The emergence of new Euro zone risks

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Lately, analysts have noted the emergence of new risks to a global recession and new Euro zone risks saying they are more elevated now than two months ago.

The global picture has grown more challenging certainly with the new omicron waves in China that is proving to be more disruptive than anticipated.

The Institute of International Finance says the sense was that the war in Ukraine would take a considerable toll via elevated uncertainty, which would weigh both on firms and their investment decisions as well as consumer spending.

“This has been playing out, with forward-looking soft data like the IFO expectations component falling sharply. Since that forecast change, the global picture has grown more challenging.

The Omicron wave in China is more disruptive than we anticipated and – in our estimation – will take a substantial toll on growth. Separately, US financial conditions are tightening in a disorderly fashion, with the rise in long-term real rates now comparable to the 2013 taper tantrum.

“The confluence of these shocks threatens global recession. We are downgrading global growth significantly, such that we see a de facto flatlining in world GDP in 2022. That leaves little room to avoid an outright GDP contraction. Recession risk is elevated,” it says in its latest statement.

Euro zone uncertainties

IIF cut Euro zone growth in 2022 from 3.0 to 1.0 percent almost two months ago. Because the statistical carry-over from 2021 into this year is 1.9 percent, this is a recession forecast that anticipates falling GDP in the second half of the year.

Forward-looking indicators like the IFO expectations component have fallen sharply (Exhibit 1), which – unfortunately – suggest the Euro zone economy is deteriorating in line with our view.

“Since we made this change, the Omicron wave in China looks worse than expected, which signals GDP contraction in the second quarter, with high frequency soft data already pointing that way (Exhibit 2).”

US matters

Furthermore, a disorderly tightening in US financial conditions is playing out, with the rise in real long-term US interest rates now comparable to the 2013 taper tantrum.

This rapid tightening in US financial conditions risks further destabilizing the global growth picture, which is already teetering from Russia’s invasion of Ukraine and Omicron in China.

“We are sharply revising down our 2022 growth forecast given these headwinds, such that – adjusting for statistical carryover – the world is essentially flatlining this year (Exhibit 3). Weakness radiates out from Russia and Ukraine, where GDP is literally collapsing, while the rest of the world trudges along at very low growth once we take out the carryover (Exhibit 4),” it says.

Relative to Bloomberg consensus and the IMF’s latest forecasts, IIF’s growth downgrades are most notable for the Euro zone, Eastern Europe, and China.

The rest of the world is impacted less adversely, given positive terms of trade effects – especially in commodity-exporting Latin America – and given less critical trade links to Russia and Ukraine (Exhibit 5).

Effects of the recession

“Risks to our forecast are tilted to the downside because markets are taking an increasingly dim view of central bank policy normalization.

“We have some sympathy for this in the Euro zone, given that recession will likely limit second-round effects from supply shocks. In the Euro zone, markets are lodging their protest by widening periphery bond spreads over German Bunds, while something similar is playing out in the US with the stock market sell-off.

“Either way, a disorderly tightening in financial conditions is underway, which further increases recession risk,” it concludes.

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