Thawing growth prospects amid milder European winter…

Since we last published the Global in November the economic outlook has evolved again. One element of this is the abruptness of the relaxation of China’s zero-Covid policy. This presents opportunities for the global economy, such as through the easing of supply chain disruptions. However, the sharp U-turn does come with risks, some of which have already materialised: the unlocking resulted in a mass surge in Covid-19 cases, leaving streets deserted. The ‘ripping of the band-aid’ approach has however resulted in activity in the major cities having rebounded as quickly as it fell (Chart 1), limiting sustained economic pressures. The next test is the Lunar New Year holiday, which may well cause mass urban-to-rural Covid transmission.

Chart 1: Chinese activity now recovering in post-zero Covid policy era

Sources: Investec, Macrobond

While Beijing had started to dismantle its Covid restrictions last November, we have been taken by surprise by how quickly this has unfolded. Bearing in mind the anecdotal signs of an upturn in activity and reports that up to 80%-90% of the population has already gained Covid immunity through infection, we have upgraded our view of GDP. Talk of further monetary and fiscal stimulus has also helped, including a special bond quota*. Our 2023 China forecast is now 0.5%pts higher at 4.9%. But downside risks remain. The economy still faces fundamental stresses from the housing market and an ageing population.

Furthermore, slower momentum in the global economy, as indicated by Taiwanese new export orders, is likely to constrain China’s economic recovery. Indeed although we, in common with international institutions, are more optimistic on the global growth outlook, upgrading our forecast by 0.2%pts to 2.4%, we still believe that we face a challenging year. Geopolitical tensions remain rife, with no obvious endpoint in sight to the Russia-Ukraine war, whilst China-Taiwan tensions are still firmly on the radar. Meanwhile, the lagged effect of a higher interest rate world is likely to take its toll on economic momentum this year. We are more optimistic about 2024, however, looking for global growth of 2.9%.

Chart 2: Investec global growth forecasts – upgrade from a low base (2023 change in brackets)

Note: Brackets represent difference from November forecasts
Sources: Investec, Macrobond

Much of the economic outlook also depends on the scale of additional tightening however, which in itself hinges on the inflation outlook. News on this has been more encouraging as of late, with headline inflation falling in many of the major economies, albeit from an extremely high base. Greater spare capacity should help inflationary pressures to ease across 2023, but there are risks. Firstly, the additional demand stemming from the reopening of China threatens to keep energy prices higher for longer and secondly, for now at least, services price inflation continues to rise. Central banks have greater influence over services inflation, as it is less directly impacted by supply chain disruptions and higher commodity costs. As such, further rises in services inflation may add pressure on central banks to continue tightening for longer. Our base case however is that many of the major central banks are in the final stages of the fight against inflationary pressures. We believe that globally the tightening bias is starting to come to an end with many central banks heading to a pause. With policy stances restrictive, a lower inflation profile and a weak economic backdrop, we still see a need for rate cuts from the Fed and the BoE later this year.

Although markets now concur that the Fed will cut rates this year, it appears that the jury is still out on potential BoE easing (Chart 3). But in all, markets seem to be preparing for a break from monetary tightening, which seems to be supporting risk assets, particularly equities after a tough 2022. In FX markets, we expect that narrowing interest rate differentials will continue to weigh on the dollar, particularly against the euro, resulting in the safe-haven currency losing some of its shine in 2023. Meanwhile, in sovereign bond markets, we envisage that yields will move lower still as less restrictive monetary policy comes further into view.

Chart 3: Interest rate expectations were a key driver of markets over 2022. This year too?

Sources: Investec, Macrobond

CPI inflation fell again in December, the core measure easing to a 1-year low of 5.7%. The main policy related question is whether inflation is set to fall towards the Fed’s 2% objective. Contrary to the overall trend, shelter costs (rents and owners’ equivalent rent) shot up through 2022, hitting a year-on-year increase of 7.5% in December. With a weight of 42% in the core CPI basket and 17% in the Fed’s preferred core PCE measure, rent trends matter. Data from Zillow show that new rental rates have declined sharply and Chart 4 shows average rents tend to track them. A fall has yet to occur, but when it does it should contribute to a material decline in inflation over 2023.

Chart 4: The CPI rental component should weaken soon…

Sources: Investec, Macrobond

But even against this background, the FOMC has become still more concerned over the labour market. It did break its pattern of three successive 75bps hikes in the Fed funds target with a 50bp move (to 4.25-4.50%) in December. But the committee’s tone was unequivocally hawkish. Members raised their core PCE projections for 2022-2024 and their views of the policy rate by 0.25%-0.50% over 2023-2025 (Chart 5). A key factor was a gloomy assessment of the labour market – the FOMC no longer assumes that the participation rate will recover to pre-pandemic levels, thus worsening the trade-off between unemployment and wage (and therefore) price inflation.

Chart 5: The FOMC raised its projections of the policy rate in December…

Notes: Dots represents individual FOMC views on rates. Red dots from Sep projections, blue from Dec.
Source: Investec 

Meanwhile December’s payrolls rose by 223k, the 11th month out of 12 of consensus outperformance, while U3 unemployment fell back to its pre-pandemic low of 3.5%. But in the context of labour supply, the participation rate rose by 0.2% to 62.3%, the joint second highest rate since the Covid trough. This included an 0.2%pt increase for those over 55-years old, encouraging in the context that this age group has seen participation fall by 1.4%pts from pre-Covid levels. Note too that the other age category experiencing a sharp drop in participation has been 20-24 year olds, possibly because of a rise in student numbers. These individuals may be expected to enter the labour force in due course. In short, the Fed’s labour supply assumptions may be too pessimistic.

While we are not convinced by the Fed’s participation rate U-turn, the FOMC seems set to be guided by it for now. We have therefore pencilled in a 25bp hike in Mar as well as in Feb, taking the Fed funds range to 4.75%-5.00%. Little has changed to alter our view of a mild recession in H2 and with inflation easing, we still look for two 25bps cuts in Q4 this year, as well as 125bps of easing next. At end-2024 the target range would stand at 2.50%-2.75%, a level the Fed broadly considers to be neutral. The forward curve meanwhile has flattened aggressively recently (Chart 6) and is now reasonably consistent with our view, including Fed easing from later this year.

Chart 6: The yield curve now also expects the Fed funds target range to fall this year…

Source: Investec, Macrobond

Fed Chair Powell has pushed back hard against arguments for rate cuts this year. A reason cited is that the Fed eased too early in past cycles, leading to still greater inflation problems later on. This was certainly true in the 1970s. But an 8-month gap between the final hike and the first cut, as we expect, is typical of rate cycles since the ‘90s. Also underpinning the Fed’s hawkish narrative is that the market pricing of lower rates loosens monetary conditions. As the December FOMC minutes stated, ‘an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee's reaction function, would complicate the Committee's effort to restore price stability’.

On 19 Jan, Treasury Secretary Yellen announced that the $31.4trn debt ceiling had been reached and that extraordinary measures were being deployed to stave off a breach for a few months. The US has been here before. But a defining feature this time may be that the Republicans have narrow control of the House of Representatives. The House GOP seems remarkably dysfunctional – it took 15 voting rounds to elect Kevin McCarthy as the new Speaker. Accordingly, fears are that the path to a resolution could be more painful than in 2011, when the US came within two days of default. We still see 10y US Treasury yields falling back to 3% by end-year, but the path could be a rocky one, as it might also be for the dollar and equities.

1 January 2023 marked another milestone for the Euro area, Croatia becoming its 20th member. Clearly from a political perspective it will be seen as a win for European cohesion, against recent years where Euroscepticism had raised its head on occasion. From a macro perspective Croatia’s economic performance has been robust over 2022, on our forecasts having grown by 6.4% and only surpassed by Ireland, Portugal and Malta. However in broader terms its Euro area membership will not alter the growth dynamics of the EU20 given Croatia’s weight of just 0.5%. The broader EU20 story is a better-than-expected performance over the winter period owing in part to a less tense energy backdrop, where mild temperatures in late 2022 have helped to maintain high gas storage levels: German storage stands at 89%. Despite the more positive tone we are mindful not to rush into broad forecast upgrades for this year given the headwinds to growth. Energy remains a risk next winter, despite the current relief. Meanwhile our revised ECB terminal rate forecast is 100bps higher than previously, which will drag on demand. As such we still expect a recession this year, although our forecast for the calendar year 2023 is revised up to +0.1% from -0.1%. We do however expect a recovery in 2024, with GDP growth forecast at +0.9%.

Chart 7: Croatia was the 4th fastest growing country ahead of its Euro area membership

Source: Investec, Macrobond

The ECB’s December projections show an acceleration of growth in H2 ‘23, which we believe is too optimistic. Nonetheless it was these forecasts that framed December’s press conference, which was one of the most hawkish in memory. Clearly inflation remains the key concern. President Lagarde argued that even with a rate profile which saw rates rising to 3%, inflation was still forecast above target until H2 2025 - hence additional tightening was needed. We continue to believe the ECB is too bearish on inflation and too optimistic on growth and that data will persuade it to ease back on the 150bps worth of hikes intimated by Lagarde and to ultimately settle for two further 50bp Deposit rate hikes in Feb and March followed by a 25bp rise in May to reach a peak of 3.25%. A recent press report had suggested some members of the ECB had softened their views and were considering a 25bp hike in March. We find it difficult to square this with the clearly very hawkish tone in December, where the subsequent account revealed that a large number had wanted a 75bps move. Price data has also failed to provide convincing signs that inflation is moderating. Headline HICP may have edged lower to 9.2% in Dec, but the core measures made for uncomfortable reading, reaching new record highs. For example, ex food, energy, alcohol & tobacco inflation hit 5.2 %.

Besides interest rates there are wider ECB policy considerations for the year. Liquidity will be one given the voluntary TLTRO-III repayment windows. €1.1bn of the €2.3trn initially borrowed has been repaid and by the end of this year we expect just €180bn to be outstanding. This may feed into the ECB policy framework review scheduled for Q4. No details have been given, but one issue the ECB may be considering is if/when it might return to normal operations with the refi rate once again the primary rate. This may be a goal but reducing excess liquidity to a sufficiently low level to allow the refi to control market rates is problematic in the short-term. For example a full repayment of TLTRO would cut this to €3bn, a level which is still too high. QT will also play a part albeit slowly. We expect 2023 to see the pace of QT roll-off ramp up to 100% of redemptions in Q4, which would see the ECB’s holdings shrink €200bn. This plays a part in our uprated 10yr Bund yield forecasts which now stand at 2.00% for Q4 2023. Crucially the end of QE and the start of QT represents a shift in bond market dynamics that should keep pressure on yields given the major buyer of EU20 sovereign bonds is shrinking its balance sheet at a time when government issuance is rising, leaving the private sector to absorb a net €600bn* of extra supply this year. Our revised ECB view is not only a factor in our yield forecast change, but also in FX where we have nudged up our €:$ forecast to $1.12 in Q4-23 and expect a further rise in 2024, to $1.18.

Chart 8: Euro expected to make gains against both the USD and GBP over the next 2 years

* medium and long term debt and adjusted for forecast €160bn PSPP QT
Source: Macrobond, Investec 

Inflation, and the cost-of-living crisis it has triggered, continues to be the main worry in the UK. There is, finally, growing confidence that inflation will fall markedly over this year. Partly that reflects easing supply chain disruptions. Non-energy industrial goods price inflation has already fallen from 8.0% in Apr ’22 to 5.8% in Dec; the end of zero-Covid policy in China stands to accelerate this. Most importantly, UK wholesale gas futures prices have plunged as European storage levels have stayed high with mild weather and lower demand (Chart 9). Indeed, if futures prices prove accurate, consumers may see average energy bills even below the current EPG level of £2,500 in H2, as per our Utilities team.

Chart 9: The UK natural gas curve is broadly back to where it was at the May ‘22 MPC meeting

Note: 2022 dates chosen are those on which MPC policy decisions were announced and Monetary Policy Reports published
Sources: Bloomberg, Macrobond and Investec

Heightened optimism, however, does not carry through to prospects for core inflation. There is no sign of demand plunging steeply relative to supply: the latest GDP data make it a borderline call whether the economy was in recession in H2 2022. Conditions in the labour market also remain very tight. Vacancies, for example, have slipped but still almost match the number of unemployed. The risk has, if anything, risen that employees secure wage settlements that exceed productivity gains, fuelling costs for firms, some of which are passed onto consumers. This limits the fall in our inflation forecast. Our 2023/24 CPI forecasts are 6.3% & 1.0% (headline) and 4.8% & 2.0% (core) (Chart 10).

Chart 10: From later this year, utility prices may subtract from, not add to, UK inflation

Sources: ONS, Macrobond and Investec

Viewed through the lens of the MPC, it must be of some concern that its message that adverse consequences of the terms of trade shock on aggregate incomes cannot be avoided is yet to cut through. Further strikes on the day before its policy decision is announced could sharpen their resolve and keep the pace of tightening at 50bps on 2 Feb. But on balance we expect the MPC to deliver only a 25bp rate hike. After all, the committee will be mindful that cumulative rate hikes, even ahead of the upcoming meeting, have been faster than in recent tightening cycles. Over time, this stands to weigh on inflation, via its negative impact on economic activity.

The channels for this are, first, that corporate funding costs are much higher, which, along with uncertainty about future energy costs, disincentivises investment. Other effects relate to housing. Although down from their post-‘mini’ Budget peak, mortgage rates are still far above their levels in recent years. Without income growth to match, affordability of house purchases has thus reduced. Diminished appetite for moving home lowers associated purchases of goods and services. And those refinancing existing mortgages – over 1.4m households this year – will see their spending power on other items fall. As a result, we continue to expect weak GDP outturns this year. Our forecasts are for output falls in Q1-Q3 2023, giving annual full-year growth of -1.0%. A further, if still relatively modest, negative factor factored in over the near term are strikes, which have become increasingly widespread. But we do see recovery coming in 2024, pencilling in growth of +1.0%. One factor why is that we think the improved inflation outlook will allow the MPC to start cutting rates again from Sep ’23 onwards. Over time, we also expect Europe’s energy crisis to be resolved as new long-term supplies to replace Russia’s are secured – gas, but also non-fossil fuels. This will lower costs and boost confidence for firms and households alike.

Sterling has made faster progress than we had expected against the FX levels we had previously anticipated to be reached by the end of this year. We are cautious about further gains over 2023, especially against EUR: markets are pricing in about as many rate cuts in the UK by the end of this year as in the EU20, but we see the MPC going further and faster than the ECB Governing Council once, eventually, rate cuts come back onto the agenda. Hence we have nudged our EURGBP forecast up to 90p for end-’23, expecting no change by end-’24. Against the backdrop of a weaker USD, Cable could however keep rising, to 1.25 by end’-’23 and 1.31 by end-’24.

Chart 11: We see more scope for GBP appreciation against USD than against EUR

Sources: Macrobond and Investec