The five key themes and risks our House View team expect to drive financial markets.
8 minute read
- Weak global growth
- Dovish bias to monetary policy
- Trade dispute continues
- Fiscal activism returns
- Volatility here to stay
1. Weak global growth
The global growth slowdown has continued so far in 2019 and the outlook remains fragile and uncertain.
The best that can be said is that it has not intensified dramatically on a global basis (although it has in a few key regions) in recent quarters. But with risks skewed to the downside and recession threat rising in some countries, it is entirely understandable that questions are being asked about the sustainability of the present economic expansion.
Global GDP is likely to increase by around three per cent in 2019 overall (Figure 1), which would be the lowest pace since the crisis year of 2009.
Figure 1. Global growth continues to slow Could dip below 3 per cent next year
In a longer historical context, only nine of the last 40 years have seen weaker global growth, so we are looking at a bottom quartile macro-economic performance in 2019. Moreover, on current momentum 2020 is likely to be even weaker, with aggregate growth slipping further to an annualised rate of 2.75 per cent or so.
In calendar-year terms, all major regions are expected to slow in 2020, with even the previously resilient US slowing appreciably and to a belowtrend pace.
The main drivers for slower growth have been well documented: ongoing trade tensions and a widening of the arena of conflict between China and the US have weighed heavily on world trade and on global manufacturing which still dominates such flows.
Global trade, which was growing at an annual pace of five per cent or more as recently as last October, is now stagnating and the malaise within industry is hurting those nations that depend most heavily on trade in manufactured goods.
The worry is that the longer this goes on, the more likely it is that weakness will be passed on to domestic demand, which until now, has been extremely resilient. The channels by which any such transmission takes place are likely to be first, business sentiment, second, investment and finally, employment.
Business surveys have already dipped in most nations, quite alarmingly in some cases and investment has slowed significantly too (Figure 2). But so far labour markets have generally been robust (or better) which has helped support household incomes and expenditure.
Figure 2. Investment growth has slipped As weak as 2015/2016 and still falling
Until or unless this final trend changes, or if consumer confidence were to suddenly plummet, the outlook remains one of low growth rather than no growth.
2. Dovish bias to monetary policy
In response to weaker growth, subdued (and in many cases, below-target) inflation and the threat from trade tensions and mounting protectionism, central banks around the world have adopted or re-adopted an increasingly accommodative monetary policy stance.
After the extended period of ultra-loose policy that was implemented in the wake of the Global Financial Crisis (GFC) and maintained for years, the eventual moves towards normalisation may have seemed incredibly brief. (They never actually started in a number of jurisdictions.)
But, in fact, the recent US hiking cycle, for example, is one of the longest in history in terms of time (43 months), beating the previous one (2004-2007) by four months, and more than double the previous post-war average of 15 months.
There is a lively debate about where the new “neutral” is in the post-crisis world and indeed whether it is even positive in several countries. But the key point is that central banks are back in stimulus mode almost everywhere and the main issue now is simply how far they will go (Figure 3).
Figure 3. Bias to easing in the major nations Markets expect further cuts everywhere
Financial markets are expecting a lot and while we agree that a dovish bias is appropriate in today’s conditions, should downside risks ease, they may not need to (or want to) deliver quite as much as is currently priced in.
Nevertheless, in our central scenario the dovish bias is likely to remain over the next year or more. In common with earlier cycles it may be that financial imbalances have built up in some areas, but what is missing in the current experience is any sign of more generalised overheating.
In the past, such episodes have been characterised by rising inflation pressures to which central banks have been obliged to respond, often killing off the economic upswing. The absence of such pressures today provides the monetary authorities with almost total freedom to react to growth concerns and downside risks and that is what they are doing.
Until growth revives and/or risks dissipate (and assuming inflation stays well behaved), they will be comfortable in adopting such an approach.
3. Trade dispute continues
The trade war between the US and China will continue to frame the investment landscape for the foreseeable future.
As has been the case since it began, there will be intermittent shifts of mood – both up and down – with periods of calm interspersed with a ratcheting up of tensions as Trump and others pursue the America First agenda and China responds.
Before condemning the Trump administration totally, it needs to be acknowledged that some of their grievances with China are legitimate, especially with regard to intellectual property theft and access to China’s markets.
But weaponizing tariffs and the like sets a dangerous and worrying precedent. Moreover, the risk of such measures spreading to other nations and eventually resulting in an all-out, tit-for-tat and damaging trade war is one that is already impacting business sentiment and financial markets, even if it were never to materialise fully.
Financial markets will be susceptible to “headline” or “tweet” risk, but our central view is one where there is continued tension and intermittent escalation rather than resolution.
Our base case also assumes that the planned (announced) additional tariffs are implemented in full. In addition to the direct impact on trade flows, the uncertainty about trade policy, which has recently reached a new all-time high, is hindering cross-border investment and disrupting supply chains which will harm medium-term growth prospects.
More immediately, the bilateral tariffs introduced by China and the US since the start of 2018 will reduce global growth by about 0.6percentage points by 2020/21 (Figure 4) according to analysis undertaken by the OECD, with much of that hit coming from lower business investment (Figure 5).
In the event that trade tensions ease, global growth could be stronger, but the most likely scenario is one where uncertainty persists and that this in itself will be sufficient to hurt growth.
Figure 4. Adverse impact from US-China tariffs 1 Hit to GDP (difference from base)
Figure 5. Adverse impact from US-China tariffs 2 Business investment hit most (difference from base)
4. Fiscal activism returns
Whether monetary policy has reached its “natural” limit or not, the marginal return to additional measures is almost certainly lower than it was.
With public finances now restored to health in most countries, pressure on fiscal authorities to provide policy assistance where possible (and prudent) is building. It has even been suggested that the arbiters of the fiscal purse should pick up the policy baton from their monetary equivalents. In the era of independent central banks, policy boundaries were generally respected.
Today the edges are more blurred, the latest example being the ECB stating explicitly that the time was right for fiscal authorities to share the burden in the provision of policy stimulus.
Both the IMF and the OECD have been unusually vocal recently in their support of such initiatives, with the latter stating that “exceptionally low interest rates provide an opportunity to invest in infrastructure that supports near-term demand and offers (long-term growth) benefits for the future”.
While a return to the large-scale Keynesian fiscal interventionism of the 1960s and 1970s is highly unlikely, fiscal policy is set to provide a small boost to growth in coming years, which is a marked change from successive years of fiscal retrenchment. If the downturn were to become more severe, the healthier state of fiscal aggregates means that there is now greater scope in some places for public demand to step in to support growth.
However, caution is warranted in any assessment of the room for fiscal expansion. Despite the improvements in recent years, vulnerabilities remain in many countries.
After Trump’s fiscal largesse in 2017/18, the US budget deficit is approaching 5 per cent of GDP with the economy now slowing – there is very limited capacity for any repeat.
Meanwhile in Germany there is ample scope for fiscal stimulus, but little desire to embark on such policies (Figure 6). For most of the rest of Europe there is no such room given high public debt levels.
Our central view is that fiscal policy can deliver a valuable lift to aggregate demand in many countries in future years but that it will not be a game-changer.
Figure 6 . All countries are not equal The scope for fiscal easing varies enormously
5. Volatility here to stay
Recent years have been characterised by extended periods of relatively benign price moves in financial markets, interspersed with episodes of relatively large asset price moves.
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. We expect to see this pattern continue.
History shows that extremes in cross-asset volatility occur at the ends of economic expansions when growth begins to slow meaningfully.
Yield volatility is currently exhibiting levels more consistent with historical norms, having spent the last few years at historically very depressed levels (Figure 7). Equity volatility is generally the first to exhibit persistently higher levels towards the end of the economic cycle, but historically also shows increasing levels of volatility in the second half of expansions (Figure 8).
Figure 7. US 10-year 60-day realised volatility
Figure 8. S&P 500 60-day realised volatility
Since we are likely well beyond the midpoint of the current global expansion, we expect volatility to continue to be an episodic feature of equity markets. Furthermore, 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 while 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.
Conversely, the market impact of crowded position de-risking and closing out of short volatility positions has been accentuated by the dearth in trading liquidity over recent history, 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, provided that global growth does not fall significantly further below potential.
However, since risks to the global economy seem skewed predominantly to the downside at present, there are already a number of catalysts for asset price volatility to persist. Were growth to deteriorate further, cross asset volatility will likely remain at more consistently elevated level across the board.
Risks to the House View
Trade war deepens and goes global
As before, elements of this risk are contained in our central view, but in reality it is a continuum of possibilities of which there are many at the adverse (risky) end.
Further escalation in the trade war very likely
What began as a “simple” trade dispute between the US and China has already mutated into a more generalised geopolitical clash between those nations that could easily become more severe and also spill over into new areas.
Other bilateral US-China relationships could become affected, including currency wars, services trade (including tourism and foreign students) as well as more specific corporate restrictions, such as those initially applied to Huawei. The wider this scope becomes, the more detrimental the likely impact on global growth from both direct and indirect effects (Figure 9).
Figure 9. Trade policy uncertainty in unprecedented territory Has only become a major issue since Trump was elected
In addition, the conflict could spread to other countries: the spectre of tariffs still hangs over Europe and Japanese autos, for example. Escalation, sometimes on a whim, is a riskthat is likely to be here throughout 2020.
China stimulus fails
China is still learning how to use its policy weapons
It may seem unfair to single out China – policy stimulus could fail anywhere after all – but there are reasons. China is employing a range of policy instruments (not just rates) to provide stimulus, including monetary (Figure 10), fiscal, as well as imposed rules and guidance via national and local government.
Required longer-term structural adjustment and the importance of China to the global economy – think back to the concerns in 2015/16 – mean that it merits its own risk.
Figure 10. China stimulus rising once more Earlier tightening is now being reversed
Simply put, if stimulus worked everywhere else, but not in China, the world economy would still be affected. China has plenty of ammunition at its disposal but is still learning how to use its policy weaponry effectively. Recent measures have generally been domestically focused and should help offset weakness in the external sector related to the trade dispute.
In the last 40 years global growth has dipped below 2.5 per cent seven times. On four of those occasions, what followed could legitimately be described as a “global recession”.
Today global growth has slowed to under three per cent from more than four per cent not very long ago and momentum is still poor, so it is no surprise that recession threat is heightened (Figure 11).
The fragility of the global economy is being met by additional policy accommodation, but it would not take much more bad news to push the world into a more serious downswing.
Recession not inevitable, but dangers most elevated for a decade
A global recession is not inevitable (although some countries may experience one), but the main concern is that chronic weakness within manufacturing and trade migrates to services and domestic demand. Even if borrowing rates stayed low or moved lower still, a global recession would also expose vulnerabilities in over-indebted sectors.
Figure 11. Global growth has slowed significantly Threat of recession (shaded areas for the US) has risen
One of the unintended consequences of the GFC and its aftermath has been a marked reduction in liquidity in key markets.
Ample market liquidity may be a thing of the past
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, among 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 change of leadership in Britain has altered Brexit dynamics, but not the fundamental issue of stalemate with the EU.
Initially the hard-line approach adopted by PM Johnson had raised the probability of a No-Deal exit, but the subsequent political logjam and passing of the Benn Act has probably reduced it again.
Populism and messy politics are having an impact
Nevertheless, the risk remains and is, it should not be forgotten, the default. The uncertainty of the outcome has impacted sentiment and activity in the UK already, but the threat of more turmoil and contagion is very real. A No-Deal exit would be even more damaging and would hurt Europe too.
More generally, Brexit is just the most pressing example of the thrust of populism and discordant politics that has emerged in recent years (Figure 12). But there are others: Italy still looks vulnerable, while the possibility of disruptive election results in Spain and Germany is a genuine threat.