Our current base case scenario is for continued global GDP growth in 2018 and 2019. A stream of strong earnings figures is driving global equity markets, and we expect global GDP growth to continue its current path toward 4% this year. But bifurcating growth, trade wars and tightening monetary policy pose risks to that scenario. Here is a closer look at these risks and insight on how investors can ensure portfolios are positioned for the next stage of the cycle.
1. Bifurcating economic growth
We are seeing a greater divergence between the performance of major economies. The US continues to power ahead, thanks to momentum from cheaper energy and the temporary stimulus provided by President Trump’s tax cuts. In particular, the ability to expense 100% of investment is showing up in order figures. Such a late-cycle sugar rush could push the US to grow above 3% in 2018, and between 2.5% and 3% in 2019. Europe and Japan, meanwhile, continue to disappoint after stronger growth last year, while China is showing signs of a more significant slowdown, accelerated by trade issues. This divergence is a challenge because, while the US backdrop looks good now, it will be difficult to maintain that pace as monetary and fiscal policy wane and other regions are not in a position to pick up the slack. Convergence to the downside is the more likely path, while investors preparing before it shows up in the data is a risk for markets in 2019.
2. Trade wars
Trade wars remain the most significant risk to our base case for global GDP growth. If the US-China trade war situation escalates, leading to tariffs between 25% and 30% on all trade between the two countries, and perhaps tariffs as high as 10% on European cars, we could see some real damage to the global economy. The good news is that it seems like the US is making progress with Europe and the recent deal of the United States-Mexico-Canada Agreement will help relieve some of the market uncertainty.1
As China exports less to the US than vice versa, the Chinese are likely to respond to the trade war with other measures such as fees, quotas, restrictions and inspections designed to deter foreign trade. According to UBS, if this scenario ensues, we could see a whole percentage point knocked off global growth, bringing a near 4% rise down to 3%. It would also probably reduce both China’s and the US’s GDP growth by 2%. Markets are not currently pricing in such a scenario and could react sharply to any trade dislocation if it became clear how supply chains, confidence and jobs may be affected.
Such an outcome could have a systemic impact on businesses, consumer sentiment and investment, resulting in damage to productivity and a spike in inflation. We believe that the probability that this will happen is low, but it remains a risk to monitor.
3. Tighter monetary policy
Another risk to global GDP growth is monetary tightening. In addition to rising rates in the US, the UK and Canada, the European Central Bank is likely to bring its quantitative easing program to an end in the final quarter of 2018. While the Bank of Japan shows no signs of ending its program, observers believe it could consider reducing it if inflation holds up in 2019.
When the cost of borrowing rises, it can hamper corporate growth, as cashflows are discounted forward at higher rates, hurting highly leveraged companies. This is a particular concern in emerging markets (EM) and other regions outside the US which hold a considerable amount of USD-denominated debt.