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As the largest economy in the world, the United States has long been the most dominant player in global economic, military, political and financial market developments. Indeed, since the end of the Second World War, the President of the United States has been known as the “leader of the free world” and the US dollar the global reserve currency.
However, since the accession of China into the World Trade Organisation in 2001 and the recovery of emerging market economies from various financial crises in the 1980s and 90s, the US has fallen in relative economic importance (Figure 1). Indeed, in the raw commodities sphere, China has been responsible for nearly all the global demand growth for the past two decades.
While their economic supremacy has waned, the US has continued to benefit from the “exorbitant privilege” of issuing the global reserve currency and being the home to the biggest and deepest global capital markets. Having led the world into the global financial crisis of 2008, the US has also led the recovery, albeit in a disappointingly slow and uneven way for much of the past decade. However, the US economy is now in the strongest position it has been since 2008, and on many measures stronger than in the decade leading up to the financial crisis. With growth expected to be well above potential again in 2018 (helped by a significant boost from tax cuts and fiscal spending), spare capacity is set to diminish further and inflation is expected to remain above target. As such, we expect that the Federal Reserve will continue raising rates at the pace of 25bps per quarter through to the end of 2019.
Strong economic growth in the US ought to drive global growth in 2018 to its fastest pace of increase since 2011. That should be a good environment for global risk assets, such as equities, but tighter monetary policy in the US will also have important ramifications both domestically and in the rest of the world. In the near-term, it is likely to mean greater divergence in monetary policy between the US and rest of the developed market economies (Figure 2). That is likely to have important implications for global term premia and the value of the dollar. It is also likely to put increasing strain on those households, businesses and countries that have borrowed heavily in US dollars.
However, the most important driver of global markets over the remainder of 2018 may not be US economic developments, but rather politics.
President Trump has taken the view that the relative decline in US economic supremacy needs to be stopped and indeed reversed. He sees this primarily through the lens of trade and the desire to reduce the US trade deficit. His proposed solution has been to threaten and then impose tariffs – albeit so far not to the point of being economically significant at the national, let alone global level. But his desire to break down the multi-lateral global agreements of the post-war era and replace them with new bilateral deals that better favour the US, the increased use of sanctions and restrictions on foreign investment could have serious ramifications for markets in the near term and beyond.
Perhaps more than ever, the outlook for global markets is in the hands of the United States. Whatever form the “America First” policy takes, it is likely to be a disruptive factor for at least the next two years.
Growth slowed in the major developed market economies in 2018 Q1 (Figure 3). According to the OECD, GDP growth among the G7 economies slowed to an annualised pace of 1.3 per cent, down from 2.3 per cent in Q4 2017. While the slowdown was broad-based across the major economies, we do not think it signals a fundamental slowdown. Indeed, in each case there were one-off factors (including unseasonably cold and snowy weather) that should largely reverse in Q2. Outside the G7, growth was steady in Q1. As such, when looking ahead to growth over 2018 as a whole we continue to expect global growth close to 4 per cent, with growth in the US, Eurozone and Japan all expected to be above potential this year and next. We therefore also expect to see further declines in unemployment rates and upward pressure on wage growth and inflation.
The US is, of course, more advanced in the cycle and therefore we expect monetary policy to tighten, becoming modestly restrictive during 2019. We have marked down our growth expectations for the Eurozone modestly this year, and given recent announcements from the ECB expect the first rate rise to now come in the second half of 2019. Despite good growth, and a somewhat better spring wage round this year, inflationary pressures remain muted in Japan and we have therefore also pushed back our expectations for any adjustment to yield-curve control (YCC) until 2019.
The outlook for the UK remains clouded by Brexit uncertainty. The recent moderation in growth, fairly rapid decline in inflation and the uncertainty regarding the outcome of the Withdrawal Agreement should mean that the Bank of England will be slow to raise rates, with just one hike expected later this year. Finally, Chinese growth was a little better than we expected in Q1, but has shown some signs of slowing more recently. We expect growth this year to be around 6.3 per cent, with modest easing in reserve requirements to more than offset higher policy rates.
While the central scenario remains a positive one, the downside risks have undoubtedly intensified. In particular the trade tensions between the US and the rest of the world have recently escalated into trade skirmishes, in particular between the US and China. The risk is that it progresses into full-scale trade war, threatening to reverse the progress made in lowering trade barriers over the past 25 years (Figure 4).
At the time of publication the US had imposed new tariffs on steel and aluminium imports from Canada, Mexico and the EU. They had also announced, but not yet imposed, tariffs on $34bn of Chinese goods. But much more significantly, they have threatened tariffs on as much as $400bn in Chinese goods, almost the entire value of US goods imports from China, should the Chinese retaliate with tariffs of their own.
Moreover, they have also suggested investigating the imposition of new tariffs on automobile imports, which are worth close to $200bn. While these threats may prove to be part of a negotiation that ultimately results in minimal imposition of new tariffs, the risk has intensified that the Chinese walk away from the negotiating table. If tariffs were imposed on goods valued at over half a trillion dollars, the economic impact would be meaningful, not least as it would imply that retaliatory tariffs had also been imposed in China and elsewhere. Such a scenario would undoubtedly see growth expectations revised down sharply in economies with large export sectors, including China, Japan, Emerging Asia and the Eurozone.
Beyond tariffs, the US is also seeking to reduce inward investment from China (and potentially others) in technology sectors, as well as restricting exports of technology to China. If imposed in a wide-reaching way, these restrictions could also have major ramifications for global trade.
Given our central scenario, we remain constructive on global risk assets, but recognise the increased market risk.
We have adjusted down our expectations for equity returns, in particular for those with more trade and US dollar sensitivity, including Eurozone, Japanese and Emerging Market equities, while we have adjusted up our US equity expectations. We continue to expect risk-free assets to under-perform, with short duration views across the major developed markets. With tighter global dollar funding conditions and less attractive valuations, we have reduced our expectation for emerging market local debt and currencies. More broadly we see continued upside in the US dollar over the near-term, although have a more neutral view over a longer horizon.
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