The US is at risk of another economic recession.

The gloom that pervades the economic and financial market outlook seemingly knows no bounds. The IMF’s recently released forecasts pin advanced country growth at just 1.1% in 2023. Inflation will come down but could take at least until 2024 to get back to the 2% level most advancedcounty central banks are targeting.

Europe will be the epicentre of this weakness given the extent of the hit to growth from surging gas prices and reduced gas supplies following Russia- Ukraine conflict. Energy blackouts this winter seem very possible and, even without that, much of Europe will be in recession over the winter period.

Central banks are tightening monetary policy to bring demand down to the reduced supply we have seen since Covid-19 pandemic ravaged supply lines. The good news is that supply chain pressure is easing and measures of global costs, such as shipping charges, are falling. But as much as these factors will help moderate inflationary pressure, there are other headwinds, such as the tightness of labour markets in developed countries, that will make inflation reduction a long slog.

The IMF suggests that advanced country CPI inflation will fall from 7.2% this year to 4.4% next year. Mr. Jeremy Stevens, Asia Economist at the Standard Bank views this forecast as likely a shade too optimistic.

“What we have on our hands is undoubtedly an economic crisis created primarily by a pandemic crisis and then a military catastrophe. It has been exacerbated by central banks that were too slow to tighten monetary policy, particularly the Fed. The question now is whether this economic crisis becomes a financial crisis. So far, while asset prices have plummeted, there have been no widespread liquidity and funding strains in financial markets. Many of the repair mechanisms developed by policymakers since the global financial crisis appear to have worked, such as central bank liquidity swaps, and new instruments have been developed recently to cope with the risk of new strains, such as the ECB’s anti-fragmentation tool for the bond market”, said Mr. Jeremy Stevens.

Despite these successes, we can’t help but feel that the world is hanging on the edge here. Already, some liquidity strains have emerged, as we saw with the implosion of the UK gilt market in late September. This might have been a reaction to bad policymaking by the government but the extent of the collapse in gilt prices reveals a soft underbelly to the market. This could prove a one-off.

Alternatively, it might be the first sign of much wider financial strains, just as we saw back in 2007 when the difficulties of certain lenders first alerted us to the difficulties created by sub-prime mortgages in the US. Today, it is seemingly harder to pin down a particular sector that’s vulnerable, unlike the 2008 crisis.

However, we can’t forget that it spurred a surge in global central bank liquidity that has become so central to the fabric of the financial system that its removal would cause untold upheaval.

In short, a stagflationary debt crisis, which is the worst of all possible outcomes, is not off the radar screen. This might not be our base case but asset prices look set to flounder until this risk has been removed. On the flipside, such economic and asset price destruction should mean that, when central banks are in a position to ease, which might not be until 2024, they will likely do so with more gusto than is priced into the market right now. Continued asset price weakness would play into the hands of a stronger dollar and clearly if this economic crisis morphs into a financial crisis, the rally could clearly accelerate.

“Any turnaround for the dollar would have to await stability/recovery in asset prices, for the reasons stated on the next page – and we don’t see that for another 3-6 months at least. Should the dollar not turn “naturally” as asset prices recover, we’d expect coordinated intervention from the major central banks to weaken the dollar. For without recourse to quantitative easing or rate cuts to ease financial strains, the central banks may have to try to lower the dollar to ease pressure – not just advanced countries but emerging market countries as well”, said Mr. Jeremy Stevens.