Wider outcomes with increased downside risk
At the same time, it is important to note that the distribution of outcomes is widening and increasingly skewed to the downside.
Intensifying energy shock
The longer the Iran conflict remains unresolved, the larger the energy shock is likely to be. A more sustained energy shock would risk a more forceful policy response. The doubling in energy prices this year could add as much as four percentage points to headline inflation, and a more prolonged increase would risk a larger pass-through to core inflation. Many central banks have made clear that how they will respond to a larger energy shock may not be linear, implying that the bigger and more persistent the energy shock, the larger and faster the series of hikes.
A more persistent and larger energy shock could also lead to a sharper repricing of term premia in the bond market if the monetary and fiscal tightening is deemed inadequate. The starting point for government finances is already stretched — the average G10 deficit this year is close to 6%, a level normally associated with crises rather than periods of exceptional nominal GDP growth. If the market suspects central banks aren’t serious about fighting inflation and governments aren’t safeguarding debt sustainability at a time when high yields are eroding fiscal space, investors could deliver the tightening policymakers don’t want to undertake via a sharp rise in term premia. Increasing term premia have already driven around half the rise in G10 yields since the start of July.
Growing doubts about select countries’ debt sustainability
Countries with the most challenging public finances — France, the UK and the US — are the bellwethers to monitor. We are getting to levels on yields where, for some countries, the sell-off is becoming self-perpetuating without a clearer commitment to conservative fiscal policy. If these yields persist, their governments would need to improve their primary balances by three to four percentage points to stabilise the debt-to-GDP ratio, even at these high nominal growth rates. Such an undertaking seems extremely challenging in the current political climate.
Risk to consumption
Consumption has so far proved resilient despite the squeeze in real incomes from higher energy prices. Consumers have been willing to run down savings to smooth the energy shock, even amid some of the weakest consumer confidence levels on record and the lowest labour share of GDP in at least 30 years. Low real rates have encouraged households to pull forward consumption. But if wage growth and employment do not lift into year-end to alleviate the squeeze in real incomes from higher inflation, the gap between confidence and spending could resolve to the downside.
AI capex is critical
Other than a longer, larger energy shock, the most significant downside risk to growth to monitor is the risk of a slowdown in AI capex driven by a reassessment of the returns AI will create or that can be captured by firms. The potential for the recent debate on safety and regulation to weigh on AI investment is an important risk to monitor in that regard.
What’s the positive tail?
If the disruption to Middle East oil supply were resolved, oil prices could fall rapidly. Another positive tail risk is the potential for a positive supply shock from rising productivity growth, which could help to offset the negative supply shock from oil, if large enough. The productivity leads have been pointing in that direction for some time but, so far, any increase has been limited.
Market response likely to drive growing divergence
The market may increasingly reward credible policy and penalise inappropriate policy. It is striking that in this latest leg higher in yields since July, there has been an almost indiscriminate repricing of rate expectations higher across the G10 and a sell-off in yields — in lockstep with rising oil prices. But the rise in energy prices has very asymmetric implications across countries, depending on whether they are net energy importers or exporters. The risk of second-round effects differs by country too. And policymakers will respond with different degrees of orthodoxy. We expect the market to increasingly price this divergence. Bond markets and currencies in countries with orthodox central banks and relatively favourable fiscal starting points — like Germany and Australia — should outperform those with less credible central banks and more unstable debt dynamics.
A sensitive moment for the global outlook
In short, we are at a sensitive moment for the global outlook. So far this year, loose policy and AI-related growth have more than offset any drag from the energy shock and amplified the inflationary implications. Private sector balance sheets are strong and less sensitive to rate increases. The rise in energy prices to date and the policy response will weigh on nominal growth but should not undermine it.
But we are not at a stable equilibrium for the oil market or the consumer. If the energy shock keeps growing and the policy response becomes more forceful, the downside risks will grow, potentially exposing unstable fiscal dynamics in some countries. The longer and larger the shock, the more challenging it will be for consumers to keep spending in the face of a squeeze on real income. Conversely, an easing of oil prices or a significant lift in productivity could quickly return us to the positive dynamics of the first half of the year. Investors need to keep a close eye on the evolving macro conditions in the months ahead.
