Executive Summary
Several events that were considered as risk scenarios in spring 2022 have realized over the summer. Inflation worldwide has been picking up more than expected. The central banks in the US and the euro area have surprised the markets with their interest rate hikes.
The beginning of the second wave of the Russian invasion to Ukraine in 2022 has emphasized political risks and values in trade. The EU has decided to stop buying Russian oil and Russia is ending the supplies of natural gas. During the adjustment period several European countries are in a vulnerable position as a swift replacement of Russian gas is costly. Natural gas has turned out to be pivotal in the energy market and the electricity produced using the costly natural gas has pushed up price of electricity.
The world has changed over the last years. The Covid pandemic demonstrated very clearly the dangers of just‑in‑time supply chains. Firms are currently looking for suppliers closer to clients and keeping more inventories, making the economy less efficient from before. Major indexes of economic confidence, both at the consumer and corporate side, show economic contraction in Europe. Chinese housing market is collapsing and economic growth has disappeared over last quarters.
On the positive side, the commodity prices have started to decline over the last months. Though financial markets lost value over the year, they situation stabilized over the summer as some the of the interest rate increases and global slowdown has been already priced in. The outlook for the world economy remains weak, as real wages are falling, and inflation expectations have led to reduced savings which will translate into future weaker demand.
World economic situation
The world economic growth rate and the outlook for coming years has been slowing down in the first half of 2022. The IMF world economic outlook predictions for the world in January were downgraded in April and again in July.
The economic growth in the United States has been negative for the first two quarters of the 2022. During that periode the economy was been on shrinking, losing about a percent of the GDP level in Q4 of 2021 instead of growing. The labour market in the US has remained throughout this year with many jobs created. Real wages have been falling as nominal wage growth has been smaller than inflation during the first half of 2022. The stock markets have lost value over the year with a modest stabilization in summer. The outlook remains weak and vulnerable as profit outlooks for companies are revised down and interest rates are increasing.
Euro area has continued to grow in the first half of 2022. As the European economies have been rather slow in recovering from the Covid pandemic, this is rather the adjustment to the pandemic, rather than current strong growth position. The economic sentiment indicators for major European economies have declined and currently stand in the territory that has previously reflected an economic contraction. The inflation rate continues to increase with the core inflation on the rise.
There are several challenges that the world is facing. Many risks that were described in the first half of the year have realized. The European Union will stop buying Russian oil and Russia has effectively stopped selling natural gas to Europe. Inflation and interest rates are increasing fast across the world, several emerging market countries need to deal with the increased private and sovereign debt that emerged during Covid. Though, new variants have been rather resistant to vaccines, fortunately hospitalizations and death rates have declined drastically.
Inflation rate in the US reached 9,1% in June compared to the year before, moderating to 8.5% in July. This is the highest inflation rate the US economy has seen during last four decades. The core inflation rate, prices that exclude energy and food items, accounts approximately two thirds of the price increase, reaching 5.9% over a year. This is the highest value since 1990.
The euro area inflation rate reached also 9.1% and has not started to moderate so far. The increase in core inflation above 4% show how the inflation that was considered as transitory during the first months of this year is passing through the economy and creating wider inflationary environment.
Although the headline figures have been rather similar, the US inflation was more driven by domestic demand factors than in the euro area in the first half of the year. The euro area core inflation has picked up later with the initial price increases more related to the cost of energy and commodities. Additionally, the euro exchange rate has depreciated against the US dollar by more than 15% over the last year. The persistent decline started even earlier, from the summer of 2021. In June 2021 the exchange rate stood at 1.2 and it has dropped below unity in September this year. This is adding an additional burden in terms of costs for the European firms.
The persistent increase in inflation and core inflation above the target values has led to hikes in monetary policy interest rates. The Federal reserve has increased interest rates from the 0.5% level in April to 2.5%. There have been two 0.75% increases in the interest rates, one in June and one in July. The last time when the interest rates were increased by 0.75% was in 1994.
The European Central Bank increased the main policy rate, the main refinancing rate, from 0 to 0.5% in July and increased in the interest rate again by 0.75% on September 8, reaching 1.25% short term interest rate, 0.75% for the deposit rate and 1.5% for the marginal lending facility. The interest rate hike in July was larger than the markets expected just few weeks before. Market estimate currently on the neutral interest rate is around 2%. With persistent inflation and increasing inflation expectations as the core inflation is above the target, the European Central Bank might need to increase the interest rates above the natural rate to bring inflation down to the target range of 2% over the medium horizon.
As a result of the expectations of increasing policy rates and increased uncertainty about the rates, the money market interest rates have surged with some days the rates going up by even more than 0.1%. The 12‑month Euribor stood at 2.1% and the 6‑month Euribor at 1.5% on 12 September.
The unexpected component is the late increase in the policy interest rates and the very fast adjustment, not the level of the interest rate as such. With the annual inflation rate at 9.1% in the euro area in August, the real interest rate has been deep in the negative territory – values that have not been seen before. With the negative interest rates, saving is strongly discouraged, and the low rates give rise to speculation. The real interest rates are expected to remain in the negative territory for the coming months.
The Federal Reserve and the European Central bank are struggling to find the right target for the interest rate and also the right pace for increasing interest rates. The speed at which the interest rates are increased should be taken as a good signal that the central banks are following the mandate of controlling inflation. If the central banks would not be increasing policy rates, longer‑term inflation expectations could start increasing and rebuilding trust in the system would be even more costly.
Another risk was related to the Russian oil and natural gas with the two having rather different dynamics. EU has decided to stop the purchases of oil from the Russian Federation by the end of the 2022. Only Hungary and the Czech Republic got an exception. As a result of the sanctions, Russian oil exports to the EU should drop by 90 percent.
The oil, previously purchased from Russia, needs to be obtained from other sources. In the short‑run, Russia will not be able to sell the oil to other countries due to infrastructure limits. This has led to a shortage of oil in the world markets and to an upward pressure on price of oil. Initially Saudi Arabia has taken a rather positive view in supplying some of the necessary oil, but recently and OPEC+ has agreed to reduce production. At the same time India has increased oil imports from Russia already in spring this year, easing somewhat the pressure on oil prices, but reducing the effectiveness of the decision as part of economic sanctions.
While the income from oil is pivotal for the Russian economy and the state budget making almost half of the state revenues. The importance of natural gas in the Russian state budget is smaller. Moreover, the infrastructure for transporting oil is much more flexible as done by ships, compared to the infrastructure of natural gas that requires pipelines. As a result, it is much easier for the European Union to stop buying Russian oil than gas. Unfortunately it is cheap for Russia to stop supplying European countries with natural gas, a decision that has strong effects on European economies.
Over the summer, the European countries have taken the objectives of filling natural gas reserves for the coming winter as supplies from Russia could be reduced. As the fast expansion of LNG capabilities is complicated and Russia has been reducing natural gas exports, the supply of natural gas remains at the level of 2021. Therefore, when all countries are trying to increase the reserves at the same time, the price must increase. If prices are expected to increase, it opens space for speculations. Owing partly to that reason, the natural gas prices have been very volatile over the summer with a lot of uncertainty on how much LNG would Europe be able to buy and how much natural gas is necessary for the winter ahead. Even with full reserves, but limited supply in the foreseeable future, the consumption of natural gas needs to be restricted in some countries to keep some reserves for vital services.
During the summer there have been temporary cuts of the supply of Russian natural gas to the European Union market and cuts were already made at the end of 2021 when Jamal‑Europe pipeline was halted. With the Russian official view that they are ready to supply but having technical difficulties. Recently Russia declared that it will not sell natural gas to Europe until economic sanctions are abolished but leaving Europe still in expectations of possible deliveries later.
Argumentation on the technical reasons and keeping the hopes for future supply, Europe had less incentive to reduce the consumption of gas and build additional LNG capabilities. Only recently Germany has announced that it plans to build new LNG terminals. The uncertainty of Russian supplies has led to underinvestment into alternative energy sources and made Europe much more vulnerable to Russian natural gas halt.
Looking ahead, Russia has reasons to start supplying natural gas again once the additional capabilities for LNG are built at a price just below the LNG price to create political pressures in Europe and show that there was not need for additional investments. For Europe, however, there is no choice, but to build additional terminals. Otherwise, the countries remain at the mercy of political games of Russian natural gas exports.
The economic sanctions imposed by the European Union only concern selected categories of goods. Therefore, the immediate effect on trade with Russia was very limited. On the contrary, due to the expectations of further sanctions, the trade increased in the first months as firms were anticipating restrictions and increased stocks or supplied goods at the earliest dates possible.
As a result of increasing price of oil and natural gas, the flow of funds to Russia did not stop in the first half of 2022 and the Russian budget did not directly suffer because of that. Data from July hows decline in revenues as the rouble has appreciated and the Russian Urals oil prices have dropped to 66 USD/barrel Due to limited exports of technological goods, there are specific problems in some of the industries in Russia, such as the car industry, that depended on imported parts. The economic sanctions will have effects over longer periods as Russian firms do not have access to many high‑technology investment goods and components. As the economic sanctions widen, new contracts are not signed and the Russian economy shrinks, the trade links with Russia will decline over time.
During the Covid period, many emerging economies were borrowing to support the economy. As the debt levels have increased substantially, a risk to the world economy was related to sovereign debt crisis in the emerging markets. The problems have manifested since the spring outlook. In May, the government of Sri Lanka defaulted on the debt. The situation in public finances was feeble and as the price of energy and fertilizers grew. The government decided not to buy fertilizers to reduce imports also claiming for an idea of ecological farming. Additional strong Covid restrictions destroyed the tourism sector at the same time.. As the fertilizers were not used, agricultural production dropped, and the country had to import some of the food that it had produced before. As a result, the country was unable to service the debt obligations. The events lead to political unrest and the change of the government. Pakistan has recently signed an agreement with the IMF for help. The situation is fragile in several other countries and even small unexpected negative events can trigger a sovereign debt crises. For example Egypt, Ghana, El Salvador and Tunisia are likely to go through tough times in the coming months.
The economic problems in China have not been solved, economic growth has been declining and outlook is worsening. GDP growth in the first quarter of 2022 compared to a year ago was a mere 0.4%, falling strongly short of market expectations and is much below the growth rates seen before. Compared to the quarter before, the GDP fell by 2,6%, having increased by 1.4% the quarter before.
The real estate and construction sectors have been booming in China over many years. The activities related to real estate make up almost a third of the Chinese economy, making it a vital sector for the macroeconomy. Over the summer the ratio of non‑performing loans of four biggest banks has increased severely. After a long period of declining share of non‑performing loans for real estate developers, reaching the range of 0.5‑1.5% in summer 2020, the share of non‑performing loans has again increased fast to a range of 3‑6% in two years.
There are reasons to believe that there has been a real estate bubble in some regions in China and the bubble has burst. The number of residential transactions is down by a third compared to a year ago in the first half of 2022. The second largest real estate company in China, Evergrande, is under restructuring. The economic size of the company requires solutions at the country level, and it is too big to fail without proper handing.
The problems in the real estate and construction sector are fast to spread to other activities. Construction sector is using about half of China’s steel production. Consumer demand has already been on a declining path. The central bank has reduced recently the policy interest rates to help the economy. In august 202 the one‑year policy loans interest rate was cut by 10 basis points to 2.75% and the seven‑day reverse repo rate was reduced to 2% from 2.1%.
With the real estate crisis in China, a lot of the steel used currently in construction in China could be used for production elsewhere and the price of steel on international markets could drop significantly. However, this would come at the price of declining exports to China.
The Covid policies in China continue to be restrictive following the zero‑rate rule. Many European and US companies have changed their just‑in‑time delivery policy and preparing for supply disruptions. This reduced the efficiency of the firms and increases costs related to production, which results in plans to leave China due to these restrictions. The importance of the trade with China remains to be high and disruptions in the production lines remains an issue for the winter ahead.
The 20th National Congress of the Chinese Communist Party will take place on 16 October. The current Chinese leader Xi Jinping is expected to be re‑elected as the General Secretary of the Chinese Communist Party or elected as the Chairman of the Chinese Communist Party, a title that has not been used for three decades. It is expected that no big negative news will be released up until the elections and larger challenges will be faced only after the elections.
Recently the tensions over Taiwan have reappeared and further escalation of conflict between the United States and China brought tensions in international relations. As transport through Russia is becoming more complicated and expensive for China, the sea transportation and access to the South China sea becomes even a bigger issue for the Chinese government.
On the positive side, China has not taken a strong position supporting Russia in the Russian invasion of Ukraine, that could have led to a strong conflict between Europe and China that would lead to much more severe economic consequences that the sanctions against Russia ever would. Germany is in a particularly unfortunate situation as it has imported a lot of energy from Russia and used it to produce investment goods for China. Overall the trade links with China are much more vital for the Western economies than the links with Russia.
The commodity markets have gone through rough and volatile times over the last six months and the situation has not yet stabilized. Even if the financial markets have started to decline since summer 2021, the commodity prices kept increasing with the rising demand after Covid as supply was limited. Limited supply, increasing demand and low interest rates fed expectations of further price increases which opened markets for speculators. In many commodity markets, the late spring and summer have brough a change in the direction of prices as firms had managed to create additional stocks that were necessary because of the supply and transport delays and the world economy took a turn down with international organisations cutting growth outlook for major economies in the world.
The euro exchange rate has added an additional layer of costs for the European firms and consumers. While the Brent Europe oil price peaked at 133 dollars per barrel on 8 March this year from a low of just below 15 dollars on 31 March in 2020. The price increase is almost nine times. The peak of 133 dollars is not the historic high as 144 on 4 July 2008. The picture in euros looks different. Because the value of the euro was much higher in 2008, the oil prices in euros have never been so high as in spring this year. Recently the Brent Europe oil price has been on a continuous, through volatile, decline since June from 123 euros per barrel to 90 euros per barrel in the beginning of September.
The price of copper has dropped by more than 20% since March, with the levels similar to the beginning of 2021. The price of aluminum is down by almost half seen last in July 2021. Iron ore price has been cut by one third compared to the level in April 2021 and more than halved from the peak in May 2021. The Steel prices were peaking between April and October last year but having a new boom in spring in 2022. Current prices are 40% below the peak levels of 2021. The trend in prices is on a downward path, but price discovery is happening at the same time because of weakening outlook of world growth rates.
The price of corn and wheat made records in summer as the exports of Russia and Ukraine were severely limited and there was little hope for Ukrainian exports. The international agreement for allowing Ukraine to export wheat through Black Sea were however reached and first ships have successfully left Ukrainian ports. With the prices still at elevated levels, the fears of food shortages in Middle East countries and Northern Africa seem to be avoided.
With strongly volatile markets, the prices of futures have turned out to contain very little information about the prices in the future. The future contracts have been used to fix prices for future agreements, often, without taking a strong stance on the direction of the price move. As the prices are currently declining, the speculators are leaving the market, but still some clients see their costs remaining high comparted to the current market conditions. Therefore, the cost pressure in the US and Europe will remain longer than the spot market prices would imply.
Scenarios for the world economic outlook
The baseline scenario is a world economic slowdown. Major confidence indicators are worsening and have reached negative territory. The GDP growth numbers in euro area will go negative for a few quarters. The recovery from Covid will be postponed and governments will face pressure to support the economy through various measures.
As inflation becomes a more serious issue because the core inflation remains above the target level and inflation expectations above the target remain, the central bank has no other option, but to increase the policy interest rates. As demand in Europe is declining, the demand for the Baltic exports is weak and increasing interest rates put a pressure on the economies that are already in vulnerable position. Labour markets remain relatively strong compared to previous economic slowdowns because the real wages are not catching up with inflation and the cost of the recession is spread more evenly. As the spending related to housing, food and loan payments is high, there is little room for additional activities so demand for services that are not directly necessary will see a demand drop, leading gradually to higher unemployment.
The main risk scenario is where the world enters a recession that means a significant drop in the GDP in China, emerging markets and the United States which the euro area will follow. Even if nominal wages increased, real wages fall strongly and this reduces consumer demand. As the price level remains high, inflation rate is decreasing, inflation expectations are going down and interest rates stay up, the consumer are poorer in terms of labour income and savings. In order to build up the saving levels from before in real terms, consumption falls further and unemployment increases. Governments in several countries in Europe cannot increase public spending because of higher interest rates. With reduced consumption, investment plans are postponed. Covid restrictions might continue causing supply side issues, not allowing the commodity price declines to pass through to consumers. As the demand for commodities falls and real income starts to increase, the economy will find the through and growth resumes.
There is also a more optimistic view possible. Commodity price declines can also reach consumers faster than expected, energy prices can decline if the winter is mild and Europe has built enough capacity for importing LNG gas with the current stocks estimated to be sufficient. This puts an end to the increase in the interest rates and with easing financing conditions stock markets gain value and start‑ups find easier to finance new investments. Positive news on technology, such as breakthrough in battery or solar energy production, growth prospects may turn and households are eager to spend their remaining savings and take more loans against future income.
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