A hard landing looks increasingly likely due to tightening financial conditions, the soaring US dollar, an energy crisis in Europe, and China’s weak economy.
Winter is coming to the northern hemisphere. With it arrives an energy crisis that will affect much of Europe as the ongoing war in Ukraine severely disrupts the region’s gas supplies. Interest rates in developed markets continue to rise, ushering Europe and increasingly the US towards recession. The US dollar continues to strengthen, draining capital from other regions, while the UK has nosedived into a gilt market accident on the back of unfunded tax cuts. Direct policy action to mitigate contagion from these developments is now becoming a reality. One potential bright spot is China, where the economic impact of zero-Covid policy and a struggling property sector may be mitigated by central bank and government support.
Fidelity’s latest Quarterly Outlook outlines the thoughts of our investment teams as they navigate these changing landscapes.
Three themes for Q4
Our Q4 Outlook highlights three key themes that we expect will dominate this quarter:
1. Soft, hard, or crash landing
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Hopes that the Federal Reserve (Fed) would soon pivot away from its tightening path have been quashed. In two consecutive meetings, the Fed hiked rates by 75bps and it has struck a consistently hawkish tone since the Jackson Hole Economic Symposium at the end of August. The Fed appears fully committed to getting inflation under control, even at the cost of significant demand destruction.
Nevertheless, economic data in the US is proving relatively resilient. The labour market is still healthy and inflation remains high. Our future activity trackers improved in August, and the US dollar continues to strengthen. We have pushed out our expectations for a hard landing in the US to mid-2023.
Recession in Europe, meanwhile, appears more imminent. The region faces a severe energy crisis that we estimate could lead to a 4-5 per cent hit to euro area GDP. High prices and threat of gas storage depletion are sapping consumer spending and hobbling industry. The European Central Bank (ECB) has hiked rates to 0.75 per cent, but the window for further tightening is closing quickly given the deteriorating outlook.
2. China – all eyes on the Party Congress
While Europe and the US wrestle with recession, Chinese policy is heading in a very different direction. China is continuing to loosen policy where most developed markets tighten, and it has room to go further still. Nevertheless, the country faces its own problems this winter. Its recovery from the economic downturn triggered by zero-Covid policy lockdowns has been mixed. Activity has improved, but recurring lockdowns and a worsening property crisis have left a dent in China’s economy. In response, China has ramped up both fiscal and monetary support. This support should improve the outlook for China as we head into Q4. We also expect Chinese earnings to improve, as companies begin to enjoy a post-Covid recovery and lower commodity prices.
We believe sentiment could improve further following October’s 20th party Congress. While President Xi is likely to retain all his leadership positions for an unprecedented third term, adjustments in other leadership ranks could offer clues for the forward path of economic policy and serve as a catalyst for a more progressive growth policy. Expectations heading into the Congress remain muted, meaning any positive news around leadership positions or zero-Covid policy could provide an immediate boost to sentiment.
3. From monetisation to fiscalisation
Europe faces a bleak winter. Much now depends on how governments, many of which face their own separate domestic challenges, will try to support households and businesses over a winter of severely elevated gas prices. The risk of fiscal largesse in an environment of high inflation and rates has been underscored by the UK, where radical changes brought in by new Prime Minister Liz Truss, triggered a collapse in sterling and sharp rise in gilt yields necessitating interventions by the Bank of England. The ECB meanwhile is trying to normalise monetary policy, despite the near certainty of recession across Europe.
At the same time, there are reasons not to be too pessimistic. Governments are likely to up their fiscal support for households, many of which still have a pot of lockdown-induced savings to draw upon (though these are dwindling fast). Confidence across the region might be at rock bottom but retail sales are holding up for now and unemployment remains low, though deterioration in hard data looks to be in the pipeline.
After last quarter’s “great reset”, a catalogue of unknowns clouds the outlook for the remainder of the year. Questions abound over central banks’ hiking paths across developed markets and where the tightening window appears to be closing for some, while pressure grows to separate monetary policy from liquidity provision. We don’t know yet how cold this winter will be, along with the knock-on implications on gas demand, nor how the current phase of global financial conditions tightening will impact future policy settings.
Specific regions pose their own questions. The UK government’s “mini” budget has left markets reeling, while the rest of Europe looks almost certain to land in recession. The picture in the US may be less bleak, though recession next year still looks likely. We will continue to monitor the situation in China, where a clear policy direction will only begin to emerge once October’s 20th Party Congress has passed, and similarly watch carefully for developments in Japan and the Bank of Japan’s yield curve control regime.
Originally published by Andrew McCaffery, Global Chief Investment Officer, Asset Management, Fidelity