The global economy started to slow in the latter part of 2018 and forecasts for 2019 have been revised down as a result. In many countries, unemployment is at record lows and labour market shortages are beginning to emerge. But rising risks could undermine the projected soft landing from the slowdown. Trade growth and investment have been slackening on the back of tariff hikes. Higher interest rates and an appreciating dollar have led to an outflow of capital from emerging market economies, weakening their currencies as a result. Adding to this, monetary and fiscal stimulus is being progressively withdrawn across the developed world.
Looking ahead over the next twelve months, trade tensions between the United States and the rest of the world, especially China, represent the main downside risk to the outlook. It is still not clear how this will play out, but recent comments from both US and Chinese officials have sounded a more conciliatory tone, which hopefully will lead to a satisfactory resolution to their differences. In Europe, political risks remain elevated in the form of a potential “no-deal” Brexit, a populist government in Italy and weakened German leadership. In practical terms, the European political year will turn on May 23-26, when the 27 member states left in the EU after Britain’s exit will elect a new, slightly smaller European Parliament. About half of Britain’s seats will be distributed among the remaining members, the rest will simply vanish, reducing the size of parliament from 751 seats to 705. The election and its aftermath will be between old and new forces, with every chance that the new “Italian style forces” will win the day, which could have implications for the conduct of fiscal policy going forward.
Meanwhile, Brexit remains as uncertain as ever. Two-and-a-half years after the referendum, we are still none the wiser as to how things will play out in the end. The likeliest scenario (though there are plenty of other potential outcomes) is that UK parliament will eventually vote through a soft Brexit option. For all her rhetoric about no deal being better than a bad deal, May and other EU leaders have always known that to leave without a deal would be highly damaging for all. The European economy has faltered. An acrimonious Brexit would be irresponsible at a time of increasing geopolitical tensions globally.
All of this of course has implications for monetary policy around the world. The Federal Reserve raised interest rates in December for a ninth time in its tightening cycle, but future rate-hikes are likely to be data dependent. It’s a case of less rather than more at this stage, with the US central bank taking a cautious stance from here, as it tries to avoid the risk of putting the world’s largest economy into recession by hiking too much. At the end of the day, further rate-increases will all boil down to what happens on the trade talks front and how the US economy performs as a result.
Elsewhere, the European Central Bank has ended its bond-buying programme, but will continue to reinvest the dividends from its existing bond holdings for some time to come. The ECB continues to signal that it intends to raise interest rates towards the latter part of the year, but it is hard given signs of a slowdown in Eurozone economic activity, and with “core” inflation well contained, to see an increase in 2019. We continue to believe that ECB President Mario Draghi will leave office in October, without having overseen a rate-hike in his eight-year term in office. In the UK, the Bank of England would like to raise rates again given the pick-up in wage inflation, but is unlikely to do anything until there is greater clarity on the economic impact from Brexit. At most, we see no more than one rate-increase in 2019, most probably in the final quarter of the year.
From a currency perspective, we think the dollar will lose some of its shine in 2019 as the Fed brings a halt to its monetary policy tightening. Sterling will be the big winner if as we expect the UK leaves the EU with a soft Brexit while the euro despite economic and political concerns, will likely out-perform against the dollar but under-perform against the pound.
All in all, 2019 promises to be a challenging year for financial markets on both the economic and geopolitical fronts, but if the monetary/fiscal authorities adopt a prudent approach to policy, then there is every chance that risk-on assets will prosper.
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