Tentative signs of an easing or even ending of the downtrend in global growth have emerged. Financial markets have gotten a lift from both an easing of trade tensions and some more constructive developments on the Brexit front, with equity values boosted, credit spreads narrowed, and yield curves steepened. PMIs and other leading indicators of business activity appear to be forming a trough. Our view for some time has been that global growth would bottom by the turn of this year and begin to pick up gradually over the year ahead, although with significant downside risks attached to this baseline scenario.
Assuming the global economy is nearing a turning point, could we be too pessimistic in our perception that a current bottoming is fragile and our expectation of only a slow pickup in growth over the year ahead?
While some risks remain, there are reasons to be feeling a bit better. We began by reviewing recent more favourable developments in the key headwinds to global growth, namely trade tensions between the US and China (and others) and the prospects for a disruptive UK exit from the EU. We considered in particular empirical evidence of the extent to which key policy announcements have affected the level of policy uncertainty. We reviewed global evidence, namely the recent behavior of leading indicators of global economic activity, including global PMIs and various measures of global financial conditions. Our analysis pointed to a near-term bottoming of global growth that should prove sustainable as long as risks related to trade policy and Brexit are resolved positively.
Recent developments suggest the global economy may have dodged a bullet in late summer, when the Trump Administration announced significant new tariffs on China with a response in kind by China, and simultaneously, developments in the UK appeared to push the likelihood of a no-deal Brexit above 50/50.
The uncertainty created by these events weighed significantly on global trade and investment. The Fed staff’s trade policy uncertainty index jumped during August on these developments. The stock market dropped, the US manufacturing ISM fell below 50, and a key conventional US yield curve slope (2s-10s) inverted for the first time since before the great recession. This caused recession probability models to flash warning signals of elevated recession risk. Some major European countries were already in or near recession, and growth in China and the US was showing clear signs of slowing. But, the picture changed this fall when risks associated with both trade tensions and Brexit appear to have taken a turn for the better.
The Trump Administration appeared to shift course when it announced on October 11 a tentative Phase I of a larger trade deal with China. The announcement included an indefinite delay of the scheduled mid-October tariff increase. A finalized Phase I deal would also remove or delay through next year the tariffs scheduled to be imposed in mid-December on remaining imports from China (mostly consumer technology goods, including cell phones, laptops, and other consumer goods). In exchange, China is expected to commit to larger agricultural purchases, rein in technology transfer, bolster protection of intellectual property, and commit to greater transparency on foreign exchange reserves with a commitment not to manipulate the currency market.
There are risks on both sides of this assumption. It is possible that China will seek a rollback of existing tariffs to agree to such a deal. The US Administration has sent mixed signals on the likelihood that it would go along with this condition. Should this or events surrounding Hong Kong prove to be a major sticking point, the deal could fall through and trade policy uncertainty remain elevated, yielding a worse outcome than we expect. Should the US agree to a rollback, the outcome could prove more positive than we expect. In other very recent developments on the trade front, US Administration and Congressional officials (most notably Trade Secretary Ross and Senate Finance Committee Chairman Grassley) have indicated that prospective tariffs on imports of autos from Europe and elsewhere will be delayed or dropped, though no official announcement has been made.
Hopes for a positive Brexit outcome improved when new UK Prime Minister Boris Johnson renegotiated the Withdrawal Agreement with the EU by adopting a Northern Ireland-only backstop. Although the Government won a vote on the second reading of the Withdrawal Agreement Bill in Parliament, a procedural motion was subsequently lost, and to break the impasse a general election on 12 December was called.
However, two issues still create risk. First, even if Johnson’s deal is ratified in January, the UK could still crash out of the EU at the end of 2020 unless a new trade agreement is reached. The ‘deal’ only secures transition. This means another Brexit cliff edge will occur in June 2020 when a decision must be made on an extension of the transition period beyond December 2020. In our view, it would be next to impossible for the UK and EU27 to agree to even a simple free trade agreement in the next 12 months.
Secondly, the size of the Conservative majority will have important ramifications. The larger the Conservative majority, the less dependent Johnson will be on hard Brexit MPs and the more the door opens to a closer economic partnership with the EU than the one suggested in the current draft of the future relationship. Conversely, the smaller the Conservative majority, the greater the risk of a more distant economic relationship.
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