The return of the policy put
In the face of weaker global growth, inflation and financial markets over recent months, the Federal Reserve has become more data dependent while Chinese authorities have further loosened policy. This return of the policy put is a key reason why we do not expect a recession within the next two years, though we do expect the global economy to slow further.
According to our proprietary indicators, global economic momentum has moderated further over recent months. Only the US was able to sustain above-trend underlying growth in the second half of the year (see Table 1). Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK, while our China Activity Indicator has shown few signs of responding to recent policy stimulus. Emerging market (EM) growth momentum (ex-China) has improved modestly but is also subdued. The deceleration has been concentrated in the global industrial sector. Industrial production growth has declined to under 2%, on a six-month annualised basis, led by developed markets (DM).
Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK.
Table 1: Micro to Macro Indicator*proxied with Germany in recession modelling.
Notes: macro momentum measured as diffusion index between 0 and 100; Nowcasts measure is deviation of current nowcast value from potential growth and if the pace of growth is increasing, decreasing or being maintained in the current quarter.
Source: Haver, Bloomberg, Eikon, Aberdeen Standard Investments (as at 31 December 2018)
Capital spending growth, including residential investment, has weakened across most economies. Non-residential investment growth has also started to moderate, with weakness most pronounced in the UK and Italy, where ongoing political uncertainty is weighing on business sentiment. There is little evidence that US tax cuts have altered the trajectory of domestic capital spending. By contrast, consumption has been a more consistent driver of growth in most DM economies. This mostly reflects the strength of the labour market, although in the US, housing activity slowed in response to the earlier rise in mortgage rates. Consumption will be further supported by the recent plunge in oil prices.
With the main drivers of our view that global growth will slow further over the coming quarters – tighter global financial conditions, elevated trade and other geopolitical tensions, and fading US fiscal stimulus – still largely intact, we have made few changes to our forecasts this time around. That said, there is scope for an inventory-led rebound in industrial growth around the middle of the year, as some temporary factors weighing on activity fade and production catches up with stronger consumer demand. However, any pick-up in industrial growth is likely to be far more modest than in the previous upswing.
Oil swings and roundabouts
We expect to see lower rates of headline inflation into 2019, mainly reflecting the sizeable 30% fall in oil prices since the beginning of October. This will drag headline inflation down in the advanced economies over the coming months, but to a lesser extent in those emerging markets where prices are more regulated (see Chart 1). By contrast, wage cost growth in the advanced economies has been surprising to the upside lately, implying a modest upwards trend in underlying inflation pressures.
Chart 1: Oil feed throughSource: Bloomberg, OECD, Aberdeen Standard Investments (as of 31 December 2018)
Nevertheless, the translation of stronger wage growth into higher core inflation is by no means straightforward. The theoretical relationship involves higher wages pushing up unit labour costs, which feed into core inflation. However, any increase in productivity growth would moderate the boost. Indeed, unit labour cost growth in the US actually moderated through 2018. Moreover, corporate margins may absorb some of the pressure of higher unit labour costs, implying less read across to core inflation. This appears to be happening in the Eurozone where unit labour cost increases have accelerated but core inflation has been fairly stable. The upshot is that we expect core inflation to rise in most of the advanced economies, but still only slowly.
In emerging markets, there is still some lagged effect of earlier currency depreciation passing through to consumer prices. The most obvious examples are in Turkey and Argentina, where their earlier currency crises have driven headline inflation as high as 25-45%. More modest currency depreciations in China, India, Russia and Brazil are also pushing up imported goods prices and therefore headline inflation in the near-term. Nevertheless, the recent drop in oil prices will push inflation down over the coming months just as currency effects fade. The sequential trend in EM inflation is therefore likely to be down as 2019 progresses.
Geopolitics: a thaw but for
The truce in the trade war between the US and China announced at November’s G-20 meeting, followed by China announcing a cut in tariffs on auto imports from the US, produced a short-term circuit breaker in a conflict that was at risk of spiralling out of control. The ceasefire, which was reinforced by further progress in mid-level trade talks in early January, may be a sign that both sides have become more concerned about the economic and market fallout from the dispute and are looking for ways to de-escalate tensions. However, we are sceptical about its durability. The list of contentious issues remains very long, with China needing to reform its economic and policy model to satisfy US demands. Moreover, because the dispute has become much broader than trade, compromise will be even more difficult.
In Europe, the smell of compromise is also in the air as the Italian government scaled back on its fiscal giveaways to satisfy the EU’s budget rules. Resolving the impasse involved the careful consideration of the political cost of walking back on tax and spending promises. Further bouts of Italian financial stress remain a risk as the government’s fiscal projections appear too optimistic. In addition, the European Commission has warned it will closely monitor Italy’s spending to ensure the budget agreement is honoured.
The outlook for Brexit also remains highly uncertain, as British politics has descended into chaos. Prime Minister Theresa May did not give parliament the opportunity to vote on the Withdrawal Agreement in December, and then faced down a no confidence motion from her own party. Though May survived, she is weakened, and at the time of writing has not elicited the concessions on the Withdrawal Agreement from the EU to secure its safe passage before March. This opens up a wide range of possibilities, ranging from a no-deal Brexit all the way to a second referendum with the option of staying in the EU. An extension to the Article 50 timetable has become much more likely, and a disorderly exit somewhat less likely.
On all three fronts – US-China relations, Eurozone fiscal tensions and Brexit – the message is that uncertainty will either be sustained, or could quickly resurface. This should continue to weigh on investment spending in particular.
A challenging environment for central banks
Amidst this more challenging environment, financial conditions have tightened. Global equities shed almost 15% from last September to year end, though there has been a modest bounce in the first weeks of January. Meanwhile, equity volatility has picked up, corporate and EM credit spreads have widened, and our US Financial Stress Index has increased. Equities initially fell as US bond yields rose, but yields have rallied since early November; the US 10-year yield fell by more than 0.5% between November and January while German yields are at their lowest since the end of 2016.
Critically, although the Federal Reserve (Fed) lifted rates again in December, it has reacted to the weaker global economic and financial landscape by dropping one of the projected increases this year. Rhetoric has also become more dovish, implying greater caution and data dependence than was the case earlier in the year. This explains part of the bond rally, as does the fall in oil prices. Bond markets are also reacting to fears that the global growth slowdown has further to run.
We expect the Fed to deliver two more rate hikes over the next year, beginning in June, followed by a further one in 2020 (see Chart 2). However, that view is conditional on there being no further correction in risk assets or sharp drop-off in domestic growth. As such, the risk of the Fed overtightening and accidentally causing a recession has receded. The Fed put is still alive and well.
There will be little tightening elsewhere in 2019. The ECB has ended its asset purchase programme but the dramatic deterioration in growth, combined with stagnant, below-target inflation, means that further policy adjustment is a distant prospect. Japan’s yield control targets are unlikely to change, and Chinese monetary policy will continue to loosen to support growth. The direction of policy in other EM economies is highly dependent on whether currencies resume their downward trend.
Chart 2: Rates to increase in most regionsSource: National Sources, Haver, Aberdeen Standard Investment (as of December 2018)
Risks to the outlook more finely balanced
We still think it is premature to call the end to the current economic expansion. Our recession probability models have not yet crossed the necessary thresholds to call a near-term recession. More fundamentally, US and global imbalances are not severe enough to prevent most economies responding to policy loosening, as long as the current US tightening cycle does not go too far.
Although we are not forecasting a recession within the next two years, our US recession probability models imply that the likelihood of a more serious slump in 2020 has increased to around a third. Recession probabilities at these levels for the US naturally tilt the risks to our baseline projections to the downside. Those risks relate to the dangers of policy being tightened too much amidst limited spare capacity and increasingly fragile financial markets.
While it is rare for either economic or earnings growth to accelerate persistently and meaningfully at this point of the cycle, when unemployment rates are very low and wage growth is picking up, there are upside risks to our projections, especially in the near-term and relative to what is priced into markets. As pointed out earlier, industrial growth has slowed more quickly than consumer demand, raising the possibility of an upswing by mid-2019, as production and inventories catch up with solid consumption growth driven by improving real income dynamics and more fiscal stimulus outside the US.
The Fed is another wildcard; further increases in financial stress could keep policy on hold throughout the year in a re-run of 2016. This would support stronger growth and financial markets through 2019. Similarly, our current expectation is that Chinese policy easing cushions growth rather than leading to a meaningful acceleration in growth. However, past experience has been that the authorities have overstimulated, creating upside risks to the Chinese growth outlook.
Meanwhile, our political risk analysis has led us to maintain our cautious outlook for US-China trade protectionism, as well as European political tensions. But if either or both dissipate more quickly, the boost to consumer and business confidence would be very positive.
Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK.