We see greater economic uncertainty ahead after a stretch of unusual calm, as we write in our new Global macro outlook Macro uncertainty on the rise.
Hefty U.S. fiscal stimulus and the risk of trade wars create a wider array of potential economic outcomes – both positive and negative – with implications for financial markets.
U.S. fiscal stimulus brings positives but also the risk of overheating and an inflation overshoot. Stronger capital spending and productivity growth can spur upgrades to potential growth and contain any overheating, yet such an outcome is far from certain and will take time to materialize. On top of these unknowns, trade protectionism is an important risk to the outlook for growth and inflation.
We have found that a global economy deeply integrated via trade can help keep the U.S. expansion from overheating. That is now coming under attack from an increasingly protectionist U.S. that potentially marks a major reversal in the U.S.-led opening up of global trade over the past 70 years. This is why the White House’s more aggressive and transactional approach, counter to the rules-based system the U.S. helped set up, is so worrisome – even as other countries press ahead with free trade deals such as the Trans-Pacific Partnership.
Protectionism has the potential to hurt sentiment and growth via both the trade and confidence channels, we find.
Trade helps redistribute demand across regions and limits inflation pressures from heating up in any one region. What drives global trade ups and downs? We find that trade is more sensitive to investment than consumption in developed market (DM) economies. This happens through capital spending. Consider the elasticity of emerging market (EM) exports to DM capex. A positive 1% shock in DM capex leads to a 0.4% increase in EM exports – about twice what it was in the mid-2000s, our research shows. This is global integration at work.
Today, DM capex is enjoying an upswing and EM exports have bounced back in the past year, showing this dynamic in action. This is on top of the lingering investment shortfall we have found previously in both the U.S. and eurozone, suggesting there is pent-up demand for capex that should reinforce the rebound. Strong export data for South Korea and Taiwan at the start of 2018 suggest this is playing out. China is a big part of this story – about half of its goods exports are machinery and equipment, and it is by far the largest such exporter of such equipment in EM Asia. The threat from protectionism casts a shadow over this dynamic.
Our research shows that if global integration were to slip back to the levels seen in the mid-2000s, the EM export boon from DM capex would shrink by half. Such a disruption has the potential to weaken EM growth while stoking more overheating and inflation in cyclically advanced economies – especially if rising trade barriers mean less DM demand leaks abroad via imports.
The confidence channel
Trade is important, but its influence on global growth goes beyond the physical exchange of goods and services. Sentiment plays an outsize role: The confidence channel tied to trade serves as the conduit for shocks to spread across countries. The Much in common chart below shows how much of the co-movement of 18 of the largest DM and EM economy growth rates can be explained by a common global factor rather than a country-specific one.
Somewhat surprisingly, about half of all the individual country variance can be explained by a single common factor. We break the past 40 years into two 20-year periods – the latter coincides with the latest bout of globalization, such as the European Union’s expansion and China’s inclusion into the World Trade Organization. Confidence matters a lot for this common factor, research shows. It serves as the conduit for shocks to spread across countries.
Growth conditions are shaped by animal spirits. That makes protectionism a bigger danger to the growth prospects of many countries, going well beyond the direct impact of simple bilateral trade exposures. As a result, we see heightened macro uncertainty ahead and the potential for higher risk premiums across assets. Read more macro insights in our Global macro outlook.