Lower for longer or lower forever?

While at the start of 2018 there was probably too much optimism around the global economy, the reverse has been true this year: most people have been too pessimistic. There are signs of stabilization and UBS economists believe that after a weak spot, the global economy will start to recover.

Inflation

Central banks are in an unprecedented position, as the world no longer seems concerned about inflation and yet they are working harder than ever. The FOMC seems quite divided over how to react in the current environment, which makes communication a challenge. Over the last six months communications from the FOMC have contributed to volatility. If there isn't a united board then it is hard for the chair to give coherent answer.

Trade headwinds

The biggest concern for many investors is the US-China trade conflict, because essentially the outcome is expected to be binary, which is hard to prepare for. Many expect that governments would look for a solution rather than let the problems escalate, which suggests the problems will be resolved - if not at the G20 this week, then more likely through additional negotiations rather than an immediate escalation. But, there is a real concern that there could indeed be an escalation.

A hard landing in China seems highly unlikely. Concerns about a crash have been around for most of the last 15 years, since China started becoming a more active player in the global economy, and yet it has continued to grow at a decent rate. Chinese authorities have the ability to act divisively in terms of monetary and fiscal policy to keep the economy going forward, at around 6% GDP growth per year, for now¹.

European outlook

Pessimism about Europe and the European Union seems to grow the further away you get from Europe. But reforms and progress in the EU are happening, they just happen very slowly. As a result of the crisis, small policy levers have been added and this process will continue. There are no clean-cut, fast solutions but over the course of time the advances contribute to increasing integration.

Center stage for central banks

The world's global central banks have become not just the repairmen for the economy but in fact the fire brigade, acting often and fast to solve problems. Central banks have infinite tools if they are willing to take infinite risks. It comes down to how much risk each one is willing to take against the background of an economy where central banks are at the core of crisis management.

This happened during the global financial crisis and was absolutely needed, because they are fast actors and can take quick decisions. Responses from other parts of government tend to be much slower. But that should not be the role central banks play all the time, and they need to find a way to exit this emergency mods. To do that, they need to see a much more resilience in the economy and banking systems.

Global debt

Total global debt is heading north of 319% of the world's gross domestic product and debt levels continue to rise fast, which is an important risk¹.
In 2018, debt levels moved sideways for the first time in many years, but it will be interesting to see if, as a result of a new round of easing, debt levels begin to reignite.

In the US, there is renewed interest in Modern Monetary Theory, which essentially suggests that a combined expansionary fiscal and monetary policy doesn't matter. That is true – until it matters. When 'bond vigilantes' as they used to be known grow hawkish on debt and go on strike, the price of borrowing goes through the roof. Debt defaults have been historically low but they're a real risk now.

When is a safe haven not a safe haven? It used to be a benefit, and being a bank in a safe haven was a great thing to be. Now it's almost a curse. For instance, look at Germany. Whenever there is a problem in world markets, bond yields in Germany go down, which in turn puts pressure on banks. Being a safe haven is more complex than it used to be.

There is much debate about the wage–price transmission mechanism, which appears to be broken, or at least malfunctioning. In the past, when Europe was largely a closed economy, wage pressures translated quite quickly into higher salaries, giving corporations more power to raise prices. It's hard to spot but one possibility is that, because the economy is now much more open, models may be missing the global competition on wages – where lower wages in emerging markets such as China are limiting wage increases in Europe, which means companies lose pricing lose pricing power. A bigger, more global economy has broken some of these transmission mechanisms.

European capital markets reform has focused too much on creating a level playing field within the EU but it has not addressed the fact that capital markets need to be globally competitive. There is competition between financial centers for share of wallet rather than a concerted effort to rebuild European capital markets. It looks a lot more like a zero-sum game than a positive-sum game. With the UK leaving the EU, the biggest capital market is leaving, which puts additional pressure on the remaining European capitals to compete.

Brexit

Brexit is creating enormous political and economic upheaval in the short-term, but there is a risk that these concerns are overblown. The UK economy had been growing above potential, but this was unsustainable, so it seems natural that it should slow more than other European economies. Brexit will come and go, it will be a process. The more fundamental shifts, just as in other countries, is going to be more important going forward.

While the political instability is in focus at the moment, looking around the political problems around the world suggests the UK is far from unique: the world is facing greater political volatility. By that measure, the UK stands out less. Perhaps the risk premium on investing in the UK should rise, but in this world the UK doesn't look that exceptional in terms of political volatility. It has strong institutions, a large economy and a deep and talented labor force. There is nothing to suggest the Independence of the Bank of England is being called into question, so sterling's status as one of the reserve currencies is unlikely to suffer.

¹ UBS June 2019, Reserve Management Seminar