Today, I focus on risks to the global economy and the financial system in 2019. We expect the world economy to pick up speed from Q2 onwards, which financial markets appear to price in currently. However, our call hinges on several assumptions: (1) the US and China reach a trade deal in H1, where the latest developments support our view (see here), (2) the Eurozone growth slump since Q3 18 is due to trade war worries, oil price rises and bottlenecks in the German car sector. Eurozone growth is set to recover during 2019, (3) a no-deal Brexit is averted. Moreover, even if there were a no-deal Brexit, it would have limited spill over to the Eurozone, (4) no Italian debt-crisis over the next one to two years and (5) no black swans. What if we are wrong? How bad could it be?
First, let us take a step back and look at the typical causes of a financial crisis or economic downturn. Every financial crisis is different, which make them so hard to predict. The outcome of a crisis depends on fundamentals, confidence and the policy response, which are also difficult to predict. However, most financial crises are preceded by similar patterns. A major credit boom, a substantial increase in asset prices and a sharp rise in leverage typically precipitate a financial crisis, with the financial system and in particular banks at the epicentre of systemic risks. Moreover, fragilities in the balance sheets of households, corporations and governments often prolong and deepen a crisis. Sharp increases in inflation due to rising input costs, e.g. the oil price, may cause a large economic downturn. Contractionary monetary and fiscal policies could trigger a recession.
How do the typical causes of crises and recessions compare with the current risks to the world economy? A full-blown trade war between the US and China could trigger a sharp increase in input costs, dampen investments and tighten financial conditions. The IMF has analysed this in detail, assuming that the US imposes a 25% tariff on all imported cars, which Trump threatened to do last year (see p. 33 here). In the analysis, the fund incorporates the hit to business confidence, tightening of financial conditions and likely policy responses. The IMF estimates that the total hit to China’s economy would peak at 1.6%. For the US, a full-blown trade war would shave off up to 1%, while the hit to the Eurozone would be around 0.5%. Hence, a full-blown US-China trade war and the US imposing tariffs on cars would have substantial negative implications for both China and the US. However, according to the IMF it would not push the economies into a recession.Hence, a full-blown US.
I am more worried that an escalation of the trade war could damage an already weakening Eurozone. The weakness in Eurozone exports in H2 18 dragged down domestic demand. What if the slowdown continues? In that regard, I am concerned about the combination of structurally low growth and high government debt in several large Eurozone countries. In highly indebted Italy and France, the percentage of government debt to GDP was roughly flat during the Eurozone boom years from 2015-18 (it actually rose in France). During the same period, the average nominal growth rates in Italy and France were 2.1% and 2.2%, respectively. On Friday, Bank Italia warned that Italy might have stumbled into recession in Q4. Meanwhile, France has a very modest buffer as growth dropped to 1.4% y/y in Q3 18, while the manufacturing PMI is below 50. We forecast Eurozone growth at 1.5% this year driven by a rebound in exports and solid domestic demand. However, if some of the risks I discuss here materialise, growth could in my view fall to, say, 0.5%-1.0%. In this case, Italy is doomed as it is set to fall into recession, putting renewed pressure on its fiscal situation. At its upcoming monetary policy meeting this week, we expect the ECB to state that risks to growth have shifted to the downside from its current assessment of balanced growth risks (see here for details). The ECB has other measures in its crisis arsenal (see here). However, I believe the bar for e.g. restarting QE or cut interest rates is very high.
On Brexit, we believe the overall damage to growth for the European economy of a no-deal Brexit would be relatively modest. However, in the case of a no-deal Brexit, slowing growth and falling house prices in the UK are set to hit its financial system hard. This could have kneejerk negative repercussions for the financial system in Europe, given the size of the UK’s financial system and its interconnectedness with European banks. Over time, financial hubs in the Eurozone could benefit from a no-deal Brexit, but I do not believe that will be the immediate impact. Finally, a US corporate debt crisis or a financial crisis in China are low-probability events, but would have devastating consequences. However, those events are hardly unpredictable and therefore do not classify as black swans, although we should monitor the risks and the possible repercussions.
In closing, we have a positive view on the world economy and financial market performance this year, but risks are substantial. That was all for today’s comment. I wish you a great Sunday night and coming week, best regards, Thomas.