2020 Economic Outlook: A Battle of Three Cycles
- In 2020, we see three forces in the global outlook: the macro, monetary policy, and political cycles.
- While the macro cycle is typically the dominant market influence, in 2020, we see monetary policy wielding the most sway.
- The political cycle will also deserve attention, however, given its ability to trigger sudden changes in policy priorities.
Heading into 2020, we see a marked difference from what global macro conditions were like at the start of 2019. This time last year, we saw our role mainly as risk managers trying to identify whether the end of the business cycle was at hand. We concluded a recession was likely – if the Federal Reserve (the Fed) continued its tightening policy and China failed to implement sufficient stimulus to offset the headwind from the increasingly confrontational US trade policy. The good news was that it became clear early in 2019 that the Fed had overplayed its tightening hand and would pivot toward a new easing cycle. And China did implement a broad range of growth-enhancing measures, successfully preventing a more serious slowdown.
Once we were confident enough that a recession wasn’t about to strike anytime soon, our focus shifted to determining what the dominant macro and market drivers would look like in an extended late-cycle economy. The term “late-cycle” applies mainly to the world’s developed economies, where both the IMF and OECD estimate 2019 output gaps have moved into positive territory, signaling the excess supply overhang from the Great Recession has finally been absorbed. In contrast, most emerging market economies continue to show negative output gaps and hence are more ‘mid-cycle’.
Looking ahead to 2020, we see the global outlook determined by three cycles fighting for supremacy: the macro cycle, the policy cycle, and the political cycle. Our key investment thesis is the assertion that the policy cycle will be the dominant market driver rendering the traditionally more important macro cycle less relevant.
The macro cycle typically dominates in market influence. The question here is still whether the inverted yield curves are right, and the developed world finally faces a more serious slowdown, or whether the expansion can continue. The monetary policy cycle usually depends on the broader macro cycle, but due to changing central bank priorities, it’s now increasingly divorced from the latter. The political cycle is still part of the risk analysis. However, due to the ability to trigger sudden changes in policy priorities, it deserves elevated attention in 2020 – and indeed for the next few years.
Growth should converge toward long-term potential rates
Traditionally, the macro cycle dominates. Early in the business cycle, improving labor markets provide the fuel for recovery, allowing the economy to grow faster than its longer-term, structural growth potential and to close the output gap that opened up during the recession. Once full employment approaches, and in the absence of other late-cycle growth sources, the rate of expansion converges toward that longer-term potential rate, which is determined by labor force and productivity growth. In the late 2000s, US consumers’ ability to monetize soaring housing values was such a late-cycle growth source that kept growth above potential. This time around, we don’t see anything equivalent.
Now more than 10 years old, the current US business cycle has been the longest on record. The unemployment rate has fallen to a 50-year low, consumer confidence remains close to a 20-year high, and real incomes are still growing faster compared to the previous cycle in the 2000s. It’s true that job growth has started to slow, but that’s at least partly due to supply constraints, considering that the number of job postings has stayed well above the number of people registered as unemployed. Basically, everyone who wants a job can have a job in this economy. The same supply constraints should keep wage growth above the rate of inflation and ensure real consumer spending can continue to grow at a rate above 2%.
Three troughs for businesses but no recession
Actually, the US consumer isn’t the source for recession concerns. While the overall economy has enjoyed one decade-long expansion, businesses have seen three up and down cycles, with troughs in late 2012, early 2016, and mid-2019, none of which ended in a recession. The best indicators of current business conditions are orders for durable goods, which have stalled but aren’t declining. The sector is in a wait-and-see mode, but it hasn’t given up on the expansion continuing. In fact, amid tight labor markets, businesses are more reluctant to lay off workers, fearing they may not be able to get them back if the current trough is just another pause.
It shouldn’t take much to boost US business sentiment and release some of the pent-up investment demand that has been building since last summer. A truce in the US-China trade war would help, as would a stronger signal that the Fed understands this isn’t a moment for “fine-tuning.” Instead, the central bank needs to do “whatever it takes” to prevent a more serious slowdown. The three rate cuts in 2019 ought to help. Yet we expect further easing steps in 2020 and more supportive rhetoric to generate a modest rebound in business investment that should keep overall US GDP growth just above the 2% potential growth rate.
With its more export-oriented economies, Europe has been hit much harder by the broad-based slowdown in global trade. Not that long ago, the acceleration in trade growth amid a more synchronized global business cycle was cause for celebration. But the escalating US-China trade conflict put an abrupt end to that, and trade volumes have been contracting in 2019 for the first time since the last recession. European exporters’ struggle to adjust has been chief reason eurozone growth has fallen below potential, and in some cases, such as Germany, all the way to 0%.
Labor markets are showing resilience
However, as in the US, eurozone labor market walls are holding. Even though not all eurozone members have seen jobless rates recover fully from the financial crisis, the eurozone average has done exactly that, indicating a significant number of economies are experiencing the same stabilizing effect from sustained tight labor markets that’s fueling robust consumer spending in the US. That’s particularly true in Germany. Hence, eurozone consumer spending is likely to endure, while a rebound in US business investment could help bolster European manufacturing and allow GDP growth to converge back up to the region’s 1.25% long-term potential growth rate.
Naturally, Chinese manufacturers have also taken a hit from the aggressive US tariff policy. But even here, the labor market wall argument applies. Most of the government’s stimulus measures targeted consumers rather than traditional infrastructure. That’s why the rest of the world didn’t benefit as much this time around compared to previous Chinese stimulus cycles. In addition, China used its currency more actively to offset the impact of tariffs on exporters. Throughout 2019, China’s service sector indicators showed growth in the domestic economy holding up, while activity in the more export-oriented manufacturing sector stalled.
What complicates the picture is the resumption of China’s structural slowdown trend – essentially the result of lower productivity gains – that will produce weaker expansion rates in the coming years. Given those structural trends, China would clearly benefit from easing trade tensions. Yet, the global nature of supply chains suggests even a rebound of US and eurozone business investment could provide at least a mild stimulus that should limit downside risks for Chinese manufacturers. As long as unemployment remains low, Chinese consumers will continue to prevent a more serious slowdown in the world’s second-largest economy.
Macro cycle points to continued moderate growth
Our economic analysis shows the macro cycle remains quite flat but still indicates no recession. Robust labor markets continue to insulate consumers from most of the business weakness. And central banks have pivoted toward more growth support, which should help spark some investment and allow a modest pickup in global growth to 3.4% in 2021 from 3.2% in 2020. Granted, that can’t be described as strong growth, let alone a boom. Before the financial crisis, the global growth rate exceeded 4%, but in current conditions, it will barely match the longer-term global growth average.
Policy cycle indicates the unconventional has become the conventional
Economic fundamentals usually determine the policy cycle. Get growth and inflation forecasts right, and with transparent reaction functions you have a good idea of what central banks will be doing. Yet, in a world where most of them persistently miss their inflation targets, that’s not so easy anymore. In fact, the European Central Bank’s (ECB) decision last summer to push rates even deeper into negative territory and restart its asset purchase program – without ever seriously attempting to normalize policy – sent a signal that the temporary emergency tools are here to stay. The unconventional has become the conventional. The result will be a more intense downward pull on bond yields irrespective of underlying economic fundamentals.
The Downward Pull
Benchmark 10-year government bond yields
Central bank policies have led to a gravitational pull downwards on global bond yields.
Source: Macrobond, Bloomberg, PineBridge Investments calculations as of 3 November 2019.
The ECB is now leading global central banks in a race to implement more stimulative monetary policy. Core consumer price inflation in the eurozone has averaged 1.1% since the financial crisis, not once coming near the bank’s “below but close to 2%” target. Now the ECB is concerned that persistently weaker global growth could further diminish the chances of ever hitting that target. The bank’s monetary policy moves have far-reaching consequences beyond the eurozone. Other European central banks concerned about the disinflationary impact of appreciating currencies will have to follow suit. Political pressure on central banks to ease regardless of the growth backdrop will also get stronger as more governments eye the additional fiscal space gained from essentially eliminating the interest cost on public debt.
The Fed needs to cut rates more aggressively to regain control of the yield curve
The Fed’s dramatic policy reversal from raising rates in December 2018 to cutting them in July 2019 signaled that the window for policy normalization had closed. Ten-year Treasury yields fell, and the yield curve – the difference between longer-term and shorter-term government bond yields – flattened completely. The ECB’s quantitative easing (QE) decision pulled yields down even further, creating the yield curve inversion that some now fear is forecasting a recession.
We see the policy cycle is now dominating the macro cycle, and we expect more central bank easing around the world in 2020, no matter what the economic fundamentals show. If bond yields don’t rebound, or to say it differently, if the macro cycle doesn’t reestablish its traditional dominance, the Fed will have to cut rates much deeper to regain control of the yield curve.
The Bank of Japan (BOJ) demonstrates that yield-curve control is the next wrench in the monetary policy tool kit. Swimming against the stream of more policy easing, the BOJ is actually looking at reducing its still-active asset purchase program to maintain some steepness in the Japanese government bond curve and create an incentive for banks to lend to the private sector. If the BOJ succeeds, it could show a path out of ever-more central bank easing and end the policy cycle dominance. The risk lies in the currency market. If the yen appreciates against the euro and the dollar as the ECB and Fed ease, the BOJ will have no choice but to return to more aggressive policy easing to prevent damage to the country’s exporters.
Fiscal stimulus is unlikely and probably counterproductive
Fiscal policy will remain a sideshow. The US tax cuts in 2018 should have proven to everybody that fiscal easing in a late-cycle economy is a highly ineffective use of future taxpayer money. And it should be obvious to most that an infrastructure program in an environment of essentially full employment will only disturb the stable labor market. The lack of faster wage growth, despite extremely low jobless rates, is a special feature of the current business cycle, and it’s chiefly responsible for the inflation undershoot that is fueling the dominance of the policy cycle. Upsetting that equilibrium could prompt central banks to abandon policies that are extremely supportive for markets and set in motion the forces that could bring about the very recession central banks are fighting to avoid.
Policy cycle dominance allows us to forecast stronger growth and lower rates
Our policy analysis highlights why the policy cycle is ascendant. Structurally, lower inflation is forcing central banks to renew more aggressive easing measures despite generally healthy fundamentals. That has been going on for a while, but the ECB’s decision to restart QE is likely to amplify the dominance of policy over macro as the main market driver. That’s why it’s possible for us to have an above-consensus global economic growth forecast, while still expecting more US rate cuts and greater downward pressure on bond yields.
We all have to become election analysts
Finally, there’s the political cycle. It’s normally part of the risk analysis, but we believe it deserves special attention in the coming years. The biggest risk in a world dominated by the policy cycle is a sudden change in policy priorities. And the fastest way to get that is a surprise election result that forces investors to reassess asset quality and prices. That’s what made the last recession a great one: The sudden reassessment of quality and prices of mortgage-backed securities paralyzed financial markets. That’s what we’re looking for when we try to identify the main risks to our outlook.
The biggest such event in 2020 is likely to be the US election. Far gone are the days of business-friendly US economic policy (under either party) having a stabilizing effect on financial markets. The current Republican administration did deliver a corporate tax cut, but the market effect was barely noticeable due to its adoption of more hostile trade policies. At the same time, one of the most pressing economic issues of our time is growing income inequality, which in part is fueling the rise of populist governments around the world. Hence, a change in government in the US could bring with it a major change in policy priorities, for better or worse.
And it’s not just the US elections we’re watching. Europe deserves even more attention in the coming years. In the UK, new elections highlight a more uncertain future while the Brexit crisis remains unresolved. Elections in other European countries in the next few years could bring about a similar clash in economic priorities that we expect will dominate the US presidential campaign. Spain and Italy seem to be in a state of permanent electioneering, with populist anti-EU parties challenging for power in both countries. Germany, the EU’s anchor, faces elections in 2021. Following long-running Chancellor Angela Merkel’s decision to retire, the outcome is highly uncertain. And in France, anti-EU forces could take control in 2022 if the current economic situation doesn’t improve. All of these elections could threaten the EU and the euro, with possibly disastrous consequences if just a few of those elections go the wrong way.
A paradoxical world where downside risks boost markets and upside risks may cause recessions
The risk analysis is dominated by, but not confined to, the election watch. It seems the US-China trade conflict has reached “peak escalation.” Both economies are suffering from a decline in exports. That doesn’t mean trade policy is fading as a serious growth risk. In fact, we remain concerned that the standoff between the US and Europe over aircraft subsidies will open a new front offsetting any improvement that may come from the original one. However, any downside risk to global growth will most likely result in even more central bank easing, which will only elevate the policy cycle’s dominance.
Traditional risk analysis is less important when the policy cycle is in command. Any downside risk that materializes only means more central bank easing. Conversely, any upside risk to growth would diminish market-friendly policy support and could paradoxically hasten the advance of the next recession through a sharp market sell-off.
Battle of three cycles in an extended late-cycle economy
In an extended late-cycle economy with tight labor markets and low inflation, economic growth rates should converge toward underlying potential rates determined by longer-term labor force and productivity growth. But structurally low inflation rates, mainly the result of slowing or negative population growth, are forcing central banks to maintain a significant easing bias, which elevates the importance of monetary policy as the dominant market force. Meanwhile, the ECB’s decision to restart QE should amplify the downward pull on global bond yields, which is forcing other central banks to follow the ECB in a race to zero. It’s an environment where growth will remain lackluster, but we think financial markets can deliver above-trend performance as a result of further policy-induced declines in bond yields.
Global Growth Forecasts
Source: IMF, Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 6 November 2019.