Smart policies needed


An overview of macro-economic tendencies for 2019 and 2020. How the US, European and Chinese economies might react faced with global political tensions

The beginning of 2019 is a good opportunity to reflect on how the world might develop over the next couple of years. In a nutshell, we might be heading towards weaker economic growth, increased unpredictability of trade, economic and fiscal policies, and shaky financial markets.

After the strong and synchronized global upswing of 2017 and the deceleration of 2018, the pace of global expansion will likely continue to ease moderately this year, from 3.6% to about 3.4%, followed by a more pronounced loss of momentum in 2020 to below 3%.

The US economy will play a major role in the global slowdown story, due to its very long expansion phase – about to become the longest on record – and the expected waning of the fiscal boost, which might start to expose the weakening of underlying fundamentals. Cracks might take some time to develop though, allowing the Fed to raise interest rates further in the first half of the year, before entering wait-and-see mode. Corporate balance sheets seem to pose the biggest risk to the US economy. Businesses have significantly releveraged throughout this long recovery and the cost of servicing the associated debt has increased measurably even as interest rates remain below their long-term average. Moreover, companies have been the biggest buyers of domestic shares for some time, meaning that stress on their cash flows as the economy slows might affect demand for equities, amplifying any turbulence in financial markets caused by lower earnings. Other factors contributing to a weakening of the US growth outlook would be a slowing of employment gains due to labor shortages and a less-favorable global growth environment as protectionism bites.

The direct impact of higher tariffs on trade flows has proved manageable so far, but the greater uncertainty that comes with them has already started to drag on business sentiment, damaging the outlook for fixed investment, both in the United States and abroad. This is especially the case for those businesses that are more exposed to economic shocks due to their high leverage. A turning point in the business cycle will increase the likelihood of the United States slipping into recession, possibly in 2020. If such a recession were to occur, it would likely be mild, broadly similar to that of 2001, but would be enough to induce the Fed to change policy course and start cutting rates.

As the United States initially slows and then enters a downturn, global trade is bound to take a hit and the eurozone is unlikely to be able to decouple, especially in 2020. However, an improvement in domestic fundamentals might provide a valuable cushion to help mitigate the economic slowdown on this side of the Atlantic. The tightening of the eurozone labor market achieved in the last few years is finally supporting wage formation, with the growth rate of nominal disposable income of households currently running at a decade-high level. Any easing in the coming quarters due to a weakening of employment prospects is likely to be largely offset by a slowdown in inflation, keeping the purchasing power of consumers on a trajectory of moderate growth. Moreover, from a balance-sheet perspective, eurozone households are in good shape, as indebtedness remains low in most countries despite brisk growth in consumer credit.  

On the investment front, the eurozone shows no clear signs of excessive spending. On the contrary, a number of indicators suggest that some pent-up demand for fixed investment remains, particularly in the construction sector. This evidence is consistent with the fact that the business cycle in the eurozone is at a far less advanced stage than it is in the US, given its later start following the sovereign debt crisis. With wide disparity between countries, the balance sheets of eurozone firms are not as strong as those of households. However, the prevailing trend over the last few years has been one of improvement, as businesses in countries hit by the sovereign debt crisis have undergone sizable deleveraging, improved their profitability, meaningfully raised their liquidity buffers and diversified their sources of funding. This is likely to have strengthened their resilience to shocks, although some pockets of vulnerability remain.

The window of opportunity for the European Central Bank to normalize its policy rates is likely to start closing fast in about a year’s time. We think the central bank will just manage to raise the deposit rate back to zero by early 2020, before being forced to abort its tightening plans. The main risk is that there may be even less removal of accommodation. The new European Central Bank president, who will succeed Mario Draghi in November, will most likely not change the European Central Bank’s reaction function in any meaningful way.

China will likely continue to slow gradually over the coming two years. Beijing’s difficult transition from a high-speed to a high-quality growth model is slowly eliminating important growth engines, reining in credit growth and expanding the role of market forces at the expense of state involvement. The rebalancing is under way, as shown by a sharp reduction in state-led investment growth, the contraction of steel and coal capacity and the adoption of measures aimed at curtailing the shadow-banking sector. We expect the Chinese authorities to be able to deploy fiscal and credit tools to prevent growth from slowing too sharply.

Emerging markets will probably struggle amid the cyclical downturn in advanced economies and tighter financial conditions. The tightening of global financial conditions that has been observed as a result of higher US rates, the appreciation of the US dollar and the correction in equity prices has already translated into large capital outflows from emerging market economies with weaker fundamentals (especially large external financing needs) and higher political risk. If investors further reduce investment flows, some of these countries may ultimately have to resort to requesting financial support from international financial institutions. This would increase the likelihood of contagion, although a generalized crisis in emerging markets remains unlikely. When the Fed starts to reverse the course of monetary policy by cutting rates, emerging markets might feel some relief, although it’s not clear whether this will be enough to offset the drag from slower global trade activity and rising risk aversion in financial markets.  

There are several risks to the outlook, most of which are not rooted in purely economic and financial factors, but largely depend on bad policy decisions. These include an escalation of United States-China trade tensions, the materialization of a no-deal, no-transition Brexit scenario, an intensification of Italy’s woes (with negative spillover to other eurozone countries) and, last but not least, a hard landing in China.

You will find this article in the eastwest paper magazine at newwstand.

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