A global perspective

September 25, 2018

Global growth holding steady

Global economic growth for 2018 appears to be holding steady. Any perceived weakness earlier in 2018 dissipated and the ongoing expansion remained firm through mid-year. We anticipate that global growth should clock in around 3 percent, the strongest growth rate since 2011. The key locomotives of economic growth, the U.S. and China, continue to drive the expansion. U.S. growth accelerated in 2018 due to fiscal stimulus and deregulation while China continues to use centralized control to manage its economy toward its target growth rate. Although other major developed economies trail relatively far behind the U.S. on growth, they are not deteriorating either. Growth in the Eurozone firmed after a shaky first quarter, while Japan and the UK appear steady, if not spectacular. A convergence of multiple factors has impacted emerging market economies – a strengthening U.S. dollar, tightening of liquidity, and spreading concerns regarding spillover from places like Turkey and Argentina. These factors should drag on growth in the coming quarters, but not derail its expansion.

But risks to the longer-term outlook took clearer shape over the last quarter. Beyond the risks stemming from emerging market economies

"…political risk has not abated, inflation again increased, monetary policy  continued to tighten, aggregate debt levels kept rising, and trade tensions continued to escalate."

While these factors are not expected to curtail economic growth in the near-term, as they continue to build they will increase the probability of slowing over the next few years.

Monetary policy continues to slowly tighten

Monetary policy around the world should converge in the coming quarters, though not fall into synchronization. Among developed economies, the relatively strong growth in the U.S. is driving Fed policy: the Fed continues and will continue to tighten, raising interest rates at a pace of roughly 25 basis points per quarter in the near term.

"Economic growth in the U.S. accelerated in the second quarter while  inflation and wage growth continued to tick higher."

The labor market has likely pushed past full employment while inflation, measured by virtually all major indexes, sits at or above the Fed's 2-percent target rate. With two more rate hikes set for this year (including this week), interest rates in the U.S. across the yield curve will continue to sit hundreds of basis points above yields in most other developed economies. Although other major developed nation banks remain generally accommodative, policy appears to be changing. The Bank of England (BOE) hiked after briefly pausing earlier in the year, but with inflation and wage growth remaining tame, evidence for additional hikes this year looks scant, particularly with Brexit looming next year. The European Central Bank (ECB) did not much alter its outlook at its most recent meeting this month and looks likely to adhere to its plan to eliminate its quantitative easing (QE) program by the end of this year. Rate hikes still seem a somewhat distant prospect at this point. With inflation not quite reaching 1 percent on a year-over-year basis, the Bank of Japan (BOJ) will not change its policy stance. Its 2-percent inflation target stays solidly in place, but the probability of achieving that target in the near term remains minimal.

Rising interest rates in the U.S. put pressure on yields around the world. Interest rates in many nations have ticked up in response to tightening in the U.S., even without central banks raising rates. And emerging markets have certainly felt some pain, particularly as U.S. monetary policy has led to a strengthening of the dollar, making it more difficult for emerging markets to service their dollar-denominated debt. The combination of generally rising inflation and wage growth around the world, coupled with ongoing rate hikes from the U.S., should continue to put upward pressure on global yields, even if resulting in just modest rate increases.

Trade tensions escalating

Growth in global trade has started to ebb and appears headed for a slowdown over the coming quarters. Although growth was inevitably going to slow from its brisk pace of the last couple of years, trade policy should contribute to the slowing.  The Trump administration has continued to implement more tariffs on an increasing number of goods. Just this week, the administration put into effect a 10-percent tariff on an additional $200 billion of Chinese imports. The tariff rate will rise from 10 percent to 25 percent next year. Once again, as previously, China retaliated with tariffs of 5 to 10 percent on $60 billion of U.S. exports. And the trade tensions should not stop there.

"The Trump administration has recently threatened to place tariffs on yet another  $265 billion of Chinese imports, which would effectively cover all of the imports from China to the U.S."

On other trade fronts, progress was made on renegotiating the North American Free Trade Agreement (NAFTA) during the second quarter. But the agreement was concluded between only two of the three partners – the U.S. and Mexico – and concerned only broad outlines, not fine details. Canada, which was not a party to the agreement, continues to talk with the U.S. about reconciling their differences and joining the reworked NAFTA. And ultimately, the parties to any final trade deal will need to hammer out the finite details before the U.S. Congress even considers voting on a new proposal.

Anyone paying attention to the trade situation now knows that cooler heads are not prevailing and that we are likely in for a long, protracted battle over trade. The situation should get worse before it gets better. The measures implemented thus far should begin to drag on global growth in over the next 12-15 months because they directly impact that world's two largest economies. Businesses around the world have become dourer on the outlook for trade and the economy because of the tensions, which further threatens growth prospects.  And the risk of other trade barriers will remain in place. Countries that continue to run trade surpluses with the U.S., such as Japan and South Korea, could find themselves also in the line of fire.

Implications for the U.S.

Continued global economic growth still helps U.S. economic growth. Most directly, global growth provides a favorable environment for U.S. exports. Although a strengthening dollar complicates this picture, demand for competitive U.S. products and services should not collapse. Nonetheless, we expect international trade to become more of headwind for U.S. economic growth. Most immediately, trade deficits are set to widen now that the boom in the export of soy products (to get out ahead of tariff implementation) has ended. We expect international trade to once again subtract from economic growth, starting in the third quarter.

The implemented tariffs should put upward pressure on prices in the U.S., further fueling inflation at a time when it was already accelerating due to underlying scarcity. That will act as a tax on U.S. consumers and eat into real consumption and real economic growth. Oil price increases should only add to and further complicate the picture. That could provide the Fed with extra ammunition to keep raising rates at it tries to head off inflation before it becomes more damaging to economic growth.

Higher interest rates will keep pulling money into dollar-denominated assets, including Treasury securities. That will continue to keep a lid on rates at the long end of the curve, although accelerating growth and inflation should apply pressure there, even with the yield curve likely to invert with the Fed's ongoing rate hikes. The hawkish members of the Federal Open Market Committee (FOMC) will likely keep pushing for higher rates, even past the estimated neutral rate, barring a slowdown or an idiosyncratic disruption.

"Commercial real estate (CRE) in the U.S. will continue to reflect the state of the economy. Fundamental space markets are holding up well, with demand remaining relatively firm in the face of rising new construction across property types and metropolitan areas. Supply growth remains the key internal concern for CRE, though any fallout from the escalating trade war could certainly impact the demand side of the ledger.

For CRE capital markets, foreign capital continues to find a home in the U.S., even if much of it remains on the sidelines. Transaction volume across virtually all sources--both foreign and domestic—looks set to pull back slightly this year. Rising interest rates have not yet posed much of a problem for CRE, but as they continue to rise they will eventually become more of a drag on pricing and volumes. Trade tensions could certainly exacerbate this if they further fuel inflation, preventing the Fed from slowing its pace of tightening."

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