On the revenge of the Phillips curve, growth in the US and China, and risk in the eurozone
Investors have been waiting for inflation to arrive for what feels like an eternity. Even in the eurozone, it feels as though the recovery is well-established and in the US, investors fret that the recovery is getting long in the tooth. Unemployment has fallen to low levels by historical standards and yet core inflation seemingly remains under lock and key. Labour costs have risen, but the inflationary impact has been suppressed somewhat by a cyclical recovery in productivity.
Reports of the death of the Phillips curve (see exhibit 1) have been exaggerated – although perhaps not greatly so. You can find evidence that capacity pressures do put upward pressure on prices in at least part of the consumption basket. So we do expect greater awareness of the Phillips curve in 2019 than has been the case of late. However, the inflationary headwinds of trade and technology are unlikely to abate, so it is too early to talk about revenge.
In our view, recession risks in 2019 are quite low. On the monetary side, assuming inflation remains near the Federal Reserve’s 2% objective, the policy stance will likely remain broadly accommodative until around the middle of the year. Thereafter the move into restrictive territory should be quite gradual in speed and modest in degree.
The tailwinds from tax cuts should fade in 2019, but the bulk of the increases in discretionary spending approved by the US Congress in 2018 still lies ahead.
Exhibit 1: The Phillips curve: historically, the inverse relationship between rates of unemployment and corresponding rates of rises in wages; 2000-2018
Source: Bloomberg, BNP Paribas Asset Management, as at 02/11/2018
Meanwhile, improved business investment has led to a more balanced profile for gross domestic product (GDP), which is an important development given that the housing sector will likely contribute little to growth in 2019. A tight labour market that is lifting real wages should also support consumer spending.
As for downside risks, further escalation in the trade dispute with China would weigh on growth, but if the impact is more severe than anticipated, the Federal Reserve will likely prove quite willing to pause the tightening cycle, while it considers the economic consequences of supply chain disruptions.
The more significant risk is the high level of non-financial corporate leverage. This represents a significant vulnerability should the US economy face any sort of exogenous demand shock.
China’s GDP growth may slow towards a low 6% rate in 2019. With China having turned inward to boost growth to fight the fallout from the Sino-US trade war, it may still be a contributor to world growth, and especially growth in emerging Asia, amid policy normalisation by global central banks and geopolitical volatility.
Evidence of China’s growth contribution can be seen in the year-to-date, growth in exports from emerging Asia (excluding China): the region’s exports to both the eurozone (despite its recent recovery) and the US (despite its robust economy) have declined since early 2018. Only export growth to China has risen and quite strongly. Indeed, shipments to China contributed twice as much to export growth in emerging Asia in 2018 compared with exports destined for the US and the eurozone.
Crucially, China’s imports of global manufactured goods have risen steadily despite the trade war risk began. Data on the level of Chinese imports of goods to be assembled and re-exported show imports have been growing at a steady, roughly 10% for a year now. So re-exporting assembled goods to beat US tariffs is not behind the rise in China’s imports of global manufactured goods.
As long as China’s growth holds up at an annual rate of more than 6%, the country will likely continue to contribute to world growth in 2019.
Expectations that the election of French President Macron would usher in an era of relative tranquillity on the political front with tangible progress on reforms to complete the currency union have proven wide of the mark.
There have been discombobulating developments aplenty: from the independence movement in Catalonia, the election of a radical coalition government in Italy to an unstable grand coalition in Germany, to name but three.
However, the two key political risks in 2019 are likely both external in nature: a disorderly Brexit on the eurozone’s doorstep and an escalation in protectionism on the other side of the Atlantic.