In his latest Quarterly Economic Outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues that markets are still taking a ‘glass half full’ view of the macro outlook, with little real consideration of the new risk emerging. 

Until now, this has made sense, with speculation the US would open the fiscal box having justified ‘reflation trades’. However, while better for growth (see chart 1), markets are ignoring the darker cloud looming. Rather than financial distrust, we may need to brace for political distrust with the threat of beggar-thy neighbour policies – from the US to anti-European populism – rising.

 2018 could be a ‘year of two halves’… 

In which case, 2018 could be a year of two halves, where stimulus- euphoria gradually gives way to stagflation concern. Helpfully, the trade-off is that policy rates stay lower than many expect.

As chart 2 attests, the world’s appetite for international trade has, as a share of GDP, more than doubled in the past 50 years. Nevertheless, without care, the unhelpful jigsaw piece of retaliatory protectionism from the 1930s, might come crashing into place.

 

In 1930, it was triggered by the Smoot-Hawley reforms that raised US tariffs to up to 20% on over 20,000 imported goods. This hit the US’s relatively small number of trading partners, most notably Canada and Europe, and prolonged the depression.

The impact of protectionism this time would be more complicated than the 1930s. First, economic and financial linkages suggest the knock-on would be more far reaching. Global retaliation would activate second-order effects that later offset the growth impulse from President Trump’s tax cuts.

Second, the deflationary return to the US could be much larger than anticipated. China’s commitment to US Treasuries would be questioned, supply chains for US corporates disrupted, and the US’s already shrinking labour supply and potential growth reduced further.

Third, should protectionism build, inflation will reappear. However, with the possible exception of the US, it will be the ‘wrong sort’ of inflation – cost, rather than demand led. Central banks will turn a blind eye as economies stagflate, so the inflation flame may snuff itself out.

 Even in the US, true real policy-rates will stay negative…
In which case, ‘loose for longer’ probably has years left to run. Even in the US, true real policy-rates (adjusted for QT) will stay negative, with peak rates much lower than we’re used to.

Therefore, the question after nine years of QE is, how do central banks turn off the taps without unintended consequences? Their skin in the game suggests they cannot take us off guard. In the 1930s – the only real comparator – US QE ran unbroken for 14 years.

Whilst that was a different time, if it is any indicator, should protectionism come again it may mean we are little more than half-way through this current era of cheap money.