NN IP: The global soft patch and the G3 outlook

Global growth has clearly entered its third soft patch since the Great Recession of 2008-09. The first soft patch was driven by the euro crisis and US fiscal fights, which produced a considerable tightening of global financial conditions as well as lower private confidence. The second soft patch was driven by a combination of sharp US dollar appreciation and a big decline in commodity prices, which caused problems for overindebted EM economies. Once again, global financial conditions and private confidence acted as the main transmission channels to the rest of the world. The current soft patch has multiple causes, ranging from the Chinese growth slowdown to idiosyncratic factors in Europe and Japan, the combination in the US of fiscal easing and hawkishness on trade policy, Brexit uncertainty, and so on. All of this is taking place in an environment of Fed tightening, making the overarching theme one of political and policy risks, which are again having a detrimental effect on private confidence and financial conditions. It is understandable that all this has raised recession fears for many participants. While one can never rule out a recession, there is still considerable domestic strength in the G3 economies. What’s more, the traditional factors that make these economies vulnerable to recession are largely absent: inflation remains subdued and there are no large and widespread financial imbalances. Finally, the G3 economies still have room to respond to downside risks at the margin, and if this is done pre-emptively, it could well stabilise markets further.

US monetary policy has a lot of room to respond

The US economy still has significant domestic momentum. An important source is fiscal policy, which will support growth for most of this year, even though the strength of that support will fade the further we look out. A legitimate question is how the government shutdown affects this. Normally, shutdowns are hardly visible in the growth data and have no lasting effect on markets unless they involve a fight over the debt ceiling, which is not the case this time. The shutdown affects around 0.5% of employed US citizens, who may well use their savings to smooth consumption somewhat. Still, this will get harder as the shutdown continues, which is probably why it is already having a moderately negative effect on consumer confidence. The reason why this particular shutdown has such an impact on the markets is that it is yet another piece of evidence of the political risks attached to the Trump presidency.

A second important source of strength is the US labour market, which is delivering solid nominal income growth for households and continues to draw discouraged workers back into the labour force. Combined with still-elevated levels of consumer confidence and a savings rate that is well in positive territory, this should keep consumer spending going as a main engine of growth. The elevated savings rate is important here because it is actually much higher than one would expect historically, given the level of net wealth. This raises the possibility that households will feel little need to increase savings in response to the decline in financial wealth. As far as capex is concerned, US margins have been rising over the past year and capex intentions in the regional Fed surveys have stabilised at a very solid level. Nevertheless, there is a risk that the latter will not hold. According to the Institute for Supply Management (ISM) report, new orders fell by more than 10 points in December. The level of ISM new orders is a pretty good indicator of US capex trends. Of course, one should not overinterpret a one-month drop that could yet be reversed, but given the deteriorating confidence environment in general, we should be cautious here.

As we previously argued, these positives must be balanced against slower global growth and especially the tightening of US financial conditions (FC). At current levels, the balance of force between the latter and the fiscal pulse is still such that the economy should grow north of 2% on a trend basis, but the downside risks here are substantial. Continued moderate inflation pressure crucially enables the Fed to switch from two-sided risk management towards mostly downside risk management for now. The minutes of the December Federal Open Market Committee (FOMC) meeting make it clear that by the phrase “some further increases”, the Fed intended to convey only a relatively limited amount of additional tightening. We would not be surprised if this rate guidance were to be made more data-dependent at the next FOMC meeting. Ideally, “some further increases” would be replaced by “further adjustments”, which would signal the real possibility that the next move could be downwards. Once again, this is not our base case because we expect the heavy cloud of risk to clear up somewhat, but should this not happen, we could well have reached the top of the rate cycle already. Hopefully, the Fed will also put some more flesh and bone on balance sheet optionality at the next meeting. Taking the 2017 balance sheet strategy literally, the message seems to be that quantitative tightening (QT) will stop only once the Fed has already cut rates by a certain amount. This strategy may even give the wrong signal. Historically, a limited number of Fed cuts has not necessarily implied an extended easing cycle. In the 1990s, there were two occasions on which the Fed cut moderately (in response to the Mexico and Long-Term Capital Management crises) and then resumed hiking. Given this stated strategy, an end to balance sheet roll-off after only a few cuts may give the market the impression that something is seriously wrong, which would lead to a further tightening of FC. Hence, we would not be surprised if the Fed revises its 2017 balance sheet strategy and starts by signaling that the pace of QT will become an instrument with which it can indicate its willingness to respond to downside risks.

Finally, in the event of a more severe slowing of the US economy and/or a further sharp tightening of FC, we believe the Fed would swiftly change course on both rates and the balance sheet. In a recession scenario, rates would be quickly brought back to zero and QE would be resumed. The Fed may also introduce a temporary price level target, which could be seen as a commitment to allow inflation to rise well above target during the next expansion. If credible, this commitment would help to lower real rates in the present.

Question marks around EMU growth momentum

It is becoming harder to remain optimistic about the European outlook, but we have not abandoned hope yet. The latest consumption and labour market data are pretty decent and suggest that European consumers can maintain a solid pace of spending. Whether they will be willing to do so is a bit more of a question mark. On current readings of consumer confidence, the answer is still very much in the affirmative, but consumer confidence has been weakening. In particular, this holds as far as the assessment of the economic situation is concerned, and also stems partly from somewhat higher fears of unemployment. The latter seems inconsistent with the still very solid and sideways-moving level of employment intentions in the European Commission (EC) business survey. Still, we see business sentiment gradually decreasing further, even though it remains well above its long-term average. In general, it seems that a decline in the optimistic EC survey is helping to close the gap with the pessimistic PMI, at least for now. Meanwhile, industrial production seems to be surprising on the downside, suggesting some more broad-based weakness outside the car and pharma sector. This could well be a case of trade risks and the China slowdown starting to bite harder.

All in all, the risks to our growth forecast remain firmly to the downside. There is a pretty good chance that growth will fall back to a potential rate (around 1.2%) this year; if that happens, it may have important implications for the inflation outlook. Core inflation is moving sideways at a pace of approximately 1%, while wage growth is picking up. All else being equal, this implies some pressure on profit margins unless productivity growth has held up well. This seems to have been the case until mid-2018, but to what extent this still holds is less clear. Normally, margin pressure in an environment of solid growth would lead to higher core inflation. However, pricing power may remain more limited in the current environment, in which case this could lead either to some cost-cutting or to a decline in wage growth. In both cases, it will be more difficult for the European Central Bank to tighten policy.

It will be interesting to see how the ECB deals with the increased downside risks at this week’s meeting. In December, President Mario Draghi maintained that risks are broadly balanced because the ECB was determined to end QE in view of the risk of Italian fiscal dominance. Now that the ECB and Italy have reached a compromise, the risk of Italian fiscal dominance has declined, which may give the ECB a bit more leeway to become more dovish. The ECB will mostly do this by emphasising the automatic stabiliser in its rate guidance: a deterioration of the outlook will induce the market to price out ECB rate hikes, as has already happened over the past few months. The ECB could increase the strength of this mechanism by changing the “date” part of the guidance, but it may face stiff opposition from the hawks on the Governing Council. At any rate, if this happens it will most likely be combined with the announcement of the modalities of new targeted longer-term refinancing operations (TLTROs).

It is important to bear in mind that, in contrast to the Fed, it is difficult for the ECB to get ahead of the risk curve—i.e., the Fed can implement some pre-emptive dovishness, while the ECB is mostly constrained to some kind of ex post/reactive dovishness, which is less effective. As we have previously argued, a new TLTRO is also likely to be introduced, and its modalities could be used to send a further dovish signal. In the event of a severe downturn, the ECB would probably first supply more generous conditions for TLTROs and stretch rate guidance to the maximum. The hurdle for reactivating QE is high but could be taken if the core countries also enter a recession. In a dire scenario, the ECB could even consider yield/spread caps, but the political backlash from the core countries would be considerable. Perhaps purchases of private assets stand a better chance, where the ECB could even move into equities, as the Bank of Japan has done. Still, to us it is absolutely clear that the only foolproof policy weapon against the next recession in the European Economic and Monetary Union (EMU) must come from fiscal easing, which is mostly a core country issue.

The BoJ will not move for a long time

We have a lot more confidence in Japanese domestic strength than we have in the case of Europe. Household income growth remains very solid, which should keep consumers in spending mode. Having said that, consumer confidence has declined somewhat. Profit margins and investment intentions remain robust, which should keep investment going. Additional positives include the need to increase the capital/labour ratio in an overheating economy and the run-up to the 2020 Olympics. Fiscal policy will become more complicated this year. For now, more offsetting stimulus measures are being announced around the VAT hike in the fourth quarter, but in Japan it is always difficult to distinguish between new stimulus and “repackaged” stimulus that is already in the pipeline.

Various measures of inflation expectations remain sticky, while actual underlying inflation is making only moderate progress. The recent yen appreciation will be a bit of a risk if it continues. Hence, we expect the BoJ to maintain the 10y and overnight targets at current levels, at least until well into 2020. The big question is whether the BoJ will engage in further stealth tightening by further widening the bands around the 10y target. Still, this question is less important now that the 10y yield is well below the upper band. Over the past few months, the BoJ has been relatively silent on the cost side of its unconventional policies, and we do not expect this debate to return in the near term. If Japan falls into a recession again, it is difficult to see what the BoJ could do. The experiment with negative rates led to a lot of criticism, so the hurdle for going more negative is high. This would probably only happen in the case of sharp yen appreciation, which is not unimaginable in a global recession scenario. The BoJ could of course step up its purchases of exchange-traded funds and conceivably also lower the 10y yield target in combination with the overnight rate. Nevertheless, we would not be surprised if the next Japanese recession were to push the BoJ into helicopter money territory. That would be very interesting to see indeed!

Emerging markets: China’s deleveraging focus is fading

In times when investors are worried about global growth prospects, it is particularly important to watch China. Concerns about declining Chinese growth pushed risky assets down in the 2018 fourth quarter. Evidence of more Chinese stimulus has probably been one of the factors behind the recovery since Christmas. The December data confirm what we have been seeing already for months: weakness in trade and manufacturing, a modest pick-up in infrastructure and construction activity and still-declining aggregate credit growth.

The weakness in trade and manufacturing can be explained by the tariff war with the US, the slowdown in global demand and the negative impact on the car industry when an earlier stimulus programme ended. The pick-up in infrastructure is helping overall fixed-asset investment and construction growth, due to infrastructure-focused policy stimulus since the beginning of last year. We expect this to continue. We are not yet seeing much effect of tax cuts for consumers and private companies, but it is still early days. We do expect more tax cuts and more initiatives to stimulate specific sectors like the car sector initiative of two weeks ago. A big one to watch is the housing sector, where forward-looking data point to more weakness.

In the end, the most important thing to watch is the aggregate credit data. This would eventually give the most concrete evidence of stimulus. December credit growth was 7.6%, half a percentage point lower than a month earlier and the lowest in decades. Looking at this data, we see no monetary stimulus yet. The positive thing is that the authorities have started to move away from their strong focus on deleveraging. We think they will keep a close eye on excesses in the financial system and will try to avoid the mistakes of 2008-09. Still, they will turn on the credit taps a bit more. We have already seen announcements such as earlier local government bond issuance and a 60% increase in the total quota for local government bond issuance.

But if we look at the current credit data, we can also see that credit to the government is already growing at levels above 20%. Credit to the private sector is growing at 12%. The weakness has been in the shadow-banking activities, where growth turned negative in the past quarters. This weakness should continue. Meanwhile we expect credit growth to governments and private companies to pick up by a few percentage points. All in all, monetary stimulus is still modest, but more than anticipated and probably enough to push domestic demand growth higher starting in the second quarter. Overall Chinese growth should stop slowing and might accelerate if the trade conflict with the US moves to the background. Our 2019 GDP growth forecast is 6.2%. From a longer-term perspective, we still believe that Chinese growth is on a structural decline to levels of around 4% by the mid-2020s.