Will U.S. Economic Growth Dip, or Will the Rest of the World Catch Up?
(Bloomberg Businessweek) -- An important issue facing the global economy and markets in the final quarter of the year is divergence—the widening economic and policy differences among advanced economies as U.S. growth outpaces that of Europe and Japan. The next few months will also shed light on a second crucial issue—how these divergences will ultimately be reconciled. Will the U.S. lose momentum, dragged down by slow global growth and/or a loss of domestic policy momentum at home? Or will Europe and Japan gain speed and converge with the U.S.?
These questions raise consequential issues well beyond financial markets, affecting the prospects for trade wars, currency turmoil in emerging economies, the path for orderly normalization of monetary policy in the advanced world, and, in the political realm, the future of anti-establishment movements and polarization.
Since the end of 2007, and including International Monetary Fund projections for 2018, gross domestic product in the U.S. has expanded a cumulative 17.1 percent, compared with 11.6 percent in Europe and 6.7 percent in Japan. The initial phase of U.S. outperformance resulted mainly from bigger problems in other parts of the advanced world, particularly in Europe, where the debt crisis dragged down economic activity. Then followed a short period of synchronized expansion and, most recently, a pickup in the U.S. as both consumption and business investment responded to tax cuts and deregulation—a policy-induced boost that the Federal Reserve expects to last for up to three years.
The robust U.S. labor market and an inflation rate consistent with the 2 percent objective have opened a bigger window for the Federal Reserve to continue to deliver, adapting a phrase Bridgewater Associates’ Ray Dalio used in a different context a few years ago, “beautiful normalization” of monetary policy. That is, it could raise rates closer to their typical range and close the chapter on a protracted period of experimental and unconventional policies implemented to deal with the messy aftermath of the global financial crisis. Already, the central bank has stopped its program of large-scale asset purchases, hiked interest rates eight times, rolled out a program for the gradual contraction of its $4 trillion balance sheet, and gotten the market to price in an additional set of rate hikes for the next 12 months—all without causing economic and financial distress domestically.
Because economies in Europe and Japan are less buoyant, the process of monetary policy normalization has been a lot slower. After a prolonged period of aggressive asset purchases and negative interest rates, the European Central Bank is finally reducing its monthly bond buying and has signaled both the likelihood of ending it this year and the initiation of rate hikes at the end of the summer next year. At the same time, it would explicitly keep on the table the option of reversing course should the economy lose steam and inflation fall away from its target. The Bank of Japan remains more cautious.
The Fed’s rate increases, along with concerns about the contagion and the spillover of a possible trade war, have contributed to a significant downturn in currencies and stocks in emerging markets. U.S. stocks have continued to outperform those of other countries, with particularly large recent and cumulative differences vs. emerging markets, including some 20 percentage points so far this year.
This economic and policy divergence will become increasingly challenging for the global economic system. Here’s how the timeline is likely to play out, through the fourth quarter and beyond. Higher growth and interest rates in the U.S. would fuel both capital inflows from abroad and the repatriation of some U.S. funds held there, thereby bolstering the dollar. That could also aggravate trade tensions, the intensity of which would likely depend largely on the degree to which U.S. trading partners (particularly China) are willing to make concessions.
This would threaten emerging countries with renewed currency turmoil, higher borrowing costs, and lower availability of private credit to roll over maturing debt. The longer these conditions persist, the higher the probability they would undermine economic growth, aggravate inflation, and expose an expanding set of financial vulnerabilities. Such spillovers would, in turn, increase the probability of spillbacks creating headwinds for the advanced economies.
Further economic and policy divergences in the next few months would also be planting the seeds for their own demise over the longer term. How this gap will close matters a great deal for both the global economy and financial markets.
Convergence from below—a pickup in European and Japanese growth—would lower financial tensions by reducing pressures on foreign exchange markets and interest rates, easing trade tensions, and opening a wider window for the gradual and orderly normalization of monetary policy. This would benefit both advanced and emerging countries, reducing the risk of destabilizing feedback loops.
Convergence from above, with U.S. growth rates falling closer to those of others, would be bad news. Lower income growth in the U.S. would likely weaken a critical global growth engine, intensify trade tensions, and further polarize the political landscape. Also, the likelihood of lower global income in this scenario would offset the relief that emerging economies would feel from lessened dollar and interest-rate pressures. It would also expose them to unsettling periods of strained market liquidity in the midst of waves of forced selling.
How should investors navigate this in both the short and longer term? With such large dispersion in asset prices between the U.S. and the rest of the world, it would be understandable for investors to position their portfolios in the fourth quarter for the “antidivergence” trade. Yet, as tempting as this may be, it could also be premature.
Over the next few weeks, we should expect the continuation—indeed, intensification—of the economic and policy divergences that favor U.S. assets in relative terms. It gets a lot more interesting over the longer term: The longer divergence persists, the higher the probability of a regime break in markets.
Should investors anticipate a pickup in the implementation of sound pro-growth measures in Europe and Japan, they would be well-advised to evolve into greater global diversification, and do so in the context of an overall increase in risk-taking. But if the expectation is for policy implementation to continue to underwhelm—the more likely outcome based on current indications—then continued favoring of U.S. assets would need to be accompanied by a reduction in overall risk exposures.
©2018 Bloomberg L.P.