- Economic growth has slowed globally in 2018, but this conceals divergence between regions
- Europe has slowed the most, Asia a little less so while the US economy has actually gained growth momentum.
- The slowdown in Europe has been caused by slower export growth, linked to a weakening of world trade growth.
- A variety of factors have most likely contributed to the slowdown: normal volatility, inflation, the trade conflict, weaker growth in China and the tightening of financial conditions are the most important.
- Fiscal stimulus has boosted activity in the US.
- The big question whether or not key economies will fall in recession before too long. Recessions are painful as unemployment shoots up as do defaults while they cause havoc on equity markets.
- Recessions are generally caused by shocks or excessive monetary tightening. We cannot forecast shocks, but excessive monetary tightening looks unlikely.
- We think global growth in 2019 will be a little lower than in 2018, but not by much. Recessions are unlikely.
- Inflation will pick up a little, but nothing to worry about; Chinese policymakers are taking measures to support economic growth; and the worst of the tightening of financial conditions is behind us as the Fed is approaching the end or a pause to its tightening cycle and currencies of emerging economies are set to regain some ground.
- The trade conflict and, to a lesser extent, Brexit are uncertainties that could cause more damage to the global economy than we are anticipating.
Slowing growth in 2018
Global economic growth has started to slow in the course of this year, though at varying degrees in different countries. Having said that, the pace of growth is still roughly in line with trend and full-year growth for 2018 is almost comparable to 2017’s pace.
In all honesty, we are still struggling somewhat to determine what exactly the key drivers of the slowdown are. In order to assess the growth prospects for 2019 and beyond, one needs to have a view on the factors that have contributed to the slowing of 2018. This document aims to develop a view on the 2018 slowdown and the prospects for the world economy as a whole in 2019. In a series of separate documents to be released in the next two weeks or so, we will provide a more detailed view on how we think 2019 will pan out in individual economies. We will also provide reports on how we think various FX and fixed-income markets will fare next year.
The clearest and earliest sign of the slowdown was the persistent and sharp drop of various confidence indicators, in particular business confidence in the eurozone and some Asian countries, since the start of the year. Lower GDP growth, lower world trade growth and lower growth of industrial production duly followed. The US has fared better this year than other economies as its growth has actually accelerated compared to 2017. The fiscal stimulus provided by the Trump administration has been the main driver. Some emerging economies have also done better as they emerged from recession in 2018. Business confidence in the eurozone has fallen significantly but is still at a reasonable level.
A number of possible explanations for the drop in confidence and growth outside the US can be identified.
· Volatility of the business cycle
The business cycle does not evolve in straight lines. Periods of above-trend growth are bound to be followed by periods of below-trend growth. This is normal and nothing to be particularly worried about. 2017 was clearly a year of above-trend growth, certainly in Europe. The strength of 2017 is also illustrated by the sharp acceleration of world trade last year, after years of sluggishness. All of this may have been driven by pent-up demand following the 2014/2015 slowdown and the inventory cycle. Reduced austerity and the ECB’s policies may also have helped. While policy did not become restrictive in 2018, pent-up demand may have run out.
· Higher inflation
Short-term inflation fluctuations can impact the business cycle. Eurozone headline inflation accelerated from 0.2% in 2016 to 1.5% on average in 2017. During the first ten months of 2018 headline inflation has further accelerated to 1.7% on average.
As inflation has accelerated more than nominal wage increases, this has been negative for purchasing power. These effects tend to work their way through the system with a lag. Eurozone retail sales grew 2.3% in 2017 in volume. During the first nine months of 2018 the growth rate has averaged a more modest 1.5%. The broader measure of total private consumption has slowed less, it must be said.
· The trade conflict
US president Trump has unleashed a trade conflict this year. This has undoubtedly played a role in deteriorating business confidence and has probably held back corporate investment around the world. These things are hard to measure. In their recent World Economic Outlook, the OECD estimates that the tariffs so far implemented reduce world GDP by 0.1%, but world trade growth by 0.4%. It is important, however, to point out that the worsening of business conditions started before the width of president Trump’s protectionist agenda became clear. It is therefore highly uncertain how much of the slowdown must be blamed on the trade conflict.
· Slowing world trade growth
Business surveys around the globe show a remarkable drop in export orders. This suggests that a sharp deceleration of world trade growth has taken place. The data on trade, indeed, shows weakening, but certainly not to the degree suggested by the confidence indices. In fact, world trade growth has only slowed moderately this year after the sharp pick-up in 2017. Digging into the eurozone data, it would appear that exports to Asia have softened, which may well reflect this slowing of world trade growth. That said, China’s overall import growth (in value terms) remains remarkably strong so far this year (around 20% yoy ytd), despite the escalation of the trade conflict with the US, although ‘front loading’ by companies trying to beat import tariffs may be boosting trade temporarily.
Slower trade could be a reflection of the cyclicality of the industrial sector. Industrial output growth had outpaced overall global growth in 2017. Perhaps a correction was inevitable.
· Weaker Chinese growth
The Chinese economy is crucially important to the global business cycle because of its size, its growth rate and its openness. Unfortunately, the Chinese economy is less well documented than other key economies. The amount of data is relatively limited, its accuracy is sometimes doubted and policy transparency is also limited. In short, China probably knows a lot more about ‘us’ than we know about ‘them’.
Chinese policymakers have, for some time, aimed measures at addressing the problem of high indebtedness in parts of their economy. And they have been successful in stabilising the debt ratios of non-financial corporates and reducing shadow banking. But, the restrictive measures aimed at deleveraging must have had slower economic growth as a side effect, although this is not too obvious in the various overall growth indicators.
In the course of 2018 the policymakers have shifted their focus somewhat. They have taken various measures aimed at supporting growth and appear to be giving deleveraging a lower priority. This must mean one of two things. Either, the slowdown has gone further than they are willing to tolerate, or the actions must be seen as a response to the US trade measures, aimed at preventing too severe a slowdown.
· Tightening financial conditions and ‘inappropriate’ US monetary policy
Financial conditions have tightened in many countries in 2018. Higher US interest rates, a stronger dollar, the shortening of the balance sheet of the US Federal Reserve and weak stock markets (outside the US) have contributed to this tightening. Emerging economies are particularly vulnerable to this phenomenon and in a range of emerging economies monetary policy has been tightened. Some of them have, in addition, had their own home-grown problems related to a lack of macroeconomic stability.
But a key issue for the world economy and for financial markets has been the continued tightening of US monetary policy. While this may be the slowest pace at which the Fed has ever conducted a tightening cycle, they have actually accelerated the pace this year. That is fair enough. The Federal Reserve sets policy for the US economy. Most of the time that is not a big problem for the rest of the world as business cycles tend to move in a parallel fashion. But when economies diverge, it can become a problem. The Trump fiscal stimulus has led to an acceleration of growth in the US, while large parts of the rest of the world have slowed. The problem lies in the fact that US interest rates are important to the rest of the world and to global financial markets. Arguably, higher (US) interest rates are not particularly suitable at this point in time for other economies or financial markets. Fed policy may be appropriate for the US, but it is not for the rest of the world.
· Country specific developments
The slowdown in the eurozone was exacerbated by particular problems in the car industry. The diesel-emission scandal has hurt car manufacturers. On top of that, the new emission-testing procedure, introduced in September, has apparently wrong-footed car companies and production has fallen sharply. One must assume this is a temporary phenomenon and the most recent data shows some improvement.
The European economy is also affected by uncertainty created by the Brexit process and the debate about the Italian budget. The effects of this are hard to measure, but confidence is bound to have been hurt.
The US economy has not slowed, but interest rate sensitive parts of the economy, such as residential construction, home sales and car sales have softened, suggesting that the past tightening of monetary policy is making itself felt.
Temporary growth pause or recession?
In order to assess the cyclical prospects for 2019 and beyond, the following table summarises our thoughts on how the factors that we think played a role in the 2018 slowdown will evolve in 2019. When we weigh them, we think that a recession in key economies remains unlikely next year. Instead, we are counting on continued growth but at a modest pace, more or less in line with trend.
Inflation moves up further, but not by much; this is a key call
Inflation has risen in the course of the year in the main economies. Higher oil prices have pushed headline inflation higher. Currency weakness has added to inflation pressure in a range of emerging economies. Core inflation has also accelerated in the US this year, but has stayed stable in the eurozone. Despite somewhat higher core inflation in the US, it remains remarkable how modest underlying inflation still is given the tight labour market.
This means either that US inflation will move up materially at some point, possibly in the not-too distant future, or that structural changes in the economy are keeping wage increases and inflation in check. We favour the latter view, although a further modest rise in underlying inflation is likely in the US. This is a key call. Should US inflation move up more than expected, then the Fed will have no alternative but continue tightening or even accelerate its tightening. That would have a negative effect on other economies, in particular emerging economies, and global financial markets.
We have not changed our view on the oil market despite the recent sharp price fall, as we continue to think that the market will face shortages next year. At least, we think that the alarm over an oil glut next year are exaggerated. It remains to be seen how the Khashoggi killing and the subsequent leverage US president Trump now seems to have and use over Saudi production policy will play out. Should oil remain considerably cheaper than we have pencilled in, then headline inflation will be lower than we are forecasting.
Core inflation has remained stable around 1% in the eurozone for three years. While unemployment has fallen, we think enough slack remains to prevent a serious acceleration of wage increases and of inflation. The lower overall growth rate of the eurozone economy will do little to change this. Increased flexibility of labour markets appears to have weakened the negotiating position of labour and thus changed the relationship between the tightness of the labour market and wage increases.
The trade conflict
The trade conflict has a large potential effect on the global economy. A further escalation and renewed US measures against Europe would be very damaging. The uncertainty over the prospects will dampen business confidence and investment. On the other hand, it is possible that the US and China resolve their conflict and that the US administration does not take further measures against other trade partners. Clearly, in any economic forecast, this is a big unknown. We are assuming that the US will increase import tariffs on Chinese goods to 25% and apply it on all Chinese products.
Slower world trade growth
The outlook for world trade is unclear. To the extent that the 2018 slowdown was caused by the cyclicality of the industrial sector, that effect is by definition temporary. The outlook for world trade depends on this cyclicality, underlying growth in the various countries and, of course, on how trade relationships are affected by trade policies.
A gradual but extended slowing of Chinese economic growth is inevitable and has been in process for several years. However, we expect the policymakers to keep that process under control, meaning that the slowdown will remain gradual. We are encouraged by recent measures to support growth. Experience suggests that the policymakers are continuing their efforts until they have reached their target.
Trade data show that exports to Asia from the eurozone weakened significantly early this year. But it looks like the growth-supporting actions of the Chinese authorities are contributing to a better eurozone export performance.
The tightening of financial conditions
It is difficult to forecast the tightening of financial conditions. The Fed will undoubtedly raise rates further, but most of the tightening through rates must be behind us.
The shortening of the Fed’s balance sheet will continue at its current pace. That still means that the reduction of the Fed’s holdings of securities will be bigger in 2019 than in 2018. To what extent that is relevant is something debated by economists. Some argue that the key effect is the announcement or signalling effect. If that is correct, the biggest impact must have happened when the Fed published its strategy on this point. The effects on global financial conditions should then be limited in 2019. The ECB will stop its asset purchases at the end of 2018. This has also been well flagged and the amounts currently purchased are small anyway.
The currencies of emerging economies have fallen significantly in 2018. We now consider most of them cheap and we are not forecasting further dramatic falls. In fact, we think that quite a number of them will regain ground in 2019. That should help preventing a further tightening of financial conditions in 2019.
Key policy changes
Perhaps the most important development we are expecting for 2019 in terms of policy effects is a material slowing of the US economy in the second half of the year as the fiscal stimulus wears off. The US has grown above trend for some time, but is expected to fall below trend growth in the course of 2019.
Another important change in 2019 is the UK’s departure from the EU. At the time of writing, the EU has agreed the divorce papers with the UK government and also agreed on a document outlining the future relationship. Whether or not Mrs May can get this agreement through the UK parliament is highly uncertain. The risk of rejection by the parliament is high. Therefore a no-deal, disorderly Brexit is a distinct possibility. In our main scenario, we are assuming a more orderly procedure. This would guarantee the continuation of normal trading relationships, at least in 2019 and 2020 and perhaps longer. If the UK ‘crashes’ out of the EU without an agreement, one must assume that significant damage will be done to those trading and financial relations and thus the economies of the UK and also of the EU. The damage to the UK economy will obviously be much more significant.
Other possible reasons to expect a more material slowing than we are forecasting in 2019
The recovery in the US started early in 2009 and the current upswing is already the second longest on record. This makes it tempting to talk about the end of the cycle. However, according to an old saying among economists, recoveries do not die of old age. Historically, recessions are caused by shocks, bottlenecks in the economy or overly aggressive monetary policy. Shocks are, by definition, impossible to forecast. The main bottleneck in the US economy at the moment is the tight labour market. As it becomes more difficult to hire additional staff, companies will find it increasingly difficult to increase output. As long as this does not cause a burst of inflation, this bottleneck should only lead to slower growth, not a contraction of the economy.
Whether or not the Federal Reserve will tighten too much, remains to be seen. Recent communication from the chair and vice-chair suggests that the Fed is keen to avoid tightening too much. The inflation outlook is not such that the Fed needs to tighten aggressively. So they can play it by ear. The problem for the central bank is that they do not really know, nor does anybody else, where the so called ‘neutral rate’ is. This is the rate that keeps the economy on an even keel, not too hot so inflation can be avoided, and not too cold so rising unemployment can be avoided. The Fed will let itself be guided by incoming data.
Another possible sign that the end of the cycle may be near and the US may face a recession before too long is that the yield curve (here defined as the spread between 10yr and 2yr Treasuries) has flattened. Inversion of the curve may occur in the months to come. Inversion of the curve is one of the most reliable, if not the most reliable warning signal for an approaching recession, even if it is not being totally clear why this may be the case. Should the flattening of the US yield curve lead us to forecast a recession next year or in 2020? Two arguments can be brought against this. First, the curve has not inverted yet. The current, relatively flat curve is consistent with a low-growth, low-inflation environment. Second, it may be argued that the longer end of the curve is still distorted by the large-scale asset purchases by the Fed and other central banks. If that is correct, the yield curve may not give a correct signal this time around. We are inclined to be cautious. ‘This time is different’ has usually been a costly premise.
Momentum in the US economy is currently high. As momentum builds on itself, this is a reason not to expect a US recession any time soon. It must be said that slower growth outside the US, the fading of the fiscal stimulus in the course of 2019 and the effects of past monetary tightening all argue for slower growth next year, but are not enough, in our view to cause a recession. The US consumer, the key driver of that economy, is in good shape. Employment levels are high, income growth is decent, household indebtedness has fallen in recent years and the savings rate is relatively high. Any setbacks can be cushioned.
Monetary policy and interest rates
We think the US Federal Reserve will raise interest rates a couple more times. A hike in December 2018 seems a foregone conclusion. To what extent the Fed will raise rates further will be data dependent. In their September dot plot the median forecast of the FOMC members was for three more hikes in 2019 and two in 2020. We think the Fed is more likely to hike twice between now and the end of 2019 and not at all in 2020.
Given the weakening US economy in 2019, modest inflation and the end of the rate-hike cycle, we think that US bond yields are currently near their peak and will gradually fall somewhat in the course of 2019.
The ECB is expected to end its QE programme at the end of the year. As inflation is likely to undershoot the ECB’s forecasts, especially core inflation, any pressure to raise rates will be weak. We are only expecting the ECB to start raising rates in 2020.
Bond yields in the core countries are expected to remain close to current levels, particularly as the ECB will be forced to, once again, lower its inflation forecasts. Later in 2019, we expect bond yields to drift upwards as market participants start pricing in higher official rates. Spreads of the budgetary weaker countries are expected to remain relatively stable. Italy is a special case. Our base case is that the Italian spread stays around current levels. But should the rating of the Italian government be lowered further, then institutional investors may be forced to sell and the spread could widen further.
While we do not expect a recession in the key economies over the forecast period, such a development cannot be ruled out. Should a recession occur, what can policy makers do? The US Fed has some room to cut rates. They can also restart QE. In theory, the tool box of a central bank is never empty. They can always buy other assets than they have already done. And they could resort to ‘helicopter money’. The limit here is the public’s confidence in the money system. The Fed will be careful not to try and find out when that point is reached. Another option is fiscal policy. While that can, in theory, also always be loosened the already elevated budget deficit and relatively high US public debt suggest that the credible room for manoeuvre is limited.
European policy makers have even less room. The ECB can, of course, lower interest rates, but the key rate is already negative. It is not clear how much more negative the rate can go without the public losing confidence. Further asset purchases are also always possible, but the ECB would have to loosen the limits they have set for such policies in the past. This may lead to legal challenges. Fiscal policies could be loosened too, of course, but that would quickly be a violation of the rules of the common currency and lead to difficult discussions.
We think that the factors that contributed to the slowing of growth in 2018 will be less forceful in 2019. There is one factor working in the opposite direction, which is the effect of US fiscal policy. The effects of tax cuts, tax reform and spending increases boosted US activity in 2018 and will continue to do so, but the effects will wear off in the course of 2019. On balance, we therefore expect the pace of global growth to ease marginally from its current levels. That will translate in lower overall growth number for 2019 compared to 2018, but the differences are not huge. We are not expecting a recession in key economies in 2019, nor in 2020.
If we are going to be wrong, the most likely reason will be that US inflation accelerates, forcing the Fed to tighten more aggressively. All bets are off if that happens as such a policy may be appropriate for the US, but it will be highly inappropriate for the rest of the world.
A second big risk to the outlook is a possible escalation of the trade conflict between the US and China and a renewed conflict between the US and Europe. Direct effects will increase and confidence effects will worsen.
China remains a risk to the world economy, if only for the lack of transparency. The policymakers appear to have been successful in their deleveraging efforts. The risks of financial instability have been reduced, but most likely not eliminated.
 The OECD estimates current tariffs to cost the US 0.2% of GDP and China 0.3%. Should the US tariffs on Chinese goods be raised from 10% to 25% at the start of 2019, the loss of activity will double, according to the OECD.
 The Fed has raised official rates by 25 bp every quarter so far this year and looks likely to do so again in December. In 2015 and 2016 the Fed hiked rates only once a year. In 2017 they raised rates three times. In addition, the Fed has been allowing its balance sheet to shorten by not reinvesting all the monies from redemptions. The pace at which the Fed is reducing its outright holdings of securities has been well flagged and has been gradually raised. The pace has only recently reached maximum speed of ca USD 50 bn a month. Until 23 November, the reduction amounted to USD 319 bn year-to-date, mostly Treasuries and MBS.
 German car manufacturers produced some 25% fewer cars in August and September than in the same months of 2017. As the sector makes up 3.5-4% of German GDP, this has been a damaging development.
 Jamal Khashoggi was a Saudi dissident and journalist for the Washington Post. He was killed at the Saudi consulate in Istanbul early October, allegedly by agents of the Saudi government.
 One can think of the yield curve as a discussion between the market (10 yr yield) and the Fed (2 yr yield). An inversion of the curve can then be seen as the market saying to the Fed they are going too far. History of the last 50 years, in which all recessions have been preceded by an inversion of the curve, suggests that the market gets it right most of the time and the Fed gets it wrong. The Fed would be well-advised to heed the message from the market.