Is an economic storm approaching?

Principal Economist's View 

After rebounding strongly in late 2016 and throughout 2017, momentum in the global economy appears to have peaked around the turn of the year. Global growth is also becoming less synchronised, with the US continuing to expand strongly and a number of emerging markets facing sharp slowdowns in light of heightened political uncertainty, tightening financial conditions and increased global trade tensions.

While the downside risks to global growth have clearly increased, at this stage we are not expecting a sharp drop-off in economic activity. In fact, our latest global forecasts finalised in early August expect 3.9% real GDP growth in both 2018 and 2019, only a modest slowing from the 4% growth experienced in the global economy in late 2017. 

The resilience of global growth is largely underpinned by the US economy. Growth in the US economy has received a sharp boost from US$1.5 trillion worth of tax cuts (over the next decade) enacted by Congress in late December, which is expected to add around 0.3-0.4ppts to growth in the US economy in both 2018 and 2019. The impact of the stimulus was evident in the Q2 National Accounts in the US, with real GDP rising at a 4.2% annualised pace in the June quarter. While growth is unlikely to maintain this stellar pace in coming quarters, robust above-trend growth is likely to continue in the US economy and we expect real GDP growth to average 2.8% in 2018 and 2.4% in 2019, up from 2.2% in 2017.

Although we expect above-trend growth in the US and global economy to continue, downside risks to the outlook are intensifying. Trade tensions continue to build between the US and China, while Europe and the UK economy lost momentum over the first half of 2018. Furthermore, dislocations in financial markets continue to build across emerging and developing economies, with sharp falls seen in many equity markets alongside large currency devaluations.   

How worried should we be about these building economic clouds? First, consider the trade tensions. Our baseline forecast only incorporates the protectionist measures implemented to date; this is what we call Phase 1 of the trade war, a tit-for-tat 25% tariff on $50 billion of US imports from China (and Chinese imports from the US). The impact from these protectionist policies are minor for the global economy –  it wipes off 10bps from the level of global real GDP after 3 years and 20bps from the level of US real GDP. However, if the trade war between the US and China continues to escalate to include all trade between the two countries (and higher risk premiums), our modelling suggests a much more significant hit to US real GDP of 1.2 percentage points (ppts) after 3 years and around a 1 ppt hit to global activity. No one wins from an all-out trade war. 

Second, what about the loss of momentum in Europe over the first half of 2018? We are far less concerned around this development, with part of the moderation in growth in early 2018 due to temporary factors, including poor weather and strikes in France. While political and fiscal risks remain elevated in Italy, the combination of the fading impact of the temporary disruptions, the recent fall in the euro, stabilising oil prices and signs of progress with US trade talks bodes well for a modest rebound in euro area growth to around a 2% pace in H2 2018.

What about the UK? The UK outlook remains clouded by the need to negotiate a withdrawal agreement from the EU. Heightened uncertainty around the future trading relationship with the EU continues to weigh on activity, with real GDP growth slowing to 1.3% over the year to the June quarter. We expect growth will remain lacklustre in the UK, averaging around 1.3% in 2018 and 1.5% in 2019, down from 1.7% in 2017. Our baseline forecast assumes the UK manages to negotiate a withdrawal agreement with the EU over the next 6 months, although the outcome for the BREXIT negotiations remains highly uncertain and we can’t rule out a no-deal hard BREXIT that could wipe off as much as -5% to -10% from the level of UK activity over a 15-year period. 

Finally, what about the prospects for emerging markets? In our view, the prospects for emerging markets are very divergent, with the region buffeted by conflicting forces. Our forecast expects growth in most commodity exporters to continue to improve, benefitting from the recovery in commodity prices over the past 18 months, particularly for energy products. However, recent political developments and tighter financial conditions are expected to weigh heavily on a few economies, particularly Turkey, Argentina and Venezuela.

Supporting the outlook for emerging markets is ongoing robust growth in Asia. While growth in China has slowed over recent months, authorities have responded to the recent slowdown via modest fiscal and monetary easing. We expect further support from Chinese authorities, allowing growth to slow in an orderly fashion from 6.7% in the June quarter 2018 to 6.5% in H2 2018 and 6.3% in 2019. Should the trade tensions with the US escalate further, we’d expect the Chinese authorities to embark on even more stimulus to support their domestic economy.

Recent developments suggest that growth in the global economy has peaked. But while growth is becoming more uneven and the downside risks continue to build, at this stage we expect the storm will pass with only minor economic damage.

Table 1: Financial market movements, 23 - 30 August 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,901.1

1.5%

US

2.86%

2.9 bps

US Dollar Index (DXY)

94.72

-1.0%

Nikkei 225

22,869.5

2.0%

Japan

0.11%

1.1 bps

USD-JPY

110.98

-0.3%

FTSE 100

7,516.0

-0.6%

UK

1.46%

18.5 bps

GBP-USD

1.301

1.5%

DAX

12,494.2

1.0%

Germany

0.35%

0.7 bps

EUR-USD

1.167

1.1%

S&P/ASX 200

6,351.8

1.7%

Australia

2.57%

3.8 bps

AUD-USD

0.726

0.2%

Source: Bloomberg

 

For the economic update by region, click here

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