Head of Macro Analysis
Summary: Evidence is mounting that we're edging inexorably closer to another recession and to make matters worse, it'll be deeper than currently expected.
A last-minute trade agreement after a new Trump-Xi meeting
It is rather a gloomy update on the global economy that we provide today. We still expect a trade agreement between the US and China (however, not covering all the issues). The likelihood that this happens before the Chinese New Year (February 5) has decreased over the past few days. The negotiations are continuing smoothly: China has made many gestures in favour of an agreement, especially by pledging to buy up to 7 million tons of US wheat, and the summit meeting on January 30 and 31 in Washington between the Vice Premier of China and the US Treasury secretary is a clear positive signal that has been well-noticed by investors. However, based on decades of US-Chinese talks, it seems more and more likely that the US and China could wait for a last-minute deal, to get the best deal they can. To make it happen, a new Trump-Xi meeting could be needed by March 1 (which corresponds with the end of the 90-day trade truce) to resolve the last outstanding areas of divergence. Such a deal would not solve all the issues – we firmly believe that the next battleground of the Cold War will be the frontier technology and notably the 5G – but it could bring welcome short-term market relief.
Small open economies are sending a very worrying message to markets
In the meantime, risk factors are increasing, especially on the macroeconomic front, which means that the month of February could still be tricky for financial markets. Looking at small open economies, such as South Korea and the Nordic countries, which serve as a good proxy for global trade and the global economy, we see warning lights popping up almost everywhere. Q4 2018 was a very negative quarter for economies highly dependent on trade. South Korea, which is a window on the Asian economy and especially China, saw industrial output sink 1.7%, a deeper contraction than expected by the consensus. As it leads global industrial production (excluding the US) by roughly four months, we know what we should expect for Q1 2019 in terms of industrial production. Looking at Japan (a much bigger economy but a good barometer of global trade), the outlook is even worse. December exports decreased by a stunning 3.8% YoY versus -1.8% expected and Japanese exports to China are even down -7% YoY. There is little doubt that 2019 data will be much more disappointing that anyone expects unless we get fast a policy response to offset the ongoing slowdown.
The slowdown will be longer and deeper than the consensus expects
As we all know, there is no such thing as global decoupling. Unsurprisingly, headwinds are also starting to hit Europe and the United States. The euro area OECD leading indicator, which is designed to anticipate turning points in the economy six to nine months ahead, has fallen sharply over the past few months, led by Germany and France. The year-on-year rate experienced quite a swing over 11 months: it started the year 2018 at 0.5% and it now stands at minus 1.4%, the lowest level since October 2012, when the euro area was in the middle of the sovereign debt crisis! We notice big declines in the industrial production data for the main European economies but our more negative view concerns Germany, which accounts for one third of European industrial activity. Q1 2019 should be gloomy due to low sentiment in the automotive industry, China and decreasing credit impulse. The only hope is that the expected rebound in consumption in Q2 will strengthen economic activity.
Though less worrying, the outlook is also deteriorating in the United States, before even we can assess the impact on the economy of the longest government shutdown in history. The US OECD leading indicator is also falling. The year-on-year rate is now in contraction at minus 0.4%. Interestingly, looking at the NY Fed’s recession-risk model, which has just been updated, it seems that the risk of recession has substantially increased in the space of three months. It was at 14.1% in October; 15.8% in November and jumped to 21.4% in December, which is the highest level since summer 2008 as you can see in the chart below.
Unfortunately, a rebound in activity is very unlikely, which means, in our view, that they will stay in “wait-and-see” position for a prolonged period of time as slower growth will be longer and deeper than the consensus expects. We should very soon get more dovish signals from policymakers in February as Draghi and Powell will testify respectively before the EU Parliament and US Congress. The next step for central bankers will be to assess possible policy responses in a world of constraints to stimulate the economy. The bright side is that they are clearly not running out of ammunition.