We are halfway through the worst part of the business cycle, in our view. Activity is weakening, inflation is rising, the market correction we have seen is not enough to change the bias of policy makers, and these conditions are likely to remain in place throughout the first half of 2019E, we believe. Inflation is likely to peak in the first half of next year.
The key ingredients of the economic downturn are the continuing US monetary tightening and the erosion of purchasing power of households globally. The former, in our view, is likely to push the 10-year Treasury to 4% next year, weighing on US demand, as well as on emerging markets’ funding and growth. The latter is more subtle, but harder to stop. The overall cost of living is understated by CPI, as the index cannot capture the dynamics in the housing market, nor the faster depreciation of a growing number of items, nor can it pick up more complex pricing strategies supported by big data. Wage growth is underwhelming, given the exceptionally low unemployment rates everywhere, and credit is no longer as easily accessible as it used to be, so consumers’ balance sheets are being squeezed.
In our view, there is downside of approximately 1ppt to the 2019 Bloomberg consensus forecasts for real GDP for the Eurozone and the US, and strong downside risks for US growth in 2020E. Our projections signal a sharp downturn, but not outright negative GDP as, in our view, policy makers are likely to react strongly to avert a protracted contraction. However, the risk that the policy response proves too small or too late is significant. Equally important is that the timing of the economic downturn would be delayed, but not averted, if the Fed stops the monetary tightening completely in December. The erosion of the income of the majority of households is a process that will not stop in the current industrial structure and policy mix.
There are three very important mega trends that are likely to remain in place in 2019E and beyond, regardless of how the business cycle unfolds in the next two years.
First, European wage convergence is a multi-year mechanism that is lifting living standards in central Europe, while depressing those in the lower and middle income segments in France, Italy and Germany.
Secondly, the distribution of corporate profits is becoming more skewed: big and super-large companies are becoming more profitable structurally, while small- and medium-sized companies are having a hard time keeping up. This depresses the potential GDP growth everywhere by reducing employment and investment, and thus has long-term implications for the sustainability of housing market valuations. The combination of points 1 and 2 supports the shift of voters’ preferences towards non-traditional parties. So, “populism” is here to stay.
Thirdly, the historically low policy rates are likely to remain in place for another decade, in our view. We expect the Fed to cut rates in 2020 and halt the narrowing of its balance sheet, while the ECB is likely to restart QE. Also the EU Finance Ministers will need to come to terms with some form of coordinated fiscal stimulus.