Authored by Chetan Ahya, Morgan Stanley global head of economics
Amid market volatility and continued downside surprises in global growth, investors are focusing on the Fed and China. Regarding the Fed, the issue is whether and when it could signal potential changes in balance sheet normalisation (as it has on the policy rate path). On China, the question is when growth could stabilise. We think policy-makers will take the actions necessary to manage their countries’ respective growth trajectories. We believe that China’s growth will bottom in 1Q19, while the Fed has begun to signal some flexibility on its balance sheet policy, if there is a material deterioration in the growth outlook.
The Fed has altered its policy trajectory on rates, but not yet on the balance sheet. Despite robust trailing consumption growth and strong labour market dynamics, the US economy is unlikely to remain immune to slowing global growth. In addition, the recent tightening in financial conditions has affected capex intentions, and we expect the impact of fiscal stimulus on growth to fade in 2019. Recognising this slower growth environment, the Fed has signalled its flexibility on the policy rate path. However, the Fed has not yet given a clear signal on when the balance sheet reduction would end.
The normalisation process has not been as smooth as assumed. The Fed had anticipated that once it announced the path of balance sheet normalisation, markets would discount that “passive and predictable” pathway and that the process would be akin to “watching paint dry”.
However, we see the challenge as follows:
(1) Even though the Fed communicated the pace of the unwind well ahead of its start, uncertainty remains as regards the final, optimal size of the Fed’s balance sheet. Moreover, we believe investors are concerned that the Fed has remained on a set course, even though the US and global growth outlook has weakened.
(2) The normalisation process also appears to have had a greater-than-expected impact on asset and financial markets via the portfolio balance channel. In his remarks on Friday, Chair Powell indicated that he does not believe that the balance sheet normalisation process “is an important part of the story of the market turbulence that began in the fourth quarter last year”. However, as my colleague Vishwanath Tirupattur noted in this publication a few weeks back, shrinking the Fed’s balance sheet has produced cracks in various asset and credit markets. Indeed, US high yield credit spreads are at their widest in 30 months, and financial conditions are the tightest in 17 months.
We think that sustained tightening of financial conditions can be the trigger for change. New York Fed President Williams indicated in December that the FOMC could be open to altering the path of balance sheet reduction if the outlook were to deteriorate considerably. Chair Powell also acknowledged this possibility in his remarks on Friday. If financial conditions continue to tighten, we believe the Fed could (a) acknowledge the impact of balance sheet reduction (via the portfolio balance channel) on broader financial conditions and (b) hint at an early end to the process. (We expect the minutes of the previous FOMC meeting, to be released on January 9, to reveal that not all FOMC participants agree that the runoff has proceeded smoothly). Policy-makers have ample opportunity to further calibrate their response: Chair Powell and Vice-Chair Clarida are slated to appear this week.
Growth in China has decelerated over the course of 2H18, persistently surprising on the downside in recent months. While policy-makers have responded by stepping up the pace of easing efforts, investors remain concerned that these measures are not enough to stabilise growth.
The degree and nature of easing has been different in this cycle. Policy-makers in China have made a concerted effort to maintain financial stability. While they have eased in reaction to rising external uncertainties, maintaining the objective of controlling financial stability risks has kept them from moving too aggressively. What’s more, easing measures have aimed at encouraging private sector spending, but weak private sector sentiment (dampened further by trade tensions) has prevented spending from picking up.
We expect China’s growth to bottom in 1Q19. Past easing measures have not yet stabilised growth. We think policy-makers are focused on the growth outcome and will calibrate their response as necessary. Indeed, they have recently taken a different tack, front-loading the issuance of a temporary quota of local government bonds before the annual budgets are finalised (by March). We expect further monetary and fiscal easing to lift broad credit growth to 12.5% from 10.6% currently (the latest move being the 100bp cut in RRR), and the cumulative fiscal easing could result in a 1.5pp of GDP increase in the augmented fiscal deficit. Moreover, there has been some progress reported in bilateral trade negotiations, lowering the chances of escalation beyond March 1. Both of these factors will help investor sentiment and the growth trajectory.
Watch for a shift from the Fed and stabilisation in China. We think the Fed could signal its flexibility around the balance sheet normalisation process in the coming weeks and China’s growth will stabilise in 2Q19. However, until we get an all clear on both fronts, the risk is that the macro backdrop for markets could remain challenging.