Mid-Year Sovereign Outlook: Slowdown, Inflation, Rising Rates Create Divergent Rating Risks

Download Scope’s 2022 Sovereign Mid-Year Outlook.

Explainer video: Scope Ratings introduces the 2022 Mid-Year Global Economic Outlook

Figure 1. Scope’s global economic outlook, summary, as of 18 July 2022

We are forecasting weaker global growth for 2022 but our forecast remains consistent with an economic baseline entering this year, of above-potential for the calendar year but uneven economic growth. While there is significant likelihood of technical recession over 2022-23 in certain countries, such recessions are likely to be mostly shallow with annual growth rates probably remaining moderately positive.

Annual growth for 2023 will display further slowdown or normalisation across many economies, although China is a crucial exception here, as high prices restrict purchasing power while post-Covid rebounds fade in force.

One legacy of the Covid-19 crisis has been a government debt overhang. In this respect, high inflation can be credit positive near term for sovereign credit ratings via the trimming of debt ratios. However, inflation derails real economic growth and, with time, increasingly constrains central banks’ room for manoeuvre should price-stability mandates be compromised.

As such, if persistent inflation restricts lender-of-last-resort functions of a central bank to intervene during market failures, current conditions lean towards being negative for sovereign ratings.

Stagflationary conditions present divergent positive and negative effects for sovereign risk

Stagflationary conditions hold divergent positive and negative effects for sovereign credit ratings, with more borrowers seeing downside rating actions than upside actions since the escalation of the Russia-Ukraine war. Since 24 February 2022, Scope Ratings has revised three countries’ ratings lower: Russia (WD), Ukraine (CCC/Negative), Turkey (B-/Negative), changed three rating Outlooks to Negative: Japan (A), China (A+), Czech Republic (AA) and revised only three countries’ ratings/Outlooks to an upside: Croatia (BBB+/Stable), Portugal (BBB+/Positive), Cyprus (BBB-/Positive). Russia has defaulted while Ukraine contemplates debt restructuring.

Further significant market instability is likely, although global financial crisis not anticipated

Impediments to global growth include elevated energy and commodity prices, weakened economic sentiment and a slowdown of economic trading partners. Inflation remains elevated even with tighter monetary policies. Even when inflation peaks and starts to moderate over the coming quarters, significant market instability and correction are likely, although we do not anticipate a global financial crisis.

Economic slowdown and the gradual easing of elevated inflation will cause front-loaded central bank tightening to decelerate, halt or even reverse in many cases by 2023. Currency depreciation is seen forcing tightening by more dovish central banks such as the ECB or they risk importing further inflation.

We have cut GDP growth forecasts for this year (Figure 1), to 2.8% for the euro area, 3.5% for the UK, 1.7% for the US, 3.6% for China, and 1.8% for Japan. Next year, continued moderation of annual rates of growth is seen for the euro area: 1.8%, UK: 1.0%, Japan: 1.7%; the US sees 2% growth next year, with China recovering to 5.1%. The Russian economy is expected to contract by more than 10% this year. We marked up Turkish growth amid credit-fuelled recovery.

A central risk to Scope’s economic baseline scenario is further tightening of financial conditions

A central risk to our mid-year global economic baseline is further significant tightening of financial conditions in the form of higher long-term bond yields, a further correction in global equity markets and/or appreciation of the US dollar. This could be the result of current very high inflation further surprising to the upside and/or behind-the-curve central banks tightening faster than currently communicated.

Faster policy tightening cuts the risk of inflation becoming more deeply engrained but also raises risk of policy mistakes exacerbating financial instability. Alongside significant Federal Reserve and Bank of England hikes and quantitative tightening, we expect the ECB to start raising rates for an initial time this cycle later this week while introducing near term a novel ‘anti-fragmentation’ programme against rises of periphery spreads.

Register for Scope’s webinar presentation: Global economy in slowdown: inflation, war, Europe’s energy crisis darken the outlook (Tuesday, 26 July 2022, 15:30 CEST)

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH and lead author of the rating agency’s Sovereign Outlook. Giacomo Barisone, Managing Director of Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.