IMF’s Rosy Outlook Contains a Caveat for Investors

The report suggests the economic growth outlook, commodity prices and equity markets are all at risk of dropping.

The International Monetary Fund on Tuesday said it expects the global economy to expand 3.9 percent this year and next, a forecast that is unchanged from January estimates. That’s the good news for markets. The bad news is that there was something much more important in the IMF report this quarter: caveats about risks related to protectionism and global conflict.

Given that these risks have become more acute during the period since the last set of IMF growth forecasts were released in January, and that the IMF’s latest estimate remained largely unchanged, it’s safe to say that these risks have not been priced into the growth outlook and only partially priced into financial markets. This means that the growth outlook, commodity prices and equity markets are all at risk of dropping if U.S.-China trade relations do not see a significant thawing in the near term.

Of course, the IMF is not the only entity to blissfully forecast without incorporating significant — and rising — macroeconomic risks associated with the unpleasantries of trans-Pacific tariffs being lobbed about. The Federal Reserve’s forecasts for growth and policy rates that were released on March 21 didn’t incorporate trade risks. To its credit, the IMF acknowledged that the “shift toward inward-looking policies that harm international trade” as well as “a worsening of geopolitical tensions and strife” are critical factors.

But by leaving these as essentially footnotes, it means that the upside potential for the growth outlook is already largely priced in, while downside risks that are only acknowledged could prove to be significant. This is an especially glaring asymmetric risk and problem, since the importance of trade for recent economic growth was stressed by the IMF. As such, it should be clear just how important trade is, when considering the potential risks at play.

Beyond the risks of geopolitical strife and inward-looking trade policies that result in tariffs and other forms of protectionism, the IMF also acknowledged another set of risks that appears more certain, both in its likelihood and its historical impact: faster inflation and the removal of highly accommodative monetary policies.

While trade may have held the headlines since early March, it wasn’t trade risks that triggered a cross-market selloff in February that left investors scrambling to find uncorrelated assets. Rather, it was the risk of inflation in the U.S. and the potential for four Fed rate hikes this year that sent bond prices, equities prices, oil prices, and industrial metals prices lower — all before trade, tariffs, sanctions and Syria. In regards to inflation, the U.S. consumer price index could be juiced in coming months by tariffs and a tight labor market, as well as by the base effects from very low levels of inflation last spring and summer. Of course, the Fed prefers the personal consumption expenditure index as a measure of inflation and rudder of policy, but the CPI cannot be ignored as it is more commonly used as a reference for inflation in vendor agreements, labor contracts and tax laws.

The risk of faster inflation has kept the dollar from repeating its precipitous drop in 2017. But with other central banks looking to tighten monetary policy, the greenback is unlikely to strengthen back to levels seen in late 2016. It is not the dollar that faces the greatest upside risks from inflation. Rather, it’s interest rates and bond yields.

Even if the entire trade conflict that the Fed and IMF have blissfully left as press-conference asides and footnotes were not a risk, the potential for a slowdown in economic growth and corporate profits due to tighter monetary policies and credit would still remain in play. The trade and tariff risks only exacerbate those risks that were already on the table.

© 2018 Jason Schenker  All rights reserved.



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