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Video transcript

Economic outlook - February 2019

Introduction:

Hello and welcome to this first economic outlook podcast from Barclays Corporate Banking for 2019. It hasn't exactly been a quiet start to the year and the topics that we so often discussed in 2018 remain ever present in the news agenda.

As you can imagine our spokespeople are busier than ever helping to guide our clients through the uncertainty. And so for this edition we've taken advantage of an interview that Henk Potts did at the start of the month with our colleagues in Barclays Private Bank. Polly Whitehouse started by asking Henk about increased volatility in financial markets and some of the fundamental global factors that might be driving this. 

 

Henk Potts:

I think after years of positive returns and low volatility in the run up to 2018 markets have become more challenging over the course of the past couple of quarters with equities, fixed income and commodities all generating negative returns in many markets. And as you know there's no single explanation why we're seeing such a broad based setback but a number of culprits have been put forward. There's the trade wars of course; the impact they're going to have on global growth. There's concerns around higher US interest rates. Perhaps more importantly the potential for a policy mistake. As the saying goes long periods of economic expansion never die a natural death, always murdered by the Federal Reserve.

Alongside that we've seen political and social instability in some of the key economies around Europe. We know emerging markets have also been under pressure of course that's due to country specific issues. The slowdown that we've seen taking place in China alongside the stronger US dollar and dare we say, and we're going to mention it today I'm sure, Brexit continues to be very disruptive and all of that you could argue is creating this toxic mix of uncertainty, unnerving investors and encouraging them to take a more defensive stance. I suppose what we should remember is when you do get dramatic market movements it can create opportunities for investors particularly if there's a mis-pricing of risk.

Markets, as we know tend to overreact, there's a potential for a relief rally once the emotional dust has settled; investors are able to once again focus on the fundamentals. And that's probably what we've been seeing over the course of the past few weeks. I think it's absolutely vital that we prepare our clients for a bumpier road ahead.

We don't see a recession but we do see moderating global growth in the future, decelerating earnings growth as well during the course of 2019 and therefore I think investors should be prepared for an environment with more subdued returns from risky assets and persistently higher volatility. We still expect for example high maybe single digit returns coming through from equity markets, which is probably higher than you'd expect from other asset classes but with significantly more risk. So the world around us has been changing. Investors need to adapt to that change.

 

Polly Whitehouse:

Talking about Brexit what would be the impact of a new deal Brexit? 

 

Henk Potts:

Well no deal Brexit would have dramatic implications of course for the UK economy and for financial markets. We've done some research that suggests that sterling would come under pressure maybe fall by somewhere between five and 10 percent. I think you could also expect inflation to surge up quite dramatically. If you look at UK CPI today it's very low just above two percent, potentially you would see it above three and a half percent. You see the imposition of tariffs, the effect of course on a weaker currency.

Think about unemployment as well: UK very unemployment very low today, just above 4 percent. We can maybe see it going above 6 percent over the course of the next couple of years. So I think we could see lower business investment, lower household investments coming through, reduced domestic consumption and that would certainly weigh on growth.

So we could see growth maybe coming in at six tenths of 1 percent during the course of this year then slowing once again as you look out to 2020 with growth of maybe just one tenth of 1 percent. So a significant fall and all of that of course sounds very dramatic. What we should remember is that it's nowhere near as bad as some of the predictions we saw at the Bank of England under their disruptive under their disorderly Brexit. They were talking about significant contractions in GDP between 2019 and 2023. 

 

Polly Whitehouse:

So how do you expect the Brexit negotiations to play out? 

 

Henk Potts:

Well that's of course a big question for markets. What we do know is of course Theresa May has won that vote of no confidence which means she goes back to the day job of trying to sort out Brexit. I think she's focusing on two strands. Number one trying to get new concessions from the European Union. Number two trying and develop this cross-party consensus about how to take the Brexit process forward from here.

The concern is of course that she's not likely to make a great deal of progress because the European Union's already suggested that they wouldn't be prepared to open the Withdrawal Agreement and developing this cross-party consensus is always going to be difficult. You've got these varying political agendas taking place across Westminster at the moment, the Labour leadership potentially pushing for a general election so that's going to be hard to come through in terms of consensus. I suppose the positive is the markets decided to take this very much within its stride believing of course the risk of a no deal Brexit would be the most damaging to the UK economy, the most disruptive in terms of financial markets, still looks unlikely to happen.

Inexorably, it feels like we're moving towards a material loosening of that March headline date through an extension of Article 50 which of course would need unanimous agreement from the remaining EU27. That of course would give more time in order for a deal to be negotiated. But we should also appreciate of course it brings in some other options as well. The potential for a general election, a renegotiation or indeed of course a second referendum. So still all to play for despite the fact that headline date is looming very large. 

 

Polluy Whitehouse:

Looking to America now. What are your projections for the US economy this year? 

 

Henk Potts:

Well there's a significant pick up in economic activity in the United States during the course of last year. So we saw growth move from just two point two percent during the course of 2017 getting up to two point nine percent during the course of last year. And actually comes into this year I think with some pretty good momentum. Got robust household consumption, you got strong business investment, you got the impact of that fiscal stimulus, the sugar rush put in place under the Trump administration.

Perhaps we should step back and think about the US consumer, not only the driving force of course behind the US economy, some would say behind the global economy. The US consumer's in great shape today, benefiting from very low levels of unemployment. The US economy created 2.6 million jobs during the course of last year. US unemployment's down at 3.9 percent today. Compare that to October 2009 when it was at close to 10 percent. Alongside that we know that wages are growing at a faster rate than inflation. The tax cuts have been boosting disposable income, business investment still remains very strong. You've got this friendly White House towards corporates and they've been reacting to that.

Alongside that you've got the stimulus package, the cutting of taxes, the ramping up of government spending as outlined under the second budget from the Trump administration. So putting more government money into security into defense and into defending the border. And these are efforts that will continue I think at least in the short term to boost the economy.

So we remain pretty positive about the growth prospects for the US economy particularly during the course of this year. Think we could see similar growth maybe 2.9 percent during 2019 but we should recognise that if growth does continue through mid 2019 it would become the longest period of expansion on record. The fiscal stimulus will gradually fade. Higher interest rates of course you'd expect to eventually start to weigh on the growth of the US economy. So as you look out to 2020 we start see conditions normalising a little bit, growth going back to around about 2 percent. 

 

Polly Whitehouse:

You touched briefly on interest rates. How many interest rate hikes from the Federal Reserve do you think we can expect this year? 

 

Henk Potts:

Well remember the Fed began hiking interest rates back in December 2015 from near zero. They've now hiked rates nine times taking rates up to two and a quarter two and a half percent showing they were determined to normalise policy. I think they remain under some pressure to continue to do so, you've got a strong growth profile that we've been talking about when it comes to the US economy. Tight labour markets of course pushing up wages but also the objective from the Federal Reserve, but you see it from other central banks, about the need to have some ammunition for the next time there's an economic downturn.

I think also alongside that you should remember inflation expectations still look reasonably benign at least in the short term, financial conditions have tightened. We've seen a fall in equity markets, a flattening of the Treasury yield curve and of course widening corporate spreads. Risks to the global economy have increased quite significantly. I think the Fed have moved from this ideological stance to a more pragmatic approach. They're watching the incoming data, they expressed they are prepared to be patient and that's encouraged us I think to rein in our expectations when it comes to the Fed hiking cycle, although we still believe that we'll see two further hikes during the course of this year and one in 2020. 

 

Polly Whitehouse:

So let's talk about Europe now, why has the European economy slowed down so dramatically?

 

Henk Potts:

Well you're absolutely right. The most significant economic disappointment during the course of 2018 certainly was Europe. You go back to 2017 economists believed the continent had indeed achieved this escape velocity helped by the global rebound that we saw in manufacturing and trade, which as we know disproportionately benefits Europe's very open export-orientated economies.

Most economists believe that growth that we saw in 2017, two and a half cent, remember is the strongest that we saw in a decade, would have continued that momentum into 2018. So why was it such a disappoint? Wll there's a range of factors I suppose, there was weaker external demand, we saw the impact of the strikes and the protests in some of the key economies, particularly of course the likes of France which was impacting the supply chains and activity. What a tough time it's been for the German manufacturing sector, particularly of course the auto makers. They had to deal with tariffs they had to deal with tougher emission standards, a slowdown in Chinese demand as well for their cars. And that certainly infringed upon their growth profile.

If you look at Germany: just managed growth of one and a half percent during the course of last year, so weakest that we've seen in five years. Think about that budget battle that was taking place in Italy that had a significant impact in terms of business confidence, results in reduced investment, less hiring, household consumption is weaker than you probably would have expected as well. And all of that of course had a significant effect in terms of growth.

The good news in terms of the outlook is the fundamentals internally still look pretty supportive. They've got loose financial conditions, you got high levels of consumer confidence, unemployment's at its lowest level since November 2008. So we think actually conditions in Europe will stabilise during the course of this year and maybe we can expect growth of somewhere close to one and a half percent in 2019. 

 

Polly Whitehouse:

I see, so you mentioned the interest rate hikes in the US. How quickly can the ECB normalise policy? 

 

Henk Potts:

Well we've been talking about the Federal Reserve and their rapid approach to try to normalise policy. It's been a little bit slower, much slower in fact, from the European Central Bank. Remember they embarked upon this huge quantitative easing program back in January 2015. Since then they've injected something like 2.6 trillion euros into the system. The better data that we've seen in the past couple of years, the pick in inflation, has encouraged them to move away from that emergency policy stance so they have begun the process. They ended their bond buying program the end of last year although still remain committed to reinvestments.

But I think it's going to take some time for them to improve the forward guidance which would then set the stage finally for them hiking the deposit rate. So I don't think we'll see a hike in the deposit rate probably until September 2019 this year when we expect a 15 basis point increase.

The real debate of course is when does the European Central Bank think about hiking interest rates? They've already told the market they're committed to keep interest rates down at zero for a prolonged period time at least until the summer of this year. We believe it'll probably take a little bit longer than that. And don't think about the first hike from the European Central Bank probably until the first quarter of 2020. 

 

Polly Whitehouse:

Finally, if we can talk about China. China's growth profile has been slowing down. What's the outlook? 

 

Henk Potts:

I don't think we should be too shocked by the slowdown that's been taking place in China. China is a much bigger much more mature economy than it was just a few years ago of course when it was growing at that 10 percent plus growth rate.

We know the numbers are in for 2018 and it showed a significant slowdown once again, three consecutive quarters of slowing down during the course of the year. Full year growth for 2018 was down to six point six percent. That's from six point eight in 2017. In fact it's the slowest growth rate that we've seen in 28 years.

Money and credit expansion slowed more than expected, industrial production, fixed asset investment; these were the powerhouses of course of the Chinese economy, still growing but below 6 percent which is a significant milestone. The future of the economy things like retail sales have also been decelerating. We've been talking about the auto sector, that contracted last year by 6 percent, that's the first time we've seen that in two decades. Manufacturing PMI slowed to its lowest level in 26 months. I think in terms of the outlook there's a couple of things really to focus on here. Number one of course the trade wars. US protectionism continues to exert downward pressure. The US remember imposed tariffs on 250 billion dollars worth of Chinese exports to the United States. China exports somewhere about 600 billion dollars worth. They threatened to put tariffs on the remaining amount if you were to take maybe a 20 percent tariff and apply it to those exports and take into account changes in terms of trade flow and domestic production.

It's certainly possible you could see Chinese growth because of those measures slowed by maybe another four tenths of 1 percent. Alongside that there's this debt deleveraging program that's been taking place in China. China's capital markets are relatively underdeveloped. Therefore companies are reliant on indirect financing. That's led to a huge increase in terms of credit growth, pushed leverage up to historically high levels and led to concerns about the shadow banking system. Authorities have been aware of that and have been trying to rein it in so they've been reducing the amount of debt given to state owned enterprises. The measures to reduce the risk of bubbles developing in the property sector.

There's also been financial market reform, as well, restrictions on credit growth, increased bank supervision. So for me there's a real balancing act taking place amongst Chinese authorities. Mitigating the risk coming through from trade wars, deleveraging the economy but still trying to maintain that strong growth profile.

But they have proved themselves both ready, willing and of course able I think to stimulate growth as and when required. We've seen reductions in things like the reserve requirement ratios, we've seen tax cuts in certain areas and of course infrastructure investment. But I think there's always this debate when it comes to China whether we're talking about hard landing or soft landing? For me it's a glide down to slower but more reliable growth over the course of next few years.

We think Chinese growth will come in around six point two percent during the course of this year, probably slowing to around 6 per cent as you look at 2020. 

 

Conclusion:

So thank you there to Polly and to Henk. We will hear from Henk again after that proposed Brexit date of March 29. Until then, thank you for listening.

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