In his latest economic outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues 2019 and 2020 will be quite different to the past two years for major economies and ﬁnancial markets. Whilst 2018 was another year dominated by simmering geopolitical risk, little of that was allowed to bubble over into markets.
The frustration for central banks remains in that recoveries have been output driven, with insufﬁcient wage-growth to dust off Phillips Curves, and meaningfully tighten policy. The US remains the pacesetter, yet, even there, interest-rate ‘normalisation’ is likely to become a fading goal. Recoveries look mature. For example, the US recovery next summer, will, at 10 years, become the longest since 1857. Even the UK economy, hamstrung by Brexit, has expanded for nine years, akin to a typical pre-crisis UK cycle.
This - plus the schizophrenia of wanting to normalise rates, drain the sink, address imbalances and distortions, and yet be alert to increasing trade tensions and voter enmity - is the starting point for 2019. It’s a wish-list that cannot please all.
Our economic projections (pages 3-6) are predicated on growth momentum ebbing away in 2019 and 2020, on the maturity of the cycle, and on creeping protectionism. The by-products of these factors include a climb down by central banks, even the US Fed, more profligate governments, and the veneer taken off equity markets still underestimating the spill-over effects
Amid these conﬂicting forces, our macro outlook rests on ﬁve core beliefs.
First, the initial stimulus from President Trump’s tax cuts will gradually become muted. Democrats may oppose a general approach to trade along the lines of the Smoot-Hawley reforms of 1929-30. These reforms imposed up to 20% tariffs on over 20,000 US imported goods, covering as much as 60% of dutiable imports. This spread like ‘bush-fire’, with Europe finding new partners, and Canada ‘retaliating’ even before they became US law.
However, President Trump could still invoke ‘Super 301’ (Section 301 of the 1974 Trade Act - his 'Trump card'?) to impose tariffs without approval on countries deemed to be engaging in “unfair” trade practices. The coverage thus far looks a likely 10% of dutiable imports. Yet, without a softening into the 2020 US Election, this should build. Therefore, for markets, protectionism this time may, like Brexit, be more a ‘crack-in-the-ice’, than a ‘cliff-edge’, event. Retaliation could include a reluctant China currency-devaluation more aggressive than the 3% fall assumed by forwards to occur within three years’ time.
Eyebrows would be then be raised about China’s commitment to US Treasuries, potentially raising US mortgage rates (priced on long yields) just as the US deficit is widening, and the Fed is tightening. This, and likely competitive devaluations elsewhere (e.g. S.E. Asia), suggest the deflationary return to the US could be larger than anticipated.
Second, we could see the opposite growth/inﬂation mix to what we've had. Should protectionism build, inﬂation will reappear, but it will be the ‘wrong sort’ – cost, rather than demand-led. Central banks will have to ‘turn a blind’ eye as economies stagﬂate, and wage-growth fails to keep up.
Encouragingly, some 'green shoots' of wage growth - 'The Holy Grail' for policy-makers - are showing, notably in the US and Germany. However, they may be trampled underfoot unless corporate pricing power builds. The chart below, using corporate implicit-price deflators as a proxy, suggests recent improvements have reflected temporary cost increases (such as Japan’s tax hikes, and sterling's depreciation) more than sustainable demand increases.
Third, the road to ‘normal’ will be closed off. Real policy rates will stay negative, with peak rates much lower than we are used to. Central banks fear that QT as the corollary of QE contributes to an asset-price deflation that throws out the baby (growth) with the bath water. This risk looks most acute in the long-rate sensitive US and euro-zone.
Yet the Fed, as the test-case, may be underestimating QT. By sustaining it, we estimate it could 'take out' 150bp of rate hikes by 2021. In which case, the US Fed should fall short of the 3.5% 'Goldilocks' rate it craves. And, if Brexit proves troublesome, the BoE may not even get to the 1.5% Bank rate it wants before turning on its QT.
Fourth, governments will offer ﬁscal solutions to add stimulus, appease disenchanted electorates, and retrieve the ‘baton’ from central banks. With concerns about Italy, a euro implosion, Greece restructurings, and with populism on the rise, there’ll be little sympathy for an easy, no-strings Brexit deal.
Given the goal of maintaining close EU ties, an associate membership (such as Norway’s) and/or access to the Customs Union (Turkey’s) or Single Market (Canada’s) seem likely. Canada’s took seven years to achieve, and each option will have strings attached (labour mobility etc.) making it unpalatable to many
Fifth, China has the tools to support growth and keep a head on its 6% growth rate, but will leave its ﬁnancial risks (leveraging, debt) for later. For those emerging markets with high exposure to short-term external debt and saving needs, the outlook is less rosy. But for most others, external debt-ratios are lower, with fewer currency pegs to have to protect. Further, where domestic debt climbs, they too could run QE.
So, while reflation trades were appropriate in 2017 and 2018, the spectre of political fragility, protectionism, cost inflation, and dissipating growth now threaten renewed volatility. The dilemma for central banks may be between ‘low for even longer’ and cutting imbalances. We suspect the former.
For fragile, more fiscally-active governments, calling for anything else would surely be like a ‘turkey voting for Christmas’.
Implicit price-inflation for non-financial corporate sectors (%yoy). Grey denotes US recessions
Source: Thomson Reuters Datastream, based on national data