The world economy increasingly resembles an unstable bicycle that can be tipped over by the slightest bump in the road.
Three months ago we said “the easing in US-China trade tensions, more flexible central banks and the benefits of lower oil prices should stabilise activity later this year and support an upgrade in our global growth forecast for 2020”. However, two of those supports have now fallen away and we are more reliant on looser monetary policy to maintain activity.
Since the financial crisis, there has been a shortage of demand in the world economy as US households have reduced borrowing and China has begun to address the bad debts in its banking system. This leaves us with a relatively slow rate of underlying growth, or “secular stagnation”.
As a result, the world economy is vulnerable to shocks such as the increase in trade tensions which threaten exports and capital spending as a result of the increase in uncertainty. We are left with a world economy that resembles an unstable bicycle that can be tipped over by the slightest bump in the road.
Central bankers have been doing an effective job in keeping the bike stable through policy easing, but there will be increasing pressure for governments to pick up the responsibility.
The positive in this is that employment has held up remarkably well particularly in the US, UK and Japan – testimony to reforms which have made the labour market more flexible. The cost, though, has been weak productivity growth which is reflected in weak real wage growth.
Economists have tended to accept this as a better outcome than one in which unemployment is much higher, but as we have seen in the recent European elections and elsewhere, this in turn has become a source of political discontent.
How have our growth forecasts changed?
We think global growth in 2019 remains on course to meet our 2.8% forecast, but for 2020 we have lowered our expectations (from 2.7% to 2.6%).
Our unchanged view for 2019 follows a good start to the year, with first quarter GDP beating expectations in the US, eurozone, UK, Japan and China. However, the this was largely due to inventory building, which is when companies stock up on goods to sell at a later date. We expect this to be temporary and to reverse in the second quarter.
Meanwhile, the resumption of the trade war between the US and China is likely to damage business confidence, causing firms to delay spending.
We have raised our forecasts for inflation for this year and next, with increases across all regions largely driven by the rise in oil prices. We now expect Brent crude oil prices to be significantly higher over the forecast period than when we last gave our forecasts in February.
Our outlook for US inflation is also higher as a result of the setback in US-China trade negotiations and the subsequent increase in tariffs to 25% (from 10%) on $200 billion of Chinese imports.
Our baseline forecast assumes that the US and China move slowly to a trade agreement by the end of the year, after which both sides reverse the latest tariff increases. Although the path to a deal is unlikely to be smooth and could include significant market volatility, we think Trump will want to prevent US consumers being hit with higher prices as he approaches re-election in 2020.
US Fed expected to cut rates in June 2020
We assume that US interest rates have peaked. We expect the next move by the Federal Reserve (Fed) to be a rate cut in June 2020 because of weakening growth.
We have pushed out our expections for rate increases in the UK and eurozone, with only one move from the Bank of England while the European Central Bank (ECB) will likely wait until 2020 before tightening monetary policy. We expect the Bank of Japan to leave its policy unchanged.
We expect the US dollar to remain firm in the near term, but weaken later in the year. Our forecast for sterling is also boosted because we assume that the UK will enter a transition period in October rather than crashing out of the EU, although there is considerable uncertainty surrounding this following the recent resignation of the prime minister.
Alternative scenarios – risks skewed towards stagflation and deflation
The forecasts above represent our baseline case, to which we attach a 60% probability. We also model a number of alternative scenarios. One of these is “Recession excluding US”, whereby the outlook in China and Europe deteriorates significantly, while another is “US Recession 2020”. These two scenarios would both have a deflationary impact on the world economy and we estimate the probability of these at 14%.
We also model three scenarios whose impact would be stagflationary (ie causing persistent inflation and stagnant growth). These are “Trade war: US vs Rest of the World”, “Oil jumps to $100” and “Italian debt crisis”. We attach a 16% probability to these three scenarios.
In terms of trade wars, we acknowledge that there is a significant risk that we see further tariff increases. We may not see a resolution to the US-China dispute and the Trump’s recent decision to impose tariffs on Mexico threatens to take the trade wars onto a new front.
Trade tensions are likely to become a permanent feature of the global economy and will drag on capital spending and exports.
We see a lower probability (10%) for two reflationary scenarios. In the first of these, “China reopens the spigots,” we assume large scale stimulus from Chinese policymakers. In the second, we model a “US supply side surprise”, whereby more people enter the US workforce, which would contain wages and inflation and extend the economic cycle.
A version of the above article was previously published by Schroders on 7th June 2019