Economic and financial context: what is the outlook for 2020 and beyond?

The global economic slowdown was more severe than expected in 2019. As well as the technical slackening after the cycle peak was reached in 2017/2018, business was weakened by factors including rising trade tensions between the US and its key partners such as China and the European Union, the repeatedly delayed outcome of Brexit and geopolitical tensions in areas like Iran, Turkey, Syria, North Korea and Hong-Kong. Despite lingering doubts over activity, indicators suggest that the overall slowdown is coming to an end and could give way to a long cycle of consolidation with moderate growth and interest rates at rock-bottom levels for some time.

Slowdown coming to an end

In this context, it should be acknowledged that financial markets, particularly equities, performed well in 2019 (+26% for the CAC 40 and the DAX 30, versus respectively -11% and -18% in 2018, +22% for the Dow Jones versus -6% in 2018, +12% for the FTSE 100 after -12% in 2018). These upturns in financial markets have pushed index valuations to high points, historical in the case of the US and cyclical in that of Europe. However, these figures need to be seen in perspective, coming in the wake of sharp falls in capitalisations posted in 2018. There may be more volatility on the cards, but current capitalisation levels are underpinned by several factors: a de-escalation of the global trade war, monetary policies that encourage investment and risk-taking, solid corporate results, and economic news that has generally not been as bad as feared, particularly in the US, which no longer looks in danger of slipping into recession in the short term. We also note that there has been more of a slowdown for industry, mainly in Germany, whereas services are still growing in most European economies.

Cycles drawing to a close

Looking at the big picture, we expect a so-called L-shaped growth scenario, i.e. a fall then a stagnation of activity, rather than the more common historical V-shaped scenario when recessions have been followed by dramatic upturns. This increased momentum, with GDP growth of over 2% in Europe, began back in 2010 (+2.2%) following the sub-prime crisis as well as in 2004 (+2.6%) after the deflating of the dot-com bubble.

Forthcoming economic cycles in developed countries should be less pronounced. Firstly, the weight of industry is diminishing, which can cause errors to be made in demand forecasts with consequences for production and stocks. Moreover, the bolstering of social security systems, whether public or private, strengthens households by smoothing their income over time. Lastly, there has been decisive action in the form of budget and monetary policies, which have proved to be relatively effective since 2009, even though tools and capacities increasingly seem to be reaching their limits.

None of this means that the economy will be protected from any economic downturn. Nevertheless, the causes of any recession are more likely to emanate from the financial sphere or a major geopolitical conflict in the future.

Lingering risks

Even though this scenario of slow convergence towards potentially weaker growth looks quite likely from a structural perspective, it could be derailed by various shocks.

From a macroeconomic standpoint, some countries may see worse slowdowns than expected. Firstly, China has been hit hard by the decline in its industrial output and the fall in profitability of its companies. Other large emerging economies with high structural external deficits should also be watched closely, particularly Argentina, Brazil, South Africa, Turkey and India.

From a microeconomic standpoint, the so-called "high-yield" companies, which are very weak financially and survive largely thanks to low interest rates, could cause significant damage to business in the event of an increase in insolvencies. This could be the case in the US, but also in Europe.

Taking climate issues into account puts major swathes of European activity at risk, notably the automotive, air transport, energy and agriculture sectors.

There are also geopolitical conflicts and social crises which are now more clearly identified but that can occur unexpectedly in many parts of the world.

All told, numerous risks must be acknowledged and, depending on their seriousness, they could cause economic activity to end up far below the central scenario. However, these various events do not currently have enough advanced indicators to be included in a baseline scenario. They remain too hypothetical both in their probability of occurrence and in their impact on the economy.

Moderate inflation

Inflation is expected to be very moderate in the coming years, at around 1% or just over across the eurozone, particularly in France (1.2% in 2020). The European Central Bank's (ECB) target of 2% inflation now looks tough to achieve in the long term. Large-scale solutions have been tested over the past decade to raise prices further, such as lower policy rates and quantitative easing. This quest for inflation has been unsuccessful so far as the last time the target was achieved was in 2011 (3.3%) and in 2012 (2.5%), after oil prices doubled, i.e. an external shock that was out of the ECB’s hands. In the absence of ongoing geopolitical conflicts, particularly in the Middle East, and a significant drop in global demand, a Brent price of around $60 per barrel is a central scenario by 2021, compared to the $70/80 high points reached in 2018. Inflation is very unlikely to peak in this context.

Yields to remain low for a while

2019 saw 10-year government bond yields slipping into negative territory for some leading European countries, namely Germany (-0.3% in January 2020) and France (-0.1%), but also other countries such as the Netherlands (-0.2%) and Finland (-0.1%).

Such levels were not initially forecast by the consensus and stem mainly from the more accommodative stance of central banks, especially the ECB, which resumed its Quantitative easing (QE) programme in November 2019 after having halted it in 2018. Furthermore, key interest rate hikes have been postponed for longer.

Against this backdrop, the factors pushing interest rates downwards are more prevalent now than a year ago, i.e. lower growth and inflation, more risks to the economy and greater liquidity. Consequently, the risk of a significant increase in bond yields is very limited for the coming years and even beyond that. A cycle of lastingly low yields appears to be on the cards. Between 2020 and 2022, about €1,000bn of German and French government bonds will mature. These self-sustaining pools of cash will automatically keep fuelling strong demand for bonds, even after an eventual halt to QE. Lastly, some of these liquid assets will be transferred to alternative investments considered more attractive, such as real estate, which will boost demand and prices.