More so than any other industry, the sector is an amplifier of the economic cycle, and the fragilities of the sector will likely subtract a percentage point from GDP growth this year, while limiting policymakers’ scope to place a singular focus on fighting inflation, particularly since the challenges facing the sector go well beyond liquidity.
For the US, the banking crisis will impose an immediate and long-lasting economic drag from reduced bank lending and the associated hit to sentiment. However, the immediate hit is from the rotation of uninsured depositors from regional banks towards the biggest lenders. The loss of cheap deposit funding among regional banks will likely reduce their propensity to lend and the pullback will most directly threaten small businesses and industries, such as commercial real estate, where small lenders are responsible for a disproportionate amount of credit creation.
To compensate for the loss of funding, banks are now forced to secure short-term funding in repos and the Fed funds market at much higher costs. The higher funding costs cause banks’ net interest margins to narrow and will likely curtail their desire to lend to the real economy, with the path ahead in sharp contrast to the previous decade of easy money and loose liquidity. In the current circumstances, the separation principle between policies to manage the macroeconomy and preserve financial stability is expected to be tested, and the tools available to inject liquidity may prove insufficient in stemming further runs from banks with flawed business models.
In light of the recent shocks and the Fed’s constrained ability to contain the broader crisis, we have raised the probability of a recession in the US from 30 per cent to 40 per cent, and the odds of stagflation from 5 per cent to 15 per cent, owing to the possibility that the Fed may have to prematurely pause its rate hike cycle to prevent further financial instability. Consistent with these adjustments, the shock has reduced the likelihood of a soft landing.
As widely expected, the Fed raised its policy rate last week by another 25 basis points to 5.0-5.25 per cent. We think this will be the last rate hike of the cycle—particularly since the debt-ceiling impasse may have reached a crisis point by the time of the June meeting. Looking ahead, we expect the Fed will cut the policy rate by 75 bps starting in Q4 of this year once the labor market confirms that the economy has softened markedly and that inflation pressure is receding towards the Fed’s target.
Internationally, the range of profound and persistent structural trends continues to impose heightened geopolitical risks to the outlook: the ongoing Russia-Ukraine war; the intensified competition for power between the US and China and the increasing use of economic statecrafts such as export controls and sanctions; the reorientation of critical supply chains for goods and technologies around geopolitical alliances; and a necessary but bumpy energy transition from fossil fuels to renewables.
In Europe, the impact from the recent bout of market turbulence will depend on the degree of contagion versus spillovers. Despite existing fault lines, such as the lack of a fiscal and banking union, there are good reasons to believe that contagion to euro area banks will remain contained. In the absence of contagion, the spillover impact from the US banking crisis will nevertheless tighten the provision of credit across the region, dampen demand, and bring inflation back to target more quickly than would have otherwise been the case.
Moreover, any slowdown in US economic activity would be expected to impact the macro outlook for both the UK and the euro area given their high degree of openness to trade and the importance of the US as a key trading partner. These concerns are expected to manifest themselves in a shallower path for further ECB rate rises and a likely lower terminal rate of around 3.5 per cent. Given recent developments, we have raised the probability of a recession in the euro area to 30 per cent from 20 per cent while the risks of stagflation remain at 45 per cent. Overall, the latest developments reinforce expectations of a weak backdrop facing Europe in the next 12 months.
For China, distinct contrasts between the cyclical and structural outlooks remain. The likelihood of solid GDP growth in line with the consensus growth projection of 5.7 per cent in 2023 has increased. Following the end to zero COVID-19 in late 2022, significant policy easing across a wide range was implemented, and recent hard and soft data confirmed some bounce back in services demand, as well as continued policy-driven strength in infrastructure investment and incipient signs of life in the property sector. Against the background of a still difficult employment outlook, especially for young cohorts, the new government is expected to keep policies supported throughout at least Q2.
Looking beyond the current year, these stimulus policies will do little to address overcapacity and debt problems, and China’s long-term outlook remains relatively downbeat. From a growth input perspective, further capital accumulation on a substantial scale is unlikely as debt is already at very high levels and funding is becoming increasingly difficult to come by; meanwhile, growth in the labor force is falling due to an already quickly ageing population. However, the most concerning aspect of China’s long-term growth case is the sharply curtailed growth in total factor productivity (TFP). If history is any guide, China’s TFP increase has slowed to a pace that seems insufficient to escape the middle-income trap.
In sum, the US banking crisis is likely to be the tip of the iceberg for the various areas of the US economy buckling under higher interest rates. The vast and complex financial system makes it difficult to know ex-ante which shoe is going to drop next, pointing to the need to maintain a humble and open mind as one tries to understand the known and unknown forces driving the global economy.
Daleep Singh, chief global economist and head of global macroeconomic research, PGIM Fixed Income
