You can hear the bearishness in everyone’s voices. They don’t trust a cycle this old. They won’t fight the Federal Reserve. They fear a market swoon in a world of unstable politics.
Risks are mounting, as indicated by recent data signalling slight economic contractions in Germany and Japan. But for now, monetary, fiscal and political headwinds hardly seem strong enough to induce a global recession.
If the biggest market worry centres on the Fed, that should begin to dissipate early this year. Rates are rising and debt service is growing more expensive, but how probable is it that US monetary policy is really ‘behind the curve’? Wages and tariffs may be nudging some prices higher, but energy and technology prices are falling.
Most forecasts have core inflation hovering just above 2%, which suggests the end of the current tightening cycle is in sight. The Federal Open Market Committee seems to be heading slowly and tentatively towards a 3% fed funds rate at the end of next year if the ‘dot plots’ hold, but futures markets are pricing in lower rates.
Meanwhile, monetary accommodation reigns in Europe, Japan, China and beyond. And long-term demographic trends and new technologies seem likely to keep any inflationary spikes in check.
The second major cyclical worry comes from the US federal budget, which seems less predictable than ever. There is a lot of talk about the budget deficit that is set to reach $1tn this year, but there is also little determination from either political party to raise taxes or cut spending as they prepare for the 2020 presidential election.
This means US firms should not expect fresh tax cuts to boost their earnings. That being said, they probably did not pass the full 2017 cuts through to earnings in 2018, and may therefore enjoy reserves to support 2019’s results. More importantly, they should expect steady domestic demand supported by continued low unemployment and strong household balance sheets.
One key trend to watch will be the prospect for rising productivity that should come from higher business investment. Recent US investment figures have been weak, and further weakness could undermine earnings beyond next year. But that, too, is probably a longer-term concern.
Meanwhile, fiscal policy globally has been generally supportive in large economies like China, Japan and even Germany. It may not be enough to accelerate global growth, but it is hardly contractionary.
Even if you are comfortable with the growth and inflation outlook, a long list of political risks looms. The trick in these polarised times is to disaggregate political preferences from economic analysis. Democrats tend to magnify risks to the economy that might undermine President Donald Trump’s re-election campaign. Republicans tend to pin outsized hopes on tax cuts and deregulation.
For the current cycle, the most important political theatre to watch in Washington involves the standoffs over the debt limit and government funding. These may trigger market gyrations, but the disruptions shouldn’t be enough to tip the US economy into recession.
In Europe, Britain’s new relationship with the European Union will (we hope) become clearer well before the official Brexit date of March 29, though this may require an extension of negotiations. Italy is Europe’s biggest challenge; there is not enough money to bail out the Italian economy if the government loses the confidence of bond markets. But the country’s debts are long-term and mainly held domestically. The budget standoff is real, but likely to subside as politicians turn their attention to European parliamentary elections that carry few direct market consequences.
The largest political risk for the global economy could be the deepening trade frictions between the US and China. Following the G20 summit at the end of November 2018, both Washington and Beijing gave bullish reports on the negotiations. Still, nagging issues around China’s economic subsidies and protection of intellectual property will not be resolved quickly.
But the greatest damage from tariffs is likely to come over the very long term, as companies reassess their investment priorities amid rising trade barriers. The near-term impact of tariffs on global growth should remain limited, as both the Chinese and US economies depend overwhelmingly on internal demand.
There is plenty of room for unpleasant surprises, especially from higher debt servicing costs and continuing pressures on some emerging markets. Still, it is important to keep these risks in proper perspective against a global economy that is slowing, but still very strong, and political tensions that are distracting, but unlikely to trigger recession.
Christopher Smart is Head of Macroeconomic and Political Research at Barings.