The UK electorate chose the populist option of leaving the EU and Donald Trump will be the new president of the US. Elections in Europe in 2017 may produce further gains for nationalism and populism or for changes of government at least. All these developments may affect economic policy in key economies, making economic predictions even more hazardous than usual. We are entering a brave new world.Macro-Outlook-22-November-2016-1.pdf (591 KB)
At the end of the day, economic forecasting is about determining how the drivers of the economy will develop and making assumptions about economic policies and their effects. In what follows below we sketch the main developments in the global economy in the period ahead, particularly 2017 but also 2018. Our main argument is that global growth will accelerate modestly in the period ahead, supported by a cyclical improvement already underway and policy support in the US in particular. We expect inflation to rise gradually, particularly in the US where the new administration looks likely to provide fiscal stimulus in an economy already close to full employment. Chinese growth is also benefitting from some policy stimulus, ensuring that the country’s slowdown remains very gradual. The European economy will continue its recent trajectory of marginally above-trend growth. Divergence will be the name of the game as regards monetary policy as we expect the US Federal Reserve to tighten policy while the ECB should continue and extend the duration of its current very loose policy stance.
Uncertainty is greater than normal for forecasters as it is not clear to what extent the new US President will deliver on populist promises made during the campaign. Elections in France, Germany and to a lesser extent the Netherlands as well as the upcoming referendum in Italy have the potential to lead to changes in policy, but also to shocks of confidence on the part of participants in financial markets. The biggest risks in emerging economies lie in a tightening of financial conditions as the dollar strengthens and the Fed tightens, while rising protectionism is also a risk for these economies. Given the growth outlook, the expected rise in inflation and monetary tightening by the Fed, we think that bond yields have seen their lows and will gradually rise during the 2017/18 period. We also think the dollar will strengthen during the course of 2017 only to lose some ground again in 2018. During the next couple of days and weeks we will publish much more detailed analyses of the outlook per country, region and by asset class.
Not too bad
While there are, as always, risks and uncertainties, the global economic outlook for 2017 and 2018 does not look bad. A number of factors that have been a drag on global growth for some time are abating or reversing and it looks likely that economic policy will be more growth supportive than it has in the past, even if this has various negative side effects. The US economic recovery is already one of the longest in the post-war period, meaning that at least the statistical chance of a recession is increasing. However, recoveries do not die of old age and it is hard to argue that sufficient bottlenecks have developed during the recovery to kill the upturn any time soon. What is more, the restyling of the US policy mix with more fiscal stimulus and tighter monetary policy may even reduce concerns over secular stagnation, although the Trump policies could lead to a boom-bust cycle over time.
Why we have all been disappointed
Lowering growth forecasts for a wide range of countries has been common practice in recent years, which begs the question why this has been so. There are probably different reasons. First, demographics and slowing productivity growth have lowered trend growth more than economists were prepared to recognise. Second, excessive debt has been the key theme of the financial crisis and making debt levels more manageable through deleveraging has been inevitable during the upturn. But deleveraging means saving, which is good for healthier balance sheets, but not for spending and growth in the short term. Tightening regulatory control has also been a feature of recent years, particularly in the financial sector. While aimed at improving financial stability, this has undoubtedly also been a drag on growth. Furthermore, China has been the most important growth engine of the world economy during the last 15 years or so, but that economy is transitioning to a lower growth path. This is inevitable and welcome as Beijing has to steer the economy towards a more sustainable growth model.
The factors mentioned so far are of a relatively structural nature. On top of these, a number of more temporary factors have been growth negative during the last two years or so. Contrary to past experience, the sharp drop in oil (and other commodity) prices since the middle of 2014 has turned out negative for global growth. US consumers have used their windfall more than in the past to strengthen their balance sheets by raising the savings rate. Oil producers, on the other hand, have reacted as one would expect by lowering their investment. More than in the past, this has hit the US as the energy sector is now larger in the US than it has been in the past due to shale. Lower investment in the energy sector has pulled overall US business investment down. For countries heavily dependent on commodity exports the drop in prices has been a substantial negative terms-of-trade shock, which has been growth negative in itself. In addition, it has forced austerity onto governments which has added to their woes. Recessions in countries such as Russia and Brazil are examples.
The inventory cycle has been another drag on growth, particularly and most clearly in the US where inventories have made a negative contribution to overall GDP growth during five consecutive quarters beginning in the first half of 2015. This is an unusually long period; the last time it happened was in the 1950s.
A last factor that needs to be mentioned is infrastructure spending. In their austerity efforts, governments have opted for the politically easy way out by lowering their spend on infrastructure. This has not only been negative for economic growth in the short term, it most likely has also negatively affected the growth potential.
Reasons to be cheerful
It does not often get highlighted, but a number of these factors pulling growth down during the last 24 months or so are abating or reversing. Commodity prices have moved higher since early this year. The windfall for consumers is disappearing as a result, but, equally, the situation for the commodity sector globally is improving. As a result, investment spending in the sector is bottoming out and countries such as Russia and Brazil are pulling out of recession.
In addition, the inventory cycle has turned. Third quarter US GDP data shows, for the first time in a year and a half, that inventories contributed positively to growth. Judging by the data, this is set to continue for several quarters to come.
While the growth trajectory of the Chinese economy is inevitably moving lower, Chinese policymakers have been unhappy with the extent of the slowdown and have taken a number of initiatives to prop up economic activity. Recent data suggests they are successful. At the margin, growth appears to be strengthening. We do not think this will lead to a sustained or significant acceleration of growth, but it is positive for global growth in the short term. We must add that we also think the Chinese policymakers are postponing addressing some other important problems such as the domestic corporate debt problem. Credit growth is, again, outpacing nominal GDP growth leading to a further rise in overall debt ratios. This is an issue policymakers will have to face at some stage.
Aggressive monetary policy in Europe, particularly since the ECB’s QE programme started early 2015, has, arguably, also gradually started to have an important impact on growth. These policies have lowered borrowing costs for households, corporates and governments. While economists disagree about the effectiveness of this type of policy, it is clear that banks have eased credit standards and that credit growth has strengthened.
Calculations about potential growth are surrounded by a wide margin of error, but it is encouraging that such calculations are suggesting that potential growth is bottoming out in the OECD area.
Another reason to be cautiously optimistic about the immediate future is that cyclical indicators have started to turn up in response to an improvement in the growth drivers. Industrial metal prices have been rising since earlier this year, usually an early indicator of cyclical improvement. The global manufacturing PMI has improved in recent months, as have the latest CPB data for global industrial production and trade. The IT sector has recently also shown encouraging signs. The SOX index (an index of stocks of semiconductor companies listed on the Philadelphia stock exchange), for example, has been rising steadily since earlier this year. This is consistent with data from Taiwan, an economy heavily dependent on the global IT sector, where industrial orders and exports have been strengthening in the course of this year.
An upturn in the global IT sector is very relevant for a number of reasons. First, it is an important sector in the economy. Second, it is early cyclical, so an improvement here is often a leading indicator for what will follow elsewhere. And third, the strengthening of IT reflects stronger business investment in IT products which should have a positive effect on future productivity growth.
Then there was Brexit, and Trump, and more to come perhaps
As the factors limiting growth in the last two years or so are gradually disappearing, abating or reversing, the outlook is for an improvement in 2017 and 2018, though global growth will remain unspectacular. On such a time horizon, economic policy comes into play for a forecast. Here is where problems in the forecasting process arise. The choice by the UK electorate to leave the EU has an impact on the economy which is hard to gauge both in terms of timing, magnitude and even direction. We do not know what relationship will ultimately replace the UK’s EU membership. A hard Brexit is likely to lead to significant negative effects on trade and thus on overall economic activity in the UK, but also, though to a lesser extent, in the EU. The process leading to the end of the UK’s membership is set to last two years, starting from the triggering of article 50. It is yet not certain when that will happen as PM May’s plan to do this before the end of March without involvement of parliament has been (successfully so far) challenged in court. Even more uncertain is how messy these two years will be politically and what confidence effects may result, should we experience a volatile political period. Not often highlighted, but it is also important what other policy initiatives the UK government will take to safeguard the wellbeing of the economy. Sterling’s exchange rate, for one, has adjusted sharply which will function as a shock absorber to the UK economy, though at the expense of higher inflation.
The election victory by Donald Trump creates its own uncertainties. We had expected a continuation of US economic policies in the case of a Clinton win, but nobody knows for sure what to expect from a Trump-led government. So we have to make assumptions here. It seems most likely to us that the new President will pursue a relatively aggressive growth agenda. Significant tax cuts and increased spending on infrastructure are very likely. Many Republicans in Congress will not be too happy with a widening budget deficit and rising government debt, but we are assuming Trump will argue that even the plans of the Paul Ryan, the Speaker of the House, would lead to a widening of the deficit. The tax cuts that are likely to be implemented will probably be skewed to higher incomes. The consequence is that the boost to overall demand in the economy is not as great as it could have been and inequality, already a serious issue in the US, will rise.
Another stimulus may come from deregulation, in particular in the financial sector. Trump has indicated he wants significantly to change the Dodd-Frank legislation and he has appointed some advisers and may appoint ministers who favour this. We think this will support economic growth, although it may come at the expense of long-term financial stability. During the election campaign Trump also indicated he wants to ease other regulation on business. Some supply-side economists are among his advisers who may turn this commitment into policy. It has to be said, though, many governments promise to ease the regulatory burden on business, but success is often disappointing.
The new administration is likely to make significant changes to energy policy, which will turn decisively pro-carbon, supporting domestic producers. This will also boost economic activity, albeit at the expense of the climate. It may also lead to lower oil prices and we have actually lowered our forecast for oil prices somewhat in response, though we continue to expect oil prices to rise in 2017 and 2018 as the supply surplus diminishes and turns into a shortage.
At the same time, one must make assumptions on what the new President will do in the areas of illegal immigrants, trade policy, foreign policy etc. Many of the populist promises he has made during the campaign will be drags on US and/or global growth should they be implemented. For example, Trump has vowed that he will force all illegal immigrants out of the country. That amounts to an estimated 10 million people or more, some 3% of the total population. Their exodus would imply a massive negative supply shock. Since his election victory Trump has toned this down to ‘criminals’, which he still estimates to number two to three million, which would still be a negative supply shock. As immigration has driven labour force growth in the US is recent years, severe limits on regular immigration would also imply a supply shock as it would reduce potential growth. We will have to wait and see, of course, what exactly can be and will be done by the new government.
Perhaps more threatening to the rest of the world is US trade policy as Trump campaigned on a strongly protectionist platform. We are assuming that trade deals currently being negotiated will be shelved. But we also assume that the new President will not start a full-blown trade war. Instead, we think he will try to seek changes to existing trade arrangements in particular in areas where he feels these arrangements are disadvantageous to the US. The resulting effects on the global economy will be modest in aggregate, but largely at the expense of emerging economies.
The total Trump effect
As said before, like all other economic forecasters, we need to make heroic assumptions about Donald Trump’s economic policy initiatives in 2017 and 2018. On balance, we think he will manage to provide a material boost to US economic activity, although it will be at the expense of rising budget deficits, increasing inequality, the global climate, emerging economies and it comes with a bigger risk to financial stability.
As the stimulus arrives when the economy is already enjoying one of the longest periods of uninterrupted growth and the labour market is operating near full employment, the risks of rising inflation are increasing. So far, inflation has been remarkably subdued, but various wage measures are showing a clear acceleration. The pass through to inflation has been limited, most likely because the strongest wage gains are occurring in areas with strong productivity growth. Nevertheless, a rise of inflation, to somewhat above the Fed’s target of 2% is likely.
Fed will do more tightening than is priced in
The Fed has clearly indicated it is set to raise interest rates in December. Given our forecast for stronger US GDP growth and somewhat higher inflation, we expect the Fed to tighten further in the course of 2017 and 2018. Including the December hike, we expect the Fed to raise its policy rates by 150bp between now and the end of 2018: 25bp in 2016, 75bp in 2017 and 50bp in 2018. This is more than we previously considered likely and, as a result, we have raised our forecast for the US dollar, which we now expect to break parity against the euro late in 2017, only to weaken somewhat again in 2018.
Europe muddling through
The eurozone economy has been neither hot nor cold in recent years, growing slightly above potential which has allowed unemployment to ease, public finances to improve while inflationary pressures have failed to build.
Opposing forces will influence the eurozone economy in the period ahead. On the positive side, stronger US growth and the strengthening of the industrial cycle globally will also be felt in Europe. In addition, we now expect the euro to weaken against the dollar, which will also provide modest support for economic activity as will the continued loose monetary policy.
A new element in the mix is a possible shift in economic policy. As budget deficits are generally still not consistent with longer term criteria, further austerity in many eurozone countries looks inevitable. However, austerity fatigue is clearly on the rise. Elections are due in the eurozone’s two main countries in 2017. Populists and nationalists are seriously challenging the incumbents in opinion polls and challenging the political establishment in general. Having seen the populist victory in the US mainstream parties in Europe may opt to adjust policies in a more expansionary direction. The European Commission is now arguing for some stimulus in countries that can afford it, in particular Germany and the Netherlands. It remains to be seen whether these countries will follow the Commission’s suggestion, as their own economies do not really need the stimulus, although there would be little harm in lifting infrastructure spending. Either way, it looks like the emphasis of fiscal policy will be less on austerity. Whether that will be enough to keep populists out of government remains to be seen, but less austerity or even a modest fiscal stimulus, will be growth supportive.
On the negative side, eurozone inflation will edge higher in the period ahead, mostly resulting from base effects and rising energy prices. Somewhat higher inflation will be at the expense of real spending power of households as wage increases have so far failed to accelerate in a meaningful way due to continued slack on labour markets. We expect inflation to remain below the ECB’s target of 2% during 2017 and 2018. Another negative for growth is the fact that bond yields and sovereign and credit spreads have widened recently, implying higher borrowing costs for a large number of borrowers.
Biggest risk: confidence shocks
Confidence shocks would appear to be the biggest risk for the eurozone economy. It is not inconceivable that within the next twelve months the constitutional referendum will throw Italy into political chaos, the Netherlands becomes effectively ungovernable after a bumper election result of the Freedom Party, Marine Le Pen is elected as the next French President and the ‘Merkel-era’ comes to a close as a red-red-green coalition takes over in Germany. We do not have a political view on such changes and the effects on economic policy may not be immediate or large. However, the more of these changes take place, the bigger the shock to confidence among financial market players will be. Should this lead to stress in markets and the financial system in general, then that will have a negative feedback loop on to the economy.
Monetary policy in the eurozone will stay very loose. We see no material increase in inflation pressures apart from higher commodity prices pushing up headline inflation adding to base effects. But we expect core inflation to remain near its current level of 0.8%. The further drop of the euro will at most add a few tenths of a percent to inflation and that will take a long time to come through. We think the ECB will respond by extending its asset purchase programme and, possibly, tweaking its programme somewhat. We expect the large-scale asset purchases, which are currently meant to last until March 2017 to be extended to September 2017 and then to March 2018. Discussions about ECB tapering are premature in our view, though they will come onto investors’ radar screens towards the end of 2017 with actual tapering most likely occurring in 2018 with a small chance of it happening from September 2017 on. The ECB is very unlikely to push official interest rates deeper into negative territory, but the ones that are negative will remain so during the period under review.
Bond yields have seen their lows
The implication for the bond market in the eurozone is not immediately clear. Continued loose monetary policy and very low inflation argue for stable bond yields. However, the rise in US bond yields we expect on the back of stronger growth, higher inflation and Fed tightening will dominate, leading to rising bond yields in Europe also.
Emerging economies should cope with tightening financial conditions and protectionism
Emerging economies are experiencing a modest cyclical improvement currently as evidenced, among other things, by a broad range of business confidence indicators. If everything stays the same this trend should continue. However, lots of things are changing. More favourable commodity prices are helpful as is the improved competitiveness following the depreciation of many EM currencies. Russia and Brazil have experienced painful recessions since 2014 but are set to end the period of contraction in the course of 2017. This will have spill-over effects to other emerging economies.
The targeted stimulus Chinese policymakers are providing appears to be effective and the stabilisation of growth in China is positive for many other emerging economies, particularly for Asian economies and commodity exporters.
The biggest risks to emerging economies comes from protectionism and from a tightening of financial conditions resulting from a stronger dollar, Fed tightening and a sharp rise in bond yields in the US and other advanced economies (sometimes referred to as ‘Trump tantrum’). History shows that such developments can lead to problems in emerging economies as capital flows out of these economies back to the US limiting the availability of credit. In addition, currency depreciation and higher interest rates mean a rise in borrowing costs. We must certainly expect these things to happen in 2017 also. What is important is the magnitude of these capital flows. The more substantial they are, the bigger the negative overall economic impact on emerging economies. We are cautiously optimistic that this process will remain manageable, although it will bite for sure. This cautious optimism is based on several considerations. First, inflows into EMs have not been excessive since the taper tantrum in 2013. What has not flowed it will not flow out. Second we think that fundamentals in EMs are strong enough to withstand some capital outflows without triggering a run. Third, we think that policymakers in EMs will be alert and that their economies and financial systems are resilient enough to cope. However, the EM asset class is very heterogeneous and averages tend to conceal vulnerabilities at the individual country level. Moreover, previous crisis episodes in EMs as well as in the eurozone periphery teach us that country-specific crises always have the tendency to create contagion to peers.
In addition, protectionist measures taken by the new US government can be painful for EMs. It is yet unclear how severe a protectionist agenda will actually be pursued. We are assuming it will not be extreme, but the risks are skewed to the negative side.
Weighing up the opposing forces affecting the various economies, we think that growth in emerging economies as a group will accelerate somewhat in 2017 but there is a wide array of macro, financial and geopolitical risks that could derail this moderately positive outlook.
All in all then, we are cautiously optimistic that the global economy will perform reasonably well in the period ahead. We wish to stress, however, that geopolitical risks are always there and that the change in leadership in the US and possibly in Europe in the course of 2017 makes economic forecasting even more problematic than usual. We really are entering a brave new world.