Executive summary

3 minute read

All hands to the pump: Central banks try to limit the damage from trade wars

Global growth slowed to below three per cent (on an annual basis) in the middle of 2019, the weakest rate of increase since the euro zone crisis of 2012.

That slowdown, which began at the start of 2018, largely reflected a sharp deterioration in global manufacturing and trade. A combination of factors have been at play, including: structural de-leveraging and slowdown in China, past monetary policy tightening in the US, the imposition of and uncertainty around tariff and non-tariff barriers between the US and China and policy changes related to auto emissions in Europe.

There was a further escalation in the trade war between the US and China in August, when President Trump announced a broadening of tariffs to all Chinese goods. Following Chinese retaliation, the proposed tariff rates were then also increased across the board to an average of around 22 per cent.

That, alongside weaker-than-expected growth outturns in the euro zone, has led us to revise down our global growth expectations through to the end of 2020. We now expect growth to remain below three per cent over the next 18 months. That would represent the weakest sustained period for over a decade.

We expect all major economies to be growing below potential in 2020, with unemployment likely to rise modestly and wage and inflation pressures set to remain muted. Given the uncertainty around how businesses and households will react to the imposition of further tariffs, as well as the use of non-tariff measures, we judge that the risks to growth are to the downside (Figure 1). Indeed, we put the probability of a mild global recession over the next 18 months at around one in three.

Figure 1.  Global growth outlook (y/y)

We expect global growth to remain weak, with risks to the downside

Aside from the global recessions of 2001 and 2008/09, growth in global export volumes has fallen to its weakest rate in the last 30 years. That reflects the impact on global supply chains of the key factors noted above.

In particular, the imposition of tariffs from late 2018 accelerated the decline in export volumes globally as uncertainty rose and orders declined. The decline in orders led to a slowdown in industrial production, which is similarly weak (Figure 2).

Figure 2.  Global manufacturing and trade

Trade wars have taken a toll on growth already

The impact of the shock to global trade has, unsurprisingly, been felt more strongly in those countries and regions in which trade plays a more important role.

In particular, Japan and other parts of Asia, as well as Europe, have seen a sharper decline in growth as exports have become a material drag.

International trade is a relatively smaller part of the US economy, but it has also seen a modest hit to overall growth via the trade channel. Perhaps more significant, however, has been the slowdown in business investment in the US and elsewhere as uncertainty has impacted spending decisions.

Thus far, the majority of the global slowdown can be attributed to trade and the associated manufacturing industries.

While the manufacturing sector is a relatively small part of most economies – usually between 10-20 per cent – the magnitude of the changes in output can be large relative to other sectors. But if the downturn is contained to manufacturing alone, it is usually insufficient to cause a recession.

Indeed, despite the slowdown, no major economies have experienced any material increase in overall unemployment so far. This reflects continued robust consumption growth, supported by real disposable income gains and solid household balance sheets. That has continued to support service sectors.

Therefore, a key factor in determining whether the current slowdown turns into something more serious, or even recession, would be a broadening in the weakness beyond manufacturing. While the “hard” data has remained solid thus far, “soft” data such as surveys of service sector like the Purchasing Managers’ Indices (PMI) have recently weakened as well, suggesting that the downside risk to growth may be more likely to materialise.

Weaker growth prospects and low inflation have led many central banks to ease policy in recent months. The Federal Reserve reduced rates by 25bps in July and September, and several on the FOMC have indicated that they expect to ease policy further. The short-term US interest rates market currently prices in between another three or four rate cuts over the next year. We expect the Fed will cut rates once more this year and again next year, but given the downside risks do not see a material market mis-pricing.

The European Central Bank (ECB) also eased policy in September, cutting policy rates by 10bps, taking them further into negative territory, re-starting asset purchases and making adjustments to its balance sheet operations to ease bank funding.

The People’s Bank of China (PBoC) has undertaken a range of policy easing measures as well in recent months, as have other central banks, such as the Reserve Bank of Australia and the Reserve Bank of New Zealand.

All of this renewed monetary support has seen global risk-free rates fall sharply, with ten-year sovereign bond yields reaching new lows in many cases (Figure 3).

Figure 3.  Sovereign bond yields

Expectations of further monetary policy easing priced into rates markets

While policy rates are at or near all-time lows in many economies, we see scope for further easing if necessary. Many are calling for an increased role for fiscal policy to stimulate economies, but we remain somewhat sceptical about the willingness of those best placed to ease fiscal policy, such as Germany.

Having marked down our economic outlook and become increasingly concerned about the downside risks, it is perhaps unsurprising that we are cautious about the outlook for risk assets, with a neutral allocation to equities (Figure 4).

Figure 4.  Asset allocation summary

Neutral equities, modestly overweight duration and credit 

While many equity markets are close to their all-time high, we think they are fragile and susceptible to further downside news on growth. We expect estimates for corporate earnings growth in 2020 will be revised lower, and with valuations already close to long-run averages, see limited scope for a sustained move higher.

That said, if there was a permanent resolution to the trade war, something we currently put a very low probability on, it could be the catalyst for a re-rating, particularly for value stocks that have performed particularly poorly over the past 12 months.

Our preference is for a modest overweight in duration, with the recent sharp rally sufficiently large for us to pare back our previous overweight view somewhat.

Similarly, we continue to prefer a modest overweight in credit and emerging market debt, with both direct and indirect central bank support expected to mitigate the risks of a default cycle in our central case. We also continue to prefer to be overweight US dollars due to heightened risk aversion.