Sitting on a beach under a blue sky, it is recommended to check where umbrellas can be found, just in case you’d need one, especially when you’re worried that so few are available and that their quality is so and so. Replace ‘blue sky’ with ‘robust growth’ and ‘umbrellas’ with ‘economic policy instruments’ and you have a description of the global economic environment: robust growth but, if a downturn would come, very little manoeuvring room for fiscal and monetary policies to stimulate growth. All the more reason to keep a watchful eye on the horizon, and to prepare for clouds to appear. The question is: where will the clouds come from? In economic terms, we must distinguish between exogenous and endogenous factors. The first are comprised mainly of sources of uncertainty, the probability of which is impossible to evaluate. Geopolitical shocks come to mind. In this case, forecasts are conditional, they are determined by the scenario (“you will be soaked if you don’t have an umbrella when there’s a pouring rain”). Conditional forecasts aren’t very satisfying since the relevant questions are whether it will rain, when and with what intensity, rather than what will happen when it rains. In contrast, endogenous risks are tied up with the natural dynamics of the business cycle: a given development triggers another, one thing follows another, and we risk ending up… in recession. These processes are not deterministic; rather they are path-dependent.

Currently, the world economy is facing several endogenous risks. Many gravitate around interest rates, starting with the United States, where a series of tightening moves through year-end 2018 are eventually bound to put a damper on growth, in keeping with the experience of past monetary cycles. After years of extremely low interest rates, we cannot exclude a non-linear reaction from corporate investment or the real estate sector. The normalisation of the Fed’s monetary policy also risks triggering an upturn in financial investors’ risk aversion, either because they fear its impact on the real economy (impact of higher interest rates on corporate earnings) or because the risk-free rate – which is generally associated with US Treasury yields – reaches attractive levels, triggering portfolio rotations into this asset category to the detriment of equities and corporate bonds. This reversal of positioning could very well be sudden, because many investors have strayed away very far from their preferred investment habitat. Like people running for the exit in a crowded room, investors would flee back to safe havens. Less appetite for risk could also have international consequences. Emerging markets in particular could be hit by a stronger dollar and higher US interest rates. These trends could also influence their monetary policies, forcing a tightening upon them to defend their currencies, thereby mirroring the forced easing when the Federal Reserve first launched its quantitative easing programme (QE).

Although the ECB has maintained a particularly accommodating message, most analysts are expecting a gradual reduction in its QE programme in 2018, before it is simply halted. This would put upward pressure on long-term sovereign rates and corporate spreads, due to the flow of funds (disappearance of an “artificial” buyer: the ECB) or anticipations of future key rate increases.

Against the background of tighter Federal Reserve policy and a gradual scaling back of QE in the eurozone, there are two other factors that are likely to drive up long-term rates: the reduction in the size of the US Fed’s balance sheet, and possible tax cuts, which would increase the US government’s financing needs while pushing the Federal Reserve to tighten monetary policy more aggressively.

One last factor is the winding down of the accelerator effect. When growth accelerates, companies eventually tend to invest more, considering that they do not have enough capital stock to meet future demand. This only reinforces the cyclical dynamics, until companies’ consider that they have restored a balance between the productive apparatus and output needs. The resulting slowdown in investment would then have a negative impulse on GDP growth.

This list of endogenous risks is not intended to be exhaustive. However, it reminds us that robust economic growth holds within the very seeds for its own reversal.

William De Vijlder

Group Chief Economist, BNP Paribas

26 June 2017