While EM sovereign risk is already reaching dangerous levels, there is room for a further increase in yields and spreads.

Several emerging market (EM) countries are at risk of balance-of-payments crises (Argentina, Chile, Colombia, Egypt, Hungary, Kenya, Pakistan, Poland, Romania, and Turkey).

We expect persistent yield-curve flattening until year-end, with recession concerns keeping long-term rates anchored at 3.25% in the US and 1.6% for the 10Y German Bund. Both the Fed and the ECB will remain hawkish compared to other recession episodes, with limited rate cuts after mid-2023.

Central banks’ determination to fight inflation could lead short-term sovereign rates to go above neutral terminal rates in both the US and the Eurozone (to 4% and 2.25%, respectively).

In the US, inflation is likely to have peaked already but should remain above 4% until Q1 2023, falling below 2% only after Q3 2023 (averaging 2.9% in 2023). Eurozone inflation should peak at 10% in Q4 2022 and then average 5.6% in 2023. We expect global inflation to average 5.3% in 2023 (after close to 8% in 2022).

Inflation will remain high until Q1 2023 after energy prices have peaked, with food and services adding upside pressure.The US will register a -0.7% fall in GDP, mainly due to rapidly tightening monetary and financial conditions, which will significantly cool the housing market, coupled with a negative external environment and low fiscal support after the mid-term elections.But it will not fully offset the shock on real disposable incomes and corporate margins. Increased fiscal support to the tune of 2.5% of GDP on average and limited monetary easing after mid-2023 will help make the recession shorter and shallower, and limit the risks of social unrest. Eurozone growth is likely to plunge to -0.8% in 2023 due to soaring energy prices and negative confidence effects.Consumer sentiment has already plunged to record lows and business confidence continues to deteriorate rapidly, which will hold back consumption and investment. We expect global growth to slip into negative territory in Q4 (-0.1% q/q), followed by a slow recovery at +1.5% in 2023.

The trifecta of lower growth, higher inflation and higher rates will hit even harder.

As Russian gas supply is coming to a halt, the fight against inflation is raging and political uncertainties coalesce, our previous adverse scenario has become reality.

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