The five key themes and risks our House View team expect to drive financial markets.
8 minute read
- Weak global growth
- Monetary policy to be supportive
- Trade war concerns linger
- Fiscal activism
1. Weak global growth
Global growth slowed sharply over the course of 2018, from well above potential to a little below. We expect growth to remain fairly soft through 2019 and into 2020 (Figure 1), as potential changes to trade and technology policy act as headwinds to business confidence.
Figure 1. Global growth has slowed in 2019
Widespread, but more marked in DM
After an estimated increase of 3.6 per cent last year, we expect world GDP will increase by a little over 3 per cent this year. The slowdown has been slightly more marked in developed nations, but all countries have been affected. While our central case is for simply a continuation of modest growth, all of the risks look to be on the downside. That raises the probability of recession.
However, the usual recessionary catalysts (such as major economic shocks, debt overhang and sharply rising interest rates) are not in place and therefore likely limit that danger. Instead, the main downside risks stem from a sharper contraction in global trade on the back of increasing economic and political tensions.
In the 25 years preceding the global financial crisis world trade volumes grew, on average, by between 6 and 7 per cent a year, comfortably above the average pace of global GDP growth of 3.5 to 4 per cent. This era of globalisation provided a major positive impulse to world economic growth over this period.
That is now changing. In the future it is plausible that, overall, world trade grows more in line with the pace of global GDP. Moreover, as we describe below, in the shorter term it is likely that world trade grows more slowly than that as the impact of US-led trade disruptions is felt. This is almost certain to weigh on aggregate world GDP growth in coming years.
2. Monetary policy to be supportive
Just over a year ago, the major central banks appeared to be on a path to reduce monetary accommodation. The Federal Reserve was expected to raise rates steadily towards 3 per cent; the European Central bank had brought QE to an end and was signalling that euro zone rates would move back into positive territory. Even the Bank of Japan was suggesting that its long period of ultra-loose policy would be ending.
But now the combination of a weaker growth impulse, subdued inflation and heightened trade tensions has led to a significant reassessment of policy interest rate prospects (Figure 2).
Figure 2. Markets now expect a strong easing bias
Policy rates in the major developed regions
Central banks in the developed world have adopted a more dovish stance within their communications, a message that financial markets have received enthusiastically, pencilling in a material policy easing at the Fed over the next twelve months, as well as a renewed easing bias almost everywhere else.
In our central scenario we doubt that as much easing as is currently priced into markets will be delivered. However, given the risks to growth and inflation are heavily skewed to the downside, we do not see current market pricing of the mean outcome to be unreasonable.
We expect that central banks will have little reason to remove their current easing bias (even if extensive easing is not delivered) over the next six to twelve months. Indeed, given the change of stance has already been reflected in lower market rates, there has already been a meaningful easing of financial conditions overall (Figure 3).
Figure 3. Financial conditions have eased recently
Goldman Sachs Financial Conditions Indices
3. Trade war concerns linger
Trade war concerns have hurt export sentiment and activity across the globe (Figure 4). What began as a Trump-inspired trade dispute between the US and China has seemingly turned into something far more serious.
Figure 4. Export order books have been hit hard
New export orders (survey)
The Trump administration perceives tariffs and other restrictive measures as a key weapon to be used in defending US interests and, more provocatively, as a means of leverage for advancing parts of the “America First” agenda. Tariffs against Chinese goods may be a blunt instrument, but many of the US criticisms are legitimate, notably those relating to the theft of intellectual property and the lack of access to Chinese markets being granted to foreign companies. Although discussions foundered more recently, it did seem that the hard-line approach on tariffs being adopted by the US was bearing some fruit in terms of bringing China to the negotiation table.
The altogether more alarming development was the initiative (since shelved it seems – but not before revealing elements of the Trump playbook) of using the threat of tariffs to try and achieve other, often unrelated, goals. Once Trump insisted that tariffs would be imposed on Mexico if it did not reduce illegal immigration to the US, they had become truly weaponised. Subsequent rumours of tariffs elsewhere if Trump did not get what he wanted in several different areas simply cemented the notion that intimidation and self-interest was now the modus operandi for the US.
Although there have been periods more recently when these tensions, especially those between the US and China, have been de-escalated, it is very likely that this approach will resurface at regular intervals. Characterising this situation as a new “cold war” between the two nations may be a slight exaggeration, but the resemblance is compelling.
4. Fiscal activism
After an extended period when fiscal policy in most countries has been a drag on growth, the next few years may witness a small positive contribution to overall GDP. In the wake of the Global Financial Crisis, public deficits and debts ballooned higher, necessitating a subsequent period of fiscal consolidation as public finances were restored to a sustainable footing.
Although there are differences across nations, that period is now largely over, meaning that there is some scope for activist fiscal policy to boost growth modestly. The Trump administration’s tax and spending policies in 2018 were a standout example of this, but its initiatives are unlikely to be repeated in other countries and certainly not on the same scale.
More recently, China has introduced fiscal measures to support growth and to offset the cyclical slowdown. The US enjoys the privilege of being the issuer of the world’s main reserve currency and while this is normally related to its current account balance, it applies to the fiscal balance too. Thus, Trump’s fiscal boost has widened the public deficit significantly, but the country has not been punished in the form of higher bond yields.
Many of the countries that make up the euro zone have a more chequered fiscal history and financial markets can have long memories. Nevertheless, public finances have healed strikingly over the last six or seven years, creating some room for possible fiscal stimulus in Europe as well.
Whether this is used and, if it is, whether it is used wisely, remains to be seen. But many euro zone countries do plan to embark on mild fiscal expansion in 2019 and 2020 which should, at the margin, lift overall demand. However, the idea that any fiscal boost will simply pick up the policy baton and replace monetary stimulus as a key driver of growth is naïve.
Public debt is still worryingly high in many countries (Germany is a notable exception) and this, together with sluggish growth and muted inflation pressures, means that the scope for fiscal expansion is very limited.
Figure 5. Change in fiscal stance
% GDP (US, EZ, JP and UK wt avg)
Recent years have been characterised by extended periods of relatively benign price moves, interspersed with episodes of relatively large asset price volatility across a range of financial assets.
This pattern has been observed increasingly in different markets including equities, commodities and government bonds despite efforts by central bankers to extend the economic cycle, which we expect to be ultimately successful.
We expect to see this pattern continue. However, risks to the global economy seem skewed predominantly to the downside at present, which will supply a ready number of catalysts for asset price volatility to persist. The about turn by the Fed this year in recognition of these risks has caused a wholesale repricing of interest rate expectations that lifted US rates volatility from the multi-decade lows experienced in 2018.
History shows that extremes in cross-asset volatility occur at the end of economic expansions when growth begins to slow meaningfully. Equity volatility is generally the first to exhibit persistently higher levels of volatility at such times, but historically also shows increasing levels of volatility in the second half of expansions.
While we think the current cycle will persist for some years to come, the structure of markets has changed considerably since the Global Financial Crisis and the predominance of non-discretionary flows and share buyback programmes are frequently the marginal buying forces. These have helped to perpetuate upside market moves whilst limiting the volatility exhibited, which is further reinforced by increasingly large waves of short-dated option selling as risk-taking sentiment coalesces.
Such forces help to provide significant downward pressure on volatility, which becomes self reinforcing as the low volatility period progresses. The market impact of crowded position de-risking and closing out of short volatility positions has recently been accentuated by the dearth in trading liquidity, contributing to spikes in volatility that are large in comparison to the conditions that preceded them. We feel this pattern of long periods of low volatility interspersed with significant spikes will continue.
Figure 6. More volatility spikes plausible
US rates and equity volatility
Risks to the House View
China/US relationship deteriorates
China-US relationship likely to stay strained
Some elements of this risk are already contained in the central view, but there are further downside possibilities. The trade war theme has dominated investor sentiment for over a year (Figure 7). But the risk is that the dispute has opened the door to a wider set of conflicts between the US and China.
Figure 7. Tariff threat had retreated but is back again
United States, Google mentions of tariff
Trump’s weaponization of the tariff threat in areas such as immigration sets a dangerous and worrying precedent. However, it would be wrong to conclude this is just another example of his belligerent methods.
There is broad cross-party consensus in the US over protecting US corporate and national interests. The confrontation with Huawei is an indication of the blurred lines that have emerged between trade and national security. These could characterise China-US relations from now on as both sides employ a range of new restrictions and obstructions which could easily escalate into a tit-for-tat exchange of retaliatory measures across many areas.
China stimulus fails
In response to slowdown concerns, China has embarked on a wide-ranging combination of monetary and fiscal stimulus (Figure 8).
Figure 8. China’s monetary stimulus
China has halted earlier tightening
Chinese policy measures may not work as well as hoped
Our central view is that these measures will be successful, but it is quite possible that they are not and that instead a negative China growth scare permeates across the globe. This would be especially damaging if it happened at the same time as any trade shock, but is largely independent of that since the stimulus is primarily intended to boost domestic demand rather than export trade.
The Chinese authorities have plenty of ammunition at their disposal. If present measures were deemed not to be working sufficiently, it is highly likely that they would do more, in their own version of “whatever it takes”.
Recession risk heightened, led by manufacturing
For the first time since the euro zone sovereign crisis, global recession risk appears to be heightened. Growth has stuttered recently, the export-orientated manufacturing sector has experienced a marked downdraft (Figure 9) and the threat of trade disruptions, protectionism and a more insular pursuit of nationalistic agendas means that there is plenty to worry about.
Figure 9. Manufacturing downturn has been severe
DM industrial production growth (3m annualised)
The “new normal” for monetary policy makers implies greater uncertainty about where neutral or equilibrium rates are compared with the past. It is possible that the modest tightening we have seen so far is sufficient to bring about another downturn.
Debt servicing strains
Era of low rates may have encouraged excessive borrowing
Historically very low interest rates over the last decade have encouraged greater borrowing from households, corporations and governments, just as they were intended to do.
The exit from the era of extreme policy stimulus is going to be unhurried and limited in the sense that rates are highly unlikely to even approach the peaks of earlier cycles. Nevertheless, it is almost inevitable that some agents will have taken on excessive debts and that these vulnerabilities will be uncovered as we very slowly move back to a more “normal” policy backdrop.
All cycles are different and there are often surprising revelations of where debt build ups have happened, but some possible candidates can already be identified. Although there has been extensive deleveraging in some areas, in others there has been only very limited adjustment (Figure 10).
Figure 10. Not all households have reduced debt levels
Ratio of household debt to disposable income
One of the unintended consequences of the Global Financial Crisis (GFC) and its aftermath has been a marked reduction in liquidity in key markets.
Smoothly functioning markets rely on liquidity
As a result of the imposition of a range of regulatory measures and restrictions, the coverage and depth of market-making has been compromised and diminished, adversely impacting the smooth functioning of such markets and leading to regular episodes of damaging illiquidity that can distort prices significantly.
The authorities that have introduced such changes have done so with the laudable aim of preventing the more questionable activities that some financial institutions had indulged in. These contributed to the instability which characterised the GFC and led to, amongst other things, the collapse of Lehman Brothers and the freezing of key markets. There are risks that more markets could be adversely affected as regulations are imposed and as agents comply.
The ongoing Brexit process has contributed meaningfully to weaker growth in Britain and to gloomier sentiment among households and businesses.
The impact on the rest of Europe has been less significant, but there is still scope for a greater hit, especially in the event of a no-deal exit from the EU. Beyond Europe, the Brexit process has progressively less relevance for economies and markets, although it is still a minor irritant in some cases.
Populism and discordant politics becoming the norm
More generally, Brexit is just one example of the thrust of populism and discordant politics which has taken root in Europe (and elsewhere) in recent years. It is still possible that such frictions could erupt again – more likely if there were another economic downturn – with Italy perhaps the most plausible setting.