Global economy: teetering on the edge
The trade tensions are taking a toll on the outlook for the world economy and following the latest escalation of tensions we are downgrading our forecasts. We now expect global growth of 2.6% this year and 2.4% next (previous forecast 2.8% and 2.6% respectively).
Rather than expecting a boost to global growth as a trade deal between the US and China is struck at the end of the year, we now see an extended period of economic weakness as uncertainty weighs on the willingness of firms and households to make significant spending decisions. Investment plans are likely to be further delayed or cancelled particularly now that tariffs are more likely to be permanent rather than temporary.
China has cut imports from the US sharply
The Chinese and wider Asian supply chain will be affected, and US activity will also suffer and we have cut our growth forecast from 2.6% to 2.3% this year and from 1.5% to 1.3% next. It has been noticeable that US exports to China have fallen faster in value than imports from China. China's planned economy has reacted faster than the market driven US.
The policy response
The danger in President’s tariffs strategy is that activity weakens considerably and inflation picks up with a knock-on effect to the equity market. Firms that may have been holding off from passing on tariffs or adjusting production as they wait for a more favourable turn in the trade talks are now likely to react. The new tariffs cover a wide range of consumer goods such as electronics and toys where tariffs will be noticed by households. We have raised our forecast for core CPI inflation as a result, which is expected to pick up to 2.5% y/y in the first half of 2020.
Nonetheless, the escalation in trade tensions is expected to lead to more rate cuts. Although core CPI inflation is higher, we expect the Federal Reserve (Fed) to look through this, especially as headline inflation will be kept close to 2% as a result of lower oil prices. Consequently, the weaker growth profile we now forecast for the US allows the Fed to cut rates twice more this year (in September and December) and bring forward easing in 2020 (to March and June). We now see policy rates at 1.25% at the end of next year (previously 1.5%). What starts as insurance rate cuts morphs into a more conventional easing cycle.
We also see lower interest rates elsewhere: the European Central Bank (ECB) is now expected to cut rates in September and December 2019 and the Bank of Japan cuts in December. The Bank of England is not expected to raise rates until late in 2020 and only then on the contentious assumption that the UK achieves a Brexit deal with a transition period. In China, fiscal policy is eased more than previously expected and next year we have more interest rate cuts.
Expectations of a long wait for monetary and fiscal policy to come to the rescue
Our latest forecast reflects the additional challenge of more protracted trade tensions behind the downgrade to growth. The effects of potential changes in monetary and fiscal policy will provide some offset to weaker activity with interest rates falling and governments looking to cut taxes and raise spending.
Rate cuts will help and have boosted markets, but the economic stimulus will come through slowly. The normal lag from policy easing to stronger activity is around 12 months so a boost to growth would not come through until the second half of 2020. In the current environment there are reasons to believe that the lags may be longer.
Firstly, this is the first easing cycle since the global financial crisis and a more cautious banking sector will take longer to expand credit whilst households will be wary of releveraging. Second, interest rate cuts do little to offset the headwind created by economic uncertainty. Both geopolitical risk and policy uncertainty are high and will not be shifted by a lower cost of credit. Instead, an end to the trade tensions or successful resolution of Brexit are needed.
Consequently, as rates fall and activity remains sluggish, we expect an active debate about whether central banks are simply "pushing on a string". Against this backdrop, there is likely to be more of a focus on fiscal policy as politicians look for ways to strengthen activity. UK Prime Minister Boris Johnson is actually in the vanguard here with regular public spending announcements on his travels around the country. China is also expected to provide fiscal support. However, the political process in the US and Europe moves slowly so we expect a long delay before the fiscal cavalry truly arrives.
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