Mounting pressure from higher dollar funding costs and trade tensions

Our central scenario does not foresee a major downturn over the next year or so, only some deceleration in world economic growth. The balance of risks is nonetheless becoming less favourable, owing to tighter US monetary policy and the escalating trade dispute between the two economic powerhouses. A progressive reduction of portfolio risk is thus warranted, towards a more neutral positioning.

As we enter the final stretch of 2018, the economic and financial picture remains globally positive. Rising employment is supporting domestic demand across all regions. Even trade volumes are still running at a decent pace. Some clouds are, however, gathering on the horizon – headwinds to the 2019 cyclical outlook.

First is the US interest rate cycle, which is ultimately the only monetary cycle that matters given the dollar-centric nature of the global financial system. Strong US growth momentum, a very tight labour market and inflation now at the target level make the Federal Reserve (Fed) unlikely to deviate from its pledged rate tightening path, with one further hike planned before the end of this year and three in 2019 (see chart I, page 04). The Fed will also continue to normalise (i.e. reduce) its balance sheet, adding to the stress inflicted on the more vulnerable economic actors. Emerging countries with large currency mismatches and highly leveraged companies are most at risk, as has been obvious for some months already. Note in the latter regard that the total liabilities of the non-financial corporate sector neared a record high at the end of 2017, and currently well exceed the peaks that preceded the past two economic downturns.

The other main cause for concern is the trade dispute between the US and China. Just as progress was being made with other US trade partners, such as Mexico, Europe and Japan, the confrontation with China has taken a nastier turn. September saw the Trump administration announce a 10% tariff on the vast majority of the initially-identified USD 200 billion Chinese products, to take effect almost immediately (see chart II, page 04). The scope of this measure exceeded expectations, even if the level of tariff was lower than could have been feared – limiting the immediate negative impact on financial markets. That said, the initial 10% rate could rise to 25% in January, if no compromise is reached in the meantime. President Trump also again threatened to impose tariffs on a further USD 267 billion of Chinese goods in the event of retaliatory Chinese action – which of course occurred.

We see no rapid resolution of the US/China trade dispute. In the US, mid-term elections look set to bring about a divided Congress, with the Democrats winning back the House of Representatives and the Republicans holding on to their Senate majority. But even if the Democrats manage to gain control of both houses, they would not have the votes to overturn President Trump's signature economic policies: stimulus, deregulation and protectionism. Not to mention that the Democrats would have little reason to become fiscally conservative and are traditionally more aligned with the President's protectionist views than some of the more old-fashioned Republicans. So, whatever the outcome of the midterm elections, there is little in the US that could get in the Trump administration's way as pertains to its dealings with China.
 

On the Chinese side, we very much doubt that currency devaluation will be actively used to counter US tariffs. This is not to say that the yuan could not be allowed to depreciate somewhat relative to the dollar, while remaining broadly stable versus the basket of currencies against which it is managed (see chart III, page 04). Letting market forces weigh on the currency would clearly help mitigate the impact of US tariffs on the Chinese economy. A sustained yuan depreciation would, however, undermine Chinese policymakers' rebalancing efforts in favour of domestic activity, increase financial sector risks and trigger capital outflows. Rather than a repeat of 2015, we thus expect adjustments at the margin and continued volatility.
 

With President Trump unlikely to drop the issue and China reluctant to back down, odds of a near-term trade agreement are low, even if additional rounds of negotiations take place in coming weeks. Our base case continues to be that a full-blown trade war will be avoided, given the economic costs involved – but probably only after some of these costs have started to materialise. Put differently, some escalation of the conflict is to be expected before an eventual compromise can be reached.
 

The resulting slowdown – but not collapse – in Chinese and US growth will weigh on the global economic trajectory next year. For China, we currently project GDP (Gross Domestic Product) expansion of 6.3%, slightly below the 6.5%+ pace of 2018. And in the US, where the effects of fiscal stimulus will also begin to wane, growth should slow to around 2.5%, versus the 3% to be posted in 2018. Other regions should, however, hold up better. Japanese cyclical conditions appear stable and sustainable. And there might even be a slight pickup in Eurozone growth (and inflation), given the robustness of internal demand and positive “export-switching" effects. For, no matter what President Trump would like, the US are simply unable to immediately source all their needs domestically.

Note: Unless otherwise stated, all data mentioned in this publication is based on the following sources: Datastream, Bloomberg, Lombard Odier calculation.