Global Macro View – Will Goldilocks stay in 2018?

by: Han de Jong

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Sensational! That best describes how business confidence indices have developed in 2017 and in particular in recent months. While they have not been equally strong everywhere, they show that all the main regions of the world economy are growing nicely. More striking, the most recent of such indicators suggest that momentum, which was already strong, is increasing further. This is particularly true for the eurozone. As inflation has actually remained very subdued in 2017, this has been a year in which Goldilocks has come back to life. Can she stick around in 2018? In the first part of this commentary we discuss the main trends we envisage for 2018, focussing on the outlook for growth and inflation in the main economies. In the second part we summarise, qualitatively, our views on specific economies.

 

PART I

It is often argued that confidence indicators are ‘soft’ and regularly overstate what is actually happening. But business confidence is a reliable gauge for the state of the business cycle and it is much more timely than official statistics on ‘hard’ data. What we find particularly compelling is the fact that the positive developments and positive surprises are so widespread. Whether one looks at Germany’s Ifo-index or Chinese consumer confidence or virtually all other such indicators, they are all strong. One must therefore assume that the actual development in the real economy is also strong. We are experiencing a powerful, synchronised global economic upturn.


What is driving global economic momentum?

The fact that all economic forecasters, including ourselves, have raised growth forecasts is a big change after years in which forecasts were generally lowered as the year wore on. The big questions are what is driving this much more positive development and can it last? The answers to these questions are not clear-cut. What is striking is that world trade growth is, all of a sudden, growing in line with, or marginally faster than the world economy as a whole. This is a change from the years since the great financial crisis when world trade growth was lagging, but it is more in line with experience before the crisis. Stronger world trade growth suggests that the epi-centre of the economic upturn is in the manufacturing sector. Geographically, it would appear that China was the epi-centre when the phase of accelerating growth began. Chinese import growth had been very weak in 2015 and 2016, but policy measures aimed at propping up activity were effective. Overall economic growth picked up late in 2016 and accelerated in the first half of 2017, after which it eased somewhat in the second half of the year.

What also helped, of course, is that capital outflows from emerging countries, including China, stopped in 2016 and made way for inflows. This changed a significant headwind into a handy tailwind for these economies.

Another factor that has played a role in explaining the improved picture is the recovery of oil prices and prices of other commodities. The sharp fall of oil prices between mid-2014 and early 2016 had decimated investment spending in the energy sector worldwide. And, in contrast to past experience, the beneficiaries of lower oil prices used part of their windfall to strengthen their balance sheets instead of spending it. As the energy sector is capital intensive, the collapse of investment had macroeconomic effects. The subsequent recovery of prices has halted the decline in investment and, at the margin, reversed it. Countries dependent on commodity prices obviously benefited as well.

Extremely loose monetary and financial conditions have surely also provided significant stimulus to the economy. This is probably particularly true for Europe where interest rates are clearly lower than they would be in several countries, especially Germany, if they were only determined by domestic factors. Perhaps the loose financial conditions are responsible for the recent further rise in various confidence indicators to multi-year or even multi-decade highs.

Other factors have undoubtedly also contributed to surprising economic strength, such as the end of austerity policies, the profits recovery, the improvement achieved in previous years in terms of balance sheet repair, the global IT cycle and the inventory cycle.

What is required to keep the global economy going?

Strong global economic momentum tends to build on itself and tends to become self-sustaining. It typically requires something significant to bring about a sharp reversal. It is therefore worthwhile asking what is required to keep Goldilocks alive.

First, as China has, most likely, played an important role in the unexpected strength of global growth this year, a significant slowing in that country could be a party pooper. It is by no means inconceivable that China will slow down significantly. The transition from an export-led and investment-led to a consumption-led growth model implies gradually lower growth rates. In addition, the debt problems in parts of the Chinese economy are forcing the policymakers to slow down credit growth, which could damage economic growth. Our view on the debt issue is more optimistic than the view of many others. The authorities have so far concentrated their ‘targeted tightening approach’ mainly on the most risky parts of the financial system. They have, in our view, been successful in reducing risks (in the interbank market and shadow banking, for example) without threatening the flow of credit to the real economy. As a result, credit growth has slowed, but that has not had a serious impact on the economy as a whole. Of course, things can change and a further reduction of credit growth could, for example, have more serious effects for the property market. It is clear where the risks are, but the authorities are handling the deleveraging successfully, at least so far.

When assessing China we must bear in mind several points. First, China matters more to the global economy now than it has done during the last 500 years. In addition, we, as almost all other economic forecasters, know less about the Chinese economy than we do about better documented economies such as the eurozone and the US. One cannot make very precise forecasts for the Chinese economy with the same degree of confidence as one does for economies such as the US, the eurozone, Japan, the UK, etcetera. Having said that, the Chinese policymakers are acutely aware that disruptive economic developments imply political risks. One must also not underestimate the spectacular developments in China in the areas of sustainability and technology that support growth and create jobs. We are therefore assuming that the gradual slowdown of China’s growth will continue in 2018 without causing trouble for the global economy. And we think that this would help in keeping Goldilocks alive. But anything worse than a modest and gradual slowdown in China would pose a threat to Goldilocks.

Corporate investment set to grow more strongly

A second development that would increase the chances that strong global growth can be maintained is a strengthening of corporate investment growth. That would create jobs and incomes and would be positive for productivity. Judging by what corporates have recently been saying in surveys about their investment plans and what capital goods orders indicate, a significant strengthening of investment growth looks imminent, both in the US, the eurozone and Japan. And that makes sense as corporate profits are generally strong, credit relatively easily available and cheap.

Can inflation stay low?

For growth to be sustained into 2018 and perhaps 2019, it is also necessary that inflation does not rise beyond expectations. 2017 has not only surprised in terms of growth, inflation has also surprised as it has remained more modest than expected. This is particularly true for the US where core inflation has actually eased although the labour market is considered tight and wage increases are accelerating a little. Average hourly earnings are rising at a rate of slightly more than 2.5%. Core CPI inflation has fallen from 2.3% yoy in January to a low of 1.7% in August and has now inched up to 1.8%. Core PCE inflation, the Fed’s favoured gauge, has eased from 1.9% yoy to 1.3%. A big driver of this inflation has been shelter costs. Core CPI, ex-shelter inflation has eased by over 1 percentage-point between early 2016 and late summer, when it reached a mere 0.5% yoy. Fed chair Yellen calls all this ‘a mystery’ and has expressed the view that the period of surprisingly low inflation will be ‘transitory’. She may be right, but it is becoming increasingly difficult to consider something transitory when it is lasting eight months or so.

We think what will happen to inflation in 2018 will be the result of opposing forces. Strong global growth, already low unemployment in a number of countries and the to be expected acceleration of wage increases will put upward pressure on inflation. Oil prices, which we expect to rise further in the course of 2018, will add to this cyclically driven boost to inflation. However, there are offsetting, more structural factors. These have most likely been behind the inflation surprise in 2017 and they are not going to go away. One of these factors is higher productivity growth, which is offsetting stronger wage gains. It is ironic that US productivity growth has started to strengthen just when the majority of economists had given up on it and were converted to the ‘secular stagnation’ view. What they have missed is that US productivity growth has sprung back to life in the course of 2017. This has been enough to actually push the rise of unit labour costs down. It is notoriously difficult to forecast productivity growth, but our view is that the tight labour market, combined with an acceleration of corporate investment spending will add to productivity growth. This will continue to put a lid on unit labour costs and, hence, inflation.

Another factor putting a lid on inflation is technology. This is changing the dynamics of the inflation process fundamentally. Websites where prices can easily be compared are making markets more transparent, limiting the pricing power of companies. More important is the disruption that digitalisation is causing in the services sector. Services have produced the lion share of domestically generated US inflation in recent years, as productivity gains have proven much more difficult to achieve in services than in the good-producing sectors. Digitalisation is changing that. Business models in services are increasingly being disrupted. Early in 2017, a price war erupted in US telecom services. Such was its intensity that it had a material effect on overall inflation. The big question going forward is if that price war was a one-off or not. We consider it likely that it wasn’t and that it was simply an example of a broader development, so part of a series of one-offs.

Another structural factor keeping a lid on inflation is the weak negotiating position of labour. The reforms in many countries aimed at making labour markets more flexible (in themselves aimed at raising the growth potential of economies) has weakened the hand of the workers in wage negotiations.

On balance, we expect the cyclical forces pushing inflation higher will become stronger in 2018. Having said that, we also believe that the more structural factors will continue to work in the opposite direction. The result will be only a modest rise in inflation in the US and in the eurozone.

On balance, we think that global growth will stay high in 2018 and exceed consensus forecasts. We expect that inflation will remain low, and be lower than consensus forecasts, albeit that it will rise somewhat from 2017 levels. The answer to the question whether or not Goldilocks will stick around in 2018 is, therefore, that she certainly can. Whether she will or not depends on a few more factors.

Cautious central banks

Central banks will have another important contribution to make, but it is not that they must provide huge additional stimulus. Their contribution to a rosy picture in 2018 will simply be that they must not cause disruption. And they are motivated, indeed, not to trigger disruption. Put differently, central banks must consolidate their achievements of recent years: preventing a depression and triggering a serious economic recovery. The key central banks are quite clear about their plans for 2018. The ECB and the Bank of Japan are perhaps the clearest and there is little controversy in financial markets about whether or not these two central banks will stick to their plans. In the case of the ECB, the plan is to lower monthly asset purchases to EUR 30 bn a month from January on, keep that going until September and taper after that. Rate hikes are not on the agenda for 2018. The Bank of Japan is also quite clear. They will continue what they are doing currently: yield curve control. They may raise their target for 10-year government bond yields a little in the course of 2018. We consider it unlikely that either of these two central banks will be forced by changing circumstances to deviate from these plans in 2018.

The position of the Fed is less clear. They are in the process of ‘normalising’ monetary policy by bringing official rates back to their ‘normal’ level while at the same time the Fed is cautiously shortening the length of their balance sheet. We think the market is OK with the latter policy. However, the market is pricing in fewer rate hikes than the members of the Fed’s Federal Open Market Committee are projecting. The median projection of FOMC members is for three hikes in 2018 after one more hike in December 2017. But the market is only pricing in one rate hike at the most in 2018. A December 2017 hike is more or less fully expected by the market. We think reality will be in the middle: two hikes in 2018. This will not lead to disruption in financial markets which could translate into poorer performance of the overall economy. Even if the Fed carries out their plan to hike three times, we think they will be able to massage market expectations sufficiently to prevent disruptive moves in financial markets. The big risk here is inflation. If inflation rises more than generally assumed, the Fed could feel forced to tighten more aggressively, which would have to lead to a sharp adjustment of market expectations. Uncertainty over Fed policy is increased by the fact that a number of vacancies need to be filled on the Fed board. The Fed has seven governors, though currently three seats are vacant. In addition, the vice-chair has only just joined and Ms Yellen will leave early next year. The Fed will also get a new chairman, Jerome Powell, but he most likely will continue the policies of the current chair, Janet Yellen.

Risks

As always, there are many uncertainties and risks, none of which have enough weight for us to change our optimistic view on the global economy for 2018. As China plays an important role in the global economy and it is difficult to make precise forecasts for the Chinese economy with huge conviction, China-related uncertainties must top this list. The Chinese authorities could step on the credit brakes too aggressively, resulting in a significant slowdown. That would have a significant impact on the rest of the world economy. Debt problems in China could also lead to financial instability there, which would also affect other markets.

Another risk that must be highlighted is that inflation might rise more than we, or even the markets, are currently thinking. In that case, central banks may tighten more aggressively, pushing interest rates considerably higher. That would damage economic growth. Markets for ‘risky assets’ such as equities will then suffer a double whammy: lower growth will hurt earnings growth while higher interest rates will force valuations down. Significant financial instability cannot be ruled out in such a scenario.

The Brexit process could lead to a hostile atmosphere in Europe. Making economic forecasts for the consequences of Brexit is a mug’s game in our view. Not only is it unknown at this stage what sort of trade relationship will replace the UK’s current EU membership, it is also unknown what policies the UK government will engage in in their efforts to soften the inevitable economic damage. And we must not forget that the exchange rate will work as a safety valve for the UK. The harder the Brexit, the more likely it is that a depreciation of sterling will cushion the blow for the UK economy. EU countries with intense trade relations with the UK will then be dealt a double blow: deterioration of access to the UK market and loss of competitiveness due to a possible further depreciation of sterling.

The presidency of Donald Trump also creates uncertainty due to his unconventional way of filling the role of leader of the free world. It has to be said that his first year as US president has also shown that the system of checks and balances is working well in the US. There are also political risks in other countries, for example in Italy where elections will be held in 2018. Or think about the tension in relation to North Korea or China’s territorial claims in the South China Sea. Geo-political risks are always lurking although one has to bear in mind that geo-political developments only have a lasting impact on the global economy and financial markets if they threaten the fundamental strengths of the economy.

All in all, we are optimistic that the Goldilocks scenario that emerged in the course of 2017 can extend into 2018. A big difference, however, will be that such a benign economic environment will be much less of a surprise than it was in 2017. It would therefore be a mistake to expect financial markets to show a carbon copy of their 2017 behaviour.

PART II – regional specifics

The eurozone

The eurozone economy has pleasantly surprised in 2017 and growth momentum appears to be strengthening. The surprise has mainly come from international trade. We see little reason why growth would slow significantly in 2018. Assuming the external environment does not deteriorate much, we expect stronger corporate investment growth to support domestic demand growth and contribute to better productivity growth. As we believe that the eurozone economy as a whole still has a relatively large amount of slack in the labour market, we expect inflation to remain below the ECB’s target in 2018. Only towards the end of the year do we expect some more underlying inflation pressure. The ECB is committed to lowering their asset purchases in 2018 to EUR 30 bn a month until September. These purchases will not end abruptly, says Mario Draghi, so a tapering process is set to start after September. The ECB has also made it crystal clear they are not going to raise interest rates before the asset purchases are finished. It could be argued that the favourable development of the economy may argue for a sooner end of these extraordinary policies. However, the ECB has committed itself, and we believe they will consider it unwise to deviate from the declared plan.

The US

The US economy is growing more or less as expected at the start of 2017. However, the drivers are very different from what was expected. The new president was expected to provide a significant stimulus through infrastructure projects and an early and sizeable tax cut. Neither has happened so far, but the economy has performed well all the same. Inflation has surprised on the downside as described above. We expect more of the same in 2018. It looks like the Republicans will be able to pass a tax reform package. That will be much smaller than president Trump promised during the election campaign and it will have no more than a marginal effect on growth. But it all counts. We expect corporate investment to strengthen. Cyclical forces will likely push inflation a little higher in 2018, but structural forces and faster productivity growth will keep the rise in inflation limited. Against this background the Fed can safely continue its policy of gradual normalisation of monetary policy. The plan to cautiously shorten their balance sheet will be followed. We expect the Fed to raise interest rates in December 2017 and then twice more in 2018.

China

The Chinese economy has grown faster than expected in 2017. This was particularly true in the first half of the year. The inevitable, very gradual slowing of growth occurred again in the second half of the year. We expect that trend to continue in the period ahead. Many commentators worry about debt problems and it is easy to understand why. Corporate debt is very high and defaults appear inevitable. What is important for the global economy is if this process leads to financial instability and contagion to other countries and whether or not it leads to a material slowing of Chinese growth. We think that the Chinese policymakers will keep the process of deleveraging under control. They have, so far, succeeded in slowing overall credit growth without damaging economic growth. Their efforts have focussed on the most risky parts of the financial system. Moreover, China’s debt is largely domestic. Foreign investors will not trigger a crisis, allowing Beijing time to engineer an ‘orderly deleveraging’. All in all, we see little reason to assume they will lose control.

Japan

The Japanese economy has done remarkably well this year. The overall numbers do not look that impressive, but one must bear in mind that Japan has the ‘worst’ demographics and therefore the lowest potential growth rate of the main economies. The weaker exchange rate has helped and the Bank of Japan’s policy of yield curve control, keeping the yield on the 10-year JGB close to 0% has also been successful. Corporate profits have been strong and investment spending has strengthened. Inflation has risen a little, but has still fallen short of the Bank of Japan’s target. However, problems of acute deflation have disappeared. We expect the Japanese economy to continue recent trends. So we are looking for another year of decent growth, somewhat higher inflation and a continuation of the Bank of Japan’s policy.

Emerging economies

Emerging economies have benefitted from strength in the main economies and from higher commodity prices. Growth is strong in emerging Europe as these countries feel the effects of a much better performance of the eurozone economy, as well as the improvements in Russia. Higher oil prices are positive for Russia and the economy has pulled out of recession. Countries like Poland, Hungary and the Czech Republic are registering solid growth in 2017. These trends are expected to continue in 2018. Inflation has risen in the region, except in Russia, not only because of oil prices. Rising inflation will be a challenge for the monetary authorities in 2018.

Inflation has remained much more subdued in Asia, although most countries have also seen growth strengthen in the course of 2017. Most economies have benefitted from stronger world trade growth, although growth momentum in India has weakened somewhat in the course of 2017. Korea and particularly Taiwan have also benefitted from the strong growth in the tech sector globally. But countries like Malaysia and Thailand have also done well in 2017. Assuming that world trade growth keeps up and China does not slow dramatically, the region is expected to do well in 2018 also.

Economies in Latin America have had to cope with a variety of challenges. Political rumblings have affected Brazil and Argentina, not to mention Venezuela. Despite this, Brazil and Argentina are in the process of recovering from recession, but growth remains modest. Uncertainty continues to hang over Brazil with general elections scheduled for October 2018. The Mexican economy has had to cope with the shock of the Trump victory in the presidential elections and elections in the country itself are scheduled for 2018, also creating some uncertainty. Here, too, growth is only mediocre despite strong international conditions. Chile’s economy has experienced a decent acceleration of growth this year, largely owing to the rise of copper prices. 2018 is expected to bring a clearly higher average growth rate for the region as a whole than 2017, as Brazil and Argentina will continue their recovery. But average growth numbers will still be unimpressive.

Oil

Oil prices have gradually risen from their early 2016 low. The key driving force has been the rebalancing of demand and supply. Of course, the agreement of OPEC countries and some others to limit production has also played a role here. But growth of demand and the limited increase of US shale production have also been important. We expect oil prices to continue to rise in 2018. Assuming that the OPEC agreement will be continued and assuming US shale producers will not be able to raise production strongly, prices will move higher as demand continues to grow.

 

Additional document – Global Economic Forecasts as of 28 November 2017