Robust US activity growth (see Chart 1), alongside moderating inflation, has further increased the probability of a soft landing. This favorable growth/inflation trade-off is the result of positive supply shocks, including rising labor force participation, improved labor market matching, unwinding global supply chain pressures, falling energy prices, and higher productivity growth.

But, in our base case, we think these improvements may now be largely exhausted. Meanwhile, household savings buffers are close to being used up, which, alongside tight credit conditions, should see US growth slow. US activity growth already seems to be moderating from the strength seen in Q3, with slower payrolls growth and falling PMIs.

In fact, the recent rise in unemployment is close to triggering the Sahm rule. This is the empirical regularity whereby a 0.5ppt increase in the three-month average of unemployment over a year has always been associated with recession. While this time might be different due to strong supply rather than demand weakness driving the increase, other medium-term recession signals are still elevated.

Despite the sharp moderation in headline US inflation, underlying inflation pressures are not fully back at target- consistent rates. While we think the Federal Reserve (Fed) has finished hiking, it may not be able to ease into this slowdown until it’s too late. We continue to expect a mild US recession from mid-2024, and Fed rate cuts from that point.

By contrast, Eurozone and UK GDP stagnations or small contractions reflect standard business cycle dynamics following a period of rate hikes. That said, activity surveys have recently shown signs of stabilization, and real wage growth has turned positive. This should keep European recessions mild and help drive the recovery later next year.

Headline inflation in Europe has declined substantially due to favorable base effects, falling goods prices, and economic weakness. But, with wage growth still well in excess of a productivity adjusted inflation target consistent rate, the European Central Bank (ECB) and the Bank of England (BoE) are unlikely to start cutting interest rates until mid-2024 despite this period of economic weakness.

As and when interest rate cutting cycles begin, we think these will be more rapid, and reach a lower level, than markets price (see Chart 2). This reflects our judgment that equilibrium policy rates remain low amid ongoing structural headwinds and fading pandemic-era distortions.

But, while r* is still low, the term-premium component of bond yields may be moving structurally higher. Large deficits at a time when economies are beyond full employment and interest rates are high has increased concerns about fiscal sustainability. We do not forecast fiscal crises, but the fiscal impulse will turn more negative and fiscal policy has little space to loosen in any downturn. In addition, changing central bank balance sheet policy, especially in Japan, mean the anchor on bond yields from quantitative easing and yield curve control (YCC) is fading.

Indeed, the Bank of Japan (BoJ) is a notable outlier among developed markets, as we now expect it to marginally tighten policy further. Next spring’s Shunto wage round should provide the BoJ with sufficient comfort about underlying wage growth to exit YCC and end negative interest rates.

That said, with higher inflation expectations only weakly embedded, Japan may only exit negative rates into a long period of zero rates.

Chinese activity data is now bottoming, and 2023 growth should beat the 5% target. While this is partly thanks to revisions, policy support is gaining traction, and we think additional fiscal stimulus and property support is coming.

Negative inflation in China is being driven by temporary factors including volatile pork prices, and should soon rise, albeit underlying inflation remains subdued. While China faces structural headwinds including from real estate, which mean that our 2024 forecast is marginally below consensus. Comparisons with Japan are wide of the mark.

Emerging market headline inflation should continue falling rapidly, with underlying pressures also receding, amid tight monetary conditions, softer growth, and favorable base effects. While El Niño-driven food price volatility and possible energy market shocks are risks, we think that a broader EM easing cycle can begin in mid-2024, especially given the high starting point for real rates.

Political event risk will be heightened during 2024, given the large number of important elections and geopolitical tensions. In the US, polls now marginally favor Trump over Biden. Trump may have less scope to cut taxes given a likely split Congress and the size of the US deficit. Alongside proposals to increase tariffs, this could make another Trump term more challenging for risk assets.

There are also downside global economic risks from escalation in the Middle East and a surge in oil prices, although we give this a low probability given diplomatic guardrails. Upside risks to the global economic outlook come primarily from a US soft landing, the path to which is widening amid supply improvements.

Source: Haver, abrdn (November 2023)

Source: Haver, abrdn (November 2023)

Source: abrdn (November 2023). Forecasts are offered as opinion and are not reflective of potential performance. Forecasts are not guaranteed and actual events or results may differ materially.

US

Activity: The economy surpassed expectations this year, helped by healthy private sector balances sheets, a recovery in the supply side, and slow transmission from policy tightening. These dynamics have widened the path to a soft landing, given the progress on lowering inflation. However, we continue to think a downturn is likely as these supports fade over 2024. Indeed, dwindling household savings, shrinking corporate margins, and tight credit conditions should push growth below trend in H1, before a mild recession starts in H2. We then expect subsequent policy easing to support a brisk recovery in 2025 and 2026.

Inflation: The combination of slower inflation and robust growth has been possible because the economy has benefitted from positive supply shocks. Recovering global supply chains have pushed goods prices lower, and stronger productivity and labor force growth are taking some of the heat out of labor costs. However, underlying inflation continues to run too hot and we see limited scope for additional supply side surprises to drag this to target (see Figure 4). This puts the onus on weaker demand to bring inflation down further, with a downturn next year likely to push inflation modestly below target in 2025.

Policy: The Fed has held interest rates unchanged since July and we think these have peaked, even if further hikes can’t be ruled out entirely should growth remain strong and financial conditions loosen further. Elevated services inflation (see Chart 3) will limit the scope for the Fed to ease over the first half of next year, even as growth slows, but we expect a sharp easing cycle once it becomes clear the economy has fallen into recession. We expect rates to fall to accommodative settings of 2-2.25% by end 2025, before rising modestly in 2026 (2.5-2.75%).

Source: Haver, abrdn November 2023

UK

Activity: After stagnating in Q3 this year, the economy is set to endure recession-like conditions into the middle of 2024. Admittedly, the pick-up in the November flash composite PMI is tentative evidence that activity may be starting to bottom as real wage growth turns increasingly positive (see Chart 4). Moreover, the Autumn Statement provided some modest fiscal stimulus, which should support growth next year. However, there is little reason to think the growth outlook has materially improved. Any supply-side boost from the Autumn Statement will take years to come through, while the impact of past monetary tightening continues to build.

Inflation: UK headline inflation no longer looks like such an international outlier, after it fell sharply in October, dropping from 6.7% year over year to 4.6%. This was in large part due to very favorable energy base effects, and the progress back to 2% is likely to slow from here as this tailwind has now passed. However fading food price growth should continue to help. While the labor market has cooled recently, the strength of UK wage growth remains an outlier, particularly given sluggish productivity growth, suggesting that underlying inflation pressures still need to moderate further.

Policy: We think the next move in interest rates is more likely to be down than up, with Bank Rate having peaked at 5.25%. Elevated wage growth and modest fiscal stimulus means the Bank of England (BoE) is likely to continue to signal an extended period of keeping rates on hold. However, a ‘Table Mountain’ profile for rates is unlikely to prove sustainable as economic headwinds mount and underlying inflation pressures fade. We expect rate cuts to start by the middle of next year. There are two-way risks on this forecast, with an earlier and later start to cuts both plausible.

Source: Haver, abrdn November 2023

Eurozone

Activity: Eurozone GDP declined by 0.1% in Q3 (see Chart 5). However, the contraction has so far been quite narrow, with a German recession and volatile Irish national accounts leading the fall. This outturn, along with a slight rebound in surveys, means we have revised up our 2024 growth forecast to 0.5%. While the GDP contraction in Q3 is likely to mark the start of a technical recession, the substantive difference between a quarter of very modest growth or of very modest contraction is small. Either way, next year’s recovery is likely to be slow, with the global backdrop challenging.

Inflation: Headline inflation fell sharply in October, with the year-over-year rate declining from 4.3% to 2.9%, due in part to energy base effects. But disinflation will now slow as base effects begin to push upwards on the headline rate again. And the removal of various government energy bill support packages will keep inflation higher in Q1 2024. Core is likely to be sticky, as tightness in the labor market means underlying inflation dynamics will take longer to return to target-consistent rates. We expect the headline rate to return to target in the second half of 2024.

Policy: The European Central Bank (ECB) kept its key rates unchanged in October. The formal policy guidance points to holding rates in restrictive territory for a significant period. In line with the ECB’s messaging, we see rates being held at their current levels until the middle of 2024. Intervention in bond markets is off the table for now, after the recent decline in peripheral bond spreads. But we anticipate a faster return to target inflation than ECB forecasts currently suggest, triggering an acceleration in the easing cycle from H2 2024.

Source: Haver, abrdn November 2023

Japan

Activity:Japanese H1 GDP growth was surprisingly strong as healthy inbound tourism flows helped boost trade data. While some payback was expected, Q3 domestic demand growth was exceptionally weak. Indeed, retail sales and industrial production were both below consensus expectations in September, with households squeezed by higher inflation and firms struggling to pass on higher costs. The government announced a Y17 trillion fiscal package including tax cuts beginning in June 2024 and plans to extend energy subsidies to April 2024. The measures are aimed at helping households manage this period of weak real wage growth before the next Shunto wage agreements.

Inflation:Leading inflation indicators suggest Q4 inflation will be strong due to utility bills and pressure from the hospitality sector. However, it remains unclear whether wage pressures are yet sufficient to motivate further policy adjustments. Japan’s largest labor union is targeting wage increases of “more than 5%” in the 2024 wage rounds compared to “around 5%” previously. But that doesn't mean realized whole economy wages will hit anything close to 5%. Indeed, August’s core earnings were stable at just 1.6% (see Chart 6), implying a sustained re-anchoring of inflation at 2% remains out of reach for now.

Policy:The Bank of Japan (BoJ) voted 8 to 1 to add flexibility to its yield curve control (YCC) settings in November. While the shift from a rigid cap to a “reference rate” of 1% will help smooth the transition out of YCC, the BoJ will not want to be seen to be tightening policy too early. YCC is likely remain in place until mid-2024, as the central bank’s communication has highlighted the importance of next spring’s wage negotiations before further policy measures are taken. But we do think the BoJ will then drop YCC and raise the policy rate to 0% at that point.

Source: Haver, abrdn November 2023

China

Activity: Official Q3 GDP growth was better than expected, and monthly data has firmed over the three months to October – consistent with an economy that is strengthening. GDP growth in 2023 should comfortably exceed the authorities' 5% target. Real estate retains the potential to spark a crisis, but we do not subscribe to the more pessimistic commentary around China. Indeed, while we continue to expect property to weigh on GDP growth in 2024 (4.4% versus a consensus of 4.5%), recent policy easing – combined with the ability to do more – suggests that fears of 'Japanification' are overblown.

Inflation: Inflation is no barrier to additional easing in China. Headline inflation remains tepid, having averaged only 0% over the past six months, and while core inflation is a bit higher at 0.7%, it remains well below target-consistent rates. Base effects from energy should put CPI inflation back on an upward trend, but we have once again revised down our annual forecast for 2024 (to 1.4%), in part as we expect the supply-side focused policy mix and a somewhat lackluster growth environment to remain.

Policy: Policy makers continue to ease, pulling a variety of monetary and fiscal levers with vigor. While it is difficult to have confidence that the plethora of actions undertaken by the authorities will be enough to drive growth materially higher and turn market confidence, financial conditions have increasingly been pushed into more accommodative territory (see Chart 7). We also expect further easing to be delivered, which guards against downside risks, while household savings, which have been untapped thus far, provide a plausible route to an upside surprise.

Source: Bloomberg, Refinitiv, Haver, abrdn, November 2023

India

Activity: India’s economy has been strong, buoyed by the service sector and public infrastructure spending. However, there are signs of slowdown, and we expect growth to fall below trend in 2024. Demand in rural areas remains soft amid squeezed budgets and weak labour market conditions. Manufacturing will also fail to provide much upside, given softer investment and demand. As such, the strength of services will be key. We expect tighter monetary conditions, weaker household balance sheets, and a drop-off in external demand to cool activity. That said, India’s economy will remain an outperformer, rebounding quickly in 2025.

Inflation: Headline inflation will remain volatile in the near term, owing to continued swings in food prices due to El Niño impacts. However, moderating core inflation should provide some offset and we expect that, as food price pressures ease in 2024, headline inflation will head towards target-consistent rates. Cooling underlying inflation suggests that upside risks to the inflation outlook remain broadly contained, however, were domestic demand to prove more resilient than we are expecting, core inflation could test the upper band of the Reserve Bank of India’s (RBI’s) 4% +/- 2pp target range.

Policy: We expect the RBI to leave its policy rate at 6.5% until mid-2024 (see Chart 8). Underlying inflation has moderated, giving the RBI some breathing room. However, the uncertainty around food prices and the path for inflation expectations, along with still strong credit growth, means that the central bank is unlikely to stop its process of withdrawing liquidity or cut rates in the near term. But the slowing economy and higher real policy rate will eventually give the RBI room to begin easing, cutting its policy rate 125bps by the end of the year.

Source: Haver, abrdn, November 2023

Brazil

Activity: Brazil’s economy grew strongly in the first half of 2023, buoyed by services and a large boost from the agricultural sector. We expect some of the agricultural strength to unwind in early 2024, while services activity is also likely to slow. Still, tight monetary conditions and a soft external demand backdrop will prove drags, and the impact of a US recession contributes to our below-consensus view on growth in 2024 (1.0% versus 1.6%). However, the labor market has held up and fiscal support will limit the severity of the slowdown, meaning we expect growth to pick up by late 2024.

Inflation: Headline inflation has already fallen notably and is now within the upper bound (4.75%) of the Brazilian central bank’s (BCB) target range. Over the coming months, we expect it to remain within the target range, while core inflation also moderates. As growth slows more meaningfully in 2024, underlying inflation should ease further. Indeed, monetary conditions remain tight such that upside risks to the inflation outlook should be contained. However, the lagged decline in consumer inflation expectations (see Chart 9) creates a risk that the final leg of disinflation is more gradual than we are forecasting.

Policy: The BCB should maintain its pace of easing until the end of the year, taking the policy rate to 11.75%. The significant moderation in inflation and Brazil’s high ex-post real policy rate of 7.4% leaves significant scope for cuts. As the economy slows more meaningfully and the Fed easing cycle begins, we see scope for the BCB to cut policy rates to 8% by the end of 2024, below market pricing and consensus expectations. That said, we believe the BCB will retain its high real-rate strategy, restarting a hiking cycle in 2025 as the economy recovers.

Source: Haver, abrdn, November 2023

Scenario Overview

Source: abrdn, November 2023

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