Capital Ideas^TM

Quarterly macro and market insights from Capital Group’s fixed income team

Global economic outlook dampens as challenges mount

• Stubbornly high inflation is forcing global central banks to take more decisive action, posing a headwind for growth
• Markets are underappreciating the time it may take for inflation to reach the US Federal Reserve (Fed)’s target range
• While our risk appetite is cautious in this environment, idiosyncratic opportunities remain as valuations cheapen

The combination of persistently high inflation, aggressive central banks and tightening financial conditions is weighing on financial markets and global growth outlooks. While valuations across many sectors look compelling after the market sell-off this year, we are exercising caution given greater uncertainty and elevated recession risk.

Inflation’s staying power is proving to be a global phenomenon. Countries across developed markets are in the throes of multi-decade highs in inflation rates, far exceeding central bank targets. In the US, the drivers of higher inflation have expanded beyond COVID-affected sectors, with acceleration in some areas. This underpins our view that markets are underappreciating the time it may take for inflation to normalise. The UK is contending with 40-year highs in inflation rates that are above 9%, pressuring cost-of-living for households. Similar trends of unrelenting inflation are also occurring in the eurozone, with wage pressures rising given higher costs and low unemployment. The Russia-Ukraine war has also pushed energy prices higher.

Central bankers are aggressively responding to inflationary pressures. The US Fed raised rates by 50 basis points (bps) in May before following with a 75 bps move in June, marking one of the most aggressive starts to a hiking cycle since 1994. Rising inflation expectations raised concerns among Fed officials that high inflation may become entrenched and this thinking contributed to the massive rate increase in June. Developed market central banks have begun or have indicated upcoming hiking cycles as well, to combat the speed of price gains. We expect the Fed to continue on its path given its heightened focus on inflation, even as concerns mount for a slowdown in global growth.

The US economy is showing signs of waning growth momentum. First-quarter gross domestic product (GDP) shrank at a 1.6% annualised pace as a sizeable trade deficit slashed growth figures.¹ Even so, high energy and food costs have hurt consumer sentiment. Manufacturing metrics have indicated a softening in business activity and soaring mortgage rates have cooled housing markets. While economic fundamentals remain solid, momentum is slowing and tighter monetary policy is likely to weaken demand.

1. Source: Business Standard

 

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