Global growth conditions are currently among the weakest since the financial crisis, and leading indicators show no signs of a turnaround yet. At the same time, we have seen a sharp rise in growth risks from further escalation of trade tensions. With inflation rates still running at or below their targets, global central banks are grabbing their liquidity fire hoses.
Trade tensions ramped up in a major way during the quarter, prior to which it appeared the US and China were on the verge of a deal. US-China talks broke down in early May, however, and the Trump administration raised tariffs from 10% to 25% on $200 billion of Chinese exports. The US threatened and then ultimately postponed auto tariffs on Europe, Japan, and Korea. Mexico also unexpectedly found itself targeted for US tariffs as the Trump administration decided to weaponize trade to get the Mexican government to further stem the flow of illegal immigrants across the US southern border. The US and Mexico ultimately reached a deal and the tariffs were not implemented, but the threat of tariffs still hangs over the markets/economy like the sword of Damocles. Finally, Brexit claimed the head of another UK Prime Minister, and odds of a “No Deal” Brexit have increased, given the shape of the Tory leadership race, raising risks for UK’s future trade relationship with the European Union.
Tariffs have not yet taken a big bite out of economic activity, as their direct impact on growth has admittedly been small. However, the second-order effects of tariffs could increase if business confidence and risk appetite continue to decline. The US yield curve is currently inverted, which historically has signaled a looming recession. However, other indicators, such as initial unemployment claims, The Conference Board’s Leading Economic Indicator, and high-yield spreads, are not validating the ominous signal from the yield curve. Nevertheless, if trade hostilities intensify, the effects of higher tariffs and supply chain disruptions could snowball and push the global economy into a full-fledged recession.
Responding to these risks, the global central bank cavalry— unconstrained by inflation pressures—is attempting to ride to the rescue. In fact, more than 16 central banks (including Australia, India, Russia, Indonesia and Chile) cut rates during the second quarter and have indicated a willingness to cut rates further, if needed. The European Central Bank (ECB) recently signaled that rate cuts and a resumption of asset purchases would be forthcoming if growth or inflation falls short of its expectations. The US Federal Reserve did not cut rates at the June meeting but joined the ECB in signaling its readiness to cut rates going forward. Several emerging market central banks have either cut rates or shifted to a dovish stance, with the People’s Bank of China cutting rates several times and undertaking other measures to inject liquidity.
The jury is still out as to whether central banks have gotten ahead of the curve and will succeed in engineering the elusive soft landing or whether the current dovish shift will be viewed as too little too late in retrospect.
Discussion of Major Regions
The US economy posted an upside growth surprise with first-quarter Gross Domestic Product (GDP) growth of 3.1%, defying expectations of a slowdown due to the US government shutdown, winter storms and trade uncertainty. Since the Q1 growth surprise was led by strong contributions from inventories and trade, there is likely to be payback in Q2 with growth downshifting to 2%. US growth continues to be underpinned by still-healthy consumption spending due to a strong labor market that continues to create about 150,000 jobs per month and a 3.6% unemployment rate, the lowest in 50 years. On the other hand, investment spending is likely to remain soft with business confidence weakening as trade tensions mount.
In Europe, the economy managed to halt the growth downtrend with better-than-expected Q1 GDP growth of +1.6% led by consumer spending. Growth was solid in Spain (+2.8%), steady in France (+1.2%), and recovering in Germany (+1.6%). Italy emerged from recession with a 0.8% increase in GDP growth. Looking ahead, Eurozone growth is likely to remain below trend, which is around 1.5%, as business confidence has fallen into contractionary territory in most Eurozone economies. The UK economy managed to post healthy 2% growth in Q1 despite ongoing Brexit uncertainty. However, continued uncertainty and increased odds of the UK crashing out of the EU without a deal is likely to depress confidence and activity.
The Japanese economy also surprised to the upside with stronger-than-expected Q1 GDP growth of 2.2% on the back of positive contributions from trade and inventories. However, risks to growth have increased as business confidence, especially in manufacturing, has moved into contraction territory and will likely depress businesses investment spending. Meanwhile, consumption spending remains solid as consumers front load purchases ahead of the consumption tax hike scheduled in October. While there is speculation the tax hike might be delayed due to external weakness, the hike remains on track for now with the government rolling out several stimulus measures to cushion the impact of the tax increase on consumer spending and the Japanese economy. Despite these measures, growth is still expected to turn negative in late 2019 before rebounding early next year.
Emerging market economies benefited from the easing of global liquidity conditions in early 2019 as the Fed and other central banks stopped tightening and moved to an easing bias. Emerging market GDP growth stabilized in early 2019 and appeared on track to strengthen over the course of the year driven by China stimulus, easing of trade tensions in Q1, lower oil prices and emerging market central banks moving to an easing bias after rate hikes in 2018. However, the reescalation of US-China trade tensions and slowing global growth have increased the uncertainty around the emerging markets growth outlook. Business confidence, which had weakened over 2018, has since recovered. However, confidence levels are still barely positive and may deteriorate again if the trade uncertainty intensifies.
In Asia, the Chinese economy lost momentum in Q2 after a positive start in Q1 as trade tensions escalated. However, the Chinese government has been quick to announce additional stimulus measures to support the economy, and growth is expected to stabilize. In India, Q1 growth disappointed, but is expected to rebound with Reserve Bank of India rate cuts and the removal of political uncertainty after a solid win for the incumbent government. In Latin America, growth expectations have been revised lower with already-soft growth in Brazil and Mexico slowing. In Eastern Europe, Russia is relatively insulated from the ongoing trade tensions but could suffer collateral damage as the decline in oil prices puts pressure on the economy.
After turning in a fantastic performance in the first quarter of 2019, global stocks delivered more modest but still solid, returns in the second quarter of 2019 (Q2). The quarter proved volatile for equities with May’s sharp declines bookended by solid returns in April and a buoyant rebound in June.
Looking forward, financial markets continue to be caught in the cross currents of the escalating trade war and the potential for more monetary stimulus. Responding to the prospect of weaker growth and monetary accommodation, global bond yields have dropped materially this year, providing some support for economic growth. Global economic conditions do not yet appear recessionary, but growth continues to slow, and the global economy would be vulnerable if the trade war escalates.
Monetary reflation can buy time and shore up confidence in the face of continued trade uncertainty; however, in an escalation scenario, we could reach a tipping point that would make an economic recession and equity bear market inevitable, rate cuts notwithstanding. All eyes were on the Group of 20 meeting in Japan in late June when President Trump and his Chinese counterpart Xi Jinping had an “extended meeting” and agreed on a trade truce and to resume trade talks.
In general, we do not share the view that the current US-China spat is simply about the economic interests of two parties seeking to negotiate the best deal for themselves. We believe US-China relations have permanently diverged and should be viewed in the context of a geopolitical competition that is unlikely to be resolved by the Chinese buying more US soybeans. Thus, the current tensions are likely to persist for some time. We also think it unlikely that a substantive deal addressing intellectual property, market access, and subsidies to state owned enterprises will be struck in the near future. That said, tensions are likely to ebb and flow around the structural trend of declining relations, and a positive scenario for risky assets could involve a trade truce ahead of the presidential election year, along with Fed/ECB reflation and more China stimulus.
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