Real estate markets, rioting in France, and other risks to the global economy in 2023

The European Union (EU) recently published a strategic document on economic security, highlighting three main priorities: promoting competitiveness, protecting economic security, and partnering with other countries. The objective of these proposals is to improve government oversight of “risky” trade with non-EU countries in a way that reflects the new global environment.

The EU’s economic security strategy focuses on addressing the concerns surrounding economic security, especially in view of geopolitical events such as Russia’s invasion of Ukraine and the Covid pandemic. The strategy includes proposals for periodic reviews and reporting to the European Council, with contributions from the private sector to help address supply chain vulnerabilities and technology leakage.

The strategy also represents a response to pressure being exerted by the United States government, which is encouraging restrictions on the outflow of sensitive goods and technologies to China. Although the EU is considering imposing export control regulation on dual-use items, while also taking into account the security risks associated with overseas investment, its approach so far is considerably less strict than the one applied by the U.S.. What the EU is trying to do is find a balance between collaboration with the United States and its own trade relations with China. Whether or not those measures are implemented will largely depend upon the incoming European Commission, and additional transatlantic tensions could also arise if the United States sees leadership changes after its 2024 presidential elections.

The objective of the Spanish presidency of the Council of the European Union is to make progress on the primary challenges now facing the EU. This includes the ongoing need to respond to crises such as the Covid pandemic and Russia’s invasion of Ukraine, along with other geopolitical changes. The Spanish government is hoping to play a significant role in plotting the future course of the EU and strengthening its global alliances, with some of its top priorities being support for Ukraine, forging new alliances in Latin America and the Caribbean, and advancing the green transition.

In the American banking and finance markets, the Chairman of the U.S. Senate Banking Committee, Sherrod Brown, has secured a significant victory with initial approval of a bill that will allow the federal government to recover salaries paid by failed banks to their executives. Meanwhile, BlackRock and JPMorgan have teamed up with the Ukrainian government to create a $400 billion reconstruction bank.

On the subject of energy, there is ongoing drama surrounding the upcoming COP28 conference, while Russian oil continues to feel the pressure of EU sanctions. In addition, European countries with significant automotive industries are struggling to respond to the flood of inexpensive electric vehicles from China now appearing on the market.

On the subject of defense and national security, controversy arose regarding recent comments by Joe Biden criticizing Chinese leader Xi Jinping. An offer from Romania to train Ukrainian pilots to fly F16 fighter jets has also been considered, and a congressional committee has approved changes that will increase cybersecurity efforts for protection against China.

The killing of a teenager of Algerian and Moroccan descent led to widespread violent protests in France, further exposing the existence of deep social divisions in the country. The French government is now facing a difficult challenge to prevent further escalation and polarization, with a need to restore order while also confronting underlying issues. The longer-term political impact of these events will depend upon how long they persist. Those seeking implementation of stricter police controls could gain popular support, as a survey by French market research firm IFOP has shown that a majority of the country’s population trust and sympathize with the police. The situation has also increased concerns about public safety, tourism, and the events leading up to the Rugby World Cup and Paris Olympics.

In the first quarter of 2023, global debt increased by $8.3 trillion to reach $305 trillion, representing 332% of global GDP (down by 8 percentage points compared to the end of 2022). This increase was driven more by the developed markets, where debt rose by $5.1 trillion, although emerging markets saw their debt level rise by $3.2 trillion, setting a new record. As the series of interest rate hikes announced by the main central banks continue to exert their effects, and despite the slowdown seen in terms of global growth, worldwide debt levels remain near historic maximums, about 50 percentage points above 2008 levels. In the case of the developed markets, increasing leveraging has been concentrated primarily in the public sector, and to a lesser degree in the financial sector (the opposite of what has occurred in the emerging markets), with a smaller contribution from households. This dynamic is continuing to increase the debt burden (with stabilization of interest rates exerting upward pressure), with productivity suffering the corresponding negative impact (primarily in economies with the highest debt ratios) and sustainability also being put at risk (with risk of a debt crisis), all in a context where the anticipated turning point in monetary policy still has not occurred, combined with less liquidity and a slowdown in growth. 

With an eye on inflation figures, the main central banks have generally decided to extend the cycle of tighter monetary policy, indicating a peak interest rate higher than the one expected just a few months ago, while also stressing that high rates will remain in place until the financial stability objectives have been met. The balance sheet reductions now in progress also represent an additional factor.

As the U.S. Federal Reserve and the central banks of the G10 countries, in their efforts to rein in inflation, move further into the territory of restrictive monetary policy, they face the increasingly palpable dilemma regarding how much demand should be curtailed, and with it, global growth, and the need to determine the inflation levels that will be consistent with medium-term and long-term expectations. Although inflation rates are starting to move away from their earlier peaks, there is still fragility in relation to risk assets, while warning signs of a potential financial accident continue to accumulate. This is taking place in tandem with a return to normality that is still being thrown out of balance by lower production capacity, which has not yet been fully recovered, and suppression of demand that has not yet shown its full impact.

Early indicators on the Chinese reopening have given way to a recovery weaker than initially expected, suggesting that this process could end up being less vigorous and more uneven. The main catalysts continue to be consumer spending and the services sector, which are being propped up by accumulated savings, along with a return of higher confidence levels. However, this reactivation of consumer demand doesn’t seem to be persisting at the level of the initial pulse observed, and consumer confidence hasn’t fully reflected the expected positive outlook. Meanwhile, China’s most recent inflation figures suggest that savings could remain above pre-pandemic levels for longer than anticipated.

At the same time, indicators in the manufacturing sector show that normalization has not entirely come about. In this context, it’s expected that some new stimulus packages will be brought in during the second half of the year, both in relation to economic policy (the PBC has lowered its rates for reverse repo operations, opening the door to measures to increase flexibility) and fiscal or quasi-fiscal policy, focused on revitalizing domestic demand and shoring up the real estate market to prevent a downward feedback loop in terms of confidence. Although these measures would help recover the traction that seems to have been lost after the initial spark of China’s reopening, they would also increase risk to the country’s economic balance, given the high degree of leveraging that already exists.

Warning signs continue to stack up in relation to the vulnerabilities brought on by climate change, as the economic costs of extreme weather events spread across the planet in an interconnected manner, with predictions of an upcoming El Niño weather cycle as one good example of a significant climate-related event.

The effects of these anomalies on prices are once again being seen in the commodities markets, for example, wheat, coffee, sugar, and cocoa futures, because of the effects they have on crop yields, energy prices, and availability of water, in a context where supply chain volatility and the corresponding impact on prices can generate an additional shock that hinders attempts to control inflation.

Inflation data continues to show a downward trend, with increasing moderation of prices for raw materials and especially energy, supply chains almost back to normal operation, and scaled-back demand for durable and manufacturing-intensive goods. However, there is no equivalent trend being seen in the services sector, where inflation continues relatively unabated, with higher-than-expected persistence. This dynamic is also being reflected in core inflation figures, now being pushed along by some unfavorable tailwinds. This is leading to inflation forecasts with a longer duration, with the possibility of additional support from higher salaries triggered by friction in the employment market, and by a cumulative loss of purchasing power.

To summarize, it is expected that price trends will continue to show signs of moderation, although at a pace that may be slower than desired, while avoiding second-round effects that could unleash new expectations of upward inflationary trends.

Disturbances in the banking sector, in combination with a context of rising interest rates and a decreasing ability to recover purchasing power, continue to put a damper on demand in the real estate sector, among both investors (with competitive yields now available in the money market and bond market), and consumers (where less attractive terms for loans are reducing demand for them). As a result, the potential for valuation adjustments continues to represent a risk in the major economies, although so far this has only been occurring at a moderate pace.

In sum, the cycle of valuation adjustments could become more abrupt and widespread, to the extent that risk appetite continues to wane, access to financing becomes stricter, and the need for refinancing leads to more insolvencies, all conditioned by an environment of more restrictive interest rates and sub-trend financial performance.

Fears of a global energy crisis have been fading during 2023, as pressure on energy-related raw materials slackens, and with natural gas prices retreating from the peak levels seen during the second half of 2022 and returning towards the levels existing prior to Russia’s invasion of Ukraine.

However, in view of the global geopolitical outlook, the energy crisis is still far from over, and there is still a significant risk of new events that could cause further price volatility, combined with an ongoing deficit of investment in alternative energies.

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