Risk factors, Macroeconomic context and forecasts - April 2018

Central scenario (70% probability): global growth is stabilising.

• Global resynchronisation: Despite the recent financial turmoil, global growth is expected to remain strong in 2018 and 2019. Surveys remain at high levels and their recent deterioration does not signal a reversal of the cycle. The advanced economies (with the notable exception of the UK) will continue to experience above potential growth. The major emerging economies will also continue to grow at a sustained pace. The ongoing rebalancing in China is progressing quietly – such that the slowdown appears to be under control. The recovery in most economies is being driven by domestic demand, and we note a recovery in investment in many regions (US, Europe, Japan, Asia). The synchronous nature of the global recovery makes it more robust.
• World trade: world trade recovered strongly in 2017 (+ 5% yoy). It has so far been stimulated by the resynchronization of the global cycle and investment in capital goods. The protectionist measures announced by Donald Trump on steel and aluminium (tariff increases) will lead to retaliatory measures (from EU and China in particular) that are theoretically damaging to trade. However, it should be noted that the products that are targeted account for a small share of world trade and partner retaliation is targeted at a few products. We continue to expect a slight decline in the world trade to global GDP ratio in 2018 (i.e., trade growth slightly below that of global GDP). The probability that protectionist tensions will degenerate into a real global trade war is low (see risk scenario).
• United States:  growth remains firmly anchored. Surveys still point to GDP growth above potential. The fiscal stimulus voted in December, combined with the bi-partisan plan to increase public spending, will extend the duration of the US cycle. No recession to fear neither in 2018, nor in 2019.
• Eurozone:  the recovery is widespread, with a pick-up in investment in most countries. Growth is driven primarily by private domestic demand. The Eurozone is at mid- cycle, with the prospect of catching up for peripheral countries. The political risk has weakened, becoming more local. In Germany, the vote of SPD members in favour of the coalition with the CDU-CSU paves the way for a grand coalition favourable to Europe and a strengthened Franco-German couple. In another vein, the reduction in asset purchases by the ECB is likely to be accompanied by a rise in both long-term interest rates in the core countries and the Euro. Hence the slight slowdown in growth expected in 2019. However, thanks to accommodative credit conditions, growth should remain well above its potential in 2018 and 2019, despite the recent drop in business surveys.
• UK: EU countries and the UK have concluded an agreement for a transition period (until the end of 2020). The dissensions on Brexit terms are strong about remaining or not in the Customs Union. In her speech of March 2, Theresa May rejects the Customs Union (recently defended in the UK by Jeremy Corbyn), without really clarifying the British approach. Uncertainty will continue to weigh on the UK economy, but in a more diffuse way. We still expect growth to weaken in 2018-2019. 
• China:  growth still robust. The reduction in overcapacity has reduced the downside risks. The economy’s growth drivers are now more diversified. Debt remains essentially domestic and has stabilised. We expect the gradual deceleration of growth to continue and a slow rebalancing (less growth, less debt). The transition looks to be under control.
• Inflation: core inflation, which is excessively low at this stage in the cycle (especially in advanced economies), is expected to recover gradually in 2018. That said, the slowdown in inflation over recent years is primarily structural (tied to supply factors), while the cyclical component of inflation has weakened (flattening of the Phillips curve). While the pick-up in core inflation promises to be modest, the likelihood of an “inflation surprise” is nonetheless increasing as surplus capacities disappear around the world (we estimate that the global output gap will close in 2018 for the first time since the great financial crisis). The risk is easier to spot in the US(we expect wages to continue to accelerate), given how close the economy is to full employment and how certain temporary factors (such as the drop in mobile phone service prices in the spring of 2017) have disappeared, which will automatically push inflation upward at the end of Q1 2018 (base effect).
• Oil prices: we expect prices to stabilise at a level close to their current level. At US$ 66 (Brent), the risk still seems to us to be asymmetric (more risk of seeing it drop). Indeed, if prices stay much above the breakeven pointfor US shale gas (estimated at around $40 pb), US production will eventually increase and weigh on prices.

• In 2018, the central banks will continue to whittle down their accommodative monetary policy, which is excessive in view of the current recovery. The Fed will continue to raise its key interest rates (we anticipate three 25bp hikes in 2018) and reduce its balance sheet at the announced pace (with a gradual non-replacement of papers reaching maturity); meanwhile, the ECB could put an end to its QE programme as soon as Q4 2018, But his recent communication remains particularly accommodating. The end of its asset purchase program is conditional on the recovery of underlying inflation, which remains excessively weak at this stage of the cycle. Moreover, it will start raising its key rates only «well after» the end of the Asset Purchase Programme. This implicitly means that the first increase in its deposit rate would not occur until mid-2019 (at the earliest). Monetary policies will remain generally accommodative because even if a little cyclical inflation materializes, total inflation will remain well below its historical average for the structural reasons mentioned (flattening of the Phillips curve, continued downward pressure on the prices of many goods and services).

The protectionist measures announced by D. Trump weigh on the markets. Nevertheless, we believe that the risks weighing on growth are balanced. The likelihood of a generalized trade war remains low because the measures envisaged by Donald Trump (as well as the retaliatory measures) ultimately target products that weigh little on world trade. In fact, it seems that the retaliation envisaged by the EU has led Donald Trump to postpone the increase in tariffs on steel and aluminum from Europe.

Downside risk scenario (15% probability): marked economic slowdown due to incorrect economic policy (excessively quick monetary policy normalisation or protectionist measures), a geopolitical crisis or a sudden repricing of risk premiums.

• The risk of increasing protectionist measures (US) rises with the approach of the mid-term elections (Trump seeking to satisfy his electoral base). Retaliation from the rest of the world would be inevitable, provoking an open trade war (US, China, EU).
• The pro-cyclical fiscal policy forces the Fed to accelerate the monetary policy normalisation process.
• International crisis stemming from acute aggravation of current geopolitical tensions (Middle East, Korea).

Consequences:

• All things being equal, a global trade war would be negative for growth and, in the short term, would prove inflationary.
• An abrupt re-evaluation of risks on the fixed income markets, with a global decompression of spreads (govies and credit, on the developed and emerging markets alike). Decline in market liquidity.
• With the resulting financial turbulence, the theme of the end of the cycle resurfaces brutally in the US.
• Central banks cease recalibrating their monetary policies and, in the most extreme case, resort to unconventional tools (expanding their balance sheets).

Upside risk scenario (15% probability): pick-up in global growth in 2018.

Several factors, which are likely to generate higher growth, should be closely monitored.

• Sharp pick-up driven by business investment, global trade, and synchronisation of the overall cycle.
• In a very promising environment, the pro-cyclical US tax policy generates a stronger than expected pick-up in domestic growth in the US. Continued acceleration cycle in the Eurozone, stabilisation in China, confirmation of the trend in Japan, etc.
• Central banks react late, maintaining excessively accommodative monetary conditions, hence a «mini boom».

Consequences:

• A marked pick-up in global growth for the second consecutive year would increase inflation expectations, forcing the central banks to consider normalising their monetary policy much more quickly.
• Rise in real key interest rates (in the US especially).
• Given the resulting financial turbulence, the mini-boom would not last long. There would be a greater risk of a boom/bust (i.e. the bust after the boom).