Macroscope: animal spirits present upside risks

Executive summary

Point forecasts are almost always wrong; the only questions are by how much and in which direction.

In the nearterm, the main risks to our forecast for global growth to track sideways this year before edging up in 2021 are to the upside. Incoming data imply that the US and China are in better shape than we anticipated, while global manufacturing sentiment is showing more ‘oomph’. With risk assets also going from strength to strength, a recession this year has become less likely.

Recent news has not all been good, however. The UK and Japanese economies appear to have contracted in Q4, with hopes for a better 2020 resting on a post-election confidence boost in the former and VAT headwinds abating in the latter. Risks in both are tilted to the downside. In Europe, meanwhile, the manufacturing sector remains mired in a slump, with only services activity providing ballast, a story also playing out in Australia and Brazil.

With risk assets arguably already pricing in some of these upside risks to growth, these contrary indicators serve as a reminder that 2020 is likely to be a ‘show me’ for financial markets. Validation in earnings will likely be rewarded with further gains, but there is significant vulnerability to disappointment.


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Luke Bartholomew

Paul Diggle

Govinda Finn

Bob Gilhooly

Jeremy Lawson

Sree Govindan

James McCann


Jeremy Lawson

Chart Editors

Nancy Hardie

Yashaswini Dunga



Chapter 1


Jeremy Lawson, Chief Economist

Animal spirts present upside risks

The story behind our global forecasts over the next two years is simple. Widespread monetary policy easing during 2019, coupled with some fading of geopolitical risks and the completion of an inventory cycle, allow growth to first stabilise and then gradually rise as the year progresses. Initially, most of the boost comes from emerging markets, particularly those where growth slumped the most. An improvement in the advanced economies follows with a lag. However, even with that better performance, growth is expected to be subdued as monetary policy efficacy remains low, a major fiscal impulse is unlikely and geopolitical risks are still elevated.

It is a truism that our point forecasts are more likely to be wrong than right. But what are the main alternative scenarios to our tepid outlook? In the next six months, it is that the data come in stronger than we have factored in. For example, we are forecasting growth to slow further in the US and China this year – the key drivers of the global economy - but the data flow has shown a great deal of resilience of late, with some cyclical indicators improving (see Chart 1). This may imply either a greater responsiveness to the stimulus already delivered, a larger impact from the trade truce between the two economies, or both. Indeed, with animal spirits rising, particularly in financial markets, there is a plausible scenario in which pent-up demand, particularly for capital goods, is unlocked, driving a meaningful cyclical upswing across the globe.

If we look further out, however, risks still appear tilted to the downside. Not only is the cycle old, but monetary policy space is low. With global debt levels elevated, and markets pricing out recession risks, vulnerability to shocks is high. If for example the US-China trade truce unravelled, as it has before, because China can’t deliver on its optimistic commitments, market and business sentiment would sour quickly, dragging the global economy and markets down with it.

Chart 1: Stabilising signs in the US and China

Source: Haver, ASIRI (as of December 2019)


Chapter 2


James McCann, Senior Global Economist

What could possibly go wrong?

We expect the US economy to slow as we move into 2020, as fiscal stimulus fizzles out, consumer spending moderates and businesses remain cautious on capex. However, a hard landing looks unlikely, with growth expected at 1.4% over the year. Even so, this downshift, alongside subdued inflation, should convince the Fed to deliver one more rate cut.

There are both upside and downside risks to the US economy this year, although the bar for policy tightening looks to be higher than that for loosening.

What could challenge this outlook? The US-China trade agreement and easier financial conditions could deliver a more pronounced decline in policy uncertainty and a larger rebound in animal spirits than expected. At the same time, our forecast for a moderation in consumer spending could be too gloomy, especially if we see the labour market continue to churn out jobs at a healthy rate, or if consumers save less. Indeed, our Nowcasts for Q4 and Q1 currently imply that the economy’s underlying growth rate is a bit stronger than expected when we updated our forecasts in November.

While stronger growth would likely torpedo our forecast for one more rate cut, it is not clear this would push the Fed in isolation towards tightening policy. For this, we would need to see a pronounced shift in inflation, which has been persistently below target over recent years (see Chart 2). Indeed, Fed Chair Powell has been explicit that he would need to see inflation notably overshoot 2% on a sustained basis to justify any hikes. Warning signs on this front would be a marked acceleration in labour costs and signals that firms were passing these on to consumers.

Of course, the risks are not all tilted to the upside, particularly in the medium term. Geopolitics provide an obvious place to start. Although market concerns about the burgeoning US-Iran conflict have eased, a more severe escalation that leads to a larger, more damaging spike cannot be ruled out. Otherwise, there is a risk that the trade agreement between the US and China breaks down, particularly given ambiguity over ambitious targets for Chinese imports of US goods and services.

While President Trump may be reluctant to reignite this conflict in an election year, trade policy has been erratic over recent years. We will need to watch carefully for signs that tensions are building again. Even absent a further escalation, there is a risk that the damage from last year’s trade war lingers, threatening a cycle that is showing one or two signs of age. The manufacturing ISM survey for December slid further into contraction territory and, while the PMI equivalent paints a rosier picture, there is a risk that the industrial slump is prolonged (see Chart 3). If so, concerns will build over contagion to the broader economy, particularly given elevated corporate debt, weak profitability and tightening bank lending standards. Better survey data in the services sector and a rebound in hiring suggest that this part of the economy remains resilient at present. If these foundations falter, a hard landing could be on the cards.

Chart 2: Split signals

Source: IHS Markit, Institute of Supply Management, Haver(as of December 2019)

Chart 3: Missing the target

Source: Bureau of Labor Economic Analysis, Haver, (as of November 2019)
There are both upside and downside risks to the US economy this year, although the bar for policy tightening looks to be higher than that for loosening.


Chapter 3


Sree Govindan, Senior Research Economist

Luke Bartholomew, UK Economist

Policy easing coming none-too-soon

Following a turbulent 2019, the decisive general election result has alleviated some of the uncertainty that had been weighing on the UK economic outlook. We expect growth to reaccelerate over the course of the next two years on the condition that a ‘no-deal’ Brexit does not materialise. A failure of Brexit noise to die down is the main domestic downside risk to our view. On the flip side, fiscal and monetary policy could turn out to be more supportive for growth than we have factored in.

Recent data have been much weaker than expected, but it is not yet clear how much of this was driven by election and Brexit uncertainty. Greater fiscal and monetary stimulus would provide a much needed fillip to growth.

Recent rates-market pessimism about the growth outlook has been fuelled by weak year-end activity data.

But extracting the signal from the data is complicated by the way that election and Brexit uncertainty incentivised corporates to first build and then run down their inventories as the year progressed. This has also distorted foreign trade data (see Chart 4). While this does not explain the extreme weakness of services and retail trade data over recent months, it is reason to wait for Q1 data to roll in before rushing to judgements about the underlying strength of the economy.

Our forecasts already incorporate support from fiscal stimulus. The Conservative government announced new fiscal rules last year, increasing the cap on public sector investment and providing the potential for extra spending of around £22bn per year. Room for tax cuts seems more limited given the commitment to balance the budget within three years. But the March budget will tell us how strictly that rule will be adhered to.

A bigger-than-expected fiscal boost would mechanically lift growth, although pledges currently seem geared towards infrastructure projects, the benefits of which will be mainly seen in future years (see Chart 5). With respect to monetary policy, up until recently our base case was for unchanged rates in 2020. However, MPC members have struck a more dovish turn recently in reaction to weaker-than-expected data and the further ebbing of inflation. While a strong rebound in the January data or a larger-than-forecast loosening of fiscal policy could yet stay the Bank of England’s hand, a rate cut is becoming more probable.

Our forecasts assume that business investment will remain weak during 2020 with firms holding back until details of the future trading relationship with the EU are clarified. However business sentiment surveys conducted after the election result revealed a sharp increase in optimism and investment intentions, suggesting scope for a stronger acceleration in private investment. Households in turn may also benefit from this shift. The pace of employment growth and vacancy rates had started to slow in recent months, as uncertainty had become entrenched. Increased private and public investment may then generate a faster pace of hiring and provide an additional boost for household spending. Although the ‘Brexit Blues’ are likely to return, policy levers will provide much needed support.

Chart 4: Potential for a fiscal surprise

Source: ONS, ASIRI (as of November 2019)

Chart 5: Brexit risks remain key

Source: ONS, ASIRI (as of Q1 2019)
Recent data have been much weaker than expected, but it is not yet clear how much of this was driven by election and Brexit uncertainty. Greater fiscal and monetary stimulus would provide a much needed fillip to growth.


Chapter 4


Paul Diggle, Senior Economist

Expect the unexpected

Our European forecasts envisage a stabilisation in economic growth over the course of 2020 as the current sharp manufacturing downturn draws to an end; a sideways inflation environment at rates that are still well below target; and incremental additional ECB policy support in the form of a 10 basis point rate cut both this year and next. But there are plenty of alternative paths around this baseline scenario. Three in particular stand out: a continuation of the manufacturing recession which spills over into the rest of the economy; political volatility, especially in Italy and maybe even in Germany; and a far-reaching ECB Strategic Review that re-defines the role of the central bank.

Our forecasts imply that the Eurozone industrial recession is approaching an end. But, with sentiment remaining subdued, there is a risk that the recovery will have to wait until later in 2020.

Eurozone industrial production has fallen 4.4% since its peak in late-2017. In Germany, the contraction has been an even larger 6.4%. There are considerable downside risks that the manufacturing recession is not over. For example, leading indicators of the sector haven’t convincingly turned around yet (see Chart 6). And there may still be lagged effects from last year’s global policy uncertainty that are set to weigh on activity. Moreover, if the manufacturing contraction continues for much longer, it is likely to spill over into the so-far resilient European services sector and the labour market.

On the face of it, European politics has entered a period of calm. But, in addition to Brexit negotiations, we are watching the Italian and German governing coalitions for signs of instability in 2020. A collapse of the PD-M5S coalition in Italy would lead to fresh elections that could bring Salvini’s Lega party back into government (see Chart 7). Although Lega have backed away from their most Eurosceptic tendencies, they could bring Italy’s precarious public finances into question. Meanwhile in Germany, the CDU-SPD coalition also looks unsteady, and there is some chance that it collapses before scheduled elections in late-2021. Current polling suggests the Greens are likely to play a role in any future coalition government which, alongside Merkel’s departure from the scene, could usher in significant changes to German and European fiscal and environmental policy.

Finally, the ECB is kicking off a Strategic Review encompassing its inflation target, policy tools, and role in fighting climate change. While we are expecting a new, clearer 2% inflation target, as well as rule changes that give the ECB more room to expand asset purchases and direct them to ‘green’ bonds, we are expecting limited actual policy action from the central bank this year, beyond a single 10 basis point rate cut. But there is a scenario in which the ECB Strategic Review catalyses significant additional monetary policy action, including larger rate cuts and a big increase in asset purchases directed at aiding the energy transition.

Chart 6: An ongoing manufacturing recession

Source: Thomson Reuters Datastream, ASIRI (as of December 2019)

Chart 7: Ever present Italian political risk

Source: National polls, ASIRI (as of January 2020)
Our forecasts imply that the Eurozone industrial recession is approaching an end. But, with sentiment remaining subdued, there is a risk that the recovery will have to wait until later in 2020.

Japan and
developed Asia

Chapter 5


Govinda Finn, Japan and Developed Asia Economist

Sailing close to the wind

In the aftermath of October’s VAT hike, Japan is facing an economic contraction in the fourth quarter and potentially its fifth recession, at least in the technical sense, since 2000. Our central case is that Japan gets back on track in 2020, driven by policy support and a stabilising global economy and, by 2021, sees a return to above-potential growth. But what could jeopardise this cautiously optimistic outlook?

Our expectations are for Japan to get back on track in 2020. However, with little policy dry powder, restarting the economy may prove more difficult in the event of a persistent stall.

Our main concern is that, with monetary policy stretched and the government having already shown its fiscal hand, policy stabilisers prove insufficient. One of the biggest concerns is that persistent, super-easy monetary policy is not only proving ineffective but is actually starting to backfire. 70% of economists expect the Bank’s next move to be a tightening. That seems incongruous given core inflation remains below 1% and inflation expectations are falling (see Chart 8). A hike only seems plausible if the Bank were to drop its current target – a remote but not infeasible possibility. There is therefore a very real risk that monetary policy is left too tight for the underlying weakness of the economy.

More alarmingly, the handing over of the baton to fiscal policy endorsed by Kuroda has delivered an inadequate response, allocating just ¥4.3trn to the supplementary budget - eligible to be spent through March 2020. The remaining ¥8.7trn will be spent over multiple years – and one suspects be used to soften the expected fall-off in fiscal spending after the Tokyo Olympics. This is a missed opportunity because Japan has both the circumstances and means to deliver a larger fiscal stimulus. In the here-and-now, we are sticking to our call that Japan will sail close to the wind in 2020 but avoid a protracted stall, in large part due to the resilience of consumer sentiment following last year’s VAT hike, especially compared with 2014. However, the hard data over the next few months will tell the true tale (see Chart 9).

Elsewhere, fading US-China trade tensions and improving liquidity as the dollar has weakened has central bankers pulling back from their dovish bias. One source of optimism has been the semiconductor sector, with investors anticipating an upturn in the NAND and DRAM price and investment cycles. This should be positive for industrial sentiment, although the spillover to real economy activity from the semiconductor cycle is relatively limited. One risk comes in the form of a quicker-than-expected ramping-up of production from chipmakers, who are notorious for capex splurges. More worryingly, Chinese semiconductor firms such as Yangtze Memory, ChangXin Memory and Jinhua Integrated Circuits are ramping up production that may undermine pricing power in the memory market. This would eat into margins and risk a more subdued cycle than currently hoped for.

Chart 8: Slow progress

Source: Ministry of Internal Affairs and Communications, BOJ, Haver, ASIRI (as of Q4 2019)

Chart 9: Not yet rock bottom

Source: Cabinet Office, Haver, ASIRI (as of Nov 2019)
Our expectations are for Japan to get back on track in 2020. However, with little policy dry powder, restarting the economy may prove more difficult in the event of a persistent stall.


Chapter 6


Bob Gilhooly, Senior Emerging Markets Economist

From headwinds to tailwinds

Emerging market (EM) growth is still expected to have troughed in 2019 and to show a modest acceleration moving into 2020, reflecting: past policy stimulus, a benign US dollar environment and a modest recovery in global manufacturing and trade. Thus far, EM data seems to be broadly in-line with our view that growth will recover, but will remain lacklustre: PMIs have recovered somewhat and global trade shows some signs of stabilisation, for example. But there are some straws in the wind that suggest global growth is accelerating more forcefully. We saw Chinese trade for December surprise to the upside (both exports and imports rose ~1.5% mom) and EM prospects are sensitive to the external environment. So, could nascent signs of a cyclical upswing signal a much stronger-than-expected EM growth recovery? And what factors could combine for a strong tailwind?

With Chinese and Indian data having turned a corner of sorts; a larger-than-expected recovery in emerging market growth this year is an increasingly plausible upside scenario.

Recent headwinds from the external environment could turn around more forcefully than we expect. EMs are more dependent on manufacturing and trade than DMs and hence, have more to gain if global trade rebounds. Historically, global manufacturing and trade have tended to show a more cyclical pattern than GDP growth. Moreover, a key judgement has been that services and consumption will remain resilient to industrial weakness. Since industry ultimately exists to provide consumption, we may find that CAPEX and industry need to catch up with households. Household balance sheets have improved notably in some DMs and they may now be sufficient to unleash pent-up consumption - the US saving rate remains surprisingly high, for example. The policy spillover from China may also be higher; the need to increase US goods and services purchases as part of the 'Phase 1' deal may spur a much broader stimulus. The centenary of the founding of the Communist Party of China in 2021 already provides another rationale for erring on the side of growth.

EM growth has disappointed post the financial crisis (Chart 10), but there is a risk that we have become too pessimistic on potential growth and have taken the wrong signal from moderating inflation. It is not just DMs where the Phillips' curve appears to have flattened; inflation may now be structurally lower across EM (Chart 11). Indeed, the flatter the Philips' curve, the greater the implied rise in slack for any given fall in inflation. Given notable falls in EM inflation, this could therefore suggest that spare capacity is higher and that potential growth is understated. Past domestic policy easing, a more buoyant external trading environment and ample slack could therefore generate faster non-inflationary growth. Indeed, a continued moderation of inflation with a sharper pick-up of growth in the near term could spur expectations that nominal policy rates are heading lower even as prospects improve. Therefore, growth dynamics could be reinforced by capital flows attracted by expectations of lower yields; hence, adding to the tailwinds.

Chart 10: Structural growth slowdown or spare capacity?

Source: IMF, World Economic Outlook, ASIRI ( as of October 2019)

Chart 11: Inflation may continue to trend lower

*Inflation data covers 93 emerging markets
Source : National Sources, Haver, ASIRI ( as of December 2019)
With Chinese and Indian data having turned a corner of sorts; a larger-than-expected recovery in emerging market growth this year is an increasingly plausible upside scenario.


Chapter 7


Gerry Fowler, Investment Director, Global Strategy

Show me the money!

2019 was a great year for investors. One could say it was actually rather difficult to lose money, as sovereign bonds, corporate bonds and equities globally all rallied significantly. However, investing did not seem so simple at the time. While risking over-simplification, three key events defined 2019 and merit understanding as we assess what the key drivers of returns could be in 2020.

Markets have scaled new heights in anticipation of a policy led rebound in earnings. These expectations need to be validated to sustain the gains.

Firstly, the sharp equity market decline in the fourth quarter of 2018 led to the Fed responding in early 2019 with what was initially a ‘pause’ in their hiking cycle. We and the market rightly perceived this as a material loosening in monetary conditions relative to expectations, and a strong equity market recovery occurred in the first quarter. The second key phase of 2019 was the breakdown in US-China trade negotiations in early May as Trump walked away from a deal at seemingly the last minute. This came as a shock to investors and caused a sharp deterioration in business and investor sentiment. US Treasuries rallied all the way from a yield of 2.5% down to 1.5% in just a few months and this supported a rise in US equity valuations relative to other markets, despite deeply negative earnings revisions globally.

Finally, after substantial easing of monetary policy across the world throughout the year, the Fed proceeded to also cut rates three times, in July, September and October. That last cut was made just as global manufacturing PMI data suggested stimulus was gaining traction and thus lower interest rates supported a further recovery in investor sentiment. This in turn fuelled a strong fourth-quarter rally in global equities – despite the global economy remaining weak in the quarter - that capped off a tremendous year for investors.

The progression of these key drivers for equity markets were nicely captured in our internal tactical asset allocation survey. Our managers are asked to score their outlook across four key drivers: 1) monetary; 2) behavioural; 3) macro profits (growth); and 4) valuations. Our manager’s overall view on equity markets shifted only modestly throughout the year (see Chart 12). But the key drivers drifted from a positive outlook on valuations, to an increase in monetary optimism, toward more favourable behavioural factors and finally t optimism about the outlook for earnings.

Our economic outlook is for a stabilisation but limited recovery in growth and inflation globally. We believe monetary stimulus has broadly peaked for now and that investors are more optimistic than pessimistic. So in 2020, we need to see equity earnings growth recover too. If we begin to see positive surprises and upward revisions to estimates, elevated optimism and valuations will be justified and we think will produce further upside this year. If the economic trough does not turn into a modest recovery in earnings growth, optimism will have been misplaced and markets will suffer.

Chart 12: Macro-profits driving positive equity score

Source: Thomson Reuters DataStream, ASI (as of January 2020)

Chart 13: Further improvement in global PMI will bode well for equities in 2020

Source: Bloomberg (as of December 2019)
Markets have scaled new heights in anticipation of a policy led rebound in earnings. These expectations need to be validated to sustain the gains.