The headwinds to US growth in 2020 have died down for the most part, leading us to expect the economy to grow at around the historical longer-term rate of 2%. This means that the Federal Reserve will be much less likely to cut interest rates further this year.
- Inflation is not much of an issue
- Milder central bank tone supports the economy and financial assets
- Watch list includes trade, the elections and… Brexit
Recent inflation developments
On the inflation side, there is little news to report. After three consecutive strong data releases for core CPI in the third quarter, the fourth quarter brought only relatively soft outcomes. Core CPI retreated slightly on a year-over-year (YoY) basis, from 2.4% to 2.1%.
The Personal Consumption Expenditures (PCE) measure – the inflation gauge favoured by the US Federal Reserve – also fell back: from 1.76% YoY in August to 1.62% YoY in November. A-cyclical items (as per the San Francisco Fed’s classification methodology pulled it lower). The data suggests that cyclical pressures are continuing to drive inflation up, but this is offset by falls in a-cyclical components.
Exhibit 1: Pro-cyclical components are pushing overall inflation higher, but non-cyclical inflation is cancelling out this effect – the graph shows muted inflation at the core (ex food and energy) level
Source: Bloomberg; December 2019
Monetary policy developments
After lowering policy rates in July and September, the Fed cut rates once again in October. However, policy was left unchanged in December. For the first two rate cuts, the central bank had emphasised that it viewed these as a ‘mid-cycle adjustment’ and ‘insurance cuts’ intended to protect the economy against any downside risks from the trade dispute with China.
Investors had reacted poorly, interpreting the comments as signifying a reluctance to embark on a full rate cutting cycle if needed. The Fed was therefore more careful in September and October. It stated rates could be cut further if evidence supporting a ‘material reassessment of the outlook’ emerged. It noted that on balance, the risks were still tilted to the downside. In December, leaving rates unchanged, the Fed referred to ‘global developments and muted inflation pressures’. This suggested rate cuts were still more likely than increases.
Developments in the Treasury and inflation protection markets
These adjustments to the Fed’s tone provided support for the economy and financial assets. The 75 basis points of rate cuts helped to hold down Treasury yields and mortgage rates, while continuing to back housing activity. A dovish Fed, better data and renewed optimism on a trade deal pushed the equity market to highs.
Changes to our outlook
Early in 2020, we take stock of developments and reassess the key risks to growth over the next few months.
- The US-China trade dispute has simmered down (for now). Focused on Chinese imports of agricultural goods, the ‘phase one’ deal should help to reduce the US trade deficit. But narrowing the trade imbalance will not address the US’s strategic concerns around technology transfer, intellectual property theft and market access. We expect little progress on these matters in 2020, while re-escalation remains possible.
Even if no escalation occurs, it should be noted that tariffs act as a tax on US consumers (who import finished goods) and US producers (who import intermediate goods). Some economists are warning of a scenario where existing tariffs hurt both business profitability and consumer purchasing power. In turn, this would hit consumer confidence, business investment and hiring.
We note that import volumes have fallen dramatically for goods subjected to tariffs, while there is scant evidence of substitution by domestic producers. Clearly, retail sales data should be watched closely for evidence of a pullback by consumers. However, higher asset prices and strong employment gains could well provide a sufficient offset to tariffs.
- The slowdown in Chinese growth appears to be bottoming out and stabilising as the authorities undertook monetary easing to stabilise the economy while keeping an eye on financial stability concerns.
Our China economist, Chi Lo, judges that the central bank’s ‘selective easing’ stance, and financial system reforms, have likely been successful. Production of consumer goods such as cars and cell phones is recovering. And credit growth and infrastructure investments are at levels that should permit GDP to grow at a 6.1% pace. A stabilisation of Chinese growth would, of course, reduce a key downside risk to global growth.
- The US Democratic primaries pose a significant risk for equity investor confidence in the coming weeks. The nomination of a relatively left-wing candidate (most likely Elizabeth Warren) could concern markets, given her proposals to implement higher corporate taxes and redistributive income and wealth taxes to fund enhanced healthcare and education entitlements.
We caution, however, that the nomination of a left-wing Democrat could be self-defeating – UK voters roundly rejected Jeremy Corbyn in the most recent election. We believe the American voter could react similarly to a Warren or Barry Sanders presidency. In our mind, the more centrist Joe Biden is the candidate with the best chance of denying President Trump a second term. He would be the less disruptive Democratic candidate for financial markets.
- After a convincing UK election victory by the Conservatives, the UK will leave the EU on January 31. However, with further extensions to the transition period beyond 31 December 2020 ruled out, the risk of a ‘hard’ Brexit appears to be merely postponed. The UK must now complete a trade deal with the EU by the end of 2020 to avoid leaving the EU on WTO terms. However, it is our view that the potential for disruption from Brexit – even no-deal Brexit – has been diminished as companies and governments have had the opportunity to plan. We do not see it as a major threat to global or US growth at this point.
Overall, we conclude that the headwinds to growth in 2020 have likely died down versus our assessment in the previous quarter. Correspondingly, we now forecast 2020 growth at around trend (i.e. around 2%).
This more constructive growth outlook, of course, means that we view the Fed as much less likely to cut rates further – although the risk on rates remains tilted to the downside. The Overnight Index Swap market is currently pricing around 25bp of cuts by October 2021. That seems broadly reasonable to us.
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