Industry Voice: House View, Q3 2019: Prepare For The Worst, Hope For The Best

The outlook for the global economy has deteriorated over recent months.

Despite a somewhat more positive start to the year than expected, with growth in both the United States and the euro zone surprising on the upside, the global manufacturing and trade outlook has worsened on fears of a protracted international trade conflict.

We have, once again, revised down our growth expectations for 2019 and 2020, with no meaningful recovery expected over the next 18 months (Figure 1). This downward revision reflects expectations of slower growth across most regions and leaves us somewhat below the current consensus for this year and next.

Figure 1. Global growth outlook (y/y)

We expect weaker business sentiment to weigh more heavily on growth

Looking across the major economies, only the United States is expected to deliver above-potential growth in 2019, with all the major economies at- or below-potential in 2020.

As a result, the steady erosion of spare capacity that has happened globally over much of the past decade is expected to stall and even reverse a little. That is expected to ease wage and price pressures and bring a more accommodative monetary policy stance (Figure 2).

Figure 2. Central banks are expected to ease policy

Market-based policy rate expectations

In our central scenario, we expect the combination of looser monetary and fiscal policy will be enough to stave off a more serious downturn. Historically, global growth below around 2½ per cent was consistent with a recession. While we do not expect further deterioration of that size, the balance of risks to our outlook is judged to be to the downside.

Early in 2019 it had looked as though trade tensions were easing, with a temporary truce between the US and China expected to lead to an agreement in around April or May for the US to ease tariffs and limit non-tariff restrictions. In return, China was expected to increase its purchases of US goods, tighten its protections around foreign firms' intellectual property rights and further open up its market to foreign competition.

However, on 5 May President Trump announced an immediate increase in existing tariff rates and a planned expansion of tariffs against all Chinese imports. That came after an apparent rejection of the draft trade agreement by the Chinese leadership. Around the same time, the US undertook restrictive actions against Chinese telecommunications company, Huawei, limiting its ability to deal with US companies or government bodies.

These actions, once again, raised the stakes in the trade dispute that began in 2018 and reinforced the fears that the negative impact on business sentiment and investment already seen would persist for longer. Just a few weeks later, Trump then threatened tariffs against Mexico, the United States' largest trading partner, over perceived inaction on border security. While that threat was later withdrawn, it was significant in moving the protectionist actions into a new sphere that was unrelated to real or perceived trading imbalances.

And while Presidents Trump and Xi agreed to a continuing dialogue at the G20 meeting at the end of June, we expect the US protectionist bias to remain in place throughout this Presidency and beyond, with regular flare-ups likely against a range of countries. That will weigh on growth by itself. However, should those flare-ups result in further actions, it could be enough to drive an already soft global economy into recession.

With inflationary pressures still muted - only in the US has inflation been close to the central bank target - the expected continuation of tepid, below potential, growth has resulted in a marked change in the outlook for monetary policy.

In the US, the Federal Reserve has indicated that it is likely to cut rates this year, a far cry from its expectations of further increases just six months ago. The market has moved to price over 100bps of cuts over the next year. While we do not expect that much to be delivered in our central scenario (where the US remains a relative outperformer again this year), we do think it likely that rates will be cut this year.

In the euro zone, the prospect of further easing from the ECB is once again on the table. Despite the limited choices given the existing level of rates and rules around asset purchases, we expect that it will move policy rates more deeply negative and adjust the parameters on the asset purchase programme to allow further QE.

Easier policy has already been forthcoming from the Reserve Banks of both Australia and New Zealand, which we also expect to continue.

Meanwhile the combination of fiscal and credit easing in China has also broadened and been extended, reflecting the desire by authorities there to try to offset the impact of tariffs and slower global growth. More recently, those stimulus measures have included increased local government financing for infrastructure, a sign that the measures taken so far to boost household consumption and state-owned enterprises' investment have fallen short of what was needed.

The stimulus measures either taken or expected around the world have supported risky asset prices, despite the concerns about global growth prospects.

Since the Q2 House View was published three months ago, government bonds, corporate credit and developed market equities (particularly in the US) have all seen positive returns (Figure 3). Given the strength of global equity market returns this year, and with valuations around their long-run averages, the scope for a sustained move higher at this point seems limited, even with policy support. Indeed, with the balance of risks to growth strongly tilted to the downside, we see the risk to equity returns to be similarly tilted to the downside.

Figure 3. Lower bond yields boost safe and risky asset returns

Macro asset market performance since 2019Q2 House View

As a result, we have reduced our preference for equity risk to be broadly neutral (Figure 4). Combined with a modest preference for duration, our asset allocation view reflects our concern about the risks facing the global economy over the next year. 

Figure 4. Asset allocation summary

Neutral equities, overweight credit

In our central scenario, the global economy avoids recession, and therefore we expect a corporate default cycle would also be avoided. That should be a good environment for positive carry strategies and as such, we prefer to be modestly overweight credit, both in the corporate and emerging market hard currency space. While the most marked change in interest rate expectations in recent months has been in the US, we do not expect that to lead to a materially weaker period for the US dollar. With heightened risk aversion and positive carry, we expect the dollar to remain supported over the year ahead.

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