Global: Recent bank problems have not derailed our outlook

LONDON (Capital Markets in Africa): Over recent months the world economy has continued to prove more resilient than expected to the raft of shocks that it has faced over the past year or so. After a slightly better-than-initially-expected end to last year, clearer signs have emerged that Q1 should prove a pretty solid quarter for the world economy. China has rebounded more sharply than we expected a couple of months ago following the ending of its zero covid policy, the US economy continues to grow at a healthy pace, while Europe, contra to earlier fears may have expanded modestly last quarter.

Nonetheless, some of this unexpected strength is likely to reflect activity and spending being bought forward in China, and policy rate tightening in the advanced economies taking time to feed through to the real economy. As a result, while we now expect world GDP to have grown more quickly in H1 this year, this is partially offset by more subdued GDP growth in H2.

Although some of the key downside concerns of last year, such as high gas prices in Europe and prolonged Covid activity restrictions in China may have melted away, recent banking problems have more recently filled the void ensuring that downside risks to the outlook remain. There is a small chance recent banking sector travails could morph into something much worse. However, we still believe the most likely scenario is that the global banking system isn’t on the precipice of a major crisis. Many of the recent developments, such as the sharp drop in US bank deposits, are likely to be a knee-jerk reaction to perceived instability rather than a sustained shift. Most of the global financial system is probably not one shock away from insolvency, and policymakers have the tools to avoid contagion and ensure idiosyncratic problems don’t become systemic.

That said, concerns about parts of the financial system will likely linger but not trigger a full-blown crisis. Recent events may encourage some behavioural shifts in the financial system that could affect the wider economy. For instance, banks might try to reduce their leverage, which could limit the pace of expansion or even cause some balance sheets to shrink if the cost of raising equity is deemed prohibitively costly.

It would be unwise to extrapolate the reduction in the size of banks’ loan books in late March. But the sharp fall in US bank lending in the latter two weeks of March, particularly among small banks, does suggest that the turmoil is already influencing banks’ lending behaviour.

We expect existing banking problems to be resolved in a steady and orderly manner with the help of central banks’ financial stability tools. Recent events are thus likely to only ripple through to the real economy, rather than create a tsunami.

Recent events will affect the wider economy via a further worsening in bank credit conditions, over and above the ongoing and substantial cyclical tightening seen in recent quarters. The risks of economic weakness via this channel are likely to be greatest in economies where banks are perceived to be most vulnerable (most notably the US) and where banks are an especially important source of credit for the private sector. On the latter, it shows that bank-funded credit to the private sector in the advanced economies is typically largest in Asia and parts of mainland Europe.

Tighter credit conditions may take at least six months to filter through to activity, suggesting that the downward force on economic growth may only become evident in the data towards the end of this year and into H1 2024. As a result, the biggest downward revisions to our calendar year GDP growth forecasts are to 2024 rather than 2023.

We expect investment to be the expenditure component that bears the brunt of the economic hit from tighter credit conditions. After all, households in aggregate are still sitting on a large cushion of excess savings. Outright falls in capital spending aren’t expected. Indeed, after four years of volatile but mediocre investment, we still expect the underlying pace of expansion to pick up a bit.

Banking concerns could affect the real economy more rapidly via confidence effects. While we think a repeat of the Global Financial Crisis is unlikely, some superficial parallels and speculation by some commentators that we could be on the cusp of GFC 2.0 could trigger businesses and households to behave more cautiously. The Oxford Economics/Penta sentiment indicators show a sharp increase in concerns about recession.

Nonetheless, sentiment can be volatile. If banking woes remain off the front page of the newspapers, then the recent deterioration in some of these sentiment measures could quickly rebound. Crucially, the key driver of consumers’ willingness to spend is typically the strength of the labour market. For now, there is little indication that households are becoming less bullish about their employment prospects, suggesting a significant shift in near-term spending patterns is unlikely. Indeed, the collapse of a bank to whom they have no financial link is unlikely to be of great concern for the average household.

Adverse wealth effects are another potential transmission channel. However, we believe any ill effects via this channel are likely to be limited in the near term. Since the collapse of Silicon Valley Bank (SVB), the S&P500 has risen by almost 5% at the time of writing. Any recent declines in major advanced economy stock markets have only been mild. Of course, tighter credit conditions could push down equities and property prices in due course, but there is so far little to suggest that large adverse effects on spending are likely.

Commercial real estate is a key area to watch because the expected weakness in the sector may undermine the strength of the wider economic recovery next year. Commercial real estate prices are typically sensitive to changes in bank lending conditions. Weaker commercial property prices could trigger a rise in bad loans to the sector or reduce firms’ collateral for lending, which would exacerbate the expected hit to investment. We now expect US all property capital values to fall by 10% in 2023 and 5% in 2024. We also project a 10% drop in European all property capital values this year.

Overall, we have made broad-based downward adjustments to our GDP forecasts for advanced economies. But we also believe recent events will only temper the global economic recovery, rather than cause it to stall. We expect world GDP growth to be 1.9% this year, which is a touch stronger than our forecast a month ago. The improved outlook is largely due to an upward revision to our forecast for China as we believe growth this year will be more front loaded as the economy continues to rebound following the termination of the zero-Covid policy stance.

We have reduced our global GDP growth forecast for 2024 by 0.3ppts to 2.2% to reflect the more subdued growth we expect at the end of 2023 and H1 2024. As a result, we expect the world economy to grow well below the average growth rate of around 3% recorded during the 2010s for a second consecutive year. In comparison to the consensus, the OECD, and IMF, our growth forecasts for both this year and next are a bit weaker..

We remain sceptical of a quick pivot to rate cuts by central banks. Although markets are now pricing in rate cuts by key central banks this year, we have not made any changes to our policy rate forecasts for key advanced economies over the remainder of 2023. If the situation in the banking sector worsens notably, then earlier rate cuts could certainly come into play.

However, there are three broad reasons why our baseline forecast still sees some further, albeit modest, policy rate hikes rather than an imminent cuts:

• The shifts to our baseline growth forecasts haven’t substantially altered our inflation outlook. If central banks take a similar view, this suggests that a significant change in monetary policy strategy is unlikely.
• Central banks will likely want to make full use of the financial stability toolkit that has been developed over the past 15 years to stabilise the banking system before opting for rate cuts.
• High headline and core inflation will prevent central banks from cutting rates at the first sign of trouble. Instead, they would likely want to see clear evidence that a financial crisis is underway and that the global economy is headed into a deep recession before loosening policy. Even if this were to happen, it could take months to develop.

While we have only modestly shifted our central forecasts, recent events have undoubtedly had a big impact on the perceived risks to our baseline. This could have much more significant consequences for asset prices. In a forthcoming Research Briefing, we will provide two plausible downside scenarios for the global economy if problems in the banking sector continue to worsen.

For a full list please of Research briefings see here.

Source: Oxford Economics Research Briefings.