2018 – the end of easy money?

By Arthur Kamp, Investment economist at Sanlam Investments

The year 2018 has seen growth in the US and the rest of the developed markets (DM) diverge substantially. US real GDP expanded faster than 4% seasonally adjusted and annualised in the second quarter of 2018, while growth disappointed in the Euro area.

Given contained core consumer price inflation, and hence still accommodative monetary policy in DM, continuing employment growth and a relatively favourable company profits environment, the global economic expansion is expected to continue into 2019, albeit reflecting less synchronised growth between countries.

Even so, risks to the medium- to long-term outlook for the global economy are building, given the intended shift towards less accommodative monetary policy in DM, China’s difficult task of deleveraging the economy, while maintaining growth momentum, and the escalation of global trade disputes.

The impact of tariffs on the US

The shift towards US trade protectionism aimed primarily at US imports from China gained momentum in the third quarter of 2018. The US has hiked tariffs on a total of $250 billion worth of imports from China since July 2018. In addition, it is threatening to implement tariff increases on the final $260 billion worth of imports from China, as well as automobile and automobile parts imports. The latter refers to imports worth $360 billion, although a tariff hike is unlikely to include all US trading partners and/or products in this import category. Indeed, by the end of the third quarter of 2018, the US, Mexico and Canada had seemingly reached agreement on a new trade deal, which effectively updates the NAFTA deal of 1994. The ultimate end-game of the unfolding trade conflict remains uncertain, but automobile exports from Europe and Japan to the US may also be exempt from tariff increases.

The import tariff increases are, however, unlikely to improve the aggregate US trade balance. A decrease in the trade deficit would only be likely in the event the tariff is viewed as temporary, in which case consumers may increase their savings and delay consumption. In any event, the US economy is running at full employment and may not have surplus labour resources to grow import-competing industries.

Is US policy sowing the seeds for a downturn?

There is also risk lurking in US fiscal expansion. US policymakers expect tax cuts to increase economic growth materially, which, in turn, is expected to lift taxes sufficiently to limit fiscal deterioration. However, fiscal multipliers tend to be smaller at full employment. Moreover, the tax cuts have been accompanied by significant government spending, implying a marked increase in the US federal deficit is likely.

On balance, the unfolding change to US macroeconomic policy may be sowing the seeds of the next economic downturn.

It’s not just the US that is tightening controls

A notable development on the monetary policy front in 2018 is the upward shift in market participants’ expectations of the future path of the US policy interest rate. At the same time the expansion of G4 central bank balance sheets is drawing to a close. This is a material development considering that, in aggregate, the assets of these central banks increased by around 30% of G4 GDP since the global financial crisis. The nascent shift towards tighter global financial conditions was accompanied by a keener focus on emerging market (EM) economic fundamentals in the third quarter of 2018 ‒ notably countries with excessively loose fiscal policies and external financing needs due to weak balance of payments positions.

The US Federal Reserve Open Market Committee (FOMC) is mindful of the risk posed by the country’s low unemployment rate (3.7% in September 2017) to wage growth and inflation expectations. Accordingly, the FOMC, which raised the target range for the federal funds rate by 25 bps to 2% to 2.25% on 26 September 2018, due to ‘realised and expected labour market conditions and inflation’, continues to signal further interest rate hikes into 2019.

Similarly, the Bank of England (BoE), which raised its bank rate 25 bps to 0.75% in early August 2018, argues that the UK economy is operating at close to full capacity and, therefore, also continues to signal a gradual interest rate hiking path.

Brexit is complicating life for policymakers in Europe

Emerging concern that the UK government and the European Union (EU) may not, after all, reach an amicable agreement before 29 March 2019 on trade and political relations has, nonetheless, complicated the outlook for monetary policymakers. Should the UK exit the EU with no deal approved, downside risk to economic activity would ostensibly increase as external trade reverts to World Trade Organization rules, regulatory uncertainty increases and a probable decline in confidence impacts investment spending adversely. Accordingly, the BoE’s Monetary Policy Committee has left room should it need to diverge from or alter its intended interest rate hiking path by indicating the economic outlook ‘could be influenced significantly by the response of households, businesses and financial markets to developments related to the process of EU withdrawal’.

Elsewhere, at the conclusion of its September 2018 meeting, the Governing Council of the European Central Bank (ECB) indicated it expects the key ECB policy interest rates to remain at their current level ‘at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path’. However, the Council also signalled that its asset purchases would end in December 2018 ‘subject to incoming data confirming the medium-term inflation outlook’.

The end of ‘easy’ global financial conditions

On balance, 2018 is likely to be the final year in which quantitative easing (QE) programmes expand the aggregate G4 central bank balance sheet. And, together, the increasing federal funds target rate and the reversal of the G4 QE programme signal the onset of significant tightening of global financial conditions.