Degroof Petercam: More evidence of economy cooling in 2019

The slowdown in global growth is expected to continue in 2019. Although talk of an imminent recession seems overdone, the world economy looks set to reveal more evidence of cooling. Company profits will be impacted accordingly. While current tariffs are still modest and the tone of debate between the US and China has softened a touch, the risk of escalation remains significant. Indeed, tensions go beyond the issue of the bilateral trade balance. China’s economic, cultural and technological rise over the last three decades have also undermined the US superpower status. True, Trump’s personal involvement in the trade talks offer a better chance to reach an agreement in the short run. On the other hand, expectations for global trade already point to further deceleration in the months to come. This is consistent with reduced prospects for global growth. The US economy is still holding up but the strong dollar, global trade tensions and fading effects of US stimulus look set to translate into slower growth in 2019. At some point, this is likely to convince US monetary policymakers to move to the side lines, possibly already from the start. Meanwhile, despite policy easing, Chinese credit growth continues to decelerate. Therefore, risks to  economic activity are  still skewed downwards.  Meanwhile, incoming data in Europe prove disappointing and confidence indicators have come down significantly. On the inflation front, despite the strong cyclical global recovery over the last two years, wages and prices have reacted only modestly. True, headline inflation accelerated significantly over the last two years. But this was mostly due to the sharp increase in energy prices. Base effects and the recent fall in oil prices will now cause headline inflation to fall pretty sharply in 2019. Core inflation, on the other hand, remains modest in general.

Fed to adopt a more cautious wait-and-see approach

The US economy has fired on all cylinders over the past two years. The combination of tax stimulus and increased government spending provided significant tailwinds to growth in 2018. In the second and third quarter economic growth came in at respectively 4% and 3.5% (annualized). Estimates suggest that a great deal of these spectacular growth figures can be explained by the budgetary initiatives taken by the new Trump Administration. Last year’s growth was lifted by around eight tenths of a percentage point. Looking forward, however, th at positive effect ebbs away. The United States are currently seeing the second-longest economic expansion in history. Expansions don’t die of old age and the overall picture remains robust but at the same time it is difficult to see how the current pace of activity can be sustained for much longer. Third quarter GDP growth (3.5% QoQa) was boosted by inventories while investment stalled and net trade contributed negatively. Indeed, the strong dollar is weighing on exports. The latest manufacturing surveys for the US have been downbeat. Markit’s PMI fell further in December while last month’s sharp decline in the ISM index was the biggest monthly fall since October 2008 . In addition, apart from the temporary fiscal boost, there are already some signs of hesitation in areas of the economy sensitive to higher interest rates such as housing and car sales. The Federal government has now been partially closed for the past two weeks. The economic is limited so far but the disruption will increase exponentially for every week the shutdown isn’t resolved, particularly if it would delay the payment of tax refunds in February and March. Meanwhile, the yield curve has continued its flattening trajectory. This is something to monitor closely as it is tends to go hand in hand with slower economic growth further down the road as the graph below suggests. Trade poses an additional risk. The conflict between the US and China remains unresolved even though we are seeing some softer talk on trade more recently. Data on the inflation front are sending mixed signals. Sharply lower energy prices mean that headline inflation will fall substantially in the first half of 2019. Core inflation, on the other hand, has firmed materially to just below 2% on the back of higher wage growth as the labour market is nearing full employment. But with unit labour cost growth still subdued, it should remain well in check. The Fed is facing a more challenging outlook, as the ongoing strength of the labor market contrasts with volatility in financial markets. The Fed increased its policy rate to 2.25-2.5% in December, the ninth since it began hiking rates in December 2015. True, President Powell softened his tone a bit. Nevertheless, the Committee judged that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Indeed, the so-called dot plot still suggests two more rate hikes this year (down from three rate in September). This contrasts with the interpretation of the bond market which sees no further hikes this year or beyond. In any case, a more cautious wait-and-see approach looks appropriate.

Eurozone economy quickly losing momentum

Weakness in confidence indicators suggest that the pace of domestic economic activity is softening. In addition, external headwinds are taking their toll on exports. Indeed, the latest eurozone PMI data are back at levels last seen in 2016. The European economic cycle has seen solid improvement since the second half of 2016 on the back of ample spare capacity and economic activity is now falling back to growth rates more in line with potential. The eurozone unemployment rate has dropped back to just over 8% and wage growth is finally picking up, implying that underlying price pressures should move somewhat higher from here. That said, headline inflation (now at 1.6%) will be negatively impacted by base effects related to the evolution of energy prices. During its last meeting, the ECB decided to end its asset purchases, as widely expected. But it is still far too soon for an actual rate hike. The ECB systematically got its inflation forecasts wrong and the 2% target is still way out of reach. As things stand, the first rate hike will probably not come before September 2019. Italy’s new populist Eurosceptic coalition government will remain a source of uncertainty for both Italy and the Eurozone. Confidence in Italy has dropped significantly following the elections earlier this year and the budget dispute with the European Commission. The country passed the 2019 budget just before a year-end deadline and cut the deficit next year to 2.04% GDP (instead of 2.4%). More importantly, economic growth remains hugely disappointing. As such, without further structural and institutional progress both in Italy and the Eurozone, the country remains vulnerable to periods of self-fulfilling panic reactions in markets. The so-called ‘yellow vest’ protests have forced French President Macron to ease budgetary policy and the budget deficit for 2019 is expected to move beyond 3% of GDP. This is not a huge issue in itself but countries like Germany and the Netherlands are likely to interpret it as more evidence of fiscal profligacy, hindering institutional progress towards more solidarity.  Meanwhile, Brexit uncertainty is still huge. But at least, Prime Minister May survived the Conservative Party’s confidence vote. As long as she doesn’t resign, and the Conservatives remain in government, the risk that the party could be led by a hardline Brexiteer for the last few months of the Article 50 withdrawal process is now much lower. While the EU could offer guarantees and promises that it will not use the backstop as a tool to permanently trap the UK in the EU customs union, there is very little chance that it will be removed. The question is whether this will satisfy the hard Brexiteers and the Northern Irish DUP. At this point, the current deal is unlikely to pass parliament.  Therefore, chances of a hard Brexit remain significant.

Boj remains put as growth remains downbeat

The outlook for economic activity remains downbeat. Although it has pledged to press ahead with the sales tax in October, the Japanese government shows awareness that demand could be hurt and is willing to offer some budgetary loosening in return. Meanwhile, incoming inflation prints remain modest. Headline inflation will decrease significantly on the back of base effects linked to energy prices while underlying price pressures may strengthen a bit further on the back labour market tightening and accelerating wage growth. An increase in the regular earnings number encouraging in this regard. Survey evidence still points to a lack of skilled labour and a high ratio of job-openings to applicants. But so far core inflation has increased only a bit. All in all, although the BoJ clearly emphasises the risk of unwelcome side effects of its policy, it remains firmly in easing mode.

Chinese credit slowdown takes its toll on growth

Budgetary and monetary policymakers in China are stepping up efforts to arrest the ongoing slowdown spurred by  a  decline in  credit growth  and  international trade  tensions. Official GDP growth, now at 6.5%, clearly overestimates actual economic activity which looks to be in the 5-5.5% range at the moment. With sentiment about the economy turning more negative and the annual cash crunch ahead of Chinese New Year just around the corner, the PBoC announced a 100bp cut to the required reserve ratio. Most likely, more easing is in the pipeline. Renminbi depreciation, lower interbank interest rates, tax cuts and extra investment spending should at some point produce stabilizing results. But for now at least the risks are still tilted to the downside. More broadly, the situation in the emerging world is very different from region to region and from country to country. Recent upheaval in EM financial markets has sparked comparisons to the debt crises of the 1980s and the 1990s but the analogy looks of the mark. Apart from Turkey and Argentina the risks facing most EMs today are significantly smaller. Indeed, the vulnerability of EM in general is lower compared to past decades. Many EM have improved their macroeconomic frameworks, including the use of flexible exchange rates, ample reserve buffers and multiple financial safety nets.