Headwinds offset by supportive policy
The global economy faces headwinds which have already slowed GDP growth, particularly in industry. However, consumer spending and services remain strong. And given low inflation, central banks have signalled easier policy ahead and government budget policies are being adjusted to shore up growth prospects.
Downside risks continue to loom over global economy
The global economy and, by extension, financial markets face two major event risks – trade war escalation and a “no-deal” Brexit. These factors have already begun to impinge on global trade, where there has been no growth in volumes over the past year, and on UK business confidence which has dipped into contraction territory. Both risks have escalated in late-July / early-August. Donald Trump unexpectedly announced a 10% tariff on $300 billion worth of Chinese goods, in addition to an existing 25% tariff on $250 billion of imported items. Boris Johnson’s ascension to the office of Prime minister signals a new phase in the UK’s Brexit negotiations where a hard, “no deal” position is a genuine policy option.
These factors have hit business confidence, particularly in manufacturing, and corporate investment plans. In addition, inventories have accumulated, and order books have shrunk,notably for exports.
On the other hand, services and consumer spending – which represent the bulk of developed-world economies – show little sign of weakening. Unemployment is falling steadily across the euro zone and is close to 50-year lows in the US and the UK. Moreover, wages are rising steadily in real terms, helping bolster consumer confidence and household consumption.
Further monetary and fiscal easing
In addition, fiscal policy has turned easier across the globe. In Germany for example, the coalition has agreed on tax cuts and spending increases which should add some 0.3pp to GDP growth for the next three years. And in China, recently announced cuts to VAT and employer social insurance contributions should amount to around 2% of GDP.
Ever since the Federal Res erve’s last rate hike in December, central banks have performed a U-turn in forward guidance on policy. It now looks likely that rate cuts, asset purchases and refinancing facilities for banks will combine to create a much more supportive backdrop for the economy.
Recession not expected yet
Much attention has been paid in recent months to a number of US recession indicators which are flashing warning signals. These models are typically based on observations of differentials in Treasury yields – long-term yields often dip below short rates ahead of recessions. However, we would caution that global government bond markets continue to be influenced by central bank asset purchase programmes, which may reduce the reliability of such models.
Moreover, economic slowdowns do not always lead to recessions – these tend to occur when economies face major imbalances, such as a rapid build-up in private-sector debt, accelerating inflation or cyclical excesses in sectors such as housing or capital expenditure. Today, there are areas for concern – such as state-owned enterprise leverage in China, or corporate bond issuance in the US – but by and large economic and financial imbalances do not seem extreme, and banks are well capitalised.
Perhaps most importantly, economic slowdowns can last for years, and usually tend to be favourable environments for risktaking. Should some of the risk events dissipate, conditions may even turn around, with a global expansion resuming again. The real danger is the slowdown deteriorating into an economic contraction, or recession. That clearly is bad for risk assets, and would be a signal for us to cut equities. However, our Leading Economic Macro Indicator (LEMI) indicates we are not anywhere near that stage yet.
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