Looking for a global recession in the new year? Watch out for this wildcard

The drumbeat of global recession for 2023 has been beating loudly of late.

Some fund managers and analysts at major banks now have recession as their baseline forecasts for the US and Europe. Even some central banks, such as the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ) are outrightly forecasting recessions in their respective economies next year.

Key indicators have been flashing warning signs of a recession on both sides of the Atlantic. For example, both the US 2yr10yr and 3m10yr yield curves have now deeply inverted, which have historically been excellent predictors of a US recession, and PMIs also point to a contraction in economic activity across major economies.

However, in the midst of all the mounting recession concerns, global financial markets seemingly shrugged off a major shift that is happening in the world’s second-largest economy. 

That big shift is a move away from China’s zero-COVID policy, which has been the biggest economic headwind for China’s economy over the past year or so. Therefore, it stands to reason that this policy change has now turned into a major tailwind.

Of course, dealing with the current massive wave of COVID cases is still a concern. While cases remain high, self-imposed social distancing is preventing a pickup in activity. But as in the rest of the world, which has dealt with COVID waves, economies have shown to bounce back quickly once cases subside.

Importantly, this shift isn’t just a shift on zero-COVID. There has been a fundamental shift in now wanting to support the economy. Rhetoric from officials suggests that the focus will be on boosting the economy next year. Most recently, the annual Central Economic Work Conference highlighted that economic stability was now the top priority.

Perhaps the biggest clue with regards to a shift towards focusing on the economy has been the discussion of China's economic growth target for next year, where officials are considering a target of 5%.

Even having a growth target would be a signal of the Chinese Communist Party's shift towards prioritising the economy. Recall that a growth target of 5.5% was set for 2022, but while zero-COVID was in place, achieving that target became less important for authorities. Instead, this year we could expect economic growth in China of close to 3%.

Although not yet officially announced, a 5% growth target would be a major step up from the likely growth outcome for this year. Moreover, most of this kind of growth¸ at least for next year, would be ‘quality’ growth – that is growth that comes from consumers and businesses rather than debt-fueled spending. Much like everywhere else in the world, there is pent-up demand after covid restrictions.

If achieved, which would be entirely plausible given the abandoning of zero-COVID, it should have a material impact on how we view the world economy in 2023. To give an example, the IMF’s latest World Economic Outlook in October forecasted a 4.4% growth rate for China’s economy. Growth of 5% next year would imply a world GDP upgrade of more than 0.1 percentage points. That would be a sizeable impact from one country. 

Is this a game-changer for the world economy? 

Maybe not, particularly given that tighter monetary policy in the US, Europe the UK and others will hurt demand in those economies. But it does highlight a major upside risk to the world economy next year.

And the above assessment doesn’t include the positive spillover impacts to other parts of the world. There is an obvious impact on China’s key trading partners, but there is also a positive impact via stronger demand for commodities and global sentiment. Indeed, a recent study by the US Federal Reserve showed there could be much larger spillovers from stronger growth in China to the rest of the world than had been previously estimated.

Intuitively, it makes sense that Chinese demand has a big impact on the global economy because China is the second-largest consumer of oil, the largest consumer of cars and the largest consumer of steel in the world.

The study by the US Federal Reserve suggests that the reason that China’s impact on the rest of the world may have been underestimated in the past is because official Chinese data has tended to smooth fluctuations in the business cycle, making it difficult to discern key relationships with other financial global indicators.

That also means, if you were a sceptic of Chinese official data, that would give you a greater reason to suspect that a rebound in China’s economic activity next year could be essentially bigger than official estimates if this practice of smoothing data were continued. If the downturn in China’s economy this year was actually worse than reported, then chances are, the upswing will be better than reported.

So global recession in 2023? Probably more like a global economy in divergence. Let’s not write 2023 off just yet. At least not the whole world.  

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