Continuum Economics Q2 2019 Global Outlook (Long Report)

Outlook Overview: Running Into Headwinds

• Chinese policy stimulation, lower oil prices and a pause in Fed tightening are providing a safety net for global growth into early 2019. Nevertheless, there are a number of headwinds that mean reflationary forces do not herald a return to a “Goldilocks” era for economic growth. The economic cycle is maturing in a number of advanced economies, while the adverse influence of high non-financial sector debt/GDP restrains many economies. The interconnected global economic cycle also risks being hurt by adverse shocks in a major region.

• Our central view remains for slowing though still-reasonable global growth in 2019, with core inflation pressures creeping higher in the advanced economies against a backdrop of tight labor markets. The Eurozone (EZ) will merely manage average growth, while the UK remains in the slow lane due to Brexit and a fatigued consumer. Crucially, EM growth will likely be sustained by being in the earlier stage of the economic cycle compared to DMs, plus our view of continued Chinese growth in the 6.0-6.5% region.

• We believe this will ensure that slow DM interest rate normalization outside of the U.S. is maintained. Meanwhile, the Fed will still deliver a couple of hikes. EM central banks can pause tightening in the wake of signs that USD is peaking and due to the short-term effects in 2019 from lower oil prices on headline inflation.

• Our baseline view on U.S./China trade is a modest deal that produces a truce in 2019 into early 2020. Nevertheless, this will not be a full-scale multi-year resolution of U.S./China trade, which has a military and political dimension as well. The U.S. will also threaten Germany and Japan over auto trade, though these should be seen as negotiations rather than a prelude to a new trade war. Trump’s re-election campaign also risks the specter of further trade flare ups into 2020. While we believe this will be manageable in direct economic terms, any sharp deterioration in business and consumer confidence would amplify these adverse trade effects enough to risk a sharper slowdown for the global economy.

• EM countries also need to navigate elections in a number of major countries (Figure 1). India’s election is of the greatest interest, where we expect only a slowing rather than a derailing of Prime Minister Narendra Modi’s reform momentum. We remain most concerned that the election outcomes in South Africa and Argentina may disappoint and slow or stall reforms and hurt financial markets.

• For financial markets we continue to favor rotation within riskier assets from U.S. equities to cheaper- valued EM equities, especially in Asia. The Fed pause, plus slowing Fed tightening in the remainder of 2019- 20, still points to USD peaking in H1. Combined with better earnings growth prospects in EMs, this will facilitate asset rotation. Occasional high-volatility bouts will also be evident, as large-scale investor positioning still exists after the yield suppression from 2009-16, e.g. corporate bond portfolios.

• Risks: A harder landing in the U.S. or China economies would derail global growth, commodity demand and risker asset prices. It would also prompt a switch to a Fed easing cycle and lower government bond yields. The probability of this severe scenario remains low.

Market implications: As discussed in more detail in our Markets section:

• Bonds: U.S. 10y Treasury yields are set to hit 3.00% by end-2019 and 3.20% by end-2020. The peak in U.S. official interest rates in late-2020 will help produce better prospects for total returns in 2020, compared to 2019 or the last few years. In contrast, ECB tightening will likely lift the EZ yield curve, as slow multi-year normalization gets underway.

• Equities: U.S. equities are now more neutral compared to our previous underweight stance, as forward P/E ratios are at more normal levels and can help U.S. equities weather a slowing in earnings growth, though not an earnings recession. We now forecast 2750 for the S&P500 by end-2019. On a one- to two-year view, we are overweight EM equities versus U.S. equities.

• FX: The slower pace of Fed tightening we now forecast reinforces our forecast of a USD peak by mid-2019. USD losses will be small to modest, both as other G10 countries are normalizing very slowly and as EM countries have stopped tightening. EUR’s rise against USD will be slow due to ECB cautiousness, and we forecast EURUSD at 1.17 by end-2019. EM currencies returns will now be split between carry and spot movement, with a slower USD decline versus EM currencies.

• Commodities: Oil prices are set to move higher through 2019, helped by the partial removal of Iran export waivers. Nevertheless, upside will be moderate, both due to resilience of new investment in U.S. shale and as our demand growth forecasts have been lowered for cyclical and structural reasons. We forecast WTI at $58 for end-2019. Elsewhere, a swing toward deficit in the copper market will still produce a move higher to $6700 by end-2019