Financial stability concerns back to the fore

A series of tailwinds that arose in late ’22 and helped the global economy get off to a strong start were overwhelmed by the mid-March failure of two large U.S. regional banks and the collapse of confidence in Credit Suisse. The events led the IMF to lower its global GDP growth forecast to 2.8% this year from 3.4% in 2022, with the potential for growth to decelerate further to 2.5% (which would represent the third-slowest outcome since 2001) if stress in the financial sector deepens.

The base case in our London office is still a mild recession in the U.S. in either the back half of this year or early ’24, spilling over to other advanced economies soon after. While March’s banking panic raised odds of a recession down the line, the swift and decisive policy response that followed averted more immediate and significant macroeconomic consequences. That said, recent events have changed the balance of risks to the downside as the banking stress adds to tightening financial conditions already underway due to 14 months of central bank rate hikes.

More generally, it is now clear that risks of accidents in financial markets have risen as the environment has shifted from extremely easy to somewhat restrictive monetary conditions. There is now awareness that something else could break, creating more episodes of stress in financial markets. This uncertainty is making for fragile sentiment and more volatile financial conditions, with the recent stress episode in the banking sector seemingly leaving a permanent mark.

Inflation remains top concern

Even as headline consumer price inflation has come down across major economies, largely due to lower energy prices, various prices gauges continue to run well above central bank targets. The composition of inflation is evolving in a concerning way, becoming more pervasive with core inflation proving increasingly sticky.

We still expect inflation to stay on its downward trend through 2024, abetted by lower commodity prices (and related base effects), further normalization of global supply chain disruptions and, later, the impact from slower demand. Even so, it is likely to end this year well above targets—at 3-3.5% in the U.S. and the eurozone, and 4.5% in the U.K. Whether it converges to target in 2024 depends on developments in economic activity and, crucially, labor markets. Year-to-date, labor markets remain tighter than expected, with buoyant wage inflation fuelling services inflation—the largest and most persistent component of inflation.

Did Covid permanently impair labor markets?

A key question is whether the Covid pandemic built on pre-existing negative demographic trends, resulting in a permanently impaired labor supply across advanced economies. The pandemic-related drop in labor supply initially was considered temporary, but participation in the U.S. and U.K. has yet to recover to pre-pandemic levels. Not true in the eurozone, where participation rates are now running above pre-Covid levels (though still below prevailing levels in the U.S. and the U.K.). There are, however, significant differences across EU countries.

Longer term, labor force growth prospects are uncertain in all advanced and middle-income economies as the population ages. While the pandemic marked a reversal in the post-global financial crisis trend of higher participation among 50+, cyclical (performance of the economy and financial markets) and structural factors (the need for sustainable public finances) likely will be bigger drivers of older-age labor participation in coming years. The pandemic showed that investment in human capital (education/lifetime training, health care) can enable people to work for longer.

The U.S.-China “Cold Tech War”

It is now a consensus view that the U.S. and China are in a de facto Cold Tech War, with the process of decoupling already underway in strategic sectors such as semiconductors. This decoupling is likely to become more pervasive over time, but slowly and, importantly, in a non-linear fashion as Western positions on China are mixed. The U.S. has focused, in a bipartisan way, on China’s containment for some time while leaders in Europe, which has stronger economic ties with China, have been more cautious and less coordinated. At the same time, China has doubled down on its self-reliance goals, increasingly focusing on the domestic developments of key technologies.

It is not clear that businesses will toe the political line as companies have been reluctant and opportunistic in reconsidering their supply chains. Indeed, Western businesses are keen to keep (or even increase) their access to the huge Chinese market, and will likely move reactively to new regulations, sanctions and incentives, making for a particularly drawn out and bumpy ride. A recent Brookings Institution paper investigating the current status of globalization concludes that while global trade, capital and labor flows have all slowed since the global financial crisis, there has yet to be a reversal of globalization.

What about “slowbalization?”

To be sure, Russia’s invasion of Ukraine sharpened the focus on onshoring and friend-shoring, but the Brookings study notes the U.S. has always shown a tendency toward trading with countries perceived as friendly. An IMF review of the impact of geoeconomic fragmentation found global direct investment already had shrunk from 3.3% of global GDP in the 2000s to 1.3% in 2018-2022, with investment increasingly concentrated in geopolitically aligned countries. Its model-based scenarios suggest foreign direct investment fragmentation could reduce global output by about 2% in the long term, with the effects being particularly pronounced for emerging economies.

Overall, our conclusions from last year’s 2023 outlook still hold. We think current geopolitical trends will likely weigh on future prospects for globalization, the main source of worldwide productivity gains in recent decades. While this “slowbalization” likely will develop gradually and opportunistically over the very long term, it does imply higher costs and efficiency losses, resulting in inflationary pressures and weighing on economic growth globally.