt burdens. The war in Ukraine will continue to pressure global food and energy prices, with more pressures filtering through later in the year as winter sets in and food inventories run low. Alongside further aggressive tightening by central banks, the financial condition will continue to deteriorate, leading to higher funding costs and dragging on economic growth. Comparison is often made with the 1970s, when interest rates rose steeply to contain inflation, thus triggering a deep global recession.[6] Similarities with prior periods when there was abundant market liquidity, growth was weak and emerging markets had become vulnerable are reflections of impending challenges.
Over the coming months, a muddling-through scenario will see inflation remaining stubbornly high and above the targets of central banks in major advanced markets and economic growth trending below potential levels.[7] As efforts to unwind supply bottlenecks progress, we can expect a gradual resumption to normalcy in terms of trade (barring any significant lockdowns in China). However, the tightening of financial conditions concurrent with rising unemployment and slowing consumption should achieve some “demand destruction”. This, coupled with well-anchored inflation expectations, would result in a soft landing for the global economy. Such an outcome broadly fits with the priority of monetary authorities to keep a lid on inflation while not suffocating growth. Alternatively, if economies and financial sectors react strongly to tightening monetary conditions, a global recession in 2023 will be highly likely.
Impacts on Emerging Markets
The vulnerability of emerging markets is one of the key messages from the June issue of the World Bank economic update. Indeed, the pandemic has done damage to emerging markets[8]. The disruption to global supply chains, international tourism almost disappearing, the rising cost of food and energy, and volatile capital flows are all adding to the challenges facing policymakers in emerging markets. The average ratio of public debts to GDP in emerging markets has risen to a record level of 67% in 2021, from about 52% before the pandemic.[9] Many emerging markets are now facing higher import bills, tightening financial conditions, currency depreciation, limited fiscal space and weakening economic growth.
As of March 9, 2022, the IMF provided financial assistance to 90 emerging and developing markets globally through different relief plans and facilities.[10] Most of the beneficiaries are located in Africa, but many are also found in Latin America and the Middle East. Despite these assistances, a number of major emerging markets have declared default recently, including Argentina and Sri Lanka. Indeed, the World Bank has projected in March that “over the next 12 months, as many as a dozen developing economies could prove unable to service their debt“.[11]
Are we facing a wave of debt crises in emerging markets? There are reasons to be concerned:
- A strong U.S. dollar – while the U.S. Fed has embarked on aggressive tightening, many emerging markets are still not ready to compensate with similar rate increases, thus leading to weakening local currencies. This could make the servicing of U.S. dollar-based external debts more demanding. Also, import bills will increase as far as imports are denominated in the U.S. dollar.
- The outlook for food/energy/commodity importers is gloomier, given the recent rises in international food/energy/commodity prices.
- External borrowing costs are rising, and servicing and rolling over existing debt will be harder for those already highly indebted.
- The weakening growth of developed markets could threaten exports from emerging markets, reducing their current account surpluses and forex reserves.
On the other hand, it should be noted that many emerging markets are still maintaining sufficient forex reserves due to (so far) favourable current account balances, IMF SDR allocation in August 2021, and other precautionary arrangements, including swap lines with central banks of advanced economies. Nonetheless, the benefits of these considerations are not evenly shared by all emerging markets. With rising interest rates globally taking hold in the second half of 2022, debt financing and capital flow into emerging and developing markets will likely see tangible deterioration. This could set the stage for more financial and debt crises in 2023. Efforts will be needed now to better tackle debt resolution and debt relief for these markets, particularly among G20 economies.
Conclusion
Coming off a strong rebound in 2021, global economic growth is heading south at different speeds. The risk of recessions in major economies is rising partly due to tightening monetary conditions. While there is a low probability of recession in the near term (3-6 months), the risk remains elevated over a longer period. Emerging markets collectively will be in a difficult position given the worsening global financial conditions, a strong U.S. dollar, limited fiscal space and rising international commodity and energy prices. However, energy/commodity/food producers and exporters are likely to fare better. Overall, we expect a global economic slowdown in this year and the next, but not in a way that fits the classic definition of stagflation, nor synchronised recession across multiple major economies. Financial stresses will mainly be manifested in increasing debt stresses on emerging markets, leading to more defaults and restructuring.
[1] See Global Inflation Tracker, Financial Time.
[2] While the FAO Food Price Index eased 0.6% in May from April, it was still 22.8% higher than in May 2021. Brent crude spot rate stayed high at USD131.14 (6 June 2022).
[3] See David Kelley, “Which Leading Indicators Have Done Better at Signaling Past Recessions?” Chicago Fed Letter, No. 425, 2019, Federal Reserve Bank of Chicago.
[4] If you are interested in some unconventional recession indicators, check this out.
[5] Source: “Stagflation Risk Rises Amid Sharp Slowdown in Growth”, June 07, 2022, The World Bank.
[6] The U.S. Federal Reserve board raised rate from an average of 11.2% in 1979 to a peak of 20% in June 1981, which is widely believed to have contributed to the 1980-1982 economic recession in the U.S.
[7] This does not preclude periods of “technical recession” but those will be temporary and reflecting idiosyncratic and cyclical, rather than structural, factors. Technical recession is defined as two consecutive quarters of negative GDP growth.
[8] See my earlier article on post-pandemic outlook for emerging markets.
[9] Source: Global Financial Stability Report, April 2022, IMF.
[10] “Total Financial Assistance for 90 Countries: SDR 122,642.5 million /US$ 170,570.29 million”, IMF.
[11] Source: Marcello Estevao, “Are we ready for the coming spate of debt crises?”, World Bank Blogs, March 28, 2022.
