Charts of the Week (Oct 20, 2023)

Middle East tension/Geopolitical risks The conflict in Israel and Gaza has been – and will likely remain – a key focal point in the weeks ahead. Normally, higher geopolitical risk is linked to a greater likelihood of economic and financial market stress, along with increased downside risks to the global economy. However, straightforward measurement of this link is challenging. Nevertheless, in Chart 1 below, we have depicted an index of global geopolitical risk, which gauges adverse events and associated risks by tallying newspaper articles covering geopolitical tensions. As the chart illustrates, this index has recently experienced a sharp increase. Nevertheless, there hasn't yet been a big follow-through from financial market stress, as measured in this case by the US VIX index.

Energy prices and stagflation The price of oil is likely to continue to play a pivotal role in how geopolitical tensions in the Middle East trigger broader economic and financial instability. In Chart 2 below, we illustrate how oil prices have historically caused significant fluctuations in economic sentiment. For example, changes in the inflation-adjusted consumer energy price in OECD economies, which are closely correlated with oil prices, have often served as indicators of unexpected shifts in economic growth and inflation. In particular, stagflation phases, which are characterized by positive inflation surprises coupled with negative growth surprises, can often be traced to higher oil prices and broader disruptions to the supply side.

US and China data surprises One reason why financial market sentiment has yet to respond too negatively to the instability in the Middle East concerns the incoming dataflow. This week’s economic data from China, for example, and most notably the estimate of GDP for Q3, surprised forecasters’ expectations on the upside. Coupled with positive surprises from September’s retail sales and industrial production, that helped to shift Citigroup’s growth surprise index for China into positive territory for the first time since June. Together with still-positive messaging from the incoming US data in recent weeks, investors have arguably started to feel more at ease about the immediate outlook for global growth in the weeks ahead.

Birth rates in China and Japan A stronger-than-expected performance from China in Q3, however, does not imply that the economy is in the clear. The challenges associated with property market and debt-related imbalances will require a significant amount of time to resolve. Meanwhile, structural obstacles to growth have been steadily accumulating, with one of these concerning demographics. According to the Science Centre at Peking University, the projected number of births in China for 2023 is anticipated to range between 7 to 8 million. This follows a 40 percent decrease in China's new-born population over the past five years. The uncertainties brought on by the COVID pandemic, coupled with weak income expectations and elevated levels of youth unemployment, can arguably be identified as key factors contributing to this decline. These factors though are further exacerbating an already significant aging trend within the economy at large.

The world economy’s growth potential Those headwinds for China’s growth potential are one factor that explains the IMF’s heightened pessimism toward the longer-term outlook for the world economy. In Chart 5 below, we compare the IMF's most recent October forecasts for global growth from 2023 to 2028, firstly with its longer-term projections made in April 2022 (and up to 2027), and secondly with the 40-year historical trend. In summary, the October forecasts have been revised downward and now fall well below the long-term average. There are a number of perhaps familiar reasons for this heightened pessimism but they underscore nevertheless some of the challenges that confront policymakers in the period ahead.

Fiscal policy space One of these challenges pertains to monetary policy and the inflationary pressures that have arisen due to reduced supply potential. However, substantial challenges also exist on the fiscal policy front. Fiscal policy tools, after all, have been used more extensively in recent years, partly due to the support required to bolster growth during the pandemic. But they have been more actively employed as well because of pressures that have surfaced from factors like ageing demographics, particularly in areas such as healthcare and pensions. As a consequence, government debt-to-GDP ratios have risen significantly (as shown in Chart 6). However, that means there is now far less room to actively employ fiscal policy tools in the period ahead, especially in an environment of higher interest rates and increased debt service costs.