Here Are The Most (And Least) Likely Paths For The Global Economy

Figuring out what’s most likely to happen with global economies is one of the most head-scratching parts of investing. It’s why a lot of people fall into the trap of taking a blanket view of things – either all positive or all negative, everywhere. But things rarely ever shake out that way. That’s why I like what Scotland-based investment house abrdn does: its economists put together a collection of possible outcomes and assign a probability to each. I’ve taken a look at the team’s latest scenarios and what they might mean for investors…

1) Winter is coming (well, a recession, anyway): 40%.

It’s bleak but this is abrdn’s most likely scenario. In this one, the investment house says Europe and the UK will slip into recession by the end of the year, China will see its economic growth continue to fade, and the US will too, tumbling into a recession by the middle of next year. That all makes sense if you look at the most prominent leading economic indicator for the four regions – the purchasing managers index (PMI). The euro area (black line) and the UK (light blue)) are already below 50, which indicates a contraction, rather than an expansion. And China (dark blue) appears to be headed in the same direction.

Composite purchasing managers indexes (PMIs) for China, Euro Area, UK and US. Source: abrdn.

Only the US (gray) is bucking this trend. But, abrdn says, maybe not for long: the rapid rise in interest rates and the swift depletion of pandemic-era household savings will eventually catch up with US consumers – and their economy.

As for those interest rates, well, abrdn says the European Central Bank (ECB) has probably finished its hiking cycle, but the still-resilient US economy might mean the Federal Reserve (the Fed) isn’t quite done. Both, though, will likely be chopping rates by early next year. The Bank of England (BoE), meanwhile, is a bit of an unknown, with persistent inflation meaning the British central bank mightn’t be able to cut rates at all next year.

And China is a whole different story: abrdn expects the slowdown there will be met with more government and central bank stimulus, which should keep the wheels from coming off completely. Fingers crossed.

What does this scenario mean for markets?

If abrdn’s crystal ball is working and all this comes to pass, my best guess is that stocks would probably continue to oscillate as they’ve been doing until investors get their arms around the shape and size of all the various recessions. Ironically, a sharp recession ( with the US contracting by, say, 2%) would kill off inflation and leave central bankers with lots of room for economy-stimulating interest rate cuts. That could provide an opportunity for investors to jump into stocks, ahead of the next upturn. The worst outcome, obviously, would be a long, drawn-out recession.

My favorite strategy here is to just be aware of what’s priced in. When the headlines are all “soft landing, soft landing, soft landing”, and markets are sunshine and light, I’d be wary. The opposite is true too, of course, and I’d be rubbing my hands with anticipation when all the worst outcomes start to get priced in. Then again, you could ignore all that and hold onto your stocks for the long-term. That’s always a good option, and it also means you could just stop reading now (not that you’d want to).

2) That so-called soft landing: 35%.

The second-most-likely scenario is the opposite of the first. In this one, those central bank interest rate hikes and a better supply environment manage to tamp down inflation, and some economic resilience continues, and everyone avoids an actual recession. Probably the reason why abrdn gives this a lower probability is its reliance on the supply side of things, which is tough to get any sort of visibility on. What we’re talking about here is a better-functioning labor market with more people coming back into full-time jobs and some increased productivity (did someone say “AI”?). That would ease pressure on wages and cool some of those inflationary winds in the process.

What does this scenario mean for markets?

I don’t want to get too carried away here, but this would be a pretty positive outcome for stocks. It’d also likely be good for bonds too, as the world would start feeling much better about long-term inflation expectations. What’s more, the economy would have settled into a new normal of 4%-5% interest rates and 2%-3% inflation. That’s pretty close to the not-too-hot, not-too-cold Goldilocks outcome that you hear so much about. And, for what it’s worth, this is the outcome that I see as being most likely.

3) The wild cards

There are also three other less-likely scenarios that abrdn says are worth watching.

First is the idea that inflation is going to hang around – abrdn says there’s a 10% chance of that playing out. The scenario kicks off a lot like the most likely outcome, with major economies dipping into recession and China slowing. But there’s one (big, ugly) difference: in this scenario, inflation isn’t tamed by the recessions. Instead, because of some huge, immovable issues, like labor market rigidity or maybe continued commodity cost increases, inflation just hangs around, unexplained and definitely uninvited. And this is possible, but it would go against economic theory. This chart shows the vaunted economic “Phillips Curve”. It dictates that when a recession kicks in and people lose their jobs, inflation falls. Clearly, abrdn’s economists are Phillips Curve believers, which is why they slapped a tiny, 10% likelihood on this outcome.

The Phillips Curve shows the relationship between inflation and unemployment.

In any case, this outcome would be very bad for stock markets everywhere. It’d suggest that inflation might be here to stay, and that’d be unexpected, and markets would end up tanking, hard.

The second wild card is a full-blown China meltdown, with the country’s flailing property sector right at the epicenter. It wouldn’t be pretty (for China, at least), so luckily abrdn is assigning only a 10% chance of this happening. Over the years, China’s economic troubles have tended to be met with forceful (and effective) government action. But, sure, theoretically, Chinese authorities might choose a different path and that’d be bad for China’s economy and probably its stock market too. Obviously, this wouldn’t be celebrated by advanced economies or their stocks, but major global economies and markets have decoupled recently, and the impact on the US and Europe might not be overly severe. I could, of course, be wrong on that.

And, third, abrdn points out there’s a small chance (just 5%, it says) that China opts for a massive stimulative response to its continued economic malaise. Again, this one’s tough to predict, and China mightn’t want to go down that route. If it did YOLO some crisis-sized yuans at the economy though, it would probably light a fire under the Chinese stock market. So if you think this outcome is more than 5% likely, you might want to add to your Chinese stock positions, or go bigger on US or European firms that have decent Chinese exposure.