30 November 2018
US: As good as it gets?

The US continues to perform strongly and wages are finally gathering pace. But protectionism and a weakening global outlook are significant risks for 2019 and the cumulative effects of Federal Reserve interest rate increases, fading support from the fiscal stimulus and the stronger dollar will contribute to a slowing in growth

Strong economy, for now

Ten years on from the global financial crisis and it is safe to say that the US has come out in a far stronger position than most other major economies. Output is up 23% from the 2009 trough, while there are over 20 million more people in work. Inflation is broadly consistent with the Federal Reserve’s mandate, interest rates have been increased, the central bank’s balance sheet is being run down and the dollar is in the ascendancy. 2018 has been a particularly good year, with the US economy likely expanding at the fastest rate for 13 years and the unemployment rate falling to a 49-year low. The key question for markets, as underlined by recent equity weakness, is how long can this continue?

In the near-term, the story remains very positive. There is broad-based momentum in the economy with huge tax cuts providing additional thrust. Given this environment, the Federal Reserve chose to raise its policy rate corridor in each of the first three quarters of the year with another rate rise looking highly probable in December. After all, the economy is booming, inflation is at or above the 2% target on all the key measures and the jobs market is finally generating wage pressures.

Growth momentum remains strong with the Federal Reserve set to raise rates again in December

However, the US economy will face increasing headwinds in 2019 as the lagged effects of higher interest rates and a stronger dollar act as a brake on activity. The support from the fiscal stimulus will also gradually fade, with the split Congress mid-term election results limiting the chances of additional significant tax cuts or spending increases. Then there is the weaker global growth outlook, with Europe and Asia seeing clear signs of slowdown. Intensifying trade protectionism could exacerbate the softening trend.

Recent Federal Reserve comments have acknowledged these external risks, although officials, in general, remain broadly upbeat on the domestic US story. Still, we see some signals that are potentially troubling. The housing market has been the most notable area of softness, which is understandable given 30Y mortgage rates are close to 5.2% right now – the highest for eight years. Home builder confidence has fallen quite significantly this year while the number of transactions has fallen gradually over the past 18 months. This suggests that construction activity will be a drag on growth in 2019.

Rates: Why EU angst is prompting talk of topping out

European politics, namely Brexit and the dispute between Italy and the EU, is keeping a lid on US 10-year rates. Though we may not have seen market rates peak just yet, the bulk of rises in long-term yields are likely behind us

Peak US 10-year rates?

We identify some diverging issues in play when it comes to core rates. First, our model for US 10-year rates continues to pitch fair value at between 3.4% and 3.9%. But second, some technical indicators are describing the 3.25% level hit by the US 10-year as the structural peak. In addition, the richening of the 5-year area of the curve that started about three weeks ago has historically been an end-of-rates-hike-cycle lead indicator.

FX: Patiently waiting on the peak

As 2019 progresses, expect to hear more about a Fed pause. US market interest rates typically turn lower before the top in the Fed cycle. And if we’re right about our call for a Fed peak in the third quarter, we suspect that undervalued risk assets can breathe a sigh of relief and the dollar will embark on an orderly sell-off

It is too early to call a top in the dollar. The Fed is now in the realm of late-cycle tightening and should deliver four more hikes. Dollar hedging costs will remain extremely expensive and, barring a US-centric shock, we would expect to see marginal new dollar highs against the euro and the Japanese yen over the next six months.

As 2019 progresses, expect a bearish dollar narrative to develop. US rates should be coming off their highs by the end of the year and as US growth converges lower on the rest of the world, expect investors to rotate out of US asset markets. A search for alternative sources of stimulus may also see the White House favour a weaker dollar.

Europe has been a big disappointment in 2018. Though sluggish growth has been blamed on a relentless stream of ‘one-off factors’, it is hard to see a significant pick-up in activity next year. EUR/USD will struggle to make it above 1.20 as the ECB barely lifts rates off the floor. European Parliamentary elections in May will also be in focus.

A lower EUR/USD in the early part of the year is typically not good news for CE4 currencies. The good news is that the Hungarian forint and Polish zloty are already undervalued, while the market’s favourite villain – the Romanian leu – is too expensive to sell. The Czech koruna should hold gains.

On Brexit, UK parliamentary approval of the Withdrawal Agreement may not be seen until February. Even if the deal is passed, 2019 is unlikely to look pretty as both the UK and the EU struggle to define what the ultimate relationship should look like. Expect the pound to continue to trade on volatility levels more common in emerging markets.

For EM, the gales blowing out of the US look set to continue through early 2019. Add in declining world trade volumes and rising late-cycle volatility and the EM environment looks challenged. But EM currencies have already discounted a lot of bad news. If they can survive the first half, modest rallies should be seen later in the year.

Within the EM space, we see China’s renminbi steadily weakening all year as the economy adjusts to the US trade agenda. Our USD/CNY target is 7.30. In theory, a softer environment for crude oil prices in 2019 – we see Brent trading more in the US$60/bbl area than the US$70/bbl area – should be good for Asia. Assuming the Indian rupee can survive elections in May, central bank tightening in 2H19 should allow the currency to take advantage of the softer dollar story.

The big beasts of Latam, Brazil’s real and the Mexican peso, will continue to see substantial volatility as investors adjust to the new political reality. Argentina aside, better external accounts, low inflation and faster GDP growth suggest more resilience in the region. However, Brazil’s ability to pass fiscal legislation will very much set the tone early next year.

China: Rough seas in 2019

The Chinese economy is set to slow down in 2019. The most likely scenario is an escalation of the US-China trade conflict, hurting exporters, manufacturing and logistics services. Pressure from trade and investment partners will also intensify

Escalation of the trade dispute is the key risk to China in 2019

2019 will be a difficult year for China in terms of economic growth and the increasingly tricky political relationships with its trading partners.

An escalation in trade tensions is the key risk to China in 2019 – and this seems like the most probable scenario. This will hurt exporters, manufacturing and logistics services, therefore slowing economic growth directly.

Indirectly, the bilateral trade conflict between China and the US has resulted in multilateral trade and investment disputes. This is exacerbated by international voices blaming the Belt and Road Initiative as a debt pile-up exercise for poorer economies. It has become more difficult to maintain existing relationships with trade and investment partners. The recent APEC meeting showed these economies having difficulties positioning themselves between China and the US.

Japan: Ready to bounce back

Economic growth in Japan contracted in the third quarter, hit by extensive damage from typhoon Jebi. But the doors are now open for a fourth-quarter bounce back as the post-typhoon clean-up spurs economic activity

Jebi wreaks havoc on 3Q18 GDP figures

Typhoon Jebi made landfall over Shikoku and then the Kansai region of South Eastern Japan on 4 September, before tracking North West in the direction of Taiwan and Far East Russia. Jebi was estimated by one source as being the most powerful storm on the surface of the planet so far in 2018. It was the most intense tropical cyclone to hit Japan since Typhoon Yancy in 1993. 

At peak intensity, Jebi was a Category 5 super Typhoon, with sustained wind speeds of 195km/h, and gusts of 280km/h.

UK: Three Brexit questions for 2019

The immediate question for the UK in 2019 will be whether the government can gain approval for its Brexit deal. A defeat seems highly likely in December, but in the absence of an election or fresh referendum, we feel a fudge can still be found to avert ‘no deal.’ Focus will then turn to full-blown trade talks with the EU, which may take several years to complete

For the UK, 2019 looks set to be a year of two very uncertain parts. The most pressing question before March is whether Parliament will get behind a plan to avoid the economically risky ‘no deal’ scenario. If that happens - and ultimately we still think a fudge can be found – then focus will turn to starting trade talks. We’ll take a look at these issues in turn.

Eurozone: Diminishing expectations

While the eurozone’s third-quarter growth was negatively affected by special factors, the rebound in the fourth quarter has so far been rather muted. So although the European Central Bank is still proceeding with its exit policy, the chances of a 2019 rate increase are diminishing

More political uncertainty

Things have been moving on the political front in Europe. A deal on Brexit has been reached, though its approval in the UK parliament is not yet guaranteed, meaning that uncertainty could still linger in the run-up to 29 March 2019 and the turbulence of a hard Brexit can still not be dismissed entirely.

In the eurozone, French President Emmanuel Macron and German Chancellor Angela Merkel have taken the surprising step to follow-up on previous agreements and establish a eurozone budget. This could be a major step forward to solidify the structure of the eurozone. However, when looking at the details, the intention seems more important than the substance, because what is on the table now so far lacks the muscle to smooth asymmetric shocks within the bloc. On top of that, a number of member states, the so-called New Hanseatic League, under informal leadership of the Netherlands, are eager to block any European initiative that has the faintest whiff of debt mutualisation in it.

So in the short run, the promised further deepening of eurozone integration will remain limited to making the European Stability Mechanism (ESM) a financial backstop for bank resolutions and probably a very tiny, though symbolic, eurozone budget. The latter will be larded with good intentions but with little commitment to finalising a banking union, morphing the ESM into a European Monetary Fund, eurozone revenues or pooling of debt. As a consequence, the solidity of the Monetary Union could be tested again, once economic growth falters.

In the meantime, there is a new episode in the Italian story. After looking at the Italian budget plans the European Commission concluded that “the debt criterion …should be considered as not complied with, and that a debt-based Excessive Deficit Procedure is thus warranted”. This will have to be approved by the Council, probably in January. After this time, Italy will have between three and six months to put corrective measures in place. This means that a judgment on Italy’s efforts may not be made until after the European elections, and even then, a final judgement is not strictly necessary.

Fortunately, the Italian government has realised that higher bond yields are now also seeping through into bank lending rates. In talks with the European Commission, the Italian government has suggested that there is no urgency to implement all of its plans immediately. The conciliatory tone might push bond yields down somewhat although this doesn’t alter the fact that most of the government’s measures will do little to improve Italy’s growth potential. Another piece of comfort for the markets is the fact that in the latest Eurobarometer (survey taken in October), support for the euro in Italy actually increased by a whopping 12 percentage points to stand at 57% (against 30% detractors). 

Reading time around 11 minutes

December Economic Update: Avoiding Hard Choices

Early signs suggest that 2019 will see lower global growth. Markets have recently been unsettled by US monetary tightening, trade protectionism, unseasonal weather and emerging market troubles. But looking ahead, there are potential upside surprises as well. Read more in our latest economic update

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