The global economic outlook is complex and precarious

Downside risk

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Amid elevated new COVID-19 cases globally, Omicron or another variant increases health risks, denting growth prospects

On November 26, the World Health Organisation labelled Omicron the fifth COVID-19 ‘variant of concern’. While Omicron appears able to reinfect people more readily, there remains much uncertainty regarding its transmissibility, severity and the extent to which it can evade existing vaccines and treatments. Confidence is growing that Omicron will be less disruptive than the Delta variant. Although BionTech say they could adapt the mRNA vaccine and deliver it within 100 days, if needed, mass production would be unlikely before mid-2022. Transmission of Omicron, or indeed another new variant yet to mutate, could therefore see a resurgence of COVID-19 hospitalisations—derailing the assumption that the virus becomes endemic in 2022.

Such circumstances would entail stricter containment measures and business disruptions that could prolong supply and logistics challenges, stoking further price pressures. Increased health risks, prolonged uncertainty about schools and childcare, and renewed restrictions on international travel could prolong labour shortages. On the demand side, the resurgence of infections could dissuade economic activity that requires close contact, weighing on services consumption. The OECD warn that output and per capita incomes would likely remain weaker than the pre-crisis path for an extended period.

The most significant impact would be on countries with low vaccination rates, higher dependence on tourism and less capacity for additional stimulus. An erosion of global investor sentiment could also cause further financial stress for highly leveraged households, corporates and sovereigns.

Inflation could continue to surprise on the upside amid persistent supply disruptions and energy, transport and labour market dislocations, necessitating tighter US monetary policy

The OECD forecasts inflation to peak in most countries by Q1 2022 and moderate gradually thereafter. But this assumption could be derailed if supply-side strains prove more severe, prolonged and widespread than expected; inflation expectations rise and become entrenched; and/or tighter labour markets trigger stronger wage pressures than expected.

While interest rate rises would do little to resolve the supply disruptions, sticky inflation could force the major central banks to tighten monetary policy earlier and to a greater extent than forecast. Indeed, US Federal Reserve Chairman Jerome Powell recently conceded that inflation can no longer be considered ‘transitory’, raising the spectre of earlier interest rate rises next year.

More aggressive monetary tightening could slow GDP growth, weigh on public revenues and raise borrowing costs for governments. This could expose vulnerabilities that persist from high debt, stretched asset valuations in some markets (especially housing), and the fragile recovery in many lower income economies. Indeed, US monetary tightening cycles have historically often entailed financial volatility for emerging markets. Importantly for Australia, emerging Asian central bankers may have more leeway to lag a hawkish US Federal Reserve in this instance given muted domestic inflation pressures and more robust financial buffers than in the past. Still, declining global risk appetite and weaker trade flows resulting from higher US interest rates could drag on business investment and consumer spending.

Financial market volatility amid vulnerabilities in the corporate sector and emerging markets

Debt generated by the pandemic poses multiple threats to the economic recovery. Corporate sector stress is currently contained reflecting significant policy support since the pandemic began and robust investor risk appetite. Indeed, bankruptcies remain well below their historical standards in many advanced economies. However, sharply higher funding or input costs or lower earnings could endanger the repayment capacity of heavily-indebted corporates.

The pandemic also saw a collapse in tax revenues and elevated public spending in many emerging markets that resulted in higher debt and weak public finances. The interest burden on emerging market sovereign debt continues to rise—despite still low borrowing costs and smaller budget deficits. This increases vulnerability to swings in global risk sentiment and higher global interest rates. It also erodes policymakers’ capacity to respond to future economic shocks. Many developing countries could face debt distress, with localised economic, social and political consequences.

A sharp economic slowdown in China, owing to persistent problems in the real estate sector, with adverse effects on commodity exporters and countries in Asia

China’s economic growth is forecast to slow to 5.1% in 2022 (from 8.1% in 2021) according to the OECD, reflecting subsiding tailwinds from base effects, continuation of a zero-COVID strategy, and weakening prospects for real estate and manufacturing investment. However, risks of a sharper slowdown have risen. While China’s property sector has long been a pivotal driver of economic growth, the financial distress of property giant Evergrande highlights the vulnerable in China's real estate market. There is a risk other indebted developers may also face financial distress. In the absence of a response from policy makers, defaults and substantially lower property prices could raise systemic risks to China’s financial stability and damp domestic demand. However, recent interventions by Chinese authorities, including establishing a risk management committee, increase the likelihood of a well-managed default for Evergrande.

Given the dominance of China in many commodity markets, a sharp slowdown would likely see lower global energy and metals prices. If the slowdown disrupted the production of key global supply inputs, adverse effects on the global economy would intensify. If accompanied by weaker global equity prices and heightened uncertainty, the shock would be even worse.

Greater social unrest

While potential flashpoints vary across countries, social unrest could increase amid high food and energy prices, widening inequalities within and between economies, and slow employment growth. Indeed, the International Labour Organisation forecasts the employment recovery to flatline significantly below pre-pandemic levels in 2022, with ‘great divergence’ between advanced and developing countries. Unwinding of stimulus measures may exacerbate public frustration. Risks will be particularly acute in emerging markets holding elections, such as the Philippines, Hungary and Brazil. In some cases, economic hardship is compounded by a long-standing erosion of trust in government institutions and long term democratic decline. A further intensification of social instability could damage investor sentiment and weigh on the recovery.

Rising trade and technology tensions

Geopolitical risks, particularly between the world’s major powers, are likely to remain elevated in an environment of rising strategic competition. Australia’s economy overall has been relatively resilient to trade disruptions. However, an expansion of protectionist policies could add to difficulties faced by Australian exporters.

Higher import substitution and protectionism could undermine the expectation that merchandise trade approaches its pre-pandemic long run trend by end-2022. A further slide toward deglobalisation would weigh on global investment and productivity growth, and in turn, economic prospects.

More adverse climate shocks

Climate change will result in more frequent and severe acute hazards such as heat waves and floods, and intensify chronic hazards, such as drought and rising sea levels. Weather-related crises may have spill overs beyond the regions where discrete disasters strike. Migration pressure, financial stress (including among creditors and insurers), and health care burdens may rise, posing further challenges to the global recovery. Longer term, transition risks associated with decarbonisation efforts will impose costs on sectors and countries reliant on fossil fuels.

Upside risk

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Faster deployment of effective vaccines

Faster global progress in deploying effective vaccines would boost confidence and spending by consumers and businesses, potentially triggering a more substantial unwinding of household savings and corporate cash holdings accumulated during the pandemic. This would boost productive capacity, see unemployment fall more sharply, and enhance the pace of the economic recovery.

Higher productivity and global connectivity

Greater automation and remote working could result in more efficient production, distribution, and payment systems. The COVID-19 pandemic has also boosted global internet connectivity. There has been an estimated 782 million additional people online since 2019 (an increase of 17%), due to lockdowns, school closures and the need to access services like remote banking. This may yield higher productivity and increased exports as more Australian exporters embrace e-commerce. The anticipated public investment push in the US and Next Generation EU plan could also lift medium term global economic growth prospects, resulting in stronger investment and more robust near term growth.

Higher global energy prices

A combination of supply factors could further push up global energy prices. Higher production costs and consumer prices would erode global economic growth; the OECD estimates that a further 30% rise in oil, gas and coal prices would see GDP growth decline by 0.3 ppts p.a. in OECD economies in the first two years, with smaller net declines in non-OECD economies.

However, energy producing countries such as Australia would benefit from higher export revenues, and perhaps investment. Coal, oil and gas accounted for 25% of Australia’s resources and energy exports last financial year. That said, higher commodity prices would also exert upward pressure on the AUD, weighing on the international competitiveness of non-resources exporters.