Last week, we discussed how 2023 will be a year of stagflation from a macroeconomic perspective. We discussed how the global slowdown, which will translate in outright recessions in several countries (a third of the global economy, according to the IMF) will be accompanied by still-high inflation. Inflation may fall for cyclical reasons (including the fall in energy prices recorded in the last few months), but will remain sticky and elevated for a series of structural reasons discussed in our 2023 Global Outlook and mentioned in our latest column. This week, we discuss the implications of this macroeconomic outlook for policy and markets. Regarding policy, we discuss fiscal and monetary policy in turn.
Fiscal policies will be inflationary in the next few years, including 2023, as governments will have to fight “wars” on at least five fronts. 1) Hot and cold wars lead to larger budget deficits that are eventually monetized and tend to cause higher inflation. 2) The war against global climate change will be very expensive as countries transitions to new form of energy consumption. 3) The war to prevent the next global pandemic will be very expensive ex ante or ex-post if we don’t prevent it and end up with another costly Covid-style pandemic. 4) The war to prevent social strife in face of rising inequality will be expensive as social spending, transfers and lower taxes for workers and left-behind households. 5) The tech war in which AI, robotics and automation will lead to job losses that require stronger social safety nets for those experiencing permanent tech or trade-related unemployment.
All these five “wars” over the next decade will lead to greater public spending, transfer and lower taxes for the those “left behind”, while the ability to raise taxes is constrained by politics and economics. Thus, higher budget deficits that will crowd out growth if financed with debt; and the eventual monetization of such deficits as a “debt trap” will force central banks to wimp out and blink.
Regarding monetary policy, with inflation much more persistent than central banks currently expect in 2023, central banks will have to either hike much more than they currently signal, thus triggering a more severe hard landing and financial markets distress; or they will need to blink and wimp out, in which case inflation expectations get de-anchored, price-wage spirals ensue and higher inflation persists. We believe that central banks will be pressured to stop tightening or even easing if there is a hard landing; and in presence of negative supply shocks and a wage-price spiral even a hard landing may not push inflation low enough towards target.
So monetary policy and fiscal policy risk being inconsistent one another, and this will cause plenty of headaches to policymakers. Additionally, central banks will face a dilemma of countering price instability (with higher rates) or financial instability (potentially, by continuing or resuming asset purchases).
What are the implications for markets? In our global outlook we discuss several scenarios, depending on how the macroeconomy and policy evolve. In a nutshell, in our baseline we expect equity prices to continue their descent, as inflation proves stickier than expected, and central banks are forced to keep rates high for longer. As a result, we also expect higher short- and long-term rates in all major jurisdictions. In the currency space, we expect the USD to weaken against its major currencies as their central banks catch up with the Fed in terms of policy tightening. As inflation remains elevated, and interest rates high, we expect alternative investments (private equity, crypto, real estate) to continue suffering. On the other hand, we expect digital infrastructure investments to continue doing well in coming years.
