Uncertainty: the only certainty for 2020 - Banking, Regulation & Risk -

Uncertainty continued to plague the world economy in 2019 and there is not much optimism among economists and market strategists that it will fare much better in 2020. Edward Russell-Walling reports.


As the end approaches for what has been a difficult year for the world economy, the runes for 2020 are not exactly promising. Global growth forecasts for both 2019 and 2020 are the lowest since the financial crisis, as intractable issues such as US protectionism and Brexit continue to weigh on trade and confidence. No one expects world growth to turn negative in 2020 but, as one researcher puts it, “we are only one shock away from recession”.

The word that crops up most often in current economic commentary is 'uncertainty'. That said, some look to better times beyond 2020, anticipating mild signs of recovery in the second half of the year. “The slowdown is slowing down,” as one economist describes it. Bond yields may rise a touch and equities, at least in the US, may lose some of their vigour.

OECD gloom

The Organisation for Economic Co-operation and Development (OECD) summed up the mood in the headline of its autumn economic outlook: 'Warning: low growth ahead'. It expects global growth to slow from 3.6% in 2018 to 2.9% in 2019 and 3% in 2020, and notes that downside risks continue to mount.

Perhaps most importantly, these risks include escalating trade policy tensions which, in the OECD’s words, are “taking an increasing toll on confidence and investment, adding to policy uncertainty, weighing on risk sentiment in financial markets, and endangering future growth prospects”.

Its view has grown gloomier as the year has progressed. The organisation has downgraded its spring estimates for 2019 and 2020 in almost all G20 economies. And it observes that uncertainty is exacting a high price in terms of annual investment growth in these economies, reducing it from 5% in early 2018 to only 1% in the first half of 2019.

US slowdown

In the US, still the world’s largest economy by nominal gross domestic product (GDP), the OECD foresees growth slowing from 2.9% in 2018 to 2.4% this year and 2% next. This reflects, in part, the fading influence of fiscal easing. While a solid labour market and supportive financial conditions continue to underpin household spending, higher tariffs continue to add to business costs, and the growth of exports and investment has moderated, the organisation says.

Some have even lower expectations and expect the US economy to go into recession next year. “In our view, there will be a US recession around the middle of the year – in the second or third quarter,” says Klaus Baader, global chief economist at Société Générale. The US is running short of free capacity and corporate margins are being squeezed by labour costs, thus slowing growth, he adds. “It will be a mild recession, not a big macro shock, but it will have a clear impact on the global economy and many economies around the world.”

While central banks elsewhere will play second fiddle to fiscal policy in 2020, the US still has the scope to cut interest rates, Mr Baader adds. Société Générale correctly predicted the Federal Reserve’s 25 basis points (bps) cut in October and has forecast another 100bps of cuts in the course of 2020.

European doldrums

In the euro area, growth is likely to remain subdued. The OECD expects 1.1% growth in 2019 (compared with 1.9% in 2018) and 1% in 2020. Germany and Italy, with their exposure to global trade and the relative size of their manufacturing sectors, are both underperformers, and likely to continue as such. This year’s growth forecast for Germany is 0.5% (1.5% in 2018), edging up to 0.6% in 2020. Italian growth is likely to be zero this year (0.7% in 2018), recovering slightly to 0.4% next year.

Germany, the engine room of the EU and the eurozone, avoided going into technical recession in the third quarter of 2019 by the skin of its teeth. Yet German manufacturing has been contracting and this is beginning to drag down services as well. Some, including Deutsche Bank’s economics team, anticipate a recovery in global car demand in 2020, and the hope is that manufacturing and exports will start to improve during the year.

“A key question for 2020 is when will the auto industry bottom out and stop weighing on growth,” says Innes McFee, head of research and macro forecasting at Oxford Economics. “We expect the German economy to bottom in the first half of the year and then start to pick up.”

Any recovery, in Europe or elsewhere, is not likely to be pronounced. “We think it will follow an L-shaped pattern, rather than a V,” says Luigi Speranza, chief global economist at BNP Paribas Markets 360. “Growth will remain sub-par, because of the implications of the trade tensions for capital expenditure and trade.”

The UK economy will grow by 1% in 2019 (compared with 1.4% in 2018) and 0.9% in 2020, the OECD believes, assuming there is a smooth exit from the EU. Slowing growth reflects persistent uncertainty and weak investment. The country was in the throes of a general election as The Banker went to press, so whether any party will emerge with an absolute majority – and thus the power to ensure the passage of Brexit legislation – was not yet known.

Even if withdrawal legislation finally becomes law during 2020, the shape of the UK’s future relationship with the EU, with all its economic consequences, would not be settled for some time, possibly years. So, the uncertainty is likely to continue. In the event of a no-deal Brexit, GDP could be 2% lower than otherwise in 2020 and 2021, pushing the economy into recession. That in turn would have negative implications for eurozone growth.

China's trade tensions

Growth in the world’s second largest economy, China, is also slowing. OECD projections suggest Chinese GDP will grow at 6.1% in 2019, compared with 6.6% in 2018, and will fall to 5.7% in 2020. It notes that exports to China from the big advanced economies have fallen substantially over the past year, hurting trade and growth in the rest of the world.

The OECD estimates that a sustained drop in domestic demand growth of 2 percentage points a year in China could translate into a significant slowdown in global growth. If accompanied by deteriorating global financial conditions and heightened uncertainty – as in China’s slowdown of 2015 and 2016 – it could knock 0.7 percentage points a year off global GDP growth, and 1.5% a year off global trade growth.

The single biggest dampener on global prosperity is the trade dispute between China and the US. In Oxford Economics’ November Global Risk Survey, more than half of all respondents thought a trade war was the number one risk to the global economy. This was far more than any other risk and still close to the highest level since the survey began in 2016. Coming a distant second in the perceived risk league was US recession, followed by policy uncertainty and a continuing Chinese slowdown.

While the intensity of trade concern has ebbed and flowed, according to a recent tweet by president Donald Trump, few in the financial markets think a full-on war is imminent. But few think the tensions are going away, either. Both parties have verbally agreed a ‘phase one’ agreement including suspension of US tariff increases and the Chinese purchase of US agricultural products. A ceremony for signing the paperwork was deferred, however.

“In trade and geopolitics, we’re looking at a ceasefire,” acknowledges Olivia Frieser, global head of Markets 360 research at BNP Paribas, referring to the phase one agreement. “But phases two and three are harder, because they touch on the most controversial issues at the core of the dispute. We think it will take a lot more to get a bigger deal done.”

ECB dilemma

With the US-China standoff taking centre stage, it is easy to overlook the US plan to hike tariffs on a range of EU products. In the face of such economic headwinds, central banks have been doing what they can to stimulate growth. The Federal Reserve may still have the luxury of further rate cuts at its disposal, but the European Central Bank (ECB) is running out of road, having cut the deposit rate to -0.5% in September 2019 and revived quantitative easing.

“The ECB will continue to purchase bonds for the foreseeable future,” says George Buckley, Nomura’s chief UK and euro area economist. Mr Buckley expects incoming ECB president Christine Lagarde to announce a strategy review, and he argues that the institution should raise its inflation target to 2%, not “just below” 2%. “Some [governing] council members believe that even 1.5% inflation would be consistent with the existing target,” he says. “So, for some that would imply significant loosening.”

Former ECB president Mario Draghi wanted EU member states to support their economies with additional fiscal stimulus. While Germany, wedded to the idea of a ‘black zero’ balanced budget, has led resistance to this option, domestic opinion may be beginning to shift. Nothing will happen in a hurry, but the subject will be increasingly on the agenda in the year ahead and Ms Lagarde, a politician in a banker’s job, may be expected to advance the cause.

“The Germans will act when there is a real need,” believes one European bank economist. “But they want to see the whites of recession’s eyes. And they will.” One possibility for German fiscal stimulus is to present it as state funding of green infrastructure projects. “It needs acceptance by the population,” says Walter Edelmann, chief global strategist at Credit Suisse. “If you sell it under the stamp of green policy, it could work.”

Bull markets

Financial markets have had a buoyant year, with some bond yields forging deeper into negative territory and the S&P 500 up by 25% since January. The surge in equities wrong-footed many investors who had positioned themselves too cautiously. Can the run continue? Some think so.

“We remain bullish on equities,” says Mislav Matejka, JPMorgan's head of global equity strategy. “We are unlikely to have a US recession any time soon; the global manufacturing downturn is probably ending and trade tensions are heading for a ceasefire because it’s an election year. Equities will continue to make fresh all-time highs in the next months and quarters.”

JPMorgan has been overweight on US equities for the past two years. But the house view changed to neutral in September, now favouring the eurozone, which is “cheap”, according to Mr Matejka, and benefits from a potential rotation into cyclical and value stocks. In emerging markets, he likes Russia (also cheap), China (more stimulus and a key beneficiary from trade truce) and Brazil (better economic management).

While JPMorgan is underweight UK equities, Citi is overweight. Citi equity strategist Beata Manthey points out that, since 70% of FTSE 100 revenues come from overseas, UK plc’s profits are more sensitive to global GDP and the oil price than to domestic GDP. “The UK is now our favourite value trade,” says Ms Manthey, adding that Brexit-induced de-rating is providing significant de-equitisation opportunities.

Armin Peter, global head of debt syndicate at UBS, thinks that prices in the bond markets will not change materially in 2020, though there may be some widening of spreads, and some US yield compression versus Europe. He expects January to be seasonally busy but not excessively so.

“I am less concerned about the start of 2020 – likely it will go according to plan, with capital and finance on demand,” says Mr Peter. “Issuers can wait until they need the money, rather than prefunding very early.” That said, with a potential Brexit decision due at the end of December, he thinks that some new year issuers may choose to bring forward their issuance by a week or two.

M&A activity

Over in the US, 2020 will be a presidential election year, with all the volatility that entails for financial markets, particularly equities, as candidates’ fortunes rise and fall. “If [Democrat candidate senator] Elizabeth Warren looks like winning, you wouldn’t want to be long financial services, pharma or oil,” observes one bank economist. “You’d want to be long domestic consumer stocks and environmental protection.”

Uncertainty has acted as a brake on initial public offerings (IPOs) and merger and acquisitions(M&A) activity this year, and 2020 is likely to follow a similar pattern. The exception has been North America, which saw several mega-mergers and a busy IPO landscape in 2019. A slower US economy and the volatility of an election year may bring North America back into line with everyone else. In their Global Transactions Forecast 2020 report, Baker McKenzie and Oxford Economics predict that global M&A volumes will fall by $700bn to $2100bn. While IPOs will also follow a downwards trend, the Saudi Aramco float will nonetheless boost proceeds from an estimated $152bn in 2019 to $215bn, they say.

In the oil market, demand is weakening while inventories continue to build. While the Organisation of the Petroleum Exporting Countries has been cutting production, discipline may not hold if the imbalance worsens. With the price-sensitive US shale oil industry acting as a swing producer, however, the oil price is likely to remain within the $50 to $70 a barrel range at least for the next year. Michael Haigh, global head of commodities research at Société Générale, foresees further weakening of demand as recession takes its toll, with the price ending 2020 towards the bottom of that range, in the mid-$50s.

Mr Haigh sees a fairer wind for gold in the year ahead, not least because it does well in times of uncertainty. “In August, the stock of negative-yielding assets was the biggest ever,” he says. “That’s positive for gold.” Against that, he expects the yuan to depreciate significantly in 2020, so that China can remain competitive. “That’s negative for gold, because they are big buyers, but the other positives outweigh it,” he says. The gold price will rise to $1575 an ounce at year’s end, he believes.

Headwinds ahead

The view from credit rating agencies is less than rosy. The latest Moody’s outlook on sovereign creditworthiness is 'negative'. It blames a disruptive and unpredictable political environment, which is “exacerbating the gradual slowdown in trend GDP growth, aggravating long-standing structural bottlenecks and increasing the risk of economic or financial shocks”.

The agency expects corporate credit, which lags macro developments, to remain relatively robust, with speculative default rates remaining broadly steady, according to Colin Ellis, Moody’s chief credit officer for Europe, the Middle East and Africa. Mr Ellis regards the gradual shift in Europe from bank to bond finance as a positive development from a credit point of view, and one that would aid the speed of economic recovery following a downturn.

In the same vein, he observes a loosening of covenants and a lengthening of maturities, even in speculative grade. “In the past, high-yield corporates might refinance every three years and start worrying after two,” he says. “That has now been extended to five years or more, which might make them more able to ride out short-term disruptions – though this is untested.”

One of Moody's defining themes for 2020 is lower-for-longer interest rates, which is not music to bankers’ ears. “Low rates will continue to be tough for banks,” says Mr Ellis. “They already complain about expansive monetary policy, and low rates may bite more in terms of their profits.”

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