Standard Life Investments

Global Outlook

Scenarios to spoil Goldilocks’ porridge


We examine our projections for the global economy with regards to shocks or events that could cause growth or inflation to differ from our baseline estimates, and their respective drivers.

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2017 was a ‘Goldilocks’ year: combining healthy global growth, subdued inflation and cautious central banks. The consensus for 2018 so far is that Goldilocks will continue, underpinned by both the US fiscal stimulus and the benefits of a weak US dollar for emerging markets. On this basis, global GDP growth is projected to rise to 3.9%, its strongest reading since 2011.

A long goodbye to Goldilocks

Over the next few years, however, we are expecting the environment to change. Growth looks set to moderate in 2019-20, as economies run up against capacity constraints; central banks tighten monetary policy; the US fiscal boost gradually fades; and China continues to rebalance its economy towards a lower, more sustainable growth path. As spare capacity dwindles, inflation is likely to rise. In response, the US Federal Reserve could increase interest rates once a quarter over the next year at least. Other central banks will probably be more cautious, but by the time we head into 2019 we anticipate that global asset purchase programmes, or overall quantitative easing (QE), will have reversed into gradual quantitative tightening (QT).

Testing the baseline

This is our baseline view of the world economy’s path over the next few years, but that path is not guaranteed. In an uncertain world, forecasting errors are inevitable. Predictions can be knocked off course by events that are familiar but cannot necessarily be anticipated in advance, such as changes in the supply of oil, fluctuating harvests or political surprises. Projections can also go awry because of technical errors, where forecasting models exclude variables that turn out to have a strong influence on economic behaviour. Over time, we would hope to learn from such mistakes and improve accuracy – much as UK weather forecasters did after the October 1987 storms.

Other sources of forecast error are more challenging because they are, by definition, harder to assimilate. They include Nassim Nicholas Taleb’s ‘black swans’ – events that occur without precedent – and structural breaks in relationships previously treated as constants, such as that between unemployment and wage inflation.

In the aftermath of the global financial crisis, economists have put much greater effort into focusing on the risks around well-anchored and articulated baselines. Central banks, firms and investors can then explore how well policy, business and investment strategies perform across a range of potential states of the world. Where these scenarios turn out (with hindsight) to be closer to reality than baseline projections, their implications can be incorporated into future forecasts, hopefully enhancing performance.

What could go wrong with Goldilocks?

Goldilocks has, so far, been supported by a substantial amount of spare capacity in the world economy. This has allowed countries to expand at an above-trend pace without triggering rising inflationary pressures. But our latest estimates of the major economies’ output gaps – the difference between actual output and its potential level – suggest these gaps are close to closure in a number of cases. So unless wage behaviour remains completely unresponsive to falling unemployment, the lack of spare capacity will begin to feed through into a higher inflationscenario. Investors may be sensitive to the risk that central banks have to tighten policy more rapidly in response, leading to a ‘tantrum’ in financial markets.

However, inflation could also turn out to be weaker than anticipated in our baseline forecast, for a variety of reasons. The forces that have borne down on price pressures in recent years – including the success of central banks in anchoring wage- and price-setting behaviour close to target inflation rates - could prove to be surprisingly persistent. If so, Goldilocks’ combination of strong growth and subdued inflation could prove more durable than in our baseline – a lowflation scenario. Alternatively, productivity growth could finally rebound as the diffusion of innovation spreads across firms. Another variant could involve the synchronised global economic upswing of the past 18 months continue virtually unabated, with a scenario where trade and investment are boostedin a non-inflationary way by expanding growth potential.

On the other hand, there are some tentative signs of growth momentum coming off the boil. Recent Eurozone purchasing managers’ index (PMI) surveys have turned down, though they remain at historically high levels. Our ‘Nowcast’ of Chinese activity – which estimates current conditions using a variety of data sources – has also dropped recently. China’s growth rate could conceivably continue to slow more rapidly than in our baseline, now that the 19th Party Congress is out of the way and President Xi has consolidated power. Our macro-momentum indicator, which gauges the pace of economic expansion, is pointing to a similar, modestly slowing outlook at a global level.

The political context also matters. Two recent developments could have a bearing on Goldilocks’ future: the US fiscal stimulus and moves towards trade protectionism. On the former, our baseline projections assume fiscal multipliers – the ratio of the additional national income created in response to the initial boost in government spending that caused it – boost the growth rate of US national income (GDP) by 0.6 percentage points in 2018 and 2019. But there is a lot of uncertainty around multiplier estimates, which could turn out to be larger. If so, to the extent that central banks do not raise rates to offset potential inflation risks, GDP growth could also be higher relative to our baseline.

On the other hand, successive tit-for-tat rounds of protectionism could test the baseline assumption that we avoid a descent into globally damaging trade wars. And while markets have largely shrugged off the strong showing of populist, Eurosceptic parties in Italy’s recent elections, Eurozone political risksremain, with possible spillover effects to confidence and economic activity.

Exploring the scenarios

Given this broad sweep of possible outcomes, Chart 1 summarises nine that appear pertinent over the next three years. Using a macro-econometric model, we examine the initial effects of each scenario – whether higher or lower tariffs, stronger or weaker inflation responses, and the like. We also explore second- and further-round effects, through time and geographically, and allow for possible policy responses. The chart indicates the overall impact of each scenario on the levels of global GDP and consumer prices (CPI) in 2021, with the size of each bubble reflecting the probability we attach to the economic or political shock that triggers the scenario.

The chart is divided into four quadrants, depending on the impact on global GDP and consumer prices. ‘Upturn’ means higher growth and higher inflation; ‘downturn’ signals lower growth and lower inflation; ‘non-inflationary growth’ indicates higher growth but lower inflation; while ‘stagflation’ means lower growth but higher inflation.

The scenarios in which China reins in credit more rapidly than expected and, alternatively, trade and investment rebound faster than expected are the largest in terms of their global impacts. Individual scenarios may, however, have much larger regional impacts. Similarly, if a global trade war were to take place, the chart shows its impacts sitting in the ‘downturn’ quadrant. This is because the consequent decline in oil prices, and the hit to demand, dominates at the global level. However, the scenario would be inflationary for the economies at the centre of the scenario – including the US, China and Mexico.

Summarising the scenarios

In reality, there is a wide range of possible outturns for the world economy and global financial markets over the next three years, with a range of probabilities attached. In some, we could see several of the shocks combining to amplify negative or positive outturns; for example, where European political risks reignite just as a global trade war is unleashed. In others, negative and positive shocks might combine to offset each other – perhaps where a market-based ‘tightening tantrum’ recedes in the light of evidence of a rebound in productivity.

Our summary view on the baseline, downside and upside risks to the level of global GDP – effectively dividing the full probability distribution of all possible potential outcomes into three bars – is shown in Chart 2. This quarter, there is a downside skew to our risk-adjusted view of global GDP. This is the fifth consecutive quarter in which our scenario analysis has incorporated a downside skew.

Drivers of Goldilocks

Given the range of possibilities around our baseline view, why do we retain confidence in our assessment? First, because the cyclical upswing in growth over the past 18 months has been remarkably synchronised globally, led by the advanced economies. The composition of global growth is also becoming more self-sustaining, with both investment and productivity showing signs of picking up across a range of economies. Since the relationship between spare capacity and inflation appears to have flattened for long-term structural reasons, inflation risks can arguably remain low - and central banks continue to respond in a measured fashion – for some time to come. In addition, our models of leverage and balance-sheet vulnerabilities – a feature of the run-up to the global financial crisis - are not pointing to significant recession risks over the next couple of years.

That is the current position: a robust backdrop against which future economic and political events will play out. As for the future, we look first to the Trump factor: what is happening on trade policy, and what is the broader impact of the fiscal stimulus? Second, there is inflation: are surveys of prices and inflation expectations picking up, and are pay settlements doing likewise? Finally, there are central banks: against a backdrop of unprecedented withdrawal of unconventional monetary stimulus, are investors retaining their faith in global policymakers?

Monitoring developments in these three areas will help us judge whether the world economy remains on the baseline, as we expect, or may be deviating away from it.