Global Macroeconomic Outlook

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Global Economy: Stagflation worries are growing 

Global Fixed Income team’s view as of 6/15/22.

U.S. Economy Slows Sharply

Several headwinds, including roaring inflation, rising interest rates, slowing corporate profits and supply chain constraints, continue to cloud the U.S. economic outlook. Additionally, the first quarter’s economic contraction combined with early-1980s-style inflation have ignited concerns about recession and stagflation. However, we remain optimistic that consumer demand will help support a modest rebound in growth. For the year overall, we expect the economy to grow at a much slower pace than in 2021.

Growth Is at Greater Risk in Europe

The eurozone economy barely expanded in early 2022, and the growth outlook remains weak as the war in Ukraine rages. Amid soaring energy prices, record-high inflation and muted economic growth, stagflation risks are rising. Similarly, growth is likely to weaken in the U.K., which is contending with surging energy costs and persistently high inflation.

COVID-19 Policies Are Stifling China’s Economy

China’s growth rate continued to slow amid the country’s zero-COVID policy, which led to lockdowns in key cities and a contraction in manufacturing. Policy stimulus, including more front-loaded special bond issuance, tax cuts, loan/interest payment deferrals and policy rate cuts, could support a subpar bounce back. In general, this scenario should support commodity exporters over commodity importing nations.

Inflation: Little price relief is in sight

Housing Costs Are Critical to U.S. CPI

In the near term, supply/demand imbalances, soaring energy prices and war in Ukraine likely will keep inflation high. We are seeing evidence of a shift from supply-driven inflation forces, which tend to be temporary, to demand-driven components, which are generally more lasting. Specifically, core goods prices appear to be moderating from multiyear highs, which may lead to lower manufacturing prices as supply chains improve. Meanwhile, the core services component of the Consumer Price Index (CPI), which accounts for more than 60% of CPI, is likely to rise amid growing wage pressures. Eventually, as supply chains improve, we expect annualized headline CPI to drift lower but remain notably higher than in recent years, partly due to growing demand for housing and other services.

Europe Faces Record Inflation as Energy Prices Soar

War in Ukraine and its effects on energy supply and food costs have led to record-high inflation in Europe. The European Central Bank (ECB) remains an outlier among its peers, keeping rates at 0%. Policymakers believe rate hikes will do little to curb inflation fueled by rising energy and food prices. Meanwhile, inflation in the U.K. recently hit a 40-year high, despite the Bank of England hiking rates several times since December 2021. Rising energy, housing and transportation costs primarily accounted for the U.K.’s elevated inflation rate.

China’s Inflation Rate Is Rising but Still Relatively Low

Inflation in China has accelerated but remains sharply lower than in developed markets and many other emerging markets (EM). Overall, emerging countries are more sensitive to food and energy costs, which constitute large portions of their inflation rates. We expect inflation expectations to remain elevated, driven by supply-side disruptions.

Monetary Policy: Central banks struggle to slow inflation

Weaker Economy Complicates Fed’s Mission

After misreading the inflation backdrop for nearly a year, the Fed faces a momentous task. Policymakers launched their inflation-fighting campaign amid an economic contraction—not the ideal conditions for raising rates. While recent data suggest the economy may improve in the second quarter, growth likely will remain weak. If policymakers raise rates too aggressively, they risk tipping the fragile economy into recession. But if they don’t act quickly to tighten the nation’s money supply, inflation may worsen. We believe the Fed views inflation as the greater threat and will continue to raise rates despite the market’s recession/stagflation worries.

Europe Slow to Tighten Policy

Unlike its peers, the ECB continues to pursue a gradual normalization of monetary policy, even with inflation sitting at a record high. Unlike the Fed, the ECB remains focused on promoting growth rather than taming inflation. Policymakers recently announced they will start raising the key lending rate, which remains at 0%, after ending their net asset purchases in early July. They also will launch a plan to protect the region’s weaker economies from higher borrowing costs. Meanwhile, the Bank of England continues to battle surging inflation, raising interest rates to a 13-year high despite a gloomy growth outlook.

China Takes Steps to Boost Growth

Promoting growth remains the main concern for the People’s Bank of China, as COVID-19 outbreaks stall output in key cities. Policymakers have focused on mortgage rates amid a sharp downturn in new bank loans. Looking ahead, the nation’s relatively low inflation rate provides room for the central bank to ease policy. Going forward, the key factors will be implementing fiscal and monetary easing and maintaining a zero-COVID policy. Elsewhere, many EM central banks have been aggressive in hiking rates to combat inflation.

Interest Rates: Rates continue to climb

U.S. Treasury Yields Head Higher

Treasury yields have increased steadily and sharply so far this year as investors have recalibrated their Fed rate-hike expectations. We still believe Treasury yields likely will move modestly higher amid continued Fed tightening and elevated inflation. It now appears the Fed’s short-term rate target may end the year at 3.25% to 3.50%. We expect the benchmark 10-year Treasury yield to settle near 3.5% in the next few months.

European Yields Continue to Rise

We expect European government bond yields to continue rising as inflation remains stubbornly high and the ECB starts lifting rates. However, rates in Germany and France likely will remain notably lower than their U.S. counterparts. U.K. rates are rising faster than their eurozone peers, while rates in Japan remain close to 0%.

Rates Are Higher in Emerging Markets

Interest rates in emerging markets generally remain higher than in developed markets. The real interest rate differential favors emerging markets, given elevated inflation rates in the U.S. and Europe. However, food and energy prices comprise a bigger portion of the inflation rate in emerging markets. So, if commodity prices remain high and supply-side disruptions continue, we prefer underweighting EM local bonds, even in a slowing global growth environment. We prefer countries with steep yield curves and proactive central banks, such as Indonesia, South Africa and Peru.

Q3 2022 Investment Outlook Resources

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