We’ve spent a long time arguing that the global economy faces a more difficult outlook than most expect. The consensus is now moving towards our view as evidence of weakness mounts. But, amid the pervasive gloom, it’s worth noting that the three largest economic blocs – the US, euro-zone and China – face challenges that are very different in nature and scale. This has important implications for the size and duration of their downturns – and for the extent of their recoveries.
As it happens, the turmoil in US financial markets over the past month stands in contrast to the strength of the latest hard activity data from the US. We expect that tighter monetary conditions will eventually cause growth to slow over the second half of this year, but this slowdown is likely to be concentrated in the most rate-sensitive areas of the economy. This includes durable goods, business equipment investment and, most notably, housing. Indeed, the increase in mortgage rates over the past couple of months is already consistent with a sharp fall in mortgage applications. (See Chart 1.)
Chart 1: US Mortgage Applications and Mortgage Interest Rates
Sources: Refinitiv, Capital Economics
Admittedly, interest rate-sensitive expenditure by consumers and businesses has declined as a share of GDP over the past decade (see Chart 2), and household balance sheets remain in good shape. We therefore expect the economy as a whole to skirt recession. But the US economy is nonetheless likely to slow as the Federal Reserve continues to tighten, and we anticipate a period of below-trend growth over the second half of this year and into 2023.
Chart 2: Interest Rate-Sensitive Expenditure in US (% of GDP)
Sources: Refinitiv, Capital Economics
By the same token, however, the slowdown in the US is likely to be relatively mild compared to other advanced economies. Those in Europe are facing much larger headwinds. This is due in part to the fact that Europe’s economic ties to Russia are deeper than those of the US. But another key difference is that, while the US is no longer a large net importer of energy, the euro-zone is. Accordingly, it has experienced a severe deterioration in its terms of trade as global energy prices have surged. (See Chart 3.) Put another way, the price of its imports has increased sharply compared to the price of its exports, meaning that the economy as a whole is worse off.
Chart 3: US and Euro-zone Terms of Trade (2020 = 100)
Sources: Refinitiv, Capital Economics
As I argued last week, this means a much larger squeeze on real household incomes in the euro-zone. The latest survey data suggest that the region’s economy is holding up a bit better than we had anticipated, but consumer spending is nonetheless likely to contract across most of the region over the next quarter or so. This will pose a major challenge to policymakers: should they focus on providing support to the real economy or reining in inflation?
In truth, there’s little that monetary policy can do to mitigate the effects of such a large terms of trade shock and, with core price pressures now building, policymakers must focus on bringing inflation to heel. As we discussed in a client drop-in last week, the European Central Bank will not have to tighten by as much as the Fed. But just getting policy back to a more neutral setting will add to the headwinds facing households and business in the euro-zone.
If the situation facing European policymakers is challenging, China’s problems are even more complex. Most immediately, efforts to quash the continuing Omicron outbreak have resulted in tightened restrictions across some of the country’s biggest and most economically-important cities. Chinese Premier Li Keqiang in a meeting last week warned officials about signs of contraction in May, urging them to ensure that the economy grows in the second quarter.
China is also facing mounting cyclical headwinds. While its recovery from the first wave of COVID in early 2020 was aided by a surge in construction activity, property developers are now struggling to finance existing projects. They won’t launch new ones until there has been a marked pick-up in sales. China’s recovery two years ago was also underpinned by a surge in global demand for consumer goods that benefitted local producers. But this too is fading as global spending on services rebounds. China’s goods exports are more likely to fall than rise further over the rest of this year.
Finally, beyond these near-term problems, China’s structural economic problems are deepening as many of the long-term challenges that we have spent the past decade warning about come into sharper focus.
Economic activity is likely to rebound in the third quarter as the government gets on top of Omicron and lockdowns are lifted. The package of policy support measures announced last week will also help the recovery, although this too was small by past standards. The rebound, when it comes, is likely to stand in contrast to weakness in the US and euro-zone and could be interpreted as evidence of the relative health of China’s economy. This would be the wrong take: China’s recovery from Omicron is likely to be muted compared to previous downturns and GDP will remain on a weaker track post-COVID.
Clouds are gathering over the global economy. But compared to other major economies, particularly the US, China’s economic problems look more intractable.
In case you missed it:
With reference to our US Recession Trackers, Senior US Economist Michael Pearce explained why we see only a very low risk of recession in the coming 12 months.
Our Europe team explored the chances of a July 50-basis point rate hike – and the ECB’s options in the event that spreads blow out.
Chief UK Economist Paul Dales discussed Rishi Sunak’s fiscal support measures and their implications for the Bank of England.