Our “World in 2022” event last week outlined our macro and market views for the year ahead. You can find key takeaways here. Many of the questions from clients, however, centred on the risks to our forecasts and where we might be wrong.
This can be difficult terrain for economists. Global uncertainties mean there are lots of ways in which the most thoughtful and rigorous forecasts can be upset. What’s more, the pandemic has demonstrated how those shocks that have the biggest economic and market consequences can sometimes be non-economic in nature. One approach is to draft a long list of risks to central forecasts. This might provide economists with a “get out of jail free” card, but it is of little practical help to investors.
A better way to think about risks is to separate the economic from the non-economic, and to concentrate on events that have a reasonable probability of occurring and will have significant consequences if they do. Low probability events should only be given much airtime if they have very substantial macro or market consequences – and even then, it’s worth keeping in mind that they are difficult for investors to price accurately.
So where do the risks lie? On the non-economic front, there are several potential political flashpoints this year. If the French election in April delivers a right-wing populist president, then it would have significant political and market ramifications in the euro-zone. (Our base case remains that President Macron will be re-elected.) Elections are also due in Brazil, where the country’s institutions face their toughest challenge since the return to democracy in the 1980s. The risk of a contested vote there, as well as that of a sharp shift to the left, could trigger a sell-off in the country’s bond and equity markets, and weigh heavily on the real.
Geo-political risks are also building. The most immediate threat stems from the build-up of Russian troops on the border with Ukraine. A conflict here would be unlikely to have major ramifications for markets beyond Russia and Ukraine, but it would add to upward pressure on global energy prices and intensify inflation pressures in the rest of the world.
But the biggest non-economic risks to our forecasts stem from the evolution of the pandemic. This could cut both ways. Omicron has dangled the possibility that a much less deadly variant of the virus might emerge to become the dominant strain. This would pave the way for a swifter return to a more normal way of economic life, and would be positive for GDP growth, particularly in those economies where vaccination rates are still low. But it’s also possible that a more dangerous, vaccine-resistant variant emerges that requires the reimposition of tighter restrictions. This in turn would be a major drag on output.
Some of the most plausible downside pandemic risks centre on China, which is currently grappling with Omicron outbreaks. If the localised lockdown measures it has introduced over the past week don’t succeed in quashing Omicron’s spread, more of the country is likely to face severe restrictions. It is possible that these will have to be applied intermittently throughout the year. The zero-COVID approach may ultimately prove untenable, but China’s leadership is likely to double down on it until it is sure. The economic impact of widespread lockdowns in China would be felt beyond its borders – it wouldn’t take many port closures to send global supply chain strains back to new heights.
Turning to threats that are more economic in nature, China is again a key concern. We’ve assumed that policy support will help shore up property sales and put a floor under the construction slowdown around the middle of the year. Economic growth is likely to be weaker than most expect in 2022 (and beyond) but we’re not forecasting a collapse. But we may have misjudged the dent that developer defaults have put in homebuyer confidence. If sales continue to weaken, many more developers will be in deep trouble, along with their creditors in the bond market and among China’s banks.
However, it’s also easy to overdo the gloom. Upside risks to global growth exist too. A key one is that supply shortages ease more quickly than we’ve assumed. Our proprietary tracker suggests that product shortages are already starting to ease, and we expect this to continue over the course of this year. But it’s possible that supply-side constraints will lift more quickly than we expect, which in turn would remove one of the key factors underpinning our below-consensus GDP growth forecasts for 2022.
Amid all of this, however, the year’s biggest risks centre on the issue that has also consumed financial markets over the 12 months – inflation. We forecast that inflation will fall this year, but at a slower pace than most currently expect. If supply constraints in both product and labour markets were to ease more quickly than we anticipate, then it’s possible that inflation will fall more quickly too.
But markets should be more concerned with the risk that inflation proves more sticky than even we expect. Strong demand, tight labour markets, squeezed margins and stretched supply chains all suggest that the risks to inflation lie on the upside. So while headline rates of inflation are likely to fall everywhere in 2022 as goods inflation eases, it’s possible that underlying inflation actually becomes a bigger concern for central banks as we move through the year. The key thing to watch for is whether the rise in goods inflation last year now spills over into services inflation. As things stand, markets anticipate the Fed and the Bank of England to raise interest rates this year. It’s not inconceivable that, faced with evidence of broadening price pressures, the ECB is forced to join the tightening cycle too. (Global policy rate forecasts through 2023 are available on our Central Bank Hub).
Stepping back, when viewed against the long sweep of history, the most striking feature of today’s economy is the unusually low level of interest rates and bond yields. As we’ve argued before, 2022 is likely to be a year in which they start to move up. However, the biggest risk to the global economy, and indeed all asset prices, is that this happens more quickly and in a more disorderly fashion than markets currently anticipate. And the most likely reason why this might occur is that inflation moderates more slowly than central banks expect.
In case you missed it:
- Our Senior UK Economist, Ruth Gregory, argues that inflation won’t be the boon for the UK public finances that many assume.
- Our Senior US Economist, Andrew Hunter, explains what’s behind the recent surge in household employment.
- Our Latin America Economist, Nikhil Sanghani, looks at the prospects for a new deal between the IMF and Argentina.