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ubs/economics This report has been prepared by UBS Limited. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 227. Global Research 7 November 2018 Global Economic Perspectives Global Economic Outlook 2019-2020 The end of “low for longer“ The aggregate global output gap closed in Q2 this year, median unemployment is at the lowest level since 1980, wage pressures in many developed markets are approaching post-GFC highs (and in Japan at two-decade highs), labour shortages in several European countries with high unemployment seem as acute as in Germany (3% unemployment), and 72% of countries already have headline inflation running above the central banks targeta share greater than during the 2003-2007 boom years. Economically, the global economy does not look like a patient in need of more monetary life support. But the evidence of being “late cycle“ is at best mixed We assessed 120 prior “late cycle“ episodes for 40 countries, and found that on several dimensions the behaviour of the data over the last four quarters in the US, Eurozone and Japan is completely incongruous with any of the recessions that took place since 1980. Employment growth in Japan, house price and productivity growth in the US, core inflation in Europe, and various aspects of consumption and investment behaviour are not consistent with being near a business cycle peak. The central banks are thus understandably cautious. Despite core inflation in DM expected to be back above 2% by end 2019, on par with pre-crisis levels, central banks are expected to lift their policy rates to only half of 2008/2009 levels by end 2020 and still be below neutral. And our now-casting models suggest the global economy is skidding We launch our global now-cast in this report and show how the deterioration in global hard and soft data is the most severe since the Eurozone crisis. We view the softness as transitory and we project consumption and investment to re-accelerate in 2020. But the knock to confidence this year is notable: survey implied growth globally has fallen from 4.9% to 3.5% YTD. Where do we deviate from 2019 consensus? We are significantly below consensus growth forecasts in 2019 for a large number of countries, including recession-hit Turkey (-160bp below consensus) and Argentina (-200bp), several of the Asian economies (-80bp in Thailand and Malaysia), and also the Eurozone (-20bp). We are significantly above consensus on Japan (+70bp next year on growth and a similar magnitude on inflation) and Brazil (+70bp on growth). We remain more cautious on the US near term than most, because of tariff concerns, but are more constructive post-2020. The fiscal cliff is more like a gentle hillweve raised potential growth to 2% in 2020 and believe the Fed, after a pause, resumes hiking in 2021. What can go right? The biggest upside risks to our forecast are (i) trade tensions de-escalating; (ii) trade diversion effects being stronger than we think (we show for several Asian economies how market share gains could outweigh value chain disruption); and (iii) the US growth acceleration being more structural. What can go wrong? The biggest downside risks are (i) central banks falling behind the curve if inflation surprises to the upside (on just a 50bp deviation from our inflation baseline we would see policy rates 70bp higher in DM); (ii) the US fiscal cliff being steeper than we project; (iii) US-China tariffs getting extended to all goods (we modelled the implications of USD/CNY potentially moving to 8.0); (iv) European peripheral debt stress intensifying on Italian debt concerns; (v) Brexit (weve estimated the global cost of a hard Brexit at roughly half of the US/China trade tensions); and (iv) oil prices being significantly above/below our baseline, which has a large (transitory) effect on policy rates in EM. Economics Global Arend Kapteyn Economist arend.kapteynubs +44-20-7567 0531 Seth Carpenter Economist seth.carpenterubs +1-212-713 4173 Reinhard Cluse Economist reinhard.cluseubs +44-20-7568 6722 Rafael De La Fuente Economist rafael.delafuenteubs +1-203-719 7127 Gyorgy Kovacs Economist gyorgy.kovacsubs +44-20-7568 7563 Pierre Lafourcade Economist pierre.lafourcadeubs +1-203-719 8921 James Malcolm Economist james.malcolmubs +81-3-5208 6214 Edward Teather Economist edward.teatherubs +65-6495 5965 George Tharenou Economist george.tharenouubs +61-2-9324 3520 Tony Volpon Economist tony.volponubs +55-11-2767 6337 Tao Wang Economist wang.taoubs +852-2971 7525 Global Economic Perspectives 7 November 2018 2 Contents Global Economy . 4 Key Economic Indicators . 5 UBS vs Consensus . 6 The end of “low for longer“ . 7 A global now-cast . 10 The 2019-2020 Outlook . 15 Are we actually “Late Cycle“? . 22 Risks and Scenario Analysis . 28 Political Calendar 2019-20 . 40 USA (ii) trade diversion effects being stronger than we think; and (iii) the US growth acceleration being more structural. - The biggest downside risks are (i) central banks falling behind the curve if inflation surprises to the upside (already the share of central banks exceeding their target is on par with pre-crisis levels); (ii) the US fiscal cliff being steeper than we project; (iii) US-China tariffs getting extended to all goods; (iv) European peripheral debt market stress intensifying on Italian debt concerns; and (v) Brexit (weve estimated the global cost of a hard Brexit at roughly half of the US/China trade tensions). UBS VIEW We are significantly below consensus growth forecasts in 2019 for a large number of countries, including Turkey (-160bp below consensus), Argentina (-200bp), and several of the Asian economies (-80bp in Thailand and Malaysia), and our Eurozone forecast for next year is now also 20bp below consensus. Most of the aggregate weakness is centred on EM, however. We are significantly above consensus on Japan (+70bp next year on growth and a similar magnitude on inflation) and Brazil (+70bp on growth). EVIDENCE As of Q4 2011, the ECB effective policy rate changed from the refi rate to the deposit rate. “ 3M HIBOR. It is the benchmark interest rate used by the Hong Kong central bank. “ 1- year -deposit rate. “ For FX, blended weighted average of several available FX rates. #Venezuela CPI: 2018 8000000; 2019 11750000. Venezuela FX: 2018 448614; 2019: 34686998 Global Economic Perspectives 7 November 2018 7 The end of “low for longer“ A decade after the Global Financial Crisis, the low for longer regime is showing signs of coming to an end.1 Core inflation in developed markets (DM) has risen from a low of 1% YoY in late 15 to 1.6% YoY today, and is projected to rise further to 2.1% YoY by end 19its highest level since the GFC. Globally, 72% of countries now have headline inflation above their central banks targeta share greater than that of countries overshooting their target during the 03-07 boom years. Labour markets continue to tighten and press up on inflation. Global (median) unemployment is now down to levels not seen since 1980. In our sample of 48 large EM and DM economies, 55% are posting unemployment rates lower than in Dec 07, and another 23% are within 1 pp of those levels.2 Surveys on labour shortages suggest firms are struggling to find workers. Even in Spain, with 15% unemployment, the surveys point to shortages on par with Germany (3 %) unemploymentresponses are about 2 to 3 standard deviations above normal. Wages are accelerating: nominal negotiated wage growth in the Eurozone has improved most visibly: +70bp over the last 12m, while scheduled wages in Japan and the US (ECI) are up 60bp and 40bp, respectively. These are the highest wage growth rates since 1997 for Japan and 2009/2012 for the US/Eurozone. We estimate that the global output gap closed in 18Q2. Thats a PPP-weighted statistic and so skewed by a few large economies (Japan, Germany, US). By count, only 35% of the countries under our coverage have closed their output gap (up from 20% late last year) but we forecast that to rise to 58% by end 19. However, in other respects, data does not suggest that world activity is peaking. Employment growth has still not slowed in aggregateto the contrary, it has recently been accelerating. Average employment growth this year in OECD countries is running at 1.9% YoY, compared to 1.8% in the previous two years, and 1.7% in 15. For the narrower DM portion of the OECD sample, employment growth in the first half of this year was running at its fastest pace in ten years (2.2% YoY). Sustained hiring rates suggest there is still slack out there.3 The behaviour of other economic variables is also not consistent with end-of-cycle dynamics. In the section “Are we actually late cycle?“, we present stylized facts on 120 recession episodes and show that data in the US, 1 We characterize low for longer as a sustained period of low inflation, low policy rates and abundant central bank liquidity. 2 Only Greece (+10.8pp), Italy (+3.8pp), Spain (+6.6pp) and South Africa (+5.4pp) are more than 2pp above their Dec 07 unemployment rate levels. 3 Again the average obscures country detail: employment growth appears to be rolling over in France, Switzerland, Canada, Portugal, Israel and Poland, for instance, and could be a sign of diminishing slack. Figure 3: DM core inflation Source: UBS, Haver Figure 4: Share of countries above CPI target Source: UBS, Haver Figure 5: Global unemployment Source: UBS, Haver Global Economic Perspectives 7 November 2018 8 Japan and the Eurozone are on several dimensions completely at variance with any of the recessions that took place over the last 40 years. That doesnt mean a recession is unthinkable a year from now; but the data flow over the last 4 quarters suggests it is at least not imminent. Notwithstanding some of the conflicting signals, central banks are starting to respond to the improving economic environment. The median DM policy ratewhich was at an all-time low of 25bp until late last yearhas inched up to 75bp at present, and on our forecast will reach 1.4% by end 19. However, as a testament to policymakers caution, that is still only half the pre-GFC level for the weighted DM policy rate, despite the fact that core inflation by the end of 20 should be fully back at pre-crisis levels. Of course, stopping our forecast horizon in 20 does not mean the world stops, too. As we discuss in the US outlook, we expect the Fed will resume hiking in 21 after uncertainty over waning fiscal stimulus effects in 20 has dissipated. Central banks policy paths are diverging. As we show in Figure 8, countries cycles are not synchronized and central banks are normalizing policy at different speeds. The min-max range of DM policy rates has moved up from a post-war low of 250bp early this year to 290bp at present (still the 7th lowest historical percentile). By end 19, we expect that range to increase to 370bp (the 20th percentile), with Switzerland (-50bp at end 19) and the US (320bp by end 19) as bookends. The range narrows again in 20 when the US pauses and other central banks catch up. Policy rate and business cycle divergence create volatility. Figure 8: Output gaps close at very different points in time Source: UBS But nothing moves in a straight lineas we show in the next section, we believe the global economy is skidding. Our now-casting models suggest the slowdown in both hard and soft data is the most severe since the Eurozone crisis in 2012. There was little evidence of such a slowdown in the Q2 GDP data (the second quarter was actually the strongest global growth quarter since 2010), but preliminary GDP releases for Q3 seem consistent with a soft patch. The now-cast models historically dont tend to stray for very long, and they explain 92% of the historical variation in global GDP growth. We believe a combination of interrelated factors lies behind the slowdown. The commodity tailwind from last year is fading and putting downward pressure on trade deflators (i.e. prices). Trade volumes are also weaker as DM import demand Figure 6: DM policy rate Source: UBS, Haver Figure 7: Contributions to avg DM policy rate Source: UBS, Haver Figure 9: Nr. of central banks hiking each quarter Source: UBS, Haver Global Economic Perspectives 7 November 2018 9 softens. This is somewhat puzzling because domestic demand in the G3 looks healthy and, in the case of the US, manufacturing productionwhich is typically comparatively import-intensivehas picked up significantly. Perhaps the overall slowing in US investment YTD (ex-inventories) is the culprit, as it seems unlikely tariffs played a role earlier in the year. But the puzzle extends to the Eurozone and Japan, where import demand is slackening despite robust investment patterns (while confidence indices seem to be turning, capex intention surveys are holding up better than broader business sentiment ones). Whatever the case may be, the deceleration in trade volumes and prices has carried through to global industrial production and pulled the global economy down from last years lofty levels. Currently, EM Asia seems to be virtually holding up global import demand on its own. That is not sustainable, and the implementation of US/China tariffs should weigh yet more heavily on trade volumes. Trade aside, however, our baseline forecast for 19 and 20 is more constructive. We expect global economic growth to settle at roughly its long-run level (3.7%). We generally still see ample slack to contain any undue acceleration in core inflation andprovided we are rightmarkets seem to be pricing central banks intentions pretty fairly for 2019. By the time we reach 20, however, things get a lot more uncertain. We spend considerable time below going through six alternative scenarios, including one where DM central banks fall behind the curve. The range of outcomes for growth, inflation and policy rates in those scenarios is vast, and much more interesting than the baseline. The difference between trade tensions escalating and de-escalating either puts us 40bp below the global growth baseline or 20bp above. Trade escalation would lower our DM policy rate baselines substantially but increase them fo
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