The global macroeconomic narrative has improved and steadied since our previous forecast (1). As we noted then, the combination of strong labor-market performance and household spending, and weak manufacturing was unstable. There were two paths forward. Either ongoing strength in the former would lead to a stabilization of the latter, or the weakness in the latter would drag down the former. This tug of war appears to have been won by the labor markets and households. They remain strong while manufacturing has stabilized.

How did this come about? Timely action by central banks again saved the day, led by the U.S. Federal Reserve. Three consecutive rate cuts of 25 basis points (bps) from July to October reduced the benchmark federal funds rate to a range of 1.50-1.75%. The European Central Bank (ECB) had less policy space, but also took bold action in September as it resumed both quantitative and credit easing, and cut interest rates (2). This lowered borrowing costs and boosted demand in rate-sensitive sectors such as automobiles and housing. Lower rates also have boosted asset prices, leading to higher spending through the wealth effect. In the financial markets, volatility remains low (as measured by the closely watched VIX index, which remains in the low teens), and the Treasury yield curve has steepened, with the slope between two- and 10-year notes once again positive (3). In a nutshell, financial conditions have again become supportive.

The outlook for 2020 is therefore shaping up as, hopefully, unexciting steady-state growth in many advanced economies. This involves two cyclical variables. First, output gaps are close to zero, meaning that the economy is close to the full level of resource utilization, neither helping nor hurting inflationary pressures. Second, GDP growth is close to potential, meaning that the pace of expansion is consistent with the growth of inputs: labor and capital. The steady-state path is equivalent to a holy grail for policymakers. The question is how long the economy can stay there. At this stage of the expansion, with the Global Financial Crisis a decade behind us, the objective should be to prolong, not juice up, the expansion.

Although the baseline outlook has turned more benign, the balance of risks remains on the downside. As the events of one year ago showed, a rosy outlook can turn rather quickly in response to geopolitical developments. In particular, ongoing U.S.-China tensions remain our top risk. While these tensions aren't necessarily trade-related--and, in fact, relate to more medium-term concerns--the uncertainty (and drama) around the ups and downs of the ongoing negotiations are damping investment, and risk-taking more generally.

Detailed Forecasts

U.S.

The world's biggest economy is in a good place (4). GDP growth in the last two quarters of just under 2.0% has been close to potential, with the drag from investment now largely gone. The labor market remains strong, with unemployment near a half-century low 3.6%. With the bounce in financial markets in the past two months, including a positive slope in the yield curve, we have nudged down our recession probability by 5 percentage points, to a range of 25%-30%.

Our forecast is for GDP growth of 1.8% next year and for the output gap to remain near zero. We see the fed funds rate unchanged during the year, as the central bank returns to a data-dependent mode following three insurance cuts in 2019.

Chart 1

Eurozone

Eurozone macro developments have also improved recently, but are more mixed and more fragile than those in the U.S. Still, the overall narrative is similar.

Consumer spending aided by strong labor markets is driving growth as a record 160 million jobs was set in the euro area last month. France and Spain are the growth outperformers, while Germany and Italy lag. Importantly, the decline in manufacturing, which had hit Germany particularly hard, is bottoming out, and industrial production in the eurozone as a whole has ticked up in recent months (5). Financial conditions have also improved, and we have lowered our year-ahead recession probability to 8% from 15%.

We forecast 1.0% GDP growth for the region as a whole next year, weighed down by a sluggish 0.5% growth in Germany, the region's largest and most trade-dependent economy (6). On policy, we expect another rate cut by the ECB early next year, but only a mildly expansive fiscal policy, despite roughly half of government yields being below zero. Given its relative openness, Europe is more exposed to global trade developments than either the U.S. or China.

China

Growth remains under downward pressure, but the slowdown is mostly homegrown. According to official statistics, GDP is expanding at more than 6%, with manufacturing pulling down overall activity. Buoyant steel output, helped by property investment, has prevented a deeper slowdown. The service sector, the engine of jobs growth, remains resilient despite some recent softening. Policymakers seem content to allow growth to slow, putting more emphasis on financial stability and steady deleveraging, while keeping an eye on the labor market. Financial conditions are close to neutral, with recent tightening reflecting a waning credit impulse.

We forecast GDP growth of 5.7% next year on the view that China's authorities will either adopt a more flexible growth target or nudge down the target growth range by 50 bps, to 5.5%-6.0%. A downward glide is consistent with our view of a necessary moderation in growth over the next decade (7). The risks around the baseline remain on the downside and include an escalation of the trade-tech war with the U.S. and weak policy transmission.

Other key emerging markets

We expect GDP growth in most other main emerging market economies to improve, on average, but remain unspectacular. This is due mainly to low levels of investment owing to high geopolitical as well as domestic political and policy uncertainty, including from ongoing U.S.-China trade tensions. The combination of subdued growth and inflation will keep interest rates low next year following significant monetary policy easing cycles in most emerging market economies in 2019, which, in our view, will help domestic demand pick up moderately.

In key markets, India is experiencing a sharp fall in growth as weakness in the real sector and stress in the financial sector feed into each other; we have again lowered our forecast for fiscal 2020 (ending in March) to 5.1%.

Growth in Russia will rise by half a percentage point, to 1.8%, bolstered by a boost in public investment. Turkey's economy is recovering faster than anticipated, helped by a drastic easing in financial conditions, and we are penciling in growth of around 3% next year, from near zero in 2019.

South Africa's economy continues to be held back by limited reform and a weakening fiscal-debt position, and we expect another year of sluggish growth of 1.6% in 2020.

Mexico's economy looks set to expand 1.0%, up from 0.1% this year, as the delays in public investment typical of a new administration subside. Brazil's economic outlook is more encouraging, with growth picking up to 2.0%, from 0.8% this year, supported by an ambitious reform drive that includes the recent approval of a long-awaited pension bill.

Macro Policy: Extend The Expansion

The primary macro policy objective next year will likely be to prolong the expansion in a sustainable manner. We are a decade clear of the Global Financial Crisis, and the ongoing expansion in many economies is in or near record territory. Moreover, output gaps are at or near zero (8), so a policy-induced upside burst in growth (a V-shaped profile) is neither feasible nor desirable from a sustainability point of view. L-shaped is the way to go next year.

Monetary policy will likely be on hold for now as central bankers adopt a "wait and see" approach following recent rate cuts. Markets largely agree, as the gaps between central bank forecasts and the markets' rate bets have narrowed. The effects of this year's rate cuts will continue to pass through to the real economy in the coming quarters, allowing policymakers to gauge the effects on demand and inflation. Our sense is that the bar is high for any near-term rate changes in either direction, except where inflation remains persistently well below target.

Turning to fiscal policy, despite concerns about debt levels, the markets continue to signal that demand for risk-free assets remains high. This is the so-called "r-g" debate (9). Ten-year yields for many advanced countries' debt (r) are well below nominal GDP growth rates (g), whereas theory asserts that the opposite should be true for debt stability. Moreover, this anomaly is present not only for risk-free assets. At times, interest rates are below nominal growth well down the credit curve (see chart 2).

Chart 2

In the event of a downward shock to growth, fiscal policy will almost certainly have to play a more prominent role in demand stabilization. Following the recent central bank mini-easing cycle--or collection of insurance cuts (take your pick)--the scope for using monetary policy to combat any future downturn is limited (10). Indeed, many central banks have a policy rate that is below the average value of cuts made combating past recessions. That leaves fiscal policy to bear the load, bringing into play the tension between high debt and low funding costs. This tension, which is at least partly political, can potentially be resolved by appealing for the need to "green" the capital stock, perhaps under the umbrella of a Green New Deal or similarly branded initiative. Any fiscal stimulus is therefore likely to come with a green bow, in our view.

U.S.-China Tensions Still Dominate The Downside

The risks to our baseline remain on the downside, led again by U.S.-China tensions. As we saw at this time last year, an unexpected escalation in the spat helped to drag down global sentiment and growth, resulting in market volatility, weak investment, and heightened recession fears. While central bank actions calmed markets and stabilized growth, there is less space for rate cuts than before, and U.S.-China relations are no nearer to being resolved.

We continue to believe that the tensions are less about trade, and more about technology and managing a rising power. As of this writing, so-called Phase One of a tariff deal has yet to be signed. This preliminary step mainly involves a steep increase in Chinese purchases of American farm goods, essentially taking us back to square one of the trade war. It is not clear whether the next round of U.S. import tariffs, scheduled for Dec. 15 (this time on Chinese consumer goods, where the pain to end users will be much more direct), will go ahead. Importantly, Phase One does little to address the structural issues such as intellectual-property protection, technology transfers, or ease of doing business in China, among others. Fitting China into the post-World War II global model remains unresolved.

As to the upside, reducing the overhang of U.S.-China uncertainties by pivoting away from tariffs would likely pay substantial dividends. The new objective would be to make meaningful progress around investment, technology transfer, and international arrangements. Both sides have incentives to make this work. The U.S. (and the West generally) wants China in the global order and to be able to smoothly access its markets. China wants access to Western technology and its rightful place at the global table. A successful pivot would provide a much-needed boost to investment, financial conditions, and growth. The road ahead is long and difficult and will require long-standing structures. No quick deals will solve the problem.

A Fragile Balance

All told, we are not in a bad position. Indeed, the global macro picture has improved steadily during the course of 2019. At this time last year, markets were stressing over the divergence between the announced normalization path for policy rates (upward) and the expected trajectory of short-term growth (downward). The VIX spiked to 30, markets were declining, and sentiment was eroding. Short-term macro forecasting was certainly less clear than it is now. Central banks calmed markets by first standing down and announcing a pause in the normalization cycle, followed by a round of insurance cuts. These served not only to soothe market jitters, but also to support labor markets and household spending, and stem the decline in manufacturing that threatened to drag down global growth.

The baseline view for 2020 is now for steady growth in many key economies. To the extent that economies have not reached that blissful point (the more open, more manufacturing-based ones, as well as some emerging markets), underperformance remains the norm. Ditto for inflation, which, if anything, remains below target in some areas despite ultra-low policy rates.

The objective now is to extend the recovery into its second decade. There are two main challenges. Geopolitics continue to threaten to topple the macro apple cart, most notably in the case of U.S.-China relations. With more tariffs looming and minimal progress on the big issues, plenty can go wrong and pull down global growth. The second challenge involves the tools (or lack thereof) to stem any deterioration in the outlook. With monetary policy rates too low to combat a typical U.S. recession and the ECB losing traction (11), fiscal policy will need to carry a bigger load. Whether governments are willing to use fiscal policy aggressively given the tension between high debt levels and low borrowing rates remains to be seen, particularly in advanced Europe. Alas, the initial budget proposals do not give us much comfort (12).

Endnotes

(1) "Global Growth Is Down But Not Out," Oct. 1, 2019.

(2) To alleviate the pain of negative interest rates, the ECB introduced a tiered deposit rate system for bank reserves.

(3) We were never 100% on board with the negative sloping yield curve equals recession argument for two reasons. First, owing to QE, the Fed's asset purchases have pushed down longer-term yields, "distorting" the market. Second, at the short end, the Fed never took away the punch bowl since the cycle topped out at a fed funds rate of 2.50%.

(4) We agree with Federal Reserve Chairman Powell: https://www.wsj.com/articles/fed-chairman-powell-says-u-s-economy-is-in-a-good-place-despite-some-risks-11570212010.

(5) Germany avoided a technical recession in the third quarter, with the economy expanding by 0.3% on a seasonally adjusted, annualized basis, boosted by net exports.

(6) Our forecast for German GDP is adjusted for working days. Without such an adjustment, German GDP is likely to increase by 0.9% next year, as the number of working days will increase sharply.

(7) See "China Credit Spotlight: The Great Game And An Inescapable Slowdown," Aug. 29, 2019.

(8) There is a considerable divergence of views about current output gap, particularly in peripheral Europe, see: https://www.iif.com/Portals/0/Files/4_IIF05232019_GMV.pdf

(9) See, for example, Olivier Blanchard PIIE and references therein: https://www.piie.com/system/files/documents/wp19-4.pdf.

(10) This is not a policy ammunition argument, as is sometimes asserted. Central banks can create unlimited amounts of reserve assets so they can, in principle, buy as many assets as they desire. The issue is whether monetary policy loses effectiveness beyond some level of asset purchases. We believe that it does.

(11) See, for example, Larry Summers: https://www.americanprogress.org/issues/economy/reports/2019/09/27/475075/united-states-not-ready-recession-can/

(12) See OECD Chief Economist Editorial: https://oecdecoscope.blog/2019/11/21/policy-changes-to-turn-the-tide/