Summary
- The global growth slowdown is reinforced within a number of indicators, including commodity prices and non-U.S. business sentiment indicators. However, the downshift in the actual data remains largely consistent with our past forecast. Peak global growth occurred in the first half of the year at about 4%. It has since stepped down to roughly 3.2% and is expected to hover just above that mark at 3.4% in the year ahead. This figure still depicts a pace that is slightly above the global economy’s long-term running speed. We embedded a modest downgrade to our 2019 global forecast to capture the anticipated negative investment and export drag from ongoing global trade uncertainty and in a nod to the growing balance of downside risks.
- Although the selloff in global risk assets is outsized relative to the magnitude of the economic slowdown, it likely reflects the build-up of unresolved global risks, coupled with a delayed adjustment in growth expectations from lofty levels. There are few signs that the economic expansion is nearing an end, but negative sentiment can become self-fulfilling. We remain vigilant in monitoring signals to that end: yield curves, business confidence, risk-assets, and labor market conditions.
- Despite the 90-day ceasefire agreement by U.S. and China on an escalation in their trade war, policy uncertainty and tariff escalation (both with China and others) remains a pressing near-term threat to global growth prospects. There was a clear rolling over of international business optimism and trade volumes when the U.S. turned threats into action by imposing steel and aluminum tariffs in March. Escalation since then risks scarring new global investment.
- The temporary ceasefire is inherently unstable. The U.S. has set a high bar in addressing politically difficult issues related to China’s record of business practice malfeasance. This leaves a strong chance that an escalation in tariffs has only been deferred, but not eliminated.
American economy passes high water mark
- The U.S. economy remains the growth-leader among the G7, by a wide margin. Tax cuts and fiscal stimulus pushed the expansion to an average of 3.5% over the second and third quarters of this year. We expect real GDP growth of 2.9% in 2018, consistent with our last forecast. The economy should moderate next year to 2.5% and 1.9% in 2020, as the impulse from fiscal policy wanes and higher rates feed through.
- Consumer spending has been the main thrust of this recent outsized GDP growth. It has averaged 3.7% in the past two quarters, on the back of impressive job market strength. Data so far in the fourth quarter suggest moderation to a still-healthy 2.9% pace.
Above-trend growth should keep the Federal Reserve biased towards further rate hikes. We expect the upper limit of the fed funds rate will reach 3.00% in 2019. This would also mark the peak in the rate-cycle within our forecast, coming to rest within the Fed’s neutral range of 2.50% to 3.50%. - We are certainly not out of the woods on sabre rattling regarding further trade actions. The U.S. has agreed to hold off on raising the tariff rate on $200 billion in Chinese imports from 10% to 25% for 90 days. But, this does not erase the negative impact on business sentiment and the potential knock-on effects to investment in affected sectors. We did not include the direct impacts from a step-up in the tariff rate in this round of our forecast, but we are injecting some negative judgement around exports and investment due to the persistence of policy uncertainty.
- Fiscal policy remains a key source of uncertainty within the forecast. If a divided Congress cannot reach a deal on extending the current spending caps by the end of 2019, automatic spending cuts would take an additional 0.5 percentage points off 2020 growth. This is not embedded within our forecast.
| Economic & Financial Forecasts | |||
| 2018F | 2019F | 2020F | |
| Real GDP (annual % change) | |||
| Canada | 2.1 | 1.8 | 2.0 |
| U.S. | 2.9 | 2.5 | 1.9 |
| Canada (rates, %) | |||
| Overnight Target Rate | 1.75 | 2.25 | 2.50 |
| 2-yr Govt. Bond Yield | 2.05 | 2.50 | 2.55 |
| 10-yr Govt. Bond Yield | 2.20 | 2.80 | 2.85 |
| U.S. (rates, %) | |||
| Fed Funds Target Rate | 2.50 | 3.00 | 3.00 |
| 2-yr Govt. Bond Yield | 2.80 | 2.95 | 2.95 |
| 10-yr Govt. Bond Yield | 3.00 | 3.15 | 3.15 |
| WTI, $US/bbl | 60 | 65 | 66 |
| Exchange Rate (USD per CA | 0.76 | 0.78 | 0.79 |
| F: Forecast by TD Economics, December 2018; Forecasts for oil price, exchange rate and yields are end-of-period. Source: Bloomberg, Bank of Canada, U.S. Federal Reserve. | |||
Canada forecast cut on oil sector woes
- Developments in the oil sector, notably production curtailments, have made their mark on the Canadian outlook. The impact on 2018Q4 GDP growth is a 0.5 percentage point markdown. We currently track Q4 growth at just 1.6%. Next year faces a further hit in the first half, which shaves the 2019 forecast as a whole by 0.15 percentage points.
- Activity in the oilpatch is expected to stage a moderate recovery by the end of 2019. By this point, takeaway capacity should be more aligned with production, restoring balance to the market and bringing curtailment to an end. Our 2020 forecast has been upgraded slightly to reflect this expected recovery.
- More broadly, recent indicators point to a reshuffling of the sources of economic growth. The fundamentals remain supportive of non-energy investment and trade. This partly reflects the USMCA’s impact to reduce trade policy risks, as well as the recently announced corporate tax measures within the Federal government’s fall fiscal update. This rotation is crucial as consumer spending is restrained by rising debt servicing costs.
- Under the assumption that oil price conditions improve and Canada’s economy returns to 2% growth in the coming quarters, the Bank of Canada should follow through with two additional rate hikes next year.
- We suspect the timing of the next hike will be in the March/April period of 2019, in order to permit the Bank of Canada sufficient time to confirm the growth narrative remains intact alongside a more fulsome recovery in oil prices.
Global Outlook: Economic Momentum Reset
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- After peaking in the first half of the year, global growth has slowed as expected to a 3.2% pace in the second half. The expansion is likely to hover at an average annual rate of 3.4% next year (Chart 1). This is not a large decline by any measure. In fact, it represents about U.S. $240bn less income generated next year in a global economy estimated to generate roughly $80tn in annual income.
- Although growth is slowing modestly toward trend, reduced momentum and an outlook clouded by downside risks has heavily scaled back investor risk appetite. The global selloff in equities in recent months is estimated to have wiped out about $5tn in wealth. Slowing economic growth has also spooked commodity markets, sending WTI oil plunging and forcing OPEC’s hand on another agreement to reduce supply in 2019.
- The financial and commodity market selloff contrasts with still elevated leading indicators in global confidence measures (Chart 2), healthy corporate profits, and falling unemployment rates in G7 economies. Although productivity growth remains subdued, there is the potential for an uptick. However, this requires businesses to remain confident in the outlook. As we’ve seen in recent months, the persistence of global trade tensions has threatened to undermine this outcome.
- Regionally, the U.S. economy has been a global growth outlier, but its position as an outperformer will narrow in the fourth quarter and thereafter. The Federal Reserve is likely to maintain a tightening bias in 2019 due to evidence of capacity constraints, including rising input costs and labor scarcity. However, we expect a more cautious pace of increases as we enter the home stretch of the rate hike cycle.
- Less rapid growth among its peers implies that interest rate differentials with the U.S. will take some time to narrow, supporting the greenback in the near-term. The dollar has already seen tremendous appreciation over the last year, especially versus emerging market (EM) currencies, which face significant pressures on equity and bond market capital outflows (Chart 3).
- Early warning indicators are not yet signaling that a recession is around the corner. However, we recognize that the legacy of easy money and the current tightening cycle present a threat to the expansion. So too does an escalation in trade tensions between the U.S. and its trading partners, a move that could exacerbate the downturn both in trade and demand (Chart 4). However, the biggest threat to the global expansion is likely a sustained negative market psychology that can become self-fulfilling.
What in the world is going on?
- Financial markets received one of their first whiffs of weakness when Euro Area (EA) growth disappointed expectations in the third quarter with a 0.6% print. A contraction in the usually-resilient German economy was particularly unnerving. However, digging into the data revealed a large, but temporary, drag coming from automobile production due to the implementation of new environmental regulations. Outside of that sector, the economy proved sturdy. Looking forward, auto production will normalize, and the EA’s growth is expected to perk up to 1.5%, just a hair above trend estimate of 1.3%.
- Elsewhere, growth in the UK surprised to the upside in the third quarter. However, financial market spirits were not lifted because the economic momentum heading into the fourth quarter already signaled a more tepid pace, not to mention Brexit fears abound with the looming deadline of March 2019.
- It goes without saying that the fortunes of the UK economic outlook materially hang on Brexit developments. If Brexit goes smoothly next March, the UK economy is likely to expand at a trend pace of 1.6% next year.
- Further afield, inclement weather in Asia drove a steep decline in Japanese economic activity in the third quarter. Naturally, this didn’t help support the already fraying nerves of financial markets. The outlook for Japan remains positive but choppy, as spending on Olympics-related infrastructure continues to support an above-trend pace of activity that will be partially distorted by the VAT increase scheduled for next October.
- Despite some temporary setbacks, G7 growth has not blinked. Inflation has perked up, proving strongest in the U.S., Canada, and the UK. As a result, central banks in these regions will remain the most proactive in removing stimulus if there’s any evidence that inflationary pressures are heating up beyond their expectations. In contrast, the ECB is largely anticipated to remain far behind their peers, at best taking the deposit rate up from -40bps to zero by the end of next year amidst a much more subdued inflation outlook.
EM slowdown intensifying
- While one-off factors have impacted some of the G7 countries, that has not been the case with emerging market economies. Here, the slowdown has been slightly more pronounced than we were expecting, with growth in the second half of 2018 to average a 4.2% pace versus a swift 5% pace in the first half of the year. Capital outflows driven by interest rate differentials and a high U.S. dollar have been crippling factors, however inflows are starting to slowly return to some regions. Although battered, many EMs are likely to grow near trend next year, with economies in Latin America the clear exception, such as Brazil and Argentina.
- Higher frequency data suggest that activity in East Asian economies remains subdued, partly reflecting a decline in confidence owing to elevated trade tensions between the U.S. and China. However, slower growth in China is likely more a reflection of past measures by authorities to rein in credit growth, than recent tariff measures. Any escalation in the trade war would shave about 0.2% ppts from growth next year, placing it close to trend at 6.0% for 2019 – a 0.6ppt reduction relative to 2018. This drag could be partially offset by planned stimulus set to take effect early next year.
Will oil fundamentals return?
- Earlier concerns about supply shortages due to Iran sanctions have given way to oversupply concerns. The U.S. granted six-month exemptions from sanctions to its allies heavily reliant on imported Iranian crude. This developments contributed to a volatile quarter for WTI, surging to U.S. $76 per barrel before collapsing to U.S. $50 per barrel. Forecasts calling for weaker global demand and rising supply have effectively taken out the bullish bid on oil in the near-term, while motivating OPEC+ to commit to a six-month, 1.2 mb/d production cut starting in January.
- Looking ahead, we see OPEC+ supply cuts, Middle East tensions, and a further reduction in Iranian oil output supporting a recovery in the WTI price towards the fundamental range of $60-$65 a barrel. This view is consistent with balanced oil inventories, slowing global growth, and increased U.S. shale oil production.
Global risks abound
- In a recent report, we detailed the high volumes of event risks on the docket for 2019. Top of mind is the potential for a temporary 90-day ceasefire on the trade war between the U.S. and China trade to re-escalate given the high bar set by the U.S. administration in addressing China’s corporate malfeasance. The U.S. has also not removed the threat of additional tariffs on $267bn in Chinese imports should the first trigger be pulled on raising the tariff rate from 10% to 25% on the initial $200bn of products. If this nuclear option occurs, we would need to mark down U.S. growth by 0.5 percentage points through 2020 and global economic growth by 0.2 percentage points over the next four to six quarters (Chart 5). However, the scale of the adjustment is highly dependent on financial market reaction. In both of these estimations, we embed a modest pullback in sentiment, but today’s jittery markets suggest otherwise.
- The spillovers from a global trade war is likely to hit East Asian economies more than G7 economies (Chart 6). They have a higher trade dependency on China, and would be prone to greater negative shocks from any tariff-induced slowdown in Chinese economic activity. While most EM Asian economies have learned from past financial crises and have ample foreign exchange reserve and limited domestic imbalances, their economic reliance on trade maintains a vulnerability.
- In Europe, risks from Brexit and populism continue to weigh on the outlook. Furthermore, populist sentiment is helping empower the Italian coalition government to take a stand against the EU at great cost to the Italian economy. Although the budget impasse is unlikely to lead to a crisis given that Italy is too big to fail, the exercise has resulted in a surge in borrowing costs that will exert a drag on an economy already suffering from excess capacity and slowing growth.
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