NN IP: The global economy reached a crossroads

The big question on everyone’s mind is still where global growth will go from here. In general terms, there are two possibilities. On the one hand, there is a conceivable equilibrium where US growth remains above potential and the rest of the world bounces back from the temporary factors that have suppressed growth. In this scenario, the Powell put and a more dovish stance from other central banks would be the dominant factors driving risk premiums. This should further underpin private confidence and allow global expansion to continue at a somewhat above-potential rate for the next year or so.

On the other hand, there is a possible equilibrium ruled by structural forces that are pushing global growth momentum down to a rate persistently below its long-term average. In this scenario, central bankers would still try to push risk premiums down, but their efforts would be overwhelmed by structural forces pushing risk premiums up. The result would be a negative feedback loop between tightening financial conditions/falling confidence and slowing growth momentum.

The most important of these structural forces is political uncertainty. This uncertainty threatens to partially undo the achievements of globalization and steer us towards a more fragmented world, in which businesses would face much more uncertainty than they have been used to over the past 30 years. A second potential structural force is the Chinese slowdown. So far, most analysts regard the latter as cyclical, resulting from the Chinese authorities’ attempt to rein in credit excesses. Nevertheless, the slowdown could indicate a structural trend, as China could get stuck in the middle-income trap, for instance. Another potential structural force is the sluggishness of investment spending. A year ago, developed market (DM) capex was booming, which suggested that investment-to-GDP ratios could return to their pre-crisis levels, in the process propelling underlying productivity growth higher. Now it seems that capex is quickly losing momentum, which raises the risk that developed markets could remain stuck in a low-productivity-growth equilibrium.

The question of which equilibrium (continued expansion or persistent slowdown) will materialize is crucial for financial markets. However, it is very difficult to tell in real time where we are heading because this will ultimately depend on the complex interaction between potentially fickle private-sector expectations on the one hand, and policy actions on the other. Private confidence and risk appetite in financial markets contain valuable information and still suggest that the risk of a bad equilibrium has increased in the past six months. Still, this is not yet our base case, for several reasons.

First of all, the political risk events (China/US trade and Brexit) are structured in such a way that all parties involved would benefit from reaching a compromise. One way to view these conflicts is in terms of a game of chicken, where both players involved are driving their cars at an accelerating speed towards a cliff edge. This allows for many possible equilibria. Especially in the case of the US/China trade conflict, both parties are likely to slam on the brakes before reaching the cliff edge, given the damage that would result from driving over the cliff. This is all the more true because both the US and China have already felt some (stock market) pain as a result of this conflict. The game between the UK and the EU differs somewhat, in the sense that the damage resulting from a crash will be many times bigger for the UK than for the EU, which may cause the former to swerve first. Of course, there is no guarantee that no cars will be driven over political cliffs, and even if both drivers agree to stop, the solution may constitute kicking the proverbial can down the road.

The second reason is that central banks, especially the Fed, have become decidedly more dovish. Continued moderate inflation outcomes and renewed falls in measures of inflation expectations provide room for this. In addition, we anticipate more support from fiscal policy.

In addition, consumers remain supported by strong employment gains, rising nominal wage growth, falling oil prices and consumer confidence levels above the historical average. The latter have fallen over the past two months, but the extent may have been influenced by the stock market decline and the US shutdown. Because of these factors, last week’s surprise sharp decline in US retail sales looks like an outlier (albeit an uncomfortable one) in a string of otherwise good DM consumer spending data. The flip side of robust consumer spending is that service-sector activity has generally held up much better than its manufacturing counterpart since early 2018, which is a pattern we also saw in 2015-16. The essential pillar on which this mechanism rests is companies’ continued willingness to maintain a certain pace of employment growth. Given that firms have built up a profit buffer over the past three years, this should remain the case as long as they expect demand growth to improve again. After all, given a low unemployment rate and concomitant high reported rates of labour shortages in surveys, businesses may fear that it will be difficult to rehire laid-off workers if demand rebounds in the near future.

A final important factor is the absence of significant private-sector imbalances, both in the real economy and in the financial sphere. In the former, inflation is under control and there are no signs of massive overinvestment. What’s more, income growth over the past two years has been relatively balanced between the household and business sectors. This means that both sectors have some resilience to income growth shocks, all the more so because they have a savings surplus and their balance sheets look relatively healthy.

How much damage has already been done?

All in all, it is not that difficult to envisage the benign scenario materialising. However, the timing and/or sequence of events will be essential. In particular, the crucial question is how much damage private-sector momentum will have suffered once the political risks diminish. For many countries, the tug-of-war between strong economic fundamentals and political risks can be mapped into a tug-of-war between domestic resilience and external weakness. The Eurozone is the possible exception here. However, the soft data suggest that the political/external risks have done some damage to DM domestic resilience. The extent of this damage will determine to what extent growth momentum in various regions will pick up when (or, more accurately, if) the political risks subside.

The clearest casualties in the various regions are business confidence and capex momentum. Until early autumn, business confidence seemed to be holding up reasonably well in the face of rising protectionist risks, although it was very difficult to distinguish the latter from the China slowdown, the idiosyncratic European and Japanese shocks, and the mindset that “the only way from the top is down”. During the autumn, however, evidence started to accumulate of a bigger and more widespread decline in business confidence, which spilled over to a slowdown in capex momentum.

We believe the capex outlook is extremely important. From a cyclical perspective, solid capex growth is vital for pushing global growth back above potential. From a more structural perspective, strong capex growth will enhance the resilience of the expansion by strengthening the supply side, both by raising the amount of capital per worker and by improving productivity growth as newly installed capital goods embody more of the latest technologies. An increase in underlying productivity growth would enable robust real wage growth and robust real profit growth to co-exist peacefully. After all, if the expansion continues, chances are that the labour share of GDP will finally start to rise somewhat and higher productivity growth will allow profit growth to remain in positive territory, even though profit margins may decrease somewhat.

We contend that capex is likely to bounce back once the political risks abate and Chinese economic momentum finds a bottom. After all, firms sit on a comfortable buffer of profits and investment-to-output ratios remain low, which suggests there is still a backlog of technological improvements waiting to be incorporated into business processes. Tight labour markets may increase the incentive to incorporate these improvements, especially when it comes to investment in labour-saving technologies. However, the risk is that uncertainty could last too long for capex to come to the rescue of the global economic slowdown.