Global growth and inflation revised down

AT A GLANCE

• We no longer expect a trade deal between the US and China to be struck within the next year. Uncertainty over trade tariffs is the main reason behind the ongoing global slowdown in manufacturing and trade. While the resolution of trade conflicts seems more remote, export-led economies, such as Germany, will remain under significant pressure. We have revised down most of our growth and inflation figures.
  
  
• The German economy is expected to go into recession this year. The Eurozone will keep growing thanks to the resilient French economy but major risks threaten the outlook (e.g. a “hard” or no-deal Brexit, US car tariffs).
  
  
• With strong fundamentals underpinning consumption, the US economy should avoid a recession despite slowing growth. With household consumption as the main engine of growth, the US economy is vulnerable to sentiment shifts.
  
  
• In China, a significant slowdown in domestic demand on top of the negative effect of tariffs will probably slow economic growth below the symbolic 6% mark in 2020. Chinese authorities stand ready to provide additional fiscal stimulus to mitigate the slowdown.
• Weak growth and persistently low inflation leave central banks with scope for additional easing. Despite an unprecedented degree of monetary stimulus, inflation expectations remain stubbornly low in advanced economies.
  
  
• Fiscal authorities will likely step up their efforts to provide stimulus. Historically low interest rates have enlarged the fiscal space and increased the effectiveness of fiscal measures as they reduce worries about debt sustainability. The impact of fiscal policy on the economy will not be seen until late 2020, due to implementation lags but the impact on business and consumer sentiment could be much more rapid.

US: A soft landing in 2020

Trade policy uncertainty and escalating geopolitical tensions have taken a toll on the US economy. Even though US consumers have thus far remained resilient, and have bolstered overall growth, business surveys are suggesting a contraction in manufacturing activity for the first time since 2016.  In our opinion, the weakness observed in manufacturing and in fixed business investment will likely impact the broader economy.

Our base scenario is that the US economy will keep growing, albeit at a slower pace, over the rest of 2019 and in 2020. A recession should be ultimately avoided due to a supportive fiscal and monetary policy. We have lowered our growth forecasts for 2019 and 2020 to 2.2% and 1.5%, respectively. We think that risks are tilted predominantly to the downside. With household consumption remaining the main engine of economic growth in the US, the prevailing consumer sentiment is of major importance. A turn in the labour market or an asset price correction may spur a sentiment shift and drive a sharper retrenchment in consumer spending than we assume. As the 2020 presidential election is fast approaching, the president might add some stimulus through executive action, if the economy deteriorates more than expected. US inflation is rising and we expect it to peak in 2020. A variety of factors, such as housing market pressure, increasing unit labour costs, and favourable base effects, will drive US inflation higher, in our opinion. We expect core CPI inflation to peak at 2.6% in the second quarter of 2020.

In response to a weakening economic outlook, the Federal Reserve initiated an easing cycle, the first one since 2008, with two interest rate cuts of 25bp in July and in September, that took the fed funds rate into a range of between 1.75% and 2%. We expect the Fed’s stance to remain accommodative in the near future and we anticipate three more rate cuts by June 2020 and therefore, thus taking the fed funds rate to 1.00%-1.25%. Even deeper cuts remain plausible, if the slowdown is sharper than our current projections.

Eurozone:  On the brink of recession

The Eurozone is entering a downturn that could weaken labour markets and depress inflation again. Leading indicators have depicted a divergence in economic activity between manufacturing and services so far, but there are several signs that the weakness in industrial production will spread to services. The German economy contracted by -0.1% in the second quarter and we expect a further contraction in the third and fourth quarters. Germany’s exposure to the global cycle and sector-specific headwinds for the automotive sector are some of the main reasons for its current economic weakness. France appears to be more resilient to these factors. We have left our 2019 growth forecast unchanged at 1.1% for the Euro area but we have revised down our 2020 growth forecast to 0.7%.  We think that risks for growth and inflation are skewed to the downside and that one more negative shock would push the Eurozone into a fully-fledged recession. Our current forecasts do not assume the materialisation of major risks, such as a no-deal Brexit or a further escalation of trade tensions.

Against the gloomy economic outlook, we expect a sizable policy response from monetary  and fiscal authorities. The ECB announced a bold package of measures in September, including a rate cut, tiering and a new QE package (EUR20bn per month) without a pre-defined end date. We also expect another 10bp cut in December. Although the ECB seems to provide the required support, a dose of fiscal stimulus is necessary for the Eurozone to keep growing. Our forecasts assume a fiscal stimulus representing 1% of GDP in Germany, where the scope is greatest, over the next two years and a moderate fiscal expansion in the rest of the Eurozone, as well. Overall, we anticipate that the fiscal stimulus in the Eurozone as a whole will be equal to 0.5% of GDP in 2020. However, the real economy is unlikely to feel the effects until the second half of next year. Even though fiscal and monetary policy measures are expected to rescue the economy from the brink of a recession in 2020, short-term news flow is likely to remain negative.

UK: Brexit uncertainty prevails

The path to a Brexit resolution seems more uncertain than ever. But given the recent developments, we have reconsidered the probabilities attached to the different possible outcomes. We now attribute only a 20% probability to a Brexit deal and a smooth exit, a 30% probability to a revocation of Article 50 leading to no Brexit at all, and finally, a 50% probability to a “hard” Brexit.

As the political environment in the UK remains volatile, we make the working assumption that Brexit remains unresolved for our forecast horizon. Uncertainty will continue to hinder business investment in 2019-20 while the global slowdown is having a negative effect on net trade. The slowdown in growth will start affecting the labour market, but possible fiscal stimulus and high employment rates will provide support to consumption. Regarding UK inflation, we expect a short-term decline but relative stability over 2020. Against this backdrop, the Bank of England will remain on hold, with a bias towards cuts in the event of a worsening global slowdown or a Brexit-related turmoil.

In our base case, we expect the British economy to grow by 1.1% in 2019 and by 0.6% in 2020 with an inflation rate close to 2% (1.9% in 2019 and 1.8% in 2020). In the event of a hard Brexit, we expect a recession that both monetary and fiscal authorities will combat with strong measures. In such scenario, the BoE is anticipated to proceed with interest rate cuts, a new start to the Term Funding Scheme and more QE. If the UK leaves the EU with a deal or revokes Article 50 and does not exit at all, we expect the BoE to make one or two hikes while fiscal policy will likely provide stimulus.

Japan: Economic growth decelerates

Although capital expenditure was firm during the first half of 2019, the Japanese economy is starting to feel the heat from US-China trade tensions. Sluggish exports and heightened uncertainty about international trade are likely to delay investments in the second half of the year, especially among manufacturers. Private consumption is also expected to lose some steam due to a scheduled VAT rate hike in October. As the economy slows, the government is expected to respond with a package of measures worth 1% of GDP in Q4 2019, but average growth in H2 2019 and 2020 will likely remain close to 0%. We expect the Japanese economy to grow by 1.2% in 2019 and by 0.2% in 2020.

Regarding monetary policy, the BoJ may cut interest rates further, thus taking them into negative territory as a response to the global slowdown, although our base case is that it won’t. We also anticipate the introduction of an expanded target range around the 10yr yield central target of 0%, from ±20bp to ±30bp. Despite many years of aggressive easing by the BoJ, core CPI inflation has not picked up and is expected to decline from 0.8% in 2018 to 0.5% in 2019 and to 0.1% in 2020.

Emerging markets (EM): Weaker growth, lower rates

Rising international trade tensions and slower global growth are not good news for emerging market economies. We expect EM growth to be hit by heightened global uncertainty, not only via a fall in exports but also through dampened investment.

Weaker growth prospects and historically low inflation have triggered interest rate cuts in emerging markets, a trend expected to intensify over the next few months. Many central bankers focus primarily on inflation targets, and to a lesser extent, on currency fluctuations. Thus, we expect EM countries with slowing inflation to end the year with lower policy rates. Another indication of looser monetary policy in emerging markets is the accommodative stance of the Fed.

In China, greater uncertainty and weaker confidence seem to be hampering domestic demand more than exports. We expect that falling exports, limited property investment and fading policy effects will drag on economic growth. In our view, Chinese economic growth will slow to 5.9% in 2019 and to 5.6% in 2020, below the government’s 6-6.5% target. The policy response from the Chinese government will be more stimulus to curb growth deceleration. The PBoC has adopted an accommodative stance by cutting interest rates and reducing banks’ required reserves. Fiscal authorities are also expected to step up their infrastructure spending and to improve the effectiveness of existing measures.

India’s economic growth has softened significantly in 2019, slipping to 5% (YoY) during the second quarter, its slowest pace since 2013. In order to address growth concerns, the Reserve Bank of India (RBI) made an unconventional interest rate cut of 0.35% in August, the fourth one in 2019. The cumulative reduction in RBI’s benchmark repo rate has been 110bp since the beginning of the year. As inflation remains below the RBI’s 4% target, we expect additional interest rate cuts of 40bp until the end of 2019, leaving the repo rate at 5% and then a pause in 2020.

The government has made progress with structural reforms but support of the economy from the fiscal side is expected to be limited. Finally, we have revised downwards our growth forecasts to 6.5% in 2019 and 6.3% in 2020.

Brazil is recovering at a slow pace as high unemployment puts a lid on growth. Private consumption is growing but the challenging international environment and the lack of fiscal stimulus are dragging on the economy. President Bolsonaro has recently managed to pass a crucial pension reform resulting in substantial savings over the next 10 years but additional measures of fiscal consolidation are needed to ensure debt sustainability. Brazil’s central bank (BCB) initiated an easing cycle in July with two consecutive rate cuts of 50bp which brought the overnight SELIC rate to 5.5%. We expect further cuts by the BCB between now and the end of the year, as inflation remains below BCB’s 4% target. Despite the significant monetary stimulus, we expect Brazil’s economic growth to be only 0.5% in 2019 and pick up to 2% in 2020.

In Russia, economic growth accelerated to 0.9% in the second quarter after a weak start to the year but growth prospects still look grim. Inflation started to decelerate, from 5.3% in March to 4.3% in August. Against this backdrop, Russian monetary authorities have adopted an accommodative stance by bringing the key policy rate down to 7% in September with three consecutive rate cuts of 25bp since April. Despite significant monetary stimulus and the government’s plans for productivity-enhancing investments, we expect a modest growth of 2.3% in 2019 and a severe slowdown to 1.2% in 2020.