- Economic growth in most major economies is set to slow in a synchronized fashion in 2019, a reversal of the near-harmonious growth we saw two years ago.
- In the near term, equity markets are likely to be the biggest threat to growth in the United States, not monetary tightening.
- Longer term, the U.S.-China trade war remains a concern: The odds of escalation outweigh the likelihood of de-escalation.
In late 2017, inboxes everywhere were inundated with outlooks heralding 2018 as the year of global synchronized growth. The same message about synchronization holds true for 2019, minus the rosy fanfare. While 2018 was initially characterized by growth accelerating globally, I believe 2019 will involve most major economies slowing down. It will be a synchronization all the same, but toward potential GDP— which is quite a lot lower than the growth we saw in 2018. In the meantime, political risks abound and could affect economies significantly as international and national unity frays, dragging on trade and investment and causing volatility in some regions.
Length of U.S. economic expansions since 1945 (months)
Source: National Bureau of Economic Research, May 2018.
* Denotes economic expansion is still continuing as of that date.
Calls for a recession in 2020 are too bearish
In a recent press conference, U.S. Federal Reserve (Fed) Chair Jerome Powell declared, “There’s really no reason to think that this cycle can’t continue for some time, effectively indefinitely.”1 This business cycle is already the second longest on record for the United States,2 and there’s a growing consensus among economists that it will finally end in 2020.
When economists come to agreement on when the next recession will hit, you can usually bet the contraction won’t fall that year. I’ve never been accused of being a bull when it comes to the U.S. economy, but I think calls for a recession in 2020 are too bearish.
Many economists are focusing on 2020 because the United States faces a fiscal cliff at the end of 2019 when the benefits of tax cuts and increased federal spending dwindle. While a divided Congress means any additional fiscal boost heading into an election year will be politically difficult, both parties may agree on additional infrastructure spending, which could breathe new life into the economy and extend the recovery. A failure to re-up fiscal stimulus should be a headwind to growth, but needn’t tip the United States into recession.
Threats to growth
For many, the biggest threat to the economic recovery in the country—and globally—is the Fed. Beginning in 2019, global central bank liquidity is set to shrink for the first time since quantitative easing began,3 led by the Fed, given its interest-rate hikes and balance sheet shrinkage. Ten of the past 13 Fed rate hiking cycles have ended in a U.S. recession. The central bank will tighten policy too far, too fast, in order to head off inflation, the story goes, and kill the expansion.
Tipping the balance: rate hikes vs. growth
Source: Manulife Asset Management, Gluskin Sheff & Associates, November 2018.
I don’t really buy this argument. The Fed is more likely to slow down its rate of normalization of monetary policy than hasten it. Chair Powell suggested as much in November when he indicated that rates were just below the range of estimates for the neutral rate.4 We think the Fed will have to adopt a more dovish stance for two main reasons.
First, the U.S. housing market has softened significantly in late 2018 and is likely to continue to do so because of rising mortgage rates, supply constraints, and tax code changes. On top of this, the government is likely to find agreement on reducing the price of drugs. Shelter and medical costs are the two heaviest weights in the inflation basket, and so we expect inflation to soften.
Second, I believe the Fed doesn’t want to invert the yield curve for fear of the signal this would send about an impending recession. With the yield curve remaining flat, the Fed doesn’t have much room to hike at the short end.
Furthermore, if you take a step back and look at the hard data, there are few signs of overheating. Bank loan growth has decelerated from 2015 highs, and most investment has been in inventories rather than productivity-boosting capital expenditure. Similarly, retail sales growth has been rangebound, and the housing recovery has been tepid. For all the optimism businesses and consumers have expressed, they aren’t deploying capital accordingly.
If there’s an immediate danger to the U.S. economy, it would be the equity markets. Corporate earnings tend to slow late cycle, and they could be further compressed by trade wars as price increases can’t be entirely passed on to consumers for fear of losing market share. S&P 500 Index earnings for the third quarter were up 25.0%, but analysts expect this to shrink to just 6.9% in the second quarter of 2019.5 If share prices stagnate or fall, it could crimp investment and confidence, slowing consumer spending.
There’s also some vulnerability in nonfinancial corporate debt—a risk I’ve been highlighting for over a year, long before it became cool to talk about it. Corporate debt to GDP remains above the levels seen just before the last three recessions; however, corporate debt to profits is well off historical highs. As long as rates remain low and profits high, companies shouldn’t have too much trouble servicing their debt; but as rates rise, albeit slowly, and profit growth shrinks, some firms may see their debt downgraded. Given the abundant issuance of BBB debt since the 2007/2008 global financial crisis, the high-yield market could find itself flooded as investment-grade firms are downgraded.
Bets on the Fed, meanwhile, are keeping short rates up, while long rates once again decline. The 5-year break-even rate—which represents investors’ views on the annual inflation rate through 2023—has dropped to below 1.90% from a 2018 high of 2.19%. Low yields tend to support above-average multiples for equities,5 but the drop in 10-year yields has brought the debate about a yield curve inversion back to the fore.
The sugar high we enjoyed in 2018 is therefore set to dwindle next year, and we’ll probably fall back toward trend growth of around 2% in 2020. That’s a different proposition from a recession, the risk of which I think will only rise from 2021 onward.
U.S.-China trade war begins to bite
The United States is hardly alone in seeing growth slow in 2019. Growth in China began slowing in late 2017, and we expect it to continue slowing through next year despite a number of stimulus measures that have been implemented. The greatest threat to Chinese growth is an escalation of the trade war between the United States and China. My view has long been that the trade war will get worse before it gets worse. Despite the temporary détente in the skirmish struck at the G20 meetings in Buenos Aires, I believe the odds of escalation still outweigh the chances of de-escalation. There’s still been no progress on addressing the issues at the heart of the trade war—intellectual property rights, forced technology transfers, and government subsidies of tech sectors. Both the United States and China want to be the world leader in machine learning, artificial intelligence, and quantum computing, and neither side is incentivized to back down.
If the trade war escalates further, the United States could impose tariffs on virtually all goods imported from China, which would have a material impact on Chinese economic growth. Additional tariffs could also push inflation in the United States up since they also eat into corporate margins; firms are unlikely to pass the entire cost of tariffs on to the end user in the form of price hikes as they try to protect their market share. Corporate margins may also dwindle as companies reroute their global supply chains to circumvent tariffs. There’s also likely to be a continued drag on investment activity because of trade. While capital expenditure picked up in the United States in early 2018 as a result of the tax bill, many businesses have suggested they’re now deferring and delaying their investment plans because of uncertainty around trade policy.
Trade could also put pressure on emerging markets (EM), many of which experienced currency crises in 2018 as the U.S. dollar (USD) appreciated. Moves in the USD this year were partly driven by moves in the renminbi (RMB). EM may enjoy some reprieve in early 2019 as financial markets digest a more dovish Fed, but if the trade war escalates, we expect the People’s Bank of China to step away from the RMB and allow it to depreciate. The Chinese central bank could argue that China’s no longer a reliable currency account surplus country, and so market forces should push its currency lower anyhow. A weaker RMB and stronger USD would squeeze EM countries that have issued USD-denominated debt and those that invoiced their trade in the greenback.
Trade tensions also pose a significant risk to European growth prospects in 2019. The eurozone in aggregate has seen growth decelerate significantly from the heady days of late 2017. This shouldn’t have come as a surprise—in the absence of fiscal stimulus measures, Europe was always likely to see economic growth converge with potential GDP growth of around 1.5%.6 With Washington threatening to slap auto tariffs on European imports into the country, growth could decelerate further. Germany reported a contraction in the third quarter of 2018 in part because of regulatory constraints on the auto industry.5 Tariffs imposed on German cars would continue to be a headwind for Europe’s economic engine.
Furthermore, there are divisions within Europe that stand to threaten growth. The Italian government has adopted a confrontational stance with Brussels over its budget deficit, which the former would like to expand in flagrant neglect of the eurozone’s fiscal rules. The rise of Italian borrowing costs since the government came into power has already tightened credit conditions for businesses in Italy5 and has contributed to a likely technical recession there in 2019.
The Italian government will either cave to the European rules slowly or will decide to take Italy out of the monetary union. Our base case is the former, but even this should cause market volatility in the meantime as Rome and Brussels/Frankfurt play a game of chicken. An Italexit can’t be ruled out, however; if it were to occur, it would pose an existential threat to the European project.
Another key division within Europe is between the United Kingdom and the European Union. Given the fluidity of the situation, there’s no telling what could happen next—the only certainty where Brexit is concerned is uncertainty.
Global growth is set to synchronize again in 2019, but it will likely be a synchronized slowdown rather than an acceleration. This should come as no surprise: Growth in most countries was well above potential GDP growth in 2018. In the absence of a huge jump in productivity growth or the labor supply, economic growth should converge with potential GDP growth. While there are some endogenous threats to growth in the United States, most potential headwinds to global growth derive from political divisions that affect economies and markets, particularly the trade war between Washington and Beijing.