At the beginning of this year the world economy appeared to be on the mend, just as the pandemic was fading. The United States and Chinese economies had already regained their pre-pandemic levels and Europe looked on course to catch up.

However, things have changed drastically over the past few months and it is now clear we are in the middle of another global downturn. That downturn is taking different forms around the world.

In the US the main cause of the slowdown is that the Federal Reserve – the country’s central bank – has raised interest rates quite sharply in an effort to contain inflation. Its main policy interest rate was zero at the end of 2021 and is now over 3 per cent and expected to rise further in the coming months. Higher interest rates are seen as necessary to slow the economy in order to bring inflation down from its current level of around 8 per cent.

This has already had a big impact. US households have cut back on property purchases, which in turn has led to a slump in the number of new houses and apartments being built. And consumers have scaled back major purchases, such as cars. On top of that businesses are tightening their belts, notably by reducing investment.

Covid strategy

Economic growth in China has also stalled this year. There has been a big downturn in the property sector; exports have weakened; and there are repeated local lockdowns due to the country’s zero Covid strategy. Unlike previous downturns, the Chinese Communist Party has been reluctant to step in with more lending because of fears that this could put the financial sector at risk. China’s economy will probably not grow at all this year, although government statisticians will not admit things are that bad.

The situation in Europe is worse. It faces similar problems to those in the US – rising inflation and interest rates – but they are compounded by surging energy prices because of Vladimir Putin’s decision to cut off the supply of natural gas through its European pipelines. There is even a risk of power cuts this winter.

European households, and likely their US counterparts, face a “cost of living” crisis driven by high energy prices and a “cost of borrowing crisis” as interest rates rise. The impact will vary between countries, but Germany is in the eye of the storm because its chemical and metal factories rely heavily on natural gas. As it is the largest economy in Europe, a recession in Germany will also drag down its neighbours.

There is no agreed definition of a “global recession” but in the past the International Monetary Fund has suggested that anything below 2.5 per cent growth would qualify for that label. On that definition, we look certain to experience a recession. In any case, regardless of the numbers a combination of declining real incomes, declining world trade and falling asset prices means it will look and feel like a recession for much of the world.

Silver linings

Needless to say, this rather gloomy prognosis is not ideal for asset prices. Equities and bonds have already fallen significantly this year and, while some commodities have done relatively well, there are no obvious safe havens in which to take refuge.

Despite all this gloom there are a few silver linings.

First, the labour market has remained surprisingly healthy. In most countries unemployment is close to record lows.

Second, the world economy has always bounced back from recessions and this time should be no exception. As the current wave of inflation fades, central banks will reverse course, cutting interest rates and nurturing growth again.

Third, this recession is likely to be shallower than the last two – caused by the global financial crisis and the pandemic. The recession of 2022-2023 should be a more typical one caused mostly by higher interest rates, and these tend not to be so severe.

And fourth, the recession seems, at this stage, unlikely to last as long as the downturns of the 1980s, which dragged on for several years, or the euro-zone crisis which lasted for around five years during the early 2010s. This is largely because the financial sector is in a healthier state and is unlikely to collapse under the weight of a relatively mild recession.

Finally, asset prices tend to recover before the economy has picked up because investors anticipate that economic activity will recover and interest rates will fall before either of those things happen.

Indeed, bond prices may now be close to their low points and it is possible that equities are not far from their lows too. What’s more, asset prices typically do very well in the years after a recession. So while the coming year may be very difficult for the economy, the next few months could turn out to be a good time to invest.