Executive summary

4 minute read

  • The era of highly accommodative monetary policy is drawing to a close
  • As the global economy enters the fourth quarter of 2018, it remains on track for another year of solid growth
  • However, the picture has become somewhat more uneven across countries and regions when compared to last year
  • While growth has become somewhat more uneven, the above-trend pace has seen spare capacity continue to be eroded in all the major economies
  • In emerging markets, policy has also been shifted to a tightening bias, in some instances in reaction to sharp currency declines
  • Although we remain constructive on the fundamental outlook, the downside risk over the coming months from increased trade tensions has made us a little more cautious on the near-term outlook for risk assets

Good fundamentals, bad politics

As the global economy enters the fourth quarter of 2018, it remains on track for another year of solid growth, likely to be just a little under 4 per cent. However, while that would be a similar growth rate to that achieved in 2017, the picture has become somewhat more uneven across countries and regions (Figure 1).

Whereas growth accelerated in a broad-based and synchronised way in 2017, led by a sharp improvement in global manufacturing and trade, this year has seen an abatement in the common global growth driver, with domestic factors playing a more important role. In the United States, the tax cuts earlier in the year have boosted household and business spending, pushing already robust growth even higher. That improvement in growth came despite the continued gradual tightening in monetary policy.

In the Eurozone and Japan, domestic demand growth has remained above potential and similar to 2017. However, the contribution from trade has weakened this year. Meanwhile growth in the United Kingdom has continued to soften since the referendum to leave the EU in 2016. The slowing in trade and resulting unevenness in growth appears, at least partly, due to a slower rate of growth in China and some other emerging market economies where financial conditions have tightened. We do not ascribe it to the imposition of tariffs by the US and China, which up to this point have not been large enough to have a material impact on global trade.

While growth has become somewhat more uneven, the above-trend pace has seen spare capacity continue to be eroded in all the major economies.

In US, Japan and the UK the unemployment rate has fallen below the level reached in the years before the global financial crisis. While in the Eurozone recent gains have left it less than 1 percentage point above the pre-crisis low.

With labour markets tightening globally, the puzzle of weak wage growth in recent years may finally be resolving itself. While the US has seen a steady increase in wage growth over the past year, other regions have more recently seen a notable pick-up as well. Figure 2 shows the weighted average wage growth rate across the major developed economies rising to pre-crisis rates of increase. Stronger wage growth, alongside continued employment gains will serve to underpin consumption growth across the major economies.

With robust corporate profitability and positive demand prospects, business investment should also continue to improve over the coming year. However, while fundamentals remain positive, the main risk to the outlook is a further intensification in the trade dispute between the US and China.

The threat of both increased rates and a further broadening in the coverage of tariffs by the US (to potentially include all Chinese imports), and the potential for China to retaliate through both tariffs and quantitative measures, could move the direct impact on growth and inflation to something more economically significant. Should it spread beyond a bilateral dispute to something more global in nature, then our growth outlook would have to be revised materially lower and inflation moderately higher.

Almost all Central Banks are now tightening policy

With growth expected to remain above trend this year and next in most of the major economies, and with inflation moving back towards Central Bank targets, the era of highly accommodative monetary policy is drawing to a close.

The US is clearly in the lead in that process, having already raised rates eight times (200bps) since the end of 2015. But other developed market Central Banks have also begun raising rates more recently as well. Still others have halted or reduced the extent of unconventional monetary policies (QE) or announced their intention to do so. The Bank of Canada has raised rates twice this year, while the Bank of England also hiked rates in August, while the Norges Bank followed suit in September. Looking ahead, markets are priced for policy rate increases across the developed market economies over the next two years (Figures 3 and 4).

In the emerging market economies, policy has also been shifted to a tightening bias, in some instances in reaction to sharp currency declines. That has followed increased pressure on the more vulnerable emerging markets, particularly those with large dollar-denominated liabilities, from higher US rates and a stronger dollar. The notable exception has been China, where domestic monetary conditions are more impacted by reserve rate requirements, which have been eased this year. Nevertheless, the tightening in global liquidity, led by the US (where the Federal Reserve has also begun shrinking its balance sheet), is likely to result in increased market volatility as more leveraged, expensive and vulnerable markets become exposed.

Periods of rising interest rates (or tighter monetary policy more generally) can be challenging for financial markets. This must be especially true after the extended period of ultra-low interest rates that has prevailed since 2008/09. While it is true that policy is being tightened because economic conditions have improved, it remains the case that the era of “easy money” is ending and that is a headwind that financial assets will have to face. There is a natural tension between better macroeconomic prospects on the one hand and tighter financial conditions on the other. And this may be more of a strain for some assets than others.

Even if there were no other concerns, there is no guarantee of a smooth ride through these adjustments. However, there clearly are other worries. Trade tensions are, of course the main ones. But we have highlighted that the likely end of the low-volatility regime also has the capacity to disrupt. Indeed, we have already seen examples of this, but so far it has been localised.

While we remain constructive on the fundamental outlook, the downside risk over the coming months from increased trade tensions has made us somewhat more cautious on the near-term outlook for risk assets (Figure 5).

As such, we are close to neutral in our view on equities, moderately favouring US, European and Japanese markets over the UK and emerging markets. Should trade tensions subside over the next few months, we would be looking to move to a more overweight position on equities. While we are more cautious on equities, we continue to prefer a material underweight in government bonds, with a similar view across the US, Japan and Europe.

We expect inflation dynamics will continue to favour higher rates, both at the short and long-end, with the latter also likely to move higher on increases in global term premia. Among the developed markets, Australia and Canada are preferred overweights.

In credit, we see global investment grade valuations as unattractive at current levels, and are also underweight high-yield. While we certainly do not expect a recession over the next couple of years, spreads are historically tight and duration risk is material.

In emerging markets, both hard and local currency valuations have improved in recent months, but in most cases for justifiable reasons. As such, we are neutral in our outlook for emerging market debt, with a need for selective exposure to the more robust economies. Finally, we are modestly underweight G10 and emerging market currencies against the US dollar, which we expect to continue benefiting in the near-term from US economic outperformance, rising interest rates and trade war rhetoric.

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