Lower growth, higher inflation

Key points

1. We see little near-term risk of recession, but trade tensions pose a risk of lower growth and higher inflation, challenging stock and bond valuations.
2. A European Central Bank (ECB) stimulus package exceeded market expectations, reaffirming a global dovish pivot by central banks.
3. The Federal Reserve is expected to cut interest rates this week, underpinning the expansion under pressure from trade tensions.

Lower growth, higher inflation

Markets breathed a sigh of relief last week on signs of easing US-China trade tensions. We see ongoing policy support, the absence of obvious financial system vulnerabilities and resilient consumer spending helping extend the US economic expansion. Yet trade tensions pose ongoing risks – threatening to weigh on growth and pressure inflation. This could call for a more defensive investing stance.

Chart of the week

Composition of US gross domestic product, 2010-2019

Sources: BlackRock Investment Institute, with data from the US Bureau of Economic Analysis, September 2019. Notes: The chart shows the annual rate of US GDP growth broken down by components through the second quarter of 2019. Personal and government spending refers to a combination of personal consumption expenditures; government consumption expenditures and gross investment. Capex refers to non-residential domestic gross investment, and housing refers to residential investment.

Rising global trade tensions are spilling over into the US manufacturing sector. This is reflected in the makeup of US GDP growth. The contribution by capital expenditure and net exports turned negative in the second quarter, as the chart shows. The pace of inventory building is still on the rise, as businesses stock up ahead of expected further rises in tariffs. Yet consumer spending – making up over two thirds of the US economy – is holding up well. Household leverage is limited, and there are no indications of over-extended spending on big-ticket goods as cars and appliances. This dynamic resembles 2015 and 2016, when strong consumer spending and services sector activity offset a contraction in industrial production. Yet there are key differences: Back then, we saw a deflationary combination of a strong US dollar, overtightened policy in China and a collapse in oil prices. Today the shock is likely to be inflationary as it stems from tariffs and supply chain disruptions.

An uncomfortable mix

A protectionist push has become the key driver of the global economy and markets, as we highlighted in our Midyear 2019 Global investment outlook. Escalating tit-for-tat actions by the two countries in late August helped push the US Treasury yield curve to invert (shorter-term yields rise above longer-term ones) – a phenomenon that has historically often preceded a recession and spooked investors. Yet structural forces such as a glut of global savings are suppressing long-term yields, making the yield curve’s shape a less reliable signal than in the past. And yields rebounded last week on signs of a more conciliatory approach by both the US and China to trade talks. We reiterate our view that tensions between the two countries are structural, reducing the likelihood of a comprehensive deal. If all tariffs announced by the US and China were implemented, US growth could fall materially below trend in coming quarters.

The US economy is unlikely to get much help from the rest of the world. Many economies are digesting the fallout from the rapid-fire protectionist measures and the potential for further escalation in trade tensions. We see China’s economy slowing further and Beijing likely to roll out additional stimulus to blunt bigger downside surprises, but a material boost to growth is unlikely. The eurozone economy could be stabilising at best, with Germany in a technical recession and a range of Brexit-related risks still looming large. Meanwhile in the US, we see inflation set to pick up, thanks to more tariffs and faster wage growth in the face of a tight labour market. A mix of lower growth and higher inflation complicates the Fed’s effort to achieve maximum employment and stable prices. A key question: Can US consumers keep supporting overall growth in the face of manufacturing headwinds, slowing job growth and tariffs on consumer goods?

Bottom line: The health of the US consumer spending will be key for US and global economic growth. Our base case points to a global growth slowdown cushioned by additional policy easing. Our moderate pro-risk stance – including an overweight in US equities and exposures to government bonds as portfolio shock absorbers – has worked well thus far. Yet trade tensions pose the risk of slowing growth and rising inflation – a potential threat to stock and bond markets alike.

• The ECB announced a broad package of easing measures including cutting the deposit rate by 0.1% to minus 0.5% and restarting asset purchases at a pace of 20 billion euro per month, with a commitment to run the program until its inflation target was met. The market reacted positively with inflation expectations and European equities rising on the announcement.
• China said it would exempt some products from additional tariffs and the US delayed a tariff increase on some Chinese goods. China’s August exports fell more than expected, highlighting the pressure on the export sector from ongoing trade frictions. The country’s consumer price index rose 2.8% on the year on soaring pork prices, while producer prices fell for the second month.
• US retail sales grew more than expected in August, underlining the resilience in consumer spending. University of Michigan’s consumer sentiment index also beat expectations, rebounding from a nearly three-year low in August.

	Date:		Event
	Sept. 16		China industrial output, retail sales
	Sept. 17		German ZEW Indicator of Economic Sentiment; US industrial output
	Sept. 18		Fed’s rate decision; Bank of Japan’s two-day policy meeting starts
	Sept. 20		Eurozone flash consumer confidence

The Fed’s policy meeting this week is the key event. The central bank is expected to cut interest rates by 0.25 percentage points, reflecting one of our key investment themes: a dovish pivot by central banks that should help extend the economic expansion. Markets are pricing in around one percentage point of easing over the next 12 months. We see the likelihood of another rate cut in the fourth quarter. Yet we view the amount of Fed easing priced in by markets as excessive, given our view that near-term recession risks are low. And the personal consumption expenditure (PCE) price index, the Fed’s preferred inflation gauge, is expected to move above the Fed’s 2% target early next year.

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Sources: Bloomberg unless otherwise specified.

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