The global economy continues to be buffeted by the cross-currents of US-China trade tensions and global central banks launching a fresh round of easing. Trade tensions have taken a toll on manufacturing confidence, industrial production and trade flows. On the other hand, the services sector remains relatively resilient as manufacturing weakness has not dragged down the services component of the global economy. With trade tensions hitting certain regions (Europe, Japan and China) and sectors (manufacturing and exports-oriented) particularly hard, there is pronounced geographic and sector divergence within the global economy, raising downside risks to growth.
On a positive note, the US economy appears to be growing at an above-trend pace, driven mainly by a robust consumer sector, which continues to be supported by healthy household balance sheets, steady employment growth, solid wage increases and low interest rates. In fact, the consumption sector appears to be healthy in most economies, as unemployment rates remain in a downtrend. This is true even in Germany, whose economy is likely already in recession due to its large manufacturing and export sectors, which have contracted due to the trade conflict and Brexit uncertainty. Nevertheless, consumer spending there remains buoyed by record low unemployment and solid wage growth.
Given the weak growth backdrop and elevated geopolitical risks, global central banks have embarked on a fresh round of easing through rate cuts and other stimulus measures. The US Federal Reserve cut rates twice in Q3, including the September rate cut. While markets are expecting more rate cuts, the outlook for additional easing is uncertain with Fed officials disagreeing about the impact of trade tensions and weaker global growth versus the strength of US domestic demand. At its September meeting, the European Central Bank (ECB) announced a comprehensive stimulus package that included a rate cut, a restart of quantitative easing and more dovish forward guidance. The Bank of Japan will likely seek to cushion the impact of a consumption tax hike scheduled in October with additional easing measures. Beyond the Big Three, 48 developed and emerging market central banks have cut rates and maintained an easing bias this year.
With policy rates already at, near or below zero in many countries and negative interest rates having adverse unintended consequences for bank balance sheets, there are plenty of doubts about the ability of central bankers to ward off a downturn. Thus, talk has shifted to the use of fiscal policy as a means of stimulating growth, especially in Europe, where both outgoing ECB President Mario Draghi and incoming President Christine Lagarde have called on Eurozone governments with low budget deficits or surpluses to launch fiscal stimulus. With a budget surplus of 1.5% of gross domestic product (GDP), Germany would be a prime candidate to do this.
However, German policy makers appear reluctant to pull the trigger in the face of still strong domestic demand. In late September, the German government announced a “green policy” package to help reduce CO2 emissions. Financed by extra spending and tax subsidies totalling €54 billion between 2020 and 2023, the package amounts to a tiny fiscal stimulus of less than 0.4% of GDP per year, just a drop in the bucket. While this is a step in the right direction, more fiscal stimulus is clearly needed, and Germany can easily afford it. The Netherlands also announced its budget for 2020, which included a modest fiscal stimulus of 1% of GDP. Even Italy may get a green light from the European Union to run fiscal deficit of greater than 2% of GDP to stimulate economic growth.
Discussion of Major Regions
US growth remains resilient with forecasts for Q3 economic growth recently revised higher to around 2%. Second-quarter GDP grew by 2% annualized with a solid contribution from consumer spending, which rose 4.7% during the same period. The outlook for consumer spending remains solid, with the labor market continuing to create jobs, the unemployment rate remaining at a 50-year low of 3.7% and strong wage growth in excess of 3%. Further, while job growth has been on a downward trend, the economy continues to generate around 170,000 non-farm jobs per month on average. A strong rise in retail sales (up 0.7% month-over-month in August), with broad-based gains, reflects solid consumer fundamentals. At its September meeting, the Fed noted that the “labor market remains strong and economic activity has been rising at a moderate rate,” adding that “household spending has been rising at a strong pace.” However, it also noted weakness in business investment and exports.
The Eurozone economy remains anemic, with Q2 growth remaining below trend at a 0.8% annualized rate. Gross domestic product growth has contracted in Germany; is stagnant in Italy; and is slowing in France and Spain. Trade and reduced consumption spending were drags on Eurozone growth, while investment spending held up despite manufacturing confidence being in contraction territory. Eurozone GDP growth is likely to remain under 1% in Q3, with falling retail sales and contraction in industrial production, especially in Germany. The ECB downgraded its forecast for Eurozone growth and inflation in September.
Brexit uncertainty appears to be finally catching up with the UK economy with Q2 GDP contracting -0.8% annualized, the slowest annual pace since Q1 2018. Looking ahead, UK GDP growth is expected to post a modest rebound in Q3. However, Brexit uncertainty continues to weigh on trade and business confidence generally and manufacturing confidence in particular. This suggests investment spending is likely to contract in Q3. Prime Minister Boris Johnson is struggling to push through a “no-deal Brexit” in Parliament, which has voted against this and against holding a snap general election. At this point, the most likely near-term scenario is a delay beyond the October 31, 2019 deadline, but the possibility of a no-deal Brexit, fresh election or a second referendum remains elevated.
Japanese GDP growth remains moderate for now with Q2 growth at 1.2%, but risks appear tilted to the downside, given slower global growth and yen appreciation. Further, increased uncertainty from the US-China trade dispute is weighing on Japan’s export outlook, with exports to China and the US remaining stagnant. Another negative is the consumption tax hike scheduled for October 2019. The Abe administration is planning several stimulus measures to help soften a downturn in consumer spending and Japanese growth. However, consumer confidence has trended lower, raising concerns about domestic demand.
The outlook for emerging markets growth remains hostage to trade tensions. Growth has continued to slow in export-dependent economies, such as China, Taiwan and South Korea, due to both the ongoing US-China trade war and tensions between Japan and South Korea. China’s growth slowed to 6.2% year-over-year in Q2 from 6.4% in Q1 as the escalating US-China trade tensions weakened business confidence and export growth. Growth is likely to fall to the lower end of the Chinese government’s target of 6.0% to 6.5% in 2019. Growth forecasts for 2020 were revised down following the recent round of tariff increases and fears that the government’s stimulus efforts will be insufficient.
Even emerging market economies that are less levered to the global export cycle, such as India and Brazil, have seen a slowdown in growth amidst weaker consumer spending and slow progress on much needed reforms. India’s Q2 growth slumped to a five-year low of 5% year-over-year, for example, but the recent corporate tax cut is likely to boost growth. In Latin America, Brazil is growing at just around 1%.
We see the potential for significant market swings between now and year-end. The clash between escalating geopolitical risks and additional monetary easing has fattened both the upside and downside risks for the global economy, and it is currently very difficult to determine which force will gain the upper hand.
The key downside risk is a continued escalation of the trade war, which would lead to an even deeper downturn in global manufacturing. This, in turn, could progressively weaken the healthier components of the global economy, namely the services sector and the US consumer, potentially triggering a broader global downturn.
Beyond US-China trade tensions, other global risks are flaring. Brexit uncertainty has risen given Prime Minister Boris Johnson’s penchant for risk and brinksmanship. Violent protests continue in Hong Kong despite a significant concession from the territory’s government in officially pulling the controversial extradition law. Growing tension in the Middle East, underscored by attacks on the Saudi oil fields, create another headwind.
A more constructive scenario for risky assets involves a tamping down of geopolitical risks, while global central banks remain accommodative and G7 bond yields stay depressed. Global bond yields plunged during the summer on signs of economic weakness, increased trade tensions, and central bank dovishness. The US 30-year benchmark Treasury rate dipped below 2% for the first time ever in August, and now more than $17 trillion in debt—or approximately 30% of the global bond market—trades at negative interest rates.
Ultimately, the performance of the markets over the remainder of 2019 will depend on the answers we get to some critical questions. Will President Trump seek a détente with China as a way to protect the economic expansion ahead of the 2020 Presidential election, or will he double down on his current path of periodic escalation? Are the Chinese even willing to make substantive concessions if Trump changes his tune? Recently both parties have made minor concessions, involving pushing back timetables and exempting certain goods from tariffs as a way of generating good will ahead of high-level meetings set for October 2019. However, we still do not have high-conviction answers to these important questions.
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