NN IP: Thoughts on the global cycle

Cross-currents continue to batter markets

After the bounce back from the strong sell-off in October, equity markets now seem to be in limbo. This should not be too surprising given the various cross-currents battering investor perceptions. In the real economy, US relative outperformance is lasting longer than was anticipated a few months ago as Europe and Japan struggle to emerge from their soft patch and the fruits of Chinese policy easing are not yet visible in the data. Meanwhile, the Fed has made it abundantly clear that it is engaging in two-sided risk management and that its ability to give clear forward guidance will diminish further as it ventures deeper into the orbit of r-star – the estimated policy rate that will keep the economy on an even keel. Given that the US unemployment rate is very likely to decline further, this has induced the market to raise its estimate of the terminal policy rate in this cycle while the increased monetary policy uncertainty has led to a slight rise in the term premium. The latter development may get further impetus from G3 central bank balance sheet reduction. Finally, as always there are cross-currents from the political arena mostly in the form of a volatile news flow surrounding US-China trade relations but also due to Italy and Brexit. Over the past six months this mix has led to struggling equity markets, widening credit spreads, higher UST yields but sideways to lower Bund yields and a stronger dollar. Not surprisingly, in view of the rise in dollar funding costs, overstretched corners of the market, most notably in EM, have suffered the most in relative terms.

Of course the big question remains where markets will go from here. A positive performance for risky assets in the foreseeable future requires an environment in which global growth remains above trend and unit labour cost growth and output price inflation do not suddenly accelerate. A further improvement in underlying productivity growth would be a great help in all this. The whole mix is surrounded by a lot more question marks compared to a year ago. In general, it seems clear that the peak in global growth momentum was reached a year ago when the room for further improvement in many of the deep fundamental drivers had become limited. Profit margins had staged an impressive recovery in many regions since early 2016, which meant that further upside had become more limited. What’s more, business and consumer confidence were close to historical highs, financial conditions were at very easy levels and in some regions, labour markets were approaching, or even beyond, full employment. The good news is that several of these deep fundamentals are still very supportive which, in combination with the absence of large imbalances, bodes well for the remaining lifetime of the global cycle. 

Still, some shifts have taken place within these deep fundamentals to which political developments usually contribute certain downside risks. It is precisely these marginal changes which markets have clearly taken note of this year. Profit growth has held up pretty well so far in most regions. The same is true for business confidence, even though a bit of a divergence has emerged between companies’ current assessment (which remains solid) and expectations (which have declined over the past few months but remain above historical averages). The aforementioned political risks, which are mostly related to trade, are probably the main driving force behind this discrepancy. An important lesson in this respect is that a decrease in political risks can quickly lead to an improvement in business expectations. On the other hand, if political risks linger too long or worsen, these diminished expectations can also start to create their own reality. Consumer confidence remains more resilient than business confidence, which is not surprising given the fact that employment growth generally continues to be solid while wage growth has picked up in many regions.

The tug of war between tightening FC and fiscal easing 

The really big change has occurred in the financial sphere, where global financial conditions (FC) have tightened considerably over the course of the year. One could say that in this respect, 2018 is the mirror image of 2017. Last year, global FC eased from the local peak reached immediately after Trump was elected (which simultaneously pushed yields and the dollar higher). Needless to say, this gave a substantial boost to global growth. By contrast, global FC have been tightening steadily for most of this year which, on some metrics, completely reversed the easing seen in 2017. A rise in bond yields was by far the most important driver behind this tightening. Of course this was very much a US story but it clearly also had a profound impact on EM local and hard currency rates, which also experienced some spread widening. In addition, equities also contributed substantially to the tightening of global FC and here, too, there is substantial diversification across regions.

Perhaps surprisingly, in DM space the biggest drag on growth stemming from the tightening in FC will probably be felt in the US and, as argued before, it can largely be attributed to the rise in UST yields on the back of a mix of fiscal easing and monetary tightening. Clearly, this very same fiscal easing appears on the other side of the GDP ledger as a boost to growth. Still, the effect of the fiscal sugar high will gradually wane throughout 2019 while the drag from tightening FC (assuming these remain around current levels) will reach a maximum in Q2 and Q3, and then gradually decrease. The combined overall effect should be a drag for most of 2019 which is not a bad thing for an economy that starts off from an above-trend growth momentum and an unemployment rate that may well be somewhat below the NAIRU (non-accelerating inflation rate of unemployment). 

Meanwhile, the Euro area will be subject to a smaller FC drag next year by virtue of the fact that Bund yields have traded sideways while most spreads (corporate and sovereign) remain well-behaved, with the notable exception of Italy. Those pundits who immediately jump to the conclusion that this is another nail in the coffin of the current Euroland expansion would do well to bear in mind that we will actually see some fiscal expansion in the Eurozone. Assuming the Italian fiscal impulse will be around neutral (instead of a deterioration in the structural fiscal balance of around 0.8pp), the EMU-wide structural deficit could still widen by some 0.5pp, mostly on the back of some German and Dutch fiscal easing. As a result, the drag from FC and the boost from fiscal policy could roughly offset each other in the early part of 2019, becoming a moderate net boost later next year. Furthermore, Japan is set to experience a moderate drag from tightening FC in the next few quarters and when that wanes, it will experience some fiscal drag due to the VAT hike in October 2019. How big that drag will be remains uncertain because the Japanese government could take countervailing fiscal easing measures. What’s more, it is important to remember that the combined fiscal/FC drag will take place in an economy where domestic demand momentum is likely to remain above potential. 

Finally, the story in EM space is a bit less benign. The entire universe will feel the drag from tightening FC, albeit to varying degrees. Meanwhile, China is about the only EM economy that will apply fiscal easing. To a large extent, the effects of this easing have yet to emerge. The important thing to bear in mind about this round of Chinese easing is that it is very different from the previous ones where the government basically ordered banks to supply more credit to state-owned enterprises (SOEs), which then quickly used this for more investment. This time around the chief aim is to support private business and consumer confidence by incentivizing credit supply to privately-owned businesses and giving consumers tax cuts. The effectiveness of these initiatives is less certain than that of credit fuelled SOE investment and the effect will take more time to filter through. Still, the tax cuts are likely to be particularly effective in raising consumer spending because they are targeted at lower income households who could well be credit constrained and have a high marginal propensity to consume.

It boils down to strong fundamentals versus political risks

In summary, it seems that on the global level the tightening of FC and the effects of fiscal policy could roughly cancel each other out. This assertion is, of course, surrounded by a lot of uncertainty as FC could easily tighten or ease again by a large degree depending on various factors. These include how political risks play out and how the Fed changes its assessment of upside and downside risks. What we are then left with are healthy profit growth, robust levels of business and consumer confidence, and tightening labour markets. On top of this, bank lending surveys in DM space continue to suggest an easing of credit supply as well as a pick-up in credit demand in some sectors. This mix is clearly stronger in DM space than it is in EM space. If it is allowed to work its magic in DM space, there should be positive spillovers towards EM space in the form of more support for EM external demand. What’s more, provided that EM FC do not deteriorate further (which depends, to a considerable extent, on the dollar), the drag exerted by the tightening this year will gradually fade. This will allow the improved fundamentals (lower leverage, better current account balances) in some parts of the region to reassert themselves. 

The big wild card in this story is the trajectory of business confidence (and, to a lesser extent, consumer confidence). Business confidence is pretty susceptible to trade risks and, in some regions, to other sources of political volatility. Even in China one can argue that business confidence ultimately holds the key, which is why it is not that surprising that the government’s policy measures are aimed at shoring it up. How the interaction between confidence and political risks will evolve over the coming months is as crucial as it is uncertain. The US–China trade situation has improved somewhat for now, but we all know that things can turn around very quickly. The best one can hope for is some kind of ceasefire after the Trump-Xi meeting, giving both countries time to work out the complicated intellectual property rights issue. From an economic perspective, the main question remains at which point the micro inefficiencies introduced by tariffs in parts of the global industrial sector start to morph into a significant macro drag. The first signs of this will appear in the industrial sector confidence data where we just highlighted the discrepancy between current conditions and expectations. Over the past month, expectations have more or less stabilized at a level still well above their average over the past decade but current conditions have deteriorated somewhat, albeit to a level that is still healthy. The latter could be a delayed adjustment to the current weakness in the global industrial sector; i.e., it could be inspired by past experience. Alternatively, it could signal a weakening of current demand or supply side disturbances. At this point it is hard to tell. 

What is clear, however, is that the industrial sector remains very much at the centre of attention for investors. This means it is easy to forget that the service sector, which is much larger, is actually holding up pretty well. The service PMI increased in October after falling for three consecutive months and at 53.4, is only marginally below the average level seen in 2017. At any rate, it is performing much better than in it did in late 2015 and early 2016 when the negative fall-out from the combined dollar/oil disinflation shock was at its maximum. Given the strength of the labour market as well as consumer confidence, it is reasonable to expect service sector activity to hold up well. This brings us back to the crucial question: is the slowdown in the global industrial sector to around 1.5% in Q3 mainly the result of idiosyncratic factors in Europe and Japan – which are reverberating throughout the tradeable goods sector via all kinds of linkages – or is it something more serious? Our base case is still the former. Global retail sales ended Q3 at a momentum of around 3% and if the decline in oil prices persists, may well improve somewhat in Q4. Meanwhile, trends in business confidence, profits, rates, durable goods orders/shipments and global capital goods imports suggest a current global capex growth momentum of around 4-5%. Once inventories cease to be a drag, this suggests that global IP momentum should improve, provided of course that final demand does not weaken going forward.

Emerging markets: a weakening growth picture

It should not come as a big surprise that EM growth is softening. The tightening of financial conditions during this year’s market turmoil and the higher US trade barriers are affecting both domestic and external demand. From a peak of 5.5% in the first quarter of this year, EM aggregate growth has fallen to 4.8% currently. Most market participants will probably have factored in a slowdown of this magnitude. The key question now is how much more EM growth will have to decline. We have pencilled in a further slowdown to 4.4% by Q2 2019. The last time we saw this level of growth was in the quarters following the Lehman shock.

The recent deterioration in EM capital flows should prevent an easing of financial conditions in the coming months. We have already seen several EM central banks turning more hawkish in recent weeks and in some cases even surprising the market. These include the central banks in Indonesia, Mexico, Philippines and South Africa. With aggregate EM credit growth still at a high level of 12%, much of the likely adjustment has yet to take place.

From the recent market nervousness surrounding Chinese and Asian growth data, we can deduce that investors can still be negatively surprised. The latest Chinese data was on the weak side, particularly in housing and property. Evidence of stimulus measures pushing domestic demand growth higher remains limited. We see some improvement in infrastructure investment data and industrial production was perhaps a bit better than expected. But doubts about the effectiveness of stimulus in the short term seem to be increasing, with credit growth still slowing and the housing market softening. So if the Trump-Xi get-together in Buenos Aires fails to deliver anything meaningful and the higher US tariffs go into effect on 1 January, investors will have to brace themselves for a substantial growth slowdown in China in the first quarter of 2019.

We are already seeing a weakening of export performance in South Korea and Taiwan. Apparently, the demand for intermediate goods from China is falling fast. The initial data on November exports in Korea (down 8% from the previous month) is suggesting that the drop will be worse than generally expected.

As long as EM export growth momentum continues to deteriorate, and EM capital outflows accelerate, the downward adjustment of EM growth expectations is likely to continue. This negative trend could be broken by a US-Chinese trade deal, earlier-than-expected traction of Chinese stimulus or a downward adjustment of the pace of monetary policy normalization in the US.