Investors’ call on the US economy may now be the single most important one to get right, and for a reason that goes beyond the fact that it’s the largest economy in the world with the most liquid financial markets. And it’s a call that also may well depend on what they do.
What happens to the US economy will determine whether the recent sell-off in global stocks, driven by global growth concerns, extends into a notable correction. The strength of the US economy will decide whether the world will continue to see divergence among advanced countries that limits market volatility or will see the deepening economic weakness elsewhere deteriorate into a truly synchronised global slowdown.
For the purposes of this discussion, the US economy is different from other advanced countries in two important ways: First, and especially when compared to Europe, economic growth picked up in the first quarter, exceeding 3 per cent on an annualised basis. Second, having been able to hike nine times since late 2015, the Federal Reserve — unlike the European Central Bank and Bank of Japan — has built up a cushion for rate cuts should the economy weaken.
These two realities have served as an important counter to the threat of a synchronised and protracted slowdown in global growth — that is, a simultaneous and, importantly, self-reinforcing loss of global momentum that throws some countries into recession, ignites debt concerns in some advanced and emerging economies, and fuels additional market instability through liquidity air pockets.
With the US economy in a better place, the biggest engine of global growth was still humming, and savers could finally secure an acceptable interest income. And, with the Fed seen as willing and able to respond to market weaknesses by cutting rates, investors were more confident about a floor for equity values.
Whether this continues — and doubts have surfaced recently as stocks have sold off and Treasury bond yields plummeted, both deepening pain trades in markets — depends on the US being able to avoid both a policy mistake and a home-grown market accident, either of which could derail growth. Otherwise, it would join the ranks of slowing economies, imparting a more serious downside bias to the global economy.
Coming at a time of greater political polarisation and nationalism, as well as little support for cooperative bilateral/multilateral approaches to conflict resolution, this would also increase the risk of “beggar thy neighbour” policies.
Two possible policy mistakes loom ever larger in the eyes of investors these days: a full-scale trade war and an unduly tight Fed policy stance. Last week’s threat by the US administration to impose tariffs on Mexico was quite a wake-up call for markets.
It came on top of continued tensions with China, the latest phase of which involves a new escalation of tariffs and other trade restrictions. As importantly, it also came just after Mexico had initiated the process for parliamentary approval of the USMCA trade deal it had reached with Canada and the US.
The White House’s threat was triggered not by economic issues but by political differences with the Mexican government on the flow of migrants. The result is a significantly greater sense of unpredictability in the conduct of US trade policy. It further weaponized an economic tool, and it is likely to raise questions in the minds of other trading partners (including China and Europe) as to the durability of trade deals reached or being pursued with the US.
Should this persist, it would raise serious doubts on the ability of the global economy to overcome the current phase of trade friction without a major hit to growth, trade and financial stability.
The possibility of a Fed policy mistake raises even more complicated issues, including a tricky trade-off.
It is now clear that the Fed’s hikes last year — and in particular the fourth one, in December, which was accompanied by the reiteration of the “autopilot” balance sheet approach — were excessive. With financial conditions tightening beyond the Fed expectations, and with the rest of the world weakening markedly, the central bank was forced into a big U-turn in the first quarter of this year.
It revised its policy guidance in two major ways: from the autopilot reduction path for its balance sheet to a September stop to the programme; and from signalling two rate hikes in 2019 to none.
Markets are now pricing in another major dovish re-orientation of Fed policies, including multiple rate cuts this year and next. If the Fed refuses to validate this quickly by again changing its policy guidance, markets may deem this as a policy error.
The resulting sell-off in stocks and corporate bonds would tighten financial conditions, threatening both investment and consumption. But if the Fed were to go along and succumb once again to pressures from the markets, this would fuel the narrative of a flip-flopping central bank that lacks proper strategic underpinning.
Also, the effectiveness of the policy transmission mechanism to the economy is far from assured, raising doubts on the extent to which a looser Fed would boost growth.
All of which brings us to the three ways in which traders and investors themselves may now pose a material threat to the economy:
Last week’s readings on personal income and consumer sentiment were a reminder that — at least for now — the US economy continues to do well even though the rest of the world faces tougher economic conditions. The data support the continuation of divergent performance among advanced countries rather than a synchronised slowdown. But the coast is far from clear.
The risks of policy mistakes and market accidents are rising. And the biggest threat of all may well be that of a marketplace that has not only become highly dependent on ample liquidity, but also feels entitled to request even looser financial conditions almost regardless of domestic economic reality.
