Capital IdeasTM

Investment insights from Capital Group

Economic Indicators
Economic outlook: Mild recession, strong recovery
Jared Franz
Ben Zhou
Equity Investment Analyst
Pramod Atluri
Fixed Income Portfolio Manager

The global economy has managed to avoid a recession in recent months, thanks to resilient consumers, a surge in travel and leisure activities, and the reopening of China’s economy following pandemic-related lockdowns.

That’s likely to change in the second half of the year, says Capital Group economist Jared Franz, as the impact of high interest rates, inflation and a banking sector crisis combine to tip the world into a mild recession.

“Global economic growth is on track to decline by roughly 1% for the full year, in my view,” Franz explains. “That should be followed by fairly robust growth in 2024, driven by strong consumer spending and potentially lower interest rates in the US and Europe.”

Many economic indicators are pointing to a recession in the United States, not the least of which is an inverted yield curve. That happens when yields on short-term US Treasury bonds are higher than yields on long-term bonds, indicating that investors expect tough economic times ahead.

An inverted yield curve has often preceded recessions

Sources: Capital Group, Bloomberg Index Services Ltd., National Bureau of Economic Research, Refinitiv Datastream. As of 25 May, 2023.

“The yield curve is more inverted now than it has been since the 1980s,” Franz notes. “Of all the recession indicators, it has been the most accurate one.”

Looking at the major economies around the world, the US may decline by 1%, Europe should remain flat to slightly negative, and China could grow 2% to 3%, according to estimates from Capital Strategy Research (CSR), Capital Group’s macroeconomic research team. CSR estimates are slightly below consensus estimates, largely due to the view that inflation could remain at higher-than-expected levels.

It may not feel like it at the supermarket but inflation is on a downward trajectory in the US, Europe and across many other markets. That’s largely due to lower energy prices, fewer supply chain disruptions and aggressive interest rate hikes by central banks. Interest rate-sensitive industries, such as housing, are already feeling the effects, with home prices falling in some formerly hot markets.

Inflation is less onerous today, but remains elevated

Sources: Capital Group, FactSet, Bureau of Labor Statistics, Eurostat, UK Office for National Statistics, Japanese Statistics Bureau & Statistics Center, International Monetary Fund. Data as of 25 May, 2023.

Rate hikes meant to fight inflation have also triggered a crisis in the banking sector. A sharp selloff in the bond market last year hammered the portfolios of numerous regional banks, contributing to the collapses of Silicon Valley Bank and Signature Bank. In Europe, contagion spread to Credit Suisse, which nearly collapsed before UBS agreed to buy it for more than $3 billion.

The next shoe to drop could be commercial real estate. Office vacancy rates are on the rise as more companies embrace work-from-home business models. At the same time, it’s become more difficult to refinance commercial real estate (CRE) loans that were taken out when interest rates were much lower. That could be a growing threat to banks with a large exposure to CRE loans.

“Office and retail properties look like the biggest concern,” says Ben Zhou, a Capital Group analyst who covers real estate investment trusts.

Interest rate outlook

Given these mounting risks, the interest rate outlook has changed dramatically since early March, when the banking crisis first hit. As shown in the chart below, investors no longer think the US Federal Reserve will raise rates as far or as fast as previously expected, largely due to a tighter lending environment stemming from the banking turmoil.

“We knew there would be consequences to one of the most aggressive tightening campaigns in history,” says fixed income portfolio manager Pramod Atluri. “The dislocations we are seeing in the financial markets signal a painful new phase for the Fed. It has clearly exposed some vulnerabilities and, as a result, I believe we are nearing the end of this rate-hiking cycle.”

The European Central Bank has also slowed its rate-hiking campaign — from 50 basis-point increases previously to 25 basis points at its 4 May policy meeting. So far, ECB officials have not indicated a willingness to pause, given that inflation is running significantly higher in Europe than it is in the United States.

Investors expect interest rates to decline in the months ahead

Sources: Capital Group, Bloomberg Index Services Ltd., Refinitiv Datastream, U.S. Federal Reserve. Fed funds target rate reflects the upper bound of the Federal Open Markets Committee’s (FOMC) target range for overnight lending among U.S. banks. The market-implied rate is based on price activity in the fed funds futures market, where investors can speculate on where they think rates will be at a future point in time. As of 26 May, 2023.

Even in the US, consumer price increases are well above the Fed’s 2% target. And there are growing signs that inflation in the range of 4% to 5% could be stickier than central bankers had thought it would be. On 26 May, the US government reported that core inflation rose 4.7% on a year-over-year basis in April, up from 4.6% the month before.

A key question looking forward is: Will the Fed and other central banks be willing to let inflation run hot for a while? Or will they decide it’s more important to bring prices under control by keeping rates higher than market expectations?

“Central bankers find themselves in a tough spot and I don’t envy them at all,” Franz says. “In my view, the Fed is going to pause its rate-hiking campaign in order to assess the damage from the banking crisis, and they may even begin cutting rates by the end of the year.”

Jared Franz is an economist with 18 years of investment industry experience. He holds a PhD in economics from the University of Illinois at Chicago, a bachelor’s degree in mathematics from Northwestern University and attended the U.S. Naval Academy. 

Ben Zhou is an equity investment analyst at Capital Group with research responsibility for REITs in the US and tobacco globally. He has six years of investment industry experience and has been with Capital Group for four years. He holds an MBA from The Wharton School and a bachelor's degree in economics from Harvard College. Ben is based in New York. 

Pramod Atluri is a fixed income portfolio manager with 25 years of industry experience (as of 12/31/2023). He holds an MBA from Harvard and a bachelor’s degree from the University of Chicago. He is a CFA charterholder.

Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.

Capital Group manages equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.