We expect that in order to bring inflation back to target, the US Federal Reserve (Fed) will have to tighten monetary policy so much that the economy dips into recession. And the US could bring most of the global economy along with it.

What would a US recession, which we anticipate in late 2023 or early 2024, mean for emerging markets (EMs)?

US recession to ripple out to EMs?

Our latest forecasts (Chart 1) assume a peak-to-trough fall in US GDP of about -1.5% with three quarters of sequential quarter-over-quarter growth contractions. We assume that the probable US recession is likely a harbinger of similar economic conditions for most of the global economy.

Source: aRI, Haver, Bloomberg, June 2022

Some recession risk is priced into markets already, but we think that there is likely more downside to come for risk assets.

China could potentially offer some shelter from US headwinds. But it’s unlikely that China will launch a stimulus plan quite as expansive as it did after the Global Financial Crisis, so we’re doubful that China could fully offset a market shock.

War in Ukraine prolongs inflation shocks

While the war in Ukraine continues to be a major humanitarian crisis, it’s less front and center for markets than it was in the first weeks following the Russian invasion.

We expect the conflict to continue and Western sanctions against Russia to remain in place. While Europe will likely stop short of an embargo on gas, European Union (EU) countries will most likely work to reduce reliance on Russian energy.

This scenario may be broadly priced into commodities markets, but tighter supply and uncertainty still make these markets vulnerable to disruption and price surges.

Frontier markets such as Sri Lanka, Pakistan and Egypt that import food and energy could be most vulnerable to surging prices. This, in turn, increases the risk of social unrest. And major import-reliant EMs with high weights to food in their Consumer Price Index (CPI) baskets may also be vulnerable.

Shanghai shock

We don’t think China’s aggressive “zero-Covid” strategy is going away in the near term. We may see change after the 20th Party Congress in November, by which point vaccination rates for Chinese people older than 60 will have likely improved, but we’ll just have to wait and see.

This Covid-containment strategy comes at a great cost to the Chinese economy. We expect second-quarter GDP to contract by about 2% quarter over quarter (not annualized), and annual 2022 growth of 3.25% — well short of the government’s 5.5% target.

China has introduced some policy easing, but it’s unclear whether this is enough. Policy work has struggled to gain traction, at least partly because monetary policy is ill suited to counter structural headwinds. Minimizing Covid and de-risking the property sector, which has been faltering for some time, are simply not very compatible with China’s growth target.

Continued lockdowns — which, given Omicron’s transmissibility, are to be expected — all but guarantee that China will continue to disrupt global supply chains, adding to global inflationary pressure.

In other EMs, recoveries have been mixed

Among other EMs, recovery has continued over the past few months, but there’s still significant divergence in economic performance. GDP is lower today in Mexico and Thailand than it was pre-pandemic, for example.

But then, in other EMs, like Chile, Colombia and many parts of central and eastern Europe, there are clear signs of economic overheating. This is one reason why about half of major EMs are suffering from double-digit inflation (Chart 2).

Source: Haver, Bloomberg, abrdn as of May 2022.

The war in Ukraine is at the heart of some of the recent food and energy price surges. But core inflation is also running in the double digits (both in year-over-year and seasonally adjusted month-over-month annualized terms). In our view, year-over-year inflation will likely peak in the second half of 2022.

Meanwhile, in some EMs, high inflation has become intertwined with political unpopularity. In Mexico, Brazil and India, for example, governments have had to turn to interventionist measures to curb price increases. This should help take the edge off of inflation in the near term, but at a fiscal cost.

For the next couple of quarters, we expect interest-rate hikes to remain the order of the day in EMs. Even if inflation peaks, headline rates will remain far above central bank targets. There may also be pressure to “follow the Fed,” which is expected to keep raising interest rates in the US throughout this year.

Over the course of 2023, central banks that introduced interest-rate hikes early (e.g., in Latin America and Eastern Europe) are likely to consider rate cuts. It’s worth noting, however, that since inflation will likely still be above-target in 2023, many EM central banks may be cautious to cut rates too aggressively.

Avoid short-term shortsightedness

We’re looking down the barrel of some potentially difficult macroeconomic months, which come on top of several challenging months already. If the US falls into recession, which will likely be necessary to bring down inflation, EMs are likely to take a hit.

But it’s important to remember that these near-term concerns don’t necessarily negate long-term potential. And it’s worth highlighting that central banks in many emerging markets were among the first to start raising interest rates to combat high inflation, in a sign of institutional maturity.

US-070722-177616-1

We expect that in order to bring inflation back to target, the US Federal Reserve (Fed) will have to tighten monetary policy so much that the economy dips into recession. And the US could bring most of the global economy along with it.

What would a US recession, which we anticipate in late 2023 or early 2024, mean for emerging markets (EMs)?

US recession to ripple out to EMs?

Our latest forecasts (Chart 1) assume a peak-to-trough fall in US GDP of about -1.5% with three quarters of sequential quarter-over-quarter growth contractions. We assume that the probable US recession is likely a harbinger of similar economic conditions for most of the global economy.

Source: aRI, Haver, Bloomberg, June 2022

Some recession risk is priced into markets already, but we think that there is likely more downside to come for risk assets.

China could potentially offer some shelter from US headwinds. But it’s unlikely that China will launch a stimulus plan quite as expansive as it did after the Global Financial Crisis, so we’re doubful that China could fully offset a market shock.

War in Ukraine prolongs inflation shocks

While the war in Ukraine continues to be a major humanitarian crisis, it’s less front and center for markets than it was in the first weeks following the Russian invasion.

We expect the conflict to continue and Western sanctions against Russia to remain in place. While Europe will likely stop short of an embargo on gas, European Union (EU) countries will most likely work to reduce reliance on Russian energy.

This scenario may be broadly priced into commodities markets, but tighter supply and uncertainty still make these markets vulnerable to disruption and price surges.

Frontier markets such as Sri Lanka, Pakistan and Egypt that import food and energy could be most vulnerable to surging prices. This, in turn, increases the risk of social unrest. And major import-reliant EMs with high weights to food in their Consumer Price Index (CPI) baskets may also be vulnerable.

Shanghai shock

We don’t think China’s aggressive “zero-Covid” strategy is going away in the near term. We may see change after the 20th Party Congress in November, by which point vaccination rates for Chinese people older than 60 will have likely improved, but we’ll just have to wait and see.

This Covid-containment strategy comes at a great cost to the Chinese economy. We expect second-quarter GDP to contract by about 2% quarter over quarter (not annualized), and annual 2022 growth of 3.25% — well short of the government’s 5.5% target.

China has introduced some policy easing, but it’s unclear whether this is enough. Policy work has struggled to gain traction, at least partly because monetary policy is ill suited to counter structural headwinds. Minimizing Covid and de-risking the property sector, which has been faltering for some time, are simply not very compatible with China’s growth target.

Continued lockdowns — which, given Omicron’s transmissibility, are to be expected — all but guarantee that China will continue to disrupt global supply chains, adding to global inflationary pressure.

In other EMs, recoveries have been mixed

Among other EMs, recovery has continued over the past few months, but there’s still significant divergence in economic performance. GDP is lower today in Mexico and Thailand than it was pre-pandemic, for example.

But then, in other EMs, like Chile, Colombia and many parts of central and eastern Europe, there are clear signs of economic overheating. This is one reason why about half of major EMs are suffering from double-digit inflation (Chart 2).

Source: Haver, Bloomberg, abrdn as of May 2022.

The war in Ukraine is at the heart of some of the recent food and energy price surges. But core inflation is also running in the double digits (both in year-over-year and seasonally adjusted month-over-month annualized terms). In our view, year-over-year inflation will likely peak in the second half of 2022.

Meanwhile, in some EMs, high inflation has become intertwined with political unpopularity. In Mexico, Brazil and India, for example, governments have had to turn to interventionist measures to curb price increases. This should help take the edge off of inflation in the near term, but at a fiscal cost.

For the next couple of quarters, we expect interest-rate hikes to remain the order of the day in EMs. Even if inflation peaks, headline rates will remain far above central bank targets. There may also be pressure to “follow the Fed,” which is expected to keep raising interest rates in the US throughout this year.

Over the course of 2023, central banks that introduced interest-rate hikes early (e.g., in Latin America and Eastern Europe) are likely to consider rate cuts. It’s worth noting, however, that since inflation will likely still be above-target in 2023, many EM central banks may be cautious to cut rates too aggressively.

Avoid short-term shortsightedness

We’re looking down the barrel of some potentially difficult macroeconomic months, which come on top of several challenging months already. If the US falls into recession, which will likely be necessary to bring down inflation, EMs are likely to take a hit.

But it’s important to remember that these near-term concerns don’t necessarily negate long-term potential. And it’s worth highlighting that central banks in many emerging markets were among the first to start raising interest rates to combat high inflation, in a sign of institutional maturity.

IMPORTANT INFORMATION

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

US-070722-177616-1