Global growth for the rest of 2018 should continue slowing, with growth in the US, which has been the engine of the global economy, to start losing momentum into year-end. For China too, the direction of travel is undoubtedly downward. These factors could be the triggers that lead to the next bout of economic and market pain.
US: Losing momentum
The US, which has been the growth engine of the global economy, is likely to start slowing into year-end but the fiscal stimulus will continue to boost growth through 2019. Broader financial conditions in the US are still easy, but mild tightening – through rising interest rates, less-easy monetary policy and a strengthening dollar – are all starting to weigh on growth. We believe both the level and pace of this tightening matter. As such, we need to see much more tightening in financial conditions, and at a faster pace, to start worrying about serious growth implications.
While the US economy has been powering on thus far, there are now signs it may be running out of room. The economy is close to hitting capacity constraints – both in labour and product markets. And as labour market conditions continue to tighten, cost and wage pressures are building up.
Chart 1: Real wage growth in the US heading into negative territory
Source: Bureau of Labor Statistics, Haver Analytics, Fidelity International, August 2018
We expect the Federal Reserve to stick to the plan of four rate rises through 2018, but next year a combination of three more planned hikes, further quantitative tightening and treasury issuance form a “triple whammy”. We believe that something will have to give – and we don’t think it will be fiscal! The biggest risk to global growth is the risk of the Fed doing too much.
Another worrying trend is the high level of corporate sector debt, which stands out as one of the biggest imbalances in the system. Debt as a percentage of GDP is now in line with previous cycle highs of around 45 per cent, although the pace of increase has been more measured relative to the last two episodes in 2001-2002 and 2008-2009. We think the size of this debt could certainly trigger a recession, but this is unlikely to be the epicentre of another crisis – at least for now.
Chart 2: Despite higher expected growth, a flatter yield curve suggests a higher probability of a recession
Source: Haver Analytics, Fidelity International, August 2018
Indicators in China have been mixed. On the positive side – PMIs are stable, imports are surprisingly strong, manufacturing PPI is healthy and house prices are still robust. However, investment, especially infrastructure, is very weak, and real estate construction is negative. Plunging retail sales volumes stand in contrast with second quarter GDP that was supported by a huge boost from consumption; this suggests that growth is materially weaker than the official number. All these factors indicate that the direction of travel has undoubtedly been downward.
Chart 3: Corporate credit only partly offsets “shadow” bank contraction
Source: People’s Bank of China, Haver Analytics, Fidelity International, August 2018
Since June, the government has taken several steps to create “easier” conditions to boost liquidity in the system. However, genuine fiscal loosening through measures such as the much-touted corporate R&D tax cuts amount to just 0.065 trillion renminbi or 0.07 per cent of GDP. Other steps include “asking” banks to lend, and “urging” local governments to use more of their 1.35 trillion renminbi “special bond” quota for infrastructure, which was only 25 per cent tapped in the first half of 2018. Overall, while we believe these measures are better than nothing, their magnitude still seems small and the numbers are unlikely to be game-changing.
What could cause the next global recession?
Outside of the US, a shock has to be pretty big to spill over globally, including into the US. A sudden stress in China’s financial system or a hard landing is an ongoing risk, but we now believe such a risk is currently higher than average. Other triggers could be the ongoing Turkey crisis, a multilateral trade war scenario or a break-up of the euro (a scenario that is unlikely for now, but has the potential to derail global growth).
The situation in Turkey may yet represent a systemic shock that could lead to global contagion. But for major central banks to react, it has to spread to other emerging markets (EM) and dramatically tighten global financial conditions. In a sense, the situation has to get much worse before a significant global policy response. But there are other factors at play that make the Turkish situation much more unpredictable: the Erdogan-Trump politics, other interested parties (namely China and Russia) and hidden exposures – all this against the backdrop of tightening global liquidity. Maybe it’s time to dust off that classic EM crisis handbook?