Blast from the (recent) past?

The economy is at a crossroads

It very much seems as if we have reached some kind of crossroads. Either financial conditions (FC) will stabilise or continue to ease while private sector confidence stabilises at levels north of its long-term average, or both elements will engage in an process of synchronized sinking. The room for some kind of middle way between these scenarios may well be limited because the prime driver of the deterioration in FC and confidence stems from a sharply increased focus on various political risks. In addition to that, much of the developed market world is operating at or above potential, which means there is much less upside than downside for investors.

The question is: to what extent have political risks contaminated DM economic fundamentals? Until the start of Q4, these seemed pretty solid on the whole and thus conducive to resilient domestic demand growth. Employment growth was generally strong and the accompanying labour market tightening was spilling over into higher wage growth. Business and consumer confidence remained well above long-term averages even though there was some deterioration in certain sector specifics and the forward-looking components of business surveys. Until early Q4 these could probably be justified by non-protectionist shocks to global trade and industrial production such as the China slowdown and idiosyncratic shocks in Europe and Japan. On top of this, financial conditions remained relatively supportive for most of 2018 and credit supply in DM space continued to ease. As for the corporate sector, DM profit margins either continued to increase (US), or stabilised at a very high level (Japan) or at an average level (Europe). This, combined with above-average confidence readings made corporates quite willing to invest, albeit to a lesser degree than in 2017. Last but not least, the private sectors of most DM economies seem in pretty good shape. Their leverage has declined from 2008 levels, and they are running substantial financial surpluses (income minus spending). In the G3 space this surplus is north of 4% of GDP.

On the other side of the ledger, we have the almost continuous slide in global manufacturing PMI over the course of 2018 and a fairly persistent string of negative trade and industrial production data surprises. As already stated, it is hard to disentangle the China slowdown and the idiosyncratic events from the influence of protectionism. Nevertheless, it seems fair to say that the influence of the latter grew over the course of the year. As a result, the tug of war between solid domestic economic fundamentals and rising political risks in the DM space could, to a considerable extent, be recast as a tug of war between domestic resilience and rising external risks. This is particularly true of the US and Japan which should not be surprising given the fact that protectionism is the main source of political risk. Still it applies less to Europe because here there is also a concentration of various other political risks. In the light of this, the underperformance of European assets makes sense, all the more so because the effective amount of policy ammunition is smaller in Europe.

The outlook for financial markets in 2019 will thus hinge to a considerable extent on how this tug of war plays out. Fortunately, there are additional elements in the story that cause us to maintain a base-case scenario of continuing global expansion this year, albeit at a slower pace than in 2018 and with increased downside risks. The most important of these is the potential for a global monetary policy that acts more pre-emptively against downside risks. The Fed has already taken a big step in this direction. Secondly, the planned amount of global fiscal stimulus has been ramped up over the past three months. Even though US fiscal stimulus will gradually wane over the year, China is turning on the fiscal tap and the same is true of Euroland. Planned fiscal stimulus in Germany and the Netherlands is now also being followed by modest fiscal stimulus in France and a roughly neutral fiscal stance in Italy. For Italy, this is a big change from the initial degree of tightening – more than 0.5% of GDP – needed to comply with Eurozone fiscal rules. Last but not least, the decline in oil prices in recent quarters is significantly boosting consumer real income, which is already translating into higher spending growth.

A look back at 2015-2016

To get a bit more perspective on this crossroads in the economy, it is useful to compare the current situation with what happened in 2015-2016. Some three years, ago investors were also confronted with a significant divergence in DM monetary policy which resulted in an appreciation of the US dollar. Back then, oil prices also declined albeit by much more than we have recently seen. Then the combination of a stronger dollar and lower oil prices proved to be highly detrimental for the EM space. One important reason for this was that the aggregate EM external balance sheet looked worse than it does today. Between 2009 and 2014, EM had been the beneficiary of huge capital inflows as DM real rates and economic growth were weak. This caused current account balances in many EM countries to deteriorate substantially and the flip side of that was an increase in dollar-denominated domestic private sector debt. In 2014 this capital inflow reversed on the back of anticipated Fed tightening and an improvement in DM growth prospects. This triggered a painful adjustment process in EM which was further compounded by the fact that the burden of US dollar debt increased due to EM currency depreciation. The decline in the oil price added insult to injury at least for EM commodity exporters which faced a severe decline in their trade terms, causing a slowdown in domestic demand in these economies. The main reason for this slowdown is that declining trade terms reduce real income which causes the private sector to cut spending and, in many cases, the public sector as well, to the extent that commodity revenues flow directly into the Treasury kitty.

Of course there was some kind of cushion for EM consumers, who benefited from lower oil prices. But this buffer diminished as a result of depreciating currencies and the fact that some countries cut energy subsidies when the oil price falls. In this respect DM consumer income growth probably got a bigger boost from falling oil prices. Even though some of the windfall gain initially went into savings, this mechanism was also instrumental in keeping consumer spending growth alive, providing crucial support for the domestic service sector and business’s labour demand. However, falling oil prices took a heavy toll on US capex as the shale oil industry cut back investment significantly. In the financial space, this created substantial headwinds for high yield bonds. In 2016 Yellen’s dovish turn played a vital role in stabilising this detrimental cocktail by pushing US yields down (some 100 bps for the US 10y) and causing the dollar to depreciate (by roughly 5%). It is crucial to understand that the backlash of EM troubles, resulting from weaker global growth and tightening US FC, on the US economy was the only reason for Yellen’s action. A very important additional consideration for the Fed was the fact that there was still some slack in the US economy, inflation momentum was below target and the policy rate was close to the zero lower bound. This mix made a stronger case for pre-emptive action to nip the detrimental dynamics in FC and economic momentum in the bud. The associated fall in dollar funding costs gave the EM space crucial breathing space in the sense that it allowed countries to adjust their net dependence on external funding in a more orderly way. In combination with a stabilisation in the EM ex-China private-debt-to-GDP ratio, it laid the foundation for a recovery in EM growth. The immediate reaction to Trump’s election seemed to put a break on this by pushing yields and the dollar higher, but thereafter, for most of 2017, yields stabilised and the dollar depreciated.

The external balance sheets in many EM countries currently look a lot better than they did three years ago. The net dependence on foreign funding has been reduced or even completely disappeared in many countries and the stock of foreign versus domestic debt has declined. The main story of 2018 was the substantial rise in the cost of dollar funding, which hit the overstretched EM niches (e.g. Turkey) very hard. For a long time we thought that EM should be able to bear this in view of the aforementioned external improvement and the fact that the rise in the cost of dollar funding was a reaction to improved global growth prospects. But this story became a lot murkier when the Trump policy mix triggered divergence and the further threat of protectionism was added to the equation. Given the fact that trade is instrumental in the structural trend of improving EM living standards, trade worries hit EM sentiment particularly hard. The slowdown in Chinese growth on the back of early 2018 measures to reign in financial excesses was another element in this mix.

The big differences between 2016 and the current situation are thus threefold. First, the external EM equation looks a lot better. Second, the US economy is arguably in overheating territory and the policy rate is well above zero. Third, the major risk for the EM space is no longer the need for domestic deleveraging but a mix of political uncertainty threats to global growth momentum; trade being the most important one. We are thus in a very different situation, but results have produced an echo of 2016 with the dollar appreciating albeit to a much lesser extent than in 2014. Another important factor is that, at current levels, the fall in the oil price should have much less of a negative effect on US capex than three years ago. Of course, the risk scenario which has been at the back of many market participants’ minds is that these dynamics could morph into a global slowdown similar to the one seen in 2016. Perhaps today there is more risk that a such a slowdown will start to feed on itself because the DM space is operating at or above potential and will not get much relief from higher productivity growth in an environment where sentiment is gloomy. For markets and a private sector that have been used to very high levels of confidence for a while, it is all too easy to think that “the only way is down”.

This argument has to be weighed against the increased EM resilience and the absence of any obvious big DM imbalances outside pockets of the US corporate sector. How the Fed fits into this story is a bit ambiguous. On the one hand, the Fed has much more room to support markets via a more dovish policy stance but on the other hand its ability to use this room is now more limited because the economy is in overheating territory. The good news in all this is that recent trends in US inflation have increased the Fed’s leeway to respond to downside risks and Powell and his companions have clearly seized this opportunity. Hence, just as in 2016, it is more likely that a stronger Fed put will go a long way towards pushing the global economy towards an equilibrium where the expansion continues (albeit at a somewhat slower pace).

Nevertheless, there is an important caveat here. Back in 2016 the Fed put had a very direct bearing on the primary source, which was the global slowdown, i.e., the troubles in the EM space, which were to a large extent about the pace at which this segment was being forced to deleverage. The Fed put ensured that in the end this process went at a much more moderate pace. This time around it will probably have less impact because the main global growth worries stem from political risks and the China slowdown. Hence, in a sense the Fed is less in control now and other put options, ideally of a political nature, may also be required to help stabilize the situation. The markets and the economy especially need protection against escalating trade risks, the capriciousness of Trump’s policies in general, EMU political risks and the Chinese slowdown. We are most confident about prospects for the last item on this list.

Emerging markets: multi-year low in growth momentum

The combination of tighter financial conditions dating from the market turmoil that hit emerging markets in the second and third quarters of last year and the US-China trade conflict has pushed EM growth down substantially since the summer. Our in-house EM growth momentum indicator fell to its lowest reading since mid-2015. Data has been deteriorating, particularly in the few past weeks, and more so in Asia than in the other regions. In contrast to a few quarters ago, the main headwinds are coming more from trade and less from tight financial conditions. With the Fed perceived to be more dovish, the pressure on the fundamentally more challenged emerging economies in Latin America and EMEA has eased. This has already led to less hawkish monetary policy in several countries and is also showing up in some of the growth data. For instance, we are seeing encouraging growth figures coming out of South Africa, Argentina and Brazil.

But all in all, the EM growth picture is weak. Although financial conditions in EM are no longer tightening, this does not mean that they are easing yet. But this is likely to happen in the coming months, thanks to the Fed repricing and the declining oil price, which is helping to push EM inflation back down again. EM capital flows, that were negative during most of 2018, have been close to zero in the past two months. While we see the headwinds from tight financial conditions moving into the background, we are still worried about the outlook for global trade and EM export growth. We might see a deal between the US and China before March, but we do not expect the relationship between the two countries to normalise. The most likely scenario is for a setback not too long after any deal is presented. The Trump administration will probably continue to fight for more access to the Chinese market and try to bring manufacturing production back to the US. At the same time, the Chinese agenda remains focused on technological transfers and maximising export growth to make use of its excess capacity in heavy and manufacturing industries.

Chinese trade data released earlier this week was weak, but not much weaker than data already published by other Asian trading nations. Export growth declined by 4%, mainly due to frontloading in earlier months but also because of weakening global demand and lower commodity prices, which reduces the dollar value of exports throughout the emerging world. The 8% decline in import growth was more disappointing. To a large extent this can be explained by lower commodity prices and weak export growth. But domestic demand in China has been weak as well. Housing market data and car sales have been disappointing for some time now. The good news is that the authorities have been stepping up their policy stimulus in recent weeks. After two years of deleveraging that led to a drop in debt-to-GDP of 5 percentage points, we can expect credit growth to pick up. So far, it has not moved much, but this is likely to change in the coming months. We still expect Chinese domestic demand growth to pick up in the second quarter of the year, but the extent of this increase might be a bit larger than anticipated. For now, we stick to our 6.0% GDP growth forecast for 2019.

Brexit: postponement likely after defeat of May’s deal

The UK Parliament voted against Prime Minister Theresa May’s transitional Brexit deal, with 202 Members of Parliament voting for the deal and 432 against. The 230-vote defeat makes May’s loss the biggest for a sitting UK government in modern history.

The result was not a surprise, but it increases uncertainty. Formally, the government has three days to come up with an alternative plan for the UK’s departure from the European Union. Parliament may now have more control of the Brexit process, but it is clearly not unified. Hard-line Brexiteers as well as Bremainers voted against the deal, making it all but impossible for Theresa May to close the gap simply by tweaking the original deal. Even with amendments or further concessions, the current deal is clearly a no-go.

All roads seem to lead to Brexit postponement

May’s government survived the no-confidence motion following the defeat. However, it may not be able to come up with a successful alternative to the current deal on the table. May could then put her deal up for a public referendum. The outcome would depend on how the referendum question is formulated, i.e., whether it is a choice between May’s deal and no deal, or May’s deal and no Brexit, or some combination. In any case, a new referendum would require a postponement of Brexit.

The biggest risk is that the government and Parliament cannot agree on which way to go. Without a postponement, the UK will exit without a deal. If this chaotic outcome looks likely, it would make sense for the government and Parliament to arrange a postponement. Any postponement would probably be at least until July to account for EU Parliament elections, but more likely for one year. Failing that, the UK government can still revoke Article 50 and abandon Brexit. A recent EU court ruling confirmed this option, and last night’s cataclysmic defeat makes it more likely.

Brexit-sensitive assets are likely to underperform

We anticipate significant market uncertainty and volatility in the coming days. Brexit-sensitive assets will underperform. We expect weakness in the sterling exchange rate, British domestic equity sectors and UK stocks overall, and we expect the Gilt yield to fall. Positioning is not underweight, indicating that investors have not anticipated significant weakness in British stocks. Therefore, UK equities have room to weaken significantly on negative news. We expect markets to stabilise when a feasible solution appears, or when it’s clear that the current deadlock will lead to postponement.

Brexit’s ultimate impact on economic growth remains hard to estimate. Of the possible outcomes, a no-deal outcome would be most destructive, as it could create chaos with regard to trade with the UK and long delays at the borders. This prospect would make markets volatile and weigh on short-term growth. A soft Brexit deal, where the UK continues to benefit from the single market, would have more limited impact on economic growth. The ongoing uncertainty about the final outcome could feed into financial market uncertainty and increase risk aversion among investors.