The five key themes and risks our House View team expect to drive financial markets.
8 minute read
- Weak but recovering global growth
- Lower for longer
- Long-term strategic competition
- Search for yield
- US election
1. Weak but recovering world growth
Global growth has slowed from 4 per cent at the start of 2018 to a below-trend pace of around 2.8 per cent in the year to Q3 2019.
China slowdown, previous tightening of monetary policy and a marked intensification of downside risks associated with escalating US-China dispute combined to drive the seemingly relentless downward momentum.
As we highlighted three months ago, the risk of a global recession had become the most heightened for a decade. Such concerns remain, but they have moderated appreciably since that time as financial conditions have eased, tentative evidence has emerged that the deep manufacturing downturn may be coming to an end and there have been signs of more constructive developments in the trade dispute.
The bottom line is that world growth appears to have stabilised in Q3 and although it is still too soon to signal an early return to above-trend world growth, the immediate outlook is a little brighter. Global growth is now expected to increase gently to about 3.25 per cent by the end of 2020 (Figure 7), providing that trade tensions do not deteriorate again or evolve into a more damaging geo-political battle (see below). Neither can be ruled out, especially in a US election year.
Figure 7. World GDP growth Growth picking up gently in 2020
The stagnation in world trade flows only really became apparent about a year ago, but it has become more established since and shows no clear sign of recovery yet (Figure 8). Export order books around the world may have stopped weakening in several countries, but they have not yet revived sufficiently to argue for a marked increase in global trade. It is to be hoped that the combination of looser policy, a more enlightened approach to freer trade and a modest cyclical upswing in the industrial sector will lead to further improvements in 2020 and beyond.
Figure 8. World trade volumes World trade flows have stagnated
One of the more encouraging features of 2019 has been the limited extent to which manufacturing and export weakness was transmitted to the more domestically-focussed service sectors around the world. Business investment, for example, has weakened rather than collapsed and labour markets remained robust. If the worst is really over for manufacturing, the point of greatest risk for such a transmission may have passed.
Overall, the prospect is for a very modest recovery in global growth, with risks now slightly more balanced than three months ago.
2. Lower for longer
Global central banks reduced policy interest rates to unprecedentedly low levels in the wake of the Global Financial Crisis (GFC) and to below zero in many regions. They also embarked on a range of other unconventional monetary policy initiatives, many of which continue today. Interest rates across the maturity curve have fallen to historic lows in response.
Central banks had signalled many times that, when the time eventually comes to tighten monetary policy once more, to use the Bank of England’s apposite language, any future interest rate increases would be “to a limited extent and at a gradual pace”.
There is a temptation in much financial market commentary to assume that things mean-revert. In the case of policy interest rates around the world this means that there can be a tendency to assume that rate cuts in a downswing have to be fully reversed in the subsequent upswing. Following that rule-of-thumb over the last thirty years would have meant getting policy rate projections consistently wrong. In fact, peaks have got successively lower (Figure 9).
Figure 9. Policy interest rates in the G4 Policy rate peaks lower
Estimates vary, but there is little doubt that neutral interest rates today are significantly lower than they have been in even the quite recent past (Figure 10).
Figure 10. Neutral and actual real rates Equilibrium rate lower than in the past
The recent US hiking cycle is a case in point, with the Federal Reserve having to raise their policy rate to a much lower level than previous cycles in order to achieve their goals. And in response to changing circumstances they have moved rates lower again in swift order. The ECB didn’t even get as far as a first hike, before restarting asset purchases once more (and cutting rates further) as economic conditions deteriorated. The bottom line is that a “lower-for-longer” environment for interest rates is likely to persist for a number of years.
In the present situation, the effective absence of inflation pressures alongside modest growth prospects at best, means that central banks are set to stay in accommodative mode for some time with a loosening bias, even if there is limited scope for additional stimulus. The next tightening cycle looks a while off.
3. Long-term strategic competition
There have always been – and will always be – battles for supremacy between global superpowers in a variety of fields. One of the things that makes the current spat between the US and China special is the impulsive and capricious nature of those in power.
On the one hand are Chinese leaders who are used to all-powerful state ownership as well as total control and deference; on the other is the combustible, populist and single-minded Mr Trump. There are a host of genuine grievances that can be levied against China in terms of unfair trading practices and intellectual property theft.
The “normal” diplomatic channels for resolving such issues move far too slowly for the Trump administration and China has no qualms about playing the system, all too aware of its current and future position of importance on the world stage. The result was first a stalemate but then an eruption of conflict, starting in February last year with “global safeguard tariffs” on solar panels and washing machines, but swiftly escalating to tariffs on up to $550bn of Chinese goods and $185bn of US goods (Figure 11).
Figure 11. China average tariff rates
The worst of the trade war could be over (although even that is not certain), and the recent “Phase 1” agreement reached between the US and China, along with the reduction of some existing tariff rates and postponement of others, points to the possibility of more constructive developments in 2020.
But while that may be enough to lift the mood, dilute the conflict and lead to a resumption of world trade growth, sparring between China and the US (and perhaps others) is almost certain to impact the global macro-economy and frame the investment backdrop for years to come.
The US and the Soviet Union endured many decades of cold war regarding nuclear weapons but found an uncomfortable and occasionally precarious equilibrium. Billions were spent, but outright, lethal conflict was avoided. It is naïve to believe that US and China differences in areas such as trade, technology and international relations can be quickly resolved. But it is not unreasonable to think that some agreements can be reached over time and that pathways towards more harmonious trading arrangements and the greater inclusion of China in free market commerce can be sketched out.
There are, however, many who do not share that ideal, believing instead in a more inward-looking future. Whatever happens, long-term strategic competition between China and the US will be here for a while.
4. Search for yield
The influential Barclays Equity Gilt study compiles a history of real (and nominal) investment returns for different assets over the last century or more. Over the last 30 years – the period over which inflation has been tamed, more or less, at around 2 per cent – the average annual real return on equities has been 5.0 per cent.
The equivalent for sovereign fixed income has been a little lower, at 4.5 per cent, while the average investment return on cash has been just 0.5 per cent (Figure 12).
Figure 12. Financial asset returns over the longer term
These numbers refer to UK financial assets, but virtually all longer-term studies for developed markets come up with similar figures. If investors have got used to, or rely on, these sorts of returns, or if they at least aspire to earn something like them, then the low level of yields that prevails today implies that there will be problems in the future.
As yields have pushed lower in recent years, especially in the post-GFC period, generating an “adequate” income return has pushed many investors into a range of new and more exotic asset classes in a relentless hunt for yield. The capital gain implied by trend declines in yields has helped boost returns but that obviously cannot go on forever. In a similar vein, the ever-lower level of interest rates has encouraged many economic agents – households, companies, financial institutions and governments – to take on much higher levels of debt (Figure 13).
Figure 13. Debt levels still high in some areas
While it makes sense to take advantage of the low cost of borrowing where appropriate, there are concerns that the level of risk-taking among borrowers (or at least those in some regions or sectors) has been excessive. Such fears may not be realised until or unless interest rates eventually start to rise again, or until the economic backdrop becomes less favourable.
The bottom line is that the behaviours of both borrowers and savers are being acutely influenced by the low level of rates/yields today. Since there is no immediate likelihood of those rates moving significantly higher in the immediate future – a direct consequence of our first two themes – there is no reason to expect those behaviours to change soon. Some borrowers may take on too much debt and some investors may take on too many risks as they hunt for higher yields. Identifying such potential weak spots in advance will not be easy.
5. US election
US elections are protracted affairs so although the event itself does not take place until November 2020, the process will influence financial markets in the short term and economic prospects over a longer horizon.
Those effects will grow gradually over the year, starting from the primaries in February and March before building to the Democratic and Republican conventions in July and August and the election itself.
Much of the focus will inevitably be on whether Trump can win a second term, but there is a lot more at stake: the Democrats will defend their majority in the House of Representatives (lower house) while attempting to take control of the Senate (upper house) where 34 of the 100 seats are up for election.
At this stage Trump does not even know who his opponent will be (Figure 14), although that is not unusual this early in the process – four years ago he was a rank outsider for the Republican nomination. But the national (and international) mood will ebb and flow in response to polling trends and their perceived implications.
Figure 14. Who will take on Trump? Democratic presidential nomination odds
The Republican party is often considered to be the more (equity) market-friendly choice and Trump himself will be quick to point out the nearly 50 per cent rise in the US stock market over the last three years.
Among the main Democratic contenders presently (this can change), the general perception is that there are two “progressive” candidates – Warren and Sanders and two “moderates” - Biden and Buttigieg. The nomenclature essentially intimates that the former have a bolder, more reformist agenda including higher taxes on the wealthy and greater regulation of big business, while the latter are considered to have a more restrained and conventional left-of-centre policy outlook.
Sentiment in financial markets over the next twelve months will be influenced by which candidate looks most likely to take on Trump and by the perception of their chance of beating him. Currently the odds are slightly in favour of a Democratic win, but it is close, and it is very early days. Political events are a distracting sideshow in many regards, but it would be negligent not to consider this one as a potential driver of markets in 2020.
Risks to the house view
Further escalation cannot be ruled out
The highpoint for the globalisation trend that characterised much of the 1980s, 90s and 2000s is probably behind us (Figure 15), but it is widely hoped that the current stagnation of world trade is temporary, and that growth will resume during the course of 2020. However, it is also plausible that the ongoing trade dispute reflects wider issues related to more insular attitudes towards free trade and openness between competing economies.
Figure 15. Annual growth of world trade and world GDP
The risk of a deepening and widening of trade tensions impacting many more nations including those of the tradedependent euro zone is very real. A ratcheting up of more narrow-minded protectionist attitudes could lead to a more permanent inertia in international trade flows as established global supply chains weaken or are replaced.
China policy glitch
In response to its own economic issues and to the impact of global ones, China has invoked a range of policy stimulus measures. The majority of these have been domestically-focussed. Any knock-on effects to the wider global economy should therefore be limited. China’s almost total control over most aspects of its system should give it a greater chance of success.
China wobbles or policy stumbles should not be ruled out
Nevertheless, there is still a risk that policy initiatives do not succeed fully. China has plenty of ammunition at its disposal but is still learning how to use its policy weaponry effectively. It is rare that emerging economies transition without shocks along the way. The wobbles in 2015/16 were the most recent example (Figure 16). Although dealt with effectively in the end, there were significant global consequences at the time.
Figure 16. Any China setback would impact elsewhere
Market liquidity still a major challenge in some areas
One of the unintended consequences of the GFC and its aftermath has been a marked reduction in liquidity in key markets.
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.
Brexit and European politics
The surprising UK election result and scale of the Conservative victory will determine Britain’s direction of travel in 2020. It now seems inevitable that the UK will leave the EU at the end of January.
The politics of populism are having a significant impact
However, the risk of a hard exit has not disappeared. If the exact terms of future trading relationships cannot be finalised during 2020 (highly likely in our view), then an extension would seem to be the most sensible course of action. But in a painful repeat of the games of brinkmanship over the last three years it is possible that a cliff-edge exit on WTO terms could still happen at the end of 2020.
More generally, Brexit is just the clearest example of the thrust of populism and discordant politics that has emerged in recent years (Figure 17). European discontent has lessened recently but could easily re-erupt: resistance to Macron’s reforms, political change in Germany and renewed budgetary games in Italy are all genuine concerns.
Figure 17. No sign yet of decline in populism
Public finances around the developed world spiralled out of control in the aftermath of the Global Financial Crisis (GFC). Deficits soared wider in 2009 and 2010 and public debts rose as percentage of GDP for many more years after that.
After many years of fiscal retrenchment (austerity to some), government budgetary positions are now in much better health. This development has led to demands for ambitious fiscal expansion packages to be implemented, with bold public investment programmes to take advantage of exceptionally low borrowing costs.
Calls for more ambitious fiscal projects are rising
While there is some merit in this line of reasoning, public deficits persist in most countries. So far, fiscal stimulus packages have been modest (Figure 18) but slightly growth-positive. (The US was an exception on modesty.) There is a risk that they become more explicitly expansionary, which could have potentially adverse effects on longer-term public finance sustainability.